KEY POINTS:
As the IRD celebrates its latest victory in the long-running Trinity tax avoidance litigation, the Court of Appeal's unanimous judgment contains plenty of warnings for tax advisers and taxpayers to consider.
In New Zealand's biggest tax avoidance case, the court found the deductions claimed by Trinity investors (which amounted to some $3 billion in tax) were disallowed. It also imposed the maximum 100 per cent penalty on each taxpayer.
The Trinity scheme, the "brain child" of Auckland lawyer Garry Muir, revolved around the right of investors to claim immediate tax deductions for expenses they would not actually pay until 2048, effectively granting them a 50-year tax holiday.
In ruling the scheme was tax avoidance, the Court of Appeal has given a timely reminder that tax schemes, no matter how clever and well crafted, must always pass the test of commercial common sense.
Tax avoidance exists when an arrangement technically complies with the tax law but nevertheless is contrary to Parliament's intention. In such cases, the IRD has the power to intervene and deny the tax benefits claimed by the taxpayers under the scheme.
The line between legitimate tax planning and outright avoidance is often difficult to draw - and stepping up to, but not over, that line keeps many tax lawyers and accountants in profitable business. The courts have acknowledged that identifying what constitutes tax avoidance is not always easy but some indicators can be found in the Trinity case.
First, simply complying with the "black letter law" will not prevent an arrangement from being tax avoidance. The Trinity scheme was "technically correct" but was nevertheless found to be "highly artificial and indeed contrived".
Second, a transaction cannot simply be entered into to obtain a tax benefit but must be commercially reasonable and driven by business, not tax, factors. Again, in the Trinity case the court found the scheme "makes no commercial sense at all".
Finally, transactions that have no actual economic effect (normally because they are circular or self-cancelling, generally because they involve only associated taxpayers) will generally be voided for tax purposes.
On the evidence, the court found that Trinity "is an entirely artificial tax-driven scheme".
The Court of Appeal found that "we are satisfied that this scheme is well and truly across the line" into being in breach of the Income Tax Act.
Given all the adverse factual findings against the scheme, the outcome was largely beyond doubt. As a result, many in the tax community have chosen to ignore the wider implications of the decision, preferring to put it down to failings by the promoters of the scheme.
The court was extremely critical of Muir and his partner Clive Bradbury.
Documents about the tax haven structure put in place to implement the scheme were obtained from the British Virgin Islands by the New Zealand Serious Fraud Office.
These recorded "murky" transactions under which millions of dollars were returned for the benefit of Muir's and Bradbury's family trusts.
The discovery of these documents, and Muir's inability to explain them adequately, led Justice Venning in the High Court to describe him as "less than candid" and "disingenuous", while his evidence was "less than satisfactory" and "simply not credible".
That is stinging criticism by a judge of a practising lawyer, and Muir's lack of candour undermined the scheme.
So too did a document apparently co-written by Muir that stated "the real benefits of the deal are tax concessions that can be obtained now by investors and the Trinity Foundation [in New Zealand]. The actual outcome of the deal in fifty years time is not considered material".
With that kind of evidence it was difficult to see how the taxpayers could ever have won - indeed once that information became known many Trinity investors rushed to settle with the IRD ( thereby preserving their anonymity). Accordingly, suggestions of a further appeal should be taken with a grain of salt.
Nevertheless, the Trinity decision should not simply be dismissed as an example of tax planning gone bad.
The fact the Appeal Court decision was both unanimous and strongly worded shows New Zealand courts may be willing to take a tougher stand against aggressive tax planning.
On the wider issue of avoidance, the Court of Appeal laid down a test that could be applied in all cases.
"It seems reasonable to assume that [tax] rules are premised on a legislative assumption that they will only be invoked by those who engage in business activities for the purpose of making a profit. Schemes which come within the letter of the specific tax rules by means of contrivance or pretence are candidates for avoidance."
This requirement should be the yardstick. It may no longer be enough to demonstrate a transaction cleverly complies with the applicable tax law.
After all, the Court of Appeal found "the Trinity scheme is clever. But this cleverness should not be allowed to obscure the reality that this particular emperor has no clothes".
The court clearly intended to put tax advisers and taxpayers on notice their tax plans must survive the same kind of scrutiny to ensure they too are not exposed as naked tax dodges.
* Mark Keating is a lecturer in commercial law at the University of Auckland.
