"Income splitting" case held by the High Court not to be tax avoidance

Summary

The High Court held that the amalgamation of the disputant’s medical practice and her husband’s business into a single corporate entity did not give rise to an impugned tax avoidance arrangement.

Impact of decision

The decision of the High Court in Philippa White v CIR is relevant to the course of litigation in the Penny v CIR ([2010] NZCA 231) appeal which is currently before the Supreme Court. In the recent White decision, his Honour Justice Heath has found that the disputant's diversion of personal services income through a corporate structure did not amount to tax avoidance.

The same issue (albeit on different facts) is before the Supreme Court in the Penny appeal. The Commissioner remains of the view, notwithstanding the recent White decision, that such arrangements may amount to tax avoidance.

The Commissioner has decided that the White case will be appealed. The Commissioner also awaits the final determination of the Courts in the Penny matter. In the meantime, he refers any person inquiring as to his view of such matters to his Revenue Alert 10/01.

Facts

1. The Appellant is an anaesthetist in public and private practice. Her husband provided quality assurance services as an employee and privately. On 1 November 2002 the couple restructured their business affairs. One reason for the restructuring was to protect their family after concerns were expressed about exposure to claims which could be made by clients against private professional services being provided.
2. The restructuring involved an arrangement whereby a family trust owned assets including horticultural land, an avocado orchard and business assets relating to the private services provided by the Appellant and her husband. A company Wharfedale Limited ("Wharfedale") was established and the disputant and her husband each held a 35% share in the company. Wharfedale leased the avocado orchard business from the Trust.
3. On 1 November 2002 the Appellant ceased being self-employed in her private anaesthetist practice and took up employment in the newly incorporated Wharfedale, which had taken over the running of her private practice. Her services were then provided to the clients of Wharfedale, those services being exactly the same as she had been providing when in private practice. However, instead of receiving a substantial income commensurate with her skills and exertions, she received no salary from Wharfedale for 5 months work in 2003 and only $4,875 in the year ended 31 March 2004 for 12 months work.
4. The reason given for the lack of salary was that Wharfedale was not making sufficient income to enable her to be remunerated at the same rate as she had been when in private practice. The avocado orchard business which was owned by Wharfedale was operating at a loss. One of the larger overheads for the avocado orchard business was the rental paid for the orchard, which was owned by the family trust. The Appellant claimed that the orchard returns were less than expected due to poor cropping results and lower than expected prices.
5. As part of his defence in the Taxation Review Authority (TRA) the Commissioner drew the attention of the TRA to the fact that Wharfedale appeared to be paying above normal market rates to lease the orchard. The Appellant claimed that rent was not an issue raised by the Commissioner in his Statement of Position and he was therefore excluded from presenting evidence regarding a market rent.
6. In the TRA Barber DCJ found that the structures implemented by the Appellant left her "unremunerated in a manner which was artificial and contrived and has no sensible reality" TRA 04/08.

Decision

7. In his decision Heath J initially looked at the concerns of Barber DCJ which appeared to be the effective assignment of the Appellant’s income from personal exertion to Wharfedale; that it was not "credible nor commercially acceptable" that an experienced anaesthetist would work for a company for virtually nothing, and that the reduction in income tax was not a "merely incidental purpose" of the arrangement.
8. Heath J quoted Ben Nevis Forestry Ventures Limited v CIR [2009] 2NZLR (SC), at [106]:
   • Put at the highest level of generality, a specific provision is designed to give the taxpayer a tax advantage if its use falls within its ordinary meaning. That will be a permissible tax advantage. The general provision is designed to avoid the fiscal effect of tax avoidance arrangements having a more than merely incidental purpose or effect of tax avoidance. Its function is to prevent uses of the specific provisions which fall outside their intended scope in the overall scheme of the [Income Tax Act 2007]. Such uses give rise to an impermissible tax advantage which the Commissioner may counteract. The general anti-avoidance provision and its associated reconstruction power provide explicit authority for the Commissioner and New Zealand courts to avoid what has been done to reconstruct tax avoidance arrangements. [Emphasis added]
9. His Honour noted that by using the rubrics "permissible" and "impermissible" the majority in the Supreme Court were discarding the distinction drawn between "tax avoidance" and "tax mitigation" in Challenge Corporation Limited v CIR [1986] 2 NZLR 513 (PC). He then stated that in his view "the terminology signals a need to scrutinise a particular transaction to ascertain whether its purpose fell inside or outside of the intended scope of a specific provision that confers a tax advantage".
10. He also noted that in Ben Nevis the court indicated that factors which would help determine tax avoidance included:
    • the manner in which an arrangement is carried out
    • the role of the relevant parties and their relationship with the taxpayer
    • the economic and commercial effect of documents and transactions, measured against the actual consequences of implementation of the arrangement
    • whether the taxpayer gains the benefit of a specific provision "in an artificial or contrived way".

The use made of the specific provisions in the Income Tax Act 2007 ("the Act") also needed to be considered "in the light of the commercial reality and economic effect" of their use and were not limited to "purely legal considerations".

11. Heath J referred to Glenharrow Holdings Limited v CIR [2009] 2 NZLR 359 (SC) and acknowledged that the "purpose or effect" of an arrangement was not equated to motive but rather the end result. He acknowledged that the test was objective and indicated that the Court's inability to focus on the intention of the parties was "counter-intuitive".
12. However, he then referred to the findings of Woodhouse P in Challenge Corporation v CIR [1986] 2 NZLR 513 (CA) and Harrison J in Westpac Banking Corporation v CIR (2009) 24 NZTC (HC) and concluded:
    • ... evidence of a subjective nature from the taxpayer and others may assist the Court in determining issues of avoidance. However, its use must be restricted to providing the context in which the arrangement was brought into being, in order to assist the Court to understand any genuine commercial arrangements involved.
13. The recent Court of Appeal decision in CIR v Penny [2010] NZCA 231 was considered. His Honour distinguished the Appellant’s case by noting that the companies operated by Mr Penny and Mr Hooper "did have sufficient money to pay salaries". He did however refer to the Penny decision and quoted Randerson J at [126]:
    • It will be a matter of assessing all the circumstances including the extent and nature of any artificiality or contrivance in order to determine whether any particular arrangement is within or outside contemplation of Parliament in enacting the tax legislation. Where there are legitimate reasons such as those discussed at [98] above for adopting a salary markedly below commercial levels, a challenge by the Commissioner may be unlikely to succeed. Nor would I expect the Commissioner to interfere in marginal circumstances. The difference here is that salaries were adopted at levels far below ordinary commercial expectations that, in the absence of legitimate reasons for doing so, there is a strong implication of tax avoidance. [Emphasis added]
14. Heath J concluded that the TRA erred in holding there was a tax avoidance arrangement. He began with the premise that a "rounded" assessment of what occurred was required, in order to determine whether the tax advantages gained were "permissible" or "impermissible". He accepted that the Appellant’s subjective intentions were not determinative in ascertaining the purpose or effect of the arrangement. But he considered it necessary to look at the nature of the arrangement and how it was carried into effect to determine whether the purpose or effect was to obtain an "impermissible tax advantage".
15. After revisiting the facts and the TRA decision, Heath J concluded that Judge Barber's real concern was with "an injection of personal/exertion professional income into a family company experiencing losses from business activities so that it did not remunerate as an employee in a fair and commercial manner". Justice Heath's response was "... at the time the arrangements were entered into, it was not expected that financial losses would be caused from business activities ... Further the reason that no money was available for Wharfedale to pay a salary to Dr White was because income had to be diverted to pay real (not contrived) debts". He also found that in arranging her affairs the Appellant "did nothing more than obtain the advantage that Parliament intended would flow to someone in her position".
16. His honour further stated that "the elements of the tax avoidance arrangement on which Judge Barber relied, reveal nothing out of the ordinary". He agreed with Ellen France J who dissented in Penny, noting that the arrangement was an "acceptable business practice and the opposite of artifice or contrivance". He also noted that decision by the Court of Appeal in Grieve v CIR [1984] 1 NZLR 101 (CA) at paragraph 110 which states:
    • It is not for the Courts or the Commissioner to confine the recognition of businesses to those that are always profitable or to do so only as long as they operate at a profit.
17. While he acknowledged that Grieve related to a test to determine the ambit of the word "business", Heath J also noted that it also helped provide a more general insight into the scheme and purpose of the Act.
18. Heath J found that there was not a purpose of "obtaining an impermissible tax advantage" but that even if that conclusion was wrong the purpose or effect of the arrangement was "merely incidental".
19. Heath J saw no need to decide on the issue of orchard rent, nor was there any need to address the issue of reconstruction.