The end of last year saw the release of a number of potentially significant decisions of the courts in tax matters. Among them are the Court of Appeal's latest decision on tax avoidance and two decisions (not involving the anti-avoidance provisions) which may suggest a subtle shift towards a more substance-based approach to the characterisation of transactions, even outside the tax avoidance context.
Court of Appeal decision addresses tax avoidance and tax residence test for companies (Vinelight Nominees Limited v CIR)
Vinelight Nominees Limited v CIR is the Court of Appeal's latest decision on the general anti-avoidance rule ("GAAR"). The Court upheld Inland Revenue's amended assessments under the GAAR as well as the imposition of the abusive tax position penalty. In addition, the Court's decision addresses the tax residence definition for companies, and important procedural questions concerning the time limitation on Inland Revenue's ability to re-assess taxpayers, and the taxpayer's ability to raise arguments in the course of Court proceedings when a statement of position has been issued at an earlier stage of the dispute.
The case arose as a result of a restructure of a family's investments. The family carried on business in New Zealand through Vinelight Investments Limited ("VIL") which through several subsidiaries invested in real property and shares, and engaged in various forms of money-lending. VIL and the family elders, Rodney and Sandra, were at all material times New Zealand tax residents.
The family also owned Weyand Investments Limited ("Weyand"), an investment company which was the repository of much of their wealth. It financed VIL’s business activities through interest-free loans which by 1996 amounted to more than $3 million. Weyand was incorporated in Hong Kong, where the family had strong ties.
The family’s affairs were reorganised in 1998, on the advice of Ernst & Young ("EY"). The main consequences of the restructure, as summarised in the judgment, were:
- The Vinelight Trust, and its corporate trustee, Vinelight Nominees Limited ("Vinelight") were created. Weyand was a beneficiary of the trust.
- VIL agreed to pay management fees to Vinelight. These were set at $12,500 per month, a sum chosen on advice to offset VIL’s taxable income.
- Vinelight assumed liability for a debt then owed by VIL to Weyand, and for the first time interest became payable. The rate was 16.5% per annum, a rate which (the Court found) was chosen to ensure that the interest would offset the taxable income (being the management fees) that Vinelight received from VIL.
- Rodney and Sandra transferred their shares in Weyand to their three children, who joined them as directors of that company.
- Vinelight registered for the purposes of the approved issuer levy ("AIL") regime and registered its loan from Weyand as a registered security under that regime. The regime allows qualifying borrowers to pay the levy, at 2 percent on interest payments, in lieu of non-resident withholding tax ("NRWT") which would otherwise be imposed at up to 15 percent.
The Court referred to an EY internal memorandum of 8 October 1998 describing the object of the arrangement as being “...to mitigate the NZ tax group’s tax by shifting all profit up to the [Vinelight Trust] and paying it out by way of interest subject to AIL”.
The tax residence question
The arrangement would achieve the stated objective only if Weyand (the recipient of the interest income) was not tax resident in New Zealand. Inland Revenue argued (and the Court accepted) that until March 2003 Weyand was in fact tax resident in New Zealand because it had its centre of management in New Zealand. The Court noted that the centre of management limb of the test for tax residence should not be conflated with the alternative test based on directorial control, and emphasised that the centre of management test is a question of "fact and substance".
In finding that Weyand's centre of management was in New Zealand during the relevant period, the Court relied on the fact that Rodney and Sandra (who lived in New Zealand) between them consulted EY about the structure and its implementation, demanded interest on the debt from Weyand (addressing the demand to their residential address in Auckland), decided that the interest rate ought to be reduced, and attended to the preparation of financial statements, in New Zealand. On this basis, at least for a company whose activities are largely passive (eg, the receipt of interest income), it would seem that the performance of administrative tasks in New Zealand may in some cases suffice for the company to have its centre of management in New Zealand.
The tax avoidance question
Inland Revenue accepted that from March 2003, Weyand was not tax resident in New Zealand. But in those later years, Inland Revenue argued that the interest paid to Weyand should not qualify for the concessionary AIL regime because the GAAR applied. The Court upheld Inland Revenue's argument on this point.
The Court accepted that the arrangement's "purpose" was set out in documents prepared by EY explaining the tax consequences of the restructure and referring to the "potential annual tax saving". The Court's reliance on EY's advice (while unsurprising given earlier GAAR decisions in which the Court has referred extensively to statements made by the tax advisors) is controversial. When determining whether an arrangement has a more than incidental purpose or effect of tax avoidance, the purpose or effect should be ascertained objectively from what the arrangement achieves. Statements made by an advisor referring to tax benefits should represent no more than that advisor's opinion. Moreover, the fact an arrangement results in tax savings should not be equated with that arrangement having tax avoidance as a purpose or effect.
Possibly the Court of Appeal's reliance on the statements in the tax advice need to be understood in the light of the factual findings, to the effect that the interest rate on the loan was set at a level that would effectively offset the borrower's income, and also references in the lower court judgments to the documentation being "template" in nature and intended to reflect the tax advice rather than being driven by commercial considerations. These factors might explain why the Court found that for the interest paid to qualify for AIL would amount to tax avoidance.
In keeping with a number of recent court decisions, the Court had little difficulty in concluding that the penalty for taking an abusive tax position applied. The ease with which a penalty of up to 100% of the tax in dispute can be imposed is a troubling aspect of this and other recent decisions involving the GAAR.
In this case, it could be argued that the Court's findings on both the tax residence issue and the tax avoidance issue arose from aspects the arrangement's implementation (the fact Weyand was not administered from Hong Kong, and the Court's findings that the interest rates were not commercially driven) and not from anything particularly complex or aggressive about the arrangement itself. It appears, however, that the Court saw those aspects of the arrangement's implementation as reflecting the tax avoidance purpose of the arrangement. This was reinforced, in the Court's view, by passages in the EY documentation describing the tax savings from the restructure they proposed.
Vinelight had argued that Inland Revenue was prevented by the statutory time bar from re-assessing certain of the relevant income years for RWT. Vinelight argued that because it had filed AIL returns for the relevant period, it had satisfied the requirement in the time bar provisions that the taxpayer have filed the relevant tax return. The Court rejected this argument on the basis that to have met the requirement, Vinelight would have needed to file an RWT return, which was the return for the particular tax.
Finally, the Court concluded that the taxpayer was prevented from raising certain arguments in Court as a result of not having disclosed those arguments in its statement of position. While the disclosure requirements have since been amended to make the required disclosure less onerous, the decision is an important reminder that steps taken during the pre-litigation disputes process can prove damaging for the taxpayer when a case subsequently reaches Court.
Supreme Court decision on definition of manufacture in Customs and Excise Act (Terminals (NZ) Limited v Comptroller Of Customs)
Terminals (NZ) Limited ("Terminals") operated a storage and dispatch facility where, upon request from Gull, it would fill tankers with fuel products for distribution to retail fuel outlets across the North Island. Since 2003, as part of its operations, Terminals had blended butane with motor spirit (petrol), which had the effect of increasing the total volume of the motor spirit. For example, if five litres of butane was added to 100 litres of motor spirit, the result would be 105 litres of motor spirit.
Under the Customs and Excise Act 1996 ("Act"), excise or excise-equivalent duty was imposed on the manufacture or importation of both butane and motor spirits, but at different rates (10 cents per litre for butane compared with 48 cents per litre for motor spirit). Accordingly, less duty would be payable if it applied separately to the constituent parts of the fuel (motor spirit and butane) before blending, than if the higher (motor spirit) rate was applied to the full volume of the fuel after blending. Whether (as Customs argued) the 48 cents per litre rate should apply to the blend (the 105 litres in the example) turned on whether the blending of the motor spirit and butane constituted the "manufacture" of motor spirit. If it did, then the output from that blending process (105 litres of motor spirit in the example) would be subject to the 48 cents per litre rate for motor spirit.
In the High Court, Mallon J had held that the blending was not "manufacturing" for the purposes of the Act. The Court of Appeal disagreed, holding that Terminals operation was "manufacturing", and so excise duty was payable by Terminals on the blended fuel (including the butane) at the motor spirit rate. The Supreme Court has now upheld the Court of Appeal decision.
The decision of the Supreme Court, given by Glazebrook J, is of interest both for its implications for the definition of "manufacture" in the excise duty context, and also more broadly for the approach taken by the Court to the interpretation of tax statutes.
The Supreme Court's decision
As excise duty becomes payable at the point of either manufacture or importation, the case turned on whether the mixing process adopted by Terminals constituted "manufacturing" for the purposes of the Act. The term "manufacture" was relevantly defined in the Act as follows:
- if the goods are a fuel, any operation, or process, involved in the production of the goods:
- if the goods are neither tobacco nor a fuel,—
- any operation, or process, involved in the production of the goods; and
- any ancillary process (as defined in subsection (3)) that takes place on premises that are not licensed, or required to be licensed, under the Sale of Liquor Act 1989
Terminals conceded that the blending constituted "any operation, or process" but argued that that operation or process was not involved in the "production" of any goods. In particular, Terminals argued that:
- a long line of English, New Zealand and Australian revenue cases had held that the expressions "manufacture" and "production" require there to be a process where the resulting goods are intrinsically different from the component parts or ingredients utilised;
- the statutory context and legislative history support an interpretation of "production" that does not include mere blending. In particular, in 2002 the definition of manufacture for goods other than tobacco and fuel (ie, alcohol) was amended to expressly include, in addition to operations or processes involved in production, any "ancillary process", which is defined to include blending. The definition of "manufacture" for fuel, however, does not expressly include such "ancillary" processes.
The Supreme Court did not accept these arguments. First, it considered there was "much to be said" for the proposition that the addition of butane produced a different motor spirit, given the evidence was that the blended product would have a higher vaporisation rate and different vapour pressure. But the Supreme Court held that, even if a different good had not been produced, it was clear that the blending process had resulted in there being a greater volume of motor spirit, which did not exist before-hand. That motor spirit must have been "produced". Furthermore, the Court observed that excise duty on the importation or manufacture of motor spirit is intended to be a proxy for motor spirit consumed, this point being reinforced, in the Court's view, by the application of excise collected towards the cost of roading and related costs. These were "powerful indications that it was not intended that any volume of motor spirit released for home consumption would be subject to duty at a lower rate than the motor spirit rate".
Turning to the case law, legislative context and history relied on by Terminals, the Court emphasised that the definition of "manufacture" for fuel had to be interpreted purposively. The Court considered the case law referred to by Terminals was not relevant, as it was decided in a different legislative and factual context; and that the fact that the definition of "manufacture" for alcohol had been amended to expressly include "ancillary processes" (including blending) did not necessarily mean that the "manufacture" of fuel could not include blending. Because motor spirit comprises a mix of hydrocarbons, and so (unlike alcohol) is an inherently blended product, the Court suggested that the amendment in respect of alcohol might equally be explained on the basis that Parliament considered "blending" was already included in the definition of "manufacture" for fuel, such that no amendment to the definition for fuel was necessary.
The decision is important for its implications for the definition of "manufacture" in the excise context. But it is important in a more general sense too, in signalling the extent to which the courts will be prepared to distinguish existing decided cases, and place less weight on indications from the text of an enactment, if those other factors do not support the purpose of the particular provision or the legislation more generally.
As regards the definition of "manufacture", it will be necessary to consider what implications the broad definition adopted by the Court might have for other operations or processes that might (intentionally or unintentionally) result in the combining of products subject to excise duty. The Court does refer (in a footnote) to a comment by the Court of Appeal that "it may be that minor additives that do not increase the volume by other than a de minimis quantity would not amount to manufacturing". So it may be that in some cases a de minimis exception can be applied.
The Court also provided some more general guidance as to the correct approach to be taken to the interpretation of taxing statutes. Referring to the Supreme Court's earlier decision in Ben Nevis, the Court summarised that approach as follows (footnotes omitted):
The first inquiry is to assess whether the legal substance of the relevant arrangement comes within the specific provisions of the statute construed purposively. It is only after the arrangement in question has been held to come within the specific provisions construed purposively, that the question of whether that arrangement contravenes the general anti-avoidance provision is considered.
The only relevance of there being no general anti-avoidance provision in the Customs and Excise Act therefore is that the analysis stops at the first stage of Ben Nevis with a purposive interpretation of the specific provision in question; in this case with a purposive interpretation of the definition of manufacture.
In one of the footnotes to that passage, the Court (again referring to Ben Nevis) stated that the "minority [in Ben Nevis] took a slightly different approach but, if anything, their approach would lead to a greater, rather than lesser, role for the specific provisions than is accorded in the majority judgment". The reference to the minority's approach in Ben Nevis being only "slightly different" is interesting. It has generally been accepted that the approaches taken by the minority and majority in Ben Nevis were conceptually distinct: under the majority approach, except when a different approach is required by the general anti-avoidance rule or other provision, arrangements must be characterised according to the legal arrangements actually entered into; by contrast the minority approach would have permitted (as part of a "purposive" approach to interpretation) regard to be had to the business substance (and not just the legal substance) of the arrangement in some circumstances. For example, the minority in Ben Nevis stated:
It would be wrong to start with any preconception that “ordinary meaning” or “legal meaning” is to be preferred to the meaning a term has in business or accounting. Similarly, where the substance of an arrangement needs to be gauged in application of the provision of a tax statute, a purposive construction of the provision may indicate that it is legal substance which is in issue or it may indicate that the statute is concerned with business substance.
The comments made by the Court could have the effect of shifting the balance, at least to some extent, towards a more purposive, substance-based approach to interpreting specific provisions. Already, in another recently released decision (Sovereign Assurance - see below) the Court of Appeal has referred to the Terminals decision in support of adopting what is arguably a more substance-based approach to the characterisation of an arrangement.
Court of Appeal rules on reinsurance arrangements (Sovereign Assurance Limited v CIR)
The Court of Appeal's decision in the Sovereign Assurance case has potentially significant implications not only for reinsurance arrangements but also for the characterisation of arrangements for tax purposes generally. The case concerned the tax treatment of treaty reinsurance contracts between Sovereign Assurance (a New Zealand resident life insurer) and three reinsurers. Simplifying matters considerably, there were two components to each of the treaties:
- Under the first, Sovereign paid premiums in return for the reinsurers agreeing to reinsure defined proportions of mortality risk that Sovereign had assumed under defined tranches of policies it had issued. (There was no dispute over Sovereign's tax treatment of this aspect.)
- Under the second, the reinsurers paid Sovereign commissions, quantified by reference to initial premiums received by Sovereign in respect of life insurance policies it issued. Sovereign was obliged to make payments, which were termed "commission repayments", calculated as a percentage of premiums received from policies to which the arrangement related.
In addition, there was a Bonus Account. Payments made to Sovereign under a treaty were debited to the Bonus Account, and payments made by Sovereign were credited to it. The purpose of the Bonus Account was to enable the calculation of any profit share to which Sovereign would become entitled once the Bonus Account reached a credit balance (ie after full payment of the commission repayments to the reinsurers). Sovereign would be entitled to a percentage of any credit balance.
The issues in dispute
Sovereign had treated the commissions as income in the years receivable and the commission repayments as deductible expenditure in the years they were payable to the reinsurer. But Inland Revenue contended that the commission received by Sovereign and the commission repayments made by it under each treaty should be treated like a loan under New Zealand's financial arrangements rules. This meant that Sovereign would recognise net expenditure over the life of each treaty rather than recognising gross receipts and payments as income earned and expenditure incurred. This timing difference mattered, because a change of ownership had prevented Sovereign from carrying forward any net losses from a certain date.
At first instance, a significant issue was whether the second component (the commission receipts and repayments) could be unbundled from the treaty of which it formed part and taxed as a financial arrangement, notwithstanding Inland Revenue's acceptance that the first component of each treaty was a contract of insurance, and therefore fell outside the financial arrangements rules. This unbundling issue was decided in Inland Revenue's favour at first instance, and Sovereign conceded the point on appeal.
In the Court of Appeal, therefore, the case turned on whether Sovereign's receipt of commissions and making of commission repayments should nonetheless be taxed according to ordinary concepts (ie, receipts are assessable on receipt, and commission repayments deductible on payment) leaving only the interest component subject to the timing rules in the financial arrangements rules.
The Court rejected Sovereign's argument to this effect, and held that once it was accepted that the financial arrangements rules applied to the commission repayments component, it followed that the gross receipts and refunds should not be recognised separately as income and expenditure. Rather the net amount should be recognised.
But two of the three Judges then proceeded to consider how the amounts would be taxed under ordinary concepts, if (contrary to the Court's decision) ordinary concepts characterisation were relevant despite the financial arrangements rules applying. The two Judges referred to the importance of the "legal substance" and concluded that the "essential legal character of the commission transactions" was that of a loan. The fact that Sovereign's obligation was to fund the commission repayments out of premiums received simply meant that the loan was a limited recourse one.
Long-standing decisions of the New Zealand courts (including Re Securitibank Limited (No 2) 2 NZLR 136 and Marac Life Assurance Limited v CIR  1 NZLR 694) confirm that, except when a different approach is required by the general anti-avoidance rule or other provision, transactions must be characterised for tax purposes according to the legal arrangements actually entered into, not by reference to some economically or functionally equivalent arrangement. Marac Life Assurance seems particularly relevant in this regard. In that case, the Court of Appeal had rejected the contention that part of the payout under a contract of life insurance should be characterised as interest from money lent, in circumstances where the contract was marketed as a bond and was functionally similar to a term deposit. While the Court did not signal any departure from those authorities, the approach taken suggests a somewhat more substance-based approach to the characterisation of transactions than has previously been evident.
Subject to the outcome of any appeal to the Supreme Court, the case is significant on at least two levels. First, it provides support for comparable reinsurance arrangements to be taxed as loans in future. Ironically, this may in some circumstances provide a more favourable tax outcome for the parties (due to part of the reinsurer's profit being taxed more favourably as interest than as income from insurance). Second (and particularly in light of the comments made by the Supreme Court in Terminals (NZ) concerning the approach to construing tax legislation, as summarised above) the decision may signal a willingness on the part of the New Zealand courts to adopt a somewhat more substance-orientated approach to the characterisation of transactions for tax purposes (in cases where the GAAR is not in issue) than has previously been the case.