The Taxation Review Authority (TRA) has held that there was a tax avoidance arrangement involving a trust. The interest deductions claimed by each taxpayer were void against the Commissioner under s BG 1 of the Income Tax Act 2004.

The background

This case related to two challenges which the parties had agreed should be heard together. In order to maintain confidentiality, the taxpayer in TRA 002/18 was called DLC Limited (DLC) as the trustee of the DLC Family Trust (DLCFT) and the taxpayer in TRA 003/18 was referred to as Mr Brown. Alternative names were also used for other entities.

The claims arose out of the successive sales in 1994, 1998, and 2010 of an interest in a joint venture, known as the NPN partnership, from one of Mr Brown’s family trusts to another of his trusts. The NPN partnership owned the rights to receive the income (the income rights) earned on the rental of residential flats at 28, 32, 34-36 and 38 Mathew Street (the properties). Each sale created a debt in the subsequent trust to another entity. That debt provided an interest expense which offset the rental income received so that no income tax was paid in respect of that income. The Commissioner contended that the interest deductions claimed by each taxpayer were void under a tax avoidance arrangement.

The challenge by Mr Brown related to the 2001 and 2003 to 2008 income years. During these years, BTC1 Limited (BTC1) owned the income rights as trustee of the Brown Family Central Trust (BFCT) having purchased the rights in 1998. In respect of this dispute, income had been reconstructed onto Mr Brown where the Commissioner considered that Mr Brown and his family had benefited from the rental income.

The challenge by DLCFT related to the 2014 and 2015 income years. During these years, DLC owned the income rights as trustee of DLCFT following that trust’s purchase of the rights in 2010. No reconstruction of income had yet been undertaken in this dispute.

The Commissioner contended that during the time that the income rights were owned by BFCT, the net rental payments (being the rental received less actual expenses) were used by Mr Brown for his personal and family expenses. This was in the form of BFCT making advances to Mr and Mrs Brown through a running current account.

Both taxpayers submitted that there had been no tax avoidance. The various transactions by BFCT and DLCFT were all normal, standard, commercial transactions of family trusts as were the beneficiary distributions. Likewise, guarantees provided by Mr Brown were normal commercial practice. It was submitted that the trusts complied with the general anti-avoidance provision so that any tax advantages resulting to the trusts from the interest deductions were merely incidental as Parliament had intended. In addition, it was contended that there had been no artifice or contrivance in obtaining the interest deductions or in the things done by the trusts. On this basis, it was contended by Mr Brown that the reconstruction of income onto him could not stand.

The issues

In respect of Mr Brown’s proceedings, the legal issues for determination for the 2001 and 2003 to 2008 income years were as follows:

  1. Was there a tax avoidance arrangement involving the BFCT, to offset rental income by way of an interest expense?
  2. Was the Commissioner able to reconstruct income under the tax avoidance arrangement onto Mr Brown?
  3. Had Mr Brown met his onus of proving that the amount of income reconstructed by the Commissioner onto him was incorrect, and by how much was it incorrect?
  4. Was BFCT a non-complying trust?
  5. Did the operation of the time-bar prevent the Commissioner from reassessing Mr Brown?

The legal issue in respect of the DLCFT proceedings was whether the interest deductions proposed by DLC in the tax years ended 2014 and 2015 formed part of a tax avoidance arrangement, and were therefore void against the Commissioner under s BG 1 of the Income Tax Act 2007.

The Taxation Review Authority’s decision

The TRA dismissed the claims under TRA 002/18 and TRA 003/18 and confirmed the Commissioner’s assessments. The TRA found as follows:

Tax avoidance arrangements

  1. The arrangements made by the taxpayers in these challenges were void against the Commissioner under s BG 1.
  2. When the interest deductibility provisions were read in tandem with s BG 1, it was apparent that the provisions were used in tax driven arrangements that lacked commercial substance. The structure which had been used for both arrangements was artificial and contrived. The loans lacked commercial reality and no economic cost had been incurred by either BFCT or DLCFT. Importantly, there was no commercial or family purpose for these arrangements. Parliament would not have contemplated that interest deductions could be claimed in such circumstances.
  3. No economic cost was suffered by BCFT or DLCFT. Put another way, no real economic consequences were incurred of the type which could be said to be in the contemplation of Parliament when the deductibility rules were enacted.
  4. The underlying premise of the specific interest deductibility provisions is that they apply only where real economic consequences are incurred of the type contemplated by the legislature when the rules were enacted (Accent Management Ltd v C of IR (2007) 23 NZTC 21,323, [2007] NZCA 230 cited).
  5. The loans in this case were rolled from one trust to the next. BCFT and DLCFT and X Property Trust claimed the benefit of tax deductions but had not paid any interest under the loans. Additionally, based on the pattern adopted by Mr Brown, it was reasonable to infer that this would have continued.
  6. In 2010, the value of $3.6m was attributed to the income rights on the transfer to DLCFT which Mr Brown said was the market value of the rights. However, Mr Brown did not produce any valuation evidence. In the absence of any corroborative valuation, it may reasonably be inferred that the value of the income rights was fixed by reference to the loan amount.
  7. The successive transfers and accompanying loan transactions did not serve any commercial or family purpose particularly when regard was had to the fact that the properties and associated income rights were always owned by a Brown family trust. Rather, the structure used by BFCT and DLCFT was artificial and contrived. It was designed and implemented by Mr Brown using British Virgin Islands (BVI) companies and the Brown Trust bank account to enable interest deductions to be claimed and for the rental income to be expended and allocated by Mr Brown as he wished.
  8. The BFCT and DLCFT arrangements were designed not for any commercial or family reason but rather to allow Mr Brown to obtain tax benefits.
  9. In respect of both arrangements, the tax purpose was more than merely incidental to any other purpose. The tax benefit obtained from the transactions did not flow naturally from any ordinary or family purpose.

Reconstruction of income

  1. Mr Brown failed to satisfy the onus on him of proving that the assessments were incorrect and the extent to which they were incorrect. The totality of the evidence supported a finding that BFCT was used for the benefit of Mr Brown and his children and the Commissioner’s reconstruction of income onto Mr Brown was appropriate. In view of this finding, it was not necessary to consider the alternative reconstruction of income under ordinary concepts.

Non-qualifying trust

  1. For the purposes of reconstruction, BFCT was treated by the Commissioner as a non-qualifying trust. If BFCT was a non-qualifying trust, then the amount of trust funds utilised by Mr Brown that exceeded the income of BFCT for the relevant income year was able to be reconstructed as taxable distributions. Taxable distributions from non-qualifying trusts were taxed at the higher rate of 45%.
  2. The BFCT arrangement was a tax avoidance arrangement and the interest deductions claimed by BTC1 were void as against the Commissioner. In these circumstances, BTC1 did not comply with all its tax obligations and as a consequence, BFCT was a non-qualifying trust.

Application of time bar

  1. The purpose of the BFCT arrangement set up by Mr Brown was to reduce or avoid tax. Taking these factors into account, it was reasonable to infer that Mr Brown knew that his returns were misleading either on the basis that he had actual knowledge that the arrangement constituted tax avoidance or that he knew it was highly likely tax avoidance and was reckless as to whether his returns were correct or not.
  2. Mr Brown failed to meet the onus on him of proving that his returns were not wilfully misleading. Accordingly, the exception under s 108(2)(a) of the Tax Administration Act 1994 applied. The operation of s 108(1) did not therefore prohibit the Commissioner from reassessing Mr Brown’s 2001 and 2003 to 2008 tax returns.
  3. Alternatively, Mr Brown failed to make mention of any current account loan advances or their source in his tax returns so that the exception under s 108(2)(b) of the Tax Administration Act applied (Krukziener v C of IR (2010) 25 NZTC 24,563 cited).

Taxation Review Authority [2019] NZTRA 5, 27 September 2019.