Two recent (connected) cases at the Taxation Review Authority (TRA) demonstrate that unnecessarily complex transactions can raise a red flag for IRD.
Both cases related to a taxpayer referred to as Mr Brown, who acquired a 2/3 interest in a joint venture known as the NPN Partnership (NPN) back in 1981. NPN held several residential property investments, of which a 2/3 share was transferred into one of Mr Brown’s family trusts.
Over a period spanning 20 plus years, the income rights to the rental income derived by NPN were sold from one of Mr Brown’s family trusts to another on three separate occasions. Although each transaction was slightly different, broadly, on each occasion the trust acquiring the income rights funded the purchase by way of vendor loan, with the interest capitalised and not payable until the expiry of the loan.
Close to the end date of each loan, the trust would sell the income rights to a newly settled family trust for a price equivalent to the outstanding loan with accumulated interest. In effect, each of these sales from trust to trust created a new loan. On each occasion, the new loan gave rise to an interest expense which the trust claimed as tax deductible, offsetting the rental income derived from NPN such that no tax was paid.
The Commissioner contended that the arrangements constituted a tax avoidance arrangement pursuant to BG 1 of the Income Tax Act, and sought to deny the interest deductions whilst reconstructing the income derived by NPN onto Mr Brown. The Commissioner contended that during the time the income rights were held in trust, the rental income was used my Mr Brown for his personal and family expenses. The taxpayer contended that the transactions were all standard commercial transactions, and there was no artificiality in the trusts obtaining the interest deductions.
However, the TRA supported the Commissioner, ruling that the transactions were driven with a tax motive in mind, with no commercial reality, given that the loans resulted in no economic cost to the trusts. The structure was artificial and contrived.
In sentencing, the TRA allowed IRD to impose re-assessments dating back to 2001, as they considered Mr Brown’s tax returns to be wilfully misleading. As a further sting in the tail, it was deemed that the Trustees of the family trusts had failed to meet their tax obligations, hence the income was taxable at the ‘non-complying trust rate’ of 45%.
A good reminder that whilst all taxpayers are entitled to arrange their affairs in a tax efficient manner, tax should not be the main motive for a transaction with no commercial substance.