General Anti-avoidance Rule

The general anti-avoidance rule (“GAAR”) in the taxation system

The GAAR allows Tax Authorities to override the tax consequences that would otherwise apply in a given situation, if those tax consequences are the product of tax avoidance.

A General Anti-avoidance Rule can perform a useful role in the tax system, as a mechanism for combating tax-driven arrangements that are artificial and contrived to such an extent that they could not reasonably have been addressed when the relevant tax policy was being designed.

The GAAR does play a role in protecting the tax system against artificial schemes detached from ordinary business and commercial arrangements and which could never have been anticipated in the tax policy design. But in a well-designed and well-administered tax system, the GAAR’s role should be confined to those cases, and should not extend to well known or commonplace tax saving opportunities against which Parliament could have (but has not) legislated.

Tax Authorities have the power to increase the amount of tax a taxpayer would otherwise have to pay by relying on the GAAR. The GAAR applies if there is an arrangement which has a more than merely incidental purpose or effect of reducing the tax a person would otherwise pay.

Tax Disputes

In New Zealand, a statutory provision which empowers Inland Revenue and the courts to override the tax consequences specifically provided for in tax legislation is of course a powerful tool from the perspective of Inland Revenue when litigating against taxpayers. As Justice Tony Pagone observed (see below) “…tax is imposed through, or by application of, the anti avoidance provisions where tax is not otherwise imposed”. So if the taxpayer succeeds in establishing that tax is not imposed by the specific provisions, Inland Revenue has a second chance, as it were.

It is hardly surprising, therefore, that those representing New Zealand’s Inland Revenue in tax disputes should prefer to be unconstrained in framing their arguments in litigation, by Inland Revenue’s Interpretation Statements or other boundaries on the GAAR’s operation. But that approach is not in the interests of the tax system as a whole, because a GAAR with unrestricted operation will ultimately lead to tax policy being made in the courts and not by Parliament. In the long run, that is not in anyone’s interests. In fact, courts in other jurisdictions have explicitly rejected such a role for themselves. For example, the Canadian Supreme Court, in Canada Trustco Mortgage Co v Canada (2005), has warned:

“The courts cannot search for an overriding policy of the Act that is not based on a unified, textual, contextual and purposive interpretation of the specific provisions in issue. First, such a search is incompatible with the roles of reviewing judges. The Income Tax Act is a compendium of highly detailed and often complex provisions.

To send the courts on the search for some overarching policy and then to use such a policy to override the wording of the provisions of the Income Tax Act would inappropriately place the formulation of taxation policy in the hands of the judiciary, requiring judges to perform a task to which they are unaccustomed and for which they are not equipped. Did Parliament intend judges to formulate taxation policies that are not grounded in the provisions of the Act and to apply them to override the specific provisions of the Act? Notwithstanding the interpretative challenges that the GAAR presents, we cannot find a basis for concluding that such a marked departure from judicial and interpretative norms was Parliament’s intent.”

The difficulties posed by the General Anti-avoidance Rule

Until 2008, it was generally understood that commonplace arrangements which resulted in tax savings should not be subject to the GAAR. The basis for this understanding is best captured by the following passage in the Australian Tax Office statement summarising the principles of Australia’s GAAR: (Australian Tax Office Practice Statement: “Application of General Anti-Avoidance Rules”(PS LA 2005/24) available at https://law.ato.gov.au/atolaw/view.htm?Docid=PSR/PS200524/NAT/ATO/00001)):
“When a provision is inserted into the income tax law, policy-makers may be taken to contemplate the obvious exploitation or use of the provision. The ordinary dealing or obvious case should not result in uncontemplated consequences.

It is reasonable to assume that the tax opportunities of straight-forward dealing have been considered by those who design tax laws, and having been considered, if not then prevented, have in effect been implicitly sanctioned. Moreover, from a taxpayer’s perspective a provision will be seen to offer, for straightforward dealings, tax opportunities that are untainted with any notion of abuse. Doing the obvious is use, not abuse.”

Most tax specialists would agree that this statement no longer reflects, as mentioned below, Inland Revenue’s practice in New Zealand. Nor does it reflect the approach being taken by at least some High Court and appellate court Judges. That sea-change, as it has been described (in Craig Elliffe and Jess Cameron “The Test for Tax Avoidance in New Zealand: A Judicial Sea-Change”(2010) 16(4) New Zealand Business Law Quarterly 178), has introduced an additional and significant layer of uncertainty and complexity into the New Zealand tax system.

Jurisdictions with General Anti-avoidance Rules

Many countries do not have a GAAR at all.

Jurisdictions which have a GAAR include (and see below):

(a) Canada. When this country introduced its GAAR, the revenue authority issued an Information Circular (Information Circular 88-2), which contained over 20 examples and indicated whether the Canada Revenue Authority regarded those transactions as constituting tax avoidance or otherwise. A further supplement (Information Circular 88-2S1) provided additional examples.
(b) Australia. It has released a comprehensive Practice Statement on the application of the GAAR (PS LA 2005/24). The Practice Statement not only directs taxpayers to relevant public rulings, which give examples of when the GAAR will or will not apply, but also includes a list of warning signs in order to better inform taxpayers of when the GAAR is likely to apply and when it is not.
(c) South Africa. When South Africa redrafted its GAAR in 2006, a draft Comprehensive Guide to the GAAR was released for public comment prior to finalisation. The Draft Guide contains an explanation of the provisions of the GAAR, a consideration of its role in the light of other countries’ GAARs, as well as an overview of how the GAAR will be administered.

New Zealand

The New Zealand GAAR is being used (or its use is being threatened) to overturn the tax consequences of mainstream arrangements. In some cases, the GAAR is being applied in a way that really amounts to retrospective law-making, to address situations in which Inland Revenue encounters gaps in the tax laws which could have been addressed at the outset during the tax policy design stage, or by enacting remedial amendments to the tax laws to address an identified concern.

A consequence of this has been that the GAAR has assumed greater significance in the operation of the tax system. A recent study confirms anecdotal evidence that the GAAR has become a major source of disputes between taxpayers and Inland Revenue and (therefore) a significant source of uncertainty.

The study found that nearly 30 per cent of all reported judgments of the courts concerning questions of tax law over the past decade, have dealt with allegations of tax avoidance.(Mark Keating and Kirsty Keating “Tax Avoidance in New Zealand: The Camel’s Back that Refuses to Break!”(2011) 17(1) New Zealand Journal of Taxation Law and Policy 115 at 115-116). If New Zealand is serious about having a “world class tax system”4 the impact of significant uncertainty arising from the GAAR cannot be ignored.

Examples of Arrangements in New Zealand

The difficulty with the deceptively straightforward language of the GAAR in New Zealand is that numerous commonplace arrangements can and do have a more than incidental purpose or effect of reducing a person’s tax liability. Examples include:

(a) borrowing to invest in a residential property where (as is commonly the case) tax deductible expenses exceed the taxable rental income, and any gain on the sale of the property is a capital gain and therefore tax free;
(b) a small business owner who decides to incorporate a company to carry on the business instead of carrying on the business in his or her own name, with the consequence that the business’s profits, to the extent retained by the company, will be taxed at the lower rate than if derived by the business owner in his or her own name;
(c) a person with significant savings on deposit with a bank, who withdraws money from his or her call account and invests it in a managed fund established by the same bank. Money invested in the managed fund earns the same rate of interest as money invested in the call account, but because the managed fund is a portfolio investment entity (or “PIE”) for tax purposes, the tax rate on the person’s return may be lower than if the interest had remained on deposit in the call account;
(d) a person who purchases a high value item of jewellery for personal use, such as a bracelet or a watch. The person enters into an agreement to buy the item at a city retail store, but arranges to take delivery of the item on the airside of the customs and immigration barrier prior to departing for (say) Sydney.

On this basis, the item is treated in the same way as an export for GST purposes, and no GST is payable. On return two days later, the purchaser need not declare the goods as they are classified as jewellery for personal use. The item is therefore not subject to GST, even though it was purchased for consumption in New Zealand. (This so-called loophole was recently publicised in the news media. See Abby Gillies “Rings wing way past GST”The New Zealand Herald (New Zealand, 9 July 2011).

All of the above examples may have an effect of reducing the tax the person would otherwise pay. And in many instances, it would be hard to argue that the tax saving is “merely incidental”:

(a) In the third example the only rational reason for investing through a PIE instead of the more conventional bank deposit is to achieve the tax savings.
(b) In the rental property example, the tax savings will frequently be the means by which an otherwise loss-making investment can be made profitably.

GAAR difficulty

The courts in New Zealand have observed on numerous occasions that the GAAR cannot be read literally. Justice McCarthy, then President of the Court of Appeal, observed, in CIR v Gerard (1974), that:
“The [GAAR] is notoriously difficult. It cannot be given a literal interpretation, for that would, the Commissioner has always agreed, result in the avoidance of transactions which were obviously not aimed at by the section. So the Courts have had to place glosses on the statutory language in order that the bounds might be held reasonably fairly between the Inland Revenue authorities and taxpayers.”

Similarly, the High Court has observed, in BNZ Investments Ltd v CIR (2000), that:
“It is a recognised reality that most business or family transactions have tax minimisation (to use a neutral term) as one of their purposes or effects, and with a degree of significance such that it realistically cannot be termed “incidental”. Read literally [the GAAR] avoids for tax purposes the majority of business and family transactions. Whatever else may be said, it is widely accepted that extreme outcome cannot have been intended by Parliament. The difficulty has been to ascertain the intended boundaries. The purist says this is an exercise in statutory interpretation. The realist might say the Courts have been left to resolve the question on a policy basis.”

A related difficulty caused by the absence of principled boundaries on the operation of the GAAR is that litigation becomes the main forum for working out those boundaries. In their article, Keating and Keating presented, in the same above document, empirical evidence demonstrating that “… a disproportionate amount of time is spent by Inland Revenue, taxpayers, practitioners and the court on both the procedural and the substantive aspects of tax avoidance disputes.”

Australia

Elements

The Australian GAAR, which was enacted in 1981, requires the presence of three elements in order for Part IVA to be invoked. There needs to be a scheme, a tax benefit, and an objective conclusion (not having regard to the parties’ actual intentions) that the dominant purpose of the scheme was to obtain a tax benefit. Of interest from a New Zealand perspective is that the statutory framework includes eight indicia designed to assist the taxpayer, administrator and judiciary in forming the view as to whether a scheme or any part of the scheme was entered into for the purpose of enabling a party to obtain a tax benefit (see the attached legislation – section 177D of the Income Tax Assessment Act 1936 Part IVA).

key indicia

These key indicia include, inter alia, the manner, form and substance of the scheme, the time and timing the scheme, the resultant change in financial position (or lack thereof) of the relevant taxpayer, and the nature of the parties (and the relationship to each other) including all the participants in the scheme. The Commissioner is given discretionary power when these criteria are satisfied to determine that the GAAR applies and then reconstruct the transaction to produce the tax outcome that would have prevailed had the scheme not been entered into.

Section 177D

The interpretation of section 177D was considered in the Full Federal Court in Consolidated Press (FC of T v Consolidated Press Holdings):
“The section requires the decision-maker, be it the Commissioner or the Court, to have regard to each of these matters. It does not require that they be unbundled from a global consideration of purpose and slavishly ticked off. The relevant dominant purpose may be so apparent on the evidence taken as a whole that consideration of the statutory factors can be collapsed into a global assessment of purpose.”

The High Court decisions such as FC of T v Peabody (1994), FC of T v Spotless Services Ltd (1996), and more latterly FC of T v Hart (2004), have been argued by Michael D’Ascenzo (the current Australian Tax Commissioner) to
provide “important consistent statement of principles”.84 This judicial guidance, together with the statutory guidance85 in section 177D leads D’Ascenzo to conclude:86
These reference points arguably provide a more certain basis than is available in other jurisdictions as to when the General Anti-Avoidance Rule (GAAR) is likely to be applied, or, in jurisdictions which do not have a GAAR, as to when the courts will intervene on the basis of judicial doctrines that have been developed in those jurisdictions to counter tax avoidance

Of course this is the view of a tax administrator rather the view of taxpayers or their advisers. An outsider looking at the Australian provision would however suggest that the eight indicia must be helpful guidance to all the concerned parties in a transaction which may potentially be subject to the GAAR.

Possible Model

A former Commissioner of the Australian Tax Office, has indicated that New Zealand’s current GAAR was considered as a possible model, but not considered adequate, when Australia was considering the adoption of its current GAAR: (Trevor Boucher Blatant, Artificial and Contrived: Tax Schemes of the 70s and 80s (Australian Taxation Office, Canberra, 2010))
“In the course of the OECD process the New Zealand experience was mentioned. In that country, there had long been a sister provision to Australia’s section 260, section 108. In 1974 after a process extending over a number of years that section was replaced by a new provision, section 99. In our work on the transformation of section 260 to Part IVA we had considered the New Zealand approach and concluded that it might not adequately address the deficiencies which Australian courts had found to exist in section 260.”

The current Australian Tax Commissioner, Michael D’Ascenzo, in “A practical guide on Part IVA”(paper presented to the 15th National Convention of the Taxation Institute of Australia, Sydney, March 2001), expressed the following view:

“These reference points arguably provide a more certain basis than is available in other jurisdictions as to when the General Anti-Avoidance Rule (GAAR) is likely to be applied, or, in jurisdictions which do not have a GAAR, as to when the courts will intervene on the basis of judicial doctrines that have been developed in those jurisdictions to counter tax avoidance.”

Canada

The Canadian GAAR was introduced in 1988 and since that time has remained much the same. A three-step analysis demonstrating the application of the provision was summarised by the Supreme Court in Canada Trustco Mortgage Co v Canada (2005):
“The first step is to determine whether there is a “tax benefit”arising from a “transaction”under s 245 (1) and (2). The second step is to determine whether the transaction is an avoidance transaction under s 245-(3), in the sense of not being “arranged primarily for bona fide purposes other than to obtain the tax benefit”. The third step is to determine whether the avoidance transaction is abusive under s 245-(4).”

Factors

The assessment of the primary purpose of the transaction under section 245(3) is, according to Canada Trustco Mortgage Co v Canada (2005), “an objective assessment of the relative importance of the driving forces of the transaction.”Like the Australian provision an objective factual analysis is required and the taxpayer’s motivation can be ignored. Unlike the Australian provision, but similar to the position in New Zealand, there is no further statutory guidance on the types of factors that the court should consider informing its view as to whether the purposes are “bona fide”.

The Misuse or Abuse Test

The difference between the Canadian approach and the New Zealand approach is manifested in section 245(4) of the Canadian Act. This is sometimes known as “the misuse or abuse test”. In Canada Trustco it was held that this test involves a two-part enquiry.

The first is, in Canada Trustco Mortgage Co v Canada (2005) words, “to interpret the provisions giving rise to the tax benefit to determine their object, spirit and purpose”.89 The second is to examine the factual context of the case in order to determine whether the avoidance arrangement defeated that purpose.

The first question is one of law that is, as in all cases, ultimately the courts to decide. But the second involves a mixed question of law and fact, with the onus being on the Commissioner in respect of the factual part. Whether a transaction results in a finding of tax avoidance is determined by “conducting a unified textual, contextual and purposive analysis of the provisions giving rise to the tax benefit in order to determine why they were put in place and why the benefit was conferred.”(Canada Trustco Mortgage Co v Canada (2005))

The “misuse or abuse”test in section 245(4) requires the court to consider the purpose of the provision. In Canada Trustco when the Supreme Court considered misuse, it held that Section 245(4) requires a single, unified approach to the textual, contextual and purposive interpretation of the specific provisions of the Income Tax Act that are relied upon by the taxpayer in order to determine whether there was abusive tax avoidance.

In the light of criticism of the New Zealand GAAR and the imprecise nature of the “Parliamentary contemplation”test it is interesting to note the words of warning provided by the Canadian Supreme Court justices:
“The courts cannot search for an overriding policy of the Act that is not based on a unified, textual, contextual and purposive interpretation of the specific provisions in issue. First, such a search is incompatible with the roles of reviewing judges. The Income Tax Act is a compendium of highly detailed and often complex provisions.

Did Parliament intend judges to formulate taxation policies that are not grounded in the provisions of the Act and to apply them to override the specific provisions of the Act? Notwithstanding the interpretative challenges that the GAAR presents, we cannot find a basis for concluding that such a marked departure from judicial and interpretative norms was Parliament’s intent.”

An outsider looking at the Canadian provision would find the explicit statutory definition of the relationship of the GAAR to the rest of the Act to be of assistance in interpreting the provision.

Conclusion: Three-step Analysis

Under the Canadian GAAR, a three-step analysis is undertaken to determine whether tax avoidance has taken place. First, there must be a tax benefit arising from the arrangement. Second, this arrangement must not be entered into “for bona fide purposes other than to obtain the tax benefit”. Third, the avoidance arrangement must misuse or abuse the specific provisions when read as a whole. Such an approach targets those arrangements which misuse or abuse specific provisions, rather than those that utilise choices extended to taxpayers by Parliament that are apparent to Parliament when passing income tax legislation.

The Canadian GAAR would provide a statutory basis for reaching the conclusion (about which there is seemingly a consensus in New Zealand) that a taxpayer who withdraws money from a call account and invests it in a managed fund that qualifies as a PIE is not committing tax avoidance

South Africa

Background

The first GAAR was introduced into South African tax legislation in 1941. The succeeding provision, section 103(1) of the Income Tax Act 1962, did not fundamentally change. A substantial amendment occurred, after public consultation, with the introduction of the new Part IIA of the Act in 2006. The GAAR, while retaining many of the same concepts from its predecessor section 103 is regarded as “an overhaul”. (see 92 South African Revenue Service Draft Comprehensive Guide to the General Anti-Avoidance Rule www.SARS.gov.za)-

For the GAAR to apply four requirements are necessary:
(a) the existence of an arrangement;
(b) existence of a tax benefit;
(c) the sole or main purpose of the avoidance arrangement is to obtain a tax benefit;
(d) the avoidance arrangement is characterised by the presence of any one or more of four tainted elements for arrangements in the context of business, and any one or more of three tainted elements for arrangements in the context other than business, which renders it an impermissible avoidance arrangement.

Elements Test

The tainted elements test, in a business context, includes an arrangement:
(a) entered into or carried out by an abnormal means or manner, not used for a bona fide business purpose (the business abnormality test) other than obtaining a tax benefit;
(b) lacking commercial substance; which consists of objective indicative tests and an object or “presumptive”test;
(c) creation of non-arm’s length rights or obligations;
(d) abuse or misuse of the provisions of the Income Tax Act.
In the context other than business the tests are repeated with the exclusion of test (b) above.

Taxpayer

As can be seen from the statutory definitions the tainted elements tests are creatures of statute. The taxpayer, where there is a tax benefit in the arrangement, is subject to a rebuttable presumption that the avoidance arrangement has been entered into for the sole or main purpose of obtaining a tax benefit (section 80G). The taxpayer must prove that, reasonably considered in the light of the relevant facts, obtaining a tax benefit was not the sole or main purpose of the avoidance arrangement.

“Impermissible avoidance arrangement”

Once it is established that arrangement is an “avoidance arrangement”, as defined, the next step is to determine whether such an avoidance arrangement is an “impermissible avoidance arrangement”. This will be so only if any one or more of the tainted elements tests are met.

Section 80C

When the South African provision was originally enacted it simply had the abnormality test. This proved to be insufficient by itself to combat relatively blatant avoidance arrangements. The commercial substance test was added and section 80C sets out certain factors to guide the conclusion as to commercial substance. Section 80C(1) provides a general rule as to a lack of commercial substance where there is a significant tax benefit, with there being no significant impact on business or commercial risks or net cash flows. This addresses the fact that tax avoidance schemes often create a faÃ§ade of substantial investments which are largely illusory, and insulate the taxpayer from economic risk contrary to the impression of the investment.

List of relevant factors

Section 80C(2) sets out a non-exclusive list of relevant factors that are indicative of arrangements that lack commercial substance:
(a) the legal substance of the avoidance arrangement is inconsistent or differs significantly from the legal form of its individual steps;
(b) round trip financing (described in section 80D);
(c) an accommodating or a tax-indifferent party (described in section 80E); or
(d) elements that have the effect of offsetting or cancelling each other.

Balance

Overall, commentators have suggested that the South African provisions have gone some way to balance legitimate commercial transactions against the need to combat tax avoidance arrangements. It is suggested that “Part IIA contains many positive aspects that make it preferable to Australia’s Part IVA”. (Julie Cassidy “The Holy Grail: The Search for the Optimal GAAR”(2009) 126(4) South African Law Journal 740).

Conclusion

In the case of Australia and South Africa features of tax avoidance are specifically identified. In the case of Canada the legislation attempts to tie the GAAR to the purposes of the Income Tax Act itself.

As Judges and academics have long recognised, a given commercial transaction can often be implemented in a number of ways, and if the tax legislation provides that one way involves a lower tax burden than another way, taxpayers will naturally prefer the transaction involving the lower tax burden. In the case of New Zealand, that is why it is unrealistic and unworkable to expect the GAAR to fill in gaps in tax policy and tax legislation. The GAAR must be there to address artificial schemes which could never have been anticipated in the tax policy design, but not to address the mainstream.

Extracted from “Improving the Operation of New Zealand’s Tax Avoidance Laws”

General Anti Avoidance Rule