The Trinity Case: tax avoidance or no more than what the law intended

Mathew McKay, Senior Associate | Wednesday 29 August 2007

Many readers will be aware of the Court of Appeal's recent Trinity judgment confirming that the Trinity forestry investment scheme was a tax avoidance arrangement.

The case was the IRD's largest ever tax litigation success in terms of the tax dollars involved.

However, what is perhaps more significant than the outcome of the case is the approach adopted by the Court of Appeal to determine whether or not the scheme amounted to tax avoidance. In this Update we outline the approach the court adopted and review how it differs from the approach traditionally preferred by the IRD.

The scheme with no clothes

Investors in the Trinity scheme were granted a 50-year licence to use land in Southland to plant pine trees. The licence gave investors the right to receive proceeds from the sale of the pine trees at harvest. Investors issued a promissory note to pay a fixed fee for the licence in 50 years time. The licence fee greatly exceeded the value of the land at the time the investment was entered into.

Investors were also required to enter into an insurance arrangement under which an insurer assumed the risk for the decrease in the value of the forest at the time of harvest below an amount equal to the fee payable for the licence in 50 years. A small premium was payable upfront but payment of the majority of the premium was deferred until harvest. The investors issued a promissory note to the insurer to secure payment of the deferred premium at harvest.

The result of the scheme was that over 99% of the total expenditure claimed by the investors and 87% of the expenditure claimed in the first year was deferred for 50 years. However, investors claimed a deduction for tax purposes for the insurance premium in the first year on the basis that the premium had been incurred for tax purposes in that year. Investors treated the cost of the licence fee as "depreciable intangible property" (which includes a "right to use land") and sought to amortise the cost of the licence over the term of the investment. A total of $3.7 billion of tax revenue was at risk if the scheme had run to maturity. A draft business plan prepared for the insurer stated that "the real benefits of the deal are tax concessions that can be obtained now by investors... The actual outcome of the deal in fifty years is not considered material".

The Commissioner of Inland Revenue challenged the deduction of the insurance premium and the depreciation of the licence under the general anti-avoidance rules.

The court's decision

The Court of Appeal acknowledged that the scheme was clever but commented that "this cleverness should not be allowed to obscure the reality that this particular emperor has no clothes".

The court held that the arrangement was a tax avoidance arrangement void for tax purposes because the real purpose of the investment was to obtain what it described as "spectacular tax benefits" and not to profit from a forestry business.

It upheld the imposition of penalties equal to 100% of the tax benefit claimed by investors on the basis that the position adopted by the investors was "abusive" from a tax perspective.

Court's approach to tax avoidance

IRD'S TRADITIONAL APPROACH

The IRD's traditional approach to applying general anti-avoidance rules is outlined in a Policy Statement released in 1990. The approach has been to analyse:

• the underlying scheme and purpose of the Income Tax Act as a whole and the specific regime and/or provision(s) under review;

• the arrangement, to ascertain its purpose or effect; and

• whether a fair and reasonable inference can be drawn that tax avoidance is a more than merely incidental purpose of the arrangement.

Only after this analysis does the IRD consider whether it can be inferred that the arrangement in question frustrates the underlying scheme and purpose of the legislation.

The IRD's Exposure Draft on the interpretation of the general anti-avoidance provisions released in 2004 confirms its view that it is first necessary to determine whether the anti-avoidance rules apply on their terms and then to assess whether the arrangement frustrates the underlying intention of the applicable provisions or the Income Tax Act as a whole.

THE COURT'S APPROACH

In the Trinity case the Court of Appeal treated the consideration of whether or not the arrangement frustrated the scheme and purpose of the Act as the first and most fundamental step in the application of the general anti-avoidance rules. The decision confirms the view held by many tax practitioners that the IRD has been conducting its analysis of tax avoidance in the wrong order.

The court's approach is best summarised in this statement: "Obviously, there is a need to recognise that in some instances the legislature must have intended to encourage particular types of behaviour. Behaviour of that type (being the sort of behaviour which was within the contemplation of the legislature) cannot be within the general anti-avoidance provisions because the overall legislative purpose is that such behaviour should attract the tax consequences provided for by Parliament. Likewise, it may sometimes be obvious that the specific tax rules relied on were not intended to confer the tax benefits in issue. Such a case, however, is likely to be decided simply by construing the relevant specific tax rules so as to accord with the legislative intent and without any need to resort to the general anti-avoidance provisions."

Adopting this approach may cause taxpayers and the IRD to examine the underlying purpose or object of applicable provisions and tax regimes to assess whether the tax outcome of an arrangement is consistent with that purpose or objective before analysing whether the tax advantages of the arrangement were a more than merely incidental purpose or effect of the arrangement.

In cases where tax avoidance is alleged by the IRD it should not be necessary to "step-through" the individual requirements of the general anti-avoidance rules if it can be demonstrated that the underlying scheme and purpose of the legislation has not been frustrated.

In the Trinity decision the court recognised that "legislation necessarily creates both incentives and disincentives and it would be perverse to hold that rational and intended taxpayer responses to those incentives (or disincentives) are caught by anti-avoidance provisions". This approach is not dissimilar to the so-called "choice principle" developed in Australia which, in summary, states that anti-avoidance rules should not apply to a transaction which is structured in a way that minimises tax if the legislation, upon its true construction, is intended to give the taxpayer the choice of minimising tax in that way.

At a more practical level, the Court of Appeal stated that in determining whether the general anti-avoidance rules apply it is important to recognise:

• the reality that commerce is legitimately carried out through a range of entities and in a variety of ways;

• that tax is an important and proper factor in business decision making and family property panning;

• that something more than the existence of a tax benefit in one hypothetical situation compared to another is required to justify attributing a greater tax liability; and

• that what should reasonably be struck at are artifices and other arrangements which have tax induced features outside the range of acceptable practice.

While the Court of Appeal did not have any difficulty deciding that the Trinity scheme was a tax avoidance arrangement, the court's approach to that issue is, in our view, positive for taxpayers. That approach will compel the IRD to first consider whether a tax advantage claimed under an arrangement is in fact an advantage intended to be conferred upon the taxpayer despite the fact that the taxpayer may have entered into the arrangement with a view to obtaining that advantage.

For further information, please contact your usual Bell Gully adviser or:

Niels Campbell
Partner

David Simcock
Partner

Willy Sussman
Partner

John Bassett
Senior Associate

Mathew McKay
Senior Associate

Graeme Olding
Senior Associate

Summer Deverell
Senior Solicitor