Elmiger- A founding document of section BG1

Elmiger and Another v Commissioner of Inland Revenue (1966) NZLR 683 (SC) [Elmiger]

Facts of the case

This is a 1960’s case, two brothers based in Waikato carried a business in partnership of earthmoving contractors. Earthmoving machines as shown in the picture are heavy duty vehicles used for executing constructions. The business was profitable and involved use of heavy machinery. They owned substantial assets of this type and each machine had a high income generating capacity. Having a substantial number of these kinds of machines in 1960’s means taxpayers were high profile people.

In 1962 they restructured their business, formed a trust and sold two machines to the trust by way of interest free loan. The machines were leased back to the partnership by the virtue of this arrangement they received deductions for the partnership and on the other hand received income for the trust.
The trust deed provided them arbitrary powers of controlling trust assets and income. And it contained a provision that at the termination of the trust on 31 March 1968 the trust capital should revert to them.

Issue

Trust income created deductions for the partnership, in 1960’s top marginal tax rate for the individuals was 66% and trust tax rate was 35%. The arrangement resulted in 31% of tax savings for the taxpayer. The commissioner disallowed the hire charge deductions to the partnership income and stated the agreement for sale and purchase and the hiring were null and void.

Legislation

Section 108 (Land and Income tax Act 1954, s108) states:
Every contract, agreement or arrangement made or entered into, whether before or after the commencement of this Act, shall be absolutely void so far as, directly or indirectly, it has or purports to have the purpose or effect of in any way altering the incidence of income tax, or relieving any person from his liability to pay income tax.

Judgement

It was held the arrangements created fictitious deductions and by the process taxpayer achieved favourable position in the incidence of income tax. By doing that taxpayer was relieved from some part of their liability to pay income tax.

Analysis

Elmiger was a case of income splitting where the trust was used for splitting the income to receive favourable tax position. The case itself was based on the judgement of Newton. Prior to this case there were only two tax cases on tax avoidance in New Zealand both were just a year before this case. In each case the decision went in the favour of the taxpayer:-
In Elmiger the taxpayer’s main argument was that the arrangement was genuine and they had genuine intentions behind it. They argued since the arrangement was not a sham there would be no application of s108 Land and Income Tax Act 1954.

The analysis of arrangement shows arrangement in Elmiger was not a sham. Justice Woodhouse referred Newton to arrive at his judgement. Newton is an Australian case, which has routinely been referred to by New Zealand judges in New Zealand tax avoidance cases. Lord Denning developed the following principles in the Newton case, know and Newton Predication Test:
1. An arrangement can be partly oral and partly written and can be inferred from the circumstances
2. In applying the section one should look at what the arrangement effects, what it does irrespective of the motives of the parties.
3. Purpose is judged by what the arrangement intended to effect and is discerned from an examination of the terms of the arrangement.
4. In order to apply the section, one must be able to predicate form the overt acts by which the arrangement was implemented that it was implemented in that particular way so as to avoid tax.

Using Newton approach Justice Woodhouse arrived at the decision when arrangement is in doubt one should look at the wider scope of the arrangement and that whole arrangement must be looked together. He said in Elmiger purpose of the whole arrangement was to avoid tax. It is axiomatic that the concept of tax avoidance applies to transactions that are not shams . Tax avoidance applies to all genuine contracts that do create the legal rights and obligations that they intend to create. The same principle used in many New Zealand tax cases also evidenced in Glenharrow Holdings Limited v Commissioner of Inland Revenue [2008] NZSC 116, 24 NZTC 23 at [33] (SC) by applying general anti avoidance provision found in section 76 of Goods and Services Act 1985. The court said at para [33]:
Section 76 assumes that the arrangement under scrutiny is not a sham. The concern under s 76 is whether, notwithstanding juristic compliance with other provisions of the Act, the commissioner may set a particular arrangement aside and make a reconstruction because the arrangement constitutes tax avoidance.

Elmiger- Description of Arrangement and Tax Benefit

A list below shows structure of arrangement created by the taxpayer-

1. Formation of Trust
a. 12 November 1962 trust was formed trustee were both brothers and beneficiaries were respective wives and children’s.
b. Extraordinary and arbitrary powers were given to the trustees, and when trust ceases on 31 March 1968 all capital was to revert back to the brothers.
2. Acquired Machinery
a. On 28 November 1962 partnership sold two earth moving machines to the trust for £5,250.
b. Amount of £5,250 was treated as interest free loan, which is payable to the partnership by the trust on demand.
3. Interest Free Loan
a. There was no monetary transfer of funds, the partnership provided interest fee loans to the trust for selling the machinery.
b. From operational point of view machinery never left their hands.
4. Leased the Machinery Back
a. Trust leased these machines back to the partnership for £3 and £2 per hour with a minimum monthly charge of £250 and £175 respectively.
5. Dissolution of Trust
a. Upon dissolution of a trust retained earnings of the trust were reverted back to the brothers.

It is evident from the above arrangement that the minimum monthly charges were able to produce an annual income for the trust of £5,100 upon a capital outlay of £5,250. All outgoings in relation to the operations were borne by the partnership and income received by the trust was virtually its net income subject to depreciation. On the other hand the partnership received deductions of all those payments made to the trust. Below is a working of tax benefit received by the taxpayers-
1. First four months of operations (Dec 1962 to Mar 1963) resulted in £3,355 income for the trust.
2. Second year of operations year ending Mar 1963 resulted in £4300.
3. Interest free loan started off with £5250 payable to the partnership by the trust and after 16 months of operation closing balance of £1460 was payable to the trust by the partnership.
4. Whole arrangement resulted in lease charges for the sixteen months in question amounting to £7,655. In their business accounts this was claimed as a deductible expense, and their personal net incomes were reduced accordingly.

Elmiger- Purpose of the Arrangement

Purpose of the arrangement argued by the taxpayer was there were genuine transactions between families to safeguard family assets. They never intended to alter the incidence of tax, and the advantage they received was incidental. In supporting their submission they expressed the view that the section 108 (Land and Income Tax Act 1954) could not apply to their situation as the transactions were not sham. They also mentioned since the section does not deal with the future tax liability, it only deals with the present or accrued liability.
Commissioner said purpose of the arrangement was to avoid tax, and whether the transactions were sham or not does not matter as the section 108 applies to all transaction. Commissioner referred to s260, Commonwealth of Australia Income Tax and Social Services Contribution Assessment Act 1936-1951 (as stated below) which was similar to New Zealand legislation and said Australian case law does not give any importance to sham test and applies to all transactions-
Every contract, agreement, or arrangement made or entered into, orally or in writing, whether before or after the commencement of this Act, shall so far as it has or purports to have the purpose or effect of in any way, directly or indirectly -
(a) altering the incidence of any income tax;
(b) relieving any person from liability to pay any income tax or make any return;
(c) defeating, evading or avoiding any duty or liability imposed on any person by this Act; or
(d) preventing the operation of this Act in any respect, be absolutely void, as against the Commissioner, or in regard to any proceeding under this Act, but without prejudice to such validity as it may have in any other respect or for any other purpose.
Commissioner also argued if the legislation can only deal with present or accrued liability and not future tax liability, then the legislation will appear very shallow and will have no operational strength.
Woodhouse J, agreed the transactions were not sham and said despite unusual powers given to trustees to control and dispose trust assets, and tax benefit they achieved from the transactions. These transactions cannot be regarded as sham, and the whole scheme was legitimate.
Then he went on to express his opinion on broad purpose of s 108 at page 688
The broad purpose of s108 is to prevent deliberate attempts by individuals to obtain tax advantages denied generally to the same class of taxpayer. Therefore, it is important to test the purposes and effect of contracts, agreements, or arrangements, against the words of the section.
He said to test the transaction one has to verify whether an income tax advantage was one of the actuating purposes of the transaction. Then he said to come to the conclusion whether tax avoidance present in the arrangement or not the decision is to be made objectively by looking at the overt acts done in pursuance of the whole arrangement. He expressed his opinion on family or business dealings will be caught by s108 (ITA 1954) despite their characterisation as such, if there is associated with them the additional purpose or effect of tax relief (Elmiger v CIR at page 694)
He stressed on series of transactions which have been applied as a part of predetermined outcome. There clearly was an overall plan preceding the individual steps taken, and equally clearly the intention was that those steps should take effect as a whole. It is said that this whole arrangement was intended to give each family a share in the capital assets of the business or in the business itself. On this basis the claim is made that this should be regarded as one of those normal family transactions described by Lord Denning in Newton case
Elmiger led foundation for all upcoming tax avoidance disputes for example just a year later in another matter Carlson vs Commissioner of Inland Revenue [1970] NZLR 182 (CA) the taxpayer carried on the business of dairy farming. They were sole traders owning the land. A family trust was established and the farms were leased to the trust. The farmers were then employed by the trust to farm the property. Such kind of arrangement was found to constitute tax avoidance because-
1. The trust was temporary in nature
2. There was no change in the way the business was carried on in day to day operations.