The Judicial Committee of the Privy Council Decisions

O'Neil & Ors v. Commissioner of Inland Revenue (New Zealand) [2001] UKPC 17 (10 April 2001)

Privy Council Appeal No. 40 of 2000

(1) Brian Andrew O'Neil

(2) Moira O'Neil

(3) Lyndon Lee McDougall and

(4) John James McDougall Appellants

v.

Commissioner of Inland Revenue

Respondent

FROM

THE COURT OF APPEAL OF NEW ZEALAND

JUDGMENT OF THE LORDS OF THE JUDICIAL COMMITTEE

OF THE PRIVY COUNCIL

Delivered the 10th April 2001

Present at the hearing:-

Lord Nicholls of Birkenhead

Lord Steyn

Lord Hoffmann

Lord Millett

Dame Sian Elias

[Delivered by Lord Hoffmann]

Mr Russell's scheme

1. The four appellants ("the O' Neils" and "the McDougalls") are shareholders in two trading companies which participated in schemes devised by an accountant named J.G. Russell for the avoidance of income tax. He

offered to take, year by year, the entire net profits of their companies and immediately to return them to the appellants (less remuneration for his services) in the form of tax-free capital. They found this prospect attractive, as did a considerable number of other New Zealand entrepreneurs who bought the same scheme.

Section 99

2. The Commissioner was less impressed. He assessed the appellants to income tax under section 99 of the Income Tax Act 1976:

""(1) For the purposes of this section - 'Arrangement' means any contract, agreement, plan, or understanding (whether enforceable or unenforceable) including all steps and transactions by which it is carried into effect: 'Liability' includes a potential or prospective liability in respect of future income: 'Tax avoidance' includes - (a) Directly or indirectly altering the incidence of any income tax: (b) Directly or indirectly relieving any person from liability to pay income tax: (c) Directly or indirectly avoiding, reducing, or postponing any liability to income tax. (2) Every arrangement made or entered into, whether before or after the commencement of this Act, shall be absolutely void as against the commissioner for income tax purposes if and to the extent that, directly or indirectly, - (a) Its purpose or effect is tax avoidance; or (b) Where it has two or more purposes or effects, one of its purposes or effects (not being a merely incidental purpose or effect) is tax avoidance, whether or not any other or others of its purposes or effects relate to, or are referable to, ordinary business or family dealings, - whether or not any person affected by that arrangement is a party thereto. (3) Where an arrangement is void in accordance with subsection (2) of this section, the assessable income and the non-assessable income of any person affected by that arrangement shall be adjusted in such manner as the commissioner considers appropriate so as to counteract any tax advantage obtained by that person from or under that arrangement , and, without limiting the generality of the foregoing provisions of this subsection, the Commissioner may have regard to such income as, in his opinion, either- (a) That person would have, or might be expected to have, or would in all likelihood have, derived if that arrangement had not been made or entered into; or (b) That person would have derived if he had been entitled to the benefit of all income, or of such part thereof as the Commissioner thinks proper, derived by any other person or persons as a result of that arrangement. (4)Where any income is included in the assessable income of any person pursuant to subsection (3) of this section, then, for the purposes of this Act, that income shall be deemed to have been derived by that person and shall be deemed not to have been derived by any other person."

3. The Commissioner decided that the purpose or effect of the scheme was tax avoidance. It was therefore void as against him under subsection (2). In order to adjust the appellants' assessable income to counteract the tax advantage which he considered that they had obtained, the Commissioner undertook what is commonly called a "reconstruction". That means that in accordance with subsections (3)(a) or (b), he formed an opinion about what would have happened if there had been no scheme. He decided that the net profits would have been received by the appellants in the form of directors' remuneration and increased their assessable incomes accordingly.

Challenges to the assessments

4. The appellants objected to the assessments under section 30 of the Act. The objection of the O'Neils was duly determined by the Taxation Review Authority (Judge Barber). After a hearing which occupied 43 days he affirmed the Commissioner's decision that the scheme fell within section 99 and (subject to minor variations) allowed the assessments to proceed: see Case R25 (1994) 16 NZTC 6,120. On 29 May 1997 Baragwanath J. dismissed the O'Neils' appeal: see (1997) 18 NZTC 13, 219. A further appeal to the Court of Appeal was dismissed: [1999] 1 NZLR 275. On 26 May 1999 an application for leave to appeal to the Privy Council was dismissed. Their Lordships understand that the order was made by consent. The objection of the McDougalls under section 30 has not yet been finally determined.
5. In parallel with these appeals, the O'Neils and MacDougalls brought consolidated proceedings for judicial review to quash the assessments. These applications were dismissed by Baragwanath J. in a series of judgments (see (1997) 18 NZTC 13,001, (1997) 18 NZTC 13, 127) and (1997) 18 NZTC 13, 219). The Court of Appeal heard an appeal from Baragwanath J. at the same time as the appeal in the objection proceedings and dismissed it. It is against that decision that this appeal is brought.

The scheme in more detail

6. In order to explain the issues in the appeal, it is necessary to give some more details of the scheme by which the profits of the trading companies were to be converted into capital receipts in the hands of the shareholders. The first step was for the shareholders to agree to sell their shares to a company controlled by Mr Russell, the price being left outstanding and secured by a mortgage over the shares. This transaction was not intended to be a sale in any commercial sense. The vendors declared themselves trustees of the shares for Mr Russell's company but remained on the register and they remained directors, continuing to run the company as before. And they had an option to repurchase the shares when the scheme had run its course. The sale had two purposes, both of which were entirely tax-related. The first was make the appellants' company part of a group of companies controlled by Mr Russell, some of which had tax losses. This would enable Mr Russell to take advantage of the group relief provisions in section 191. The second was to create a debt to the shareholders which could be satisfied out of the profits of their company.
7. The next step was for the trading company to agree to pay its net profits, half-yearly, to the purchaser company controlled by Mr Russell. This was called an administration charge. It was income in the hands of the purchaser company, but group relief under section 191 was relied upon to avoid tax. In reality the administration charge was partly a conduit for the money which was to be returned to the shareholders and partly a fee payable to Mr Russell for the use of the scheme. The proportion was calculated by reference to the amount of tax saved. In addition, the company paid a consultancy fee representing 5% of the administration charge to another Russell company.
8. The third stage was for the Russell company to pay the shareholders their part of the administration charge. This was designated an instalment of the purchase price. The amount of the purchase price was calculated, not by reference to the value of the company but to enable the scheme to mop up a given number of years of expected net profit. When that had been accomplished, the appellants could exercise their option to repurchase the company and carry on as if nothing had happened. Alternatively (as happened in the case of the O'Neils) Mr Russell's company could agree to buy a release of the option for a sum which would create a sufficient new capital debt to enable the scheme to start up again.

How section 99 works

9. Given the highly artificial nature of the scheme, their Lordships are not surprised that the Commissioner and every judge who has considered the matter have been of opinion that it amounted to an arrangement which had the purpose or effect of tax avoidance within the meaning of section 99(2). As this is such a plain case, their Lordships think it unnecessary to examine in any depth the criteria by which arrangements caught by section 99 may be distinguished from those which are not. There are, however, two points in the thoughtful analysis of Baragwanath J. which require comment. The first is that they are in complete agreement with his observation that the distinction between tax mitigation and tax avoidance is unhelpful: as the judge pithily said, it "describes a conclusion rather than providing a signpost to it": see (1997) 18 NZTC 13,001 at 13,031. The other is that they doubt the wisdom of using the concept of "impropriety" instead. (Ibid.) This suggests a moral judgment which their Lordships think is inappropriate and has been consistently repudiated in cases on tax avoidance schemes in England and New Zealand.
10. It may be more fruitful to concentrate on the nature of the concepts by reference to which tax has been imposed. In many (though by no means all) cases, the legislation will use terms such as income, loss and gain, which refer to concepts existing in a world of commercial reality, not constrained by precise legal analysis. A composite transaction like the Russell scheme, which may appear not to create any tax liability if it is analysed with due regard to the juristic autonomy of each of its parts, can be viewed in commercial terms as a unitary arrangement to enable the company's net profits to be shared between the shareholders and Mr Russell. (Compare Macniven v. Westmoreland Investments Ltd [2001] 2 WLR 377) Their Lordships consider this to be a paradigm of the kind of arrangement which section 99 was intended to counteract. On the other hand, the adoption of a course of action which avoids tax should not fall within section 99 if the legislation, upon its true construction, was intended to give the taxpayer the choice of avoiding it in that way.

The tax advantages

11. The complication of the scheme affected the forms of reconstruction available to the Commissioner under section 99(3). It produced tax advantages for different people at a number of different points. The artificial grouping of the trading company with Mr Russell's tax loss companies made the scheme viable because it enabled his companies to receive the profits without themselves becoming liable to tax. The artificial arrangements for payment by the trading company of administration and consultancy fees enabled the trading companies to eliminate their own liability to tax by claiming deductions under section 104 of the Act. And of course the primary objective of the scheme was to give the appellants the tax advantage of receiving part of the company's profits without paying income tax.

Track A and Track B

12. In the early stages of his attempts to deal with the scheme, the Commissioner appears to have concentrated upon the tax saving afforded to the trading company by the disappearance of its profits in the form of administration fees. He made assessments upon the companies on the basis that the administration fees would not have been allowable deductions. This form of assessment has been called "Track A". The Commissioner discovered, however, that the assessments went unpaid because the trading company was an empty shell which had disposed of its assets and goodwill to a successor. He then turned his attention to what their Lordships regard as the essence of the scheme and assessed the appellants on the footing that they would have received the company's net profits as remuneration. These assessments were called "Track B" and those made upon the O'Neils and the McDougalls form the subject-matter of this appeal.

The limits of judicial review

13. The issues before their Lordships are limited by the fact that the proceedings are for judicial review. Section 27 of the Income Tax Act provides:

"Except in proceedings on objection to an assessment under Part III of this Act, no assessment made by the Commissioner shall be disputed in any Court or in any proceedings (including proceedings before a Taxation Review Authority) either on the ground that the person so assessed is not a taxpayer or on any other ground; and, except as aforesaid, every assessment and all the particulars thereof shall be conclusively deemed and taken to be correct, and the liability of the person so assessed shall be determined accordingly."

14. Despite the broad language of this section, judicial review is not precluded where proper grounds are made out: Commissioner of Inland Revenue v Lemmington Holdings Ltd [1982] 1 NZLR 517, 522; Commissioner of Inland Revenue v Canterbury Frozen Meat Co Ltd [1994] 2 NZLR 681, 688. Although the correctness of the assessment may not be challenged except by statutory objection, the legitimacy of the process adopted by the Commissioner and the validity of the outcome may be challenged in proceedings by judicial review on established administrative law grounds. In some circumstances the making of an assessment, whether correct or not, may be an abuse of power: see Commissioner of Inland Revenue v Lemmington Holdings Ltd. supra.
15. When the O'Neils' judicial review proceedings were originally launched, the Commissioner applied to strike them out on the grounds that most of the claims amounted in essence to a complaint that the assessments were wrong and did not disclose any arguable case of abuse of power. Blanchard J. acceded to the application (see (1993) 15 NZTC 10, 187) but the proceedings were reinstated by the Court of Appeal on the ground that the statement of claim contained an allegation that the Commissioner had decided to adopt Track B and assess the O'Neils "simply because [the trading company] was not solvent."
16. In giving the judgment of the Court of Appeal, ([1995] 3NZLR664, 671, 672) Richardson J. described the allegation that the assessments were solely motivated by the solvency of the appellants as "perhaps the only truly significant allegation of fact" which bore upon the validity (as opposed to the correctness) of the amended assessments. He said that if such motivation was proved, it "would have to be characterised as an abuse of power". The statement of claim also contained many other allegations, but Richardson J. commented that there was "considerable force in the argument for the Commissioner that…a substantial part of the plaintiffs' case is directed to the correctness of the assessments, although dressed up as a process argument" (p.670). In order to avoid the trial spilling over into issues excluded by section 27, he recommended (at p.673) a judicial conference at which the trial judge would make "rigorous rulings" to restrict the evidence to the process followed by the Commissioner and the reasons for it.
17. In the event the separation of issues proved less than rigorous because Baragwanath J. heard both the judicial review proceedings and the appeal from the Taxation Review Authority. Noting that there was considerable overlap between the issues raised by the appellants in the two sets of proceedings, he invited their counsel to elect whether he wanted them dealt with in the one or the other. The appellants chose the judicial review proceedings, which came on first. The judge therefore decided them and treated some of them as res judicata when he came to deal with the appeal. In the Court of Appeal, both appeals were heard together.
18. Their Lordships respectfully agree with Richardson J. that apart from what was in substance an allegation of bad faith in the Commissioner's motive for making the assessments, all the other points taken in the judicial review proceedings and on appeal were directed to showing that the assessments were erroneous in law or based upon an incorrect appreciation of the facts. These are matters which it was open to the appellants to raise in the statutory objection and on further appeal to the courts. The application for judicial review appears to have been made at the time because it was wrongly considered by the Taxation Review Authority that the objection procedure was not apt to deal with the administrative law challenges. They were accordingly not argued before the Taxation Review Authority. Before the application for judicial review was heard by the High Court, it had been established that the Taxation Review Authority was properly able to deal with challenges to assessments brought upon administrative law grounds: Harley Developments Inc v Commissioner of Inland Revenue [1996] 1,WLR 727; Golden Bay Cement Co. Ltd v Commissioner of Inland Revenue [1996]2 NZLR 665. In view of the course which these proceedings have taken, their Lordships will briefly deal with all of these points in the order in which they were taken by Mr Judd Q.C. on behalf of the appellants. But they must not be taken as accepting that relief by way of judicial review would have been appropriate. It will only be in exceptional cases that judicial review should be granted where the challenges can be addressed in the statutory objection procedure. Such exceptional circumstances may arise most typically where there is abuse of power: Harley Development Inc v Commissioner of Inland Revenue [1996] IWLR 727 at 736: But they have also been held to arise where the error of law claimed is fatal to the exercise of statutory power and where it would be wasteful to require recourse to the objection procedure: Golden Bay Cement Co. Ltd v Commissioner of Inland Revenue[1996] 2 NZLR 665 at 671.

The time bar

19. The appellants submit that the Track B assessments were out of time. They were made by way of amendment more than four years after the original assessments for the tax years in question. Section 25(1) of the Act provides that the Commissioner may not increase an assessment more than four years after it was made. This point raised an error of law which affected the validity of the assessment and was amenable to judicial review: Golden Bay Cement Co. Ltd v Commissioner of Inland Revenue [1996] 2 NZLR 665 at 671. But their Lordships consider that it ought properly to have been taken by way of objection. In any event, they also think that it was rightly rejected by Baragwanath J. and the Court of Appeal.
20. Section 25(2) disapplies the time bar where "in the opinion of the Commissioner, the returns so made…omit all mention of income which is of a particular nature or which is derived from a particular source". The returns contained no mention of the source of the income (Mr Russell's company) or its nature (the indirect return of the profits of the trading companies). So the Commissioner says that the bar does not apply.
21. Mr Judd submitted that the appellants' returns did not altogether omit mention of income of the nature or from the source in respect of which they were being assessed under section 99. They had included various sums paid by way of remuneration by the trading companies. The Commissioner's reconstruction had treated the money they received under the scheme as if it were remuneration. Therefore it was income of a nature and from a source which had been disclosed.
22. Their Lordships consider that this argument is based upon a misapprehension about the effect of a reconstruction. The Commissioner's duty is to make an assessment with regard to what in his opinion was likely to have happened if there had been no scheme. But that does not mean that he is actually rewriting history. The reconstruction is purely hypothetical and provides a yardstick for the assessment. Although the income is deemed to have been derived by the person assessed (see section 99(4)), the nature and source of the income remains what it is was, namely the company's net profits routed to the shareholders through Mr Russell's company. None of this was disclosed.

The Commissioner's Policy Statement.

23. It appears that the decision of the Privy Council in Challenge Corporation Ltd v Commissioner of Inland Revenue [1987] AC 155 created some uncertainty in the minds of taxpayers about how the Commissioner might apply section 99. In February 1990 he therefore published a Policy Statement, which has in these proceedings been called the CPS, setting out in some detail what he regarded as the proper scope of the section. It is relevant to observe that the question of whether an arrangement is void against the Commissioner under section 99(2) is not a matter for his discretion or policy. The Act says that an arrangement falling within the terms of the section "shall be absolutely void." Likewise, the Commissioner is under a statutory duty to reassess the taxpayer's assessable income to counteract any tax advantage. Discretion enters into the matter only as to the method of calculation by which the Commissioner discharges that duty.
24. The CPS nevertheless reassured taxpayers that, before invoking section 99, the Commissioner would undertake a careful and thorough analysis of the meaning and purpose of the statute and the purpose or effect of the arrangement. He would consider whether it was a fair and reasonable inference that one purpose was tax avoidance. He would decide whether the scheme frustrated the underlying scheme and purpose of the legislation. It says that section 99 will not be used without such an analysis having been undertaken and adds "Departmental Officers are not empowered to invoke section 99, or indicate that it is intended to invoke this section, without having completed the analysis."
25. Mr Judd relies particularly upon this last sentence to say that an assessment by one of the Commissioner's officers under delegated powers must therefore be ultra vires if the promised thorough analysis has not been undertaken. The decision to make the assessments was made by Mr Phizacklea, to whom the Commissioner had delegated power under section 11 of the Inland Revenue Department Act 1974. But section 11(2) says that any such delegation is subject to any conditions which the Commissioner may impose. Mr Judd says that the statements in the CPS about a thorough analysis amounted to such conditions and that the documentation shows that Mr Phizacklea did not comply with them. He therefore had no power to authorise the issue of the assessments and they are unlawful.

26. Their Lordships think that there are at least two answers to this submission. There may well be more. But one is that the judge and the Court of Appeal found on the facts that Mr Phizacklea did all that the CPS required. These are concurrent findings of fact which their Lordships would not disturb. A more fundamental point is that their Lordships do not think that the CPS was intended to lay down conditions at all. They do not consider that the parts of the document relied upon by the appellants do more than to reassure the public that the Commissioner and his officers will think very carefully about whether section 99 applies to any particular case. But his statutory duty is to reassess the taxpayer in any case in which section 99 applies and this duty cannot be made subject to internal conditions. Nor do their Lordships think that he intended to restrict his duty in such a way.

26. In any case, their Lordships think that the proof of the pudding is in the eating. It would be very strange if an assessment which has been held valid by the Taxation Review Authority and the courts should be invalidated on the ground that the Commissioner's officers did not give sufficient thought to whether it was valid or not. So this point also turns out to be an attack on the correctness of the assessment dressed up as a process argument.

Irrationality

27. Mr Judd next submitted that if the Commissioner had thought about section 99 and the Russell scheme properly, he could only have come to the conclusion that it fell outside section 99. His decision to make the assessments was therefore irrational. Their Lordships consider that this submission can only be called preposterous. The assessments have been held to be correct. In the case of the O'Neils, this is res judicata between them and the Commissioner as a result of the finality of the objection proceedings. And although no such formal bar applies to the submission by the McDougalls, the fact that the scheme was in all material respects the same makes it a hopeless one. It is again an attack on the correctness of the assessments.
28. These observations also apply to the submission that the Commissioner was irrational in assessing the appellants on the footing that they would have received as remuneration the whole of the profits paid to Mr Russell's company, including the part which he retained for his own remuneration. In any case, their Lordships do not think that it was unreasonable for the Commissioner to have taken this view. The payments were fees for the use of Mr Russell's scheme and companies. On no footing could they have been legitimate deductions by the trading company or the appellants. Such payments would have had to come out of taxed income.

Abuse of power

29. The next issue is that identified by Richardson J. as arguably sufficient to constitute a claim of abuse of power. It was alleged that the Commissioner, had been solely motivated by the fact that the shareholders were solvent and their former trading company was not. Baragwanath J. said of this argument (1997)18 NZTC 13,001, at 13,045:

"The true issue is not whether the question of solvency was important to the Commissioner and a major motivating factor – as I have no doubt that it was. It is whether the Commissioner lacked honest and reasonable belief that he was entitled to assess the plaintiffs…. I am satisfied that the Commissioner's decision to shift from Track A to Track B was not 'simply because [the trading company] was not solvent'. The true reason for the decision is that both [the trading company] and [the O'Neils] were seen by the Commissioner as having obtained a tax advantage. "

The Court of Appeal took the same view. On the facts, Baragwanath J. held that the Commissioner was not improperly motivated and the Court of Appeal agreed. It follows that unless the way Baragwanath J. characterised the question shows some error of principle, their Lordships would follow their usual practice of declining to review concurrent findings of fact.

30. Mr Judd argued that there was an error of principle. Under section 99(3), he said, only one party can obtain a tax advantage from the arrangement. It follows that if the Commissioner thought that the trading company had obtained an advantage, he could not properly have thought that the appellants had obtained one. Their Lordships do not accept this submission. Section 99(3) says that the Commissioner shall adjust the assessable income of any person affected by the arrangement to counteract any tax advantage that person has obtained. There is no reason why an arrangement should not confer tax advantages upon more than one person and, as their Lordships have already explained, this one plainly did. There were different tax advantages in relation to different payments. Mr Russell's company obtained the advantage of using group relief on income received from the trading company; the trading company obtained the advantage of deducting the administration and consultancy charges and the shareholders received the advantage of receiving payments as capital when they would otherwise have been income. There was no reason why the Commissioner should not adjust the assessable income of each or any of these persons. Of course his assessments would have to be consistent with each other. He could not maintain an assessment on Mr Russell's company on the basis that it had received the whole trading profit but was not entitled to group relief and at the same time assess the shareholders on the basis that they had received the trading profit in the form of remuneration. But provided that he was not using inconsistent hypotheses for his reconstructions, he was in their Lordships' opinion entitled to assess any party who had obtained a tax advantage.

Inconsistent assessments

31. Mr Judd's next point was that the Track A and Track B assessments were in fact inconsistent. Track A treated the trading company as having made the profits it would have made without deductions for administration charges whereas Track B treated those profits as having been paid to the appellants. Section 99(4) says that income included in the assessable income of a taxpayer under section 99 shall be deemed to have been derived by him and not by another person. Consequently, the Commissioner could not validly make a Track B assessment while a Track A assessment in respect of the relevant company was outstanding.
32. Their Lordships consider that an assessment which wrongly includes income deemed, by virtue of section 99(4), to be the income of someone else is not void, any more than an assessment which is wrong on some other ground. It is merely open to objection under section 30. It follows that the Commissioner or Taxation Review Authority may remedy the position by amending the inconsistent assessment at any time before the objection proceedings have run their course. It is only when the assessments are no longer open to amendment that an objection on grounds of inconsistency will be incapable of remedy.
33. The only inconsistent assessments in these proceedings were made against the McDougalls. They were assessed under Track B at a time when the relevant trading companies had been assessed under Track A. The Track A assessments had been objected to and in one case the trading company had requested and obtained a case stated to take the matter to the Taxation Review Authority. Baragwanath J. and the Court of Appeal agreed that once a case had actually been stated for the TRA in respect of a Track A assessment, any amendment was a matter for the TRA and the Commissioner could no longer amend it. Since the Commissioner did not challenge this holding either in the Court of Appeal or before this Board, their Lordships express no view on the point. But the Court of Appeal did not accept the further proposition of Baragwanath J. that the Commissioner lost his power to amend or withdraw the assessment when the objector required that his objection be heard and determined by the TRA. Their Lordships agree with the Court of Appeal, for the reasons which they gave.

Tentative assessments.

34. Mr Judd submitted that the Track B assessments were not really assessments at all because they were only tentative. That was demonstrated by the Commissioner's alleged vacillations in getting from Track A to Track B and proposed to be reinforced by evidence that he was contemplating Track C and even Track D. Mr Judd relied upon the case of Commissioner of Inland Revenue v Canterbury Frozen Meat Co Ltd [1994] 2 NZLR 681 in which it was held to be arguable that a protective assessment made upon one of two taxpayers whom the Commissioner considered alternatively liable with a view to awaiting the outcome of objection proceedings by the other was invalid. But, as the Court of Appeal observed, that is far removed from the present case. The Commissioner has defended his Track B assessments through thick and thin; for 43 days before Judge Barber, again before the judge and again in the Court of Appeal. And they have been held to be valid. It would be a misuse of language to describe them as tentative.

New evidence

35. The Court of Appeal refused to admit an affidavit by Mr Russell on the ground that the matters which he proposed to canvass could make no difference to the appeal. Their Lordships consider that this was a matter for the discretion of the Court of Appeal and in any case agree that the proposed evidence went to matters which their Lordships have already held to be irrelevant.

Conclusion

36. Their Lordships will humbly advise Her Majesty that the appeal should be dismissed. The appellants must pay the Commissioner's costs before their Lordships' Board.