Inland Revenue targets "dividend stripping"
The IRD’s crackdown on what it regards as tax avoidance is encroaching further into areas which have, in the past, been considered normal business practice.
Its latest target is “dividend stripping”, creating a scenario where all forms of corporate restructuring, even those with a clear commercial purpose, could be struck down as tax avoidance.
On 13 March 2018, Inland Revenue issued a Revenue Alert (RA 18/01) Dividend Stripping – some share sales where proceeds are at a high risk of being treated as a dividend for income tax purposes and is investigating several taxpayers who may fall within its ambit.
Taxpayers who have had, or will be involved in, a corporate restructure where the sale proceeds are credited to a shareholder current account (even if that can be drawn down only as funds become available) should be concerned. The Revenue Alert warns taxpayers that certain types of corporate restructuring may be subject to the general anti-avoidance provision (s BG 1, Income Tax Act 2007) or constitute a specific dividend stripping arrangement (s GB1, Income Tax Act 2007).
This is the first Revenue Alert issued by Inland Revenue in more than two years (that being RA 15/01 Employee Share Schemes, which related to allegations of tax avoidance in the structure and operation of employer subsidised share schemes for employees) and highlights what it considers to be “a significant and/or emerging tax planning issue that is of concern”.
Like a warning shot, the Alert was a first step in flushing out as many potentially affected taxpayers as possible with the promise of more lenient treatment (ie, any reassessment will apply only to the core tax and not include what can be significant penalties of up to 100% of the underpaid tax).
The second step is for Inland Revenue to issue “Risk Review” letters to potentially affected taxpayers who have not voluntarily come forward. These taxpayers have a final opportunity to “own up” in return for more lenient treatment. These Risk Review letters are causing considerable distress for clients caught unaware that their business restructure may now be considered tax avoidance.
Once Inland Revenue has disposed of the taxpayers who come forward under steps one and two (either voluntarily or when prodded), the third step is to start aggressively auditing any other taxpayers it suspects have participated in this kind of alleged tax avoidance arrangement. Step three may involve reassessment of core tax and the full imposition of any penalties.
Many taxpayers being caught within Inland Revenue’s new net may have done nothing wrong – and many tax practitioners consider this to be an example of over-reach by Inland Revenue.
Revenue Alert 18/01
The Revenue Alert applies the reasoning of the High Court decision in Beacham v CIR (2014) 26 NZTC 21-111,  NZHC 2839. That case involved an aggressive and entirely uncommercial scheme that even the taxpayer conceded was tax avoidance.
Under that arrangement:
- The shareholder had an overdrawn current account of $1.1 million (upon which it would normally have to pay tax); while
- The company itself had retained earnings of $1.8 million (yet with no available imputation credits as it had utilised loss-offset elections each year to pay no tax while those earnings accumulated).
To solve its dilemma and get access to the retained funds tax free, the taxpayer sold the company to a newly-incorporated company for $1.8 million. That sale price, payable by the new company, was used to settle his outstanding current account in full with the old company, with a $700,000 surplus remaining available to fund future capital withdrawals.
Following an investigation of the arrangement by Inland Revenue, the taxpayer acknowledged the restructuring had no commercial purpose and was tax avoidance. The only question for the court was whether the commissioner could assess the taxpayer for a deemed dividend of only his former current account of $1.1 million or, alternatively, the full sale price of $1.8 million. The High Court ruled the full sale price was a deemed dividend liable for tax. The court’s reasoning was that the transaction effectively converted the retained earnings of the company into a debt owed to the taxpayer so he should pay tax on that full amount.
This case is extreme but Inland Revenue has relied upon it in the Revenue Alert to support its warning that all forms of corporate restructuring, including those with a clear commercial basis, may potentially amount to tax avoidance.
The Revenue Alert explains:
“In essence, a dividend is a transfer of value by a company to a shareholder or related person and the transfer is caused by that shareholding. Dividend stripping refers to the sale of shares where some or all of the amount received is in substitution for a dividend likely to have been derived by the seller but for the sale of the shares.”
The focus of the Revenue Alert is transactions whereby the corporate restructuring does not result in a meaningful change in the former direct or indirect ownership of the group:
“…. if the sale is to a related entity, such as a company in which the seller or sellers have a significant shareholding, the economic effect of the transaction may be that the seller indirectly continues to substantially own the target company. The greater the similarity between the seller’s pre and post-sale ownership of the target company, the greater the risk that the transaction should be treated as a tax avoidance transaction. This risk exists regardless of whether or not the target company has liquid assets or retained earnings at the time of sale.”
Controversially, the Revenue Alert claims the result would be the same even if the company has no retained earnings that it could pay out as deemed dividends. Crediting sale proceeds to the shareholder’s current accounts could be sufficient as these credits can later be drawn down as funds become available.
Even more controversially, the Revenue Alert concludes tax avoidance may arise regardless of any commercial or business rationale for the restructuring, such as the exit of minority shareholders or the amalgamation of unrelated companies. Using these two examples it explains:
“Again applying the Parliamentary contemplation test, the Commissioner’s view is that these transactions are likely to be a tax avoidance arrangement. Although there is a commercial purpose [the exit of shareholders or merger of two different businesses], given the facts and circumstances, that purpose has been achieved in a way that means the transaction has a more than merely incidental purpose of tax avoidance.”
The Revenue Alert is accompanied by a brief Q&A responding to potential uncertainty that may be created by such a wide and novel approach to the dividend stripping rules. Worrying for many taxpayers, the Revenue Alert and the Q&A explain that:
- The four-year time bar may not apply to previous restructures.
- Any reconstruction is not limited to taxing the shareholder on only the difference between the 28% corporate tax rate and the shareholders’ marginal rate of 33%, even if the company itself had sufficient imputation credits to pay a dividend on any retained earnings. The full amount of the credit to the shareholders’ current account may be still be taxable.
- Inland Revenue may assess the company for resident or non-resident withholding tax.
- Shortfall penalties (in addition to interest and late payment penalties) may apply.
EY Law’s view
We question whether the extreme facts in the Beacham case can be interpreted and applied as widely as the commissioner alleges. Most worrying, the Revenue Alert repeatedly asserts that restructuring for genuine commercial purposes is not protected from allegations of tax avoidance. It refuses to recognise that taxpayers enter restructuring transactions for economic or business reasons unrelated to the alleged future tax benefits.
Taxpayers experienced a similar unrealistic approach from Inland Revenue when it alleged that debt capitalisation may also constitute tax avoidance under QWBA 15/01: Income tax: tax avoidance and debt capitalisation.
In that instance Inland Revenue’s overly-bullish interpretation of how the general anti-avoidance provision could apply to entirely commercial debt capitalisations was eventually over-turned by Parliament when it passed amendments to the Income Tax Act 2007. This expressly permits such arrangements. That law change would not have been required had Inland Revenue not taken such an unreasonable approach in the first place.
The hard-line approach in this latest Revenue Alert accords with our experience as well. Restructures which are vastly different to the examples in the Revenue Alert are being scrutinised through the prism of tax avoidance.
Although not all restructures (past and future) will be caught, getting Inland Revenue investigators over the line can be a long and arduous task. Rather than waiting for the tax man to come knocking on the door, taxpayers who have been involved in a restructure that is credited to a shareholder account should review that restructure to ascertain where it sits on the risk continuum and respond accordingly.
Taxpayers who are, or will be, restructuring in the future for non-tax related reasons should ensure contemporaneous supporting documentation can be produced. As part of this strategy, taxpayers with no appetite for future tax risk may consider seeking a binding ruling from Inland Revenue before the restructure is concluded.
Tori Sullivan firstname.lastname@example.org is New Zealand Tax Controversy Leader at EY Law in Auckland. She has practised tax for over 12 years and has extensive experience helping clients in tax advisory and compliance.
Last updated on the 31st August 2018