The Case for Taxing Capital Gains in New Zealand - SSRN papers

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1. Building a Better Bridge: The Case for Taxing. Capital Gains in New Zealand. CRAIG ELLIFFE*. Professor of Taxation Law and Policy, University of Auckland, ...
Building a Better Bridge: The Case for Taxing Capital Gains in New Zealand CRAIG ELLIFFE* Professor of Taxation Law and Policy, University of Auckland, Business School, Consultant, Chapman Tripp, Barristers and Solicitors

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INTRODUCTION

From medieval times toll bridges have been used for the collection of revenue. On busy market days it is possible to envisage substantial delays as people queued to pay their toll and get across. To maximise revenue those people who crossed the bridge could be charged more. For those waiting to pay an increasingly expensive toll the incentive to find another route, perhaps a ford upstream, or to hire a boat would be attractive. As an alternative they may have decided to trade among themselves, obviating the need to go to the market and cross the toll bridge. The New Zealand tax system is like a toll bridge. Its central span is based on an income tax system. A good consumption tax was bolted on to the sides of the central span nearly 25 years ago. There are some engineering concerns over the construction of this bridge. If the bridge could be widened, more people would cross at a lower toll rate. Reform of the tax system is necessary. Government indebtedness and persistent fiscal deficits necessitate either a reduction in Government spending, policies to raise new revenue, or a combination of the two. The current and future fiscal budget position is a concern to the Government, as are the generic problems with the New Zealand income tax system, highlighted by various Treasury and Inland Revenue reports and considered by the Victoria University’s Tax Working Group.1 Suggestions for tax reform include the alignment of corporate, trustee, and individual marginal tax rates2 in order, first, to overcome the problems that exist in the system arising from a lack of horizontal equity and, secondly, to remove the incentive that taxpayers have to use entities and income splitting in order to arbitrage a more favourable tax outcome. To overcome the undesirable characteristics of these *

The author would like to thank Professor Susan Watson, Chye Ching Huang, and Barnard Hutchinson of the University of Auckland, and Pip England and Pam Kam for their much valued comments. Controversial opinions and any errors remain those of the writer.

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The Victoria University Tax Working Group has released a considerable number of papers as a background to their consideration of the tax reform process including the report by The Centre for Accounting, Governance and Taxation Research, Inland Revenue and New Zealand Treasury A Tax System for New Zealand’s Future (Victoria University of Wellington, 2010).

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At the Tax Working Group conference on 1 December 2009 the final session went through some fiscal modelling. All proposals started with the principle that there should be an alignment between the corporate, trustee and highest individual tax rate. This is the presentation document found at .

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two problems, it is suggested that alignment would be achieved by reducing the highest marginal personal tax rate. This strategy, whilst desirable, has a fiscal impact that is adverse. Treasury estimates that aligning the top individual tax rate to the company rate will cost $1.6 billion. The proposals suggested by the Tax Working Group were premised on a fiscal neutrality basis, with the guiding principle that tax reform could not worsen the budget deficit. Accordingly reductions in personal tax rates are unlikely to be economically or politically feasible without a much larger, and more broadly based tax policy plan involving the raising of revenue to replace revenue. One suggestion to achieve this, which has support from the OECD,3 is to increase New Zealand’s consumption tax (Goods and Services Tax) which is recognised as being one of the most efficient and effective taxes in the OECD. The OECD measures the breadth of consumption tax and the efficiency with which they are collected using a “C-efficiency” ratio. This measures the ratio of indirect tax revenue to consumption, divided by the standard consumption tax rate and reflects the effectiveness of the collection of GST. The Cefficiency ratio for New Zealand is 93.5 per cent, which is the best result in the OECD. Luxembourg is the second best in mid-70 per cent while countries like Australia and the United Kingdom (mid-50 per cent) are significantly behind New Zealand.4 Additionally, the current New Zealand GST rate at 12.5 per cent is the sixth lowest statutory rate in the 29 other countries in the OECD. These figures support the proposition that the New Zealand GST is compliant with the broad base, low rate, mantra which is often counted as a desired tax outcome by fiscal economists. In the year ended June 2008, GST represented 19.7 per cent of the total tax revenue. An increase to the rate of GST is an obvious potential revenue-increasing solution given its high degree of efficiency.5 Although the idea of increasing GST in difficult financial times is unlikely to generate much support

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OECD, Economic Survey of New Zealand 2007, (Paris, 2007) at 113.

4

Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 25.

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The forecast is that an increase of GST will raise $2.64 billion after increased tax transfer payments (although this figure reduces to $1.9 billion in terms of increasing revenue from the private sector alone). See the Tax Working Group paper, “Changing the rate of GST: Fiscal, Efficiency, and Equity considerations” (2009) Index of TWG Papers at 2 < www.victoria.ac.nz/sacl/cagtr/twg/>.

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from policymakers who have been trying to stimulate the economy, 6 it is receiving serious consideration.7 Another suggestion is to introduce a land tax.8 This is another efficient tax, which it is anticipated would be simple to administer and operate.9 But despite obvious revenue producing capabilities,10 a concern is the potential significant fall in land value, which is forecast to occur. It is calculated that a 1 per cent land tax would result is a 16.7 per cent decrease in the value of land.11 It is also problematic that it targets one form of wealth selectively and exclusively and may raise cash flow issues for some owners of that form of asset. Whether correctly or not, the residential rental property sector is being cast as the villain. The investment in housing is worth an estimated $213 billion but it produces negative tax of $150-200 million.12 One suggestion is to use the Risk Free Return Method (RFRM) as an alternative to the ordinary rules for taxing properties. This method, discussed extensively in the Tax Review 2001 Report,13 was certainly not popular when it was first mooted.14 The method operates to tax the net asset value of property with an imputed return calculated as a statutory risk-free rate of return. Described as

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In sharp distinction, the United Kingdom did exactly the opposite, namely reducing VAT from 17.5 per cent to 15 per cent from 1 December 2008.The 15 per cent rate remained until 1 January 2010 when it reverted to its original 17.5 per cent. The Centre for Economics and Business Research (CEBR), which is based in the United Kingdom, released a study on 13 April 2009, which claimed that retail figures for the three months after the cut in VAT show its having the desired effect of stimulating growth. CEBR reported that the temporary 2.5 per cent reduction on December 1st resulted in a £2.1 billion increase in retail turnover. CEBR called for the VAT rate cut to be extended for another six months. Douglas McWilliams, Chief Executive of the CEBR, said: “The figures are clear; the VAT cut is working. The rise in retail growth is even more remarkable given the economic context over this period”. See . The press announcement stated: “In the Pre-Budget Report the Treasury estimated that the VAT cut would reduce tax revenues by £12.5 billion. Our estimate at the time was that this overstated the cost because of the Treasury’s over optimistic growth forecasts. A more realistic figure on the Treasury’s method would have been £11bn. However, this does not take account of the impact of higher corporation tax, lower social expenditure, higher income tax and higher national insurance receipts than would otherwise have been the case. When these are taken into account our estimate of the annual net cost to public finances is £4-5 billion. Our calculations suggest that retail sales for the year are likely to be £8-9 billion higher than would have been the case without the VAT cut. The VAT cut therefore appears to be good value for the taxpayer.”

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In the Tax Working Group conference on 1 December 2009, some of the fiscal modelling had assumed an increase of GST to a rate of 15 per cent (from the current 12.5 per cent).

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See the Victoria University of Wellington Tax Working Group paper “Land Tax: Background Paper” (2009) Index of TWG Papers .

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Ibid, at 3.

10 The forecast net revenue is $3.12 billion, see the Victoria University of Wellington Tax Working Group paper presented by Inland Revenue and New Zealand Treasury, “Land Tax: Background Paper” for Session 3 (Wellington, September 2009) , at 15. 11 Andrew Coleman and Arthur Grimes “Fiscal, Distributional and Efficiency Impacts of Land and Property Taxes” (paper presented to the New Zealand Association of Economists Conference, July 2009). 12 Victoria University Working Group conference, presentation by John Shewan “Base Broadening — taxation of capital income”. See . 13 Robert McLeod, David Patterson, Shirley Jones, Srikanta Chatterjee and Edward Sieper, Tax Review 2001 — Final Paper (New Zealand Treasury, Wellington, 2001) at 27. 14 Ibid, at 30. But the speculation in “Other base broadening and revenue raising ideas”, background paper for session 3 of the Victoria University of Wellington Tax Working Group at 13, is that the publication reaction to the RFRM may have softened.

the “comprehensive reform”15 option, it is estimated the potential annual revenue is $700 million, resulting in a fiscal impact of $850-900 million from this change. If specific targeted changes were made to the taxation of property,16 described as “ad-hoc measures”, the supposed villain can be made to pay its reparatory way. These proposals highlight there certainly are options for the New Zealand Government. In the bridge analogy, additional weight would have to be borne by the GST additions as they bear a higher rate. Modification to the property base “abutment” seems possible and desirable. If income tax is the central span, then it has to be conceded that this system, though far from perfect, has been relatively effective.17 The current problems with the tax system in New Zealand are concerned not only with recent developments with tax transfers and high taxation of mobile tax bases. There are weaknesses in this central span. Not only is it not broad enough, to the extent that it does not tax all types of economic gains, such as capital profits, but it was also flawed right from its very conception. This construction flaw was perhaps due to the 1921 decision of the House of Lords in Blott’s case.18 This article looks at the origin of income tax and, using examples, highlights that these problems are directly attributable to the design flaws in this central span of income tax. When the House of Lords decided Blott’s case, they enshrined “congenital and incurable defects“,19 which are historical systemic problems, into income tax.20 There has been debate about the paternity of income tax.21 If trust law is the father of income tax, it may explain why the offspring has these birth defects. When income is passed to those parties with a life interest in the trust property, (and capital when it is instead passed to remaindermen), this makes perfect sense in trying to deal with distributions in estates and trusts, but it is not a sensible basis for discerning whether an economic gain is subject to tax. This issue was discussed in Ross Parsons in his Wilfrid Fullagar Memorial lecture:22 “The concept of income as it was received from trust law could not be ‘extended’ to include capital gains, for it did not have a notion of income as a gain, or a notion of a capital gain. It knew only a distinction between a flow that belonged to the income beneficiary, and the proceeds of capital that belonged to the capital beneficiary.” While such a discussion is of interest from an historical and academic perspective, it is the anomalies, uncertainties, and the obvious holes in the tax base which cause the practical problems in New Zealand’s tax system. These practical problems include the way that income tax taxes cash flow rather than economic income. There is also the limitation that the definition of income excludes capital income. 15 See Victoria University Working Group conference, presentation by John Shewan,”Base Broadening — taxation of capital income”. See , whereas a series of specific tax changes to property were described by the presenter, John Shewan, as “ad-hoc” measures. 16 Certain measures such as the quarantining, or denying of interest deductions, denying depreciation, or introducing a short term capital gains tax (on sales of rental home within, for example 2 years). 17 See Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 5. 18 IR Commrs v John Blott; IR Commrs v Greenwood (1921) 8 TC 101 at 132; [1921] 2 AC 171 (HL). 19 John Prebble “Income Taxation: A Structure Built on Sand” (2002) 24 Sydney Law Review 301 at 305. 20 In his article, Professor John Prebble was examining the seminal work of Professor Ross Parsons: “Income Taxation — An Institution in Decay” (1986) 3 Australian Tax Forum 233. 21 See John Prebble “Income Taxation: A Structure Built on Sand” 24 Sydney Law Review 301 and the discussion at 307. 22 Ross Parsons: “Income Taxation — An Institution in Decay” (1986) 3 Australian Tax Forum 233 at 235.

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Medieval people were taxed as they crossed the bridge, but maybe their handcart, produce and oxen should also been subject to a toll. Substantial traffic passes over the New Zealand bridge untaxed. An additional significant problem, which John Prebble highlights23 in his article, arises from the peculiarity of income tax, as a body of law, to follow legal form and create a parallel form of existence to commercial reality. It is possible for the legal form to be artificial and quite different from economic substance. Income tax is arbitrary and inadequate in its lack of breadth in the tax base. This article argues that the introduction of a capital gains tax into the New Zealand tax system will have two major benefits. The first is to broaden the base, because, for a given amount of tax revenue, taxing capital less means taxing labour more.24 It is estimated that a capital gains tax could raise $4.5 billion per annum at current tax rates (excluding owner occupied housing).25 The second major benefit is to protect the integrity of the tax system and in doing so assist in dealing with the uncertainties and anomalies, which are discussed further in this article. Introducing a capital gains tax will only ameliorate these anomalies. It is no perfect solution and it has numerous problems, which must be acknowledged.26 Many of these problems can be lessened by careful design of an appropriate capital gains tax system. The discussion here does not extend to the detail of this design. Apart from expanding the tax base, it is argued in this article that the introduction of capital gains tax would unquestionably increase equity and fairness in the tax system. It would also improve the integrity of the system by bringing some certainty to income recognition and overcoming gaming of the current system.

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THE BACKGROUND ECONOMIC CASE

2.1 Persistent Deficits The 2009 Budget27 made it abundantly clear that the New Zealand economy, as a small part of the world economy, was deeply in recession. Faced with declining economic activity, the Minister of Finance was confronted with the unenviable problem of having to balance the competing demands of maintaining and supporting employment through infrastructural and government spending, whilst at the same time trying not to expose the country to excessive government debt. The net result was an operating balance (before gains and losses) forecast to record a deficit of $7.7 billion in 2009/10 and $9.3 billion in 2010/11.

23 John Prebble “Income Taxation: A Structure Built on Sand” 24 Sydney Law Review 301 at 305. 24 H Aaron, L Burman, C Eugene Steuerle Taxing Capital Income (The Urban Institute Press, Washington DC, 2007) at xiv. 25 See the Victoria University of Wellington Tax Working Group paper by Inland Revenue Department and New Zealand Treasury “The Taxation of Capital Gains,(2009) Index of TWG Papers < www.victoria.ac.nz/sacl/cagtr/twg/>. 26 Critics of a capital gains tax point to a problem with realisation-based capital gains taxes because they create significant lock-in problems due to the retention of assets deferring tax liability, concern about administration and compliance particularly due to the length of time that records must be kept, limitations on the types of assets included (perhaps a quarantining for owner occupied homes), and concern over the quantum of tax collected relative to the cost of collection. 27 Drawn from the speech on 28 May 2009 by the Minister of Finance, Hon Bill English, found at the following reference site < www.treasury.govt.nz/budget/2009/speech/b09-speech.pdf>.

By the end of 2009 the picture was a little brighter.28 It appears the world economy is recovering from the most severe recession in more than 60 years, leading to a rerating of New Zealand’s growth expectations. The Half Year Update anticipates that the Crown’s fiscal deficits are expected to be smaller than those anticipated in the 2010 Budget. The revised forecast operating deficit for 2010/11 is $6.7 billion (an improvement of $2.6 billion). Gross Government debt was previously expected to peak at 43 per centof GDP in 2016/17, but the revised forecasts predict a return to surplus in 2016, only one year earlier. At 30 June 2014 the Crown net debt is now expected to be 29 per cent of GDP. Although it has been said “Economists are pessimists: they’ve predicted eight of the last three recessions”,29 the revisions made to the Half Year Update may be, with the benefit of hindsight, either conservative or optimistic. The position of the Government’s operating budget is still highly likely, as a result of the contraction in economic output, to be in consistent deficit for the next five to six years, with a substantial Government debt by the middle of this decade. As recently as 2001, tax experts were lauding the New Zealand tax system and holding up its broad base and low rate policies, with an excellent consumption tax, as a model system. For example Professor Alan Auerbach of the University of California, Berkeley commented:30 “New Zealand’s current tax system already conforms more closely to the standard objectives of taxation than do the tax systems of many other developed countries. Thus New Zealand’s tax system is not obviously in need of major overhaul.” More recently, successive briefings by Treasury and Inland Revenue have pointed to the need for major reforms and highlighted the following problems quite starkly. Peter Vial, a tax director at PricewaterhouseCoopers, after analysing the problems the New Zealand tax system faced, concluded:31 “Although the need for a reformed framework is self-evident, the absence of a long-term framework for reform seems to be a feature of the New Zealand tax system. . . . In the author’s view, the new Government should not only have the medium and long-term reform strategy but also demonstrate its commitment to that strategy by implementing the key aspects of that strategy early in its first term.” The New Zealand Government faces a prolonged series of anticipated fiscal deficits, and problems with the system and structure of the New Zealand income tax base.

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PROBLEMS WITH THE NEW ZEALAND INCOME TAX BASE

It might be argued that problems arising in the New Zealand tax base have only recently been dramatically exposed by the global financial crisis. As long ago as 2005, warnings about problems in the tax system were issued to the previous government. In the Inland Revenue’s Briefing for the Incoming Minister of Revenue — 2005,32 two key policy challenges were identified as follows:

28 See the Half Year Economic and Fiscal Update 2009, and the Budget Policy Statement 2010, found at the following reference site < www.treasury.govt.nz/budget/forecasts/hyefu2009/01> (15 December 2009). 29 Dr Barry Asmus, a Senior Economist with the National Center for Policy Analysis (Dallas and Washington). 30 A Auerbach, Comments on Tax Review 2001, Issues paper, June 2001. 31 Vial, “The sustainability of the New Zealand tax base: Are we at the end of the road for the New Zealand tax system?”(2009) Vol 15:1 New Zealand Journal of Taxation Law and Policy 17, at 45. 32 Inland Revenue Department, Briefing to the Incoming Minister of Revenue — 2005, (Government Printers, Wellington, November 2005), at 7.

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the risk of a reduction in New Zealand’s substantial company tax base due to lower corporate tax rate in other jurisdictions, and New Zealand’s comparatively high corporate tax rate (particularly identified was the lower corporate tax rate in Australia); and



problems arising from the 33 per cent and 39 per cent personal income tax rates, particularly with respect to tax sheltering on income splitting.

The first of these issues was somewhat addressed with a reduction of our own corporate tax rate,33 although this reduction needs a watching brief,34 but the latter income tax rate issue remains as a major structural problem in our system. So these two policy challenges remain as critical issues for the Government in 2010.35 It is possible to categorise three major generic problems with the New Zealand tax system, namely the mobility of the tax base, a lack of horizontal equity and extremely high effective marginal tax rates.

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Generic Problems in the New Zealand Income Tax System

3.1.1 The mobility of the tax base The corporate tax take in New Zealand is comparatively high. New Zealand has the third highest corporate tax burden in the OECD, when company income tax revenue as a percentage of GDP is measured.36 Treasury notes that the New Zealand company tax rate is still among the highest found in the smaller OECD economies.37 The problem with a high company tax rate is that it may “discourage innovation, constrain inbound investment and make New Zealand an unattractive place to base a business, all of which have the potential to reduce productivity and growth.”38 In addition, a higher company tax rate creates an incentive for multi-national organisations to reduce profits (and hence tax) in New Zealand using the practices of transfer pricing and thin capitalisation.39

33 From 33 per cent to 30 per cent with respect to the 2008/2009 income tax year. 34 This still remains an issue and the point was noted in the New Zealand Treasury Paper, Briefing to the Incoming Minister of Finance, Medium-term economic challenges, 2008, (Government Printer, Wellington 2008) as follows: “Ensure average tax rates on corporate income don’t get too far out of alignment with other countries and so encourage businesses to locate and invest in New Zealand.” 35 At an address to the University of Auckland Business School, the chairman of PricewaterhouseCoopers, John Shewan, described features of the New Zealand tax base as being highly mobile, and noted that companies can largely determine through location of functions and the debt equity structure where tax is paid. Note also that New Zealand has one of the most mobile labour forces in the world, he went on to describe these two features as “the sharp end of globalisation”. He noted that total tax revenue for the nine months to 31 March 2009 in comparison to pre-election forecasts was down by $1.9 billion, with the bulk of this, some $1 billion due to reduction in the corporate tax take. 36 Per a 2006 OECD report highlighted in the Inland Revenue Department, Briefing to the Incoming Minister of Revenue — 2005, (Government Printers, Wellington, November 2005) at 27. 37 New Zealand Treasury Paper, Briefing to the Incoming Minister of Finance, Medium-term economic challenges, 2008, (Government Printer, Wellington, 2008) at 17. 38 Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 34. 39 New Zealand has rules contained in subparts GC and FE of the Income Tax Act 2007 designed to reduce the incidence of these practices, but it is noted that the Inland Revenue do not regard these measures as being “completely effective” as indicated in the Inland Revenue’s report to the Minister, see Inland Revenue Department, Briefing to the Incoming Minister of Revenue — 2005, (Government Printers, Wellington, November 2005), at 34.

In particular New Zealand is concerned with issues arising from the extremely significant (54.5 per cent)40 foreign direct investment coming from Australia. The principal reason for a vigilant focus on Australian investment in New Zealand arises from the incentive inherent in an imputation system, which creates a natural bias towards the payment of domestic corporate tax. In other words Australian companies will prefer to pay Australian tax on their profits so that they can attach franking credits to their (mostly Australian) shareholders. Foreign tax, that is New Zealand tax to Australian companies, is not available as a credit, leading to a double taxation outcome, and thus to a tax planning incentive to stream profits from New Zealand companies, pre-tax, to Australia. New Zealand has made a submission on the mutual recognition of tax credits in the current review undertaken by the Australian government “Australian Future Tax System Tax Review”.41 Additionally, whilst the Australian and the New Zealand company tax rates are currently the same, the Treasury Secretary, John Whitehead acknowledges that:42 “The pressure on us will be even stronger if the review of Australia’s tax system currently underway leads to further company tax cuts across the Tasman.” Another area of considerable concern is the proportion of tax collected that is personal income tax. New Zealand raises 14.9 per cent of GDP in personal tax collections; again the third highest amount of tax collected in the OECD expressed as a percentage.43 In today’s global economy, people are highly mobile, and New Zealand’s diaspora is the second largest in the OECD after Ireland in relative terms.44 The way the burden of personal tax falls is highlighted in the 2009 budget.45 The following table in schedule 1 illustrates that 14 per cent of taxpayers pay 53 per cent of the tax, whilst the top one per cent pay 15 per cent of the tax.46 Schedule 1 Top Per Cent of Taxpayers

Per Cent of Tax paid 14

53

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36

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40 Statistics New Zealand, referred to in Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008), at 35. 41 . 42 Reported in the New Zealand Herald, 3 June 2009, from a speech to the Institute of Directors.The Henry Tax Review or “ Australia’s future tax system” is due to report to the Treasurer of Australia in December 2009. Professor Bob Deutsch of the University of New South Wales notes in his article “Tax Reform: the never-ending saga”, in the publication Atax Matters, that a well telescoped reform will see a possible reduction in the corporate tax rate from the current 30 per cent to a 25 per cent rate. 43 Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008), at 26. 44 N 35, at 15. 45 See the full schedule at . 46 The features of New Zealand personal tax rates are not that they are particularly high in comparison to other OECD countries but, in the absence of any concessions or discretion, are very high in their effective tax rate. It should also be noted that the schedule in the Budget precedes an analysis that takes into account the effect of “Working for family tax credits”, so the percentage of tax paid by higher earners is likely to be even higher (and in fact significantly higher) than those indicated in the Budget documents.

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Given that the tax burden falls on a small number of highly skilled people, it is no wonder that Treasury’s recommendation to the incoming Minister of Finance was as follows:47 “Policy direction that will contribute to productivity improvements and revenue sustainability include: • reducing high marginal personal tax rates in order to improve incentives for labour supply, entrepreneurship and the retention of skilled labour with a New Zealand”. In summary, New Zealand is at the forefront of the OECD in its reliance on highly mobile tax bases, and must be at risk, especially given our close geographic proximity to Australia. This is why Treasury has suggested: “Over the medium term, there is a need to shift taxes from bases that are internationally mobile and have the most detrimental impact on growth to tax bases that are less mobile and less damaging to productivity growth”.48

3.1.2 A lack of horizontal equity Horizontal equity is a principle used to judge the fairness of taxes, which holds that taxpayers with the same income should pay the same amount in taxes.49 It is an obvious point that in the current income tax year the tax rates are “all over the place”. So an individual is subject to tax at 38 per cent at their marginal income, the company in which he or she invests, or carries out his or her business, is subject to tax at 30 per cent, whilst the family trust of which he or she is a beneficiary is subject to tax at 33 per cent. The investments in which he or she invests are subject to the portfolio investor regime, which provides that a maximum rate of 30 per cent is charged on those investment profits. This regime also has the favourable concession that profits made on trading in shares are not subject to tax, in sharp contrast to the position of an individual trading in those shares. The proliferation of different tax rates has led, based on evidence assembled by the Inland Revenue,50 to the conclusion, that:51 “. . . current tax rules provide considerable scope for taxpayers to use companies, trusts and other entities to shelter their income from high rates of personal taxation. There is continued evidence that they are doing so, and recent reductions in the company tax rate and the capping of tax rates for [Portfolio Investment Entities] have increased both the pressure and the opportunity to tax sheltering.” In addition to the not inconsiderable question of whether it is fair to have a system whereby some taxpayers can use income earning arbitrage situations to divert income into more tax efficient entities, there is the question as to whether it is an efficient use of time and energy to spend resources diverting such income. Additionally, the question of what is unacceptable tax avoidance becomes incredibly important. The legitimate use of different business structures is generally viewed as being on the 47 N 35, at 17. 48 Ibid. 49 Joseph Cordes, Robert Ebel, and Jane Gravelle (ed) The Encyclopaedia of Taxation and Tax Policy (Urban Institute Press, Washington DC, 1999). 50 Such evidence being the aggregate taxable income of individuals which shows that a disproportionate number of individuals have income bands just at the level before graduating on to the next highest tax rate, the amount of imputation credits which accumulate in companies and the growth of trustees income in trusts (see Note 4, at pages 36 to 40). 51 Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 39.

acceptable side of tax planning, whilst the use of business structures in a way that Parliament would not have contemplated may be viewed as being able to be struck down and voided by the Commissioner.52 However it is always undesirable to have the Commissioner in a position where he needs to invoke the anti-avoidance rules to attack the use of business structures. In addition to the lack of certainty for taxpayers, significant Inland Revenue and taxpayer resources are diverted; sometimes with little prospect that the matter can be resolved satisfactorily for the Commissioner.53 It is therefore not surprising that the Minister of Revenue, Hon Peter Dunne, recently stated in an address:54 “Alignment of company, top personal and trustee tax rates is a medium- term goal on the work programme . . . I have long advocated a 30/30/30 per cent alignment of these rates as a simple solution to problems such as individuals using companies and trusts to shelter personal income.” However, he also noted, “Our economic and fiscal position will clearly limit our ability to reach this goal in the short term unless there is a quick turnaround in conditions.”55

3.1.3 Extremely high effective marginal tax rates The third generic problem in the New Zealand tax system comes about as a result of the very high effective marginal tax rates (EMTRs). EMTRs measure the proportion of an additional dollar of income that is lost either through taxation or in some other way, such as an abatement of social assistance or income contingent payments or repayments. The major contributor to this problem is the Working for Families tax credit scheme. The scheme is designed to provide assistance for families with children. It does so by adjusting tax payments sometimes to the extent that some people pay “negative amounts of tax”, that is, they receive larger transfer payments than they pay in income tax. As income increases, the amount of the assistance abates. The rate of abatement can be as high as 101.3 per cent56 with a consequence that an individual earning an income of an extra $1 would have $1.01 taken from them. While this is an extreme example, there are in fact a significant numbers of taxpayers who suffer very high EMTRs.57

52 See the recent New Zealand Supreme Court decisions of Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 289 (SC) and Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 359 (SC) and then the subsequent High Court decisions BNZ Investments Limited & Ors v Commissioner of Inland Revenue (2009) 24 NZTC 23,582, Westpac Banking Corporation v Commissioner of Inland Revenue (2009) 24 NZTC 23,340 and Penny v Commissioner of Inland Revenue; Hooper v Commissioner of Inland Revenue (2009) 24 NZTC 23,406. 53 See Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 41, where the Inland Revenue observes that if an individual who has $100,000 of income taxed at the rate of 39 per cent, decides to borrow $1 million at a 10 per cent interest rate and lend it through a PIE which was deriving a 10 per cent return, then the individual would be entitled to a deduction for $100,000, reducing their personal tax liability by $39,000, whilst the PIE income would be subject to tax at 30 per cent (or $30,000 ). The scheme would therefore produce a net tax benefit of $9,000. The Inland Revenue doubts whether the scheme could be struck down as tax avoidance without much greater clarification of that term by the Courts (note: subsequent to this briefing the Supreme Court has handed down its decision in Ben Nevis Forestry Ventures Ltd and Ors v Commissioner of Inland Revenue [2008] NZSC 115). 54 Peter Dunne, Revenue Minister “Tax Policy Update” (NZ Institute of Chartered Accountants, Wairarapa, 15 May 2009). 55 Ibid. 56 See Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 30, where a table shows the effective marginal tax rates, and illustrates that, for example a one-adult family with one child earning an income between $10,660 and $21,658 would receive this percentage rate of abatement.

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There are at least two significant problems arising from these high EMTRs. The first is of course that there is, for any taxpayer, a limited incentive to earn additional income, if the net benefit to the individual is very small, after the impact of suffering the EMTR. The second is that there is, with any egregious rate of tax, significant scope for tax planning. The outcome is that an individual’s income is not increased, but there might be some increase in income to other business entities associated with individuals. All of this is undesirable and inefficient due to the cost of taxpayers devoting time and expense to the establishment of commercial structures that have a tax-driven purpose.58

3.2

Systemic Problems with Income Tax — The inadequacies of the income tax base

3.2.1 Comparing taxable income and economic income Henry Simons’ book Personal Income Taxation: the Definition of Income as a Problem of Fiscal Policy59 put forward a notion of economic income, which revolutionised the thinking of fiscal economists. It has been said that for these fiscal economists, “Simons’ writing in their eyes ranks with the scriptures.”60 What Simon outlined was the concept of looking at “wealth” at the end of the period and subtracting “wealth” at the beginning of the period to determine net income:61 “Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question . . . The sine qua non of income as gain as our courts have recognised in their more lucid moments — and gain to someone during a specified time interval . . . This position, if tenable, must suggest the folly of describing income as a flow and, more emphatically of regarding it as a quantity of goods, services, receipts, fruits, etc.” The key difference in looking at income in this way is the departure from an approach that examines income as a flow of inward consideration exclusively (like a receipt of cash). Instead, Simons embraces a more holistic examination of the value of property rights remaining with the taxpayer after the receipt of such inward flows. The best practical example of this is the purchase of a share “cum dividend”. In most situations, the market will value the share after payment of the dividend at a lower value to reflect the fact that the share is now “ex dividend”. Accordingly, when one looks at the change in value of the store of property rights together with the receipt of the dividend, the position of the shareholder remains unchanged in terms of their net wealth. In other words, namely those of Parsons:62 “The flow may be an accretion to economic power . . . but often it will not be.

57 See Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008) at 31, where the Inland Revenue record that 668,450 people are on tax rates of 30 to 40 per cent, 383,250 people are on tax rates of 40 to 50 per cent and 167,250 people are on tax rates above 50 per cent. 58 Several examples of these tax planning techniques are given in the background paper for the VUW Tax Working Group: “Design of the Income Tax/Transfer System” (2009) Index of TWG Papers , at pages 14 and 15. Page 15 also refers to the fact that Inland Revenue have identified that there are 9700 families with rental losses who receives Working for Families tax credits. 59 H Simons Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy, (University of Chicago Press, Chicago, 1938). 60 Ross Parsons “Income Taxation — An Institution in Decay?” (1986) 3 Australian Tax Forum 233, at 237. 61 Henry Simons Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (University of Chicago Press, Chicago, 1938) at 50-51. 62 Ross Parsons “Income Taxation — An Institution in Decay?” (1986) 3 Australian Tax Forum 233 at 237.

“There has only been a conversion to cash of some part of the new owner’s property rights — the right position — which one might expect to be reflected in a decline in the value of his property rights that remain following the conversion.” However Simons was forced to concede that a pure application of this principle could not be applied in the determination of year-to-year assessments, but rather that realised gains should be recognised:63 “Outright abandonment of the realisation criterion would be utter folly; no workable scheme can require that taxpayers reappraise and report all their assets annually; and, while this procedure is implied by the underlying definition of income, it is quite unnecessary to effective application of that definition. . . . “The recognition of capital gains and losses may wisely be postponed while the property remains in an owner’s possession; a postponement should not be allowed to eventuate in evasion. Thus all accrued gains must be taxed as income to the individual owner whenever the property passes out of his hands, whether by sale or by gift, and as income to his estate when the property is transferred to his heirs or legatees.” That we measure income under our current system in quite a different way, and much less comprehensively, than the economic income proposed by Simons, is largely due to a combination of history, the process of the courts and practical administration of business concepts (like the concept of annual accounting for income). The widely held view64 is that Judges, confronted with the need to determine what was meant by income in the statute, and without any further statutory assistance, drew upon trust law, in particular, to ascertain the meaning of income. In a case concerning whether the bonus issue of shares should be considered to be capital or income the majority in the House of Lords in IR Commrs v John Blott; IR Commrs v Greenwood,65 concluded that a bonus issue of shares was not income for the purposes of the United Kingdom income tax. In Parsons’ view their Lordships reached their conclusion relying on the principle espoused in the earlier trust law case of Bouche v Sproule.66 This principle was that the remainderman was entitled to bonus shares, not the life tenant, unless the trust instrument made it clear that it should be otherwise. Therefore in the Blott decision, the owner of shares who was to receive the bonus issue did not derive income unless the income tax statute specifically prescribed that it was so.

63 H Simons Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (University of Chicago Press, Chicago, 1938) at 208. 64 In D Caygill Consultative Document on the Taxation of Income from Capital (Government Printer, Wellington, 1989) the New Zealand tax system is described: “When income tax was first introduced, it was left to the courts to define what was meant by income. In the absence of statutory guidance, the judiciary turned to trust law and other precedents for an income definition. As a result, certain kinds of income, especially most increases in the value of assets other than trading stock, were excluded from the tax base. These excluded types of income fall under the general heading of ‘income on capital account’.” This was also noted earlier in the Royal Commission on Social Policy “Towards a Fair and Just Society” (Government Printer, Wellington, 1988): “. . . in the administration of the New Zealand tax system with full trust law concepts. They differentiate the interests of the life tenant (entitled to income) from the interests of the remainderman (entitled to capital and so to the realisation of capital assets of the trust) . . . With hindsight it seems surprising the concept of trust law were considered an appropriate substitute for a direct focus on economic efficiency and equity concerns and the raising of taxes.” (emphasis added). The part emphasised above was noted by Sir Ivor Richardson in his address to the University of Canterbury on 13 March 1989, “The Concept of Income and Tax Policy” (1989) 4 Canta LR 203 at 207. 65 IR Commrs v John Blott; IR Commrs v Greenwood (1921) 8 TC 101 at p 132; [1921] 2 AC 171 (HL). 66 Bouche v Sproule (1887) 12 App Cas 385.

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John Prebble took issue with Parsons’ analysis of the Blott case. Prebble argued that the majority independently reached their conclusion as a matter of principle and then confirmed the outcome using Bouche v Sproule as authority. On his reading of the case, the two branches of law, trust and income tax, draw separately on the same concept of income. They coexist rather than one being dependent on the other. The judgment of Viscount Finlay (one of the three Viscounts in the majority) supports Prebble’s view. Viscount Finlay indicates that his approach was to examine the nature of the property on first principles to see if it were income or capital:67 “The liability follows from the nature of the property, and it seems impossible to me to say that the answer to the question whether it is income or not is to depend upon the purpose with which the question is asked.” However, in the author’s view, the decisions of Viscounts Haldane and Cave, if anything, support Parsons’ proposition. Viscount Haldane draws a much more direct connection with the decision in Bouche v Sproule:68 “. . . I do not think that the matter is one which rests merely on principle. It appears to me that the Court of Appeal have rightly held that the question is concluded inversely to the contention of the Crown by the decision in this House in Bouche v Sproule.” And Viscount Cave also seems to draw directly on the earlier House of Lords decision:69 “With regard to the authorities, Bouche v Sproule appears to me to be directly in point. It is true that the actual decision related to the rights inter se of a tenant for life and remainderman under a will; but for the purpose of deciding that question it was necessary to determine whether a transaction such as it is here in question was or was not a distribution of income.” When the two dissenting Lords (Lord Dunedin and Lord Sumner) are added into the equation, three decisions that cast doubt on whether the House of Lords in the Blott case were following the decision of Bouche v Sproule. So, if the application of Bouche v Sproule to the Blott decision is part of the case’s ratio decidendi, then Parsons is correct but, if this application is part of the obiter dicta of the case, then Prebble is right. In the author’s view the two majority decisions (Viscounts Cave and Haldane) made the adoption of trust law part of the ratio of the case. Unlike Parsons, Prebble’s argument was not solely based on the Blott decision. Prebble analysed the history of income tax,70 and concluded that, when it was introduced in the United Kingdom in 1799,71 it adopted a basis of a regular, annual flow, which had been a feature of the Triple Assessment of 1798.72 Seen in this context, namely legislation that was operating on one of the most important financial concerns of human kind, the removal of some part of a person’s wealth to fund the state, it seems incomprehensible that a definition of income could arise 120 years after the introduction of the concept in the statute.

67 IR Commrs v John Blott; IR Commrs v Greenwood (1921) 8 TC 101 at p 132; [1921] 2 AC 171 (HL) at 197. 68 Ibid, at 185. 69 Ibid, at 201. 70 Ibid, at 303. 71 (1799) 39 Geo III, c13. 72 (1798) 39 Geo III, c16.

Whether income as a judicial concept owes its origins to trust law, or simply coexists independently, seems to matter less than the real concerns about the judicial concept of income. Both Parsons and Prebble are aligned in their description of these shortcomings. These concerns are detailed in the Prebble article.73 In summary, the first problem with the judicial concept is that it sees income as a flow and not an economic gain. Secondly, as a consequence of the first problem, it taxes flows that do not actually produce gains. Thirdly, it does not tax all gains but excludes capital gains. Lastly, it relies on legal transactions rather than on underlying economic movements. These four issues are explored in greater detail in the following Part of this article. The courts in New Zealand and Australia followed the United Kingdom decisions including Blott’s case74 and the problems set out above became embedded in our system. Irrespective of whether income tax owes its origin to these trust cases, the real problem remains as set out in the 1989 Consultative Document on the Taxation of Income from Capital:75 “The result is that some forms of income are untaxed and sometimes people are taxed on income which in economic terms they do not derive. Depending upon the circumstances and the nature of the income, therefore, the Income Tax Act may over- or under-estimate the level of a person’s income.” In addition to this under and over taxation, there is clearly an incentive, and a strong incentive, to structure one’s affairs in order to achieve the most advantageous tax position possible. Let us now examine New Zealand examples of those problems referred to above, which Prebble refers to as “congenital defects”.76

3.2.2 Income Tax is a game 77 Ross Parsons wrote:78 “A tax will not have respect, and will not deserve respect, unless it is coherent in principle and has a claim to fairness. If the income tax ever enjoyed respect, it has lost that respect. Being taxed involves playing some kind of game involving forfeits, which the unwary or ill-advised may expect defeat.” This is also true of New Zealand’s income tax system and in playing the game the dice have been loaded in the favour of the knowledgeable or the well advised.

(1) Judicial concept of Income (or expenses) not equating with economic gains (or expenditure) As discussed above, it is possible to derive no economic income, and yet still be subject to tax on income as defined in the Income Tax Act 2007. The best way to illustrate this is to look at various transactions which resulted in income flow for tax purposes whilst generating an economic loss in respect of a “capital” asset. 73 IR Commrs v John Blott; IR Commrs v Greenwood (1921) 8 TC 101 at p 132; [1921] 2 AC 171 (HL) at 301 and 302. 74 The decision in Blott was followed by Stringer J in the New Zealand Court of Appeal decision of MacFarlane v C of T [1923] NZLR 801 (CA), in a case concerning the valuation of sheep and cattle (surprising for New Zealand) and was accepted by Dixons CJ in the Australian High Court in WE Fuller Pty Ltd (1959) 101CLR 403. 75 David Caygill, “Consultative Document on the Taxation of Income from Capital” (Government Printer, Wellington, 1989) at [2.2.2]. 76 John Prebble “Income Taxation: A Structure Built on Sand” 24 Sydney Law Review 301. 77 H Simons Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (University of Chicago Press, Chicago, 1938). This is the heading given to the section at 258. 78 H Simons Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (University of Chicago Press, Chicago, 1938), at 258.

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To illustrate this concept we need look no further than to the example of an annuity. An annuity is a fixed annual sum payable either for a defined time or by reference to the life of a person. Under section CC 5(1) of the Income Tax Act “an annuity derived by a person is income of the person”.79 It is normally purchased by using a capital sum and in Henry Simons’ terms this would result in the disposition of property rights with the acquisition of periodic income flow. In economic terms the income would be significantly less than that taxed under s CC 5 (this is due to the fact that the property rights disposed of would be subtracted from the income received in determining the net economic income). Another example is the purchase of a share, which is “cum dividend”. In such circumstances the dividend flow will be taxed, 80 but the loss in economic value inherent in the share, and usually reflected in the “ex dividend” share price, is ignored under the legislation. A further example is found in the area of royalties. A royalty stream or flow will be taxed as income81 whilst the purchase of the royalty producing asset which may diminish in value over time may not result in an income tax deduction.82 In some instances, the Income Tax Act will prohibit a deduction, even though the expense was clearly incurred in carrying on business, or in the derivation of gross income.83 This prohibition arises because of the capital nature of the expense84 and is due to a quest for symmetry in the Income Tax Act (ie if capital gains are not assessed then capital expenses should therefore not be deductible). A classic example of this type of expenditure arose in Milburn New Zealand Ltd v CIR.85 In this case Wild J held that expenditure incurred to obtain consents and licences relating to possible sites for Milburn’s concrete business must be viewed as capital expenditure and not deductible. This was so even though the expenditure incurred (which was significant) did not, on one site, result in the resource consent being granted. In other words, there was no capital asset that existed or indeed could be recognised in the accounts of Milburn. Economically, Milburn had expended money and had not secured any valuable property rights, but they could not deduct their expenditure.86

(2) By not taxing all gains creates anomalies In Pacific Rendezvous Limited v CIR,87 the Court of Appeal was faced with a significant issue relating to a potential apportionment of interest expenditure. Pacific Rendezvous Limited was a motel business 79 See for instance the common law development of this principle in the House of Lords decisions: Lady Foley v Fletcher [1903] AC 299 (HL); (1858) 157 ER 678 and Secretary of State in Council of India v Scoble [1903] AC 299 (HL); (1903) 4 TC 618. Note that this doesn’t relate to annuities issued by insurance companies in New Zealand, which have a different regime. 80 See s CD 1 Income Tax Act 2007. 81 See s CC 9 Income Tax Act 2007. 82 In some circumstances it may be possible that the royalty producing asset is “fixed life intangible property” as defined in s EE 67 of the legislation and hence constitute depreciable assets for which a depreciation deduction may be available under the Income Tax Act, but in many other cases it will not qualify and therefore would not be depreciable intangible property (defined in s EE 62) and therefore non depreciable. 83 And therefore meets the requirements of the general permission s DA 1 of the Income Tax 2007. 84 See s DA 2 (1) of the Income Tax Act 2007, which contains the capital limitation. 85 Milburn New Zealand Ltd v CIR (2001) 20 NZTC 17,017 (HC). 86 Under s DB 19 expenses for failed or withdrawn applications for resource consent may be expressly deductible. This concession was introduced after the Milburn case, effective as at 1 October 2005. 87 Pacific Rendezvous Limited V CIR (1986) 8 NZTC 5,146.

situated on a 25-acre beach site at Tutukaka. The business borrowed money in order to increase capacity (from 19 units to 30 units) and improve existing facilities (by adding a swimming pool and other facilities). The reason for the borrowing, it was asserted by the Commissioner, was principally directed towards maximising the capital profit but also contemplated the dual purpose of the production of additional gross income. The Commissioner issued assessments, which allowed only 25 per cent of the interest paid to be deductible, with the balance being disallowed because the interest was incurred primarily for the production of a non-assessable capital profit. In the High Court the approach of the Commissioner and the resultant assessments were confirmed. When the taxpayer appealed to the Court of Appeal these assessments were set aside. The Court was unanimous in its decision, although all three judges88 gave individual judgements. In essence, the view of the Court was that the borrowings were used in the employment of capital that was fully committed to the income earning process. As Richardson J said:89 “This is because, if the focus is on the employment of the capital and income earning process with the borrowings being represented here in the physical assets of the motel business, it is impossible to escape the conclusion that in each of the income periods those assets and that borrowed capital were employed in the production of the assessable income.” His Honour went on to consider whether it mattered that the company also had in mind that it might be able to make a significant capital profit as a result of this investment. In his view, and in the view of his fellow judges, the answer was no:90 “Is there a principal justification under the Statute for drawing a distinction between income earning investments involving the employment of borrowed funds where the taxpayer’s only purpose is to gain income on the one hand, and investments in similar assets were similar borrowings with a taxpayer also aims for capital advantages on the other?. . . I can see no justification from a loss of that kind which would seem to involve shifting statutory focus away from how the capital was actually employed in the income year in which the interest in question was incurred, to the underlying purpose of the taxpayer and raising and utilising the loan monies.” Thus the vexed question of whether interest expended for a dual purpose was fully deductible was resolved in favour of the taxpayer.91 While this was clearly the right result in terms of the statute, it is rather a remarkable result from a commonsense perspective when one considers the asymmetry of expenditure that is fully deductible when the principal purpose of the expenditure is to derive a nonassessable gain. While this feature is not inherently a defect in the concept of income tax per se, it is an example of the type of arbitrary rule which must be used in circumstances where there is taxation of only some part of the realised economic gains and not the whole. Taxpayers investing in shares or real property, when their interest expense is greater than the income stream (negative gearing), can still claim a full deduction for the interest expense even when logically the economic gain they are really or substantially pursuing is a non-taxable capital profit. Not taxing the capital profits of investors in real property is even further advanced by the utilisation of depreciation allowances. Depreciation in respect of buildings and chattels generates a non-cash 88 Cooke P, Richardson J, and Somers J. 89 Pacific Rendezvous Limited V CIR (1986) 8 NZTC 5,146 at 5,151. 90 Ibid. 91 The position with respect to deductibility of expenditure for interest expense for companies is further clarified so that in many cases a company can deduct its interest expense without even the need to have a nexus with income (see s DB 7).

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deduction, intended of course to compensate for declining asset values due to fair wear and tear. However, in the words of the New Zealand Deputy Commissioner in charge of tax policy, Robin Oliver:92 “Unfortunately, the use of depreciation as an allowance creates an asymmetry in a tax system that does not tax capital gains. Declines in asset values give rise to deductions while increases are taxfree.”

(3) Relies on Legal Transactions The rules relating to the distinction between capital and revenue have been developed and refined through a series of landmark income tax cases.93 These rules can be viewed as arbitrary and difficult to discern as the following examples indicate. Let us imagine that a company acquired a printing business. When it signed the purchase agreement it was agreed that the purchaser had the benefit of five months of trading profit prior to the final transfer of ownership. Would an ordinary taxpayer think that such a sum ($7 million in 1990) would be a capital receipt and not viewed as taxable income?94 An accountant would tell the taxpayer that the purchaser would recognise this amount as accounting income because it was probable that the purchaser would receive it, and it was capable of reliable measurement.95 Would the taxpayer be able to reconcile the approach which assessed a compensation payment made to secure a trade tie,96 to a payment made on capital account to induce the entry into a lease agreement?97 Why is one taxable, and the other not, even though both were calculated as essentially economic compensation, first in respect of the payments to the petrol retailers of earnings in respect of each litre of petrol, and secondly, as a form of rent subsidy. It is also difficult to explain to an ordinary taxpayer why the principle expressed in the Californian Copper Syndicate,98 which has consistently been applied in the taxation of gains on the realisation of investments by banks and insurance companies,99 was not applied when the National Insurance company made a $67 million tax-free capital gain on the sale of its shares in Southpac.100

92 Herbert Grubel “International evidence on the effects of having no capital gains taxes” (Symposium on Capital Gains, Fraser Institute, Vancouver, 2000), at 81. 93 These are too numerous to detail so perhaps reference might be made to the Privy Council decision in BP Australia Ltd v Commissioner of Taxation of the Commonwealth Australia [1966] AC 224, and the earlier High Court of Australia decision Sun Newspapers Ltd v The Federal Commissioner of Taxation (1938) 61 CLR 337, since both these decisions are regarded as leading judgements and particularly helpful in articulating the tests for the capital revenue distinction. 94 GPO Holdings Ltd v CIR (1996) 17 NZTC 12,429 (HC). 95 Ibid, at [44]. 96 Birkdale Service Station Ltd [2001] 1 NZLR 293 (CA). 97 Commissioner of Inland Revenue v Wattie (1998) 18 NZTC 13,991 (PC). 98 Californian Copper Syndicate (Limited and Reduced) v Harris (Surveyor of Taxes) (1904) 5 TC 159. 99 Punjab Co-operative Bank Ltd v Income Tax Commissioner [1940] AC 1055 (PC), CIR v Auckland Savings Bank [1971) NZLR 569 (CA), Union Bank of Australia v C of T [1920] NZLR 649 (SC) and AA Finance Ltd v CIR (1994) 16 NZTC 11,383 (CA). 100 CIR v National Insurance Co of New Zealand Ltd (1999) 19 NZTC 15,135 (CA).

To summarise, the ordinary taxpayer may conclude that there is a high possibility of slightly different factual situations resulting in significantly different tax consequences.101 This indeed was the advice from the Privy Council delivered by Lord Pearce in BP Australia Ltd:102 “The solution to the problem is not found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other . . . the line of distinction is often hard to draw in borderline cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree.” This subtle variance of factual situation provides taxpayers with possibility of engineering their tax outcomes. This can occur in two ways. The first is by allowing the characterisation of different transactions in different legal forms, irrespective of the economic position. Secondly, a clever taxpayer can manipulate factual matters to achieve a desired capital or revenue characterisation.

3.3

The Extension of Statutory Income

The 1989 Consultative Document103 highlighted that income from capital could be categorised so as to fall into three categories. The first is ordinary income, which is income under ordinary concepts as interpreted through judicial process. The second is where a capital profit is made in disposing of an asset other than in the course of the business. Much of the confusion arises in trying to ascertain in which of the first two categories that gain fell. The third category is where income is derived, which would not ordinarily be taxed as it is on capital account, but which, through explicit provisions in the Income Tax Act, Parliament has decreed will be subject to tax. Parliament has expanded the original trust based concept of income and capital striking at various transactions and leaving others untouched. The effect is to make the arbitrary distinctions even more so. There are many instances in the Income Tax Act where the effect of converting capital gains to statutory income is illustrated and where the statute details where the brightline is to be drawn.104 When a taxpayer buys personal property such as shares, the taxpayer should be careful to document the reasons for the purchase, such as the receipt of dividend income, in order to demonstrate a dominant purpose in the decision to invest in those shares. This is so the taxpayer can discharge the statutory onus to prove that the shares were not purchased with the dominant purpose of sale.105 But of course, as Richardson J reflected upon in National Distributors Ltd, the subjective purposes of the taxpayer will be assessed and, in the totality of circumstances, that will include the nature of the asset, 101 Indeed he or she may conclude that there is a major deficiency in the tax system. This would be reflecting the comments made in D Caygill Consultative Document on the Taxation of Income from Capital (Government Printer, Wellington, 1989) which said: “First, certain forms of income from capital presently escape taxation for reasons which are often capricious, are likely to be arbitrary and will almost certainly be divorced from underlying economic realities.” 102 BP Australia Ltd v Commissioner of Taxation of the Commonwealth Australia [1966] AC 224 at 264. 103 Caygill, “Consultative Document on the Taxation of Income from Capital” (Government Printer, Wellington, 1989). 104 The principal provisions in this area of the Income Tax Act 2007 are concerned with land and personal property. The provisions relating to land sales are contained in ss CB 6-23, whilst the provisions relating to personal property are in ss CB 4 and 5. Other provisions capture gains from any profit-making undertaking or scheme (s CB 3), provisions to do with the sale of timber or land with standing timber (ss CB 24 and 25), minerals (s CB 29), patent rights (s CB 30), stolen property (s CB 32), and emission trading (ETS) units (s CB 36). 105 Commissioner of Inland Revenue v National Distributors Ltd (1989) 11 NZTC 6,346 (CA), where Richardson J held: “If a taxpayer’s dominant purpose in acquiring the property is to sell it in the future at a price which, allowing for inflation, corresponds with or is better than its price at the time of purchase, his statutory purpose is to sell the property even though his motive is to protect savings from inflation.”

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his or her vocation, the circumstances of the purchase, the number of similar transactions and the length of time that the property was held and the circumstances involving its use and disposal.106 A property investor needs to retain, and not sell, certain types of real property for ten years or more in order to ensure that the statutory provisions do not result in the gain being assessed.107 The need for the complex rules of association arise because Parliament has decreed that certain types of people will be assessed on their capital gains. The so-called associated person rules apply to categories of taxpayers where an association with those involved in the business of erecting buildings, dealing in land or developing land or dividing land and lots, create a taint, so that any profits made by such a taxpayer would be subject to assessment.108 How difficult it must be to administer these provisions given the need for the tax administrators to second-guess a person’s purpose or intention, and then genuinely hold the view that they have the requisite statutory purpose in order to invoke the machinery of the Act after the relevant gain has been identified. One of the problems in the current income tax system is brought about by the hugely different conceptual basis of different regimes. Fundamentally the accrual rules that tax financial arrangements109 have, as their basis, are similar to Henry Simons’ definition of income. Accordingly, and upon an accrual basis (or occasionally on a market to market basis),110 economic gains are taxed. Outside the accrual rules taxation on an economic basis does not necessarily occur. This leads to similar transactions having vastly different tax consequences. For example, a foreign exchange gain made on an Australian dollar-denominated deposit account may be subject to tax.111 However, a foreign exchange gain made in respect of a holding in Australian dollar denominated shares is unlikely to be subject to New Zealand tax per se.112 Add to the picture of the exemption for realised capital gains and full accrual taxation for financial arrangements, an imputed return regime found in the foreign investment fund rules,113 and the arbitrary mix of different taxation regimes and jurisdictions illustrates the opportunity for tax planning through the use of legal form over economic substance when investment products are structured to achieve the “right” tax outcome.

4

POLICY REASONS FOR CAPITAL GAINS

The controversy associated with the suggestion that capital gains should be subject to tax in New Zealand is encapsulated by the statement that Treasury Secretary, John Whitehead, made when he recently called for its introduction. In an address to the Institute of Directors, he said:114 106 These are all factors which Richardson J considered as being the objective evidence in National Distributors Ltd (ibid at 6,351). 107 See for instance ss CB 9, CB 10, CB 11, CB 12, and CB 14 of the Income Tax Act 2007. 108 Sections CB 9, CB 10, and CB 11 of the Income Tax Act 2007. 109 See subpart EW of the Income Tax Act 2007. 110 The method used, for example in s EW 18 of the Income Tax Act 2007, which is based upon the increase (or decrease) in the market value of a financial instrument in an income tax year. 111 This assumes that the deposit account does not fall into the category of being an accepted financial arrangement under s EW 5 of the Income Tax Act 2007. 112 Although the foreign exchange gain could form part of the opening market value for the purposes of the foreign investment fund rules if the fair dividend rate method is used to compute income (see s EX 52 of the Income Tax Act 2007). 113 Section EX 46 of the Income Tax Act 2007. 114 Inland Revenue Department, Briefing to the Incoming Minister of Revenue, (Government Printer, Wellington, 2008).

“At the risk of being chased down by an angry crowd with pitchforks and flaming torches, yes this should include consideration of moving the boundaries to tax more capital gains, for example on investment property, and shifting more of the tax base towards consumption.” Capital gains tax as a topic has been previously reasonably well debated in New Zealand, although not so much in the last two decades outside of discussion in the Tax Review 2001 (known widely as the McLeod Report).115As previously indicated,116 there were significant concerns raised in that report so that the recommendation, “at this stage”,117 was against taxing capital gains more widely on a realisation basis. However the main rationale for taxing capital gains arises from the concept that it is only fair and equitable for people in the same economic position to pay the same amount of tax. There are in fact two different equity considerations; the case for horizontal equity, and the case for vertical equity. The case for horizontal equity seems unimpeachable. Simply expressed by Andrew Alston, in his book “The Taxation of Capital Gains in New Zealand”, this principle states that “people equally placed should bear equal tax burdens”.118 Rick Krever and Neil Brooks in their book “A Capital Gains Tax for New Zealand” describe it in the following way:119 “One of the most fundamental axioms of social justice is that equally circumstanced people should be treated the same. In discussions of tax justice, this axiom is referred to as the need for horizontal equity. It is an important dimension of the ability-to-pay principle, which is the principle that furnishes the ethical justification for income tax. Its attainment is particularly important in the selfassessment tax system since the widespread perception that the tax system treats similarly situated people differently can undermine its enforceability.” Underpinning this comparison of tax burdens is of course the assumption that the receipt of a capital gain is equivalent to the receipt of income. Based on this assumption,120 how can it be argued that a person who earns a wage or salary of $100,000 and pays tax of $27,550,121 is in the same position as the recipient of a capital profit of $100,000 who pays no tax at all? The fundamental issue arising from this point is that the burden of tax falls unequally on people who have derived the same economic income when the only difference between them is the type of income received, (and possibly the degree of tax and investment sophistication they possess, and the access they have to advice). As previously highlighted in this article, this lack of horizontal equity extends in New Zealand beyond capital gains, to ordinary income gains made in portfolio investment entities, trust, companies and individuals.

115 New Zealand Treasury “New Zealand Tax Review 2001 — Issues Paper and Final Report” (Government Printer Wellington 2001), also found at . 116 See above n 26. 117 See New Zealand Treasury “New Zealand Tax Review 2001 — Issues Paper and Final Report” (Government Printer Wellington 2001), also found at at 34. 118 A Alston The Taxation of Capital Gains in New Zealand-a review of the options and problems of introducing such a tax (Victoria University Press, Wellington, 1986) at 7. 119 Rick Krever and Neil Brooks A Capital Gains Tax for New Zealand (Victoria University Press, Wellington, 1990) at 43. 120 A capital gain which reflects a substantial proportion of inflation could easily put the recipient in quite a different position, so that the “real” gain is actually significantly less. 121 Based on the tax rates for the income tax year 2009/10.

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The case for vertical equity is based on an argument for progressive taxes.122 This is premised on the basis that wealthier people should bear a proportionately greater tax burden than poor people. With respect to New Zealand’s current income tax regime this proposition is already wholeheartedly accepted, and indeed, as evidenced in the Schedule One above (which detailed the percentage of tax borne by the top percentage of income earners) the greatest burden of tax is most definitely falling on those who are deriving the highest income. The distribution of the income tax burden is one of New Zealand’s income tax problems, because high income earners pay a disproportionate amount of tax whilst the wealthy to the extent that they make capital gains pay no tax. The exemption from tax for capital gains creates what is known as “an upside-down effect”. This is best illustrated in an example. Suppose our salary and wage earner above had, in addition to the $100,000, derived a capital profit of $20,000. A low-income earner derives the same capital profit of $20,000 but receives a wage of $30,000, upon which tax is paid of $5,110.123 The benefit of the exemption from taxing capital gains to the higher salary and wage earner is $7,600124 whilst the benefit of the exemption to the lower wage earner is $4,440.125 There is debate as to the true progressivity of a tax on capital gains. In his article Paul Kenny acknowledges that vertical equity is a less rigorous ideal than horizontal equity.126 Notwithstanding this he concludes:127 “Given the concentration of wealth in New Zealand it follows that the equity effect of exempting capital gains must be enormous, severely damaging horizontal and vertical equity.” In contrast, Paul Singleton puts forward the argument that when a substantial one-off gain is made and included in the ordinary income of a person, that gain can distort the analysis as to whether the capital gain is being realised by a true “high earner”.128 In his view, “a more meaningful measure of income for the purposes of examining the equity effects of CGT is recurring income; that is, income received on a regular basis.”129 Actually there is force in both these arguments, and it seems to this writer that Kenny and Singleton are not actually debating exactly the same point. Evidence presented by Leonard Burman and David White in their article “Taxing Capital Gains in New Zealand”130 supports the view that the tax is highly progressive. Burman and White cite evidence in Canada, where one per cent of returns account for 60 per cent of capital gains in 1997, whilst in the United States the highest 0.4 per cent of returns 122 The writer acknowledges that there is a school of fiscal economics that does not embrace the concept of vertical equity because of the distortions created by a progressive income tax system, but would prefer instead a flatter tax system with transfers of wealth targeted to those who need it most. 123 For the purposes of this calculation the effect of the Working for Family Tax Credits and other rebates are ignored. 124 $20,000 at 38 per cent. 125 $18,000 at 21 per cent and $2,000 at 33 per cent. 126 Vertical equity is the principle that wealthier people should bear a proportionately greater tax burden than poorer people. 127 Paul Kenny “Capital Gains Taxation for New Zealand: Fairer and More Efficient” (2001) 7 New Zealand Journal of Taxation Law and Policy 265. 128 P Singleton “Should New Zealanders be burdened with an even more comprehensive Capital Gains Tax?” (2003) 9 New Zealand Journal of Taxation Law and Policy 42. 129 Ibid at 47. 130 Leonard Burman and David White “Taxing Capital Gains in New Zealand” (2003) 9 New Zealand Journal of Taxation Law and Policy 355.

accounted for nearly 60 per cent of capital gains in 1998. In the United Kingdom, less than 0.1 per cent of returns accounted for 60 per cent of reported capital gains on the 1997/98 year, and resulted in the payment of 75 per cent of all capital gains taxes.131 The force in Singleton’s argument arises from a common objection to capital gains tax — the problem of “bunching”. When a tax system has progressive rates, and property increases in value over a long period of time, when taxable gains are recognised in the period of sale, (whereas they have accrued in value over the life of the ownership of property) then arguably a higher rate of tax will be imposed than would have been the case over the period of true growth in value.132 On the question of equity, both horizontal and vertical, there is a compelling case for the taxation of capital gains, particularly realised gains. Having made a case for capital gains tax from the perspective of fairness and equity it is also important to consider economic consequences. A number of studies have been carried out to assess the economic consequences of introducing capital gains taxes, but the conclusions in relation to efficiency, economic growth, savings and revenue seem somewhat mixed. The OECD released a report that considered the policy considerations and approaches relating to the taxation of capital gains of individuals.133 In this report information was sought and received from 20 OECD member countries relating to information on capital gains tax systems. On the question of efficiency, many members of the OECD considered that exempting capital gains from tax distorted portfolio investment decisions of households in favour of assets generating tax-exempt capital gains. Such diversion of investments may give rise to policy concerns — in particular where capital gains in assets are generally more risky than other assets implying a tax distortion encouraging risk-taking above levels consistent with tax neutrality. 134 It is considered by members of the OECD that taxing capital gains at the same effective rate on other investment returns may avoid this type of distortion:135 “Thus, exempting capital gains may give rise to tax distortions favouring capital gains assets and encourage risk-taking beyond levels consistent with tax neutrality.” In their article, Leonard Burman and David White reach a similar conclusion:136 “A criticism of taxing capital gains is that it is likely to further depress savings, discourage foreign direct investment in New Zealand companies, and further retard economic growth. In fact, taxing capital gains is unlikely to depress saving and investment. By improving the efficiency of capital 131 Ibid, at 365. 132 See R Krever and N Brooks A Capital Gains Tax for New Zealand (Victoria University Press for the Institute of Policy Studies, Wellington, 1990) at 51where the bunching problem is responded to in two ways. First, by the expectation that the majority of capital gains will be realised by taxpayers already on the highest marginal tax rate brackets, and they give the Canadian example where well over 80 per cent of capital gains are realised by taxpayers in the top marginal tax bracket. Secondly, they argue that there is no difference between someone who realises a capital gain and someone in business who earns abnormally high income in one year due to fluctuations for example athletes and artists who may have had a particularly successful period in their career. 133 OECD “Taxation of Capital Gains of Individuals — Policy Consideration and Approaches” (OECD Tax Policy Studies number 14, OECD Publishing, Paris, 2006). 134 Ibid, at 10. 135 Ibid, at 11. 136 L Burman and D White “Taxing Capital Gains in New Zealand” (2003) 9 New Zealand Journal of Taxation Law and Policy 1 at 359.

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allocation, it might actually increase economic growth. In any event, there is no evidence anywhere in the world that taxing capital gains retards economic growth.” Burman and White go on to examine the introduction of a capital gains tax in Australia and its effect on economic growth. The conclusion was that the introduction of a capital gains tax did not have a measurably negative effect on economic growth:137 “Indeed, the growth rate was significantly higher post-1985 averaging 2.2 per cent from 1986 to 1999 compared with 1.8 per cent from 1972 to 1985. It is unlikely that capital gains taxation was an important component of the growth in the late 1980s and 1990s, which was matched in much of the rest of the developed world, but it is equally unlikely that the introduction of the capital gains tax stifled it.” When capital gains are taxed on a realisation basis, the problem of ”lock-in” arises, when investors hold on to accumulated gains to defer their tax liability. The OECD report138 goes on in some detail to highlight the different approaches by OECD countries in response to this problem, some electing a lower rate of tax on capital gains, others electing allowances whereby some gains are tax-free, with many having in place “rollover relief” provisions, which extend deferral opportunities. The majority of countries responding to the OECD survey139 identified the protection of the tax base as a key objective of the legislation: “Taxing rather than exempting capital gains count as incentives to characterise or convert taxable ordinary income (ie wages and salaries) and investment income (eg interest, dividends, rents) into tax-exempt capital gains”. But in addition to protecting the tax base, (usually by countering tax avoidance strategies), the OECD countries considered that a comprehensive capital gains tax collects revenues on bona fide capital gains, which are part of a comprehensive measure of income. This policy consideration was cited as a major reason by the United Kingdom for introducing its capital gains tax.140 A key benefit arising from taxing capital gains is the fact that it will indirectly strengthen the existing income tax base significantly. It will do so in two ways. The first is by removing the incentive for taxpayers to “take a view on the law”, on the question of whether a gain is taxable or tax-free under existing legislation — views that may be marginal. Secondly, and just as importantly, given the types of planning opportunities identified earlier in this article, a capital gains tax removes the incentive for taxpayers to engineer their affairs in order to legitimately, and clearly, escape the tax net. It is impossible to quantify what the fiscal effect of this indirect benefit would be.

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CONCLUSIONS ON QUESTIONS OF EQUITY AND THE ADEQUACY OF OUR EXISTING INCOME TAX SYSTEM

In summary, our income tax system is a long way from being consistent, fair, and broad-based. Looking back to the origins of our current system in trust law, we can see some of the reasons why the capital and income distinction has come under considerable pressure. One option for New Zealand is a 137 Ibid, at 362. 138 OECD “Taxation of Capital Gains of Individuals — Policy Consideration and Approaches” (OECD Tax Policy Studies number 14, OECD Publishing, Paris, 2006) at 13. 139 Ibid. at 8. 140 Ibid, at 9.

continuation of the “sticking plaster” approach, which involves identifying various forms of economic capital gains and deciding to introduce specific provisions to capture them as income. In the writer’s view, the time has come for a full-scale debate on whether principles of economic income enunciated by Simons should form the correct basis for taxation of gains in New Zealand. If the answer to that question is yes, then some of the reforms contemplated in this article become achievable. If it were possible to broaden the base to include realised capital gains, it may also be possible to align the rates of tax (by way of reduction to personal income tax) to achieve horizontal equity between different legal structures (companies and trusts). In addition, it may be that the taxation of capital profits would ensure that resources are correctly allocated to productive sectors rather than being diverted into activities (such as the residential property market, which may have a lower pre-tax, but higher post-tax, rate of return on investment). This is summarised well by Leonard Burman and David White:141 “The current regime violates all the norms of tax policy. It is inefficient for at least three reasons. First, it taxes different sources of income at different rates, distorting the pattern of investment among assets in New Zealand as well as between New Zealand and the rest of the world. Second, because similar transactions can be taxed very differently, it creates arbitrage opportunities, for example by arranging to take losses on income account (ie deduct them from income), and gains on the exempt capital account. Thus, capital can be diverted from its most productive use into investments that only makes sense because of tax consequences. Third, it adds unnecessary uncertainty to investment decisions because the tax treatment of some investments is unclear.” In addition to these points, the most compelling case for change arises from the inequity of having significant gains not subject to tax at all, whilst other forms of economic income (particularly earned income) are taxed at a disproportionately high rate. The question of equity and fairness is usually the first principle of good tax policy. Questions arise in taxpayers’ minds relating not only to these issues of equity and fairness but also certainty, simplicity, economic growth and efficiency. The central span needs widening and a buttress added to strengthen it.

141 L Burman and D White “Taxing Capital Gains in New Zealand” (2003) 9 New Zealand Journal of Taxation Law and Policy 1 at 357.

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