Opening the floodgates to tax fraud

Is the most significant change in property law in decades slipping through Parliament virtually unnoticed

by Alastair Thompson

On October 1st one of the most significant reforms to property law in decades is due to come into effect with the abolition of gift duty.

For most in the legal and accounting industry (including the Law Commission) the perception appears to be that provision has already been passed, although it has not.

The politics of the change – which looks like a tax cut for the rich – would seem to paint it as an obvious target for some filibuster tactics on the part of the Opposition. And therefore it does seem possible that the bill will not come into effect of October 1st as intended.

It appears that the full implications of this change haven’t been fully thought through. On the papers which have been published (and considered below) it is easy to conclude that what consideration there has been has lacked rigor.

Meanwhile on its face the change will open the door to massive tax avoidance and make the defrauding of creditors (including the IRD) vastly easier than it is at present.

The change is contained in the Taxation (Tax Administration and Remedial Matters) Bill which was reported back from Select Committee last week.

Before it can come into effect (on October 1st) it will need to pass through its second reading, committee stages and third reading.

While the bill is expected to receive a clear majority of support via the National and ACT parties – the potential for political fallout is considerable given that the benefit of the provision flows mainly to the wealthy and the threat to the overall tax base via avoidance has not been quantified.

In their minority opinion in the report back Labour and the Green Party have clearly indicated they will be opposing the provision on the grounds that it is ill-considered and wide ranging in its implications.

Abolition of gift duty change was proposed as a way to simplify tax law and remove a $70 million burden in seemingly unnecessary compliance costs on taxpayers (plus a $430,000 cost to the IRD.)

However many submitters on the change and lawyers in private practice believe the impact goes far beyond this.

Without gift duty to slow things down anyone (including corporate persons, companies, trusts etc.) will be able to instantaneously move valuable assets (including cash, loans and property) more or less without restriction and without tax implications.

While in theory there are legal provisions to undo gifts in the event of insolvency – in practice if you can move assets between entities you can move them down a chain of entitites – and that becomes very hard to undo.

The change therefore has very wide ranging implications for the law of trusts, the law of taxation and the practicalities of debt enforcement – including in relation to wills and matrimonial property disputes.

According to several lawyers spoken to by Werewolf it will result in a legal environment in which:
– tax avoidance will become much easier and cheaper;
– money laundering will become significantly easier (and cheaper); and
– defeating creditors claims (including those under the Family Protection Act and Relationship Property Act) will be much easier, faster and cheaper.

In the report back on the Bill a minority opinion was voiced by the Labour and Green parties concerned primarily about the tax avoidance implications. Quoting from the report:

” New Zealand Labour and Green Party members also believe the analysis upon which the gift duty abolition proposal is based is fundamentally flawed because it does not adequately take into account the full range of potential tax avoidance opportunities. T rust structures are one subset of possibilities but these members do not accept that the analysis has been comprehensive. Accordingly the cost – benefit analysis upon which the bill rests must also be seen as fundamentally flawed, as no attempt has been made to quantify the counterfactual of avoidance risk pertaining to the full range of structures available.

These members note that no sensitivity analysis has been provided. No options analysis has been provided. The policy process would not meet the standards expected under a thorough Regulatory Impact Statement.

New Zealand Labour and Green Party members believe, in the first instance, that any legislation proposing the abolition of gift duty should be delayed until the Law Commission’ s review of trust law is complete. However , while realising that gifting to trusts is a significant component of the gifting regime, there are many other gifting
opportunities that have been used to avoid either tax or other responsibilities.

In order to understand why this change was ever thought a good idea it is first necessary understand how it relates to the Law of Trusts. Almost all of the $70 million in compliance costs around gift duty arise out of this.

Under the existing law of Trusts setting up a trust is a relatively complex matter especially if you intend to settle any significant level of assets in it.

While trusts do not need to be registered, and at law do not even have to be written down, in practice if you want one that will stand up to a legal attack you need to construct it carefully and in accordance with the letter of the law.

Typically to do so you will need to to engage a lawyer and possibly an accountant, you may need a professional trustee if you do not have the expertise yourself (i.e. you are neither accountant nor lawyer).

The paperwork to set up a trust starts at around $1000 (at the Public Trust) and commercial rates from lawyers and accountants are similar at the bargain end of the market.

The main reason that all the above is necessary is that putting valuable assets in a trust without due care can give rise to a taxation liability.

Under present taxation law if you give assets of more than $27,000 to anyone then your gift will attract taxation. Most people do not know this and almost no revenue is ever collected on this even though very large gifts to trusts are fairly routine.

And the reason for this is that the law has evolved a mechanism for circumventing gift duty in almost all circumstances . And it is administering this mechanism- which looks a little like a sleight of hand – which costs taxpayers $70 million a year.

The way trusts typically gets assets without paying gift duty works like this.
1. A family trust is set up to hold assets (e.g. a house) currently owned by an individual to protect them in case the owner gets sued by his clients;
2. The trust purchases an asset (e.g. a house) from person(s) but does not pay for them;
3. Instead the Trust agrees to borrow the purchase sum from the seller interest free;
4. The vendor then forgives the loan at $27,000 a year, each year they file a tax return to this effect and provide a deed of gift.
5. On the death of the vendor they forgive the remainder of the loan, and because there is no death duty in New Zealand that residual gift does not attract any taxation either.

There are tens of thousands of trusts in New Zealand which have been set up in this fashion. Many MPs have them as do many professionals working in fields in which there is a possibility that they may be sued by their clients.

Rich individuals, families and corporate entities of all kinds also use trusts to manage their property and wealth. Companies and corporate use them also for a variety of purposes including creating structured tax arrangements designed to minimise taxation liabilities.

The policy issues around the abolition of Gift Duty were initially addressed by IRD’s Policy Advice Division in a commentary on the bill published when it was introduced on 23 November 2010.

This paper includes a very brief commentary on the Gift Duty provisions in the bill. This states that the abolition of gift duty had been considered when death duty was abandoned in 1992 but ruled out in 1992 due to concerns around it enabling tax avoidance.

The full reasoning follows as it is not overly long (emphasis added by the author):

“In light of the increasing number of requests for exemptions from gift duty, a review was initiated. Options considered included:

• narrowing the scope of gift duty to apply only to gifts between individuals, trusts and closely held companies;
• raising the thresholds at which gift duty applies;
• removing the requirement to file gift statements for non-liable gifts;
• introducing electronic systems for the filing of gift statements and payment of gift duty; and
• updating life-expectancy tables for valuing annuities under the Estate and Gift Duties Act 1968.

As the review progressed, a strong case for outright abolition emerged. Some of the concerns which existed in 1992 have been addressed or reduced by the strengthening of existing legislative provisions. Remaining areas of concern were scrutinised in consultation with the Treasury, the Ministry of Economic Development, Ministry of Justice, Ministry of Health, New Zealand Police, the Ministry of Social Development, and Housing New Zealand Corporation. None of these agencies opposed gift duty abolition.

The review concluded that gift duty no longer raises any significant revenue and imposes a high level of compliance costs on the private sector. The protections offered by gift duty in the areas of income tax, creditors and social assistance have been incidental rather than intended policy goals. The analysis undertaken across government revealed that the protection gift duty offers is inefficient and limited and is outweighed by the significant compliance costs it imposes on the private sector.

The bill abolishes gift duty with effect from 1 October 2011. The government agencies mentioned above will monitor the effects of gift duty abolition and Inland Revenue will initiate a post-implementation review to ensure there are no unintended consequences.”

The bill received relatively few submission, just nine.

In a report on these submissions officials dismissed all the concerns of submitters – several of whom even though supporting the move in theory, asked for the Law Commission to be allowed to complete its report before the change was made.

According to the summary of submissions six supported the change and one opposed.

But while this may be technically correct – it does not really do justice to the nature of the submitters opinions.

The Institute of Chartered Accountants for example said that while it welcomed the abolition of gift duty – in its view “there are a number of tax avoidance opportunities that may arise in the absence of gift duty”, going on to list five.

The Institute said further consideration was needed of these and other issues and suggested a staged approach to allow this. In the first instance rather than abolishing gift duty the threshold for its application should be raised to $80,000, they said.

Officials response to the Institute’s submission on Tax Avoidance was curt and dismissive:

“The key feature of all the avoidance practices raised by the New Zealand Institute of Chartered Accountants is that gift duty does not prevent them. Legal title to assets (as well as any income they generate) transfers immediately when a gifting programme is set up. The outstanding debt, progressively forgiven, is of no assistance in remedying these avoidance behaviours.”

It should probably be left to tax practitioners to critique this response in detail, but what seems to be being ignored here is that more complex arrangements will be able to be built faster and cheaper.

The Institute of Chartered Accountants, The National Council of Women and the Law Society all expressed concerns regarding the impact of the abolition on Family Protection and Relationship Property proceedings.

The Family Protection Act protects children and spouses who are excluded from inheritance in wills. By allowing full gifting prior to death the interests of children who miss out on any inheritance will be extinguished.

In the case of relationship property a non-property owning spouse or partner may find that the matrimonial home has been gifted to a trust without their knowledge and is therefore out of reach when they separate.

The officials response to this submission was somewhat lengthier than the one on tax but similarly curt.

On the issue of relationship property they begin by saying that gift duty is not the best means of protecting these interests.

They then say that the Ministry of Justice disagreed with the submitters, listing a bunch of legal remedies available to those who lose their inheritance or have their matrimonial property alienated.

Finally they say that while a small number of people won’t have any legal avenue open to them, ” there is no evidence that these cases would be significantly affected by the removal of gift duty.”

On the issue of succession the officials again take the view that gift duty is not intended to prevent live people for disposing of their assets as they wish. It appears that officials see this as an unintended consequence of gift duty and therefore illegitimate in some principled sense.

“Generally, property that is owned jointly with another person or that is disposed of while a person is alive, whether by transfer to a trust or otherwise, does not fall into their estate and is therefore not available to claimants under the Family Protection Act or the Law Reform (Testamentary Promises) Act. This is consistent with the policy that these Acts do not restrict what a person may do with their property while they are alive, including gifting that property to another person. It is not clear why transfers to a trust should be treated differently.”

The third major area of concern, creditor protection, was similarly disposed of in a few brief sentences by officials.

It is notable that this problem was only addressed by one submitter to the bill according to the officials summary – but in fact would appear to be the most serious area of concern in terms of its implications for property law.

It appears the officials have forgotten that when it comes to property possession is nine tenths of the law.

Officials stated that there are three existing provisions in the law which allow for gifts to be clawed back for the benefit of creditors.

“In the context of these existing provisions, officials do not consider that any new creditor protection measures are necessary at this time. The Ministry of Economic Development has committed to monitor future cases brought under these Acts, and a government-wide post-implementation review will consider any effects resulting from gift duty abolition.”

As anyone who has ever attempted to pursue fleeing money will tell you the provisions which allow for the claw back of assets passed between entities are very hard to enforce, mainly because by the time you can find a court to address the location of an asset it has moved somewhere else.

However after dismissing all the above concerns officials concluded in summary that:

“Submitters have called for further work to be done in some related areas, notably in the area of relationship property rights and the law of trusts, and while some want to delay abolition, the general consensus is that gift duty should not be retained for these purposes.”

The question then arises – will the wider legal fraternity actually believe any of the officials’ assertions on these issues? And will Parliament?

And when answering this question the ground quickly moves to the difference between the reality of the operation of law and the theory.

Yes in theory tax law is there to collect tax and so a tax which collects very little tax and costs millions to administer is on its face something of an aberration.

And so yes Gift Duty was not intended to protect creditors, make tax avoidance more difficult or protect children and spouses from losing family property – however at present it does play a role in all three.

The relatively few submitters to this bill argued pragmatically that the unintended consequences of this reform mean that any policy move in this area should be accomplished more slowly and carefully because of this. All of them can see the potentially huge implications that this change has in several different fields of law.

IRD policy officials have responded with a very narrow and principled view that law should not act by way of unintended consequences.

On Tax Avoidance they respond that the law contains other protective provisions which it does. However the tax lawyers spoken to in the course of writing this article do not believe this for an iota.

In practice sophisticated tax avoidance involved the use of deliberately confusing structures to hide the true effect of financial arrangements. Removing gift duty will make the design, construction and execution of these arrangements easier. It will therefore make the enforcement of anti-avoidance law harder.

Meanwhile the effect the provisions will have on the IRD’s ability to recover bad debts does not appear to have been considered at all by the IRD officials. It will be interesting to find out what officials from IRD’s debt enforcement section really think about this, have they even been asked?

On the issue of Trusts officials clearly point towards the Law Commission’s work. They seem to expect the Law Commission to solve the various problems that may emerge as a result of their making a fundamental change to the nature of trust law practice in New Zealand.

This approach seems to have the IRD looking towards the Law Commission to provide the appearance of policy rigor to the change. However the timing of the Law Commission project is such that they are at present assuming that the gift duty change will be made before they begin the bulk of their work.

On Family Protection and Relationship Property matters the officials are even odder. In their report on submissions the following obiter remarks scrape the surface of a huge area of law in which IRD officials simpy have no experience of competence.

” There is a risk that making ad hoc amendments to any of these Acts may undermine the long-standing policy that underpins them and could affect the legitimate use of trusts. For example, requiring all parties to a relationship to receive legal advice before one party to a relationship transfers assets into a trust (or makes major changes) would impose significant compliance costs on couples that have a trust for a genuine purpose, particularly when the value of the trust was relatively low. It is also likely to be unnecessary, as couples who transfer significant assets into a trust would be likely to seek professional advice.”

So why then is the Government doing this?

The following section in the officials report seems to answer that question.

IS GIFT DUTY ABOLITION A TAX CUT FOR THE WEALTHY?

Submissions

(Federated Farmers, National Council of Women of New Zealand)

New Zealand’s wealthiest citizens have a continuing economic advantage of transferring assets to trusts, and as major beneficiaries of recent tax cuts, a further move to relieve them of costs is unfair. (National Council of Women of New Zealand)

Abolition of gift duty will cost the Government just 0.003% of total tax revenue, while relieving the private sector of $70 million in compliance costs. Gift duty has been an impediment to farm succession from one generation to the next. Although farmers must have land assets, this does not mean they have high incomes, with recent data from the Ministry of Agriculture and Forestry showing meagre incomes for farming, with poor rates of return and increasing agricultural debt. (Federated Farmers)

Comment

Officials note that gift duty applies only to aggregate gifts over $27,000, made by a person in any 12-month period. Therefore, abolition affects only those who have assets greater than this value and who wish to give up their legal ownership of them.

It has been noted that gifting programmes are widely used; therefore gift duty is rarely incurred, often only by mistake. The extent to which abolition can therefore be considered a tax cut is limited to the $1.5 million (before administration costs) that it raises annually, resulting from approximately 900 gift statements.

The real savings will be in compliance costs (an estimated $70 million each year). The benefit of these costs goes to private practitioners who assist with drawing up deeds and filing gift statements.

Recommendation

That the submissions be noted.

So in the opinion of the report writer the beneficiaries of the law as it stands are “private practitioners who assist with drawing up deeds and filing gift statements.”

Not mentioned are the wealthy who have to pay these fees in order to organise their affairs to protect and administer their assets.

Therefore, the correct answer to the question – Is gift duty abolition a tax cut for the wealthy?- is YES.

ENDS