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Eat the Rich

Deborah Hill Cone

Friday 12th December 2003

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Inland Revenue has weathered years of criticism from some quarters for not doing enough about the so-called winebox transactions. It has been slammed for picking on the little guy, condemned for hassling Hendo and demonised for making taxpayers afraid, very afraid.

Well now it has found the perfect way to redeem itself ­ it is going after the people everyone, except perhaps The National Business Review, loves to hate. It is on a winning streak by pursuing high net worth individuals (HNWI) and the high risk investments only they can afford to take a punt on.

"The IRD post-winebox is running an incredibly slick PR campaign," one tax practitioner noted.

Rich people are unlikely victims, so don't expect anyone to leap to their defence, but there are wider implications from shutting down these structures that have not been widely discussed or even debated at all.

The investments the IRD has in its sights include software scheme Actonz, technology investment Digi-Tech and forestry ventures Salisbury and Trinity ­ but those are just the ones publicly identified.

Any investment where tax benefits form part of the attraction is fair game. The high profile ones involve a transfer of property that is difficult to value with precision ­ such as software ­ and typically at a price that amplifies the available tax deductions.

They are financed in such a way the investor is not at any real risk of having to pay the purported purchase price, using non-recourse loans or other features that give investors an out.

IRD head of litigation Mike Lennard, who looks like he should be a history lecturer rather than the taxman's legal rottweiler, has led an army of in-house investigators on this crusade. And with the department's emphatic court win in the Actonz case, it has reaped the benefits of appearing to be on the side of all that is right and good for once.

The mainstream media loves to see the authorities coming down like a ton of bricks on what they call "tax dodge" schemes ­ and the IRD received lots of approving coverage when it won the first round in the Actonz case. "Tough line on tax abuse," "Investment scheme too good to be true," "Court finds for commissioner," the headlines said.

But the same media that slapped the IRD on the back was also trawling through the thesaurus for superlatives ­ historic, momentous, sensational ­ when the final Lord of the Rings film premiered in Wellington last week.

Yet they do not seem to have joined the dots and come to the conclusion it is unlikely the landmark films would have been made if they had not benefited from the grandfathering of a structure with several hundred million dollars of tax advantages ­ the same sort of deals the IRD is busy outlawing.

The crucial issue of whether tax can ­ or should ­ be used as a way of influencing investment in startups and high risk ventures is a valid policy question but it has barely had a look-in during the frenzy of self-congratulation over the IRD's war against mass-marketed tax schemes.

Are tax breaks for high risk investments really such a bad thing? They appear to be the only way certain types of initially loss-making projects will ever get off the ground, especially in this country's babyish venture capital market. Without Australian-style superannuation schemes to back bright ideas, individual wealthy investors are the major source of funds.

"And there's no other way you are going to divert people out of housing," one veteran, but anonymous, investment figure observed.

The IRD's latest move to clamp down on what it calls mass-marketed tax schemes is to introduce what is known as the deferred deduction rule, passed through Parliament as part of the Taxation (Annual Rates, GST, Transtasman Imputation and Miscellaneous Provisions) Act.

The deferred deduction rule means investors can claim deductions only if they relate to income that has already been generated ­ something that typically doesn't happen with startup companies, which take a while to generate sales.

It also means the taxman takes a view over what point a legitimate company ought to be generating income.

The deferred deduction rule has not been universally welcomed by the tax community, with some observers questioning why it is needed at all.

Ernst & Young tax director Michael Stanley said there was a tendency within the IRD to rush into new legislation without waiting to test the existing law.

"With Actonz the courts have already taken a very strong view ... the department is applying the penalties ­ I really don't think such legislation [the deferred deduction rule] is necessary and will inevitably catch other things in the net."

Even more significantly, Stanley said it was an attempt by the IRD to make judgments about the viability of a business. "It is not up to IRD to assess whether business is going to succeed or fail."

Tax barrister Denham Martin is also sceptical. He gave a provocative paper to the Institute of Chartered Accountants tax conference: "The deferred deduction rule ­ a proposed response to taxpayer weapons of mass destruction: sensible tax rule design or revenue spin?"

Martin said the way the IRD had gone about preparing and advocating its case for this reform was "disconcerting."

"Few advisers will have a problem with a new tax rule that addresses investment schemes that are fraudulent or lack any credible economic purpose. Such schemes are not only bad for investors, particularly unsophisticated ones, but can also be bad for the proper and considered development of tax rules," Martin writes.

But he notes the IRD has had to back away from the wider scope of its original issues paper on mass-marketed tax schemes ­ and questions whether the IRD is simply following similar developments in Australia rather than responding to the actual position in New Zealand.

Stanley said the IRD had been very aggressive in its approach to Actonz ­ initially slamming investors using loss attributing qualifying companies (LAQCs) with 200% penalties ­ 100% for the LAQC and an additional 100% for the individual investor. That has now been reduced to 100% but it is still a very severe penalties regime.

"There's a very real downside to people taking part in these schemes," Stanley said.

The red-rag-to-a-bull words to the IRD at least are high net worth individuals (HNWIs). Some wealthy taxpayers who have been picked out for an IRD fishing expedition are also questioning the focus on the country's small group of wealthy.

One of the HNWIs targeted wrote to Prime Minister Helen Clark asking how the individuals were selected for auditing ­ it has nothing to do with their past compliance with tax laws apparently ­ and questioning whether outspoken opponents of the government were being singled out.

They were not the only wealthy taxpayers to wonder whether government cheerleaders such as Dick Hubbard and Stephen Tindall were also having to jump through these hoops. But with IRD confidentiality no one would know.

The Lord of the Rings might not have been made here if Finance Minister Michael Cullen had not allowed it to be "grandfathered" by keeping the favourable tax structure in place. Former National leader Bill English, and Dr Cullen's predecessor as finance minister, told the Financial Times: "The Lord of the Rings people came in and did some of the most creative tax accounting I've ever seen." He might have added it has been a great boost to the economy and is roundly praised as a good thing.

The key question is: could another Lord of the Rings happen here under our revamped law?

Simpson Grierson film finance specialist Deborah Fox, who represented New Line Cinema for The Lord of the Rings, Warner Brothers for The Last Samurai and Paramount for Without a Paddle, said the legitimate tax efficient investment structures were removed in 1999 and replaced with a grant system. This involves productions with budgets over $15 million getting a rebate of 12.5% of expenditure.

Fox said it was a step in the right direction but the overseas studios needed some opportunity that helped them manage the financial risks in film.

"I don't think [grants] alone were ever going to be particularly attractive. We have to offer something which is competitive with Australia or Ireland ... It remains to be seen how our system is going to work."

Everyone seems agreed on one concern: the issue of what happens with lower budget productions costing less than $15 million ­ the kind of projects Peter Jackson started out making.

"With the recent changes in deferred deduction it has made it even less accessible to structure [film finance here]. I don't know why the IRD introduced this particular rule ­ it is complicated and potentially onerous," Fox said.

She was uncertain whether there was a real need to clamp down on this area, which she noted had wider implications than the film industry. But Fox said if the government was serious about encouraging New Zealand's creative industries, such as film, it needed to treat them a bit differently "rather than tagging everything under mass-marketed tax schemes."

IRD film policy manager Jim Gordon is keen to make the distinction between mass-marketed tax schemes directed at rich individuals ­ which are bad in IRD terms ­ and film financing with major backers, which seem to be more acceptable to the taxman. It's those dirty words ­ high net worth individuals ­ again.

"Large budget films are not marketed to high net worth individuals," Mr Gordon said. All the direct investors were corporate, with none of the benefits passing directly to HNWIs.

Gordon said the answer to whether The Lord of the Rings might still be made here without the grandfathered tax benefits is "probably yes." He maintained the grant system was attractive enough to lure major productions to New Zealand ­ pointing out Mr Jackson was proceeding with his next project, King Kong.

"The 12.5% grant has been sufficient that [King Kong] is going on in New Zealand."

But what does worry people who take tax policy seriously is that there seems to be little or no debate over these issues and how they affect business.

Says tax barrister Martin: "We simply do not know enough about, or have thought enough about, how a rule like this will impact on the promotion and funding of sensible commercial activities, particularly in respect of those investment schemes that are too small for large institutional investors and too large for most individual investors and where tax benefits may form some part of the investment attraction."

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