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Analysis & reform: a review of section HK11 of the Income Tax Act 2004 and its effectiveness
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This research refers to section HK11 in the Income Tax Act 2004 (“ITA04”). At the commencement of this research the New Zealand Income Tax Act was undergoing its final phase of a rewrite programme. The ITA04 is now Income Tax 2007, HK11 is now HD15 and the sections name “liability for tax payable by company left with insufficient assets” is now “asset stripping of company”. Apart from these changes the actual wording of the section remains the same. The Income Tax Act 2007 came into effect on 1 April 2008. The Commissioner of Inland Revenue (“CIR”) has the power to recover income tax owed by a company, directly from the company’s directors and shareholders. This is achieved by invoking section HK11. However, for this section to be successfully invoked the CIR must prove that the company’s directors and/or shareholders entered into an arrangement with intent to deplete the company’s assets thereby leaving it unable to fully satisfy its tax liabilities. This problem or mischief, commonly referred to as “asset stripping”, has been a long-standing conundrum for administrators, both domestically and internationally. However, overseas jurisdictions refer to this problem as ‘phoenixing’. Phoenix behaviour is an invalid transfer of assets to the detriment of creditors. Although this appears similar to asset stripping, it is not. Asset stripping is defined as the practice of taking over a failing company at a low price and then selling the assets piecemeal before closing the company down. A more common overseas reference of asset stripping is the process of buying an undervalued company with the intent to sell off its assets for a profit. But, this is not what is intended by section HK11. The distinction in the New Zealand ITA04 is that although the behaviour involves disposing of company assets the focus is not on its profit but its inability thereafter to meet its tax obligations as a result of that transaction. Considering that the assets were deliberately depleted or removed, it is unlikely that the company will be able to meet its tax obligations. A closer look at the problem however, shows that the benefit offered by the “corporate veil” or "limited liability” of companies provides certain taxpayers with the incentive for this abuse. The CIR is therefore faced with a dilemma. The CIR is statutorily bound for the care and management of the tax system. In order for the CIR to ensure the robustness of the tax system he has to maintain its integrity. The strategy adopted by the CIR to achieve this is to encourage voluntary compliance. The CIR uses a compliance triangle model to match a taxpayer’s behaviour with the best remedy. Those who do not comply with their tax obligations are brought to account in an appropriate manner. The CIR needs to achieve this because if people see certain taxpayers being able to escape their tax obligations, the tax system will be undermined and also seen as unfair. The CIR’s dilemma is that he cannot ignore this problem. The CIR needs to reflect on:•The optimal remedies available to target this problem/mischief?•The most effective and efficient remedy to deter such behaviour?•How well does this remedy stack up against international best practice?In order for the CIR to have direct access to the person (s) behind this mischief/problem, legislators have armed the CIR with section HK11. The problems with section HK 11 are:•It is entirely unsettled law i.e. there is no successful case on its application. •Is it a tax recovery or tax assessment provision? •Do taxpayers challenge its use against them via judicial review or the disputes process? But there are other remedies available to the CIR as well. The CIR is not bound to only rely on remedies available under tax legislation. The CIR being a creditor (even though an involuntary one), can make use of remedies available under other legislations – for example:•The Companies Act 1993•The Fair Trading Act 1986•The Commerce Act 1986The CIR may also consider invoking common law remedies – for example the remedy of “tracing and constructive trust” to follow assets which have been squirreled out of ailing taxpayer companies. The CIR is a major unsecured creditor in many liquidations and sometimes is the only major unpaid creditor. Yet there is little written about the CIR’s status as creditor of an insolvent company. This however is consistent with the lack of recovery action in these types of cases by the CIR. If there were more cases where the CIR was seeking to enforce his statutory rights either under the Companies Act 1993 or ITA04, it would enhance the body of knowledge in this area. There is also an argument that HK 11 is a “revenue remedy” (i.e. within the Revenue legislation) whereas non-revenue remedies such as reckless trading are not within the Revenue Acts hence the reluctance of the latter by the CIR to apply non-revenue remedies. But this is not borne out by the facts. The CIR has never been inhibited with using the various provisions of the Companies Act 1993 to pursue unpaid tax liabilities. I respectfully submit that this argument is unsound as clearly the CIR makes regular use of non-revenue remedies and is indeed required to do so – consider the prevalence of utilisation of such remedies and non-revenue law as, for example liquidation, statutory demands, the Crimes Act, District Courts Act, High Court Rules, Summary Proceedings Act, Serious Fraud Office legislation, etc. Einstein once remarked that the very definition of insanity is “to do the same things whilst expecting different results”. This dissertation is focussed on the need for reform. The type of mindset which has created or allowed the widespread abuse of corporate entities and complex tax structures cannot deliver the CIR from his valley of troubles. This mischief requires a new approach of responding to such wilfully non-compliant taxpayers. The view that the CIR ought to confine himself to the Revenue Acts, or automatically prefer remedies within the revenue acts is both unsound and short-sighted. The Companies Act is of pivotal importance and relevance to the CIR when dealing with corporate taxpayers. There is, in my view, no good argument against using non-revenue remedies (e.g. remedies within the Companies Act) when recovering debts from companies and delinquent directors. The CIR ought to apply the law and legal remedies which are deemed to be most effective and appropriate in the circumstances of each case. A good reason for the CIR to use an alternate remedy is that alternative remedies might be based on more settled law compared to the jurisprudentially troubled section HK11. An example of a remedy which has more settled law in New Zealand jurisprudence is reckless trading under section 135. The advantage of using this remedy was stated by Professor Gower at page 115: “…in practice this section represents a potent weapon in the hands of creditors which exercises a restraining influence on over-sanguine directors. The mere threat of proceedings under it has been known to result in the directors agreeing to make themselves personally liable for part of the company’s debt. Of all the exceptions to the rule…it is probably the most serious attempt which has yet been made to protect creditors generally…from the abuses inherent in the rigid application of the corporate entity concept.”