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Jones Industries Ltd v Commissioner of Revenue [2008] TOLawRp 18; [2008] Tonga LR 77 (28 April 2008)

IN THE TAX TRIBUNAL OF TONGA
Tax Tribunal, Nuku'alofa

1/2006

Jones Industries Ltd anors

v

Commissioner of Revenue

Andrew J, Mrs Miller, and Mr Liava'a
28 April 2008

Tax assessment – bonus deducted – tax deduction claimed – arrangement analysed – bonus disallowed as expenditure

The applicants appealed to the Tax Tribunal against a decision of the Chief Commissioner to disallow as expenditure a payment by the applicant group of companies of $2,140,000 to the taxpayer, Michael Jones, as a bonus in the 2005 fiscal year. The tax saving through the bonus arrangement was $367,750. The taxpayer asserted that, as the sole owner of the group of companies, he was able to pay the amount to himself. The Commissioner gave a number of reasons for disallowing the deduction and submitted that the subjective purpose or motive of the company was the obtaining of a tax deduction in circumstances where on a commonsense approach one would have expected dividends to be paid. The purpose of the payment was the obtaining of a tax deduction in the hands of the company and Mr Jones being assessed on salary and wages at a lower rate of tax than the company would have been assessed at if the payment had not be made. The Commissioner also sought to rely on an alleged admission by Mr Jones (which was disputed) that the whole idea of creating the bonus was to minimise his group of company's corporate tax liability. The Tribunal analysed the bonus arrangement in the light of section 6(1) and the relevant considerations in section 38 of the Income Tax Act.

Held:

1. The Tribunal accepted that the taxpayer had made the admission in dispute. It concluded that the arrangement had as its purpose the avoidance of tax and the bonus was not connected to performance. The arrangement altered the incidence of tax; relieved the taxpayer from a substantial liability to pay tax and also avoided liability to pay tax.

2. The tax assessments made by the Chief Commissioner were reaffirmed as was the decision of the Commissioner to disallow the taxpayer's objection to the assessment. Penalties and interest were ordered to be resolved between the parties. Costs were awarded to the respondent Commissioner.

Statutes considered:

Companies Act 1995

Income Tax Act 1976

Judgment

This is an appeal to the Tax Tribunal concerning the decision of the Chief Commissioner to disallow as expenditure the total payment of $2,140,000 to Michael Jones as a bonus by the Jones group of companies (as listed above) in the 2005 fiscal year.

We think that it is not in dispute, as submitted by the Commissioner, that the amount was accrued by the companies but not paid in that year as the companies did not have sufficient funds. However the taxpayer returned the amount in his 2005 individual tax return. It was indicated that the amount was "returned" to the companies for further investment as capital.

The tax saving through the bonus arrangement was $367,750.

The taxpayer asserts that he is the sole owner of the group of companies and is able to pay the amount to himself. He asserted in a meeting of 9th March 2006 that he is now the sole owner. There is no evidence that ownership of the company has changed. Shareholding is the same in the 2005 year as it was a 2004 and other years. However it appears to have changed on 2006 (from tax return schedule of share holding).

The reasons for disallowing the deduction for the total amount of the bonus are said to be as follows:

"1. The applicant has not proven to the satisfaction of the Respondent that it was justifiable expenditure necessarily incurred in gaining or producing the assessable income of the applicant for the financial year.

2. The Managing Director had been employed in the applicant companies and had never been paid a bonus to the extent claimed and further the applicant's previous returns of payments to the Managing Director is evidence that this is an out of the ordinary deviation from the norm.

3. That the applicant's have often in the past allowed bonuses, however this was often a percentage of the profit or turnover and was divided amongst the employees.

4. That the bonus should be a dividend, i.e. taxable to the Managing Director and as a distribution of after tax profits, and hence is not a deductible expense to the company.

5. That the applicants have not provided sufficient proof that the bonus represents a reward for "real services" provided by the Managing Director and hence is a sham and not an allowable deduction.

6. That the Managing Director advised the Respondent's officers, namely Kolopeaua Tonga and Puniani Tu'ipulotu on the 9th April 2006 (later amended) to 9th March that the bonus was to avoid the higher corporate tax and that as a sole shareholder the money would be going back into the company operations.

7. That the assessment was based on taxing the company profits as allowed by law and the bonus paid to the Managing Director was company profits having allowed all the expenditure and loss necessarily incurred in the gaining and producing of the assessable income - and should be taxed accordingly.

8. The bonuses paid by the applicants to the Managing Director was an arrangement that reasonably was entered into and complemented in that way with one of its main purposes to avoid tax.

9. The overall effect of the bonus on the practical carrying out of the business was in effect to avoid corporate tax as the funds would be injected back into the business as capital.

10. The Managing Director as sole shareholder is the sole controller over the affairs of the company and hence can decide on his own to award himself whatever bonus he decrees.

11. The Managing Director and applicants obtain a huge advantage over the arrangement.

12. That the bonus is not an allowable expense as it is a distribution of profits (and not an expense quantified by reference to profits).

13. That in effect, this "BONUS" paid to the Managing Director can only be viewed as an arrangement that –

(i) alters the incidence of corporate tax for the applicants.

(ii) relieves the applicants from paying corporate tax ; and

(iii) reduces the liability of the applicants to pay corporate tax according to law."

The taxpayer contends, amongst other things, which shall be referred to later, that the bonus was paid after a profitable year and that the payment of a bonus is a common place event and it is unreasonable to assume that the whole idea of creating the bonus was to minimize his group of companies tax liability. Further that, it is submitted "there is no mention of an express limitation in the Act (i.e. the Income Tax Act) to the amount of salaries or bonus to be paid to an employee. Employees other than the Managing Director did receive bonuses which were not disallowed. This means that the Revenue Services recognize a bonus (as an extension of salary).

Dispute of Facts

The Chief Commissioner relies on the alleged verbal statement of the managing director Mr Michael Jones (cited at paragraph 6 above) that the whole idea of creating the bonus was to minimize his group of company's corporate tax liability and therefore pay less tax.

It is asserted on Mr Jones behalf and by his employees that this was in fact never said. The statement, if said, would be clear evidence of the taxpayer's intention as to whether the purpose or one of the main purposes of the bonus arrangement was tax avoidance.

In resolving such a dispute on the facts we propose to apply the normal test applied in law, namely that of the balance of probabilities.

In the minutes of a meeting on the 9th March 2006 the two tax officers Mr Kolopeaua Tonga and Mr Puniani Tu'ipulotu have recorded the Managing Director as making this disputed statement. The taxpayer has said that firstly, it is unreliable as it was recorded as having occurred on the 9th April 2006 and not the 9th March 2006. However we think that this was a typographical error. The point is that this was a contemporaneous recording of what was said at the meeting. We do not think there was any incentive or reason to record anything other than what was said. The Managing Director is giving his memory of what was said well after that meeting (nearly two years later). On the balance of probabilities we think it more probable than not that in fact the Managing Director did make that statement at that time. As such it is a clear statement of the intention of the taxpayer to avoid tax or at the least one of the main purposes was to avoid tax via the bonus arrangement.

We accept that the comments at the meeting were relied upon by the Commissioner in determining the subsequent objection not the initial Assessment but it is a relevant consideration before the Tribunal.

The Law

The taxpayer has asserted that there is no express limitation in the Income Tax Act ('The Act') to the amount of a bonus which can be paid to an employee and further says that in response to the objections lodged by the applicants, the Respondent never referred to specific sections of the Act which the Respondent deemed the applicants to be in violation of. We do not consider that the Commissioner is required to quote chapter and verse of the Act in determining objections to a tax assessment. What is required is for the reasons to be based on expressed terms and concepts of relevant taxation law.

We consider that the most relevant provisions of the Act in the circumstances of this case are ss 6(1) and 38:

"s 6(1) In calculating the assessable income of any taxpayer any expenditure or loss to the extent to which it is necessarily incurred in carrying on a business for the purpose of gaining or producing the assessable income for any fiscal year may, except as otherwise provided in this Act, be deducted from the gross assessable income derived by the taxpayer in the fiscal year in which the expenditure or loss is incurred."

and

"s 38 Every arrangement shall be absolutely void as against the Commissioner for income tax purposes if and to the extent that its purpose or one of its main purposes is tax avoidance."

Section 38(2) sets out the relevant considerations in determining whether the purpose or one of the main purposes of an arrangement is tax avoidance and s 38(5) defines "arrangement", "liability", "purpose" (which means the end in view or object of the arrangement and does not include the motive or intention of the taxpayer except insofar as evidence in the arrangement) and Tax Avoidance (which includes directly or indirectly –

(a) altering the incidence of any tax;

(b) relieving any person from liability to pay tax;

(c) avoiding, reducing or postponing any liability to pay tax.

[1] S.6 of the Act : Expenditure or loss necessarily incurred in production of assessable income.

We agree with the taxpayer that a bonus can be and usually is an allowable expense. But that is subject to its purpose. By S.2 of the Act "salary or wages" includes bonuses. We agree also that the specific amount of a bonus is not directly limited by the Act in terms of percentage nor as to its quantum.

We consider that:

• The bonus was not necessarily incurred for the purpose of gaining or producing the assessable income.

Firstly we agree that there is an artificiality to the arrangement as the amount has only been accrued in the company and not paid. That is, the profits had already been made. That is, the expense was not necessarily incurred to make the gross revenues. The bonus hasn't really accrued and it was not necessary to do this transaction. It is a series of book entries or paper transactions which are not at arms length. There does not appear to be any employment agreement. What is the input of the taxpayer to take out $2,140,00 bonus out of a taxable income of $2,662,740?

• The expenditure has been paid without any clear evidence that the taxpayer has added any value or performed any substantive functions.

• The statement of the taxpayer himself discloses that the sole purpose of the arrangement was the avoidance of tax. It was not necessarily incurred for the purpose of gaining or producing the assessable income.

• We accept the submission of the Commissioner that:

"Applying the principles to the facts of Mr Jones case, it is suggested that the subjective purpose or motive of the company, as evidenced through the actions and decisions of Mr Jones was the obtaining of a tax deduction in circumstances where on a common sense approach one would have expected dividends to be paid. The purpose of the payment was the obtaining of a tax deduction in the hands of the company and Mr Jones being assessed on salary and wages at a lower rate of tax than the company would have been assessed had the payment not been made. There is no obvious commercial connection between the outgoing and the deriving of assessable income. The income has been derived and the deduction is in substitution of dividends which would have been paid or the profit accumulated.

• Further, as the Commissioner points out

(i) Mr Jones does not appear on PAYE statements of 3 of the companies (other than E.M. JONES LTD) where he was paid a salary and directors fees totaling $228,652, with director's fees of $14,000.

(ii) The largest bonus ($1,575,000) is paid by Jones Industries Ltd, where he does not appear on the list of employees.

(iii) There is an unreasonable proportion between the profit before tax without the bonus and the bonus itself. It's unreasonableness and lack of commerciality is demonstrated by the figures below, unveiling as a farce, not a legitimate deduction and an instrument of tax avoidance.

[2] S.38 : The tax advantage obtained under an arrangement must not have as its purpose or one of its main purposes that of tax avoidance.

We agree with the Commissioner's assertion that the tax advantage was the deduction claimed by the taxpayer company(s) of an amount accrued but never paid. Also the advantage of the lower tax rate that Mr Jones was assessed on in his individual return. Further,

"The arrangement could be said to be the decision by the company to pay Mr Jones the bonus and claim the tax deduction. The accrual of the deduction in the book of accounts of the company(s). The inclusion by Mr Jones of the amount in his individual return (even though he had not received the amount). The subsequent decision/action of Mr Jones to "return" the money to the company for use as working capital. In essence no money changed hands. The company(s) claimed a tax deduction and Mr Jones included the amount in his assessable/chargeable income."

Section 38(2) of the Act sets out 10 considerations in determining whether the purpose or one of the main purposes of an arrangement is tax avoidance.

"S.38(2)(a) whether the arrangement might reasonably be expected to have been entered into and implemented in that particular way if tax avoidance had not been its purpose or one of its main purposes."

The only purpose that we can see was for the assessment of the bonus at a lower tax rate than the companies would have been assessed on.

"S.38(2)(b) whether the rights and obligations arising under the arrangement might reasonably be expected to have been created under an arrangement not having tax avoidance as its purpose or one of its main purposes."

We agree that had the arrangement not had tax avoidance as its purpose or one of its main purposes, there would have been no payment of the bonus and no rights given to Mr Jones.

"S.38(2) (c) the extent to which the emphasis in the arrangement is substantially on income factors."

The arrangement converts a payment of dividend with a bonus and ensues that the payment is received by the taxpayer as employment income and not as dividend income (as submitted).

"S.38(2)(d) the overall effect of the arrangement on the practical carrying on of any existing business or other activity to which it relates."

The arrangement has had no practical effect on the carrying on of the business. As indicated the companies received a large tax deduction and not paid out any money. It accrued the amount which was then subsequently re-paid.

"S.38(2)(e) the dependance on the taxpayer for the earning or accruing of income under the arrangement".

In the circumstances of this case this condition does not arise.

"S.38(2)(f) the extent of the control over the earning and disposition of income under the arrangement in practice achieved by the taxpayer".

The Commissioner indicates that tax returns of the companies still show shareholding with other shareholders but "at this stage there are no minutes to show or memorandums to show management approved the payment of the bonus. What control the taxpayer has achieved is not clear.

"S.38(2)(g), any disadvantage accruing to the taxpayer from the arrangement.

There appears to be no disadvantage to the companies but as indicated the disadvantage is to the shareholders who receive less dividends.

"S.38(2)(h) the tax advantage obtained through the arrangement."

As already spelt out the tax advantage is the obtaining of a deductible payment (the bonus) by the various companies in lieu of a non deductible payment (dividends).

"S.38(2)(i) the income tax and other implications of other courses of actions open to the taxpayer at the time he entered into the arrangement."

If dividends had been paid there would have been no deductions to the companies.

Conclusion

We can only conclude that the arrangement in this case had as its purpose the avoidance of tax. We accept that the taxpayer himself made this admission. But even without that admission we are satisfied that the main purpose and certainly one of the main purposes of the arrangement was tax avoidance.

We accept the Commissioner's contention as to the arrangement, that it was entered into to gain a tax deduction for the companies and "whilst it is true that a taxpayer can take advantage of a deduction provision in the Act, it cannot prevent an anti avoidance provision applying where there is a transaction that is artificial or contrived. The arrangement achieved a manufactured tax advantage which was essentially void of economic reality" Further

"Objectively the method adopted was the payment of a bonus" In essence the "bonus" was a disguised dividend."

A consideration that indicates that the purpose or one of the main purposes was tax avoidance are that the bonuses that were paid were not connected to performance. Mr Jones was not an employee of 3 of the companies that paid him the bonus and as stated "there is no record of how the bonuses were worked out. No minutes have been produced to show the shareholders/directors agreed to pay the bonuses. If there was no tax advantage, no bonus would have been paid. It did not appear that bonuses had been paid in previous years to Mr Jones. The bonuses are unrelated to profit before tax.

There are various resolutions of the Directors resolving that the bonuses be paid nearly a year later but they may not be in conformity with the Companies Act nor how the amount was determined nor why the bonus was merited. There are no minutes or statement that it is 'fair to the company'.

We are satisfied that the arrangement in this case altered the incidence of tax; relieved the taxpayer from a substantial liability to pay tax and also avoided liability to pay tax.

Accordingly the Tribunal reaffirms the tax assessments issued to the applicant on the 8th March 2006 and reaffirms the decision of the Commissioner to disallow the objection (dated 10th April 2006) to the tax assessment s by the Commissioner dated the 9th June 2006.

Penalties and Interest to be resolved by the parties.

Costs awarded to the Respondent Commissioner.