Report to the Treasurer and Minister of revenue - by a committee of experts on tax complianceBill Birch Treasurer
Report to the Treasurer and Minister of revenue
By a committee of experts on tax compliance
Chapter 17 -
THE RULINGS PROCESS
17.1 Part VA of the Tax Administration Act 1994 268 provides for the Commissioner to issue binding rulings. There are three types of binding rulings, namely public rulings, 269 private rulings 270 and product rulings. 271 Each states how the Commissioner considers that a taxation law applies in relation to a particular 'arrangement' or (in the case of product rulings) type of 'arrangement'.
17.2 A public ruling binds the Commissioner to assess in accordance with its terms if the ruling reflects a taxpayer's circumstances and the taxpayer applies the taxation law in the way stated in the ruling. Similarly, a private ruling binds the Commissioner to assess a taxpayer in accordance with the terms of the ruling if that ruling is strictly applicable and the taxpayer applies the taxation law in the way stated in the ruling. The same is true for product rulings, where the Commissioner is required to follow the ruling if it applies in a particular taxpayer's circumstances and that taxpayer adopts the approach set out in the ruling.
17.3 Public rulings are published by the Commissioner, and are freely available. Private rulings are confidential between applicants and the department. Product rulings are confidential until they are issued, but the legislation then requires the Commissioner to notify the making of a product ruling in the Gazette and to make a copy of the ruling available to anyone who may request it.
17.4 Because the system of binding rulings is limited to ruling upon 'arrangements', and because many of the topics upon which clarification is sought are broader or raise factual variations, the department frequently issues other public statements which are not formally binding rulings. Usually these are described as 'interpretation statements', although where they cover a general area of taxation or related law they may be termed 'interpretation guidelines'. These are not formally binding on the Commissioner, but they will generally be followed administratively. The processes for research, analysis and consultation adopted for interpretation statements and interpretation guidelines are identical to those followed for public binding rulings. Over and above the rulings, statements, and guidelines mentioned so far, the Inland Revenue Operations business group produces 'standard practice statements', which are public statements regarding the administrative practices of the department or exercises of particular discretions vested in the Commissioner. The committee did not have time to review standard practice statements as to quality or coverage.
17.5 When the Rulings unit begins work on any ruling, three people are identified in relation to the project - the analyst (who is the principal researcher and author for the project), the manager (whose role is to assist the analyst and provide guidance throughout the research and analysis), and the sign-off (whose function is to challenge and be satisfied as to the robustness of the technical reasoning and logic contained in the background issues report). A directions meeting is held at the beginning of a project to identify issues, suggest relevant research sources and (when required by the legislation) to set recommended timeframes and fee estimates. Subsequent meetings will be held between the three officials during the project. Before a ruling or statement is produced, a detailed issues report will be prepared by the analyst. The process provides for conclusions to be agreed by the manager and approved by the sign-off. In some projects where specialised issues arise, an additional member of the Adjudication and Rulings business group may be nominated as 'adviser' in relation to the project where he or she has relevant expertise or background.
17.6 All public rulings, interpretation statements and interpretation guidelines are subject to an extensive consultation process, both within and outside the department. (Consultation includes circulation to professional bodies and industry groups, advertising the drafts for comment in the Tax Information Bulletin and placing a copy on the department's website.)
17.7 Upon receipt of a private or product ruling application, copies of the application are automatically forwarded to the Policy Advice Division of the Inland Revenue Department and to the Operations segment that is responsible for the particular applicant. In that event, a summary memorandum is prepared in order to seek relevant input from other analysts within Adjudication and Rulings. A copy of the memorandum also goes to the Policy Advice Division and to National Operations Policy. Before an issues report is completed in relation to any private or product ruling, the analyst is required to provide an opportunity for both Policy Advice Division and the relevant Operations segment to provide comments and/or technical submissions concerning the matters raised in the application. The ultimate decision on the ruling application, however, rests with the Rulings unit, which attempts to apply an objective interpretational approach, rather than a policy-based or revenue protective one, in reaching its conclusions.
17.8 At the conclusion of every rulings project, the file goes through a post-issue review process, where it is checked by a different person within Adjudication and Rulings to ensure that relevant processes have been correctly followed and that the conclusions and recommendations are appropriately analysed and sustainable.
17.9 The committee considered two aspects of rulings that are issued by the Inland Revenue Department: quality, and the relationship between rulings and policy making.
Quality of private binding rulings
17.10 Most binding rulings are private. By section 91EH(2) of the Tax Administration Act 1994 the Commissioner notifies the existence of a private ruling by sending a copy to the applicant. This is the only notification. There is no publicity unless the applicant chooses, which rarely if ever happens.
17.11 Before part VA of the Tax Administration Act 1994 established binding rulings in 1995 there was a lively debate about whether private rulings should be confidential, or whether they should be disclosed, though rendered anonymous if the applicant wished. The principal argument for disclosure is that binding rulings are in a sense delegated legislation, and, being akin to law in a manner similar to court judgments, they should not be secret. Against disclosure it was argued that the contents of a ruling would be likely to identify the taxpayer involved, and that rendering rulings anonymous would not be enough to protect taxpayer identity in New Zealand's relatively small marketplace.
17.12 The second argument won the day. One result is that, probably, more private rulings are issued than might otherwise have been the case. Since 1995 the numbers of private rulings issued are: 1995, 168; 1996, 176; 1997, 302; 1998, until 6 October, 153. The committee has no reservations about this result. The certainty offered by the rulings process is a good thing, and, since applicants pay a full price for the work involved in issuing rulings, there is no reason to limit numbers.
Quality control and utility of the rulings process
17.13 A second result that is less immediately obvious is that there is no quality control of rulings that is external to the Inland Revenue Department. Such an absence of quality control is unusual in respect of law. Legislation, court judgments, and public interpretation statements of the Commissioner are all subject to scrutiny by members of the public who are affected and by their advisers. Legislation and interpretation statements are also likely to be scrutinised by the courts, as are judgments, in the context of appeals and later cases.
17.14 As will be understood by the last paragraph, the quality control that the legal process ordinarily applies to law is informal and sporadic, but it is nonetheless real. For example, the statute book is replete with rules that have been amended and improved after the courts found something wanting in their earlier form.
17.15 As a matter of principle, the committee is concerned that, external to the Inland Revenue Department, there is no control over private binding rulings by way of independent scrutiny of this growing body of quasi-law. The department strives to overcome this problem by ensuring that rulings are checked at several levels of seniority before they are issued.
17.16 Counterbalancing this lack of external quality control of rulings is the consideration that the ruling process has a very useful role in the administration of the tax system. Through people applying for rulings, the Commissioner receives early notice of business and tax planning structures. The rulings process can therefore give the Commissioner notice of matters that he could draw to Parliament's attention if legislative countermeasures are needed.
Conclusion as to private rulings
17.17 The department is aware of the importance of maintaining the highest of standards in the operation of the rulings process. It tries to ensure that Rulings unit staff are of very high calibre. Moreover, every six months the department estimates for the Minister of Revenue the amount of tax that is at risk because of rulings that have been issued (that is, tax that will erroneously be foregone should it turn out that one or more rulings are wrong).
17.18 The committee considered whether private rulings should be required to be published in an anonymous form. This step would have the merit of permitting public scrutiny of rulings and of allowing public access to a growing body of quasi law. But it would result in fewer rulings. On balance, the committee decided that the advantages of the rulings process (certainty for the taxpayer and intelligence for the Commissioner) outweigh the advantages of publication. The committee therefore does not recommend a change.
Interpretation statements, interpretation guidelines, and public rulings
17.19 From time to time, the Commissioner issues statements that, in contrast to private rulings, are for the guidance of taxpayers in general. In chapter 6 of this report, beginning at para 6.54 the committee considers several of such statements that concern tax avoidance and related matters.
Rulings and principles of tax policy formation
17.20 In principle, tax policy should be driven by economic policy, not by legal policy. When Parliament translates economic policy into law by passing tax legislation, the legislation becomes the vehicle for carrying economic policy into effect. Legal rules or principles cannot tell us what tax law should try to achieve: that is a matter of economic policy and of government objectives. Nevertheless, drafters of tax legislation must take general legal rules and principles into account in the drafting process, because these rules and principles influence the way in which statutory law is interpreted and takes effect.
17.21 Broadly speaking, New Zealand's tax policy formation and execution take account of the factors that are explained in the last paragraph. The government's generic tax policy process starts with asking what is to be achieved from an economic point of view, and finishes with tax law that is enacted to put that objective into effect. Along the way, the policy is tested from both economic and legal points of view within both the Treasury and the Inland Revenue Department, and by consultation with the public and with professional groups.
17.22 The processes of composing and issuing private rulings and product rulings do not observe these principles. Private and product rulings are composed within the Rulings unit of the Inland Revenue Department. Like courts, the unit's brief is to issue rulings that state the current law, not to consider whether the unit's view of the law promotes or frustrates fiscal policy. That is, the unit starts by treating law as a base of accepted correct principle, whether the law is found in statute or in judicial decisions. In contrast, tax policy formation, and in particular New Zealand's generic tax policy process, start one stage earlier, by looking at economic principle.
17.23 Where the law (or the unit's interpretation of the law) correctly states economic policy, there is no cause for concern: that is, whether new law is created by general legislation or by a binding ruling the result is what Parliament would have laid down had Parliament thought about the matter.
17.24 On the other hand, where the law as interpreted by the Rulings unit does not reflect economic principle (either economic principle that Parliament has considered, or principle that Parliament would support if it considered the matter) the ruling that is issued may well be contrary to good tax policy. This matter is not one to be laid against the door of the Rulings unit. Its task is not to make policy but to work out the law and to state that law in rulings. Indeed, the unit would be acting unlawfully if it issued rulings according to economic policy rather than according to law.
17.25 The situation described in the last paragraph, of having binding rulings that may be contrary to good tax policy when the policy is measured according to economic principle, carries a cost. In deciding to adopt procedures for issuing binding rulings, New Zealand has decided to bear this cost. The benefit is that binding rulings can give taxpayers certainty about the fiscal consequences of their transactions. On an individual taxpayer basis, that certainty is worth having, and in many cases the cost to society will not be great, or there may be doubt whether there is any cost. For example, in some cases it would be hard to decide whether rulings that draw the line between capital and income are right or wrong from an economic point of view, because the very distinction between capital items and revenue items, which is fundamental to New Zealand income tax law, often makes little sense when it is examined in the light of economic principle. For the reasons just described, one can justify the idea of binding rulings. So long as rulings are issued to taxpayers on an individual basis, benefits appear to outweigh costs.
17.26 The considerations just described do not apply to public rulings. Public rulings are much closer to ordinary delegated legislation than are private rulings: anyone who wishes may take advantage of a public ruling. Government policy makers have recognised this implication of public rulings. For this reason, among others, section 91D of the Tax Administration Act 1994 provides that it is discretionary rather than compulsory whether the Commissioner issues public rulings. Secondly, the Commissioner has adopted the practice of notifying proposed public rulings to the Treasury (as well as other parties) before issue, which permits consideration of whether any change to the law is required. The committee endorses both measures.
17.27 When it comes to product rulings, there is a seeming weakness in the system. By section 91F (1) it is not in terms compulsory for the Commissioner to make product rulings. Although in drafting terms that sits uncomfortably with an apparently unfettered discretion in section 91F (1), section 91F (3) may limit the Commissioner's power to decline applications to the fairly limited circumstances set out there. More importantly, there is no provision for proposed product rulings to be examined for consistency with fiscal policy. Despite this lacuna, a product ruling, or a series of product rulings, can have an effect similar to public rulings.
The passive fund rulings
17.28 A good example is the series of product rulings issued between 1996 and 1998 that relate to passively managed investment funds. These rulings state that capital gains derived by passive funds are exempt from tax. To understand the importance of these rulings it is necessary to have some knowledge of their context.
17.29 The context of the 1996 to 1998 rulings starts with Californian Copper Syndicate Ltd & Reduced v Harris. 272 Californian Copper involved the boundary between capital gains and income profits. It dealt with the tax consequences of the sale of assets that for most people are classified as being on capital account. At the risk of over-simplification, the case held that when a taxpayer's business involves selling such assets, even if only once, then profits that the taxpayer derives are taxable as income.
17.30 Throughout this century, the Californian Copper principle has had a steadily increasing impact on the finance sector. Progressively, courts have decided that the principle applies to the profits from increasing numbers of transactions. In the present context, the Australian High Court case of London Australia Investment Co Ltd v FCT 273 was a watershed. Again at the risk of over-simplification, that case held that, in general, profits that investment companies make when they realise investments in order to buy other investments are taxable as income. This is so even though such profits would ordinarily not be income for people who happen to be, as individuals, shareholders in investment companies, if these individual shareholders had directly bought and later sold the same investments. That is, the taxable status of certain transactions changes from capital to revenue if people undertake these transactions via investment companies. For present purposes, mutual funds and investment unit trusts are in the same position as investment companies.
Product rulings in respect of passive funds
17.31 The 1996 to 1998 rulings that are the subject of this part of the committee's report hold that passive funds that simply track the stock market, or a fraction of it, are not affected by the Californian Copper principle. The fundamental approach of these funds is that they hold shares in, say, companies listed on the New Zealand stock exchange in proportion to the respective market capitalisation of those companies. For example, if company A's capitalisation represents four per cent of the capitalisation of all listed companies, a passive fund that covers the whole sharemarket will ensure that four per cent of its funds are invested in company A. Typically, passive funds invest in only part of the market, say the leading 20 or 40 companies.
17.32 As the relative capitalisation of listed companies changes, so does the portfolio of a passive fund. If the shares of company B go down in value relative to the value of shares in other companies, a passive fund sells some of its shares in company B and buys shares in the appropriate proportions in other listed companies.
17.33 The 1996 to 1998 rulings protect the fund from paying tax on any gain in the value of company B shares that it may realise in the course of this transaction. This result contrasts with the position of an ordinary fund that manages its investments actively and that, say, quits shares in company B because it calculates that they are overvalued or because the dividend yield is too low, or for any of the other reasons that might cause a fund manager to change an investment. For ordinary funds, the Californian Copper principle as understood nowadays says that gains on the sale of company B shares are taxable as income.
Implications of passive fund product rulings
17.34 For New Zealand investors nowadays the contrast is between the tax positions of passive funds and active funds. A second contrast is between cases where the Californian Copper principle operates and cases where it does not operate. The outcomes of those contrasts include:
Generally, if funds take care over their investments, they suffer a harsher tax regime than funds that follow the market automatically.
Passive funds cannot act to protect their investors by quitting even the most unpromising of stocks, for fear of rendering themselves liable to tax on all profits derived on investment switches.
Generally, the bigger and more diversified an investment portfolio, no matter who holds it, the more chance there is that the Californian Copper principle applies.
The fiscal advantages of passive funds have resulted in a major shift of New Zealand investment patterns to the benefit of these funds. In fact, one investment adviser, argues that these fiscal advantages are so significant that it is unethical except in rare circumstances for advisers to recommend actively managed investment funds to New Zealand taxpayers.274
17.35 The 1996 to 1998 rulings are not the only cause of the shift to passive funds on the New Zealand stockmarket. Another factor is investors' increasing disillusionment with the performance of actively managed funds. In recent years, the press has published survey after survey to show that when management fees are taken into account (and sometimes even when they are not) the performance of actively managed funds over time often does not even match the market. The committee is advised that throughout the world there is a trend for investors to move from active to passive funds.
17.36 The impact of this trend in New Zealand more or less coincided with the 1996 to 1998 rulings. As a result, it is not possible to disentangle the effects on the New Zealand stock market of these two separate influences. Be that as it may, there can be little doubt that the rulings had a very significant impact, not only on investment advisers but also on investors. Until the rulings were issued, passive funds hardly existed in New Zealand. The following table shows the increase in investment in New Zealand passive funds since the 1996 to 1998 rulings.
TABLE 9: RETAIL INVESTMENTS IN NEW ZEALAND PASSIVE FUNDS
|Asset class|| September 1996
| March 1998
| NZ equities
International and Australian diversified
All retail funds
|* all in the New Zealand Stock Exchange TeNZ fund established in June 1996|
Policy and the passive fund rulings
17.37 Some people have reservations about the way in which the Californian Copper principle is applied to actively and passively managed funds, and whether nowadays that application is correct in law. However, these reservations may be put to one side. The more important issue concerns the fiscal effect of the 1996 to 1998 product rulings. They have had a major effect on the managed fund industry. On the face of it, the effect may be detrimental, in that the rulings encourage people to invest via vehicles that calculatedly do not manage investments for the best yield, if one ignores tax considerations. On the other hand, the overall effect of the passive fund rulings may be beneficial to the economy. That is so if managed funds in general are indeed an inefficient investment vehicle, as some disillusioned investors suspect. In the present context, however, the important consideration is that the factors that caused the change are questionable, in that one factor with at least some responsibility was an announced change in tax treatment of investments.
17.38 For some years, New Zealanders have become increasingly aware that it is bad policy for the tax system to drive business and investment decisions. This thought is fundamental to many of the tax reforms that have occurred since the mid-1980s. Elsewhere in this report the committee has noted its concern that, despite policy makers' best efforts, some lack of neutrality remains within the tax system.275 But, at least, to the extent that there is a lack of neutrality, this position is ordinarily a function of the Income Tax Act.
17.39 To have product rulings on income tax law contributing in a major way to the structure of New Zealand's investment market is questionable. The present shape of the market may or may not be optimal. The government would no doubt reject any suggestion that it should directly regulate the stock exchange in a manner that promotes one investment vehicle at the expense of others. Nevertheless it is achieving the same result indirectly by tax legislation.
17.40 The committee endorses the current rulings process. It recommends that the issuing of product rulings should clearly be discretionary, as is already the case with public rulings. In exercising its discretion to issue public and product rulings the policy implications of such rulings should be taken into account.