Frucor Suntory New Zealand v Commissioner of Inland Revenue
[2018] NZHC 2860
•5 November 2018
IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY
I TE KŌTI MATUA O AOTEAROA TĀMAKI MAKAURAU ROHE
CIV-2012-404-0219
[2018] NZHC 2860
BETWEEN FRUCOR SUNTORY NEW ZEALAND LIMITED
PlaintiffAND
COMMISSIONER OF INLAND REVENUE
Defendant
Hearing: 2, 3, 4, 5, 9, 10 and 11 July 2018 Appearances:
L McKay, M McKay and J Q Wilson for the Plaintiff JBM Smith QC, J Norris, L K Worthing for the Defendant
Judgment:
5 November 2018
JUDGMENT OF MUIR J
This judgment was delivered by me on Monday 5 November 2018 at 2.30 pm Pursuant to Rule 11.5 of the High Court Rules.
Registrar/Deputy Registrar Date:…………………………
Solicitors:
Bell Gully, Auckland
Crown Law, Wellington
FRUCOR SUNTORY NEW ZEALAND LIMITED v COMMISSIONER OF INLAND REVENUE [2018]
NZHC 2860 [5 November 2018]
Table of Contents
Introduction [1]
The issues [5]
The key parties [7]
Diagram of the key steps [12]
The Note and the Forward Purchase — Outline [13]The Note [13]
The Forward Purchase [16]
Subsidiary documents [18]
The Convertible Note guarantee [19]
Mutual acknowledgment as to the lowest price of shares [20]The Forward Purchase guarantee [22]
The cashflows, share issues and transfers [23]
The commercial context of the Arrangement [27]
The basis of the Commissioner’s assessments [37]Approach in statement of position dated 25 January 2011 [42]
Approach of Adjudication Unit, 22 November 2011 [45] The Commissioner’s expert evidence [49] Comparison of experts’ approach with accounting treatment [76]
The tax avoidance framework [80]
Section DB 7 and the financial arrangements rules [96] The wider quest for legislative intention — the group approach [117]
(a)The imposition of NRWT on dividend, interest and royalty flows [120]
(b)The transfer pricing regime [123]
(c)The thin capitalisation regime [128]
The three regimes in a wider context [130] What is the “Arrangement”? [136]
Assessment in light of the Ben Nevis factors [140] The manner in which the Arrangement was carried out [141] The role of all the relevant parties and their relationship to the Taxpayer [142] The economic and commercial effect of the documents [149]
Artificiality and contrivance [158]
The Commissioner’s “no cost” argument [173]
Was therefore s BG 1 appropriately invoked? [194] In the alternative: was this merely incidental tax avoidance? [205] Reconstruction — s GB 1 [212]
In the alternative: would liability for penalties arise? [213]
Result [223]
Costs [224]
Introduction
[1] This case concerns application of the much-litigated general anti-avoidance rule in s BG 1 of (relevantly) the Income Tax Act 2004 (the Act).
[2] In issue are deductions of $10,827,606 and $11,665,323 which were disallowed in the 2006 and 2007 income tax years respectively.1 In addition, the Commissioner has imposed shortfall penalties of $1,786,555 and $1,924,779 for those years.2 The outcome of the case also governs the taxpayer’s liabilities in the 2008 and 2009 income tax years for which it has not claimed what would be broadly equivalent deductions but in respect of which it has issued notices of proposed adjustment seeking to do so.3
[3] The claimed deductions arise in the context of an arrangement (the Arrangement) entered into by Frucor Holdings Ltd (FHNZ) involving, among other steps, its issue of a Convertible Note (the Note) to Deutsche Bank, New Zealand Branch (DBNZ) and a forward purchase of the shares DBNZ could call for under the Note by FHNZ’s Singapore based parent Danone Asia Pte Ltd (DAP).
[4] The Note had a face value of $204,421,5654 and carried interest at a rate of 6.5 per cent per annum. Over its five-year life, FHNZ paid DBNZ approximately
$66 million which FHNZ characterised as interest and deducted for income tax purposes. The Commissioner says that, although such deduction complied with the “black letter” of the Act, $55 million of the $66 million paid was in fact a non- deductible repayment of principal.5 She has invoked s BG 1 to treat the $55 million as non-deductible, allowing an interest deduction of $11 million only over the life of the Arrangement.
1 These figures represent the deduction disallowed by the Commissioner, as compared to the deductions claimed by the taxpayer: $13,250,998 in 2006 and $13,323,806 in 2007.
2 Based on an allegedly abusive tax position but mitigated by the taxpayer’s prior compliance history.
3 In so doing, avoiding any exposure to shortfall penalties for the 2008 and 2009 years in the event it is unsuccessful in the present proceedings. The income years 2004 and 2005, in which interest deductions were also claimed under the relevant transaction are time barred.
4 Which I will refer to hereafter as $204 million without derogating from the Commissioner’s argument that the precise amount of the Note is itself evidence of artifice in the transaction.
5 As the parties did in both the evidence and the argument, I use the $55 million figure for illustrative purposes. In fact, as recorded in fn 3 above, the Commissioner is time barred from reassessing two of FHNZ’s relevant income tax returns.
The issues
[5] The primary issue in the proceedings is whether s BG 1 of the Act applies to the Arrangement.
[6]Two further issues arise if s BG 1 is held to apply:
(a)whether the Commissioner’s reconstruction of the Arrangement pursuant to s GB 1 of the Act is correct or whether it is, as FHNZ submits, “incorrect and excessive”; and
(b)whether the shortfall penalties in ss 141B (unacceptable tax position) or 141D (abusive tax position) of the Tax Administration Act 1994 (TAA) have application.
The key parties
[7] The key parties to the Arrangement were FHNZ, DBNZ and DAP. In addition, several other entities had subordinate roles as I will discuss later.
[8] FHNZ is the successor company to Danone Holdings NZ Limited (DHNZ) which is the company named as issuer of the Note. On 30 January 2009, DHNZ changed its name to FHNZ and on 19 May 2009 amalgamated with the plaintiff (then named Frucor Beverages Limited).
[9] For convenience, I intend to refer to FHNZ throughout as the party which issued the Note, made payments to DBNZ through the Note’s life and which, in satisfaction of the relevant liability, issued shares to DBNZ at the conclusion of the Note’s five-year term.
[10] During all periods relevant to the dispute FHNZ was wholly owned by DAP, itself part of the multinational Danone Group of which the ultimate parent is Groupe Danone SA, a French-based company. As indicated, DAP entered into a Forward Purchase Agreement with DBNZ.
[11] DBNZ is the New Zealand branch of Deutsche Bank AG a banking and financial services company based in Germany. DBNZ entered into the two primary transactions which feature in the dispute namely the Note (with FHNZ) and the Forward Purchase Agreement (with DAP).
Diagram of the key steps
[12] The key steps on entry into the Arrangement, the money flows which occurred during the life of the Arrangement and the steps taken at maturity are best represented diagrammatically:
The Note and the Forward Purchase — Outline
The Note
[13] On 14 March 2003 FHNZ and DBNZ entered into a Convertible Note Deed whereby DBNZ agreed to pay FHNZ $204 million for issue by FHNZ of a Convertible Note.
[14]The key terms of the Deed were as follows:
(a)The Note was denominated in New Zealand dollars.6
(b)It matured on the fifth anniversary of the issue date (being 18 March 2008).7
(c)FHNZ paid interest at 6.5 per cent per annum in respect of the principal amount of the Convertible Note, payable semi-annually in arrears.8
(d)Redemption of the Note was governed by cls 5.1 and 5.2 in terms:
5.1Redeemed for cash: subject to clause 5.2 on the Maturity Date the Company shall satisfy the principal obligations of the Company in respect of the Note by paying to the Investor an amount equal to the Redemption Amount.
5.2Conversion: if, but only if, the Investor has given the Company written notice not less than 10 Business Days prior to the Maturity Date that it elects to have all the obligations of the Company in respect of the Principal Amount satisfied by the issue of the Shares then the Company shall issue to the Investor the Shares by not later than 4 pm (time being of the essence) on the Maturity Date and those obligations shall be satisfied in full by such issue.
(e)The option to convert to shares was not detachable from the Note.
(f)The Note did not confer on the holder any right to attend or vote at any meeting of FHNZ.9
6 Clause 1.1.
7 Clause 1.1.
8 Clause 3.1 in the definitions of interest payment date, interest period and interest rate in cl 1.1.
9 Clause 2.3.
[15] FHNZ issued a Note Certificate with respect to the Note on 18 March 2003 (the issue date).
The Forward Purchase
[16] DAP entered the Forward Purchase with DBNZ on 14 March 2003 in respect of the shares that DBNZ would receive on maturity of the Note if it so elected. The key terms of the Forward Purchase Agreement were as follows:
(a)DAP agreed to pay $149 million to DBNZ on 18 March 2003.10
(b)DBNZ agreed that, if it elected to convert the Note and receive the shares, it would transfer those shares to DAP.11
(c)In the event DBNZ elected to convert but FHNZ failed to issue the shares (and instead repaid the principal in cash), DBNZ would pay such sum to Campagnie Gervais Danone (CGD) (another Danone Group company), with CGD assuming all of DBNZ’s obligations under the Deed, including delivery of the Shares to DAP, as a novation counterparty.12
(d)In the event DBNZ did not elect to convert for shares, then it would pay to DAP the $204 million principal received from FHNZ together with an additional amount reflecting the tax imposed by Singapore on the difference between the $149 million paid under the Forward Purchase Agreement and the $204 million received.13
[17] The Commissioner’s expert, Professor Lewis Evans calculated such potential Singaporean tax liability as $13.9 million. This was not disputed by FHNZ, nor did it dispute that in all but a “Doomsday” scenario the tax “gross up” provisions in cl 3.4 would mean that DBNZ would inevitably call for conversion to shares.
10 Clause 3.1 and the definition of purchase price in cl 1.1.
11 Clause 3.2
12 Clause 3.3.
13 Clause 3.4. The additional amount was calculated by reference to a formula in cl 3.4.
Subsidiary documents
[18]These were threefold.
The Convertible Note guarantee
[19] On 14 March 2003 Groupe Danone SA (the ultimate parent company) entered into a first demand guarantee for the benefit of DBNZ. Under that document Groupe Danone SA guaranteed the payments made by FHNZ under the Convertible Note Deed up to a maximum of $250 million. In return it received a fee equal to 0.10 per cent of the $204 million principal amount advanced to FHNZ. This fee was payable by DBNZ under the Convertible Note Deed.
Mutual acknowledgment as to the lowest price of shares
[20] On the same date DBNZ, DAP and CGD executed a mutual acknowledgment that the lowest price of the FHNZ shares under the Forward Purchase was $204 million (the face value of the Note).14
[21] It is common ground that such acknowledgement confirmed, pursuant to the financial arrangements rules in the Act an income tax deduction to DBNZ equal to the difference between the $149 million received from DAP under the Forward Purchase and the $204 million acknowledged lowest price of the shares it transferred to DAP at maturity.
The Forward Purchase guarantee
[22] Again on 14 March 2003, Groupe Danone SA entered into a further guarantee for the benefit of DBNZ in terms of which it guaranteed the payments made by DAP under the Forward Purchase up to a maximum of $67 million. No fee was payable by DBNZ for this guarantee.
14 For the purposes of s EH 48(3) of the Income Tax Act 1994, the equivalent of s EW 32 of the 2004 Act with which these proceedings are concerned.
The cashflows, share issues and transfers
[23] These occurred exactly as anticipated by the transaction documents and involved:
(a)DBNZ paying FHNZ $204 million on subscription for the Note.
(b)DAP simultaneously paying DBNZ $149 million under the Forward Purchase Agreement for the shares which DBNZ had the option of taking on the Note’s maturity.
(c)FHNZ paying periodic interest at the rate of 6.5 per cent per annum on the $204 million subscription amount up to the maturity date of the Note.
(d)DBNZ paying a guarantee fee of 0.10 per cent on a periodic basis to Group Danone during the currency of the Note.
(e)DBNZ electing to convert the Note for shares on maturity, receiving 1,025 shares from FHNZ; and
(f)DBNZ transferring 1,025 shares to DAP in satisfaction of obligations under the Forward Purchase.
[24] As to application of the subscription monies ($204 million), immediately upon their receipt in 2003 FHNZ paid:
(a)$60 million to DAP by way of a repurchase of 400 shares (thereby reducing its share capital from $150 million to $90 million); and
(b)$144 million to Danone Finance SA (the treasury function of the Danone Group) by way of repayment of earlier advances made by that company.15
15 I discuss initial debt-equity arrangements more fully later in my judgment.
[25] So summarised, the cashflows disclose the genesis of the Commissioner’s argument under s BG 1. She says that because the $204 million paid by DBNZ for the Note (and on which interest accrued at 6.5 per cent) was funded as to $149 million by DAP’s forward purchase of the shares to be issued under the Note,16 DBNZ’s advance was, in an economically and commercially real sense, $55 million only and the $66 million nominally paid as interest on the Note over its five-year term in fact represented repayment of the principal with $11 million of interest only on the amortising debt. In the result, she disallowed deduction of what she calculated to be the principal repayments totalling $22,492,929 in the two income years in issue.
[26] In summary FHNZ’s riposte is that there is no basis to suggest the arrangement as documented is not “economically real”. It says the Commissioner’s approach wrongly assesses the arrangement’s economic effects at a group or consolidated level, contrary to fundamental principles involving the taxation of New Zealand subsidiaries of foreign companies, and incorrectly treats the shares issued by FHNZ as valueless.
The commercial context of the Arrangement
[27] This was provided by FHNZ’s sole witness Mr Stanley Marcello Jnr who was the Senior Regional Tax Manager of DAP between April 2015 and November 2016.
[28] Mr Marcello was not personally involved in the transaction at its inception. Indeed he only joined the Danone Group in 2006. Consistent with the authorities requiring the test in s BG 1 to be applied objectively and without reference to the intentions or motives of any party to the impugned arrangement, he confined himself to providing a linking narrative based on the primary transaction documents.17 In the event, his evidence was largely uncontentious.
[29] Significantly, Mr Marcello described the initial $297,522,000 acquisition by FHNZ of Frucor Beverages Ltd and its subsidiaries in January 2002 as having been funded by way of:
16 Itself funded as to $60 million by the capital reduction.
17 In the manner recognised as appropriate by Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] NZLR 175 at [27].
(a)equity of $150 million from DAP, provided on the issue of 1,000 shares by FHNZ to DAP; and
(b)a loan from Danone Finance SA for the balance of the purchase price under an “Agreement for Operations carried out within Danone Cash Management” (the Cash Management Agreement).
[30] Under the Cash Management Agreement Danone Finance SA maintained a current account for FHNZ which was subject to interest at the “market rate” being the monthly average EURIBOR/LIBOR rate over one month plus 1/8th of one per cent.
[31] FHNZ’s statutory accounts to 31 December 2002 record that total advances under the Cash Management Agreement were, at that time, $143,924,000 and it is common ground that, in the period down to repayment from the Note issue, interest of
$9,840,466 accrued and was properly deductible to FHNZ. In turn, the interest payment was subject to New Zealand non-resident withholding tax (NRWT) for which Danone Finance SA received a credit against its French tax liability on the interest.
[32] So-described it will be apparent that the initial funding model involved an almost even split between debt and equity on FHNZ’s balance sheet immediately following the acquisition.
[33] Almost immediately after the acquisition of Frucor Beverages was settled, however, the Danone Group started to investigate alternative funding structures. This is evident from a January 2002 presentation by Deutsche Bank entitled “Efficient Financing Alternatives for Danone in New Zealand”. That document states in its Executive Summary:
Deutsche Bank understands that Danone is currently looking at various alternatives to (re)finance the acquisition of the New Zealand beverage company Frucor Beverages Group Ltd in connection with its (NZ$ 294 million) take-over offer of all the shares of New Zealand’s largest juice maker.
[34] DBNZ proposed two alternative structures, both of which it said had been executed in New Zealand and had received “positive rulings from New Zealand tax advisors” being:
(a)a convertible note structure; and
(b)a structure based on the sale and lease-back of registered trademarks.
[35] The convertible note structure emerged as the preferred refinancing approach. Early iterations had the Forward Purchase undertaken by a United Kingdom or European Danone subsidiary but ultimately DAP was identified as the entity most appropriate.
[36] Referring to contemporaneous documents, Mr Marcello identified the reasons advanced at the time for the transaction as being:
(a)The convertible nature of the note enabled retention of funds within the New Zealand company to facilitate growth as recorded in a contemporaneous Danone memorandum in terms:
The use of Convertible Notes enables … [FHNZ] to save cashflows (in order to invest and grow faster) as there should be no repayment of the debt but a conversion to shares as opposed to a standard financing.18
(b)It would increase FHNZ’s equity capital at maturity of the transaction by $204 million, resulting in an expanded capital base to support further investments as recognised in a further contemporaneous Danone memorandum in terms:
[DAP] … to make a capital increase of NZD 215 M [an earlier indicative transaction figure corresponding to the eventual $204 million] in five years while investing only NZD 150 M [$149 million] today. The NZD 215 M [$204 million] of capital increase in [FHNZ] could be necessary in five years to be able to raise new debts to make investments in New Zealand or Asia.
(c)It would produce an offshore taxation advantage in comparison to alternative funding structures. This was identified as early as DBNZ’s January 2002 Efficient Financing document which noted both that:
18 Assuming DBNZ elected to take shares which, as indicated, was a reliable assumption in the absence of some unexpected circumstance.
The coupons paid by NZ entity on the convertible would be fully deductible:
There should be no capital gains tax on the acquisition of the NZ … shares … (provided such shares are not sold).
(d)Such offshore position was subsequently confirmed by advice dated 9 May 2002 from PricewaterhouseCoopers Singapore in terms that DAP would not be subject to Singaporean tax on the difference between the $149 million paid to DBNZ at the commencement of the transaction and the $204 million of shares received on maturity. In his evidence Mr Marcello contrasted this position with that applying to the previous loan from Danone Finance SA under the Cash Management Agreement. In that context the interest deductions which FHNZ was entitled to take gave rise to taxable income in France. The Arrangement therefore allowed for FHNZ to preserve its New Zealand tax deductions for interest paid on debt funding (albeit formerly subject to NRWT) while altering the Danone Group’s offshore tax treatment of its funding of FHNZ.
(e)It provided committed five-year funding to FHNZ at a fixed rate rather than the floating rate charged under the Cash Management Agreement. This aspect was identified in the same memorandum referred to in sub para (a) above:
The use of the Convertible Note enables … [FHNZ] to hedge its interest rate and liquidity on the medium term as it is a fixed rate medium term financing (versus a floating rate short term financing up to now). Our International Treasury confirms that a financing through a bilateral bank line would have been more expensive.
Other internal and contemporaneous memoranda variously describe the arrangement as providing “a cost of funding more alternatives than Frucor would have obtained from plain borrowings” and that the “benefits obtained” included “Financing Cost: extremely attractive for NZD financing”.
(f)It was consistent with the Danone Group’s policy to create a natural currency hedge for cashflows generated outside Europe by funding the relevant investments with local debt. This was referenced in an undated but contemporaneous Danone Group memorandum identifying “why the Group needs to hedge its cashflows from foreign investments by funding such investments with local debt” and the fact that refinancing through issue of convertible notes “answers to the objectives of the above policy”. In a further Danone Group internal memorandum, dated 11 March 2003 the same point was made in terms:
“Benefits obtained
…
NZD financing: putting a debt in the same currency as cash-flows of the company acquired provides us with a natural hedging; furthermore, interest are [sic] located in the same country as operating income.
(g)To better balance the debt to equity position of the New Zealand group during the term of the Note by application of part of the Note proceeds to the repurchase of shares from DAP. In the memorandum referred to in sub para (a) above this was stated as “the purpose of the transaction” and it was to enable an “increase [in] value creation for the New Zealand Group”.19 Likewise in an undated Frucor Beverages Ltd memorandum, which in its terms appears to have been prepared shortly after the Arrangement came to an end and within the 2008 tax year, the “key commercial divisions” of the transaction were stated to include:
To attain a more appropriate debt to equity level for the New Zealand Group.20
19 I record the content of the Memorandum, as Mr Marcello did, without elevating declared subjective purpose at the time to a relevant consideration in terms of application of s BG 1.
20 The other identified “drivers” are noted as:
·Securing fixed term funding at a lower cost of borrowing under a convertible note facility than under a more expensive syndicated loan structure.
·To fund the New Zealand operations in a manner consistent with Groupe Danone’s policy for subsidiaries to self-finance as much as possible and prevent any shares being held by an entity outside the Danone Group by use of a forward purchase agreement.
It was common ground between the parties that as a result of the repurchase of shares the debt-equity ratio on FHNZ’s balance sheet increased from approximately 50:50 to approximately 63:37.
The basis of the Commissioner’s assessments
[37] The Commissioner reassess FHNZ’s income tax position on the basis that s BG 1 permits her to treat $55 million of the payments made by FHNZ on the Note as repayment of non-deductible loan principal.
[38] As FHNZ submits, the Commissioner’s case is “not grounded in the argument that the Arrangement gave rise to income tax deductions that did not exist before the arrangement was entered into and was accordingly, for that reason alone, a tax avoidance arrangement”. Nor could it because, limited only by the thin capitalisation rules,21 it was always open to the Danone Group to introduce additional debt funding to FHNZ and to retire a portion of its equity funding. And as Mr Marcello said in evidence (which I accept), broadly equivalent tax deductions to those claimed under the Arrangement would have been available if the initial financing under the Cash Management Agreement had been retained.22
[39] Rather the Commissioner has, at various times, advanced two principal and one now-abandoned alternative approach to application of the anti-avoidance provisions.23
[40] The abandoned alternative approach was introduced in the Commissioner’s revised Notice of Proposed Adjustment dated 22 October 2010. It was premised on a rejection by the Court of her primary argument that the (greater) portion of FHNZ’s claimed interest deductions should be denied. It assumed a deeply discounted zero-
21 Which do not limit the amount of debt that may be introduced but only the deduction of interest paid on that debt. I will refer to these rules in greater detail later.
22 Mr Marcello’s reconstruction of interest payable under the Cash Management Agreement, had it been retained, indicated deductions of $10,619,354 in the 2006 year and $11,263,777 in the 2007 year. This compares with claimed deductions under the Arrangement (on the higher principal sum of $204 million) of $13,250,998 and $13,323,806 respectively and the interest deductions allowed by the Commissioner of $2,423,392 and $1,658,483 based on her reconstruction.
23 FHNZ’s submission being that the several changes in the Commissioner’s approach reflect adversely on the reliability of her avoidance analysis.
coupon bond with a face value of $204 million, an issue price of $149 million and NRWT on the deemed accretion of deductible interest over the term of the bond.
[41] The remaining approaches are those advanced in the Commissioner’s statement of position dated 25 January 2011 and in the Adjudication Report dated 22 November 2011 issued by the Commissioner’s Adjudication Unit.24
Approach in statement of position dated 25 January 2011
[42] Under this approach the Commissioner argues the presence of the Forward Purchase Agreement reduces the “real” or “economic” amount borrowed by FHNZ from $204 million to a “net loan” of $55 million with a commensurate reduction in interest entitlements.
[43] Because of the acknowledged receipt by FHNZ of $204 million and its application by way of capital return and repayment of facilities under the Cash Management Agreement, the Commissioner recharacterizes the $149 million as a payment made directly by DAP to FHNZ by way of an equity injection for which no deduction arises. That approach is premised on the fact that under the Forward Purchase, DBNZ would, having elected to take shares, hold them for a scintilla in time only before transferring them to DAP. In the result, the Commissioner characterises DAP as having “paid for shares which it knew it would receive in the future” so that the payment should be seen as “an equity injection in substance” despite the shares not being issued or received for five years.
[44]On this basis the Commissioner defines the “real” arrangement as being:
(a)A $55 million advance from DBNZ to FHNZ repaid as to both principal and interest on an amortising basis over the term of the Note, with payments of $55 million comprising principal, and interest deductibility limited to $11 million.
24 The parties agree that since this Court operates as a “hearing authority” for the purposes of the Tax Administration Act 1994, my jurisdiction is not limited by either of the positions referred to (s 138P). In argument Mr Smith QC stated that the first alternative “remains on the table” but that “the Commissioner’s primary argument is theory 2”.
(b)A $149 million advance subscription by DAP for the issue of equity in FHNZ in five years’ time, with no income tax implications either in respect of FHNZ’s receipt of the sum, its retention for the five-year period or issue of the shares at the conclusion of the Arrangement.
(c)The aggregate $204 million being available to FHNZ for the term of the Note.
(d)Liabilities in respect of that $204 million being fully discharged by FHNZ through the issue of shares in five years’ time.
Approach of Adjudication Unit, 22 November 2011
[45] The Adjudication Unit appears not to have been persuaded by the approach adopted in the statement of position. It clearly regarded the approach as involving a recharacterisation which breached the “economic equivalence” prohibition confirmed in Commissioner of Inland Revenue v Europa Oil (NZ) Ltd25 and other authoritative decisions under s BG 1, including the High Court and Court of Appeal decisions in Accent Management Ltd v Commissioner of Inland Revenue, later known in the Supreme Court as Ben Nevis26 (all as endorsed in the Commissioner’s own interpretation statement on s BG 1).27
[46] Its alternative position was, as I consider Mr L McKay fairly puts it, to regard FHNZ’s position as essentially the “reflex” of DBNZ’s economic position. Accordingly, the Adjudication Unit considered:
(a)DBNZ’s economic outlay on the subscription was $55 million only (having received the $149 million prepayment from DAP).
25 Commissioner of Inland Revenue v Europa Oil (NZ) Ltd [1971] NZLR 641 (PC) at 648 per Lord Wilberforce.
26 Accent Management Ltd v Commissioner of Inland Revenue (2005) 22 NZTC 19.027 (HC) at [135]–[142]; and Accent Management Limited v Commissioner of Inland Revenue [2007] NZCA 230, (2007) 23 NZTC 21.323 (CA) at [97]–[100] and [118].
27 Public Rulings Unit, Office of the Chief Tax Counsel Tax avoidance and the interpretation of sections BG 1 and GA 1 of the Income Tax Act 2007 (IS13/01, 13 June 2013).
(b)in return for that economic outlay, DBNZ received $66 million in interest over the term of the Note and, having regard to its initial outlay, this resulted in a net return of $11 million in economic terms.
(c)FHNZ’s economic position was equivalent. It received $204 million from DBNZ and paid $66 million to it. It also issued shares to DBNZ on termination of the arrangement which, although they represented consideration such as to discharge FHNZ’s obligations under the Note, had no economic cost to FHNZ.
[47]The Adjudication Report noted:
3.188 This leaves the $66 million the Taxpayer paid to Deutsche Bank. The Taxpayer argues that the entire $66 million was its [interest] cost under the Note. However, this is inconsistent with Deutsche Bank’s
$75 million economic cost under the note and its $11 million return. Deutsche Bank’s $11 million return under the Arrangement suggests that only $11 million of the Taxpayer’s $66 million outgoing represents a cost to the Taxpayer. The $55 million balance appears to be repayment of part of the $204 million lent under the Note …
…
3.191 … The balance of the $204 million (that is $204 million less $55 million, being $149 million) does not appear to be repaid by the Taxpayer other than by issuing of shares. There was no cost associated with the issuing of shares. This left the Taxpayer with a
$149 million gain.
[48] This alternative approach does not involve recharacterisation of DAP’s $149 million payment to DBNZ as prepayment of equity to FHNZ. Indeed the approach treats DAP’s payment as being made to DBNZ so as to reduce its economic exposure to $55 million. It is because DBNZ is seen to have an economic outlay of $55 million and an economic return on that outlay of $11 million that FHNZ’s claim for deduction of the full $66 million is said to be “inconsistent” with DBNZ’s position.
The Commissioner’s expert evidence
[49] The Commissioner called two expert witnesses: Professor Lewis Evans and Professor Moorad Choudhry. Professor Evans is an Emeritus Professor of Economics at Victoria University of Wellington. He holds a doctorate in economics and has had
a distinguished career in that field, including a Fellowship of the Law and Economics Association of New Zealand and a Distinguished Fellowship of the New Zealand Association of Economists. Professor Choudhry is an Honorary Professor of the University of Kent Business School. He has a doctorate in financial economics and, in combination with his successful career in the banking industry, has published extensively on the subject of banking and financial products.
[50] Both experts gave evidence on the commercial and economic effects of the transactions (or aspects of them) in issue in the proceedings.
[51] Professor Evans considered that, overall, the transaction “had the effect of the [Danone] Group borrowing and repaying $55.4 million over five years and rendering interest and principal repayment tax deductible.” He estimated that $11.1 million of the $66.5 million coupon repayments were properly characterised as interest, with the remaining amounts being repayment of principal.
[52] He defined the transaction to consist of “the actions specified in the Convertible Note Deed, the Forward Purchase Deed, the two guarantees and the Fee Arrangements”. He explicitly excluded “transfers that can be considered ancillary to the transaction” including the use to which FHNZ put the $204 million it received from DBNZ and the $89 million third-party financing received from BNP Paribas.
[53] He calculated that at the close of the transaction the Danone Group experienced an economic cost of $2.1 million, reflecting the fees paid to enter the arrangement.
[54] However, he further explained that, “while the transaction provides a negative pre-tax value to the Danone Group, it is significantly positive on a post-tax basis.” He considered this to be the case irrespective of the form of settlement (by share conversion and transfer, novation or cash payment) and attributed such result to the fact that the coupon payments were fully tax deductible.
[55]In the case of conversion and transfer he stated that:
(a)Adopting a discount rate of 6.4 per cent28 and discounting to the date of closure of the transaction (18 March 2003), the pre-tax cost to the Danone Group was $2,092,793.
(b)Because in his view the “issuance and concomitant transfers of shares have no cost to the entity that is FHNZ” the value of that entity “increases substantially” from the CN transaction. He identified that increase as $146,041,192 on a discounted basis, all attributable to “transfers within the Danone Group”.29
(c)On a post-tax basis30 and assuming full deductibility for the coupon payments the transaction enhanced the value of the Danone Group by approximately $14.9 million at the date of closure (with a $162,252,097 uplift in value to FHNZ, a $149 million reduction in value to DAP and a $611,000 increase to Groupe Danone SA.31
(d)Assuming that the coupon payments of $55.4 million in fact constituted principal payments of $44.3 million and interest payments of $11.1 million (which was the Professor’s thesis) and that only the latter was deductible (as the Commissioner contends), the post-tax value to the Danone Group would have been approximately negative $1.4 million at the date of closure.
[56]Accordingly, he concluded that:
The value of the Danone Group is enhanced by approximately $16.2 million by principal repayment deductibility of the coupon payments: being the difference between the present value of $14.9 million with full deductibility and $1.4 million with interest only deductibility.
[57] The Professor posited that this resulted in the New Zealand tax base subsidising the borrowing, at “social, equivalently economic, cost to New Zealand.”
28 Being the difference between the coupon rate of 6.5 per cent and the guarantee fee of 0.1 per cent.
29 Derived from DAP’s payment of $149 million.
30 Using a post tax discount rate of 4.29 per cent being 6.4 per cent less tax of 33 per cent.
31 Being the guarantee fees it received.
[58] In the case of novation, Professor Evans identified the same $16.2 million enhancement to the Group on a post-tax basis and the same pre-tax cost of $2.1 million, with the only significant change being that “FHNZ’s value from the [convertible note] transaction changes to negative because of the $204.4 million payment at settlement”.
[59] Under the cash repayment alternative, Professor Evans calculated the amount required to be paid by DBNZ to DAP as $218.3 million.32 Having regard to the $204.4 million paid by FHNZ to DBNZ under this scenario, the Professor noted that “this changes the economic effects of the transaction assessed on a pre-tax basis”.
The transaction is now positive on a pre-tax basis for the Danone Group and negative to the DBNZ group, in the order of $8.1 million in present value terms at the date of closure …. However, Singaporean taxation affects the post-tax outcome.
[60] On a post-tax basis and assuming a Singaporean tax rate of 20 per cent33 he again concluded that from the perspective of the Danone Group there would have been a $16.2 million (discounted) advantage arising from what he termed “full deductibility versus interest only deductibility”.
[61] However, the Professor calculated DBNZ’s position to be materially worse under the cash settlement option — identifying a “value fall” of $8.1 million on a pre- tax basis and $9.9 million on a post-tax basis.
[62] And, as with the novation option, settlement by cash payment meant that FHNZ’s “value” from the transaction changed to negative.34
[63] This can be contrasted with Professor Evans’s view that, under the share conversion and transfer option, FHNZ suffered no economic cost when it issued shares to DBNZ, and suffered no further economic cost when those shares were transferred
32 His calculation assumed that no acceleration event had occurred and that the applicable Singaporean tax rate at the relevant time was 20 per cent.
33 Professor Evans acknowledged in his brief that he understood the relevant Singaporean tax rate varied between 2003 and 2008 (reducing over that time from 22 to 18 per cent) but nothing turned on this variation.
34 The corresponding value “uplift” being to CGD in the case of novation and DAP in the case of cash settlement.
to DAP — an opinion which formed one of the pillars of the Commissioner’s s BG 1 argument. In his brief of evidence the Professor put the position as follows:
87.The economic cost is measured by changes in the cash surplus of FHNZ going to its shareholders. There is no economic cost to FHNZ in the issuance of shares per se. There will be dilution of per-share payments to the share owners (dividends per share) but not of the aggregate company dividend that is available for distribution to owners. For there to be an economic cost or benefit the issuance and transfer would have to effect some change in decisions that affected the value of FHNZ. There is no reason to expect different management because of the act of issuing the shares. Setting aside the small cost of the legal process of issuance there is no obvious rationale for the issuance and associated dilution of per-share dividend to have economic costs or effects for FHNZ.
…
88.DAP did not suffer an economic cost when the [convertible note] converted to shares. I have explained that the issuance of additional shares in FHNZ would have de minimis legal costs, but otherwise no costs to the shareholders. In addition the act of transfer of shares to DAP had no economic or commercial costs (excepting de minimis legal costs) for either FHNZ or DAP. DAP owned the shares before and after the issuance and transfer of the shares. The issue and transfer of shares simply shuffled the ownership records of DAP. They were, with the legal process cost caveat, costless and had no effect on the ownership and control of FHNZ, or DAP.
[64] Significantly, however, even in respect of the cash novation option35 Professor Evans considered that the coupon payments would still exhibit features of principal payment deductibility for the Danone Group from an economic perspective.
[65] I accept FHNZ’s submission that while this may be correct from the Professor’s economic perspective, it cannot be correct as a matter of New Zealand tax law or be considered consistent with Parliamentary intent. The Commissioner could have no objection to a deduction accruing to FHNZ for the full $66 million of coupon payments under the novation or cash settlement alternatives. In both such cases the $66 million would simply represent the price of the money, borrowed and ultimately repaid by the same taxpayer, over the life of the instrument. The fact that Professor Evans’s economic perspective suggests that such an arrangement would involve principal payment deductibility does tend to emphasise the divergence between his economic
35 And presumably also cash settlement option.
model, itself premised on a group approach, and Parliament’s assumed intentions about the operation of New Zealand’s tax rules. I consider that a significant caveat in terms of what importance I should place on the Professor’s evidence.
[66] Professor Choudhry’s evidence drew broadly consistent conclusions to that of Professor Evans.
[67] He considered the transaction unconventional in a number of material respects. For a start he said that convertible bonds and notes were characteristically priced on the basis of a “volatility play” with the borrower benefiting from obtaining funding at an interest rate that is lower than it otherwise would be if it issued straight “vanilla debt” and the lender acquiring the right to shares at a potentially cheaper price than if it subscribed at the time of the note’s maturity. He suggested that none of these considerations influenced the pricing of the DBNZ note.
[68] In his view an unrated and unlisted wholly-owned subsidiary would never feasibly be able to use a convertible bond to raise funds because, unless the company was the subsidiary of a listed parent and that parent was itself considered a proxy for its subsidiary’s position,36 there would be no share price volatility to observe and thus no way to value the embedded option in the bond.
[69] He said it would also be usual for a company raising money through a convertible bond to identify, by way of an offer document, the purpose for which the funds were to be used and that this was not the case here. And, in a related point he drew a comparison with the orthodox situation where the amount of the bond is linked to some specific capital requirement and is in a rounded sum. The face value of the DBNZ bond, he said, “was arrived at in what can only be described as an unorthodox and not market conventional fashion”, which worked backwards from the coupon rate resulting in a principal amount Professor Choudhry described as “a very exact number” that “is not commonly how conventional bond issue notional amounts convertible or otherwise are arrived at in the market”.37
36 A proposition with obvious limitations.
37 The evidence established that the value of the Note was established by adding the present value of five years’ worth of coupons (priced by the Deutsche Bank swaps desk in London) to the Forward Purchase payment amount of $149 million. The resultant amount was $204,421,565.
[70] And significantly, he relied on what he considered to be the unorthodox manner in which the note was priced, contrasting:
(a)The typical case where the issuer is listed or an exchange, is rated and has “a transparent share price” and where the rate is set by taking the baseline coupon (the ordinary rate for a vanilla fixed coupon bond) and making an adjustment downwards based on the value of the embedded option in the bond (which is itself a function of the volatility of the share price and the time to conversion); and
(b)The pricing in this case, which was simply referenced off the NZD swap curve with a spread of 30 basis points as “expected for an A1/A+ rated borrower”.38
[71] Professor Choudhry’s views also aligned with those of Professor Evans when it came to the “economic substance” of the transaction:
33.Because of the number of parties connected to the deal, it is illogical to view the transaction economically as a standalone one or from the viewpoint of the bond issuing entity alone. The deal included DAP, DBNZ, the novation counterparty CGD, and Groupe Danone (the ultimate parent of FHNZ). When the transaction is viewed from a wider perspective, FHNZ has paid interest of $11.09 million on a borrowing of $55.42 million. In addition, FHNZ benefits from an interest-free injection of cash, via the [forward purchase] arrangement, of $149 million for 5 years from its parent DAP.
[72] And he took a similar position to Professor Evans in respect of the absence of economic cost to FHNZ on the issue of shares to DBNZ saying:
55.Issuing shares to the Note holder on maturity had no effect, economic or otherwise, because the shares were transferred simultaneously to its existing parent DAP, who already owned 100% of the shares in FHNZ. I can deduce no economic cost to FHNZ in this circumstance.
…
…
57.From a practical economic and control (ownership) viewpoint there was no cost or impact from the conversion of the note debt to shares in FHNZ. This does not mean there would have been no book- keeping impacts, primarily accounting entries in the general ledger,
38 Which FHNZ effectively was with the Groupe Danone SA guarantee.
but this has no practical impact from an economic cost and ownership viewpoint; there was no cash flow cost at all.
[73] Significantly, both experts considered the economic effects of the transaction on the Danone Group as a whole. Professor Evans referred to the Danone Group as consisting of FHNZ, DAP, Groupe Danone SA, CGD and Danone Finance SA. In cross-examination, he explained that the economic costs or benefits to a company in turn required reference to its shareholders and that his approach was “a summary way of treating the commercial and economic performance of the company as being the benefit to the shareholders, in the absence of externalities”. Indeed he went further and said that “to me the company is the shareholders”, a proposition which is open to obvious objection as a statement of legal principle.39
[74]Likewise Professor Choudhry said:
[T]his was a transaction involving three group entities designed to facilitate a particular desired outcome above and beyond securing term funding. As such, it would not be logical from a banking perspective to view this transaction purely with regard to one legal entity. It is the consolidated impact that must be considered.
[75] However, as the following extract from his cross-examination confirmed, he accepted that, looked at as a separate entity, FHNZ had received and applied the full amount of the note and that the interest paid by it reflected a coupon rate of 6.5 per cent on the sum advanced:
Q. … If we just stay with Frucor Holdings again on that separate entity basis, would you agree that Frucor Holdings received 204 million from DBNZ?
A.Oh yes absolutely. In my view … there’s no doubt about that. It issued paper to DBNZ and received 204 million, yes.
Q. And again from [a] Frucor Holdings New Zealand entity standpoint there’s nothing in your term on several occasions this morning nothing nominal about that 204?
A. Are you asking me if it’s real money?
Q. Yes.
A. Oh yes.
39 See s 15 of the Companies Act 1993, confirming that a company is a legal entity in its own right separate from its shareholders.
Q. And it is real to the extent of 204 million?
A.Well, yes, FHNZ from my reading of the documents, FHNZ receives 204 million on issue date from DBNZ, yes.
Q.And it’s also from paragraph 39 of your evidence accepted by you that it spent 204 million?
A.Yes that my – from the documents that’s what it appeared to have done, yes.
Q. And this time from paragraph 31 of your evidence, I think it’s accepted by you that on an entity basis it paid 66 million for its use of that 204—
A. It made a coupon of six and a half per cent on 204 million, yes.
Q. Aggregating around 66 million?
A. That’s right, yes.
Comparison of experts’ approach with accounting treatment
[76] The “group” approach adopted by Professors Evans and Choudhry was reflected in the consolidated accounts for Danone. In his brief of evidence Mr Marcello explained that the Danone Group (including FHNZ) adopts International Financial Reporting Standards (IFRS) to prepare its financial statements. IFRS 10 requires an entity that controls one or more other entities to present consolidated financial statements. IFRS 10 defines “consolidated financial statements” as:40
The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity.
(Emphasis in original).
[77] By contrast, FHNZ’s own accounts were prepared on a “standalone basis” and reflected the gross cash flows it received under the transactions.
[78] In the result, the evidence (including not only the financial statements but a number of internal documents, emails and spreadsheets) uniformly established reference to a “net loan” of $55 million in the context of documents concerning DBNZ,
40 IFRS Foundation “IFRS 10: Consolidated Financial Statements” at A477.
DAP or the Danone Group generally. And in the context of FHNZ they referred in a similarly uniform way to the full face value of the borrowing namely $204 million.41
[79] In FHNZ’s submission all this says is that although Professor Evans’ and Professor Choudhry’s “group” approach was mandated (and followed) at a consolidated accounting level, such is the limit of its applicability. It was not relevant in terms of FHNZ’s accounting treatment at an entity level and, even more particularly, is not relevant to the principal inquiry under s BG 1 for the reason that, in applying s DB 7 and the financial arrangements rules, Parliament did not intend a “group” approach. I expand on this submission in subsequent sections of this judgment. In doing so, however, I emphasise that FHNZ did not submit that the tax treatment of the arrangement must necessarily replicate the accounting treatment. That would be to promote a long-discredited view. Rather the argument about accounting methodology was advanced to illustrate the areas of consistency and difference between accounting treatment and expert evidence.
The tax avoidance framework
[80] As indicated, the Arrangement was governed by the provisions of the 2004 Act. Under s BG 1(1) of the Act, “[a] tax avoidance arrangement is void as against the Commissioner for income tax purposes.” The Commissioner may then “counteract” the “tax advantage that a person has obtained” under pt G of the Act.42 This is known as “reconstruction”.
[81] The Act defines “arrangement”, “tax avoidance” and “tax avoidance arrangement” in s OB 1 (definitions). An arrangement is “an agreement, contract, plan, or understanding (whether enforceable or unenforceable), including all steps and
41 There is one exception. One document, an “approval paper” prepared by DBNZ, referred to FHNZ receiving net funds equal to the difference between the convertible note and the forward purchase. But that document reflected a different structure to the transaction than the one ultimately adopted. At the time it was suggested that FHNZ would use the entire forward purchase amount (then
$154m) towards repayment of its establishment equity (i.e., the $154m would be immediately paid from DAP to DBNZ, DBNZ to FHNZ and FHNZ back to DAP). This feature of the transaction did not eventuate, with FHNZ instead only redeeming $60m of its establishment equity in order to rebalance its debt to equity position. I do not therefore consider the netted figures referred to in this document are materially relevant to the Arrangement as it eventuated.
42 Income Tax Act 2004, s BG 1(2).
transactions by which it is carried into effect”.43 The definition is broad and the parties agree that the transaction amounts to an arrangement.
[82]Tax avoidance is not defined exhaustively; rather the Act says it “includes”:44
(a)directly or indirectly altering the incidence of any income tax:
(b)directly or indirectly relieving a person from liability to pay income tax or from a potential or prospective liability to future income tax:
(c)directly or indirectly avoiding, postponing, or reducing any liability to income tax or any potential or prospective liability to future income tax
[83]Finally, a “tax avoidance arrangement” is defined as follows:45
Tax avoidance arrangement means an arrangement, whether entered into by the person affected by the arrangement or by another person, that directly or indirectly–
(a)has tax avoidance as its purpose or effect; or
(b)has tax avoidance as 1 of its purposes or effects, whether or not any other purpose or effect is referable to ordinary business or family dealings, if the purpose or effect is not merely incidental
[84] These provisions, taken together, are referred to as the general anti-avoidance rule (or provision). I pause to make a brief observation on the words “purpose or effect” in the last definition. As will be clear from the discussion that follows, the question of tax avoidance is objective. In Glenharrow Holdings Ltd v Commissioner of Inland Revenue, the Supreme Court said that (despite the word “purpose”) the inquiry is not into the subjective intentions of the taxpayer but rather involves asking “what objectively was the purpose of the arrangement, which in turn requires examination of the effect of the arrangement.”46 And so, “working backwards as it were from the effect, you are able to determine what objectively the arrangement must be taken to have had as its purpose.”47
43 Section OB 1, definition of “arrangement”.
44 Section OB 1, definition of “tax avoidance”.
45 Section OB 1, definition of “tax avoidance arrangement”.
46 Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2008] NZSC 116, [2009] 2 NZLR 359 at [36].
47 At [38], applying Lord Denning’s approach in Newton v Commissioner of Taxation for the Commonwealth of Australia [1958] AC 450 (PC) at 465.
[85] The difficulty caused by the broad scope of the general anti-avoidance rule has been extensively discussed.48 It was the subject of detailed comment in the Supreme Court’s judgment in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue.49 As Tipping and McGrath JJ explained in the majority judgment:50
Taxpayers enter into many transactions which have been structured with the purpose of taking advantage of specific provisions in order to reduce tax. While the general anti-avoidance provision is expressed broadly, its purpose cannot be to strike down arrangements which involve no more than appropriate use of specific provisions. On the other hand, strict compliance with the requirements of specific provisions cannot have been intended to immunise all arrangements involving their use against being categorised as tax avoidance arrangements, which it was the purpose of the general provision to avoid.
[86] The majority summarised their approach by explaining that appropriate effect must be given to each of the specific provisions and the general anti-avoidance provision — “they work together.”51 The focus is on whether the use of the specific provisions has crossed the line and transformed a “permissible arrangement into a tax avoidance arrangement,”52 The inquiry is one not to be distracted “by intuitive subjective impressions of the morality of what taxation advisors had set up”.53
[87] The High Court has previously observed that it is generally unnecessary to review the law on tax avoidance as it stood before Ben Nevis, except insofar as some decisions remain material to specific parts of the overall inquiry.54 In this case the parties similarly focused their analysis on Ben Nevis and referred to other cases only when necessary to elaborate on specific aspects of the tax avoidance framework.
48 See, for example, Michael Littlewood “Tax Avoidance, the Rule of Law and the New Zealand Supreme Court” [2011] NZ L Rev 35 and the cases and articles cited therein.
49 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289.
50 At [12]. Tipping and McGrath JJ wrote on behalf of themselves and Gault J. Elias CJ and Anderson J agreed with the conclusion reached by the majority but expressed reservations about the majority’s approach to the interpretation of the relevant provisions.
51 At [103]. In John Prebble Fundamentals of Income Taxation (Thompson Reuters, Wellington, 2018) at 412, the author describes this tandem approach as “not particularly helpful because the GAAR often overrides a specific provision” and “whenever it is invoked it is dominant”. However, he acknowledges as “true that the application of the GAAR is informed by the apparent objectives of the remainder of the Income Tax Act 2007.”
52 At [104].
53 At [102].
54 See BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582 (HC) at
[114] and Westpac Banking Corp v Commissioner of Inland Revenue (2009) 23 NZTC 23,834 (HC) at [170].
[88] In Ben Nevis the Supreme Court posited a two-stage inquiry to determine whether an arrangement is a tax avoidance arrangement.
[89] First, “[t]he taxpayer must satisfy the court that the use made of the specific provision is within its intended scope.”55 Such is not in issue here. The Commissioner accepts that the transaction met the “black-letter” of s DB 7 (relating to interest deductibility) and of the financial arrangements rules in the Act. Both are discussed in more detail below.
[90] The outcome of this case therefore depends on the second stage of the inquiry. In terms of the Ben Nevis test, this involves an examination of the use of the specific provision “in light of the arrangement as a whole.”56 The focus is on whether the taxpayer has used the specific provision “in a way which cannot have been within the contemplation and purpose of Parliament when it enacted the provision”.57
[91] It is not necessary, however, for Parliament to have contemplated the specific transactions in issue. As Wild J said in BNZ Investments Ltd v Commissioner of Inland Revenue:58
I agree with Mr Brown’s submission for the Commissioner that it is unreal to suggest that Parliament, when it enacted the deductibility and subvention provisions and the FTC and conduit regimes, might actually have contemplated transactions structured as are those in issue in these proceedings.
[92] In Ben Nevis the Supreme Court emphasised that enquiries into tax avoidance are primarily exercises of statutory interpretation. Ascertaining whether the use of specific provision “cross[ed] the line” is to be “firmly grounded in the statutory language of the provisions themselves”.59 The Court explained that the general anti- avoidance rule functions:60
… to prevent uses of the specific provisions which fall outside their intended scope in the overall scheme of the Act.
55 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [107].
56 At [107].
57 At [107].
58 BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,582 (HC) at [134].
59 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [104].
60 At [106].
[93] The statute does not confine the Court’s inquiry; rather, the Supreme Court observed that “the Commissioner and the courts may address a number of relevant factors, the significance of which will depend on the particular facts.”61 The Court posited the following examples:62
(a)The manner in which the arrangement is carried out;
(b)The role of all relevant parties and any relationship they may have with the taxpayer;
(c)The economic and commercial effect of documents and transactions;
(d)The duration of the arrangement;
(e)The nature and extent of financial consequences the arrangement will have for the taxpayer;
(f)Whether the arrangement was structured so that the taxpayer gains the benefit of the specific provision in an artificial or contrived way.
[94] In some cases artificiality may be indicated not by the structure itself but by the rates at which a deduction is taken, or for example a salary. In Penny v Commissioner of Inland Revenue, for example, the Supreme Court considered the adoption of “a familiar trading structure” (incorporation of a company and transfer of personal business to that company) “cannot per se be said to involve tax avoidance”.63 But Parliament could not have been seen to contemplate “using a company structure to fix the taxpayer’s salary in an artificial manner.”64 A “gross disparity between the price and size of the purchaser” was also indicative of tax avoidance in Glenharrow Holdings.65 In that case, the Supreme Court explained why a factor such as “commercial effect” is relevant; because “[t]ransactions which are driven by
61 At [108].
62 At [108].
63 Penny v Commissioner of Inland Revenue [2011] NZSC 95, [2012] 1 NZLR 433 at [33].
64 At [47].
65 Glenharrow Holdings Ltd v Commissioner of Inland Revenue [2008] NZSC 116, [2009] 2 NZLR 359 at [54].
commercial imperatives are unlikely to produce tax consequences outside the purpose of the legislation”.66 Although it would be incorrect to describe underlying commercial purpose as immunizing a transaction from challenge under s BG 1, it is nevertheless a significant consideration both at the threshold and potentially “merely incidental” steps of the inquiry.67
[95] A focus on individual factors (like artificiality or commerciality) may indicate Parliament’s intention but cannot detract from the “ultimate question” which the Supreme Court in Ben Nevis identified as:68
… whether the impugned arrangement, viewed in a commercially and economically realistic way, makes use of the specific provision in a manner that is consistent with Parliament’s purpose. If that is so, the arrangement will not, by reason of that use, be a tax avoidance arrangement. If the use of the specific provision is beyond parliamentary contemplation, its use in that way will result in the arrangement being a tax avoidance arrangement.
Section DB 7 and the financial arrangements rules
[96] The transaction relied on two separate parts of the Act: the interest deductibility provisions and the financial arrangements rules. Accordingly, Ben Nevis mandates that I consider the “intended scope” of both sets of provisos within “the overall scheme of the Act.69
[97] Under s DB 7(1) of the Act, “A company is allowed a deduction for interest incurred.” Interest is defined in s OB 1. It “includes expenditure incurred under the financial arrangements rules”.70 Interest is “incurred” where a legal obligation to make a payment in the future has accrued, the taxpayer is definitely committed to it and it is more than impending, threatened or expected.71 FHNZ submits that s DB 7 provides for an “unqualified entitlement”72 to deduct the $66 million in payments made to DBNZ, save only for potential application of s BG 1.
66 At [49].
67 See, for example, Westpac Banking Corp v Commissioner of Inland Revenue (2009) 23 NZTC 23,834 (HC) at [206].
68 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [109].
69 At [106].
70 Income Tax Act 2004, s OB 1, definition of “interest” at (d)(i).
71 Case Y17 (2008) 23 NZTC 13,171 (TRA) at [31]. See also Commissioner of Inland Revenue v Mitsubishi Motors New Zealand Ltd [1995] 3 NZLR 513 (PC) at 517.
72 The phrase was Mr (L) McKay’s.
[98] That approach is supported by both policy and pragmatic considerations. In an article examining the calculation of interest, Sir Ivor Richardson observed:73
Dissecting interest payments and receipts on income account so as to exclude any capital elements would be costly and uncertain. There is usually no incentive for tax reporting purposes to depart from the historical position of treating the full percentage rate of interest as income of the recipient and as a revenue deduction against income of the payer.
That characterisation can cause problems … where hybrid arrangements may be mischaracterised as debt (or equity) under corporate law or revenue law (where the Commissioner of Inland Revenue can invoke special legislative provisions and the general anti-avoidance provision). …
[99] The legislative history of s DB 7 indicates that it was intended to provide companies with a deduction as soon as interest was incurred and without reference to some of the historic restraints which applied. The Commissioner explained the introduction of new interest deductibility rules for companies in a Tax Information Bulletin in November 2001:74
The general interest deductibility rules for companies have been clarified and simplified. The changes ensure that interest incurred by most companies is deductible, subject to the existing thin capitalisation and conduit interest allocation rules. …
The purpose of these changes is to reduce compliance costs for taxpayers by removing both the uncertainty that surrounded these tax rules and their need to structure to achieve the same result.
…
For the majority of companies, interest deductions are no longer confined to interest incurred either in deriving gross income, or in the course of carrying on a business, or in relation to borrowings used to capitalise subsidiaries.
[100] Both the section and the policy behind it therefore indicate that a taxpayer is entitled to a deduction for interest that has been incurred whether or not for the purposes of deriving gross income, carrying on a business or in relation to borrowings to capitalise subsidiaries. I accept in that context Mr McKay’s characterisation of the rule as providing the taxpayer with an “unqualified entitlement” to deduction where interest is incurred, subject of course to s BG 1.
73 Ivor Richardson “The Calculation of Interest” (2014) 20 NZJTLP 231 at 249.
74 Inland Revenue Department “Interest Deductibility for Companies” (2001) 13(11) Tax Information Bulletin 34 at 34.
[101] Turning then to the financial arrangements rules, these are provided for in sub- pt EW of the Act. The Act identifies three purposes to the rules:75
(a)to require the parties to a financial arrangement to accrue over the term of the arrangement a fair and reasonable amount of income derived or expenditure incurred under the arrangement, and so to prevent the deferral of income or the advancement of expenditure; and
(b)to require the parties to a financial arrangement to disregard any distinction between capital and revenue amounts; and
(c)to require a party to a financial arrangement to calculate a base price adjustment when the rights and obligations of the party under the arrangement cease.
[102] A financial arrangement includes “an arrangement under which a person receives money in consideration for that person, or another person, providing money to any person” either “at a future time” or “on the occurrence or non-occurrence of a future event, whether or not the event occurs”.76 A debt and a debt instrument are specifically contemplated to be financial arrangements.77
[103] Though the financial arrangements rules “require the parties to a financial arrangement to disregard any distinction between capital and revenue amounts”,78 they nonetheless recognise the distinction between debt and equity. That is clear from the list of excepted financial arrangements.79 An “excepted financial arrangement” is not a financial arrangement.80 Excepted financial arrangements include “a share, or an option to acquire or to dispose of shares”,81 but “[a]n excepted financial arrangement may be part of a financial arrangement.”82 In this case the option to acquire shares itself formed part of a broader financial arrangement which included the Note.
[104] Ordinarily a financial arrangement is taxed on the basis that all returns on the arrangement, whether income or capital in nature, are brought to tax.83 It also requires
75 Income Tax Act 2004, s EW 1(3).
76 Section EW 3(2).
77 Section EW 3(3)(a) and (b).
78 Section EW 1(3)(b).
79 Section EW 5.
80 Section EW 4(3).
81 Section EW 5(12).
82 Section EW 6(1).
83 Section EW 15.
all income and expenditure related to the arrangement to be spread over the term of the arrangement.84
[105] A taxpayer must adopt a methodology to calculate income or expenditure over the term.85 In respect of certain types of financial arrangements this is governed by “determination methods” identified by the Commissioner.86
[106] The Taxpayer must further calculate a base price adjustment on the maturity of the financial arrangement.87 Such calculation is made by reference to a formula: consideration less income, expenditure and amount remitted.88 Income is income derived under the financial arrangement;89 expenditure is that which is incurred under the financial arrangement;90 and an amount remitted is an amount that is remitted by the person or by law.91 Consideration is “all consideration that has been paid and all consideration that is or will be payable, to the person for or under the financial arrangement”.92 But that definition is adjusted in “particular cases”, where a more specific section applies.93 In this case s EW 32 is more specific. It applies to agreements for the sale and purchase of property and services.94 The value of the property or services is to be determined by “the lowest price the parties would have agreed on for the property or services, on the date the agreement … was entered into”.95
[107] The optional convertible note in issue in this case is an example of a hybrid tax instrument. The reason that is so is explained in The New Zealand Accrual Regime — A practical guide, where the learned authors say:96
84 Section EW 14(1).
85 Section EW 12.
86 Section EW 20.
87 Section EW 29(3).
88 Section EW 31(5).
89 Section EW 31(9).
90 Section EW 31(10).
91 Section EW 31(11).
92 Section EW 31(7).
93 Section EW 31(8).
94 Section EW 32(1).
95 Section EW 32(3). Note [20]–[21] above, where the parties agreed to the lowest price of the shares at the date the Note was executed.
96 Susan Glazebrook and others The New Zealand Accrual Regime — A practical guide (2nd ed, CCH, Auckland, 1999) at 199.
In broad terms, a convertible note can be considered to be a debt instrument which provides at least part of the return in the form of shares in a company or rights to subscribe for such shares. Such instruments have always been particularly difficult to bring within an income tax system which operates by drawing a distinction between the tax treatment of debt and equity. A convertible note is a hybrid instrument: it is part equity and part debt. To the extent to which the convertible note offers note holders a share option or a right to shares, the note is an equity instrument. To the extent to which the note offers coupon interest returns and/or a cash redemption option, it is a normal debt instrument. … The hybrid nature of a convertible note means that it is appropriate to treat the note neither as a debt instrument nor as an equity instrument.
[108] It is inherent in the final sentence of that passage that if taxed under the ordinary provisions, “some part of the hybrid instrument is being taxed in a way in which it should not be taxed.”97 To avoid the potential issues that may result, the Commissioner has issued determinations that relate specifically to convertible notes.
[109] The Commissioner’s power to issue determinations is contained in pt 5 of the TAA. Determinations are made under s 90 of that Act and apply in principle to a financial arrangement until a new determination relevant to that arrangement is made.98 The Commissioner may determine, inter alia, the method to be applied in the determination of income derived or expenditure incurred under the financial arrangements rules, or, for example, how certain values are to be determined under contracts for property.99
[110] For the purposes of taxing convertible notes there are two relevant determinations: Determination G22 (optional convertible notes) and Determination G5C (mandatory convertible notes). The need for two different approaches is explained in The New Zealand Accrual Regime — A practical guide:100
For the purposes of applying the accrual rules to convertible notes, a distinction has to be drawn between notes where conversion into shares is mandatory and notes where it is optional. The distinction is important because, with mandatory convertible notes, the equity component of the note is an agreement to purchase shares. An agreement to purchase shares is not an excepted financial arrangement (unless it falls within the definition of a short-
97 Joanna Khoo “Line in the Sand of the Debt/Derivative Desert: The Tax Treatment of Optional Convertible Notes” (2011) 17 NZJTLP 209 at 210.
98 Tax Administration Act 1994, s 90AA(1).
99 Section 90AC(1).
100 Glazebrook and others The New Zealand Accrual Regime — A practical guide (2nd ed, CCH, Auckland, 1999) at 200.
term agreement for sale and purchase of property); the agreement itself is a financial arrangement. An alternative is that a mandatory convertible note can be viewed as a loan which is repaid in shares — again, not an excepted financial arrangement. On the other hand, with respect to optional conversion convertible notes, the equity component is an option to acquire shares which, as noted at [902], will in general be an excepted financial arrangement.
[111] In FHNZ’s submission, it is irrelevant which of the two determinations applied to the subject transaction — because both provided for full deductibility of the $66 million paid. To the extent it is germane, I consider determination G22 applied.101
[112] The explanation to Determination G22 (which does not form part of the determination itself) states:
This determination applies to those optional conversion Convertible Notes where conversion into company shares is at the option of the holder and the convertible note is denominated in New Zealand dollars.
[113] This passage summarises in brief terms the section of the determination addressing its scope102 (which is binding). In this case, the probabilities of DBNZ choosing not to exercise its option do not, in my view, change the fact the conversion was, on the document itself, “at the option of the holder”. The Commissioner did not argue to the contrary.
[114] In its terms Determination G22 sets out the method for apportioning the part of the acquisition price of the note attributable to the option to buy shares. It also sets out what amounts are not included in calculating income or expenditure, how the base price adjustment is to be calculated and certain principles relating to consideration under the base price adjustment. As the Court of Appeal explained in Alesco New Zealand Ltd v Commissioner of Inland Revenue, where the taxpayer issued such a note (in that case with a zero coupon):103
The OCNs are a financial arrangement. G22 is no more than the Commissioner’s prescription for severing and calculating the amount of Alesco NZ’s obligation attributable to the excepted financial arrangement – that is the equity element of the OCNs constituted by the share option. Its legal status and effect is limited to providing the appropriate methodology for that
101 Determination G22 was later replaced by Determination G22A. The parties also referred to the latter determination and I will do so to the extent relevant.
102 Section 3.
103 Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] 2 NZLR 145 at [78].
purpose. It is not determinative of the underlying question of whether notional interest deductions claimed on the debt component of the instrument amount to “expenditure” or “expenditure incurred” in terms of the financial arrangements rules.
[115] As to the wider purpose of the financial arrangements rules, Lord Hoffmann, delivering the Board’s advice in Commissioner of Inland Revenue v Auckland Harbour Board, outlined the regime in the following way:104
This innovative system was introduced in 1986. It has two main features: first, in principle and subject to exceptions, it taxes the entire yield from a financial arrangement without regard to whether it is income or capital. Secondly, it deems that yield to be receivable over the expected life of the arrangement. In its simplest form, it requires the whole of the expected cash return from the arrangement to be calculated, the acquisition price deducted, and the difference treated as taxable income which will be received evenly over the tax years until maturity. Mr McKay, who appeared for AHB, pointed out that this approach required one to discard traditional and intuitive reactions based upon the principle that income tax is a tax on income. As Glazebrook and Oliver say in their book, The New Zealand Accrual Regime (1989) at para 301:
“[The traditional] legal/accounting approach to defining what constitutes income can be compared with an economic approach. Under economic principles all gains in wealth are generally considered to be ‘income’ and all reductions in wealth are subtracted from income. Whether any ‘gain’ or ‘loss’ can be categorised as capital or revenue assumes no relevance, the only issue is whether there is an overall gain or loss of wealth over the period for which the income is being measured.
The accrual regime can be interpreted as a fundamental shift from the rest of the income tax regime which operates on traditional legal/accounting principles. It is a move to a regime where the Act operates more on economic principles.”
[116] Those observations about the economic approach under the financial arrangements rules are echoed in the Court of Appeal’s judgment in Alesco. After reviewing the rules and the Commissioner’s power to issue determinations, the Court stated:105
[71] In our judgment, the financial arrangements rules were intended to give effect to the reality of income and expenditure – that is, real economic benefits and costs. They were designed to recognise the economic effect of a transaction, not its legal or accounting form or treatment. The question is whether the taxpayer has “truly incurred the cost as intended by Parliament”. This construction is reinforced by the relevant addition, in three critical
104 Commissioner of Inland Revenue v Auckland Harbour Board [2001] 3 NZLR 289 (PC) at [2].
105 Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] 2 NZLR 145.
provisions, of the word “incurred”. In the Mitsubishi Motors case the Privy Council affirmed, with reference to an earlier statutory provision, that expenditure is incurred on the premise that it arises pursuant to a legal obligation.
[72] These features suggest that Parliament did not intend that a taxpayer would be entitled to use the financial arrangements rules as a basis for claiming deductions for interest for which the taxpayer was not liable or did not pay. The rules were intended to operate as a net regime – that is to bring to tax the amount yielded after deducting the entire economic cost from a taxpayer’s entire economic benefit. In the absence of a liability a taxpayer claiming the benefit of a deduction for interest payments would be purporting to incur that liability without suffering the economic burden. We are satisfied that the intended purview of the rules is to exclude notional transactions.
— as would be interest paid under a vanilla loan structure.
[193] I accept also Mr McKay’s submission that, apart from constituting good consideration, the shares must be taken as having had real value. His observation in relation to the subsequent sale to Suntory is compelling in that context. And even with the restriction on voting rights it is inevitable that a price would have been achievable for them if offered in the market. In that sense the transactions also involved an opportunity cost to FHNZ. And there was always some commercial risk, however well managed, in issuing shares to an unrelated third party.
Was therefore s BG 1 appropriately invoked?
[194] I admit to finding application of the s BG 1 test difficult, as many judges before me have likewise done. Benchmarking against parliamentary intention, for all the appropriateness of the exercise, can be an elusive quest. Courts have an understandable resistance to structured transactions which may be seen to cost the
155 Determination G22 consistently excludes coupon interest payments from the excepted financial arrangement component of an optional convertible note – see cls 6(1) and (2), and 5(a). But the relationship between holder and issuer does not change this approach under the determination. Under Determination G5C, coupon interest payments are pro-rated to income years and this too is unchanged by the relationship between note holder and share issuer (see cl 4(4)).
156 See cl 6(3) which states that for parties in a wholly-owned group, or with the same beneficial ownership or control, the equity component of an optional convertible note is treated as zero.
New Zealand tax base but intuitive subjective assessments based on any such thought processes must themselves be firmly resisted.
[195] In my view, Parliament can be assumed, at a minimum, to have intended that the taxpayer could:
(a)Take a deduction for interest economically incurred;
(b)Deduct financial arrangements expenditure deemed to be incurred over the life of a financial arrangement;
(c)Account for tax on a separate entity basis, if the member of a multi- national group; and
(d)Issue shares to satisfy a liability owed to a third party, including its parent.
[196] It is also in my view tolerably clear that the grouped “economic” approach adopted by the Commissioner’s expert witnesses is inconsistent with at least three specific aspects of New Zealand’s international tax regime and more broadly the individual entity framework which underpins them. It is also selective because it ignores the fact that $89 million of the forward purchase amount was funded outside the Danone Group by BNPP.157 Were the group approach to be accepted, it would be difficult to suggest that only internal transfers within the group should be assessed for tax purposes.
[197] In assessing whether the subject transaction crossed the line between permissible arrangement and tax avoidance arrangement I accept (adopting the legislative framework at the time) that:
157 By way of example and of potential relevance to any reconstruction that an appellate court might be required to consider, prorating the $66 million of interest deductions by reference to the Danone Group’s external lending position would suggest at least $46.5 million of interest may be deductible on a reconstructed basis.
(a)Parliament contemplated the use of OCN’s and that the coupons on them, if calculated at an arm’s length rate, will ordinarily be deductible;
(b)It was agnostic about the use of convertible note structures between parent and subsidiary.
[198] I accept as relevant also that other debt structures, incapable of realistic challenge under s BG 1, would have produced the same or similar tax benefits in New Zealand and that the particular appeal of DBNZ’s structure was that it provided for non-assessibility of income in Singapore, albeit that the Arrangement delivered other benefits such as better balancing FHNZ’s debt to equity position and creating a natural currency hedge. It was in that sense a transaction which assumed a status quo in terms of New Zealand deductibility but with significant added commercial advantages.
[199] What cannot be gainsaid is that the taxpayer received $204 million in cash from DBNZ. It was real money and it was expended. It attracted interest at 6.5 per cent which was incurred. Over the life of the Note, FHNZ’s payments corresponded to that interest liability.
[200] The Commissioner adopts the grouped economic approach of her experts but the economic purity of their model drives a conclusion — that the Arrangement involved principal payment deductibility even in the context of cash settlement or novation — which raises significant questions about the utility of the model in predicating whether the transaction “crossed the line”. And it is significant that Parliament should choose to define the limited circumstances in which a grouped approach applies and that this transaction is not among them. New Zealand’s status as a net importer of capital would mean serious erosion of its revenue base if cross- border money flows between group members were routinely assessed on the basis predicated by the Commissioner’s experts. Demonstrably that was not Parliament’s intention.
[201] Likewise the “no cost” proposition, which underpinned the Commissioner’s expert evidence and her submissions, does not in my view establish avoidance. Payment of cash by a parent to a subsidiary, for which the consideration is the issue of
additional shares, represents a routine commercial transaction. The consideration is real and has never been doubted as such. The financial arrangement rules, determinations and other aspects of the legislative and regulatory framework point to Parliament recognising the issue of shares by subsidiary to parent as economically real, irrespective of what the Commissioner calls “economic cost” to the subsidiary. This is the landscape on which the s BG 1 inquiry is necessarily imposed. Against the legislative background that existed at the time, there is, on account only of the method of repayment, simply nothing in my view to suggest non-deductibility of coupon payments on a MCN (or OCN on which the option was exercised) issued to an offshore parent by a New Zealand subsidiary. And if that is the case then it seems to me to be a long bow to suggest that the same method of repayment invokes a tax avoidance analysis in this case. If anything the interposition of DBNZ and the risk, however small, that it failed to on-transfer the shares elevates the case to a higher level of assumed conformity with parliamentary purpose.
[202] Nor am I persuaded that the “unorthodox” features of the Note identified by Professor Choudhry tip the analysis in the Commissioner’s favour. I adopt the approach of the Court of Appeal in Alesco that these considerations are of “marginal assistance”.158 Parliament must be taken as recognising that related entities may use funding models which, within a different context, may exhibit other features. It cannot be assumed to stifle market activity to the extent I consider Professor Choudhry’s evidence contemplates.
[203] This was a transaction which I consider had real and (from a New Zealand taxpayer perspective) legitimate economic drivers, primary among them offshore tax minimisation. It was self-evidently more “commercial” than the zero-coupon arrangements in Alesco. Interest was incurred by FHNZ both legally and, at a single- entity level, economically. And it was actually paid. The deduction did not depend on the taxpayer reverse engineering a deduction by application of the financial arrangement rules. Nor did the transaction involve back-to-back arrangements, each akin to the other, in the manner now typically assumed to infringe s BG 1.
158 Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] 2 NZLR 145 at [57].
[204] I conclude therefore that the section was not appropriately invoked by the Commissioner. In reaching that conclusion I note for completeness Mr L McKay’s concession that as from 1 July 2018 the transaction is unlikely to satisfy the “black letter” of the 2007 Act, in light of new provisions introduced to counteract base erosion and profit shifting (BEPS).
In the alternative: was this merely incidental tax avoidance?
[205] I briefly address this issue on the assumption I am incorrect in my primary findings. FHNZ argues the “purpose or effect” of tax avoidance was “merely incidental”. It relied on the following definition in the Act:159
tax avoidance arrangement means an arrangement, whether entered into by the person affected by the arrangement or by another person, that directly or indirectly—
(a)has tax avoidance as its purpose or effect; or
(b)has tax avoidance as 1 of its purposes or effects, whether or not any other purpose or effect is referable to ordinary business or family dealings, if the purpose or effect is not merely incidental
(Emphasis added).
[206] In Westpac, Harrison J explained what was meant by “not merely incidental”:160
[W]hen used in conjunction with the word “incidental”, I think the phrase “not merely” is designed to emphasise that a tax avoidance purpose, if found, will offend s BG 1 unless it naturally attaches or is subordinate or subsidiary to a concurrent legitimate purpose or effect, whether of a commercial or family nature. Identification of a business purpose will not immunise a transaction from scrutiny where tax avoidance can be viewed as “a significant or actuating purpose which ha[s] been pursued as a goal in itself”: see Tayles per McMullin J at NZTC 61,318; NZLR 736. Conversely, a transaction will not offend where tax avoidance naturally attaches to that other acceptable purpose or effect.
[207] In Ben Nevis, although reliance had not been placed on the “merely incidental” exception, the majority observed it would “rarely be the case that the use of a specific
159 Income Tax Act 2004, s OB 1, definition of “tax avoidance arrangement”.
160 Westpac Banking Corp v Commissioner of Inland Revenue (2009) 24 NZTC 23,834 (HC) at [206].
provision in a manner which is outside parliamentary contemplation could result in the tax avoidance purpose or effect of the arrangement being merely incidental.”161
[208]FHNZ argued:
(a)The arrangement was motivated by legitimate commercial objectives: refinancing the New Zealand subsidiary and introducing local currency debt with a fixed rate of interest at a higher level.
(b)These objectives required deductions at (or over) the level achieved by the convertible note.
(c)The deductions achieved would have arisen whether the funding involved bank debt, related-party debt, a combination of the two, a hybrid instrument, or a vanilla loan repayable at the end of the funding term.
(d)As the deductions were a “constant” throughout, the use of the convertible note and DAP’s role in the transaction can be explained by the Singaporean tax advantages of the arrangement.
(e)The New Zealand tax consequences were therefore merely incidental to the Singaporean tax advantages.
[209] Counsel submitted that a passage in the Commissioner’s Interpretation Statement on tax avoidance is “clearly correct” where she says:162
Under the merely incidental test, a non-tax avoidance purpose for the adoption of the particular specific structure may be relevant. Again, tax for this purpose is New Zealand tax, so avoidance of foreign tax would count as a non-tax avoidance purpose. If the New Zealand tax avoidance purpose or effect is merely incidental to a non-tax avoidance purpose, the arrangement is not a tax avoidance arrangement. As was explained, a tax avoidance purpose will be merely incidental if it follows as a natural incident from an arrangement structured a certain way for a non-tax avoidance purpose. If it can be shown
161 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [114].
162 Public Rulings Unit, Office of the Chief Tax Counsel Tax avoidance and the interpretation of sections BG 1 and GA 1 of the Income Tax Act 2007 (IS13/01, 13 June 2013) at [545].
that a structure was put in place in the specific way it was to gain a tax advantage from another country, then it is possible that the New Zealand tax avoidance purpose follows as a natural concomitant. If the New Zealand tax avoidance purpose is pursued as a goal in itself in any respect, however, the tax avoidance purpose will not be merely incidental.
(Emphasis added).
[210] The Commissioner submits FHNZ’s non-tax avoidance purposes could have been achieved in a simpler way. She argues unnecessary complexity in the transaction indicates the tax avoidance purpose was not merely incidental. The Commissioner also submitted that the Singaporean tax “benefit” was exaggerated by FHNZ — the absence of tax in one jurisdiction or another was “a given” and the transaction was primarily concerned with New Zealand deductibility. The features of artificiality and contrivance raised by the Commissioner in her submissions on the substance of the arrangement show, Mr Smith submitted, the purpose or effect was not merely incidental. The Commissioner said further the size of the tax benefit obtained means FHNZ was being paid to borrow. Taking advantage of the tax base to this extent could not have been merely incidental but must have been an independent driver of the arrangement.
[211] In some ways these competing arguments simply reflect the substantive arguments on the primary issue. As such they underscore the difficulty in saving an Arrangement under the “merely incidental” limb in circumstances where, ex hypothesi, it has already been found to use a specific tax provision in a way which is outside parliamentary contemplation. I have some sympathy with FHNZ’s argument that domestic deductions were a “constant” and therefore a “concomitant” of the Singaporean tax advantages. But that is unsurprising given the conclusion I reach on the principal issue. Assuming a different conclusion, I am, perforce, also assuming at least one of the purposes or effects of the transaction was domestic tax avoidance. To then say that New Zealand deductibility was simply a “concomitant” of Singaporean non-assessibility would, as the Supreme Court suggested in Ben Nevis, appear to be a difficult argument. Ultimately however, I am not required to decide it.
Reconstruction — s GB 1
[212] In the course of the hearing the parties advised that, in the event I decided that the Arrangement was not a “tax avoidance arrangement” for the purposes of s BG 1, there would be no utility in my endeavouring to address how the Arrangement should be reconstructed on the assumption my conclusion was in error. I do not therefore take that aspect of the mutual submissions further.
In the alternative: would liability for penalties arise?
[213] The Commissioner considers FHNZ took an “abusive tax position” and assessed the taxpayer for shortfall penalties of $1,786,555 and $1,924,779 for the 2006 and 2007 income tax years respectively. My finding on the issue of tax avoidance has the effect of quashing these penalties. But had I reached the stage of assessing whether shortfall penalties were rightly imposed, I would have found they were not. My reasons follow.
[214] FHNZ is liable for a shortfall penalty if it took an “unacceptable tax position”.163 Taking an unacceptable tax position results in a 20 per cent penalty.164 But if, viewed objectively, taking that unacceptable tax position was “with a dominant purpose of avoiding tax, whether directly or indirectly”, the taxpayer will have taken an abusive tax position.165 That results in a 100 per cent penalty.166 As is the case here, previous good taxpayer behaviour can then reduce those penalties by half.167
[215] An unacceptable tax position is one that, viewed objectively, “fails to meet the standard of being about as likely as not to be correct.”168 That must be determined as at the time FHNZ took its tax positions169 and the court must have regard to:170
163 Tax Administration Act 1994, s 141B(2); the quantum of shortfall in this case satisfies para (a) and
(b)of this section.
164 Section 141B(4).
165 Section 141D(7).
166 Section 141D(3).
167 Section 141FB.
168 Section 141B(1).
169 Section 141B(5).
170 Section 141B(7).
(a)the actual or potential application to the tax position of all the tax laws that are relevant (including specific or general anti-avoidance provisions); and
(b)decisions of a court or a Taxation Review Authority on the interpretation of tax laws that are relevant (unless the decision was issued up to 1 month before the taxpayer takes the taxpayer’s tax position).
[216] The “about as likely as not” standard does not require the taxpayer to show it “had a 50 per cent prospect of success” but rather that there was substantial merit in the taxpayer’s argument.171 Mr M McKay pointed to a select committee report on the Taxpayer Compliance, Penalties and Dispute Resolution Bill 1995, where the committee observed:172
Officials advised us that “about as likely as not to be correct” means that a position does not have to be the correct position, or even have a 50 percent chance of success, but must be a position which would be seriously considered by a court.
[217]Mr M McKay argued the Commissioner’s three theories about the arrangement
— in his words comprising “multiple, and contradictory, positions” — illustrated FHNZ’s contention was about as likely as not to be correct. The Commissioner rejected this characterisation saying that nothing could be read into her raising “alternative arguments” on the facts.
[218] I accept Mr McKay’s submission that there were elements of inconsistency in the three different approaches. For example, assessing FHNZ for NRWT simply cannot be squared with theories challenging the deductions. This is favourable to the taxpayer insofar as it suggests difficulty in articulating a coherent theory which justifies description of the arrangement as tax avoidance. However it is not decisive. Whether the standard “about as likely as not to be correct” has been met involves an objective assessment. It must be made at the time the taxpayer’s position was taken and cannot be answered solely by reference to later vacillations in the Commissioner’s theory of the case.
171 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2 NZLR 289 at [184].
172 Taxpayer Compliance, Penalties and Dispute Resolution Bill 1995 (119–2) (select committee report) at v.
[219] The relevant tax positions were taken on 24 July 2006 and 21 December 2007. The most authoritative statement on the relationship between avoidance provisions and other aspects of the Act (specifically, the accrual rules) at that time was the decision of the Privy Council in Commissioner of Inland Revenue v Auckland Harbour Board.173 Lord Hoffmann, giving judgment of the Board, described the anti-avoidance rules as a “long stop”.174 His Lordship observed:
[11] Their Lordships will return in due course to consider whether a base price adjustment on the basis of a transfer for a nil consideration is inconsistent with some fundamental principle of the accrual regime. But they should first draw attention to the fact that the Commissioner's argument involves putting s 64J(1) to a very unusual use. The section appears to Their Lordships to contemplate that the circumstances which justify its application will be specific to a particular transaction, arising out of the relationship between the parties and other relevant circumstances. In this respect it is similar to other anti-avoidance provisions such as s 99. Their Lordships do not of course suggest that the two sections necessarily cover the same ground, but what they have in common is that they are, generally speaking, aimed at transactions which in commercial terms fall within the charge to tax but have been, intentionally or otherwise, structured in such a way that on a purely juristic analysis they do not. This is what is meant by defeating the intention and application of the statute. Some of the work such provisions used to do has nowadays been taken over by the more realistic approach to the construction of taxing Acts exemplified by (W T) Ramsay Ltd v Inland Revenue Commissioners [1982] AC 300, although Their Lordships should not be taken as casting any doubt upon the usefulness of such tax avoidance provisions as a long stop for The Revenue.
[12] In the present case, there is no tension between the commercial and juristic character of the transaction. It is, in legal, commercial or any other terms, a transfer of financial arrangements for no consideration. Such a transaction either attracts a deduction or it does not. The Commissioner accepts that it does, but claims the right under s 64J(1) to be able to amend the law to ensure that it does not. Their Lordships do not think that the section was intended to confer such a power. It would amount to the imposition of tax by administrative discretion instead of by law.
[220] The Commissioner argued that in the 2007 income tax year, the Court of Appeal in Accent Management had confirmed deductibility provisions “should only be invoked in relation to the incurring of real economic consequences of the type
173 Commissioner of Inland Revenue v Auckland Harbour Board [2001] 3 NZLR 289 (PC).
174 At [11].
contemplated by the legislature when the rules were enacted.”175 Similar observations were drawn from earlier judgments.176
[221] But the inquiry is not with whether the taxpayer has correctly invoked the deductibility provisions. It is whether there is substantial merit in its arguments — that is whether they would be seriously considered by a court. FHNZ paid interest to DBNZ and claimed a deduction for it. Focusing on the “commercial and juristic character of the transaction”,177 there was a strong argument in the taxpayer’s favour. For the reasons previously outlined, I also consider FHNZ was always credibly in a position to challenge the relevance of the economic analysis on which the Commissioner relied. I therefore consider that FHNZ did not take an unacceptable tax position. It is unnecessary in that context to consider whether the arrangement was abusive.
[222] In the result, if I am wrong in my principal conclusions I would have set aside the shortfall penalties.
Result
[223]In accordance with the relief sought in the statement of claim I:
(a)Declare that Commissioner’s Assessments for the 2006 and 2007 income years are incorrect.
(b)Make orders pursuant to s 138P of the Tax Administration Act 1994 cancelling the Assessments.178
175 Accent Management Ltd v Commissioner of Inland Revenue [2007] NZCA 230, (2007) 23 NZTC 21,323 (CA) at [126].
176 The English case of Inland Revenue Commissioners v Willoughby [1997] 1 WLR 1071 (HL) at 1079 per Lord Nolan; Peterson v Commissioner of Inland Revenue [2005] UKPC 5, [2006] 3 NZLR 433 at [45]; and Challenge Corp Ltd v Commissioner of Inland Revenue [1986] 2 NZLR 513 (CA).
177 Commissioner of Inland Revenue v Auckland Harbour Board [2001] 3 NZLR 289 (PC) at [12].
178 Adopting the definition of “Assessments” in paragraph 77 of the statement of claim.
Costs
[224] Costs have not been addressed in submission. If FHNZ seeks to have these fixed at this stage then, in the absence of agreement as to quantum, memoranda (maximum five pages plus any supporting schedules) may be filed. Counsel are to confer to limit any areas of difference. Any submission, in opposition is to be filed within 14 days of the plaintiff’s submission and any submission in reply within seven days thereof.
Muir J
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