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Security for Costs - Another Brick in the Wall?
Security for Costs – Another Brick in the Wall?
In this article, Mike Lennard discusses a recent decision in which the High Court required the taxpayer to provide security for costs, and considers whether such a decision is fair to taxpayers involved in disputes with the CIR.
The dismal experience of practitioners involved in tax disputes is that the current procedures for resolving tax disputes have led to substantial disillusionment with the tax system. The procedures are not meeting the purpose for which they were enacted and which are set out in s 89A of the TAA 1994.
A recent High Court decision (DT United Kingdom Ltd v Commissioner of Inland Revenue HC Auckland CIV-2009-404-5580, 9 July 2010, Bell AJ) shows the Commissioner (CIR) adding to the disputant’s catalogue of woes by requiring the taxpayer to provide security for costs as a condition of the challenge proceeding concerning related transactions to the reasonably well-known Digitech transactions of the late 1990s.
This article describes the background to the judgment and the judges’ reasons in this case and an earlier decision on the same issue, and examines the fairness of the result.
The Digitech (or Digi-Tech, depending on which judgment you read) scheme was one of a number in the 1990s which featured investment in technology, stocks or intellectual property, with most of the payment being deferred to the end of the scheme and subject to some sort of limited recourse, usually reliant on insurance (itself subject to a largely deferred premium obligation). The tax advantage in these schemes constituted the immediate insurance premium deduction and/or depreciation or amortisation of the purchased asset available as opposed to the more remote and defeasible actual payment obligations. Investments of this sort were robustly and successfully attacked by the CIR as tax avoidance (eg the ACTONZ investment, Erris Promotions Ltd v Commissioner of Inland Revenue  1 NZLR 811 (HC) and the Trinity investment, Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue; Accent Management Ltd v Commissioner of Inland Revenue (2009) 24 NZTC 23,188 (SC)).
Digitech’s debut in the judgments was accidental and inauspicious. In the matrimonial property case Walker v Walker HC Christchurch M455/98, 18 October 1999, Young J (as he then was) had to adjudicate on whether tax consequences on excess salaries taken by the husband should be taken into account as matrimonial debts. It was argued that those salaries were sheltered by losses from Digitech and a successor investment known as “NZIL”. Young J said:
“I think that the tax schemes hail from the wilder shores of tax avoidance. I think the schemes are plainly ineffective…”
Further details of the Digitech scheme emerge from an unsuccessful criminal prosecution for conspiracy to defraud brought against some of those involved in the scheme. In R v Connolly (2004) 21 NZTC 18,844 (HC) Fogarty J described the company and the scheme as follows:
Both Digitech [Communications Ltd] and NZIL were companies whose future prospects were quite uncertain. Digitech, as the name suggests, was a company with expertise in digital products. In particular the company was developing products designed to be sold to persons who leased circuits from telephone companies. These products were designed to enable the lessors of the circuit to maximise the capacity leased by inserting data transmissions into existing traffic. The particular exciting prospect of Digitech was a project known as "Free Rider"…
The first component was an agreement by the investor to purchase the shares of Digitech over a ten-year period; structured so that the bulk of the purchase price was payable in year 10.
The second component, designed to de-risk the speculative character of the investment, was a loss of profits insurance policy in the event that in year 10 the shares were not of a particular value. The second component of the structure was optional. The third component was a loan to the investor to pay the bulk of the insurance premium. This was a non-recourse loan. The financier took security in the form of a mortgage over the purchasers' rights to the shares and the proceeds of the insurance policy. All the investors bar one took up the insurance policy and loan.
It appears that the majority at least of investors settled their dispute on the basis of conceding the losses, for the cases show no determination of whether the scheme involves tax avoidance (from which we can infer that that was conceded) but show that the terms on which some settled left evident financial hardship [eg Clarke & Money v Commissioner of Inland Revenue (2005) 22 NZTC 19,165 (HC)] and at least one bankruptcy among the investors: Re Marra; ex parte Commissioner of Inland Revenue (2004) 21 NZTC 18,494 (HC).
DT United Kingdom
In 1997 Digi-Tech (Communications) Ltd, presumably the same company as the one referred to in the judgment of Fogarty J noted above, sold its intellectual property rights in three products, including the Freerider product referred to in Fogarty J’s judgment, to subsidiaries, including one called DT United Kingdom (“DTUK”). DTUK bought the rights for the United Kingdom and Europe for $395,100,000. Five years later DTUK sold those same rights to a related company for $8,100,000, or a loss of $387 million, claiming a deduction accordingly. It appears that DTUK received a loan from its parent to enable it to purchase the rights; a loan which is yet to be repaid.
The CIR assessed this claimed loss as being a tax benefit under a void tax avoidance scheme, and DTUK filed challenge proceedings in the High Court. The CIR then sought security for costs under r 5.45 of the High Court Rules.
Security for costs
The security for costs provisions enables a judge to order the plaintiff to give security for costs if the plaintiff is resident out of New Zealand or it appears a plaintiff will be unable to pay costs if the proceeding fails. Whether or not to order security and, if so, the quantum, are discretionary. The Court of Appeal in A S McLachlan Ltd v MEL Network Ltd (2002) 16 PRNZ 747 (CA) emphasised the importance of balancing the interests of plaintiff and defendant, saying at paras  and :
“The rule itself contemplates an order for security where the plaintiff will be unable to meet an adverse award of costs. That must be taken as contemplating also that an order for substantial security may, in effect, prevent the plaintiff from pursuing the claim. An order having that effect should be made only after careful consideration and in a case in which the claim has little chance of success. Access to the courts for a genuine plaintiff is not lightly to be denied.
“Of course, the interests of defendants must also be weighed. They must be protected against being drawn into unjustified litigation, particularly where it is over-complicated and unnecessarily protracted.”
Outcome in DTUK
Associate Judge Bell found that it was undisputed that DTUK was unable to pay costs, and indeed was reliant on outside funding to conduct the litigation. He assessed the strength of the underlying case as weak (albeit arguable). Based on these findings, and taking some support from the judgment of McKenzie J in Reefdale Investments Ltd v Commissioner of Inland Revenue (2004) 21 NZTC 18,683 (HC) (as to which, see below), he considered that this was an appropriate case in which to order security for costs.
Comparison with section 138I
Section 138I of the TAA 1994 provides for the payment or otherwise of “tax in dispute”. It used to be the case that 50 per cent of the tax in dispute was payable, and the other 50 per cent was deferred to the end of the dispute. However, now the default position is that the tax in dispute is not payable until resolution of the dispute, but under s 138I(2):
the Commissioner may require a disputant to pay all tax in dispute that is the subject of the challenge if the Commissioner considers that there is a significant risk that the tax in dispute will not be paid should the disputant's challenge not be successful.
The parallel with the test for security for costs is obvious. An impecunious taxpayer faces the double prospect of paying tax in dispute and security for costs before determination of the merits or otherwise of the challenge.
In Reefdale Investments Ltd v Commissioner of Inland Revenue (2004) 21 NZTC 18,683 (HC) McKenzie J dealt with an application for review of a decision of Master Thomson who had ordered the taxpayers pay $150,000 security for costs: Reefdale Investments Ltd v Commissioner of Inland Revenue (2002) 20 NZTC 17,583 (HC). This was an action brought by investors in scheme which appears to have some conceptual similarities to the Digitech scheme - here involving forestry options offered by Salisbury Securities Finance Ltd. Investors would speculate on the movement in the value of timber over the 10-year term of the option. If prices increased over the price at the start of the option, the difference would be a profit to the option-holder and taxable under the New Zealand Income Tax Act. The taxpayers were insured so that if prices declined and the option was exercised, they would have the money to pay for the timber at the starting price.
The Reefdale taxpayers challenged the application on the basis that an order for security for costs effectively denies the taxpayers access to the Court to challenge the assessment. They also argued that such rule is contrary to the New Zealand Bill of Rights Act 1990 and/or unconstitutional.
The Bill of Rights and constitutional grounds were quickly dismissed, on grounds that are hard to quibble with. On the more merit-based ground of review, McKenzie J relied on the fact that the TAA 1994 provides that it is the CIR's assessment, not the taxpayer's claim, which is determinative, unless a challenge is initiated in the courts. The onus for objecting to the assessment is on the taxpayer, so the taxpayer and the CIR have the role of plaintiff and defendant respectively in the High Court. He held accordingly that the procedural consequences of that allocation of roles should follow the normal course, and there was no basis for treating tax litigation as different from ordinary litigation.
But is it really the taxpayer who commences a tax challenge? Unlike other civil litigation, where the briefest of formalities take place before court proceedings are issued, there is a complex and lengthy pre-assessment dispute resolution process in Part IVA. This almost always starts with some action by the CIR – either a default assessment or (much more commonly) the CIR initiating the formal process by issuing a NOPA to the taxpayer who must then respond. In Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue the Supreme Court drew a close analogy between the issue of NOPAs and the filing of a Statement of Claim in ordinary civil litigation, saying at para :
"NOPAs, NORs and SOPs are the equivalent of ordinary civil pleadings in the taxation field."
Hard cases make bad law, it is said, and perhaps the apparent hopelessness of the taxpayer’s case made it easier for the judges in both Reefdale and now Digitech UK to impose security for costs. However, the CIR is a litigant with deep pockets, and unlike most defendants, he is usually the real initiator of the litigation. The other side of the same coin is that the ability to dispute tax liability before a genuinely independent and impartial tribunal is an important constitutional safeguard which should not be lightly discouraged. Obtaining security for costs further increases the power disparity and the difficulty which taxpayers experience in disputing their tax liabilities. Finishing this article as it began, maybe the CIR’s motto when it comes to security for costs applications should be “Leave them kids alone”…