A Tale of Two Banks – November 2009
A Tale of Two Banks[1]
Mike Lennard, Barrister
This year has seen two banks and the CIR engage in trench warfare in the High Court on whether “structured finance” transactions entered into in the late 1990s were tax avoidance. In mid July Wild J had delivered his judgment, in a challenge by members of the Bank of New Zealand group[2]. On the very eve of the publication deadline for this edition, Justice Harrison released the decision in the second case, involving Westpac Banking Corporation[3]. This article provides a brief background and contrasts the two decisions.
Background to the Decisions
Both cases involved essentially similar transactions, whereby a subsidiary of the bank acquired shares[4] in a special-purpose foreign issuer from a subsidiary of an overseas counterparty. This acquisition was subject to a repurchase obligation (or “repo”) at the end of a fixed period – typically three or five years. The shares paid dividends[5] at a fixed rate, and the bank entered into a fixed to floating rate swap with a member of the counterparty group. The bank also paid the counterparty subsidiary a “guarantee procurement fee” (“GPF”), typically 2.95% per annum, ostensibly for the subsidiary’s services in procuring a guarantee from its highly-rated parent.
The transactions were structured in such a way that the dividends were subject to conduit relief or attracted foreign tax credits (“FTC”). On the other hand, the banks claimed deductions for their funding costs, the GPF, and the net loss in the swap. The dividend paid to the bank was calculated according to a formula which took into account the value of the fixed leg of the swap and the GPF, and the agreed share of the tax benefits between the bank and the counterparty group.
The periodic cashflows under a typical transaction can be represented diagrammatically like this:
The tax results claimed were a deduction for funding costs, a tax liability for the floating leg of the swap (in practice these first two items were treated by the CIR at least as cancelling out) and a deduction for the GPF and the payment under the fixed leg of the swap. Because the treatment of the repo transaction in the counterparty’s jurisdiction was to tax it according to its substance as a secured loan, the tax consequences to the counterparty were largely neutral. Consequently the tax advantage turned what would otherwise have been a loss-making transaction for the bank into a profitable one.
Both banks had obtained binding rulings on other, similar, transactions. While Westpac’s ruling was in relation to a structure which was materially identical[6], apparently BNZ had obtained a ruling on a variation of the structure which had the issuer paying tax in New Zealand[7].
Westpac’s approach in the litigation was different to some degree from BNZ’s in that it did not accept either that its funding costs were part of the arrangement for the purposes of tax avoidance analysis, or that if they were, that those costs were the same as the floating rate return under the swap.
The Judgments
Against that background, the following table tries to capture some of the key differences and similarities between the judgments, including cases where the arguments or points taken appear to have been somewhat different but the end result the same.
| Wild J in BNZ Investments | Harrison J in Westpac | |
| Significance of binding rulings | No relevance. First, a binding ruling expressly applies only to the transaction ruled upon. Second, even if a taxpayer is entitled to place some reliance on a binding ruling as indicating the way in which the CIR will treat an identical transaction (not accepted), the six transactions in issue were not identical with the ruled transactions.[8] | The ruling is irrelevant. Time has moved on in the eight years since it was issued, and the Court’s inquiry is much more extensive than that which the CIR was able to undertake. What the CIR’s Rulings Unit may or may not have concluded on the material then available is of no consequence.[9] |
| GPF – at black letter | The GPFs are part of an “arrangement whereby [the repo counterparty] obtained money in consideration for a promise by [the parent] to provide money (the guarantee payment) to [the BNZ] upon the occurrence of some future event (default by the repo counterparty)”[10], and thus are expenditure under Part EH and therefore deductible.[11]Alternative argument, that GPFs are deductible under ordinary deductibility tests, does not succeed because there is no nexus with deriving assessable (as opposed to exempt) income[12]. | The GPF agreement was not a ‘financial arrangement’. The repo counterparty did not ‘obtain money [the GPF] in consideration for a promise by the parent to provide money to the Westpac subsidiary’. The repo counterparty obtained GPF in consideration for its promise to procure and maintain its parent’s guarantee.[13]Alternative argument fails for the same reason as it failed in the BNZ case.Consequently GPF was not deductible under black letter law principles[14] |
| Analysis required by the Supreme Court’s judgment in Ben Nevis | A two-step analysis is required:a) Step 1 requires the Judge, upon an ordinary interpretation of the applicable specific provisions, to decide whether the arrangements comply with those provisions.b) Step 2 requires the Judge to decide, upon the scheme and purpose of the Act including s BG 1, whether the legislature would have contemplated and intended that the specific provisions be deployed as they were deployed by the taxpayer in the transactions in issue.[15] “Armed with a thorough grasp of the detail and workings of the arrangement, the Court asks itself: would it have been within Parliament’s contemplation that the specific provisions be “deployed” in the manner in which they were deployed by the taxpayer in this particular arrangement?[16] | A principled identification of the objectionable element or elements of a particular transaction within its statutory context is required.[17] Ben Nevis at [84]-[89] is a “diplomatic rejection” of Richardson J’s judgment in Challenge while endorsing Woodhouse P’s approach in the same case, departing from Richardson J’s emphasis on the specific provision (which led to reading down or negating the specific provision) and from a “formalistic or juristic” approach which excluded examination of the circumstances surrounding the transaction[18]. Applying key paragraph [107] in Ben Nevis, there may be cases where a taxpayer’s misuse of a specific provision is so extreme or clear cut that a finding of tax avoidance will inevitably follow. But a wider inquiry will necessarily be appropriate where the arrangement involves a number of composite or interdependent steps, including the step which is the subject of a disputed deductibility claim.[19] |
| How the Ben Nevis analysis should be applied | [T]he question for the Court at step 2 is necessarily an hypothetical one. Guided by the considerations and the approach set out by the Supreme Court in [108] and [109] in Ben Nevis, the Court is essentially asking itself: had Parliament foreseen transactions of this type when enacting the specific provisions deployed in the transactions, would it have viewed them as within the scheme and purpose of those specific provisions?[20] | The inquiry, as [108] and [109] envisage, is wide ranging and includes the provision’s use in the light of commercial reality and the transaction’s economic effect. That use, assuming it was lawful, cannot be isolated from wider considerations.[21] |
| Scope of the arrangement | The BNZ apparently accepted that its funding formed part of the relevant arrangement.[22] | Westpac’s funding arrangements were part of the statutory arrangement with each counterparty.[23] |
| Cost of funds | The BNZ apparently accepted that the transactions were pre-tax negative or unprofitable before tax and that its cost of funds was at LIBOR or equivalent[24] | Westpac’s notional or marginal cost charge to the structured finance unit equated with its assessment of the actual costs of the funds applied in each transaction – that is, at a floating LIBOR rate – and was and remained the bank’s best estimate.[25] |
| Findings on GPF and commerciality | While complexity is typically a feature of structured finance transactions, it is unusual in transactions that are in substance straightforward loans, as these were.[26] The distribution rates in the six transactions neither reflect the then current market conditions, nor the credit status of the counterparties, nor any normal commercial or economic levels.[27]The GPF was a contrivance[28]. No fee was justifiable.[29] The transactions had no commercial purpose or rationale.[30] | The bank never intended to provide a discrete funding facility to a stand-alone subsidiary. The counterparty group was to be the economic beneficiary. It was always envisaged that the parent alone would be responsible for all repayment obligations[31]. A discrete fee, whether paid to procure a guarantee or for the guarantee itself, was never commercially justifiable.[32] Viewed objectively, the transaction did not make commercial sense[33] |
| Swap rates | The primary purpose of the swap was to facilitate a fixed distribution rate under the transaction, and thus fix the tax benefits shared by the parties. The manner in which the interest rate swaps were transacted was not in accordance with market practice in several respects. This had the consequence that the fixed interest rate in at least two of the transactions was well out of line with the market rate.[34] | Westpac acted commercially in swapping currencies immediately after the transaction was entered into and in using the five year swap rate as the benchmark for the opportunity cost component of the dividend rate[35] |
| Circularity | Economic circularity as a result of the fixed distribution rate necessitating the fixed swap payment[36] Appears to accept CIR’s evidence of circular payments at [410] and [412]. | No significant circularity. Circularity in this context is normally understood to refer to movements of money which conceal the fact that there was no underlying activity at all: Peterson per Lord Millett at [45]. Here each payment discharged a genuine contractual liability; the existence of periodic exchanges of funds of similar amounts does not connote circularity, given that there was a proper commercial basis for the underlying currency swaps.[37] |
| Ancillary evidence | Evidence about the economic implications and social cost of the transactions for New Zealand society is relevant.[38] | Evidence about the economic implications and social cost of the transactions for New Zealand society is irrelevant.[39] |
| Scheme and purpose of the FTC regime | No tax corresponding to the FTC was in fact paid (the operative word in s LC 1(1)) in the United States. Actual payment of foreign tax is the policy foundation of the FTC regime. Unless there is such payment, there is nothing against which to credit a FTC.[40] | The CSFB transaction circumvented the policy behind the regime, which was intended to provide New Zealand taxpayers with credits for tax paid in a foreign jurisdiction. Yet the economic burden of the US tax on the gross distribution was not in fact paid or economically suffered by either Westpac or the counterparty.[41] |
| Scheme and purpose of conduit regime | The legislative policy was that some at least of the conduit relieved income would be passed on as dividends by the New Zealand subsidiary to its foreign owner, thereby attracting 15% NRWT[42] | The fact that the transactions were loss making, and thus never resulted in dividends being paid to non-resident shareholders, is an objectionable consequence of the transaction as a whole. It would not have been within Parliament’s intention to allow a taxpayer to structure a transaction in such a way that NRWT would never be paid. [43] |
| End Result | Win for the CIR[44] | Win for the CIR, with a sting: “[Westpac] may count itself fortunate that [the CIR] did not, on his hypothetical reconstruction, [also] disallow the bank’s claim for its exempt income.”[45] |
Conclusion
This article is intended as a quick overview and comparison of some aspects of the decisions, rather than the in-depth analysis which both call for and which will no doubt follow. However it can be shortly stated that while the CIR won both cases, he did so for somewhat different reasons. In summary on the similarities, both judgments show:
- Show broad agreement as to how Ben Nevis applies
- Conclude that the GPF was a contrivance – the lending was always regarded as being to counterparty, with the unrated subsidiary interposed to justify GPF
- Conclude that no GPD was justifiable
- Agree that the transactions did not make commercial sense
- Conclude that the transactions did not comply with scheme and purpose of FTC or conduit regimes
- Regard previous binding rulings as irrelevant
As regards differences between the judgments:
- Unlike Wild J in BNZ, Harrison J found that the GPF was ineffective, even under the ordinary provisions of the Income Tax Act, to deliver the claimed deductions.
- While rejecting Westpac’s attempt to differentiate its case on the bases that the funding costs were not part of the arrangement and/or that the costs of funding were different from the CIR’s assertion (points not contested by BNZ), Harrison J has found in Westpac’s favour on the commerciality of the swap transactions.
- Wild J appears happy to regard the circularity in the transaction as a hallmark of tax avoidance; Harrison J clearly regards any circularity as irrelevant to his conclusion.
- Perhaps as a result of his conclusion in relation to swaps and circularity, the GPF assumes greater significance in Harrison J’s decision on tax avoidance. Indeed his view is that but for the GPF, the CIR would not have questioned the transactions[46].
- Wild J was prepared to take into account the costs of the transactions to New Zealand’s economy and society; Harrison J regarded this as irrelevant.
With both banks having signalled appeals[47], life in tax avoidance will continue to be interesting!
[1] Disclaimer: The author was part of the CIR’s legal team in the Westpac and BNZ Investments cases which are discussed in this article. The author also represents taxpayers in a number of tax avoidance cases currently before the High Court or the Taxation Review Authority. The views in this article are the author’s own, and should not be ascribed or applied to individual clients.
[2] BNZ Investments Limited & Ors v CIR (Unrep 15 July 2009, High Court Wellington, CIV 2004-485-1059, Wild J)
[3] Westpac Banking Corporation v CIR (Unrep 7 October 2009, High Court Auckland, CIV 2005-404-2843, Harrison J)
[4] Or, in some instances, interests in a Trust
[5] Where the structure used a trust, the trust paid distributions
[6] Harrison J’s judgment para [158]
[7] Wild J’s judgment para [44]
[8] Para [45]
[9] Para [163]
[10] Para [152]
[11] Para [145] to [157]
[12] Para [162] to [172]
[13] Para [293]
[14] Para [312] and [313]
[15] Para [137]
[16] Para [126]
[17] Para [13]
[18] Para [176]
[19] Para [189]
[20] Para [135]
[21] Para [190]
[22] Summary at para [488] of the Westpac judgment
[23] Para [574]
[24] Summary at para [488] of the Westpac judgment
[25] Para [528]
[26] Para [284]
[27] Para [298]
[28] Para [330]
[29] Para [359]
[30] Para [526]
[31] Para [360
[32] Para [387]
[33] Para [586]
[34] Para [404]
[35] Para [578]
[36] Para [370]
[37] Para [580]
[38] Para [468]
[39] Para [577]
[40] Para [205]
[41] Para [612]
[42] Para [243]
[43] Para [611]
[44] Para [542]
[45] Para [688]
[46] Para [341]
[47] BNZ has announced it has filed an appeal; para [16] of the Westpac decision notes “Counsel have confirmed that an adverse decision will be challenged”