Tax Avoidance Revisited – Alesco
Three years ago, the Supreme Court decision in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 289 (SC) (“Ben Nevis”), determining that the “Trinity” scheme was a void tax avoidance arrangement, avowedly “settled” the law in relation to tax avoidance.
Settling the law has not, however, resulted in settling all tax avoidance disputes. On the contrary, at least as many tax avoidance disputes seem to have come before the Courts in the time since Ben Nevis as in any comparable period beforehand.
This article summarises two developments in the way in which the Commissioner of Inland Revenue (CIR) is litigating, and the courts are considering, alleged tax avoidance. Those two developments are the reliance on unhelpful statements by taxpayers and/or their advisers, and the setting up of vanilla alternatives as a way of determining whether the transaction in question is artificial and contrived. The article then discusses the recent High Court decision of Alesco New Zealand Ltd v Commissioner of Inland Revenue[1] (“Alesco” and “Alesco NZ”) in the context of those developments.
Taxpayers’ Statements
A common recent feature of the CIR’s litigation strategy is his reliance on statements by those associated with the development of the transaction in question, discussing the role of tax in the transaction.
This issue probably first arose in the High Court litigation of the Trinity scheme – litigation which culminated in Ben Nevis. In the course of establishing the structure, a draft business plan (“the business plan”) for a company which was to fulfil the role of insurer in the structure was deposited with the authorities in the British Virgin Islands. That plan included this statement:[2]
The real benefits of the deal are tax concessions that can be obtained now by the investors and the Foundation. One of the conditions required to gain the tax relief is that the insurance must be in place. The actual outcome of the deal in fifty years time is not considered material.
Evidentially, a written admission by a third party is admissible against a civil litigant if the circumstances relating to the making of the admission provide reasonable assurance that the admission is reliable.[3]
However admissibility of evidence is subject to the overriding criterion that to be admissible, evidence must be relevant.[4] As Lord Simon of Glaisdale observed in Director of Public Prosecutions v Kilbourne [1973] AC 729 at 756: “Evidence is relevant if it is logically probative or disprobative of some matter which requires proof ….. relevant (ie. logically probative or disprobative) evidence is evidence which makes the matter which requires proof more or less probable”.
At first glance, what someone involved in the creation of a transaction says about the reasons for that transaction would seem to be very relevant to discerning its purpose or effect. However, it is well–established that the purpose or effect (the two terms in fact seem to be synonymous) of an alleged tax avoidance transaction are to be determined objectively, by reference to the arrangement itself, and not subjectively in terms of motive. As Viscount Dilhorne, delivering the advice of the Judicial Committee in Ashton v Commissioner of Inland Revenue [1975] 2 NZLR 717 (PC) held at 720:
If an arrangement has a particular purpose, then that will be its intended effect. If it has a particular effect, then that will be its purpose and oral evidence to show that it has a different purpose or different effect to that which is shown by the arrangement itself is irrelevant to the determination of the question whether the arrangement has or purports to have the purpose or effect of in any way altering the incidence of income tax or relieving any person from his liability to pay income tax.
Reliant on these dicta, and subsequent cases[5] which confirmed and consolidated this view, the CIR has successfully nullified taxpayers’ and their advisers’ attempts to explain away their participation in transactions on the basis of their perceived non-tax attractions. How then can the CIR rely on advisers’ or taxpayers’ statements as to the tax attractions of a transaction to suggest that, objectively, it has tax avoidance as a more than incidental purpose or effect?
In Accent Management, Venning J and the Court of Appeal justified admitting the business plan on the bases that it was (a) an incriminating statement by a party to the proceeding (the LAQC directed by the person from whom the statement originated) and (b) that:[6]
…the business plan is part and parcel of the overall arrangements and thus the tax avoidance arrangement identified by the Commissioner. It is thus admissible in relation to all who were parties to or affected by that arrangement.
In ANZ National Bank Ltd v Commissioner of Inland Revenue (2008) 23 NZTC 21,918 (HC) Wild J, in considering whether tax advice documents prepared by the taxpayer’s advisors, PricewaterhouseCoopers (“PwC”), should be discovered, found it unnecessary to determine the issue, but did express a preference – relying on Accent Management – for the CIR’s argument which he summarised as:
The established objective test did not require the Court to disregard tax advice received by the taxpayer. That advice may assist the Court to determine the objective purpose of the arrangement. Certainly, a taxpayer cannot seek to avoid a finding of tax avoidance by relying on documents preceding or contemporaneous with the arrangement, in which the taxpayer asserts “I am not entering into this arrangement to avoid tax – the resulting tax benefits are incidental”. However, the CIR can call in aid documents generated by the taxpayer or the taxpayer’s accountant tax advisers which state that tax avoidance is an aim of the arrangement: Accent Management at [142]. In other words, there is an “asymmetry” in the parties’ ability to rely on documents of this sort.
On appeal[7] O’Regan J held that the tax advice documents prepared by the taxpayers’ advisers were discoverable in the challenge proceedings because those documents met the broad test of relevance set out in the Peruvian Guano case[8] – i.e. where a document may lead a party to a train of inquiry which enables that party to advance its own case or damage its adversary’s case. This test for relevance in discovery is broad, and not necessarily the same as the test of relevance for admissibility purposes, so discoverability did not necessarily mean that the documents would be admissible.
His Honour disagreed with Wild J’s High Court analogy between the advice given to ANZ National and the business plan in the Trinity case because in Accent, the author of the business plan was the architect of the tax avoidance scheme and was instrumental in setting it up.
O’Regan J held that the tax advice might assist the CIR in establishing the scope of the arrangements at issue, although the opinions would not be of assistance to the extent that they were merely a statement of the taxpayers’ subjective purpose. Consequently this appears to be a rejection of the CIR’s “asymmetry” argument which found favour at first instance.
Emphasising the judicial uncertainty as to whether, and if so how and to what extent and for what purposes, such evidence can be received, the appellant taxpayers in Ben Nevis disputed that the arrangement they entered into for the purposes of ss BG 1 and GB 1 of the Income Tax Act 1994 included the statements in the business plan. In response the Supreme Court noted at para [161] that:
We will assume, without deciding, that the arrangement entered into by the appellants did not include the admission concerning ‘the real benefits of the deal’ in the CSI business plan or the letter of comfort.
In summary, it seems (although it is not certain) that a statement along the lines that “it’s all about the tax” will only be admissible to a limited extent – evidence of the scope of the arrangements – and possibly only if the statement in issue can be regarded as part of the arrangement itself.
Artificiality and contrivance – the contrast with a vanilla transaction
At least since Ben Nevis, categorisation of the degree of artificiality and contrivance inherent in the arrangement in question is (it arguably always has been) a key step to determining whether avoidance exists. Certainly this aspect is a major factor in any Inland Revenue investigation of suspected tax avoidance – to the degree that “artificial and contrived” are words which trip off the CIR’s counsel’s lips with the same frequency and fervour as mediaeval inquisitors said “sinful and heretical”.
But how to show artificiality and contrivance, when much of commerce can be described (at least at some level) as artificial and contrived?[9] The CIR’s usual approach in recent tax avoidance cases is:
· To posit a common – “vanilla” – alternative to the feature which gives the tax effect under consideration;
· To assert that – absent tax – there were no reasons (or, no sufficient reasons) justifying the feature which gives the tax effect;
· And to say that, therefore, the feature is artificial and contrived.
For example, in Ben Nevis the vanilla alternative which was put forward was purchase of the land and planting the forest by the investors themselves. This approach found favour with the Courts, as shown by this passage from the Court of Appeal judgment:[10]
“(a) The structure makes no commercial sense at all. For practical purposes the taxpayers provided all the funds which were necessary to acquire the land and plant the forest. There is no commercial reason why they should agree to pay another $2m a hectare for the privilege of using land the purchase of which they had funded. The option to acquire the land at half its value does not go anywhere near to balancing the ledger. The prospects of a profit are remote.
(b) The insurance arrangements likewise make no commercial sense. If Trinity 3 and taxpayers are treated as a single entity (as they largely are under the insurance policy) the insurance arrangements offer no substantial reduction of risk (given their circularity). The proceeds of payment of the initial insurance premiums were largely paid by the insurer to entities associated with Dr Muir and Mr Bradbury.”
Since the Trinity litigation, the Courts have shown themselves very sympathetic to this sort of approach, even when faced with types of transactions which were common and CIR’s counterfactuals which were themselves, arguably artificial and contrived:
· In Penny v Commissioner of Inland Revenue (2011) 25 NZTC 20-073 (SC) the counterfactual was the taxpayers (as proprietors of a business) paying themselves the majority of the business profits as salary, even though the evidence was that there was no market for salaried employees at their level of expertise and – as business proprietors – their risk and reward profiles were quite different from those of employees. The creditor protection elements of the structure were given little regard.
· In Krukziener v Commissioner of Inland Revenue (2010) 24 NZTC 24,563 (HC) the counterfactual was the property developer taxpayer (instead of taking repayable drawings from projects) paying himself a salary while developments were being undertaken, even though the evidence was that taking drawings was common in the industry and had the advantage of maintaining the development entity’s balance sheet equity while a project was being developed.
Alesco – the facts
Alesco NZ is a wholly owned subsidiary of an Australian company, Alesco Corporation Ltd (“Alesco Corp”). The Alesco group wanted to buy two New Zealand businesses. Alesco Corp advanced $78 million to Alesco NZ so that Alesco NZ could settle the purchases of these businesses. Alesco NZ issued optional convertible notes (“OCNs”) totalling $78 million to Alesco Corp in return for those advances. The OCNs had a term of 10 years, at the end of which Alesco Corp had the option of being repaid $78 million or converting the notes into 78 million new Alesco NZ shares.
An OCN is a hybrid financial instrument – a combination of a fixed-payment debt instrument and an option to acquire shares – in which some components are subject to the financial arrangement rules and others are excepted. The CIR issued[11] a determination[12] which applied where an excepted financial arrangement (being the option to acquire shares) is part of a financial arrangement (being the OCN) and specifies the method for determining the amounts receivable by the holder or payable by the issuer that are attributable to the financial arrangement. Any amount arising under an OCN that (applying the determination) is solely attributable to the option component of the OCN is not income or expenditure under the financial arrangements rules.
The effect of the determination is that the holder and issuer of the OCN are taxed as if it were a bond, issued at a price which excludes an amount paid or received for the option to convert to shares, and redeemable at the Cash Redemption Amount with Coupon Interest Payments throughout the term of the note if applicable.[13] The result is that the deduction to an issuer is determined by taking the subtracting from the issue amount the present value of the eventual cash redemption amount (determined using the Government Stock rate[14]) and the present value of the interest (coupon) payments.
The OCNs in question paid no interest – they were “zero coupon” OCNs and, as above, the redemption price was the issue price. In such situations, the result of the determination is that Alesco claimed a deemed interest payment at the Government Stock rate, without actually having paid any cash or deducted withholding tax.
The interest notionally received by Alesco Corp was not taxable as such notes were treated as equity instruments under Australian tax legislation.
Alesco – the judgment
The High Court found that tax avoidance was established. Justice Heath found that although the accounting treatment of the notes was appropriate, the tax advantage secured was not within parliamentary contemplation, for three reasons:
· First, there was no corresponding taxable income return for the expenditure incurred.[15] Parliament would not have considered that the financial arrangement rules should be used in such a way to give rise to a deduction where no real economic cost arose.
· Secondly, the option component of the arrangement was artificial because it had no value to Alesco Corp as Alesco NZ’s parent and because there was no negotiation between the parties to the subscription agreement, unlike in an arm’s length transaction.[16]
· Thirdly, no real interest expense had been incurred and the notional interest claimed did not represent a real economic cost.[17] Nor did the notes have any inherent economic value to an arm’s length third party.[18] The scheme of the financial arrangement rules, as interpreted in judgments, emphasises the concept of the accrued amounts matching real income and real expenditure that are to be realised or incurred at a later stage.[19]
Justice Heath found that the CIR was entitled to disallow all the interest deductions and loss offset elections arising from the use of the optional convertible notes to counteract the tax advantage gained, and the CIR was not required to act on evidence that Alesco NZ would have funded the acquisitions through an interest bearing loan from Alesco Corp had the notes not been used.
Extending the trends
The litigation and judgment in this case seems to follow the current trends, with, perhaps, some surprising outcomes in the two areas discussed above: the use of statements and the consideration of the vanilla alternative.
The statements
At paras [17] to [34] Justice Heath discusses and quotes extensively from correspondence and advice given by Alesco’s advisors, KPMG Australia and Alesco’s own Finance Director. Points which are picked up include:
· KPMG recommended a product which it had devised, known as “Hybrid into New Zealand” or HINZ, and had been utilised by others of its clients;
· The documents mentioned that “the hybrid structure produces a deduction for deemed or notional interest expense in New Zealand but does not give rise to either New Zealand withholding tax or assessable income in Australia”;
· The KPMG documents identify the potential tax benefits from the HINZ structure;
· The KPMG structured finance division suggested the OCN structure as the most tax effective way of financing the acquisition;
· Alesco identified that the Australian and New Zealand revenue authorities treated the convertible note differently, giving rise to a differential tax treatment and hence a tax advantage;
· Alesco’s internal communications identified three New Zealand tax advantages: Alesco NZ can claim interest on its notional interest, Alesco NZ can transfer the resulting tax loss to other group companies in New Zealand, and Alesco NZ does not have to pay NRWT.
So far, so utterly normal, one might think. A taxpayer wants to make an investment and seeks advice as to the most tax-effective way of doing it. These things happen from time to time.
The point which appears to have made most impact, however, was that KPMG Australia considered that the Australian anti-avoidance provisions would not apply, opining that the scheme entailed substantial New Zealand tax benefits compared with an equity investment, thereby pointing to non-Australian tax purposes. At para [31] Justice Heath held:
The highlighted extract from KPMG Australia‘s advice makes it clear that the dominant purpose of the arrangement was not to secure an Australian tax benefit. As the purpose was to secure the most tax-effective funding structure, the natural inference is that the dominant purpose of the arrangement was to obtain a New Zealand tax advantage.
The KPMG advice here seems no different in principle from the PwC tax advice given to ANZ National (and differentiated by the Court of Appeal from the Trinity statements as “not part of the arrangement”) and so are not able to be classed as part of the arrangement. Moreover, the opinion, even if able to be attributed to the taxpayers, seems to fall squarely within the ambit of “merely a statement of the taxpayers’ subjective purpose”.
To look at this from a different angle, had the KPMG opinion said the opposite – that the dominant purpose was not to secure an New Zealand tax benefit – would that have been regarded by the Judge as at all helpful for the taxpayers? Most probably not, but as noted above, the Court of Appeal has rejected the notion of any “asymmetry” in this area. So if the opposite advice could not have helped the taxpayers, why was what was actually said able to assist the CIR?
The vanilla alternative
At para [107] Justice Heath outlines the alternatives:
It was always intended that real money would flow from Alesco Corporation to Alesco NZ. That could have been achieved in a number of ways – for example, by a capital injection, a loan at market interest rates, an interest free loan or an “unbundled” transaction, involving elements of debt and equity.
At para [126] the mechanism of one particular vanilla alternative (presumably, therefore, the most likely or feasible) is outlined:
Mr Schubert gave evidence that, if the transaction were “unbundled”, its equivalents would comprise:
(a) An issue of shares (or an option to acquire shares) in 10 years time for $40 million; and
(b) A 10 year zero-coupon bond, with a face value of $78 million and an issue price of $38 million.
The surprising thing (to this author, at least) is that it appears common ground that this vanilla alternative would have generated exactly the same New Zealand tax consequences[20] as those actually claimed – and the CIR accepted[21] that the vanilla alternative would not have run foul of the GAAR.
However, His Honour concludes his brief survey of the alternatives at [109]:
The other ways in which the transaction could have been documented involved less tax benefits, either through the operation of Australian or New Zealand tax law.
In the writer’s view, this is a remarkable extension from the now usual approach of the CIR and the courts. The vanilla alternative involves the same tax consequences in New Zealand; it is the Australian tax consequences which change.[22] It is, however, clear that tax avoidance can only be determined with reference to New Zealand income tax;[23] the fact that Australian income tax may have been avoided by using the OCN structure rather than the vanilla “unbundled” alternative should be no concern of our CIR or our courts.
Conclusions
The fact that the most likely vanilla alternative had disadvantages for Australian, not New Zealand, tax reasons appears to support the taxpayer’s evidence recorded at para [36] that “taxation advantages in Australia drove the note structure (as opposed to those which were available in New Zealand)”. However, Justice Heath rejected that as “inconsistent with the contemporary documentation and not objectively sustainable”.
As above, however, the taxpayer’s contention appears objectively undeniable, in that the structure was clearly driven by the unattractiveness from an Australian perspective of the vanilla alternative, and the contemporary documentation is mostly unexceptionable and cannot, in any event, be used to determine the objective purpose or effect of the transaction.
In conclusion, the Alesco judgment seems to depart from the emerging orthodoxy in its use of contemporaneous advice to assist in determining the arrangement’s objective purpose and effect, and regarding an Australian tax advantage as an indicium of domestic tax avoidance. It is understood that the decision is to be appealed to the Court of Appeal; it will be watched with interest.[24]
[1] Alesco New Zealand Ltd v Commissioner of Inland Revenue HC Auckland CIV 2009-404-2145, 12 December 2011, Heath J.
[2]Accent Management Ltd v Commissioner of Inland Revenue (2004) 22 NZTC 19,027 at [251].
[3] Section 34 of the Evidence Act 2006.
[4] Section 7(2) of the Evidence Act 2006.
[5] For example, Tayles v Commissioner of Inland Revenue [1982] 2 NZLR 726 (CA).
[6] Court of Appeal judgment: Accent Management Ltd v Commissioner of Inland Revenue (2007) 23 NZTC 21,323 (CA) at [142].
[7] ANZ National Bank Ltd v Commissioner of Inland Revenue [2009] 3 NZLR 123 (CA).
[8] Compagnie Financiere et Commerciale du Pacifique v Peruvian Guano Co (1882) LR 11 QBD 55 (CA).
[9] Companies and trusts have no objective reality; they are legal fictions.
[10] Accent Management Ltd v Commissioner of Inland Revenue (2007) 23 NZTC 21,323 (CA) at [144].
[11] Under 90(1)(g) of the Tax Administration Act 1994.
[12] Determination G22, since replaced by Determination G22A which was issued in 2006.
[13] See excerpt at para [74] of the Alesco judgment.
[14] Determination G23.
[15] Alesco at [147].
[16] At [113].
[17] At [131].
[18] At [145].
[19] At [105].
[20] It is not clear to the writer whether this would include withholding tax consequences – potentially withholding tax consequences could arise at the end of the option period.
[21] At [128]: “The Commissioner does not dispute that if Alesco Corporation had injected $40 million into Alesco NZ by way of working capital and issued a 10 year zero coupon bond with a face value of $78 million at an issue price of $38 million, the interest could have been legitimately claimed.”
[22] Also at [128]: “It is clear that the “unbundled” transaction did not take place because of concerns about tax implications in Australia where, in the absence of a hybrid instrument, Alesco Corporation would have been obliged to return the interest component as part of its assessable income.”
[23] Section YA 1 definitions: tax avoidance includes—
(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
“income tax means income tax imposed under section BB 1” (there is an extension to include ancillary taxes for the purposes of section BG1).
[24] No pun intended.