Alesco had its case relating to tax avoidance heard by New Zealand’s Court of Appeal in Wellington last week, after it disagreed with an earlier High Court ruling.
The Commissioner of Inland Revenue is attempting to use the GAAR (section BG 1, Income Tax Act 2007) to declare a transaction structure used by Alesco as void.
As the Commissioner has won the other cases concerning the GAAR that have been heard by New Zealand’s appellate courts in recent years, the outcome of Alesco is of great concern to taxpayers.
Alesco transaction
The dispute concerns assessments and penalties of about NZ$8.6 million ($7.1 million) in connection with a financing arrangement between Alesco NZ, a wholly-owned subsidiary of Australian parent Alesco Corporation (Alesco AU), which allowed the New Zealand subsidiary to acquire two domestic businesses.
In 2003, Alesco NZ issued optional convertible notes (OCNs) to its Australian parent in return for advances totalling $78 million for a term of 10 years. The money was to be used for the acquisition of two companies – Biolabs and Robinhood.
The notes are debt securities sold on the basis they can be redeemed as cash or equity in the issuer when they mature.
Alesco AU had the option, at maturity, of being repaid the $78 million or converting the OCNs into shares in Alesco NZ. No interest was payable on the OCNs.
Shaun Connolly, of Russell McVeagh, said the structure resulted in no New Zealand interest withholding tax and no assessable income in Australia for the holder.
“Using the method prescribed by the Inland Revenue Department (IRD) in a determination, the subscription price of approximately $78 million was bifurcated into an amount paid for the debt instrument – approximately $38 million – and an amount payable for the option, $40 million,” said Connolly.
“The debt instrument component was subject to a set of rules in the Income Tax Act known as the financial arrangements rules, and under those rules the difference between the amount deemed to be paid for the debt component ($38m) and the amount payable on redemption ($78m) was treated as interest and spread over the term of the arrangement, giving the New Zealand issuer interest deductions,” he added.
Because no coupon interest was payable, there was no New Zealand withholding tax; the deemed interest arising under the financial arrangements rules did not attract withholding tax.
The holder of the OCN, which was tax resident in Australia, was not required to recognise any income from the OCN, because in contrast to the New Zealand position, the Australian rules did not deem an amount of interest income to arise.
Taxpayer’s position
Alesco needed funding to complete the acquisition of Biolabs and Robinhood.
It argues that if OCNs were not used, Alesco NZ would have been funded by ordinary interest-bearing debt, so interest deductions would have arisen in New Zealand anyway.
By using OCNs, the group had interest deductions in New Zealand but no requirement to return income in Australia because there was no coupon interest payable to the holder of the instrument.
Moreover, Alesco argued that the structure that delivered these tax consequences involved no more than following the requirements of the IRD's determination.
Connolly said the IRD's claim that the determination in question did not contemplate that OCNs would be issued between members of the same group of companies seemed to miss the point that, on its terms, the determination applied to zero-coupon OCNs and did not exclude from its scope intra-group arrangements.
“The Inland Revenue had in the meantime revoked that determination and replaced it with a determination that did not apply to intra-group OCNs, meaning that in seeking to apply the GAAR to Alesco's transaction, it was really seeking to give retrospective effect to the restriction in the replacement determination on intra-group transactions,” said Connolly.
IRD’s position
Mike Lennard, of Stout Street Chambers, said the IRD’s argument that the transaction should be deemed void under the GAAR hinged on three points:
there was no corresponding taxable income return for the expenditure incurred. 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;
the option component of the arrangement was artificial because it had no value to Alesco AU because there was no negotiation between the parties to the subscription agreement, unlike in an arm’s-length transaction; and
no real interest expense had been incurred and the notional interest claimed did not represent a real economic cost. And the notes did not have any inherent economic value to an arm’s-length third party. 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.
Implications
The commissioner has won all GAAR cases heard before the Court of Appeal and/or the Supreme Court since the right to appeal to the Privy Council was abolished several years ago.
Connolly said taxpayers should be concerned if Alesco loses this case, because it will demonstrate that even in the context of a commercially motivated transaction, and in circumstances where there was a detailed and prescriptive regime for classifying the instrument and determining the amount of the interest deductions for tax purposes which was complied with, the GAAR can apply to negate the otherwise permissible tax benefits.
“If Alesco loses, the implication for taxpayers is that falling into a specific regime previously approved by Inland Revenue is not an answer to tax avoidance, justification would still need to be provided for choosing a particular arrangement,” said Patrick McCalman, of Deloitte.
“Further, it illustrates that having established a transaction is avoidance the Inland Revenue is under no obligation to construct the alternative transaction but can simply void the transaction and all its tax effects. This illustrates the second important feature of the case – the need for the taxpayer to ensure that the base case of the alternative transactions is established,” McCalman added.
McCalman said as such, taxpayers need to consider two issues before entering into these types of arrangements:
· taxpayers need to understand and be able to evidence the commerciality of all parts of the transactions they enter into and be able to evidence why they have chosen a particular structure; and
· taxpayers need to consider how they might evidence the commercial alternatives as a means of demonstrating that the tax advantages sought are not offensive.
If Alesco's appeal is successful, it will be a reassuring indication for taxpayers that not every arrangement that is structured to achieve a desirable tax outcome attracts the application of the GAAR.
“A win for Alesco would also hopefully go some way to fending off concerns that the Commissioner is able to deploy section BG 1 to effectively rewrite legislation that is considered to be deficient,” added Connolly.
Lennard said the case may also have broader implications.
“A big picture issue is that this case concerns the extent to which the New Zealand courts feel able to set aside the specific statutory regime (and/or the statutory determinations, whose aim is avowedly to give taxpayers certainty) in favour of a vague anti-avoidance provision. This issue has not, in my opinion, arisen as starkly before in our jurisprudence,” said Lennard.
Lindsay McKay, of Thorndon Chambers, is representing Alesco under instruction from Bell Gully’s Auckland office.
Alesco declined to comment on the case.
