An Australian industrial supplies company, Alesco, gave a loan to its subsidiary, Alesco NZ, to help it buy two local companies.
Alesco NZ made the acquisitions, in 2003, through the issue of optional convertible notes (OCN) to the parent company,
As the notes had debt and equity components, Alesco NZ regarded parts of them as interest payments- for accounting purposes and deductible under IRD guidelines.
The IRD claims that, because the funding was between related parties, there was no economic cost to Alesco NZ and the transaction
“The use of zero coupon OCNs by companies within the same group can create an opportunity for interest expenditure deduction which was not incurred in economic terms,” said an IRD spokesman. “The Commissioner's view is that the use of OCNs in this manner is outside the intended scope of his determination and is tax avoidance. We cannot comment further as this case is before the courts.”
The case involves a type of hybrid financing. Hybrid financing is a common and accepted feature of the New Zealand financing landscape.
“As such, the Commissioner's change of heart as to raising concerns about this type of financing took many by surprise,” said Kirsty Keating of Ernst & Young in New Zealand. “Also, the taxpayers relied upon the commissioner's own Accruals Determination (issued pursuant to New Zealand income tax legislation ) in their treatment of the OCN. Although this has more recently been amended, in many people's view it is surprising that the IRD would then seek to retrospectively attack reliance upon the old determination, particularly as the IRD allowed a
The question the court is trying to answer is whether Alesco NZ really did face an economic cost when it borrowed from its parent company.
“This is because the financing is between related parties and the share issue has no dilutive effect on the overall shareholding of the issuer and, supposedly, no significant effect when examined at a group level,” said Mark Loveday, also of Ernst & Young.
The taxpayers for the OCN transactions relied upon the Accruals Determination. This Determination (G22) effectively allowed a part deemed interest deduction for OCNs, which in the Alesco case were for zero coupon instruments. The determination has subsequently been amended prospectively (Determination G22A) to only apply to non-related party transactions.
Uncertainty now surrounds the case, which could have an impact on foreign investment in New Zealand.
“If the IRD were to be successful in their arguments, potentially it could restrict the opportunity for related parties to use optional convertible notes, and potentially other types of notes issue funding,” said Keating. “As these types of facilities are often flexible and cost effective, this would not be welcome news for corporate, for whom hybrid financing - that is financing with both debt and equity components - is a common form of long-term financing.”
Loveday said the new determination by the commissioner does not change the methodology used, and as such, many view this as an admission that the economic cost, gives rise to the deductions where the ultimate repayment of the financing upon conversion happens with shares. As such, the commissioner is left to argue that although this is fine for arm’s-length parties, it is not acceptable for related parties.
“If the IRD is saying that issuing shares to a related party has no economic cost, it is only one step away from saying that cash repayments between a parent and a subsidiary have no economic cost at a group level,” added Keating. “This highlights the problem with what they are arguing. The fact is that whether related or not, parties are required to deal with each other at arm’s-length.”
The two-week hearing began in the High Court at Auckland on September 12 and is the first in a queue of cases against trans-Tasman companies accused of using the same tax avoidance technique.
