OCN funding is tax avoidance
Alesco New Zealand Limited v CIR  NZCA 40
The Court of Appeal has dismissed an appeal by the taxpayer, Alesco NZ, against Inland Revenue determinations that it owes $8.6 million on avoided tax transactions relating to its purchase of two New Zealand businesses between 2003 and 2008. The taxpayer’s Australian owner, Alesco Australia, funded the purchases advancing $78 million to the taxpayer in consideration for a series of optional convertible notes (“OCN’s”). The OCN’s were non-interest bearing for a fixed 10 year period. Upon maturity, Alesco Australia was able to convert the OCN’s to shares in the taxpayer company.
Between 2003 and 2008, the taxpayer claimed deductions for notional interest liabilities deemed to have arisen on the OCN’s in accordance with relevant accounting standards, and Determination G22 (“G22”), which in essence provides a methodology for separating the debt and equity components of OCN’s for the purpose of spreading income and expenditure under the financial arrangement rules. No New Zealand interest withholding tax was payable as no actual interest payments were made and there was no assessable income in Australia for Alesco Australia. As the Court noted, the OCN’s attraction lay in this asymmetrical cross border taxation treatment.
The Commissioner of Inland Revenue (“Commissioner”) issued assessments to the taxpayer denying the interest deductions on the basis that the funding structure was a tax avoidance arrangement. Shortfall penalties were imposed on the basis that the taxpayer took an abusive tax position in claiming the interest deductions.
The primary issue before the Court was whether the OCN arrangement had tax avoidance as its purpose or effect. To determine that, the Court’s inquiry was whether the use of the financial arrangement rules and G22, viewed in light of the whole arrangement was within Parliament’s contemplation and purpose. Determining whether an arrangement involves tax avoidance involves firstly satisfying the court that the arrangement itself is technically compliant with the statutory provisions. The Commissioner accepted that the taxpayer had in fact complied with the relevant financial arrangement provisions and determinations, and accordingly, the Court did not explicitly address this first stage of enquiry in its judgment.
Central to the judgment was the Court’s assessment of the purpose and effect of G22. Under G22, which has now been replaced with Determination G22A, the taxpayer was required to notionally split the OCN’s into a debt component and an equity component and attribute values to each. This is because the financial arrangement rules treat the components differently for tax purposes. The calculations under G22 and the financial arrangement rules, which the Commissioner accepted were technically compliant, resulted in the notional interest payments, which had no economic or legal substance, being deductible to the taxpayer. The Court’s main focus was whether Parliament intended for taxpayers to be able to claim under the financial arrangement rules expenditure that it was not liable to pay and would not ever suffer in an economic sense. The Court said that the financial arrangement rules were intended to operate as a net regime to bring to tax the amount yielded by a taxpayer after deducting the entire economic cost from a taxpayer’s entire economic benefit. That does not include notional transactions. The Court accepted that notional interest can be treated as expenditure for the purposes of the financial arrangement rules and G22 but that did not translate into a deduction for tax purposes. The Court said G22 does not operate to turn “a pretence into a reality”. In other words, the notional interest amounts were fictitious and the taxpayer did not as a matter of fact incur the liability for which it was claiming a deduction. The Court reinforced this concept when it said, at paragraph 83 that “the underlying premise for the statutory deductibility rules is that they are to apply only when real economic consequences are incurred”. On that basis, the Court was satisfied that the taxpayer used the financial arrangement rules and G22 to claim deductions in a way that was outside Parliament’s contemplation. Accordingly, it dismissed the appeal on that point.
The Court’s conclusion that notional interest payments do not meet the ‘incurred’ test for deductibility begs the questions of how the Court might have treated notional amounts of income for tax purposes on an OCN with similar terms. There is no overriding provision in the tax legislation that allows for a deduction for expenditure incurred under the financial arrangement rules. The expenditure must fall within the general permission, or under one of the ‘financing costs’ rules to claim a deduction. In contrast, there is a provision that includes as income for tax purposes amounts that a person is treated a deriving under the financial arrangement rules. This is a clear mismatch in the tax legislation between expenditure and income related to a financial arrangement. While not expressed by the Court, this suggests that Parliament may have indeed have contemplated that to claim a deduction for expenditure under the financial arrangement rules, the general deduction permission must be satisfied and that to do that an actual economic loss must have been suffered by the taxpayer. However, it also suggests that Parliament contemplated that notional amounts of income derived under the financial arrangement rules are to be treated as taxable income.
If that was in fact within Parliament’s contemplation, it could have serious impacts on non-interest bearing OCN’s entered into between two New Zealand entities that attract notional interest and income under the financial arrangement rules and relevant determinations. Notional income would be taxable to the holder of the note, while notional interest incurred by the issuer would not be deductible. It is worrying that the Court, in reaching its decision, may have overlooked the reach of its decision that for expenditure to be deducted, it must be incurred in the economic sense. It is possible, however, that the Court may have considered that the OCN structure was used only for cross border funding because of the asymmetrical tax outcomes in Australia and New Zealand and so was most unlikely to be used between tow onshore parties.
The absence of an express statutory permission to deduct deemed expenditure under a financial arrangement also suggests that, despite the concessions made by the Commissioner in the proceedings, notional interest deductions would not have been allowed under the black letter law. While the Court stated that it did not consider whether the OCN arrangement technically compiled with the statutory regime, and that it does “not express an opinion on it”, in effect it did through its comments on the meaning of “incurred” and Parliament’s contemplation of that meaning.
Upon finding that the transaction was a tax avoidance arrangement, the Court considered the Commissioner’s powers of reconstruction. The Commissioner may adjust elements of a transaction for the purposes of counteracting a tax advantage where that transaction is void as a tax avoidance arrangement. The Court noted that the Commissioner’s discretion in this respect is broad. In exercising her discretion in the present case, the Commissioner simply reversed the interest deductions that were claimed. The taxpayer unsuccessfully argued that the Commissioner should have had regard to the commercial “counterfactual” funding structure that it would have employed instead of the OCN structure. The company argued that if the OCN had not been used, it would have entered into a ‘traditional’ interest bearing loan with its Australian parent and of course the interest would have been deductible in NZ. The Commissioner in that case would have been no worse off than under the OCN claim, it was asserted. The Court did not accept this argument and agreed with the Commissioner that it is not her job to reconstruct by having regard to the tax affect of what is said to be the most likely counterfactual transaction. In short the claimed deduction was for interest; that was the advantage obtained under the arrangement; reversing the interest was the most direct means of countering the advantage.
Finally, the Court upheld the imposition of shortfall penalties on the basis that the taxpayer had first taken an unacceptable tax position (in that it failed to meet the standard of being about as likely as not to be correct) and more significantly, also held that it had taken an abusive tax position. This was on the basis that at the time the transactions were entered into in 2003, the principles relating to the construction of the anti-avoidance provisions were well settled and that a Court in 2003 would have come to the same conclusion on the nature of the OCN transactions. The Court cited the Privy Council’s decision in Challenge as the basis for the settled law. That decision did not deal with a situation involving a reasonable commercial counterfactual as in this case. It seems the conclusion by the Court that Alesco NZ entered into the transactions with the dominant purpose of avoiding tax (and thus took an abusive tax position) oversteps the mark. The fact that Alesco NZ could have entered into an alternative transaction with Alesco Australia that would have seen it able to claim tax deductions through an alternative route suggests its position was not abusive. While the commercial counterfactual argument may not be applicable on a reconstruction argument, it should be applicable in the argument on imposing shortfall penalties.
Finally the observations of the Court about shortfall penalties raise a perplexing question for taxpayers and their advisers. If as the Court says the position was so clear in 2003, how did so many taxpayers (there are a number who used OCN structures) and their advisers get things so wrong for so long?
© G D Clews