In his judgment in the case Alesco New Zealand Ltd v Commissioner of Inland Revenue Dec 2011, Heath J noted that although this case was not a designated test case his decision will be very influential.
Alesco 1 of 16 challenging CIR
Similar financing structures had been used by other taxpayers and that this taxpayer was one of 16 taxpayers who had challenged the CIR’s decision to treat the arrangements as tax avoidance arrangements. The total amount in dispute in all these cases including core tax, shortfall penalties and UOMI) the CIR believes totals over $300 million.
- The taxpayer’s challenges to the CIR’s assessments in all four proceedings were dismissed and the CIR’s assessments were upheld. The shortfall penalties imposed by the CIR met the statutory criteria and those assessments were also upheld.
- With respect to OCNs, Heath J found that there are very limited circumstances in which arm’s length investors and issuers would choose to enter into a subscription agreement for an OCN when it is not traded on a transparent public market.
- It was accepted that there was an arrangement in terms of s BG 1. The parliamentary contemplation test requires a determination of whether Parliament ever contemplated that the type of transaction undertaken in this case would provide a taxpayer with a right to deduct an interest component. To answer this Heath J needed to compare the purpose of the financial arrangement rules with the way in which the inter-company funding was undertaken. His Honour recorded that Alesco Corporation decided to acquire the Biolab and Robinson businesses before settling on the way in which the financing arrangements between Alesco Corporation and the taxpayer were to be structured and documented. The way in which the inter-company advances were structured between the two companies was driven solely by tax considerations. It was not an agreement to lend money on particular terms. It was a way for the Alesco group to obtain tax benefits and therefore, reduce the transaction costs of acquiring the two businesses. The commercial decision to buy the two businesses had been made. Money was raised in Australia for Alesco Corporation to pay for the new assets. The OCNs were nothing more than a means of obtaining the New Zealand tax benefits identified by KPMG. Other ways in which the transactions could have been documented involved less tax benefits.
Heath J found:
(i) There was no commercial purpose served by the taxpayer providing an option for Alesco corporation to convert the debt to shares because at the time the Notes were issued Alesco Corporation owned 100,000 shares in the taxpayer and therefore held 100 per cent of the taxpayer’s capital. If Alesco corporation ad exercised the option there would have been no change to the taxpayer’s status as a wholly owned subsidiary. That aspect of the arrangement was artificial. It was always open for Alesco Corporation to procure the issue of new shares in the taxpayer without recourse to the OCNs.
(ii) There was no negotiation between the parties as there would be in an arm’s length transaction. There was no account taken of factors such as the appropriate coupon rate, the number of shares that may be offered to discharge the debt on conversion and the time at which the holder may elect to convert from debt to equity. Rather the terms were crafted to secure the tax advantages and were therefore artificial.
(iii) The Notes contained detailed terms designed to mimic those into which arm’s length parties would enter. This concerned protections agreed between the companies over appointments to the boards of Biolab and Robinhood which made the transaction look more justifiable from a commercial perspective but was merely window dressing.
Heath J preferred the expert evidence offered by the CIR, that not only was no economic cost incurred by the taxpayer but it in fact obtained an economic benefit through its ability to use the $78 million received from Alesco Corporation for its own purpose, pending repayment or conversion to equity on maturity and that there was no commercial reason for a wholly owned subsidiary to issue an OCN to its parent company at par because the parent already owned 100 per cent of the issue share capital. Heath J focussed on the economic reality of the transaction. There being no economic benefit. The taxpayer had the use of an interest free loan from its parent from the time of the advance through to maturity. It did not incur an actual expense on an annual basis during that period.
As long as the OCNs stayed in the hands of Alesco Corporation they were an interest free loan. The option element carried no practical purpose or value because Alesco Corporation already owned the taxpayer. A sale of the OCNs whilst a possibility was not a realistic proposition because a third party purchaser would never present itself. The warrant component of the OCNs had no value at the time of issue but were really only interest free loans from the parent to its subsidiary with an option to turn that into an injection of equity capital on maturity.
Were the deductions claimed within Parliamentary contemplation?
The interest deductions claimed were not within parliamentary contemplation because there was an absence of any match between expenditure incurred and income to be returned. The terms of the agreement were not negotiated but designed to enable the taxpayer to claim interest deductions without any corresponding return of taxable income. The arrangement was artificial designed to secure a tax advantage that could not otherwise have been obtained; no real interest expense was incurred and there was no real economic cost; and the OCNs had no inherent commercial value to an arm’s length third party other than perhaps a speculator.
The Decision cont. –
4. With respect to reconstruction the Court needed to apply the Privy Council in Miller v Commissioner of Inland Revenue  3 NZLR 316. Once an arrangement is treated as void under s BG 1 the purpose of the CIR’s decision to reconstruct is to counteract any tax advantage achieved by the taxpayers. No relief could be granted under s 138P of the TAA.
5. In considering whether a taxpayer has taken an unacceptable tax position the Court must determine whether viewed objectively the tax position fails to meet the standard of being about as likely as not to be correct. Following the Supreme Court in Ben Nevis the taxpayer in this case took a tax position in 2003 which viewed objectively was not about as likely as not to be correct and it was therefore unacceptable. Having regard to his findings that the arrangement was to finance the Biolab and Robinson acquisitions in the most tax effective manner (to secure benefits that would reduce the transaction costs otherwise involved), the notes were artificial; there was no actual expense incurred and the option component had no real economic value) viewed objectively the taxpayer entered into the arrangement with the dominant purpose of avoiding tax. Therefore, the tax position taken by the taxpayer fell within the definition of an abusive tax position for the purposes of s 141D of the TAA. A 50 per cent credit for the taxpayer’s prior good tax history was also granted.
In 2002 Alesco Corporation Ltd (Alesco Corporation) an Australian company listed on the Australian stock exchange contemplated acquiring the industrial businesses in New Zealand, namely Biolab Ltd (Biolab) and Robinson Industries Ltd (Robinson). Alesco Corporation nominated the taxpayer to purchase 100 per cent of the shares in Biolab for the purchase price of $46 million. Of that sum, $6,040,280 was satisfied by Alesco Corporation assuming a debt owed by Biolab (Aust) Pty Ltd (BiolabAustralia). A contractually agree earn-out payment of $9,191,000 became payable and the total purchase price was therefore, $55,191,000.
The major shareholder in Robinson declined to give the warranties sought by Alesco Corporation in relation to the sale of shares. Therefore, Alesco Corporation arranged for the taxpayer to acquire the Robinson business through the taxpayer’s wholly owned subsidiary, Robinhood Ltd (Robinhood) for the purchase price of $28,653,345 with $27,850,000 on settlement (30 April 2003) and an earn-out payment of $1 million in August 2004.
In all Alesco Corporation raised around $85 million through debt and equity financing to enable the transactions to be completed. The transactions were not artificial, real businesses were acquired with real money. The Alesco group sought to secure the most tax effective means of financing the transactions. Following receipt of advice from its tax advisers, KPMG, Alesco Corporation used a form of optional convertible notes (OCNs) to record payments amounting to $78 million to the taxpayer. The OCNs were issued by the taxpayer in favour of Alesco Corporation with the $78 million being paid to the taxpayer in three tranches, pursuant to a separate OCN. Each OCN contained debt and equity components which Alesco Corporation were advised would allow the taxpayer to claim interest deductions inNew Zealand. KPMG marketed the scheme on the basis that it had previously been used by a number of Top 100 Australian listed companies that had invested in New Zealand enterprises. Each Note was priced at $1 and the terms were for around 10 years from the date of issue. At maturity the Notes were convertible into ordinary shares in the taxpayer or could be redeemed for cash at an amount equivalent to the issue price. The agreements were an interest free debt of $78 million owed by the taxpayer to Alesco Corporation with a conversion option at the end of the term.
The tax outcome of the taxpayer issuing interest free OCNs to meet future financial commitments arose by virtue of the requirement to follow Determination G22 which provides for a deemed interest deduction being allowed in certain interest free OCNs. The taxpayer claimed interest deductions and its liability to pay income tax (or reduced tax either directly or indirectly) because of its ability to claim those interest deductions and offset losses among the members of its group.
There were four proceedings on foot:
(i) the taxpayer challenged the CIR’s decisions to disallow interest deductions totalling $5,687,79 for the 2003,2004 and 2005 tax years;
(ii) Parbury Building Products (NZ) Ltd (Parbury), Robinhood and Alesco NZ Trustee Ltd challenged the CIR’s decision to reduce loss offsets form the taxpayer totalling $1,910,846 for the 2003, 2004 and 2005 tax years;
(iii) the taxpayer challenged the CIR’s decisions to disallow interest deductions totalling $9,277,629 for the 2006, 2007 and 2008 tax years and Parbury, Thermo Fisher Scientific New Zealand Ltd and Concrete Plus Ltd challenged the CIR’s decisions to reduce loss offsets from the taxpayer totalling $2,469,282 for the 2003- 2008 tax years; and
(iv) the taxpayer challenged the assessment of shortfall penalties totalling $2,469,282 for the 2003- 2008 tax years.
What the CIR contended
The CIR contended that there was tax avoidance with respect to the inter-company advances made by Alesco Corporation to the taxpayer enabling the transactions to be effected. It was the CIR’s contention that the OCN was a structured financial product that Alesco Corporation bought from KPMG for the purpose of allowing the taxpayer to obtain impermissible tax benefits inNew Zealand. The product was not selected from a suite of alternative financing structures (there being no negotiation between Alesco Corporation and the taxpayer in relation to terms or pricing of the debt and option components of the Notes) The instrument was chosen as a means of documenting the inter-company advances after Alesco Corporation had made a decision to acquire the two New Zealand businesses and had already raised its own external funds. They lacked commerciality in their terms based on economic reality. They being no more than an interest free advances stapled to valueless and purposeless warrants (a share warrant, being the right to convert Notes into new shares). The CIR also sought to impose shortfall penalties on the basis that the taxpayer took an abusive tax position.
What the taxpayer contended
The taxpayer contended that there was no tax avoidance arrangement and that the financial arrangement rules were designed to deal with a transaction of this type. The OCNs complied strictly with those rules and the monetary calculations were made in accordance with Determination G22 and Determination G23. The financial arrangement rules reflected economic reality by treating notional interest, deductible as an expense, as an economic cost. The taxpayer contended that the CIR had used s GB 1 to reconstruct the arrangement and was wrong in failing to take account of the next best alternative to the Note funding structure being the provision of a loan at market rates between Alesco Corporation and the taxpayer. There was no tax advantage to counteract because had that alternative method been chosen the taxpayer could legitimately have claimed greater deductions. The taxpayer also disputed the imposition of the shortfall penalty.