No tax avoidance where purpose of providing tax benefit follows from the purpose of raising capital on particular terms
The High Court of Australia has unanimously held that the provision of franking credits as part of the return on a hybrid instrument was an "incidental purpose" to that of the overall purpose of raising capital for the issuing banking group. Accordingly, the Court concluded that the relevant anti-avoidance rule under which the Commissioner had sought to deny the benefit of franking credits did not apply.
The judgment will be of interest to many New Zealand taxpayers, particularly given the references to a "merely incidental" purpose in the definition of "tax avoidance arrangement" for section BG 1 purposes, and in section GB 35 (the specific anti-avoidance rule directed at arrangements involving imputation credits). Reflecting its recent more aggressive approach to applying the anti-avoidance provisions, Inland Revenue often argues that, even when a tax advantage is consistent with the attainment of a commercial objective, the tax advantage is more than incidental and therefore caught by the anti-avoidance provisions. The decision in Mills illustrates that, so long as the transaction is shaped by commercial factors, there is a strong case that any tax advantage will be incidental and therefore not caught by the anti-avoidance provisions.
The judgment is one of a series of recent decisions of the Australian courts in which the Australian Tax Office has been unsuccessful in its attempts to invoke Australia's anti-avoidance provisions. From a New Zealand perspective, this judgment is the most significant to date because it is a unanimous decision of Australia's highest court, and also because the wording of the Australian legislation in issue is similar to that of the equivalent New Zealand provisions.
"PERLS V" - stapled securities issued by CBA
Mills v Commissioner of Taxation concerned the issue of a stapled security by Commonwealth Bank of Australia ("CBA") known as "PERLS V" (Perpetual Exchangeable Resaleable Listed Securities V). PERLS V were issued to provide CBA with non-innovative residual Tier 1 capital for the purposes of the capital adequacy requirements of the Australian Prudential Regulation Authority.
The security constituted an unsecured subordinated note issued by the New Zealand branch of CBA and a preference share issued by CBA in Australia. The note and the share were "stapled" such that one instrument could not be traded separately from the other. The terms of the securities meant that holders received interest on the notes, with the shares to become dividend-paying only in specified circumstances. The securities were characterised (under the debt/equity rules in Australia's tax legislation) as equity for Australian tax purposes, which required interest payments on the notes to be franked. But, for New Zealand tax purposes, the notes were debt instruments and the interest payable was deductible accordingly.
Issue: was imputation benefit provided to holders an "incidental purpose"?
The Commissioner sought to invoke section 177EA of the Income Tax Assessment Act 1936 to deny the imputation benefit to the holders of PERLS V. That section sits within Part IVA of that Act and is a specific anti-avoidance rule that broadly applies to schemes involving the proscribed use of franking credits through dividend streaming and franking credit trading schemes. The Mills decision was a test case being conducted by CBA for the holders of PERLS V.
The critical question under section 177EA was whether it could be concluded that CBA had undertaken the issuance of PERLS V "for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit".
High Court of Australia: provision of imputation benefit was incidental purpose to that of capital raising
The Court considered the application of section 177EA on the basis of two "sub-questions": (1) In issuing PERLS V, did the bank have a purpose of enabling holders to obtain franking credits? (2) If so, was that purpose subordinate to or in subsidiary conjunction with some other purpose?
The answer to the first question was obviously "yes". The franking of distributions was outlined in the prospectus for the PERLS V issuance and was integral to yield calculations for holders and the bank's calculation of its after-tax cost of capital.
The Court held that the answer to the second question was also "yes". The purpose of enabling holders to obtain franking credits was incidental to the bank's purpose of raising Tier 1 capital. The intended franking of distributions on the PERLS V served no purpose other than to facilitate the capital raising. The appeal of the taxpayer was allowed accordingly.
Relevance for New Zealand
Although Mills is a decision of the High Court of Australia, it is of relevance to New Zealand taxpayers. The analysis adopted in the judgment is very similar to that applied by Woodhouse P in Challenge Corporation (dissenting but upheld as to the result by the Privy Council on appeal). In both cases the overriding principle is that conscious recognition of a tax benefit as part of a transaction should not give rise to tax avoidance where such benefit arises as a natural concomitant to the transaction's commercial purpose.
The approach espoused by Woodhouse P is one that many have historically regarded as providing the best explanation of how the statutory phrase "merely incidental" should be interpreted. The Court in Mills notes that "a purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose". This sentiment is consistent with the principles expressed by Woodhouse P and one that many New Zealand taxpayers and advisors would agree with. The judgment usefully reinforces those principles in the New Zealand context at a time when Inland Revenue is, in some cases, adopting a narrower view of the circumstances in which a tax advantage will be an incidental purpose and therefore fall outside the relevant anti-avoidance provision.
The Mills decision also emphasises the importance of the applicable statutory scheme and underlying legislative policy when considering anti-avoidance matters. As part of its analysis, the Court begins by stepping through the relevant tax debt/equity rules, the objectives of the imputation regime and expressly refers to the explanatory memoranda of the Bills that introduced the relevant anti-avoidance rule. It is apparent that the Court placed significant weight on such policy material in reaching its conclusion.
It is noteworthy that the Court placed no particular emphasis on the fact that the distributions on the PERLS V were deductible for New Zealand tax purposes. The Court noted that this formed part of the "relevant circumstances" to be considered for the purposes of section 177EA. However, the New Zealand tax result had no bearing on the Court's analysis of CBA's purpose in undertaking the transaction for the purposes of capital raising. This can be contrasted with the recent New Zealand decision in Alesco New Zealand Ltd v CIR (2011) 25 NZTC 20,099 in which the Court at first instance apparently attached some significance to the fact that a cross-border hybrid instrument has asymmetric tax consequences in New Zealand and the other jurisdiction.
Finally, the case also highlights the importance of recording the commercial reasons underlying the legal arrangements by which a transaction is to be implemented. The judgment refers extensively to the commercial context of the transaction and the recommendations made in management papers to the CBA board. It is also apparent that the Court considered counterfactual scenarios to be relevant and were influenced by the fact that any alternative Tier 1 issuance implemented by CBA would necessarily have also involved franked distributions to investors. The case provides a useful reminder of the importance of carefully documenting the commercial drivers of a transaction, recording the potential alternatives and recording the commercial reasons for adopting the chosen course of action in a particular case.