On 14 November the High Court of Australia handed down its decision in Mills v C of T [2012] HCA 51. The High Court found for the taxpayer, overturning a decision in the Full Federal Court.1

The case concerned the proposed application by the Australian Taxation Office (ATO) of s 177EA in Part IVA of the Income Tax Assessment Act 1936 (Cth) (the Act), a franking credit anti-streaming provision, to deny franking credits to taxpayers in respect of distributions on securities (the Perpetual Exchangeable Resaleable Listed Securities V (PERLS V)) issued by the Commonwealth Bank of Australia (CBA).

There are several aspects of the High Court's reasoning that may be relevant to the application of New Zealand's general anti-avoidance provision.

The facts

CBA is subject to capital reserve requirements imposed by the Australian Prudential Regulation Authority (APRA). Between 2008 and 2009 CBA identified a need to raise additional Tier 1 capital to continue to satisfy APRA requirements. Tier 1 capital includes, among other forms of capital, paid-up capital in respect of ordinary shares or certain equity-like securities.

In October 2009 CBA's New Zealand branch issued ten million PERLS V for an aggregate issue price of $2 billion to largely Australian resident investors. PERLS V comprised an unsecured subordinated note issued by CBA stapled to a preference share also issued by the bank.

PERLS V entitled holders to quarterly distributions paid as interest on the notes. The distributions were made at the discretion of the bank and were non-cumulative (that is, failure to make a distribution did not give the holder a right to payment in the future).

Under Australia's debt/equity classification rules PERLS V were treated as "non-share equity" instruments. Distributions paid on PERLS V were classified as "non-share dividends". As such, these distributions were frankable. The distributions on PERLS V were required to be fully franked under the equivalent of New Zealand's benchmark ratio rules.

The funds raised from the issue were either lent through CBA's New Zealand branch to ASB or utilised by the branch in carrying on its business in New Zealand. The bank obtained a private ruling from Inland Revenue that the interest distributions on the notes would be deductible in New Zealand, being incurred in the course of deriving assessable income here.

The issue

The ATO sought to apply s 177EA of the Act to deny PERLS V subscribers the benefit of the franking credits attached to distributions.

Section 177EA is an anti-avoidance provision designed to counteract abuse of the franking system. A number of conditions are required to be met before this provision will operate. In this case, the application of s 177EA to the PERLS V securities turned on whether, "having regard to the relevant [and specifically identified] circumstances" of the arrangements for the issue of PERLS V, a reasonable person would conclude that CBA entered into those arrangements:

"for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling [a holder of PERLS V] to obtain [a franking credit]".

The Federal Court decision

At first instance Emmett J found for the ATO concluding that:2

"Having regard to all the relevant matters and circumstances, some of which do not point towards the relevant purpose, I consider, on balance, that overall they point towards the purpose of enabling holders of [PERLS V], such as the Taxpayer, to obtain an imputation benefit. That is a basic and fundamentally important aspect of the terms of the Notes.... By issuing [PERLS V] in New Zealand, the Bank was able to achieve the result that it obtained a deduction in New Zealand in respect of the Distributions on [PERLS V], but had an advantage, in terms of cost, of offering Australian residents the imputation benefit."

The Full Court decision

On appeal, the Full Court split 2-1 in their decision in favour of the ATO. The majority and minority decisions diverged on several matters, most significantly as to the relevance of CBA's need to raise Tier 1 capital and what the Full Court accepted was "the practical inevitability that any distributions made in consequence of the raising of such capital would be franked."3

In the minority, Edmonds J considered that viewed objectively CBA's overriding purpose of issuing PERLS V was to raise Tier 1 capital and that the provision of franking credits to holders was no more than an incidental purpose of that capital raising.

Delivering the majority opinion, Jessup J had two difficulties with this approach. First, his Honour considered that:4

" tends to disconnect the various elements of the scheme by taking it as a given that the Bank had a dominant purpose – the raising of Tier 1 capital – to which all other purposes associated with the scheme were subordinate."

Secondly, he considered that the counterfactual analysis inherent in this approach as to the alternative courses of action that may have been taken to raise Tier 1 capital (all of which would have resulted in fully franked distributions) was not relevant for the purpose of s 177EA. Jessup J considered that CBA's inability to raise Tier 1 capital in a manner that did not involve franked distributions was:5

"...not inconsistent with the Bank having the non-incidental purpose, in relation to the scheme which was in fact entered into and carried out, of enabling security-holders to receive the benefits which conventionally flow from franking."

Put simply, Jessup J was of the view that because the attachment of franking credits to the distributions was a central feature of the scheme, the purpose of attachment was more than incidental.

The Full Court was also split on the relevance of the fact that the distributions paid under PERLS V were deductible in New Zealand. Edmonds J considered the deductibility of the distributions to be wholly irrelevant to the application of s 177EA. On the other hand, Jessup J considered the tax deduction, notwithstanding the fact that it arose under New Zealand law, to point towards CBA having a purpose of enabling the taxpayer to gain a franking benefit that was more than incidental.

The High Court decision

The High Court found unanimously in favour of the taxpayer. The leading judgment was read by former solicitor-general Gageler J, in his first appeal since elevation to the High Court.

In disagreeing with Jessup J's analysis on incidental purpose, the High Court commented:6

"...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. Indeed, the centrality of a purpose to the design of a scheme directed to the achievement of another purpose may be the very thing that gives it a quality of subsidiarity and therefore incidentality."

The High Court also disagreed with the majority in the Full Court in respect of the relevance of a counterfactual analysis to the issue of whether a scheme was entered into for a particular purpose, and if such a purpose did exist, whether that purpose was incidental to some other purpose. The High Court considered that a counterfactual analysis may well be of assistance in such an inquiry. It concluded that, while CBA obviously issued PERLS V with the intention that holders would obtain franking credits, it was equally obvious that this purpose was incidental to CBA's main purpose of raising Tier 1 capital. The High Court stated:7

"[The Bank] issued PERLS V because the Bank needed to raise Tier 1 capital in circumstances where all the means available to the Bank to raise Tier 1 capital would have involved the Bank franking distributions to the same extent and where PERLS V represented the most commercially attractive of those available means."

In respect of the deductions available under the PERLS V structure in New Zealand, the High Court commented:8

"...their probative value for the purpose of answering the question ultimately posed by s 177EA(3)(e) is elusive. It does not make it more or less likely that the Bank had a purpose of enabling the holders of PERLS V to obtain franking credits and it does nothing to alter the relationship between that purpose and its purpose of raising Tier 1 capital."

Potential relevance in New Zealand

A "tax avoidance arrangement" is defined for the purposes of New Zealand's s BG 1 as an arrangement that has tax avoidance as its purpose or effect or as one of its purposes or effects "if the tax avoidance purpose is not merely incidental".

It is unclear what on-going practical significance the merely incidental purpose analysis will have following the Supreme Court's directions in Ben Nevis Forestry Ventures Limited & Ors v CIR.9 The most specific direction given by the Supreme Court on the on-going effect of the merely incidental qualification is contained in paragraphs [113]-[114] of their Honours' judgment at the conclusion of the key section of the judgment introducing the "Parliamentary contemplation" test:

"Before concluding this section of our reasons, we should recognise that para (b) of the definition of a tax avoidance arrangement refers to cases where the tax avoidance purpose or effect of an arrangement is 'merely incidental'. If that is so, the arrangement is not a tax avoidance arrangement. It is apparent therefore that the use of a specific provision which alters the incidence of tax is permitted in two situations.

"The first is when the specific provision is used in a manner which is within Parliamentary contemplation, as discussed above. The second is when the tax avoidance purpose or effect of the arrangement is 'merely incidental'. It will rarely be the case that the use of a specific provision in a manner which is outside Parliamentary contemplation could result in the tax avoidance purpose or effect of the arrangement being merely incidental...".

It is clear that the Inland Revenue considers that the merely incidental qualification may continue to have significance as a stand-alone step in the avoidance analysis.10

Regardless of the status of the merely incidental inquiry following Ben Nevis, the relative significance of purposes or effects (tax and non-tax) in shaping the form of a transaction may be influential in an avoidance analysis at a more practical level. It will very often be the case that an allegation of avoidance is defended by reference to the non-tax reasons for entry into an arrangement and the relative significance (or insignificance) of the tax outcomes or attributes will be the subject of much argument.

It is potentially significant in any balancing of different purposes or effects that the High Court in Mills found that CBA did not have a more than incidental purpose of enabling the obtaining of a tax advantage in circumstances where: significant tax benefits could not be denied to exist; there was an expectation of their receipt; and their receipt was central to the design of a transaction. In fact, the High Court went one step further in commenting that the centrality of a tax purpose to the design of a scheme directed to the achievement of some other purpose could be the very thing that gives the tax purpose a subsidiary or incidental quality.11

The High Court no doubt found assistance in its reasoning in a counterfactual or comparative analysis of the possible arrangements that might otherwise have been entered into by CBA to raise Tier 1 capital. The fact that the same tax benefits would have arisen to holders under alternative means of Tier 1 capital raising must indicate that the purpose of the arrangement is to raise capital as opposed to generating an imputation advantage despite the "centrality" of that advantage to (presumably) all means of raising the requisite capital.

Underlying the counterfactual analysis is the assumption that some form of Tier 1 equity (or equity-like) capital would be raised. It was not necessary to consider whether a Tier 1 capital raising would have been pursued if franking credits had not been available. However, it could probably not have been said that PERLS V would have been issued had the franking credit advantage not been available.

The next logical question then is why were PERLS V selected instead of more traditional equity securities such as ordinary shares? The answer it seems lies in the foreign (in this case New Zealand) treatment of the PERLS V. Distributions on PERLS V were deductible in New Zealand as interest without compromising the expected equity/frankable position in Australia. The High Court rejected the relevance of a foreign tax benefit in its merely incidental analysis. This is consistent with the view adopted in Inland Revenue's Exposure Draft except to say that there is the suggestion in the Exposure Draft that a foreign tax benefit may even have the status of a commercial (or non-tax) purpose in considering the application of s BG 1.

If the reasoning applied by the High Court of Australia in Mills was to influence the approach of New Zealand courts, it is possible that the decision could give the merely incidental qualification to the general anti-avoidance rule more significance than might have been assumed following Ben Nevis. The decision also demonstrates the assistance that a counterfactual analysis might provide in weighing competing purposes or effects or in determining whether avoidance is present more generally (at least in cases where an underlying commercial object is being pursued). Such an analysis is something missing in a New Zealand context to date and is largely denied as necessary in the Inland Revenue's Exposure Draft. Its utility in logical and sound judgment is clearly demonstrated by the Mills decision.