The Court of Appeal has delivered its judgment (available here) in the Alesco case, rejecting the taxpayer's appeal and upholding the High Court's finding that the issue of zero coupon optional convertible notes ("OCNs") by Alesco New Zealand Limited ("Alesco") to its Australian parent, to fund the acquisition of two New Zealand businesses, was a tax avoidance arrangement and so void for tax purposes under New Zealand's general anti-avoidance provision (section BG 1).
The facts of the case are summarised in our January 2012 newsletter, which included comments on the High Court decision (available here). In short, the issue was whether Alesco was entitled to rely on a determination issued by the Commissioner (Determination G22) that prescribed the method for bifurcating an OCN into debt and equity components and attributing values to each component. Applying Determination G22 to the OCNs issued by Alesco resulted in $40 million of the $78 million subscription amount being attributed to the equity component (the embedded option) and $38 million being attributed to the debt component. This meant that the debt component was treated as a zero coupon bond issued for $38 million and having a redemption value of $78 million, such that $40 million of (tax deductible) interest arose over the life of the bond. It was these interest deductions that the Commissioner denied on the basis that section BG 1 applied. The Commissioner also imposed shortfall penalties of 100% (before reductions) of the tax in dispute on the basis that Alesco had taken an abusive tax position.
Court of Appeal decision
The Court of Appeal considered that whether section BG 1 applied to the OCN arrangement turned on the question of whether Alesco suffered an economic cost commensurate with the deductions claimed. The Court concluded that Alesco did not incur a real economic cost under the OCNs as it did not pay interest or suffer an analogous liability. In doing so, the Court of Appeal appears to have agreed with the High Court that in this case the option served no commercial purpose and had no value, and the OCNs were therefore in economic substance an interest free loan. For this reason, the interest deductions that arose under the financial arrangements rules and Determination G22 were held not to be within Parliament's contemplation, and section BG 1 applied to disallow them.
The Court rejected the taxpayer's argument that Determination G22, which prescribed an arbitrary "one size fits all" method for apportioning the subscription amount, and does not take into account the particular characteristics of the parties or the relationship between them, transformed the instrument for tax purposes into one of real economic effect by recognising or presupposing a genuine interest cost.
Whatever view might be taken as to the correctness of the result, aspects of the Court of Appeal's reasoning seem questionable:
- The Court considered it significant that neither the subscription agreement nor the notes allocated the principal amount between the debt and equity components of the OCNs. However, it would be unusual for such an apportionment to be made in the documentation in the case of a single instrument. Indeed, that is why Determination G22 prescribes a methodology for calculating the amounts to be apportioned to each component.
- Similarly, while the Court distinguished the OCNs issued by Alesco from a hypothetical alternative unbundled arrangement where a zero coupon bond was issued at a discount to face value and an option was separately issued (on the basis that the consideration for each component would in that situation be readily identifiable from the terms of the arrangement), there was little comment on why the OCN in this case should be treated differently to an OCN issued to an unrelated party on the same terms (which Inland Revenue would presumably accept was within the contemplation of Determination G22).
- Finally, the Court stated that Determination G22 only prescribes a method of severing the OCN into debt and equity components and attributing values to those components. It does not, said the Court, determine the question of whether notional interest deductions amount to expenditure or expenditure incurred. This aspect of the judgment is difficult to follow. Surely by severing the OCN into an equity component (option) issued for $40 million and a debt component (zero coupon bond) issued for $38 million and redeemable for $78 million, it follows that the $40 million discount on the debt component is interest expenditure and, further, if the issuer has an obligation to pay $78 million upon redemption of an instrument deemed to be issued for $38 million, that expenditure is incurred. That is particularly the case given that section DD 1 of the Income Tax Act 1994 (which is cited in the judgment) deemed expenditure incurred under the accrual rules (now the financial arrangements rules) to be interest payable.
The Court of Appeal also upheld the High Court's findings on reconstruction and penalties:
- As regards reconstruction, the Court held that there is no requirement under the Act for the Commissioner to have regard to a likely alternative arrangement when determining whether or how to apply the reconstruction provisions. Rather, she may do so. Further, and as stated by the High Court, on the taxpayer's approach to reconstruction, the tax advantage would not have been counteracted at all.
- On the question of penalties, the Court found that Alesco's position has always been unarguable, even applying the law as it was in 2003, so it did not meet the standard of being about as likely as not to be correct. Further, it was held that the dominant purpose of the arrangement was to avoid tax, so the abusive tax position penalty applied.
Implications for tax avoidance disputes going forward
One positive aspect that taxpayers can take from the decision is the Court's finding that the tax avoidance enquiry must be confined to the actual terms of the arrangement as implemented. The Court of Appeal considered that Heath J in the High Court was wrong to have based his decision on the ancillary documents prepared by the taxpayer or its advisors. Restricting the enquiry in this way is consistent with the focus of the avoidance analysis being the purpose of the arrangement, not the subjective intentions or motives of the taxpayer, and the principle that the purpose of the arrangement is to be determined by its terms and other objective evidence of its purpose and effect. That said, it is difficult to accept that the Court of Appeal was not influenced at least to some degree by evidence of the genesis to the transaction, and the fact it was one of a number of such arrangements entered into by a number of taxpayers. The Court did refer to those factors, and described the arrangement as a "product" with identified tax benefits.
A corollary of restricting the analysis to the objective facts, however, is that credibility, and consistency in the way those facts are presented, is critical. The Court of Appeal considered that statements made at trial by one of Alesco's fact witnesses were contradicted and undermined by statements made three years earlier in Alesco's notice of response. This observation could be seen as unfair given that the notice of response is the first formal document filed by a taxpayer in the disputes process, does not limit the facts or arguments that may be relied on by the taxpayer, and is required to be prepared within a strictly enforced two month time limit following receipt of Inland Revenue's notice of proposed adjustment. Nonetheless, the lesson for taxpayers is that documents prepared as part of the disputes process should be prepared with litigation strategy in mind, even if litigation is considered to be unlikely.
The Court has also signalled that expert evidence has a limited place in tax avoidance disputes, except on discrete matters such as valuation questions, or where the arrangements are complex or novel to an extent that requires expert analysis. This limitation on the relevance of expert evidence will pose real challenges for taxpayers in future disputes, given that New Zealand's judiciary does not sit in specialised divisions or panels, and that expert evidence can, therefore, be of real assistance in explaining the rationale for and effect of transactions which, although ordinary commercial transactions within a particular industry, may be unfamiliar to a Judge who may not have had experience working with that industry or advising on transactions of that type. It is to be hoped that the comments in the Alesco judgment do not close the door on the admissibility of expert evidence explaining the commercial context to what might otherwise be an unfamiliar transaction. But taxpayers will need to ensure that any such evidence is strictly independent in its source (for example, it should not be given by an officer or employee of a firm that has provided tax advice on the transaction, or even more generally to that taxpayer) and objective and as uncontroversial as is possible.
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