The last few days of 2011 saw three significant developments in the tax avoidance arena: the release by Inland Revenue of its draft Interpretation Statement ("Draft Statement") on the general anti-avoidance rule ("GAAR"), the decision of New Zealand's High Court in Alesco (the first of a number of cases involving intra-group optional convertible note transactions), and the Supreme Court of Canada's decision in Copthorne Holdings, concerning Canada's GAAR.
Inland Revenue releases draft Interpretation Statement
On 16 December, Inland Revenue issued its long awaited Draft Statement on tax avoidance and the interpretation of sections BG 1 and GA 1 of the Income Tax Act 2007. Inland Revenue's existing statement on the GAAR was issued in 1990. While it has not been withdrawn, it ceased to reflect Inland Revenue practice several years ago, and increasingly Inland Revenue's stance in disputes and litigation has been inconsistent with the 1990 statement.
A draft revised statement was circulated in 2004 but was never finalised. The latest draft statement takes account of subsequent developments (in particular the Supreme Court decision in Ben Nevis Forestry Ventures Ltd v CIR (2009) 24 NZTC 23,188, released in late 2008). That it took around three years following the Ben Nevis decision for the Draft Statement to be issued reflects, among other things, the need for consultation between Inland Revenue and Crown Law regarding the Draft Statement, in turn reflecting the increasingly significant role Crown Law is playing in tax administration, particularly in respect of tax avoidance issues.
Inland Revenue's 1990 statement ran for four pages, and had appended to it nine worked examples. The recently released draft runs to 115 pages, and contains no examples. The Draft Statement (presumably intentionally) does not lay down any definitive guidance that might limit the way in which Inland Revenue or Crown Law might interpret or apply section BG 1 in future. This, together with the absence of examples, means that the statement is unlikely to assist taxpayers and their advisors in predicting whether Inland Revenue might consider a particular situation to be caught by section BG 1. Taxpayers requiring Inland Revenue's definitive view in relation to a particular arrangement will therefore need to seek a binding ruling.
Where the statement will be of value is in informing taxpayers of the methodology Inland Revenue is likely to adopt in considering a binding ruling application or a dispute submitted to the Adjudication Unit. Presenting the facts and legal submissions in a ruling application or statement of position in a way that adopts Inland Revenue's preferred methodology contributes to greater efficiency in the process and to ensuring that the taxpayer's argument is framed in the most persuasive way possible.
The Draft Statement summarises the steps Inland Revenue is likely to consider in considering the application of section BG 1, in the diagram reproduced below:
In many respects, the Draft Statement is uncontroversial, providing a comprehensive summary of the relevant case law on particular points of interpretation. The discussion at paragraphs [98] to [116] of the statement concerning the definition of "arrangement" is an example.
The statement also contains a relatively uncontroversial summary of the principles for interpreting and applying taxing provisions other than section BG 1, concluding that such provisions should be interpreted purposively in the same way as any other legislation. The statement therefore endorses the majority view in Ben Nevis that the so-called fiscal nullity cases are of limited assistance in New Zealand, and that when interpreting taxing provisions other than section BG 1 the Court should (absent a statutory indication to the contrary) not take into account economic substance considerations or the existence of a tax avoidance purpose.
The Draft Statement does however advance some controversial propositions, particularly concerning the difficult question of how section BG 1 relates to the other provisions of the Act, and the so-called "Parliamentary contemplation" test. We summarise the key points in the following table:
Proposition in Draft Statement |
Comment |
Can section BG 1 apply if the tax benefit is not available under the specific provisions? "...a failure to comply with a provision of the Act does not prevent the Commissioner from taking the position that section BG 1 applies. Sometimes, when section BG 1 is potentially an issue, a taxpayer might argue that the arrangement does not comply with one or more of the other provisions of the Act in an attempt to preclude the application of section BG 1. This failure may be deliberately built into the structure to reduce the tax exposure should the Commissioner argue section BG 1 applies." (Para [89]). |
While the Westpac case provides some support for this proposition, it is contrary to other case law, and to the position the Commissioner has previously taken. For section BG 1 to apply in respect of a tax benefit that is not lawfully available under the specific provisions seems conceptually impossible, because in such a case, tax will not have been avoided. Further, this is an undesirable approach in practice because it may lead to Inland Revenue investigators invoking section BG 1 without having investigated how the specific provisions in the Act apply. |
How is the purpose or effect to be determined and what evidence is relevant? "The tax avoidance purpose or effect of an arrangement is determined objectively. The taxpayer’s intentions are not relevant. “Purpose” in the context of tax avoidance means the intended effect the arrangement seeks to achieve and not the motive of the parties, and “effect” means the end accomplished or achieved by the arrangement. Oral evidence is relevant if it relates to the purpose or effect of the arrangement, but not if it relates to the purpose of the parties. Oral evidence that is inconsistent with the purpose or effect of the arrangement is not relevant." (Para [208]). |
This proposition is correct but does not reflect the way in which Inland Revenue argues tax avoidance cases in practice. In practice, Inland Revenue (via information requests and the discovery process) seeks evidence of taxpayer's subjective intentions. And in Court, Inland Revenue's counsel often seek to rely on oral evidence going to a taxpayer's intention or to an individual's subjective purpose in implementing an arrangement. The issue is important in practice, because resort to correspondence and oral evidence concerning taxpayers' intentions (as distinct from evidence of the terms of the arrangement itself and its effects) has significant costs for taxpayers and implications for the efficient use of the Court's time. |
Determining an arrangement's commercial reality and economic effects: "The focus of the inquiry into the commercial reality and economic effects of an arrangement is to establish what the arrangement actually achieves. The inquiry is only concerned with outcomes that are able to be objectively established... . Identifying the commercial reality and economic effects of an arrangement goes beyond the legal form of an arrangement and identifies the real outcomes for the parties and those affected by it." (Para [227]). |
In a case where a tax benefit depends on some step in an arrangement which is contrary to commercial reality, or has no economic effect, then it will generally be correct, as the Draft Statement suggests, that the Commissioner should look beyond the legal form. What the Draft Statement does not acknowledge, however, is that where an arrangement as a whole, and each of the steps in the arrangement, have commercial and economic consequences, section BG 1 does not allow the arrangement to be taxed based on its economic substance. In other words, the right question to ask is whether the arrangement has economic substance, not what is its economic substance. |
How to determine what Parliament would have contemplated: "To identify Parliament’s purpose, the approach is to ask: had Parliament foreseen transactions of this type when enacting the legislation, would such transactions have been within its purpose? The test is not, however, an attempt to discern what was actually contemplated by the specific Parliament that enacted the legislation. Instead, the question is a hypothetical one." (Para [358]). |
There is a real danger that this "hypothetical" approach to determining Parliament's contemplation results in a loss of objectivity and in section BG 1 being used to fill gaps in the legislation based on what, with hindsight, Inland Revenue decides the law should have said. The Draft Statement should make it clear (as did the Supreme Court in Ben Nevis) that Parliament's contemplation/purpose should be ascertained objectively having regard to the language enacted by Parliament, not based on what Judges or officials consider Parliament should have said. |
Reconstruction: "The Commissioner’s opinion is that considering the case law and the purpose of the anti-avoidance provisions, in making an adjustment to taxable income, the adjustment is made to counteract tax advantages of the arrangement that are outside Parliament’s contemplation, and not necessarily all tax outcomes under an arrangement. However, it should be noted that the adjustment is one the Commissioner thinks is appropriate, and the Commissioner is not under a duty to precisely describe the alternative factual basis for such an adjustment. As the Court of Appeal in Miller said, the Commissioner has a wide reconstructive power and may look at the matter broadly." (Para [447]). |
The Draft Statement's acknowledgement that an adjustment under section GA 1 is made to counteract only the tax advantages that are outside Parliament’s contemplation, and not necessarily all tax outcomes under an arrangement, is correct and is to be welcomed. Of concern is that the Draft Statement also emphasises the (in effect) discretionary nature of the Commissioner's decision whether or not to reconstruct under section GA 1. Therefore, where an arrangement is void and all tax outcomes are disallowed (including tax outcomes within Parliament's contemplation) the Draft Statement would suggest a taxpayer has no effective remedy. |
Inland Revenue has sought submissions on the Draft Statement by 31 March 2012, and has stated that the statement is "likely to be finalised in mid 2012". While the statement would be more useful to taxpayers if it were shorter, and contained examples, it is understood that Inland Revenue is firm in its decision not to provide examples in the statement. Accordingly, submissions on the draft are more likely to bear fruit if they work within the overall framework of the Draft Statement, and seek to address some of the more controversial aspects of the analysis, such as those we have summarised above.
To view a copy of the Draft Statement, please click here.
New Zealand High Court decision: Alesco New Zealand Ltd & Ors v CIR
Facts
The Alesco case concerned the provision of funding to Alesco New Zealand Limited ("Alesco") by its Australian parent company through the subscription for zero coupon optional convertible notes (OCNs). The funding was required by Alesco in order to complete the purchase of two New Zealand businesses. The intended tax consequences were a deduction in New Zealand for interest deemed to arise under the financial arrangements rules, no New Zealand interest withholding tax (as no interest was paid) and no assessable income in Australia for the holder.
Alesco calculated its interest deductions in accordance with a Determination issued by the Commissioner that applied to the OCNs. The Determination in effect required bifurcation of the OCN into a debt component and an equity component (being the embedded option) and the attribution of values to each component. In the case of a zero coupon OCN, interest deductions arise because the maturity value of the debt is discounted to arrive at a deemed opening value. If, for example, a zero coupon note has a maturity value of $100, the present value of which is $60, the issuer is deemed to have received $60 for issuing a note with a $100 maturity value, and $40 for granting the option to convert that note into shares. The issuer therefore has interest expenditure of $100 less $60, being $40.
The issues for the Court
The Commissioner issued assessments to Alesco denying the interest deductions on the basis that section BG 1 applied. The Commissioner also imposed shortfall penalties of 100% (before reductions) on the basis that in claiming the deductions provided for under the Determination, the taxpayer had taken an abusive tax position.
The Court's decision
The Commissioner's contention that the OCNs were "no more than an interest free advance with a valueless option attached, dressed up in the form of a valuable option and a discounted debt" found favour with Justice Heath. The Judge considered (at [147]) that the OCN arrangement was "an artificial device designed only to secure a tax advantage" and that Parliament would not have contemplated interest deductions being available where "no real interest expense was incurred and the notional interest claimed did not represent a real economic cost". Accordingly, the Judge upheld the Commissioner's conclusion that section BG 1 applied to the OCNs.
The Judge then addressed Alesco's argument that if section BG 1 is found to apply, the Commissioner must exercise his powers of reconstruction so as to reflect the next best alternative to the transaction in fact undertaken. In this case Alesco argued that, if OCNs were not used, it would have obtained ordinary debt funding from its parent, at an arm's length interest rate, and so would have had greater interest deductions than it had in fact claimed. Justice Heath disagreed with Alesco's argument on reconstruction, stating that (at [156]) "the purpose of the Commissioner's decision to reconstruct is to "counteract any tax advantage" achieved by the taxpayers" and (at [159]) "as a matter of logic, it is not possible to counteract a tax advantage by allowing the taxpayer to obtain greater tax benefits than were actually achieved".
Finally, the Judge upheld the imposition of shortfall penalties, concluding first that Alesco had taken an "unacceptable tax position" (ie, one that fails to meet the standard of being about as likely as not to be correct) and second, that it was also an abusive tax position (ie, a tax position in respect of an arrangement entered into with a dominant purpose of avoiding tax). His Honour appears to have reached the first of those conclusions by analogy with the (very different) facts in Ben Nevis. His Honour reached the second conclusion that the arrangement was entered into with the "dominant purpose of avoiding tax" based on evidence that the "purpose of the arrangement was to finance the [relevant] acquisitions in the most tax effective manner" and on his findings that there was "no actual interest expense incurred" and that the option had "no real economic value".
Comment
Justice Heath's conclusion that Parliament would not have contemplated interest deductions being available where no "real interest" was incurred and the interest claimed did not reflect a "real economic cost" is difficult to follow. The financial arrangements rules including (in this case) the relevant Determination, deem an interest amount to arise in certain circumstances. In the case of any zero coupon OCN there will be no explicit interest cost to the issuer. The interest cost deemed by the financial arrangements rules to arise will be equal to the value (as quantified by the financial arrangements rules) of the issuer's contingent obligation to issue shares to the holder if the holder chooses to convert.
If the Judge were suggesting that the contingent obligation to issue shares is not in any circumstances a sufficiently "real" cost to support a deduction, then that is at odds with the whole rationale of the financial arrangements rules, which is to deem an interest cost to arise even when there is no explicit interest charge. If the Judge were suggesting that the contingent obligation to issue shares is not a sufficiently "real" cost where there is a pre-existing shareholding relationship between the holder and the issuer of the OCNs, then it is difficult to see what difference it makes that the holder of the OCNs has a pre-existing shareholding. The cost of a contingent obligation to issue shares must be looked at from the issuer's perspective, and the identity of the holder to whom such shares may be issued is irrelevant to the cost of that obligation to the issuer.
Another interesting aspect of the judgment is that it quotes extensively from correspondence between KPMG and Alesco, including from KPMG's advice on the potential application of the anti-avoidance provisions in each of New Zealand and Australia. As the Supreme Court has recently confirmed in Glenharrow v CIR, the GAAR turns on the purpose or effect of the arrangement, which must be assessed based on what the arrangement achieves, not based on a party's subjective intention on entering into the arrangement. It is therefore difficult to understand why so much emphasis was placed on statements made by the taxpayer's tax advisor, which represented no more than that advisor's opinion as to the tax consequences of the arrangement.
Finally, as indicated above, the Judge's reasons for upholding the imposition of penalties largely restate the reasons underlying the decision to uphold the application of section BG 1. It is to be hoped that future decisions will clarify the position, by explaining what additional requirements must be met for a tax position to which section BG 1 applies, to attract shortfall penalties.
To view a copy of the case, please click here.
Supreme Court of Canada decision: Copthorne Holdings Ltd v Canada
Facts
Copthorne concerned the application of Canada's GAAR to the Canadian law concept of paid up capital, or "PUC". PUC may be returned to shareholders in a non-dividend form in certain circumstances, and is therefore somewhat analogous to available subscribed capital in the New Zealand context.
The facts giving rise to the dispute involved a series of transactions, the three most relevant of which were as follows:
- First, two Canadian resident corporations that had been parent and subsidiary became sister corporations, as a result of the subsidiary being sold by the Canadian resident parent to a non-resident holding company of the Canadian parent.
- Second, those two Canadian corporations were then amalgamated in a horizontal amalgamation, and under the rules for determining PUC, the PUC of their respective shares was aggregated to form the PUC of the amalgamated corporation.
- Third, the amalgamated corporation then redeemed a large portion of its shares and paid out the PUC attributable to the redeemed shares to its non-resident shareholder.
The issues for the Court
The Revenue Agency, relying on the GAAR, in effect contended that the PUC of what had been the subsidiary (prior to the first of the three transactions described above) should be cancelled, rather than being aggregated upon amalgamation. In other words, the horizontal amalgamation would have the consequences for PUC that would have arisen from a vertical (parent-subsidiary) amalgamation. The share redemption transaction was therefore assessed in part as a dividend, based on the resulting reduction in PUC.
The Canadian GAAR is somewhat similar to New Zealand's GAAR in requiring two distinct lines of inquiry:
- first, as to the objectively ascertained purpose of the transaction. In New Zealand this is the "merely incidental" test; in Canada, the test is whether a transaction "would result, directly or indirectly, in a tax benefit, unless the transaction may reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the tax benefit"; and
- second, as to whether that tax benefit is consistent with the relevant specific provisions of the Act. In New Zealand, this inquiry is described as the "Parliamentary contemplation" test, or question. In Canada, the test is whether the transaction would result in a "misuse of" one or more specific taxing provisions, or in an "abuse" having regard to those specific taxing provisions "read as a whole".
The second inquiry is difficult to grasp for the following reason: The GAAR will be in issue only if the transaction otherwise has the intended tax consequences under the relevant specific provisions, construed in light of their purpose. So how can it then be concluded that the transaction and its tax consequences are contrary to Parliament's contemplation (New Zealand terminology) or result in a misuse of, or an abuse having regard to, the specific tax provisions (Canadian terminology)?
The Court's decision
The Canadian Supreme Court has addressed this question directly in Copthorne, explaining the position as follows:
[66] The GAAR is a legal mechanism whereby Parliament has conferred on the court the unusual duty of going behind the words of the legislation to determine the object, spirit or purpose of the provision or provisions relied upon by the taxpayer. While the taxpayer’s transactions will be in strict compliance with the text of the relevant provisions relied upon, they may not necessarily be in accord with their object, spirit or purpose. In such cases, the GAAR may be invoked by the Minister. The GAAR does create some uncertainty for taxpayers. Courts, however, must remember that s. 245 was enacted “as a provision of last resort” (Trustco, at para. 21).
...
[70] The object, spirit or purpose can be identified by applying the same interpretive approach employed by this Court in all questions of statutory interpretation — a “unified textual, contextual and purposive approach” (Trustco, at para. 47; Lipson v. Canada, 2009 SCC 1, [2009] 1 S.C.R. 3, at para. 26). While the approach is the same as in all statutory interpretation, the analysis seeks to determine a different aspect of the statute than in other cases. In a traditional statutory interpretation approach the court applies the textual, contextual and purposive analysis to determine what the words of the statute mean. In a GAAR analysis the textual, contextual and purposive analysis is employed to determine the object, spirit or purpose of a provision. Here the meaning of the words of the statute may be clear enough. The search is for the rationale that underlies the words that may not be captured by the bare meaning of the words themselves. However, determining the rationale of the relevant provisions of the Act should not be conflated with a value judgment of what is right or wrong nor with theories about what tax law ought to be or ought to do.
Applying that approach to the particular facts, the Court upheld the Revenue Agency's GAAR argument, concluding (at [122]): "that the object, spirit and purpose of the... section is to preclude preservation of PUC of the shares of a subsidiary corporation upon amalgamation of the parent and subsidiary where such preservation would permit shareholders, on a redemption of shares by the amalgamated corporation, to be paid amounts as a return of capital without liability for tax, in excess of the amounts invested in the amalgamating corporations with tax-paid funds". The Court noted that the taxpayer had structured the transactions so as to “artificially” preserve the PUC in a way that frustrated the purpose of the specific provision governing the treatment of PUC upon vertical amalgamation. The initial step in particular (by which the subsidiary was sold so as to become a sister company of its former parent) circumvented this rule.
Comment
To date, the New Zealand courts have not seemed inclined to borrow from Canadian jurisprudence when considering the New Zealand GAAR. The Commissioner in his submissions to the Supreme Court in Ben Nevis appears to have discouraged the Court from doing so, arguing that the Australian provision was of more assistance, and that the Canadian approach to tax avoidance had converged with the English approach (which does not rely on a GAAR) and so had become a "dead letter" ([2009] 2 NZLR 289 at 302).
Copthorne demonstrates that Canada's GAAR is not a "dead letter". On the contrary, the Canadian Supreme Court appears to have developed a methodology for applying the GAAR in a principled and objective manner, that gives effect to the rationale of the specific taxing provisions, while ensuring that the GAAR has "room" to operate in cases where a transaction achieves a tax benefit having regard to the specific taxing provisions, purposively construed, yet would be inconsistent with the rationale of those provisions viewed in a more holistic way.
To view a copy of the case, please click here.
Contributed by Brendan Brown and Shaun Connolly