October 2009

Contents:

In a sequel to the High Court's decision in BNZ Investments v CIR, released in July this year, a different Judge of the High Court, Harrison J, has issued his decision in respect of similar issues involving Westpac.  Harrison J reached largely the same conclusion as had been reached in the BNZ Investments case, but for different reasons in some respects.

Westpac subsidiaries had entered into ten cross-border sale and repurchase (or "repo") transactions with UK and US counterparties.  One of these transactions was subject to a favourable binding ruling from Inland Revenue.  Inland Revenue, however, subsequently challenged the remaining nine transactions.  The transactions all followed the same basic structure usually seen in cross-border repo financings: a Westpac subsidiary purchased from a US or UK counterparty interests in a non-resident special purpose entity, and agreed to sell-back those interests to the counterparty or an entity related to the counterparty at a future date.  In addition, Westpac paid a guarantee procurement fee ("GPF") to the repurchase counterparty, for it to procure from its parent company, a guarantee of its repurchase obligation. 

The returns from the transactions were either exempt from New Zealand tax under the conduit tax relief regime, or fully relieved under the foreign tax credit regime.  Westpac treated as deductible the costs associated with the transactions.  These costs fell into two categories: the GPF, and funding costs (the latter including net swap expenditure, as well as an assumed portion of Westpac's overall funding costs).

Inland Revenue accepted that the funding costs were deductible under the specific deductibility provisions, but contended that that was not the case for the GPF.  Inland Revenue also contended that deductions for both the GPF and the funding costs should be disallowed on the basis each transaction was a tax avoidance arrangement.

Westpac advanced two grounds for the GPF being deductible under the deductibility provisions.  The first was that the GPF was expenditure under a financial arrangement, and as such was deemed to be interest expenditure, automatically deductible for a company.  The second ground was that the GPF was incurred in deriving gross income which arose when the Westpac subsidiary disposed of the relevant repo'd interests.

Like Wild J in the BNZ Investments case, Harrison J rejected the second of these grounds.  His Honour held that the interests acquired under the repo were held on capital account, such that disposing of them did not give rise to gross income. 

In contrast to Wild J, Harrison J also rejected Westpac's first ground, that the GPF was expenditure under a financial arrangement.  Inland Revenue argued that the GPF was not expenditure under a financial arrangement, essentially because the GPF was not paid to the guarantor, and was not, on a contract law analysis, in consideration for the guarantee.  For Inland Revenue to have advanced this argument is somewhat surprising for two reasons.  First, it is contrary to the interpretation adopted by Inland Revenue in numerous binding rulings.  Second, if correct, the argument would suggest that income or expenditure can be made to fall outside the scope of the financial arrangements rules on a narrow contract-law based analysis - for example by interposing a legal entity so as to breach the required privity of contract between the entity receiving a benefit under an arrangement, and the entity providing the reciprocal benefit.  As tax practitioners well know, one of the central planks of the financial arrangements rules is that the rules apply to exchanges of consideration flows under any "arrangement", which is a far broader concept than a single document or contract. 

In concluding that there was tax avoidance, Harrison J held that even the presence of a genuine commercial purpose for the transactions did not preclude a finding that there was also a purpose or effect of tax avoidance.  In relation to the GPF, he found that, even if it had been an allowable deduction, it "did not serve an objectively ascertainable business purpose" and was a "contrivance" to allow Westpac to claim a deduction (paragraphs [594] and [595]).  Like Wild J in BNZ Investments, he found the lack of an underlying prospect of profitability (absent the tax benefits) pointed to a lack of commercial or business justification (paragraph [599]). 

While reaching the same conclusion as Wild J had reached in BNZ Investments, Harrison J did so for differing reasons.  For instance, Harrison J regarded as irrelevant evidence called for Inland Revenue regarding the "social cost of the transactions for New Zealand society".  He observed (in response to repeated references to the "formulaic" calculation of the distribution rate in each transaction) that there is "nothing inherently objectionable in using a standard formula to calculate a dividend rate" (paragraph [577]).

Harrison J also placed far greater emphasis than Wild J had in BNZ Investments on the GPF.  For instance, Harrison J found that but for the GPF, it was unlikely Inland Revenue would have questioned the transactions (paragraph [341]) and that the "interposition of the GPF" had proved "decisive on the facts of both [the BNZ Investments and Westpac] cases" (paragraph [620]).

Perhaps the most troublesome aspect of the Westpac decision is Harrison J's reasoning in respect of Inland Revenue's so-called "reconstruction" power.  The term "reconstruction" is in fact a misnomer because the power contained in section GB 1 does not use that term, but rather states that the relevant tax consequences of the arrangement may be "adjusted ... so as to counteract any tax advantage obtained ... from or under [the] arrangement".  An earlier High Court decision had held that "tax advantage" in this context referred not to every tax consequence connected with the arrangement, but rather to the elements found to result in tax avoidance.  Harrison J appears to have taken a different approach.

Harrison J's decision therefore raises an important point of principle, yet to be considered by the appellate courts.  That is to what extent one discrete category of expenditure (in this case, the funding costs) can be denied on "reconstruction", as a result of a finding of tax avoidance which turns on characteristics of a separate item of expenditure incurred under the same arrangement.

Westpac is the third High Court decision to be delivered this year concerning the general anti-avoidance provision.  The first (Penny & Hooper v CIR) and second (BNZ Investments) have both been appealed to the Court of Appeal, and it is widely expected that Westpac will likewise be appealed.  The three decisions involve differing interpretations of the now leading authorities on tax avoidance - the Supreme Court's decisions in Ben Nevis and Glenharrow Holdings, delivered in December 2008.  These differing interpretations suggest that rather than settling the law in this difficult area, the Supreme Court's decisions may have introduced even greater uncertainty for taxpayers, and for Inland Revenue.

To view a copy of the case please click here.

The Tax Working Group ("Working Group"), established in May, has been working to identify key areas for possible tax reform which they are going to present to Ministers in mid-December.  As part of this process, the Working Group is evaluating tax base broadening opportunities that may increase Government revenue.  This is of particular importance in the current fiscal climate as any major reform, such as the Government's stated objective of aligning corporate, income and trust tax rates at 30%, will need to be offset by other sources of revenue.  In the Working Group's second session (held 31 July 2009) the Working Group discussed taxing capital gains and increasing the rate of GST.  During their recent third session (held 16 September 2009) the Working Group further evaluated the benefits of a capital gains tax and compared it to a land tax.  The introduction of a risk free return method ("RFRM") for taxing rental housing, amongst other proposals, was also discussed.  We outline the Working Group's evaluation of the land tax and RFRM proposals below, and list other proposals raised for discussion. 

The Working Group considered the immobility of land as the main benefit of a land tax.  In particular, a land tax would be a sustainable long-term tax base for New Zealand compared to the highly mobile personal and corporate income tax bases that we currently heavily rely on.  The Working Group concluded that if a land tax was introduced it should be comprehensive, with the same rate applied across all land types.  In comparing a land tax to a capital gains tax, the Working Group commented that a land tax would be easier to implement, comply with and administer.  However, the paper presented by Inland Revenue's Policy Advice Division indicated that a land tax would not achieve the distributional efficiencies of a capital gains tax as a land tax would be broadly proportional whereas a capital gains tax would be highly progressive.

An important consideration in relation to a proposed land tax is that its introduction would reduce the net present value of land and therefore cause a drop in existing land values.  For example, the background paper suggests that a 1% land tax would result in a 16.7% fall in land values, other things being equal.  This is an important issue for lenders in assessing the value of land when applying credit criteria.

Another proposed alternative to a capital gains tax (presented by the Inland Revenue and Treasury departments before the Working Group) is the introduction of a RFRM for taxing rental housing.  This involves annually applying a risk-free rate of return to a taxpayer's equity in property and taxing the result at the taxpayer's marginal tax rate.  Rents from property subject to the RFRM would not be assessable income, and expenses related to the investment would not be deductible.  The Working Group is in general agreement that the "glaring hole in the current tax system is the rental property sector", and that this option would be worthwhile considering if a capital gains tax is not the preferred option.  Issues raised by the Working Group include the possibility of rent increases, the taxation of people making losses and an increased incentive to invest in owner-occupied housing if the RFRM method only applied to rental or investment properties.  Another issue raised by Inland Revenue and Treasury is the impact on banks' lending given that the RFRM would be expected to impact on property values.

Other proposals raised for discussion include placing depreciable buildings on revenue account (as an alternative to capital gains tax), removing depreciation loading on new assets, removing the employer superannuation contribution tax exemption for employer contributions to KiwiSaver funds, introducing an estate duty (which the Working Group ruled out as an option because of mobility effects with the absence of these taxes in Australia, and the issue of double taxation), increasing excise taxes on tobacco and alcohol and introducing some form of environment tax (the Working Group considered that both of the latter proposals were outside the Working Group's scope).

To view information on session 3 of the Working Group, please click here.

The Taxation (International Taxation, Life Insurance and Remedial Matters) Act 2009 ("Act") received the royal assent and became law on 6 October 2009.  The Act contains a number of major tax reforms and numerous technical amendments which are briefly outlined in our September Tax Law Update.

The date of the royal assent has added significance for provisions in the Act that apply from that date. Some of the main provisions that apply from the date of the royal assent are:

1. new associated persons definitions that apply for the purposes of determining the assessability of gains from the sale of land.  Land acquired on or after 6 October 2009 and (where relevant) land on which improvements are begun on or after 6 October 2009 will be subject to the new associated persons definitions;
2. extension of the non-disclosure right for tax advice to the discovery process applies for challenge proceedings commenced on or after 6 October 2009 and to challenge proceedings commenced before that date if no case management conference or directions hearing or other hearing has been held either in those proceedings or in proceedings involving substantially similar issues, prior to 6 October 2009; and
3. amendments to the tax pooling rules apply from 6 October 2009.

To view the Act please click here.

Inland Revenue has released for comment two draft public rulings on the deductibility of break fees paid by landlords in relation to fixed interest loans.  When issued, the rulings will clarify the tax treatment of break fees paid by a landlord to exit, or to vary the interest rate of, a fixed interest rate loan when the landlord does not report income under the IFRS financial reporting method.  The draft rulings state that both types of break fee are deductible, although for different reasons.

Where a landlord pays a break fee in order to exit a fixed interest rate loan before the agreed repayment date, the break fee will constitute expenditure under the financial arrangements rules.  The break fee increases the negative figure of the landlord's base price adjustment calculated on repayment of the loan at exit, which is treated as expenditure for which the landlord is entitled to a deduction.

The second draft public ruling concludes that where a landlord pays a break fee to vary the interest rate of a fixed interest rate loan the break fee will also constitute expenditure under the financial arrangements rules.  However, unlike a break fee paid on early exit, for landlords that are required to apply a spreading method the deduction for a break fee paid on varying the interest rate will be spread over the remaining term of the loan under Determination G25.  If the landlord is a cash basis person (who has not elected to apply a spreading method), then the break fee will be immediately deductible as expenditure incurred in deriving rental income (cash basis persons are not required to spread income and expenditure under the financial arrangements rules).

The draft rulings will apply only in respect of a loan used by a landlord solely to acquire a rental property from which the landlord derives rental income, and will not apply in respect of a loan connected with other financial arrangements between the lender and the borrower.  For example, a break fee would not be deductible if the loan was used in whole or in part for a private or domestic purpose. 

Inland Revenue has invited public comment on the two draft rulings.  The deadline for comment is 6 November 2009.

To view a copy of both exposure drafts please click here.

This publication is included in Russell McVeagh's website on the Internet: www.russellmcveagh.com

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