Tax avoidance: BNZ v. CIR

The High Court has disallowed as tax avoidance a series of BNZ structured finance transactions described as tax machines having no commercial purpose or rationale.

Losses to the New Zealand taxpayer were estimated at $335 million, with benefits of $238 million accruing to National Australia Bank, owner of the Bank of New Zealand.

The transactions relied on international tax arbitrage, exploiting the tax asymmetries under which different legs of a structured finance deal could be viewed differently in different countries. For BNZ in New Zealand, the beauty of the scheme was that its costs would be deductible while income would be tax exempt. All this unravelled when the High Court ruled that the deals constituted tax avoidance and removed all the tax advantages gained. This included disallowing the funding costs incurred by the BNZ. The BNZ hotly argued that funding costs were part of the Bank’s ordinary fundraising activities unrelated to the disputed transactions and should still be allowed as a tax expense.

The transactions in question spanned eight tax years between 1998 and 2005. Colloquially called “repo” deals, they typically involve an equity investment in an overseas counterparty on the basis that the counterparty would buy back the shares. Financially, this amounts to secured collaterised borrowing. Economically, it is a loan secured by a pledge of shares. Legally, it is an offshore equity investment.

Overseas tax authorities have got wise to the tax avoidance possibilities inherent in these cross-border tax transactions. Under US tax law, they are treated as “abusive arrangements”. In the UK, the supposed equity leg of the transaction is treated and taxed as if it were debt.

The High Court was told that National Australia Bank had second thoughts in the mid-1990s about setting up these structured finance transaction through a UK subsidiary because of what was delicately described as potential tax “uncertainties”.

Instead, they were structured through the BNZ, its NZ subsidiary.

The first BNZ transaction, in 1995, was a five year deal consummated with the AIG group. Pricing on the transaction resulted in a positive tax benefit for the NZ taxpayer: BNZ gained an $18 million tax deduction; but the counterparty paid tax of $21 million – a net tax benefit of three million dollars.

For this initial transaction, BNZ obtained a binding ruling from Inland Revenue. This operates as advance advice from Inland Revenue as to how it will view a transaction should it later be included in a tax return. A strong point supporting the favourable ruling was the knowledge that the transaction would be tax positive for the NZ tax base.

BNZ then used the same template for subsequent structured finance deals which were tax negative for NZ, but did not apply for a binding ruling. Applying for a binding ruling would obviously disclose these transactions to Inland Revenue, Justice Wild commented in the High Court.

By fiddling with the pricing parameters, BNZ could make future deals tax negative. It resulted in BNZ offering counterparties funds at well below their normal cost of funds for their participation in an arrangement whereby there was an agreed share of the resulting tax benefits.

How the benefits were split was described as bearing no relation to any normal commercial considerations such as current market conditions or the credit status of the counterparties.

Inland Revenue called the deals “tax machines”. A formulaic approach was used, churning out tax losses for BNZ on a predetermined basis.

BNZ was concerned that overuse of the tax machine would affect its effective tax rate, which would become apparent from its published accounts.

In response, BNZ attempted to restructure the deals so as to consolidate the counterparty’s side of the transaction in its consolidated accounts – and did succeed in doing so in two of the transactions. Consolidation meant tax paid in the counterparty’s jurisdiction would be recorded in BNZ’s consolidated accounts, though that payment would be of no advantage to the NZ tax base.

Applying the first test for tax evasion from the Ben Nevis Case the question was did the transactions appear commercially and economically realistic.

Justice Wild answered: No. They returned high yields for BNZ with no risks other than tax. Those tax benefits were the benefit of expenses deductible against BNZ’s other income, and the tax exempt income received.

But despite this, the transaction was not tax avoidance if it fell within the scheme and purpose of a specific tax provision: the second test from Ben Nevis.

The tax provision relied on was the conduit relief regime which allows a “pass through” of foreign sourced income; from overseas sources, through a NZ subsidiary to the subsidiary’s foreign owner. This income passes through tax free, subject to a 15 per cent withholding tax.

Justice Wild ruled that the BNZ transactions were not within the scheme and purpose of the conduit relief regime. There was no income stream to pass through to its parent company. The transactions generated only tax benefits.

The High Court agreed with Inland Revenue that the effect of the transactions should be nullified as tax avoidance.

This had the effect of increasing BNZ’s tax liability by some $416 million, and triggering penalty interest of about $240 million.

BNZ Investments v. CIR – High Court (15.7.09)

09.09.001