Sixteen different taxpayers and revenue totalling $300 million is in dispute with Inland Revenue as it targets use of hybrid securities to fund intra-group transactions.
The first shot has felled ASX listed company Alesco after a High Court finding that use of optional convertible notes to buy into New Zealand companies amounted to tax avoidance. Tax deductions of $10.95 million were disallowed for the tax years 2003-2008. In addition to tax payable on an extra $4.9 million assessable income, Alesco was ordered to pay shortfall penalties of $2.4 million and use of money interest of $1.2 million.
Alesco spent $85 million investing in New Zealand companies. It relied on advice from chartered accountants KPMG in seeking the most tax effective way of documenting the transaction.
The court was told Alesco (NZ) issued convertible notes to its Australian parent in return for advances totalling $78 million for a term of ten years. On maturity, Alesco had the option of being repaid the $78 million or converting the notes into 78 million Alesco (NZ) shares. These notes were hybrid securities, split into debt and equity components. The beauty of this arrangement was that Australian and New Zealand taxing authorities treated hybrid securities in differing ways: in New Zealand Alesco (NZ) could claim a deduction for a notional interest expense arising from the debt component of the notes with no withholding tax deduction; in Australia this notional payment was not assessable to the parent company, Alesco.
No cash would change hands. But Alesco (NZ) would be claiming a deduction for this notional interest, reducing taxable income for its New Zealand operations.
This notional liability for interest arose because of the accruals regime operating in New Zealand tax law since the 1980s. The accruals regime seeks to reflect the economic effect of financial transactions and aligns tax law with general accounting principles.
Alesco argued the financial arrangement chosen was a legitimate business transaction. Inland Revenue was dismissive, calling these hybrid securities interest free advances stapled to valueless and purposeless warrants.
In the High Court, Justice Heath ruled the transaction was invalid for tax purposes as tax avoidance. While the accounting treatment for the notes was appropriate, the tax advantage gained was not within the intent of tax legislation, he said.
First: there was no taxable income arising from the deduction claimed. Secondly: the hybrid security used was artificial, designed only to secure a tax advantage in New Zealand. There was no arms length negotiation to settle the terms of the transaction. The hybrid security had no commercial value. No third party buyer would be interested in buying the security. Thirdly: no real interest had been incurred and the notional interest deduction did not represent a real economic cost.
A shortfall penalty of $2.4 million was imposed after the court ruled that Alesco had taken an “abusive tax position” entering into the financing arrangement with a dominant purpose of avoiding tax.
Alesco NZ Ltd v. CIR – High Court (12.12.11)
(12.11.003)