Insolvency: re Contract Engineering Ltd

Creditors of an insolvent company resisting liquidators’ demands to repay money received in the two years prior to liquidation need to do more than prove they acted in good faith; they must have provided new value at the time payment was made by the insolvent company.   This Court of Appeal ruling will assist creditors supplying further goods or services on credit in return for reduction of an existing debt, but it will not assist those creditors unfortunate enough to have an existing debt simply paid at a time when the company was insolvent in its final two years.

The rule is intended to encourage suppliers to keep working with an insolvent company trying to trade its way out of financial difficulty.  The supplier gets to keep the money paid, but runs the risk that the new debt created may turn out to be a bad debt if the debtor company is later wound up insolvent.

The Court of Appeal was asked to rule on a joint appeal involving two separate company liquidations: liquidators of Contract Engineering Ltd were chasing a creditor paid about $57,800 for concrete and steel foundations constructed on a Wairakei pipeline project; liquidators of the same company wanted $105,400 from a different creditor paid for the manufacture and installation of a silencer on the same project; and liquidators of Window Holdings Ltd sought to recover payments totalling $13,000 made to a creditor for contouring and stabilising work.  In each case, the creditor was paid within the critical two year period at a time when the debtor company was insolvent. 

Insolvency law operates a pari passu rule: unpaid unsecured creditors are paid cents in the dollar on a pro rata distribution out of cash collected in by the liquidator.  Over the centuries, various statutory rules have required creditors paid 100 cents in the dollar prior to liquidation to put their payment back into the pot and prove instead as unsecured creditors.  Not surprisingly, creditors have resisted having to repay: they give up 100 cents and get back less.  Confusion over the payback rules has arisen following a series of amendments to insolvency law over the last twenty years.

The Court of Appeal has clarified the rules: an existing creditor can keep money paid in the two years prior to an insolvent debtor company being wound up insolvent only to the extent that “new value” has been provided in return for the payment made.

The Court of Appeal said “new value” can be provided by the supplier agreeing to resume supply of goods or services, or by agreeing to extend the date on which payment is due for the balance of the existing unpaid debt.

Re Contract Engineering Ltd – Court of Appeal (27.03.13)

13.009

Capital + Merchant: R. v. Ryan, Sutherland & Tallentire

Three directors of finance company Capital + Merchant have been sentenced after pleading guilty to Securities Act offences.  Over two years, investors put $23.4 million into the company on the strength of untrue statements which misrepresented the quality and risks of their investment.  Capital + Merchant went into receivership in 2007 with about 7,000 investors out of pocket.

Colin Gregory Ryan was sentenced to seven months home detention and 300 hours community work.  He agreed to pay $100,000 to the receivers by way of reparations for the loss and damage caused investors.  The court was told Ryan is a 66 year old Australian citizen from Brisbane.  He is a very experienced businessman with law and accountancy qualifications.  He had served on boards of Brisbane’s port company and airport company.  His home detention is to be served at an Auckland address.

Robert Gordon Sutherland was sentenced to six months home detention together with 300 hours community work.  He agreed to pay reparations of $60,000.

Owen Francis Tallentire was sentenced to twelve months imprisonment to be served in addition to a prison term currently being served after his earlier conviction for theft by a person in a special relationship arising out of his dealings as a Capital + Merchant director.

The untrue statements which mislead investors were in prospectuses issued to the public in 2006 and 2007.   That court said both Ryan and Sutherland had an honest belief that the information in the 2006 and 2007 prospectuses was correct, but this belief was not reasonable.  Tallentire was described as being more deeply involved such that he must have been aware critical information was false.

In particular, the prospectuses misrepresented the extent and manner of dealings with related parties; misrepresented the cash flows and future liquidity of Capital + Merchant and did not identify the extent of disputed loans or the fact of unpaid loans being rolled over rather than enforced.  It was incorrect to state that no loans were impaired and that no provision was required for past-due loans when in fact a number of large loans were clearly impaired.

R. v. Ryan, Sutherland & Tallentire – High Court (15.03.13)

13.010

Tax avoidance: Alesco v. CIR

Inland Revenue decisively won round two in a tax avoidance test case centred on use of hybrid securities to finance transactions.  The Court of Appeal disallowed as tax avoidance claimed interest deductions by Alesco (NZ) Ltd because they were a misuse of specific deductibility rules, even though the financing structure used complied perfectly with general principles of financial accounting.  This ruling has implications for ongoing tax disputes with sixteen other taxpayers having $300 million in dispute.

The case has its origins in a 2003 financing transaction between Alesco (NZ) Ltd and its Australian parent.  Alesco (NZ) issued convertible notes to its Australian parent in return for advances totalling $78 million.  The convertible notes were a hybrid security: part debt part equity, with a ten year maturity.

There was no dispute that the $78 million advance represented a real commercial transaction.  The funds were used to purchase existing New Zealand businesses: medical equipment supplier Biolab; and kitchen equipment supplier Robinson Industries.   

The dispute centred on a claimed tax deduction for notional interest payable on the convertible notes.   The economic effect of the transaction was that Alesco (NZ) received an interest free loan of $78 million.  On maturity in ten years, the Australian parent had an option: first to convert the notes to shares in Alesco (NZ) (which was of no commercial value since the parent already held all the shares in Alesco (NZ); or to redeem the notes for cash (which would result in an economic loss to the Australian parent because the loan had stood interest free for ten years).

Financial accounting rules require issuers of convertible notes to value separately the equity and debt “components” of the note.  Alesco (NZ) claimed a tax deduction for notional interest payable on the debt component, though no cash was actually payable.  Recognition of notional interest arising on an interest free loan complies with rules for financial reporting.   Inland Revenue argued that use of this financial reporting principle for tax purposes inflated taxable expenses and amounted to tax avoidance.

The Court of Appeal ruled that the financial arrangement rules in tax law were intended to give effect to the reality of income and expenditure – that is, real economic benefits and costs.  A claim for notional interest payable did not fall within the rules as intended by parliament.

Alesco v. CIR – Court of Appeal (5.03.13)

13.006

Tax advisors: Alesco v. CIR

Creative use of tax rules is getting short shrift from the courts with criticism aimed at tax advisors who promote the schemes and then stand in court as supposed independent expert witnesses justifying the tax scheme in dispute.

Accounting firm KPMG came in for stinging criticism from the Court of Appeal for its role in litigation between client Alesco (NZ) Ltd and Inland Revenue in a dispute over the deductibility of interest on an Alesco financing transaction.

In 2003, Alesco’s Australian parent advanced $78 million dollars to finance further expansion in New Zealand with Alesco (NZ) issuing optional convertible notes in return.  Both the High Court and the Court of Appeal were to rule that an interest deduction claimed by Alesco (NZ) on the convertible notes amounted to tax avoidance.  The claimed interest deduction was reversed and penalties of $2.4 million were imposed for what Inland Revenue claimed was Alesco (NZ)’s adoption of “an abusive tax position”.

At trial, supposed expert evidence was given by KPMG partner, chartered accountant  Michael Schubert.  He was described as giving expert opinion on the correct financial reporting treatment of optional convertible notes.  KPMG had provided advice to Alesco from the outset on the most tax effective way of presenting the transaction.

Mr Schubert’s evidence was roundly criticised: his narrow financial accounting approach ignored the economic reality of how the transaction was structured between related parties – Alesco (NZ) and its Australian parent.  The Court of Appeal said Mr Schubert’s analysis launched hypothetical arguments which were unrelated to the facts of the case.  This did not assist the Court and added unnecessary complications.  The Court of Appeal emphasised that an expert witness assists a court by providing specialist non-legal evidence and all expert witnesses have a fundamental obligation to be impartial.  The Court expressed its dismay at the growing trend for expert witnesses to go into battle on behalf of a client.

Alesco v. CIR – Court of Appeal (5.03.13)

13.007