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