The Inland Revenue Department has won another landmark tax avoidance case, with potential to affect disputed tax revenue of more than $300 million, involving disputes by some 16 Australian companies which lowered their tax bills using New Zealand subsidiaries.
The test case involved the Western Australian firm, Alesco, which bought two New Zealand businesses in 2002 - Biolab and stoveware manufacturer Robinhood and then used a structure known as "optional convertible notes" (OCNs) to avoid tax in New Zealand.
Judge Paul Heath's judgment, issued at the Auckland High Court today, involves around $8.6 million of tax, penalties and interest charges, and upholds the IRD's refusal to allow Alesco interest deductions based on OCN transactions which he rules were "artificial".
Among them are Telstra Corp, Toll Holdings, and Ironbridge, the Australian owners Mediaworks, which runs the TV3 and RadioLive networks. Mediaworks succeeded in having its trial delayed earlier this year, arguing it was unable to bear the legal costs, given wider cashflow difficulties which also saw the government extend a $40 million soft loan to the broadcaster to allow it to pay its broadcast licence fees.
"While this is not a designated test case, in a practical sense my decision is likely to influence the course of the remaining proceedings," Judge Heath said.
Tax advisers fear the judgment will have a chilling effect on Australian investment in New Zealand by over-ruling the use of tax minimisation practices which had previously been regarded as legitimate.
"The High Court decision clearly illustrates the line in the sand between what is acceptable and unacceptable tax avoidance keeps moving," said Jo Doolan, a senior tax partner at Ernst & Young. OCN-type arrangements were not unusual, and the IRD had given Alesco a determination on the division between debt, equity and deductible interest in the arrangement.
"In the determination that the taxpayers then applied, there is no exclusion that carves out related party debt. Alesco therefore had every right to believe the way it structured its financing was in accordance with the law," said Doolan.
OCN structures were used to allow companies to juggle debt and equity in their New Zealand arms to their groups' tax advantage and a loss to the New Zealand revenue base.
The challenge by Alesco and other taxpayers to the IRD's position turned on whether the OCN structure represented an economic reality, or was engineered only to minimise tax.
Judge Heath sided with the IRD, saying "there was no economic cost actually incurred" and evidence that a third party might have purchased the OCNs for around $34 million as "unsupportable, on any commercial analysis."
"The arrangement was an artificial device designed only to secure a tax advantage in New Zealand and could not otherwise have been obtained," and the deductions claimed "were not contemplated by Parliament" when it passed the relevant parts of the Income Tax Act, he said.
"The way in which the inter-company advances to be made by Alesco Corporation to Alesco NZ were to be structured was driven solely by tax considerations," he said. "This was not an agreement to lend money on particular terms. It was a way for members of the Alesco group to obtain New Zealand tax benefits, thereby reducing the transaction costs of acquiring the two businesses."
Judge Heath also upheld shortfall penalties, equating to half the tax deductions involved, and found that "the tax position taken by Alesco NZ falls within the definition of an 'abusive tax position'."
Alesco has a right of appeal.