The taxman has suffered a court defeat in a case of alleged tax avoidance against several high profile overseas companies worth hundreds of millions of dollars.

The Inland Revenue Department (IRD) has been knocked back in the High Court at Auckland after accusing Telstra of an abuse of court process.

Justice Edwin David Wylie has ruled in favour of Telstra after a hearing on November 25.

The Telstra case is one of two IRD designated test cases in a series of disputes with foreign owned companies over their use of optional convertible notes (OCNs).

Justice Wylie's judgment notes the OCN litigation involves nine taxpayer groups with more than 20 sets of proceedings.

There is about NZ$200 million of potential tax revenue that IRD Commissioner Robert Russell has assessed as tax avoidance, Justice Wylie added.

"This figure does not include penalties or use of money interest that will be accruing on the tax that has been assessed. Further, not all income years have been yet been assessed, and some taxpayers - including Telstra - are claiming deductions for OCNs still on foot."

"The Commissioner estimates that there are further potential assessments of approximately NZ$100 million outstanding."

Other companies involved in the dispute include TV3's parent MediaWorks (the second designated test case), former Tranz Rail owner Toll New Zealand, Qantas, and a bank which isn't one of the big four, HSBC or Rabobank, but whose identity is unclear.

A hybrid equity and debt instrument, OCNs were a popular method foreign companies - especially Australian ones - used to fund New Zealand subsidiaries in the late 1990s and early 2000s. Their zero coupon, or nil interest funding nature allowed a group's New Zealand operations to retain cashflow, thereby bolstering its financial position.

The money was typically used to recapitalise a Kiwi subsidiary, retire debt or make acquisitions.

Issued over a time frame of about 10 years, the OCN holder could either redeem them for cash or convert them into shares in the subsidiary on maturity.

As a hybrid of debt and equity, NZ$100 million of OCN funding could see NZ$55 million recorded as debt and NZ$45 million as equity. The NZ$100 million of OCNs over 10 years could allow for a NZ$45 million interest deduction spread over the lifespan.

However, IRD issued a determination in 2006 saying it wanted to stop companies obtaining interest deductions through OCNs when they had in fact incurred no business expense.

The companies, however, maintain OCNs were a legitimate form of funding their businesses.

Telstra's case involves the biggest sum in dispute. Telstra New Zealand, the holding company for TelstraClear, issued NZ$$1.46 billion worth of OCNs to its Australian parent in 2003 to retire intra-group debt.

The interest deduction sought over the term of Telstra's OCNs amounted to NZ$581 million.

However, ahead of a scheduled three week High Court trial in October, Telstra reviewed the value to it of the disputed OCN deductions and associated tax losses for the 2003 to 2005 years.

It has a "substantial" amount of tax losses available for offsetting against future profits independent of the disputed tax deductions. The company's own profit projections showed tax losses contributed by the disputed deductions wouldn't start to be used against net taxable income until the 2017 financial year at the earliest.

Telstra therefore reassessed the point of continuing its fight over the 2003 to 2005 years against IRD .

Following this Telstra initiated settlement talks with the IRD in March this year, which ultimately other companies involved in OCN disputes with the taxman joined.

However, Justice Wylie said the IRD was reluctant to settle because it viewed Telstra's case as a test case, and in early September the settlement talks died.

But rather than file a briefs of evidence ahead of the scheduled start of the High Court trial on October 26 covering the 2003 to 2005 years, Telstra instead filed a notice of discontinuance.

It then filed separate proceedings challenging the IRD's tax assessments for the 2006 to 2008 years.

By discontinuing the proceedings covering the 2003 to 2005 income years Telstra forfeited tax losses of about NZ$95 million and incurred a liability penalty for shortfall penalties of about NZ$3.9 million.

However, in reality nothing is payable to the IRD because the tax losses hadn't been offset against any assessable income and the shortfall penalties are off set against available tax losses.

The IRD asked the Court to make an order setting aside Telstra's discontinuance, arguing it was an abuse of process of the Court.
Brendan Brown QC, the IRD's lawyer, argued that the test case nature of the Telstra challenge had ramifications beyond just its case.

"He noted that the conduct of the Telstra investigation was a matter not only for the Commissioner and Telstra, but also that it had significant implications, in terms of costs and delay, for the other OCN taxpayers, and for the Court," Justice Wylie said.

Further, Brown argued that because Telstra had filed near identical proceedings for the 2006 to 2008 years, it was seeking to address the shortcomings in its own evidence by issuing new proceedings as a means of having "another bite at the same cherry."

However, Telstra's lawyer - Ralph Simpson of Bell Gully, replied by saying the telco had permanently abandoned its right to challenge the IRD's assessment for the 2003 to 2005 years.

This resulted in the forfeiture of its tax losses and a liability to shortfall penalties. Simpson said Telstra did this for "sound commercial reasons" in that the 2003 to 2005 losses under challenge had limited economic value relative to the costs of a trial, and because Telstra has other accumulated tax losses.

Simpson also said the decision to designate Telstra's case as a test case was "unilaterally" made by Russell.

In his ruling Justice Wylie said the IRD's arguments "must fail" and that he wasn't satisfied that the discontinuance filed by Telstra was an abuse of court process.

Telstra's decision to end the 2003 to 2005 proceedings reflected its conclusion that the financial costs and loss of personal time that would be incurred in the trial was "disproportionate to the economic value of the tax losses at issue, particularly having regard to the existence of other tax losses, including those that had accrued in the subsequent tax years," Justice Wylie ruled.

"This evidence was not challenged.

Telstra has done no more than make a commercial decision not to incur further costs by proceeding to trial. Litigants frequently discontinue proceedings for that reason.

To do so is not an abuse of process," the Judge added.

Furthermore, he said the discontinuance had not put the IRD to additional cost and delay.

In fact, it had avoided the "no doubt significant" costs of a three week trial.

Although accepting the IRD had lost the opportunity to obtain a judgment, which if successful, from its perspective would have been used to try and settle outstanding disputes with other OCN taxpayers, the Judge said inconvenience didn't mean Telstra had abused court process.

And there was no substance to the argument that Telstra had sought to discontinue the proceedings to enable it to address shortcomings in its own evidence by issuing new proceedings.

Further, Telstra's right to challenge the 2003 to 2005 assessments was now time barred.

"There is nothing in the evidence to suggest that Telstra's actions in discontinuing the proceedings were anything other than commercially based, and from that perspective rational and bona fide," said Justice Wylie.

"In my judgment, Telstra's discontinuance is not an abuse of the process of the Court, and the discontinuance must stand."