Second High Court decision confirms structured finance transactions as tax avoidance

Summary

Between 1998 and 2000 Westpac entered into a number of structured finance transactions with foreign counterparties. The Commissioner considered the transactions constituted tax avoidance, and issued amended assessments to Westpac. The High Court upheld the Commissioner's assessments.

Impact of decision

This judgment represents a helpful example of the practical implementation of the "tandem approach" to considering avoidance which is required by Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2009] 2 NZLR 289, where both the specific provisions and the general anti-avoidance provisions are given equal weight.

Facts

Between 1998 and 2002 Westpac entered into a number of structured finance transactions with foreign counterparties. The Commissioner issued amended assessments in relation to nine of the transactions, on the grounds that (a) the transactions were part of tax avoidance arrangement, and (b) Westpac was not entitled to deductions for guarantee procurement fees paid as part of the arrangement.

By order of the Court, four of the nine transactions were litigated. The remaining five are stayed until further court order.

Westpac had previously received a binding ruling in relation to a similar transaction. The Court of Appeal ruled prior to this hearing that the existence of that binding ruling was irrelevant and that Westpac was not entitled to place any reliance on it.

The Judgment is lengthy, reflecting the amount of evidence adduced. This summary does not attempt to traverse the facts in detail. The Judgment contains a useful summary of one of the transactions from paragraph [120].

In summary (and generally):

1. Westpac and the counterparty's subsidiary entered into a Sale and Repurchase Agreement in respect of redeemable preference shares ("RPS") carrying a fixed dividend. That dividend was exempt income, and was also relived from foreign dividend withholding payment ("FDWP") under the conduit tax relief regime. The dividend was calculated to share the tax benefits arising from the transaction. (One of the transactions used the Foreign Tax Credit ("FTC") regime instead of the conduit regime.)
2. Westpac agreed to pay a guarantee procurement fee ("GPF") to the subsidiary for the procurement of a guarantee from the counterparty. The guarantee was in respect of the subsidiary's obligations to repurchase the shares at the conclusion of the transaction.
3. Westpac and the subsidiary entered into a swap, whereby Westpac paid a fixed interest rate and received a floating interest rate.
4. Westpac funded the transaction by borrowing funds from the market.
5. Westpac claimed deductions for the funding costs, as well as the GPF. Its costs were greater than the fixed dividend received, but as the dividend was exempt the transactions were profitable on an after-tax basis.

Decision

The Commissioner won on all counts.

Deductibility of the GPF
This issue is covered in the judgment at paragraphs [252] to [315]: the Financial Arrangement ("FA") deductibility at [254] to [295]; Gross income at [296] to [315].

His Honour agreed with the Commissioner that the GPF was paid for the service of procuring the guarantee, not for the guarantee itself. The parties had deliberately structured the arrangement in that way to avoid the possible application of withholding tax payable if it was a guarantee fee. The Court agreed that it is the legal structures implemented by the parties which are relevant at this "black letter" stage of analysis; it was not open to Westpac to argue on economic substance grounds that the fee was really paid for the guarantee itself. As it was paid for the service of procurement, in this case it did not fall within the definition of an FA.

Westpac argued the RPS were held on revenue account, and that as the guarantee was in respect of the subsidiary's repurchase obligations, the GPF was paid to preserve the value of a revenue asset, and therefore there was a nexus with gross income.

On the facts, His Honour decided that the RPS were on capital account. Further, while Westpac clearly had an intention of reselling the shares, the resale was not the purpose of acquiring them. Purpose was not necessarily synonymous with intention, and in this case the purpose was to derive the dividends. Therefore, because the shares were held on capital account and were not purchased for the purpose of resale, the guarantee was not over a revenue asset. This meant there was no nexus between the GPF and gross income.

Tax avoidance
The avoidance analysis of the transactions at issue is discussed at paragraphs [316]-[620]. The recent decisions of the Supreme Court in Ben Nevis and Glenharrow Holdings Ltd V the Commissioner of Inland Revenue [2009] 2 NZLR 359 are discussed at paragraphs [170]-[201]. The following is merely a brief summary of the key findings.

In respect of the Ben Nevis and Glenharrow decisions, His Honour:

1. Agreed with the decision of Wild J in the recent BNZ structured finance decision (BNZ Investments & Ors v CIR HC WN CIV 2004-485-1059 15 July 2009) that the Ben Nevis and Glenharrow decisions render analysis of previous avoidance case law unnecessary (at paragraph [170]).
2. Accepted the Commissioner's submission that the cases are not a restatement of existing law, and represent a rejection of Richardson J's juristic scheme and purpose approach in Challenge (at paragraphs [174]-[183]).
3. Disagreed with the Commissioner's submission that the avoidance provisions only bite once the Court is satisfied that the specific provisions have been complied with.
4. Referred to the factors for consideration listed at paragraphs [108]-[109] of Ben Nevis and stated at paragraphs [193]-[196]:
   1. Ben Nevis represents "a significant shift in identifying the principles to be applied when construing s BG 1, mandating a broader inquiry than was previously required".
   2. "The previous constraints imposed by a legalistic focus, to the exclusion of economic realism, have gone".
   3. Ben Nevis prescribes "a combined form and substance test".
   4. The ratio of Ben Nevis at paragraphs [107] and [108] is "designed to prescribe the permissible scope of the substance inquiry".
5. Noted Glenharrow's emphasis that anti-avoidance provisions are concerned with the purpose of the arrangement, not the purpose of the parties. Subjective intention may be relevant to the issue of whether there was (for example) a business purpose for a scheme.

The avoidance analysis of the transactions at issue is extensive, and as much turns on the facts of each arrangement, it is not useful to reproduce that analysis in any detail here. However, a useful summary of the factors His Honour considered is at paragraph [317]:

• Broadly stated, the question is whether by using all of the specific provisions - both the conduit and FTC regimes for income and the interest deductibility provisions for expenditure - Westpac crossed the line and changed the character of the transactions from lawful to unlawful. That inquiry will take into account:
  1. The nature of the contractual relationship between Westpac and the counterparty and the legal effects of the documents;
  2. The economic substance of the transaction (investment or loan);
  3. The structure of the transaction and whether Westpac obtained the benefit of the specific provisions in an artificial or contrived way including but not limited to:
     1. the existence and amount of the GPF, the circumstances in which it was agreed, and its objective value - that is, whether it was at a market or commercial rate;
     2. the use of a pricing mechanism to fix the dividend rate and in particular whether it provided for the parties to share all of Westpac's taxation benefits - that is, both cross-border and domestic asymmetries;
     3. the cost of funds to Westpac and the profitability of the transaction (both pre and post-tax);
     4. the relationship between a transaction and the relevant level of Westpac's tax shelter or estimated tax ratio;
     5. the use of currency and interest swaps (both internal and external); and
     6. the financial consequences of the transaction.

Some key findings by His Honour were:

1. There was a commercial purpose to the transactions (paragraph [590]) but the main purpose was generating deductible expenses and altering the incidence of income tax (eg paragraphs [598] and [605]).
2. There was never any prospect of profit, and the tax benefits were significant (eg paragraphs [586]-[587]).
3. There was no commercial justification for the GPF; its function was to generate a statutory deduction for an expense which appeared genuine but was in truth a contrivance (eg paragraphs [593]-[600]).
4. Aspects of the structure (such as the GPF) were artificial. While taxpayers are free to structure their affairs in the most tax effective way, and to take post-tax consequences into account when deciding whether to proceed with a transaction, that is premised on the assumption that the transaction has an independently justifiable commercial rationale (paragraphs [603]-[604]). Further, this was not a case of a taxpayer choosing between "two means of carrying out an economically rational transaction, one of which would result in less tax being payable than the other" (paragraph [617]).

His Honour discusses the use of the specific provisions (the conduit and foreign tax credit regimes) as part of the arrangement at [605]-[618].

At [577]-[582] His Honour identifies (and rejects as irrelevant) what he describes as "tangential factors" which the Commissioner had submitted amounted to indicia of tax avoidance. These included the social cost of the transactions, the novelty of the transactions, and the use of a formula to determine pricing. His Honour accepted that circularity is relevant, but held that there was no circularity in the transactions at issue.

Reconstruction
Reconstruction is discussed at paragraphs [621]-[667].

The Commissioner did not reconstruct the arrangements in this case; he merely disallowed the deductions claimed in relation to them. The Court observed at [624] that the Commissioner may have had grounds for disallowing an exemption [of income] at least for that amount of Westpac's income attributable to the GPF equivalent of the dividend rate.

Westpac's arguments, which were all rejected on the facts, were that:

1. the Commissioner failed to identify the tax advantages accruing to the bank ([637]-[641]);
2. incorrectly disallowed deductions for the cost of funds ([642]-[648]);
3. failed to limit reconstruction to the extent to which the GPFs exceeded the market value ([649]-[667]).