The High Court of Australia recently handed down its decision in Mills v Commissioner of Taxation, which has bearing on New Zealand anti-avoidance law.
The court found for the taxpayer, overturning the decision of the lower courts.
The case concerned the proposed application by the Australian Taxation Office of an anti-avoidance provision to deny franking credits to taxpayers in respect of distributions on securities (the Perpetual Exchangeable Resaleable Listed Securities V (PERLS V)) issued by the Commonwealth Bank of Australia.
There are several aspects of the High Court’s reasoning that may be relevant to the application of New Zealand’s general anti-avoidance law.
Between 2008 and 2009 CBA identified a need to raise additional Tier 1 capital to continue to satisfy Australian Prudential Regulation Authority requirements. Such capital includes, among other forms of capital, paid-up capital in respect of ordinary shares or certain equity-like securities.
In October 2009 CBA’s New Zealand branch issued 10 million PERLS V for an aggregate issue price of $2 billion to largely Australian resident investors. PERLS V comprised an unsecured subordinated note issued by CBA stapled to a preference share also issued by the bank.
PERLS V entitled holders to distributions paid as interest on the notes. The distributions were made at the discretion of the bank and a failure to make a distribution did not give the holder a right to payment in the future.
For Australian tax purposes, PERLS V were treated as “non-share equity” instruments. Distributions paid on PERLS V were classified as “non-share dividends” and were frankable with the equivalent of New Zealand’s imputation credits.
But for New Zealand tax purposes PERLS V were classified as debt and distributions paid on the notes were deductible to CBA’s New Zealand branch.
The ATO sought to apply s 177EA of the Australian Tax Act to deny PERLS V holders the benefit of the franking credits attached to distributions.
The application of the provision turned on whether CBA issued PERLS V for a purpose, which was more than an incidental purpose, of enabling holders to obtain a franking credit.
The Federal Court
The ATO succeeded at trial and on appeal to the Full Court in a split decision.
The trial judge and the majority of the Full Court held that CBA had a purpose of enabling PERLS V holders to obtain a franking credit that was more than incidental, despite its need to raise capital and despite the practical inevitability that any distributions made in consequence of the raising of such capital would be franked.
The High Court
The High Court found unanimously in favour of the taxpayer.
In disagreeing with the analysis of the majority in the Full Court, the High Court commented: “...a purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose".
"Indeed, the centrality of a purpose to the design of a scheme directed to the achievement of another purpose may be the very thing that gives it a quality of subsidiarity and therefore incidentality.”
The High Court also disagreed with the majority in the Full Court in respect of the relevance of a counterfactual analysis to the issue of whether a scheme was entered into for a particular purpose, and if such a purpose did exist, whether that purpose was incidental to some other purpose.
The High Court considered that a counterfactual analysis may well assist in such an inquiry. It concluded that, while CBA obviously issued PERLS V with the intention that holders would obtain franking credits, it was equally obvious that this purpose was incidental to CBA’s main purpose of raising Tier 1 capital.
Significantly, in respect of the deductions available under the PERLS V structure in New Zealand, the High Court commented that the existence of this New Zealand tax benefit did not make it any more or less likely that the bank had a purpose of enabling the holders of PERLS V to obtain franking credits.
Potential relevance in New Zealand
A “tax avoidance arrangement” is defined for the purpose of New Zealand’s s BG 1 as an arrangement that has tax avoidance as its purpose or effect or as one of its purposes or effects “if the tax avoidance purpose is not merely incidental”.
It is unclear what on-going practical significance the merely incidental purpose analysis will have after the Supreme Court’s directions in Ben Nevis Forestry Ventures Ltd & Ors v CIR.
In that case, the Supreme Court suggested that where an arrangement uses specific provisions in a manner not contemplated by Parliament, it will be rare for that arrangement to have tax avoidance as a purpose or effect that is merely incidental.
Regardless of the status of the merely incidental inquiry following Ben Nevis, the relative significance of purposes or effects (tax and non-tax) in shaping the form of a transaction may be influential in an avoidance analysis at a more practical level.
It will very often be the case that an allegation of avoidance will be defended by reference to the non-tax reasons for entry into an arrangement and the relative significance (or insignificance) of the tax outcomes will be the subject of much argument.
It is potentially significant in any balancing of different purposes or effects that the High Court found that CBA did not have a more than incidental purpose of enabling the obtaining of a tax advantage in circumstances where:
- Significant tax benefits could not be denied to exist.
- There was an expectation of their receipt.
- Their receipt was central to the design of a transaction.
In fact, the High Court went one step further in commenting that the centrality of a tax purpose to the design of a scheme directed to the achievement of another purpose could be the very thing that gives the tax purpose a subsidiary or incidental quality.
The High Court no doubt found assistance in its reasoning in a counterfactual or comparative analysis of the possible arrangements that might otherwise have been entered into to raise Tier 1 capital.
The fact that the same tax benefits would have arisen to holders under alternative means of Tier 1 capital raising must indicate that the purpose of the arrangement is to raise capital as opposed to generating an imputation advantage despite the “centrality” of that advantage to (presumably) all means of raising the requisite capital.
Underlying the counterfactual analysis is the assumption that some form of Tier 1 equity (or equity-like) capital would be raised.
It was not necessary to consider whether a Tier 1 capital raising would have been pursued if franking credits had not been available. However, it could probably not have been said that PERLS V would have been issued had the franking credit advantage not been available.
The next logical question then is why were PERLS V selected instead of more traditional equity securities such as ordinary shares?
The answer, it seems, lies in the New Zealand treatment of the PERLS V. Distributions on PERLS V were deductible in New Zealand as interest without compromising the expected equity/frankable position in Australia.
The High Court rejected the relevance of a foreign tax benefit in its merely incidental analysis. This is consistent with the view adopted in Inland Revenue’s recent Exposure Draft on avoidance.
If the reasoning applied by the High Court of Australia in Mills was to influence the approach of New Zealand courts, it is possible that the decision could give the merely incidental qualification to the general anti-avoidance rule (whether in the formal or more practical way described above) more significance than might have been assumed following Ben Nevis.
The decision also demonstrates the assistance that a counterfactual analysis can provide in weighing competing purposes or effects or in determining whether avoidance is present more generally.
Such an analysis is something missing in a New Zealand context to date and is largely denied as necessary in the Inland Revenue’s Exposure Draft. Its utility in logical and sound judgment is clearly demonstrated by the Mills decision.
Mathew McKay is a tax partner at law firm Bell Gully
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