Taxman heading to trial in case of NZ$300m of alleged tax avoidance by foreign companies in September

By Gareth Vaughan

A long running dispute between the Inland Revenue Department and a group of foreign-controlled companies over alleged tax avoidance worth about NZ$300 million finally appears set for a High Court trial, but not in the way the taxman wanted.

The cases between the IRD and companies including TelstraClear's parent Telstra, former Tranz Rail owner Toll Holdings, Qantas and TV3's parent MediaWorks, relate to their use of optional convertible notes (OCNs) to fund their New Zealand subsidiaries in the late 1990s and early 2000s. A series of court skirmishes have taken place, but now a High Court judge has ordered a trial, but not of either of the IRD's preferred test cases -- those of Telstra and MediaWorks -- which the taxman had wanted heard first.

In a recent oral judgment Justice Paul Heath made an order granting priority to Alesco and directing a three week trial from September 12 this year. Alesco is Alesco Corporation, an Australian building materials and home products maker. Its local subsidiary, Alesco New Zealand Ltd, issued 78 million OCNs at NZ$1 each to its parent in 2003 and 2004.

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, for example, see NZ$55 million recorded as debt and NZ$45 million as equity. That meant NZ$100 million of OCNs over 10 years could allow for a NZ$45 million interest deduction.

IRD 'shifts the goal posts'

The dispute flared up after the 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 and that the taxman effectively shifted the goal posts in a move that potentially undermined foreign investment into New Zealand.

The IRD has been prioritising the Telstra and MediaWorks cases arguing it wanted to focus its resources on them as test cases that would resolve the essential issues in dispute across all the OCN cases. However, Telstra successfully managed to quash its case for the 2003 to 2005 tax years last November and filed separate proceedings challenging the IRD's tax assessments for the 2006 to 2008 years.

Debt-ridden MediaWorks, which has argued it can't afford the legal costs associated with being a test case, has had its case adjourned - which was scheduled to start on September 12 (the slot Alesco has been given) - after being granted special leave by the Court of Appeal for further discovery. Justice Heath has also set a timeframe for the Telstra and Toll cases culminating in hearings on the first available dates after August 10, 2012.

MediaWorks' last annual report, covering the year to August 31, 2010, notes a total of NZ$24.5 million in dispute, made up of NZ$10.2 million of core tax, NZ$9.2 million of accrued interest, and NZ$5.07 million worth of shortfall penalties.

Alesco's latest annual report says interest deductions claimed since its OCNs were issued in 2003 until May 31, 2010 were worth NZ$7.06 million. This has been fully provided for in its accounts but no provision has been made in respect of interest or potential penalties should it lose the High Court case. As of May 31 last year, Alesco NZ's accounts valued the debt component of the OCNs at NZ$63 million. Alesco Corporation, as the subscriber, can convert the OCNs into ordinary shares on the basis of one share per note in 2013.

In his December judgment on the Telstra case Justice Edwin David Wylie said the OCN litigation involves nine taxpayer groups with more than 20 sets of proceedings. There was about NZ$200 million of potential tax revenue that IRD Commissioner Robert Russell has assessed as tax avoidance, Justice Wylie added. This, however, didn't include penalties or use of money interest accruing. Russell estimated further potential assessments of about NZ$100 million outstanding, Justice Wylie said.

This article was first published in our email for paid subscribers this morning. See here for more details and to subscribe.