Court of Appeal considers cross-border financing tax avoidance appeal

The New Zealand Court of Appeal has overturned a High Court decision regarding the application of the general anti-avoidance rule. 

It concerns an arrangement under which a New Zealand company had borrowed by issuing a convertible note to an unrelated bank, with the bank in turn selling shares, under a prepaid forward purchase, into which the note may convert to the New Zealand company's foreign parent. Inland Revenue invoked the general anti-avoidance provision essentially on the basis that the arrangement would have resulted in the New Zealand company having an interest deduction in excess of the net funding cost for its group.

Background to the dispute

The dispute concerned NZ$66 million (US$43.3 million) of interest deductions over five years claimed by Frucor Suntory New Zealand Limited (Frucor) under a NZ$204 million convertible note (Note) issued by Frucor to the New Zealand branch of Deutsche Bank AG (Deutsche Bank) (an unrelated entity). 

NZ$149 million of the NZ$204 million advanced by Deutsche Bank under the Note was funded by a payment of NZ$149 million by Frucor's then Singapore-based parent Danone Asia Pty Limited (Danone) to Deutsche Bank. This payment was for the purchase from Deutsche Bank in five years' time of the non-voting shares to be issued (at Deutsche Bank's election) on conversion of the Note. 

Frucor stated that the reasons for the financing being structured in the way it was, included: 

• Obtaining funding at a fixed rate; 
• Better balancing of the debt-to-equity position of the New Zealand group; and 
• Avoiding Singaporean tax on the difference between the NZ$149 million paid by Danone to Deutsche Bank at the commencement of the transaction, and the value of the shares received by Danone on maturity under the forward purchase with Deutsche Bank.

Tax avoidance arguments made in the High Court

Under New Zealand's general anti-avoidance rule, a ‘tax avoidance arrangement’ is void against Inland Revenue for income tax purposes, and Inland Revenue "may adjust the taxable income of a person affected by the arrangement in a way [it] thinks appropriate, in order to counteract a tax advantage obtained by the person from or under the arrangement." 

Inland Revenue argued that although the NZ$66 million of interest deductions claimed by Frucor complied with the ‘black letter’ of the law, the general anti-avoidance rule permitted Inland Revenue to treat NZ$55 million of the interest deductions as repayment of non-deductible loan principal. 

In Inland Revenue's view, the agreement for Danone to purchase from Deutsche Bank the shares that would be issued on conversion had the effect of reducing (at [42]) "the 'real' or 'economic' amount borrowed by Frucor from NZ$204 million to a 'net loan' of NZ$55 million with a commensurate reduction in interest entitlements." 

The High Court rejected Inland Revenue's arguments and found that that the general anti-avoidance rule did not apply as the Note (at [203]) "had real (and from a New Zealand taxpayer perspective) legitimate economic drivers, primary among them offshore tax minimisation." 

High Court decision overturned by the Court of Appeal

Inland Revenue appealed the High Court decision and was successful. The Court of Appeal (at [59]) accepted Inland Revenue's argument that by entering into the funding arrangement Frucor achieved a NZ$66 million interest deduction without incurring the corresponding economic cost for which parliament intended deductions would be available. The purpose of the transaction, in the court's view, was therefore tax avoidance.

The Court of Appeal (at [85]) concluded that the "transaction was in many respects artificial and it was clearly contrived for the very purpose of enabling Frucor to gain the benefit of the specific provision allowing interest deductions". The court considered that the "artificial and contrived features" of the transaction revealed that "the purpose of the arrangement was to dress up a subscription for equity as an interest only loan to achieve a tax advantage". 

The Court of Appeal accepted that the NZ$204 million advance from Deutsche Bank involved as a matter of "commercial and economic reality" Deutsche Bank acting as a conduit for a NZ$149 million share subscription by Danone and Deutsche Bank making an advance of NZ$55 million. It followed that NZ$55 million of the NZ$66 million of interest paid by Frucor to Deutsche Bank was in reality the repayment of principal and not interest. It was significant to the court's reasoning that the Note (at [87]) "[w]hile technically an optional convertible note, … was to all intents and purposes mandatory" given Deutsche Bank plainly had no interest in acquiring the shares and the cost to Deutsche Bank of settling the forward purchase with cash.

The Court of Appeal (at [91]) also found that it was not relevant that Frucor could have borrowed the NZ$204 million from Danone at an arm’s-length rate of interest and been entitled to claim NZ$66 million of deductions. The court emphasised (at [91]) that the focus must be on the arrangement that was entered into, not one that might have been entered into. In so concluding, the court did not seem to address the point that Frucor had in fact borrowed and had the use of the full NZ$204 million. 

Frucor has applied for leave to appeal the Court of Appeal's decision to the Supreme Court. The Supreme Court has yet to decide whether to grant leave and hear the appeal. 

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