Frucor: Commercial and economic reality is in the eye of the beholder
Tax Alert - October 2020
By Campbell Rose, Matthew Scoltock, and Mahi Kumar
On 3 September 2020, the Court of Appeal handed down its highly-anticipated judgment in Commissioner of Inland Revenue v Frucor Suntory New Zealand Limited, overturning the judgment of the High Court and ruling that a complex financing arrangement involving the issuance of an optional convertible note to a third party was a tax avoidance arrangement and therefore void as against the Commissioner of Inland Revenue (Commissioner).
The Court’s conclusion was based upon what it saw as the commercial and economic reality of the arrangement. In that regard, the Court seemed to rely heavily on a suite of evidence, comprised of e-mails and letters/memoranda, in which “tax efficiency” was a stated goal of the arrangement (including thin capitalisation thresholds affecting transaction sizing), and in which there was a focus upon overall financial exposures on an assumption that each party would inevitably comply with its contractual obligations.
The judgment is a timely reminder that, in assessing tax avoidance, the Court will only examine the arrangement that was actually entered into, and not what could or would have been done in the alternative. Applying the Parliamentary contemplation test established by Ben Nevis Forestry Ventures Limited v Commissioner of Inland Revenue, the Court concluded that the arrangement was, in substance, a “dressed-up” subscription for equity, and that it was “tax driven”, “repackaged” and “engineered” in an artificial and contrived way.
There was a win for the taxpayer with the Court finding that Frucor Suntory New Zealand Limited (Frucor) was not liable to shortfall penalties. The Court reaffirmed that a taxpayer will not have taken an “unacceptable tax position” if there is “substantial merit in [the taxpayer’s] argument” or if “the taxpayer’s argument would be seriously considered by a court”. It will be interesting to see if Frucor has the appetite to appeal the judgment to the Supreme Court; or if IS 13/01 (in relation to tax avoidance) is updated by Inland Revenue to reflect the Court’s judgment, given that a review of IS 13/01 is already on Inland Revenue’s work programme.
- In January 2002, a third party investment bank (the Bank) discussed with Group Danone S.A. the possibility of using a convertible note structure (the Note) to fund the proposed acquisition of Frucor Beverages Group Limited in an amount of approximately $300 million. In its proposal, the Bank identified that the interest payable by Frucor on the Note was to be fully deductible.
- The Bank advanced $204,421,565 to Frucor in exchange for a fee of $1.8 million and the issuance of the Note. The Note had a face value of $204,421,565 and a five year term. Interest on the Note was payable bi-annually at a rate of 6.5% per annum.
- At maturity, the principal of $204,421,565 was to be repaid in cash unless the Bank opted to take 1,025 non-voting shares (the Shares) in Frucor in satisfaction of the loan. The Court noted that “[i]t is common ground that [the Bank] would elect to have repayment of the principal amount satisfied by the issue of the [Shares] in all but a doomsday scenario”.
- At the same time, Frucor’s immediate parent (the Parent, as purchaser) and the Bank (as vendor) entered into a forward purchase agreement in respect of the Shares. Under the forward purchase agreement, the Parent was required to make a $149 million upfront payment to the Bank in return for the transfer of the Shares on maturity of the Note.
- Of the $204,421,565 loan, $149 million was therefore financed by the forward purchase price payable by the Parent. Approximately $55 million was financed by the Bank’s offshore group treasury vehicle.
- Frucor applied $60 million of the $204,421,565 loan to buy back and cancel certain of its shares. The balance of the loan was used to repay an existing loan from Danone Finance S.A. (Danone Finance). Frucor also paid the Bank’s approximately $1.8 million arrangement fee. Over the term of the arrangement, Frucor paid interest to the Bank in the sum of $66 million, in accordance with the terms of the Note.
- The Commissioner denied Frucor’s $66 million interest deduction on the basis that, in reality, Frucor only borrowed $55 million from the Bank, being the $204,421,565 face value of the Note less the $149 million paid to the Bank by Frucor’s Parent under the forward purchase agreement. Instead, the Commissioner sought to limit Frucor’s total interest deduction to just $11 million.
Frucor in the High Court
In the High Court, Muir J found that the Commissioner had not appropriately invoked the general anti-avoidance provision, section BG 1 of the Income Tax Act 2007 (the Act). In particular, he concluded that:
Interest was incurred by [Frucor] both legally and, at a single-entity level, economically. And it was actually paid. The deduction did not depend on the taxpayer reverse engineering a deduction by application of the financial arrangement rules. Nor did the transaction involve back-to-back arrangements, each akin to the other, in the manner now typically assumed to infringe [section] BG 1.
Frucor in the Court of Appeal
Tax Avoidance Arrangement
The Court of Appeal disagreed with Muir J. While recognising that “[t]here is no doubt that, as a matter of legal form, Frucor was able to make use of the relevant specific provisions to claim a full deduction for the interest expenditure on the sum of $204,421,565”, the Court found that “Frucor used the specific provisions to claim deductions for interest in an artificial and contrived manner that cannot have been within Parliament’s contemplation”. The Court considered that, when the economic and commercial effect of the arrangement was examined in its context, it became clear that tax avoidance was, at least, not a merely incidental purpose or effect of the arrangement.
In reaching its conclusion, the Court noted that:
The primary purpose of the funding arrangement was the provision of tax efficient funding to Frucor. That was its stated goal. The tax advantage was gained in New Zealand through the interest deductions Frucor claimed. [The Parent] (in effect) paid $149 million to Frucor for the shares on day one but with the payment being structured to enable Frucor to claim interest deductions on it over a five-year term.
In the Court’s view, the Parent’s subscription for equity was “effectively repackaged” as an artificial and contrived loan from the Bank to achieve the intended tax benefits for Frucor. To that end, the Court also noted that “[t]he artificial and contrived features of the funding arrangement are not seriously in dispute” and that:
Taken together, they reveal 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 concluded that, as a matter of commercial and economic reality, the payment of $149 million by the Parent did not bring with it any liability for Frucor to pay interest. Rather, in the Court’s view, the only interest-bearing debt was the $55 million advanced in reality by the Bank to Frucor.
Significantly, the Court also found that:
It is not relevant that Frucor could have borrowed the $204 million from Danone Finance at an arm’s length rate of interest and be entitled to claim the same interest deductions. The focus must be on the arrangement that was entered into, not one that might have been entered into but was not.
In concluding that the arrangement amounted to tax avoidance, the Court relied on a variety of contemporaneous correspondence, comprising e-mails and letters/memoranda, which recognised tax efficiency as a stated goal of the arrangement. By contrast, the Court did not appear to consider in great depth a number of non-tax purposes/reasons for the arrangement, such as cash accumulation and retention benefits, foreign tax, lower fixed-interest-rate funding, New Zealand (i.e., local) dollar-denominated funding, and an improved debt-to-equity ratio. While it is perhaps understandable for the Court to have regarded the non-tax purposes/reasons as not being unique to the arrangement itself, it is interesting that the Court appeared to take issue with tax efficiency as a stated goal; as this is a not unreasonable (and not uncommon) objective - among others - for a world-wide corporate group’s treasury function to achieve in establishing cross-border acquisition funding.
One curious aspect of the Court’s judgment is its conclusion that the Note was “to all intents and purposes” a mandatory convertible note, that Frucor was always going to discharge its debt by issuing the Shares, and that the arrangement was therefore a “dressed-up” subscription for equity. This analysis does not appear to give much weight to the fact that, during the term of the arrangement, the Bank would have an enforceable right to repayment in cash (and would rank as a creditor ahead of equity) if Frucor became insolvent; i.e. it was (presumably) highly unlikely that the Bank would have allowed the Shares to be issued to discharge the debt in the event of Frucor’s insolvency. That is consistent with Frucor’s observation that it recognised a $204,421,565 liability in relation to the Note under International Financial Reporting Standards, with which it was required to comply to ensure that its financial statements were a true and fair representation of its assets and liabilities. It is therefore not invariably the case that conversion of the Note into equity was a foregone conclusion, or that the arrangement would have been at all times, in substance, a subscription for equity.
As such, it is difficult to differentiate the arrangement from a forward purchase agreement for equity, in relation to which completion is deferred and the issuer is deemed to incur interest on the basis that the arrangement is a financial arrangement. This position was submitted by Frucor as a fall-back. However, the Court found that such an outcome was not reasonable in the context of a wholly-owned corporate group. Contrary to Muir J’s view, the Court appeared to readily reject Frucor’s submission, and instead considered that the Shares did not have any value when issued to the Parent, as the Parent was Frucor’s sole shareholder (i.e., the Shares did not alter the Parent’s economic interest in Frucor).
To some extent, it is disappointing that that submission was not more fully analysed by the Court in the light of the Court’s finding that the Shares validly discharged Frucor’s debt to the Bank; and particularly given that debt is regularly capitalised in the context of a wholly-owned corporate group without any objection from the Commissioner. Thus, the Court’s finding of tax avoidance appears to be predicated on the arrangement being a “dressed-up” subscription for equity from the outset. But, unless Frucor’s insolvency was truly unfeasible, that does not appear to aptly characterise the arrangement.
Counteracting the Tax Advantage
Citing BNZ Investments v Commissioner of Inland Revenue, Frucor submitted that, because the Commissioner must only reconstruct a tax avoidance arrangement so as to counteract any tax advantage, it is necessary to identify the “base level” deduction that would have been allowed in any event. Given that the Note was issued in order for Frucor to repay a $144 million loan from Danone Finance, Frucor’s view was that if the arrangement had not been entered into, its debt-to-equity ratio would have remained about the same. As such, Frucor submitted that there was no real “tax advantage” for the Commissioner to counteract.
However, citing its judgment in Alesco New Zealand Limited v Commissioner of Inland Revenue, the Court concluded that the Commissioner was not required to consider that Frucor might have entered into an alternative arrangement. As such, the tax advantage was the $66 million interest deduction claimed over the life of the arrangement when, as a matter of commercial and economic reality, only $11 million of the deduction truly related to interest.
On the one hand, this aspect of the judgment is difficult to criticise based on the literal words of section GB 1 of the Act, pursuant to which the Commissioner “may have regard to” an alternative arrangement. However, the Court’s finding does seem punitive, given that Frucor arguably did not obtain a deduction which, but for the arrangement, would not have existed. The arrangement yielded a similar tax outcome to an ordinary shareholder loan: in fact, interest on the original Danone Finance loan (which was refinanced by the Note) was greater than the $11 million resulting from the Court’s finding. The approach is also difficult to reconcile with McGechan J’s judgment in BNZ Investments, in which he stated:
… I have no doubt [section GB 1] is intended to counteract tax advantages obtained out of avoidance, but not otherwise. Where tax advantages are increased through avoidance which would have existed in any event, it is that increment above base level which is to be counteracted, not the legitimate base level itself. That is all the preservation of the tax base - the purpose of the section - requires.
Unfortunately, the Court did not directly address the validity of this principle from BNZ Investments. If the Court did not consider it is only the “increment above base level which is to be counteracted” it would have been helpful for the Court to expressly state this.
Finally, the Court concluded that the threshold for an “unacceptable tax position” shortfall penalty - which applies when a taxpayer is not “about as likely as not to be correct” - can be described as “whether there is substantial merit in [the taxpayer’s] argument” or “whether the taxpayer’s argument would be seriously considered by a court. To that end, the Court endorsed the Supreme Court’s conclusion in Ben Nevis that the use of the word “about” in the threshold for shortfall penalties made it clear that a 50% prospect of success is not the standard. In finding that Frucor was not liable to shortfall penalties, the Court appeared to be influenced by the fact that Muir J not only regarded Frucor’s argument as deserving of serious consideration, he also “explained in a careful, closely reasoned and comprehensive judgment why he was persuaded it was both factually and legally correct”.
October 2020 Tax Alert contents
- Frucor: Commercial and economic reality is in the eye of the beholder