The Commissioner can’t have her cake and eat it too…

Tax Alert - March 2019

On 5 November 2018, the High Court delivered its judgment in Frucor Suntory New Zealand Limited v Commissioner of Inland Revenue, deciding that a financing transaction involving the use of optional convertible notes was not a tax avoidance arrangement.

The case is noteworthy for its findings on the manner in which to assess the commercial and economic reality of an arrangement - including the extent to which a lens of commercial/unrelated party orthodoxy must be applied in doing so. The Court also made important findings regarding whether foreign tax savings are relevant to a New Zealand anti-avoidance analysis, and whether an issue of shares gave rise to economic cost in the sense contemplated by Parliament so as to result in deductibility for income tax purposes.

Background facts

The key facts can be summarised as follows:

  • Frucor had issued optional convertible Notes (the Notes) to a third party bank (the Bank) with a face value of $204m. Interest was payable on the Notes at a rate of 6.5% per annum. The maturity date for the Notes was 5 years from the issue date.
  • The repayment of the principal sum owing on the Notes could be satisfied through the Bank exercising its option to acquire shares (the Shares) in Frucor on maturity of the Notes. The Shares would not carry any voting rights.
  • On the day the Notes were issued to the Bank, Frucor’s Singapore-based parent (the Parent) entered into a forward purchase agreement to acquire the Shares on maturity of the Notes for $149m (this amount was paid by the Parent to the Bank upon entry into the forward purchase agreement). The Bank and Parent had agreed in the transaction documentation that the lowest price in respect of the Shares for financial arrangements rules purposes was $204m. This resulted in interest deductions for the Bank equal to the difference between $204m and $149m i.e. $55m. The remaining $55m of the amount lent by the Bank under the Notes was borrowed by the Bank from its group’s offshore treasury vehicle.
  • Frucor paid interest of $66m over the term of the Notes and claimed deductions for this amount under the financial arrangements rules.
  • Frucor had used the funds borrowed under the Notes to buy back its shares for $60m and to repay existing loans from the group treasury vehicle of $144m.

The Commissioner of Inland Revenue (the Commissioner) denied Frucor’s interest deductions for the full $66m, arguing that the transactions constituted a tax avoidance arrangement. This was on the basis that ”in reality” Frucor had borrowed only $55m, being the $204m issue price for the Notes, less the $149m paid by its Parent to the Bank in respect of the forward purchase. The Commissioner sought to limit Frucor’s interest deductions to $11m, which represented the interest paid by the Bank on its borrowing from its treasury department.

In the High Court, Muir J disagreed with the Commissioner, deciding that the tax outcomes arising under the arrangement did not constitute tax avoidance.

Individual entity v economic group approach

The Commissioner’s argument relied heavily on expert evidence, and was predicated on what was referred to as the ‘group approach’. On this approach – which Muir J referred to as a “seductive invitation to look at what was occurring ‘in reality’” - Frucor and its Parent are treated as a single economic group, not individual entities in their own right; and the transactions are assessed at a group/consolidated level, looking at the net external position of entities under common control. At a group level, in the Commissioner’s view, Frucor had borrowed only $55m.

Muir J was not receptive to this analysis. His Honour noted that Parliament’s intention on how particular rules are to be applied must be considered within the overall scheme of the income tax legislation. He illustrated this by noting that an economic group approach was inconsistent with at least three specific aspects of New Zealand’s international tax regime - namely the non-resident withholding tax (NRWT), thin capitalisation and transfer pricing regimes - and was more broadly inconsistent with the individual entity framework that underpinned them.

Muir J noted that, because New Zealand is a net importer of capital, NRWT provides an effective tool to protect New Zealand’s tax base – and NRWT can only be effectively applied to interest payments between a New Zealand subsidiary and an offshore group member if they are separately recognised for tax purposes. His Honour went on to observe that the transfer pricing regime, and its underpinning arm’s length principles, are premised on a separate entity approach. Finally, the thin capitalisation regime assumes individual entity recognition in a multi-national group context.

Against this backdrop, Muir J found that it could not be Parliament’s intention to require that cross-border arrangements such as those at hand should be examined in terms of the overall impact at a group level.

Put another way, his Honour confirmed that taxation in a cross-border financing context where multiple tax regimes are in play requires separate entity recognition. The Commissioner could not cherry pick when to treat entities on an individual vs overall economic group basis.

Foreign tax savings

Muir J also confirmed that foreign tax savings do not constitute tax avoidance for the purposes of New Zealand’s general anti-avoidance rule. He noted that the arrangement had “real and legitimate economic drivers, primary among them offshore tax minimisation”.

His Honour found that the Commissioner had ignored (or at least understated) foreign tax motivators in undertaking her anti-avoidance analysis.

Manner in which the arrangement was carried out

Muir J noted that the transaction involved real money flows. Actual amounts were lent to Frucor. Frucor actually paid out funds of $60m for a share buy-back and $144m to repay loans. Even the Commissioner’s expert accepted that real money was involved.

Muir J noted that some aspects of the arrangements, such as the pricing of the Notes, were unorthodox. However, he did not see this as an indicator of tax avoidance in this case. His Honour noted that it is the relationship between the arrangement and the tax outcomes that should be examined - not whether a particular aspect of a transaction may seem different from an arrangement wholly between unrelated parties. He advised against placing the Notes within a “straightjacket of orthodoxy”. Muir J observed that when assessing whether Frucor had ‘gained the benefit’ of a specific tax rule in an artificial and contrived way, it was not simply a matter of focussing on whether – compared to arm’s length norms – aspects of the transaction might be described as unorthodox or even artificial.

Muir J also noted that absence of certain characteristics in a related party refinancing context, which would otherwise exist when “new debt” was being raised, cannot be regarded as a significant indicator of avoidance.

Artificiality, circularity and contrivance

Muir J accepted that that the presence of artificiality and contrivance can indicate that an arrangement has been structured in a manner that is not reflective of its commercial and economic reality. However, here the transactions had a legitimate commercial purpose, which resulted in a real change to Frucor’s funding structure. Genuine contractual obligations had been discharged, and so the Arrangement here was not circular in any sense relevant for anti-avoidance purposes.

“No cost” Argument

One of the Commissioner’s further points was that the Shares to be issued by Frucor on maturity of the Notes (which the Commissioner contended would inevitably be held by the Parent, not by the Bank) would involve no cost for Frucor and so was incapable of discharging a liability so as to give rise to a deduction as intended by Parliament.

Dismissing this argument, and endorsing Frucor’s, Muir J noted that the financial arrangements rules and the Commissioner’s determinations issued in respect of those rules (particularly in relation to convertible notes) contemplated that shares could be issued in discharge of legal obligations. His Honour could not find any distinction in this respect between share issues to a parent and to a third party.

In summary, Muir J found that Parliament must have intended for Frucor to:

  • take a deduction for interest economically incurred;
  • deduct financial arrangements expenditure deemed to be incurred over the life of a financial arrangement;
  • account for tax on a separate entity basis, even if it was a member of a multi‐national group; and
  • issue shares to satisfy a liability owed to a third party, including its Parent.

Shortfall penalties

Having decided in favour of Frucor, Muir J considered, in the alternative, whether shortfall penalties for an abusive tax position (100% of the tax shortfall) would be imposed if he had found for the Commissioner.

The starting point was whether Frucor had taken an unacceptable tax position (i.e. fails to meet the standard of being about as likely as not to be correct). The inquiry was whether Frucor’s arguments had substantial merit and whether they would be seriously considered by a court. Looking at the “commercial and juristic nature of the transaction”, Muir J considered that there were strong arguments in Frucor’s favour and that Frucor was always in a position to credibly challenge the Commissioner’s economic analysis of the arrangement. For these reasons, his Honour found that Frucor did not take an unacceptable tax position.


Muir J’s judgment is a refreshingly objective assessment of a cross-border financing transaction in an anti-avoidance context.

His Honour has made valuable comments in terms of what should really be involved in ascertaining the commercial and economic reality of an arrangement, and in particular what significance/relevance non-arm’s length features should have on the anti-avoidance analysis. He has reconfirmed that assertions of artificiality, contrivance and circularity can be easily made by the Commissioner in an anti-avoidance context, but these require the application of an objective and consistent lens in determining whether Parliament cannot have contemplated the tax outcomes in question.

Given the inevitable appeal of this decision, it will be interesting to see whether the Court of Appeal feels equally disinclined to accept the Commissioner’s “seductive invitation”, and will resist placing the transactions within a “straightjacket of orthodoxy”.

At the very least, the Frucor judgment(s) will need to be reflected in the Commissioner’s update of her interpretation statement on general anti-avoidance, which is currently a work-in-progress.

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