The recent IRD’s win in the Alesco tax avoidance case is a clear indication how far the tax law has moved.  The case involved an Australian company Alesco, which acquired two New Zealand companies. The acquisition was financed through the use of optional convertible notes (OCN). OCN is a hybrid financial instrument that consists of debt and equity component.

Alesco could have financed the acquisition using either interest bearing debt or the OCN. Income tax legislation allows a deduction for interest should interest bearing debt be used. There is a special determination, issued by the Commissioner, which prescribes how the OCN is to be treated for tax purposes and prescribes a calculation methodology for notional interest deduction.

The alarming issue resulting from the decision is the fact that the IRD has invoked anti-avoidance in relation to a genuine commercial transaction just because Alesco has chosen the means of financing that IRD did not like, on the grounds that Alesco apparently did not suffer a real economic cost – i.e. because the interest deduction they claimed pursuant to the IRD’s own determination was notional. We find it really hard to understand the logic that was applied by the IRD and the Courts given the fact that the determination, written by the Commissioner, specifically prescribes the tax treatment of OCN and a methodology for quantifying a NOTIONAL interest deduction. Notional means fictitious.

Furthermore, the use of OCN as means of financing resulted in Alesco obtaining a lesser interest deduction than if an interest bearing debt was used.  The sad reality is that Alesco has in fact chosen a financing option in relation to a genuine commercial transaction that resulted in greater tax payable than if an alternative means of finance was used and yet was penalised for this.

Another alarming issue, besides understanding how anti-avoidance provisions can be applied to a commercial transaction where the highest amount of tax is paid, is the fact that the Commissioner or Courts did not allow Alesco the next best alternative. One would hope, in societies where the tax system is fair and just, that the taxpayer would have at least been allowed a reconstruction using next best alternative. This however was not case here.  Even though the counsel for the tax payer has clearly pointed out that higher amount of deduction would have been available for Alesco if interest bearing debt was used. The Courts have rejected this argument on the grounds that there was no documentary evidence that interest bearing debt was contemplated by Alesco.  The IRD and the courts therefore simply denied the notional deduction with no reconstruction.

What does all this mean?

This clearly indicates that the environment is more uncertain than it ever was. The Commissioner and Courts are stretching the boundaries in applying the legislation as they deem fit depending on which way the wind blows. Furthermore, this demonstrates that the Courts and the Commissioner are more interested in paper evidence (i.e. notes, minutes from directors meetings) rather than common sense and what is actually prescribed by legislation.

There is no need to highlight that our country relies heavily on foreign investment and jobs that are created as a result of foreign investment. The government should therefore stop and look at what is happening. It should put a stop to the Commissioner’s total disregard to commercial transactions and her almost unlimited power to invoke anti-avoidance legislation as and when she chooses to do so. Anti-avoidance provisions are specific provisions and should be applied where avoidance is present. It should not be used where genuine commercial transactions exist, which are structured in a way that results in a greater tax payable than if an alternative structure was used.

This total disregard creates a great uncertainty for foreign investors and may result in them choosing alternative more favourable jurisdictions. There is obviously no need to say what this would mean to our economy and our jobs. Moreover, it will make both taxpayers and their advisers question what is legitimate tax planning in this modern world.

In summary, this case resulted in a horrible outcome and a greater uncertainty for tax payers. If you are considering any transaction of sizeable value, make sure that you have a documentary evidence of alternatives you have considered. The only alternative way to obtain a certainty, in relation to a transaction you may be considering, is to obtain a ruling from the IRD.