What are OCNs? 

An OCN is a financial instrument with hybrid equity and debt components that allows the holder to convert debt owed into shares of the company that issued the note.

Facts

In 2003 the Australian company Alesco loaned $78m to Alesco NZ to purchase two New Zealand businesses.  In consideration for the loans Alesco NZ issued OCNs in favour of Alesco to be converted after 10 years.  The loans were interest free.  At the end of the 10 year period Alesco could choose to be repaid the $78m loan or convert the OCNs into 78,000,000 shares in Alesco NZ.  Between 2003 and 2008 Alesco NZ claimed deductions for notional interest on the OCNs.  Although no actual interest was paid, a relevant IRD Determination (G22) permitted the Alesco OCNs to be divided into a debt component and an equity component and also permitted a notional interest to be claimed on the debt component.  Therefore a notional interest rate was deductible in New Zealand, but owing to a mismatch between the tax regimes of Australia and New Zealand, the corresponding  “notional” interest income derived by Alesco Australia was not taxable in Australia.

The High Court found that the OCNs were a tax avoidance arrangement.  Alesco NZ and its various subsidiaries appealed that decision to the Court of Appeal. 

Tax Avoidance

The definition of a tax avoidance arrangement can be summed up as an arrangement that has tax avoidance as its purpose or effect or one of its purposes or effects if that purpose or effect is not merely incidental.

The “arrangement” in this context was the OCNs, however the Court further held that the “arrangement” included “all steps taken for the purpose of implementing Alesco’s investment in the notes including the relevant funding instruments – the subscription agreement and notes – and… the cash flows themselves.”

The Court looked to whether Alesco had exceeded the scope of the OCN arrangement beyond the contemplation and purpose of Parliament when it enacted that certain financial arrangements could be exempted from income tax liability.  

The Court's Decision

The Court found that Alesco NZ did not pay any actual interest over the relevant periods yet the company had claimed for a notional interest expense.  Therefore there was no actual economic cost to the company so they could not claim a tax deduction for that “expense”.  In other words the Court found that this type of interest free loan arrangement was not an expense for income tax purposes as there was no economic loss suffered by the company.  The Court held that it was beyond the contemplation of Parliament that a taxpayer should be allowed to claim interest deductions for income tax purposes when there was no interest actually paid and no real economic loss.

Alesco argued that if the Court did hold the arrangement to be tax avoidance then the Commissioner should reassess the liability based on what type of arrangement Alesco would have used if they had known that claiming interest on interest free loans on OCNs would be deemed to be tax avoidance.  In this case, Alesco argued that the tax liability should be reassessed to the option it would have chosen if it had known that its current arrangement would be deemed to be tax avoidance.  The Court disagreed with this and said that it was at the Commissioner’s discretion as to how to reassess the tax liability. 

The Court upheld the High Court’s decision that shortfall penalties should be imposed on Alesco.  When a taxpayer takes an unacceptable or abusive tax position a shortfall penalty can be imposed which is assessed as the difference between the tax effects of the taxpayer's position and the correct tax position.  An unacceptable tax position is one where, if viewed objectively, the tax position fails to meet the standard of being about as likely as not to be correct.  An abusive tax position is one where a taxpayer has taken an unacceptable tax position, has entered into or acted in respect of arrangements or interpreted or applied tax laws with a dominant purpose of taking, or of supporting the taking of, tax positions that reduce or remove tax liabilities or give tax benefits.  The Court found that “there was no purpose for Alesco to advance $78m to  Alesco NZ interest free for 10 years under convertible notes except to secure a tax advantage by claiming expense deductions for notional interest payments…” and that Alesco’s arrangement could only be an abusive tax position and therefore shortfall penalties should be imposed.

Conclusion

Alesco is not the only New Zealand subsidiary of an Australian company that will be affected by this decision.  The media has quoted that there is $300m to be reassessed from companies with similar arrangements.  At the time of the decision the IRD had put the cases with these other companies on hold until the Alesco decision.  It will be up to these companies to carefully consider whether they will support Alesco in appealing to the Supreme Court, however they may well have at the front of their minds the ominous conclusion from the Court which stated “the more Alesco NZ’s case is examined, the more it reinforces our conclusion” and “we are satisfied that Alesco NZ’s position has always been unarguable.”  

Disclaimer: This article discusses its topic in general terms only and should not be relied upon as legal advice.