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Frucor Suntory New Zealand Limited v Commissioner of Inland Revenue: The final destination, or just the beginning?

Tax Alert - October 2022

By Patrick McCalman & Claudia Layton

After much anticipation, the Supreme Court delivered its judgment in Frucor Suntory New Zealand Limited v Commissioner of Inland Revenue (Frucor v CIR) on 30 September 2022, signalling the end of over ten years of litigation. The Supreme Court upheld the Court of Appeal’s decision that Frucor Suntory New Zealand Limited (Frucor) entered into a tax avoidance arrangement, but overturned the Court of Appeal’s decision in respect of shortfall penalties, finding that shortfall penalties should be imposed as Frucor took an unacceptable tax position.

The key facts can be summarised as follows:

  • Frucor (previously Danone Holdings NZ Ltd) acquired all the shares in Frucor Beverages Group Ltd in 2002. Two Frucor-related entities provided funding to Frucor to effect the acquisition. Danone Asia Pte Ltd provided $150million in equity funding and Danone Finance SA provided $148million in debt funding.
  • The above arrangement was restructured in 2003 as follows (the funding arrangement):
    • Deutsche Bank advanced $204million to Frucor in exchange for a convertible note (the Note) with a maturity of 5 years at an interest rate of 6.5% per annum.
    • Frucor used the $204million advance to repay $144million of debt owed to Danone Finance SA and to redeem part of the Danone Asia Pte Ltd equity for $60million.
    • $55million of the $204million provided by Deutsche Bank came from its internal treasury. The remaining $149million came from a forward purchase agreement by Danone Asia Pte Ltd for $204million worth of shares in Frucor upon maturity of the Note.
  • Over the Note’s tenure, Frucor paid interest totalling $66million (being 6.5% of $204million, per annum). Frucor subsequently took deductions for these amounts in its income tax returns.

The issues before the Supreme Court were whether:

  • The funding arrangement was a tax avoidance arrangement under s BG 1(1) of the Income Tax Act 2004 (the Act);
  • The Commissioner of Inland Revenue (the Commissioner) was entitled to reconstruct Frucor’s tax position to disallow a portion of the deductions Frucor took; and
  • Frucor’s tax position (that the funding arrangement was not tax avoidance) was “about as likely as not to be correct” per s 141B(1) of the Tax Administration Act 1994 (the TAA) and relatedly, whether shortfall penalties under s 141D of the TAA should be imposed.

The decision of the High Court

The High Court found that the funding arrangement was not tax avoidance, as the purpose of the funding arrangement was to adjust Frucor’s debt/equity ratio. Justice Muir concluded that even if he was wrong in his findings, he would not have imposed shortfall penalties on Frucor on the basis it had not taken an unacceptable tax position.

We have previously commented on the High Court’s decision.

The decision of the Court of Appeal

The Court of Appeal overturned the High Court judgement and concluded that the funding arrangement amounted to tax avoidance. The Court dismissed the Commissioner’s cross-appeal on shortfall penalties, however, concluding that Frucor had not taken an unacceptable tax position.

We have previously commented on the Court of Appeal’s decision.

The Supreme Court decided 4-1 in favour of the Commissioner in respect of both the funding arrangement being tax avoidance and the imposition of shortfall penalties.

Tax avoidance

The majority considered whether the funding arrangement was a tax avoidance arrangement by undertaking an ‘economic substance’ analysis. The majority analysed the funding arrangement at the Group level (i.e. the transactions of Frucor, Danone Asia Pte Ltd and Danone Finance SA as a whole), concluding that the ‘separate entity principle’ (i.e. looking at the transactions of Frucor as a standalone entity) should not be followed when considering tax avoidance.

By analysing the funding arrangement at the Group level, the majority found that Frucor had, in ‘economic substance’, borrowed only $55million (being $204million less $149million from the forward purchase agreement), not $204million, from Deutsche Bank. As such, the majority found that the $66million of ‘interest’ Frucor paid over the tenure of the Note was not purely interest payments, but instead consisted of repayment of the $55million principal and $11million of interest. In doing so, the majority adopted a very broad assessment of the economic substance of the transaction, seeing the Note as akin to equity even before its conversion.

The Act allowed deductions to be taken for interest payments made, but not repayments of principal (deduction provisions). After finding that $55million of the $66million payment related to principal repayments, the majority concluded that the tax advantage Frucor obtained by deducting principal repayments resulted from use of the deduction provisions outside Parliament’s intention. As such, the majority concluded the positions taken by Frucor constituted tax avoidance.

As the use of the deduction provisions was found to be tax avoidance, the majority held the Commissioner was entitled to reconstruct Frucor’s interest deductions, denying $55million of the $66million paid.

Shortfall penalties

To impose shortfall penalties, the Supreme Court had to find that Frucor’s application of the deduction provisions was not “about as likely as not to be correct” in respect of Parliament’s intention behind the deduction provisions.

The majority assessed this on the facts as they found them. Based on the finding that Frucor did not “suffer the economic burden” of expenditure that the deduction provisions provided for, Frucor’s position was not “about as likely as not to be correct” and the majority imposed an abusive tax position penalty of 100% of the tax shortfall (finding that tax avoidance was the dominant purpose of Frucor).

Justice Glazebrook considered the funding arrangement was not tax avoidance and, even if it was, shortfall penalties should not be imposed as Frucor’s position was “about as likely as not to be correct”.

Justice Glazebrook agreed with the majority that in economic substance Deutsche Bank provided $55million to Frucor, however, disagreed with the majority’s deviation from the ‘separate entity principle’, finding that by paying $66million to Deutsche Bank, Frucor bore an economic burden of $66million. Justice Glazebrook concluded that the fact $149million of the $204million was provided to Deutsche Bank through the forward purchase agreement by Danone Asia Pte Ltd did not change Frucor’s actual outlay or economic burden.

Based on the above, and the fact that if Danone Asia Pte Ltd lent $204million at 6.5% interest per annum directly to Frucor the same tax effect would have resulted, Justice Glazebrook concluded the funding arrangement and the interest deductions taken by Frucor were within Parliament’s contemplated purpose of the deduction provisions.

Justice Glazebrook concluded that even if the funding arrangement was tax avoidance, she would not have imposed shortfall penalties, based on the finding that as Frucor paid $66million, it suffered the burden of expenditure Parliament contemplated under the deduction provisions. As such, Justice Glazebrook concluded that Frucor’s tax positions were “about as likely as not to be correct” and therefore, were not an unacceptable tax position.

Tax Avoidance

Despite confirming the two-step approach to analysing tax avoidance as set out in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue, the majority focused on the impression of the funding arrangement, rather than detailed consideration or analysis of whether the funding arrangement was outside Parliament’s contemplation (which Ben Nevis specifically provides). It also adopted a very broad assessment of the “economic substance” of the arrangement and in doing so was quite willing to move away from seeing each taxpayer in the transaction as a stand-alone taxpayer with different choices and tax impacts. This was in stark contrast to Justice Glazebrook’s approach.

This impression-focused approach has become a theme in tax avoidance cases in recent years and Frucor v CIR continues the trend against the taxpayer, firmly signalling that New Zealand tax avoidance cases will be decided not only on a review of the legal principles but an impression of the facts of the case as a whole. Coupled with the broad approach to examining the economic substance of the transaction it might be said that the decision moves the tax avoidance boundary even further in the Commissioner’s favour.

Shortfall Penalties

Shortfall penalties were never intended to be imposed on every taxpayer who entered a tax avoidance arrangement, instead only being imposed when a taxpayer enters a transaction that has no credible argument that the arrangement was not tax avoidance. The potential (and alarming) effect of Frucor v CIR is that if there is a tax avoidance arrangement, shortfall penalties will almost always be imposed. As noted by Justice Glazebrook, this is inconsistent with the scheme of the shortfall penalty regime.

Given 5 out of the 9 judges who delivered judgments in the Frucor v CIR litigation (Muir J in the High Court, Kós P, Gilbert and Courtney JJ in the Court of Appeal, and Glazebrook J in the Supreme Court) found Frucor’s position to be “about as likely as not to be correct”, the imposition of penalties on Frucor seems out of step with the policy intent of the shortfall penalty regime.

When the impression-focused approach to tax avoidance is coupled with the majority’s willingness to impose shortfall penalties, the shortfall penalty regime as it stands following Frucor v CIR is concerning. For a shortfall penalty for abusive avoidance to apply there needs to be the absence of an acceptable interpretation. It is clear from this framework (and from the extrinsic materials when the regime was introduced) that penalties were not intended to apply to all cases of tax avoidance. However, if the basis of the assessment of the acceptable interpretation threshold is now to be tested on an assessment of the facts under an economic substance test, it will be very rare that an acceptable interpretation will be reached. Accordingly, we consider it critical that the shortfall penalty regime be reviewed by Inland Revenue from a policy perspective to ensure that it is meeting its original policy objective, given the way in which the Supreme Court has said the assessment of an acceptable interpretation is to be undertaken.

It is unlikely that the Supreme Court will decide on another tax avoidance case in the next few years, meaning Frucor v CIR will be the leading tax avoidance authority for some time. It is therefore critical that taxpayers consider how to safeguard their tax positions. This is important not only because of the continued evolution of the tax avoidance boundary but because the outcome of Frucor v CIR now has the potential application of moving taxpayers faced with an assertion of tax avoidance to a “double or quits” world. With binding rulings now being more readily available, binding rulings or other interactions with the Inland Revenue to achieve certainty (or a degree of certainty) of tax outcomes now merit even more serious consideration. Please contact your usual Deloitte advisor if you have any further queries.

October 2022 - Tax Alerts

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