The Orica decision and its Implications

Transcription

1 14 December 2015 The Orica decision and its Implications The first instance decision of Justice Pagone in Orica Limited v Commissioner of Taxation [2015] FCA 1399 represents a significant win by the ATO in its application of the general anti-avoidance provision, Part IVA. This Tax Brief examines the decision and its implications. 1. Background The background to the dispute lay in Orica s large US tax losses. It seems the financial auditors required that the deferred tax asset representing the accumulated losses be removed from the group s accounts until it was virtually certain that the US operations would generate sufficient income to use the losses. This de-recognition adversely affected both the profit and financial position of the group. Consequently, the group explored options to re-instate the losses by generating a stable income stream in the US. The structure ultimately settled upon was relatively straightforward: the Australian Orica tax consolidated group (Orica Australia) subscribed for three tranches of redeemable preference shares (RPS) in a US subsidiary (Orica US), which carried a right to receive a non-cumulative annual dividend payable out of distributable profits; and Orica US lent the funds back to Orica Australia at interest rates ranging from 4.46% to 5.43% per annum, guaranteeing Orica US a stable flow of interest income. From an Australian income tax perspective, Orica Australia: claimed a deduction (at 30%) for interest incurred on the loan from Orica US; remitted withholding tax to the ATO (at 10%) on the interest payments; and was not assessed on the dividends received on the RPS. In the US, Orica US: included the interest paid on the loan as assessable income (potentially taxable in the US at 40%); was able to utilise its existing US tax losses to shelter this income from tax and so was able to once again recognise the US tax losses for accounting purposes; claimed a foreign tax credit for the Australian interest withholding tax (which was carried forward to subsequent years); and did not claim a deduction for dividends paid on the RPS.

2 The higher rate of corporate tax in the US meant that the scheme only made sense, on a consolidated accounting group basis, because of the existence of the US tax losses. The scheme impacted the Orica accounting consolidated group s profit in three ways: reduced profit by increasing income tax expense (at 40%) by reference to the assessable US interest income; increased profit by an equivalent amount upon re-recognition of the US tax losses (which absorbed the US assessable interest income); and increased profit by reducing income tax expense (at 30%) by reference to the Australian interest deductions. 2. Part IVA The Commissioner sought to apply Part IVA to deny Orica Australia deductions for interest on the loans from Orica US on the basis that the dominant purpose of the scheme was to obtain those deductions. The case focused exclusively on the purpose element as the scheme and tax benefit elements of Part IVA were conceded (the tax benefits were the deductions for interest paid to Orica US). Orica argued the scheme was undertaken in order to re-recognise the US tax losses and in turn increase accounting profits. This, in turn, was anticipated to improve investor perceptions of Orica s financial performance, increase Orica s share price, reduce the risk of a hostile takeover and reduce the risk of Orica breaching its financial covenants. Expert accounting opinion confirmed that the scheme did indeed result in an increase in Orica s profits. This benefit could not be attributed to any particular one of the three accounting outcomes (identified above), but rather resulted from a combination of the three sets of accounting entries. Accordingly, the case involved a tension between the scheme s overall (non-tax) commercial objective on the one hand and its objective of securing tax benefits on the other hand. A number of cases, from Spotless Services onwards, have dealt with this difficult balancing act. However, Justice Pagone identified that the Australian tax deductions were an essential element for the improvement in Orica Australia s earnings. This was because there: would have been no point to utilise the losses in the United States by the creation of internally generated income for [Orica US] without a corresponding benefit to the group: the use of the US tax losses in the US was commercially valuable to the Orica group because its economic effect was enjoyed through the tax deductions in Australia. Therefore, even though the combined accounting entries produced the improvement in Orica consolidated earnings, only one [ie, the Australian interest deductions] explained the actual profit to the group. Justice Pagone held that all of the eight matters relevant to the objective determination of purpose pointed towards the requisite dominant purpose being present. The more noteworthy ones are discussed below. When looking at the manner in which the scheme was entered into or carried out, Justice Pagone found that the scheme: was not commercial when looked at from the point of view of the borrowing entity; 2 The Orica decision and its Implications

3 was entered into solely by commonly controlled companies; and brought no lasting advantage to Orica Australia other than Australian tax saved as a result of the interest deductions. The form of the scheme was complex but the substance was said to be straightforward and tax driven the generation of profits equal to the accounting impact of the Australian interest deductions. Perhaps this is better described as the outcome of the scheme rather than its substance. The timing pointed to a dominant purpose of obtaining a tax benefit because the scheme only operated while Orica Australia s interest deductions produced the additional accounting profit. However, it could perhaps more convincingly be said that the real reason the scheme stopped was because the US tax losses were exhausted. Interestingly, Justice Pagone was not persuaded by the taxpayer s arguments that the scheme was undertaken to improve Orica Australia s standing with its investors and financiers. He found that the evidence did not establish a causal link and, in any case: any consequence from the schemes to the perceptions of investors or financiers would necessarily have arisen from the after tax effect on reported profits for the group arising from the deductions for the interest paid Restated, in Justice Pagone s view, the identified commercial benefit represented a monetisation of a tax benefit. And so, after stepping through the relevant factors in section 177D (as summarised above), the court found that Orica Australia entered into the scheme with a dominant purpose of obtaining a tax benefit, and that the Commissioner had rightfully made a determination to apply Part IVA to Orica Australia. 3. Penalties An administrative penalty was imposed on Orica Australia by the Commissioner on the grounds that it was reasonable to conclude that Orica Australia entered into the scheme with a dominant purpose of obtaining a tax benefit. The court agreed with the imposition of the penalty, finding that a reasonable person would conclude that that Orica Australia entered into the scheme with a dominant purpose of obtaining a tax benefit because without the tax benefit the schemes made no sense. The taxpayer s defence of seeking to increase earnings by utilising unbooked US tax losses was dismissed because the taxpayer and its advisor had knowledge of the transactions and their economic effects, and knew and intended to produce the economic outcome which depended upon the taxpayer getting scheme benefits. In assessing Orica Australia s liability for penalties, the court found that the taxpayer s position did not meet the reasonably arguable threshold. In other words, it could not be said that Orica Australia s position is about as likely to be correct as incorrect, or is more likely to be correct than incorrect. In part, this conclusion was reached on the basis that the issue did not turn on a disputed construction of statutory provisions on which there is no authority or conflicting authority. Rather, the only issue was the scope and operation of Part IVA and it had been considered in detail by the courts. Orica Australia argued that the state of the authorities at the time of entering schemes demonstrated a lack of established authority but the Court disagreed. The Court thought it, significant that none of the evidence concerned any advice about the application of Part IVA. 3 The Orica decision and its Implications

4 4. Comments There are a number of occasions where Justice Pagone appears to draw negative inferences from the fact that the actors were all members of the one corporate group. This is in contrast to a number of other Part IVA cases dealing with group restructures and may be of some concern. Also, there are a number of interesting structural aspects of the case. Orica s actions had the effect of moving income from Australia with a 30% tax rate to the US which has a 40% rate. In short, income was being shifted to a higher-tax jurisdiction. It was only the US tax losses that made this a commercially sensible course of action. Secondly, the impact of the claimed interest deductions on the Australian tax base is not obvious. This is because Orica Australia was in tax loss for several years. However, Justice Pagone focussed on the immediate generation of the interest deductions and, in his eyes, their significance from a Part IVA perspective was not tempered by the fact that they could only be utilised in later years. Thirdly, the interest payments triggered withholding tax in Australia. To the extent that Orica Australia had available tax losses, this represented a real and immediate increase in Australian tax from implementing the structure. However, this aspect is not prominent in Justice Pagone s reasons. 4 The Orica decision and its Implications

5 For further information, please contact Sydney Tony Frost phone Graeme Cooper graeme.cooper@greenwoods.com.au phone Tim Kyle tim.kyle@greenwoods.com.au phone Julian Pinson julian.pinson@greenwoods.com.au phone Melbourne Toby Eggleston toby.eggleston@greenwoods.com.au phone Perth Nick Heggart nick.heggart@greenwoods.com.au phone G&HSF document ID These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Herbert Smith Freehills Pty Limited (ABN ) Sydney Melbourne Perth ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Collins Street, Melbourne VIC 3000, Australia Ph Fax QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax The Orica decision and its Implications