COMMISSIONER OF INLAND REVENUE v FRUCOR SUNTORY NEW ZEALAND LIMITED [2020] NZCA 383

COMMISSIONER OF INLAND REVENUE v FRUCOR SUNTORY NEW ZEALAND LIMITED [2020]NZCA 383 [3 September 2020]IN THE COURT OF APPEAL OF NEW ZEALANDI TE KŌTI PĪRA O AOTEAROACA740/2018[2020] NZCA 383BETWEEN COMMISSIONER OF INLANDREVENUEAppellantAND FRUCOR SUNTORY NEW ZEALANDLIMITEDRespondentHearing: 11–12 February 2020Court: Kós P, Gilbert and Courtney JJCounsel: J B M Smith QC, E J Norris and L K Worthing for AppellantL McKay, M McKay and H C Roberts for RespondentJudgment: 3 September 2020 at 9.30 amJUDGMENT OF THE COURTA The appeal is allowed.B The orders made in the High Court are set aside. The interest assessmentsare reinstated. Shortfall penalties do not apply.C The appellant is entitled to costs for a complex appeal on a band B basis andusual disbursements. We certify for second counsel.D Costs in the High Court are to be determined by that Court in accordancewith this judgment.____________________________________________________________________REASONS OF THE COURT(Given by Gilbert J)Table of ContentsIntroduction [1]The issues [7]The funding arrangementContext [9]Convertible note deed [15]Forward purchase deed [16]Side letter [18]Convertible note guarantee [19]Forward purchase guarantee [20]Steps at inception — 18 March 2003 [21]Steps at maturity — 18 March 2008 [24]Subsequent return of capital [25]Legal principles [26]High Court judgment [29]The manner in which the arrangement was carried out [32]The role of all relevant parties and their relationship to Frucor [37]The economic and commercial effect of the documents [39]Artificiality and contrivance [42]Overall assessment [48]Submissions on appeal [51]Tax avoidance [58]Evidence in the High Court [60]Assessment [82]Tax advantage [98]Shortfall penalties [105]Result [109]Introduction[1] The Commissioner of Inland Revenue (the Commissioner) seeks to disallowdeductions claimed by Frucor Suntory New Zealand Ltd (Frucor)1 in respect ofa tax-driven structured finance transaction entered into by Frucor in March 2003(the funding arrangement). In terms of the funding arrangement, Deutsche Bankadvanced $204 million2 to Frucor in exchange for a fee of $1.8 million anda convertible note (the note) redeemable at maturity in five years' time atDeutsche Bank's election by the issue of 1,025 non-voting shares in Frucor. The bulkof Deutsche Bank's advance of $204 million was funded by a contemporaneouspayment of $149 million by Frucor's then Singapore-based parent, Danone Asia Pty1 Frucor was originally incorporated under the name Danone Holdings New Zealand Ltd on17 January 2002. It changed its name to Frucor Holdings New Zealand Ltd on 30 January 2009,and subsequently amalgamated with Frucor Beverages Ltd on 19 May 2009 under the latter'sname. It eventually changed its name to Frucor Suntory New Zealand Ltd on 30 June 2017.2 Except where stated in this judgment, amounts have been rounded for ease of expression.Ltd (DAP), for the purchase of the shares from Deutsche Bank in five years' time ata pre-agreed price matching the face value of the note (the forward purchaseagreement). The balance of $55 million was contributed by Deutsche Bank.Upon receipt of the $204 million from Deutsche Bank, Frucor immediately returned$60 million of capital to DAP in a share buyback and the balance of $144 million waspaid in satisfaction of an existing loan from another Danone entity, Danone FinanceSA in France.[2] The coupon on the note was payable semi-annually in arrears at 6.5 per centper annum. A total of $66 million was paid by Frucor to Deutsche Bank overthe five-year term calculated on an interest only basis on $204 million. Frucor claimedinterest deductions in respect of these coupon payments which equated to the amountrequired to pay amortising principal and interest on the $55 million introduced byDeutsche Bank.3 At maturity, Deutsche Bank exercised its option to accept repaymentby the issue of the shares and these were then transferred immediately to DAP inaccordance with the forward purchase agreement. The funding arrangement can beportrayed diagrammatically as shown in the appendix.[3] The Commissioner contends that the funding arrangement was a tax avoidancearrangement in terms of s BG 1 of the (now repealed) Income Tax Act 2004 (the Act)and therefore void against her. The deductions in issue in this proceeding are$10,827,606 and $11,665,323 for the 2006 and 2007 income years respectively.4[4] The Commissioner claims that as a matter of commercial and economic realitythe $66 million coupon payments represented principal and interest payments requiredto fully repay an amortising loan from Deutsche Bank of $55 million. She saysthe balance of $149 million received from Deutsche Bank (to make upthe $204 million advanced under the note) was effectively paid to Frucor by its 100per cent parent DAP for the issue of 1,025 shares in Frucor at the expiry ofthe arrangement in year five at a pre-agreed price of $204 million. According to the3 The $55 million principal was provided by Deutsche Bank's internal Treasury.4 The Commissioner accepts that she cannot disallow deductions claimed for prior years in respectof this arrangement because of the four-year time bar in s 108 of the Tax Administration Act 1994.The dispute between the Commissioner and Frucor in relation to the 2008 and 2009 income yearsremains in abeyance pending resolution of the present dispute.Commissioner, Deutsche Bank was merely the conduit for the payment and issue ofthese shares which came at no cost to Frucor. DAP owned all the shares in Frucorthroughout.[5] In summary, the Commissioner says Frucor is entitled to a deduction forthe interest paid on $55 million, which she accepts was advanced by Deutsche Bank.The deduction for interest payable on this amount, $11 million over the five-year termof the funding arrangement, is not challenged. The dispute is confined to the balanceof the claimed interest expense, being $55 million paid on the balance of $149 million.Frucor contends this is a legitimate interest cost because the full $204 million wasadvanced and interest was paid on it totalling $66 million over the five-year term.[6] Frucor succeeded in the High Court.5 Muir J found that the fundingarrangement was not a tax avoidance arrangement.6 The Judge accordingly declaredthat the Commissioner's assessments for the 2006 and 2007 income years wereincorrect and he made orders cancelling those assessments.7 The Judge consideredthat Frucor did not take an unacceptable tax position and so he would have set asidethe shortfall penalties imposed of $1,786,555 and $1,924,779 even if he had beenwrong on his principal conclusion.8The issues[7] The issues on appeal are:(a) Did the High Court err in finding that the funding arrangement was nota tax avoidance arrangement under s BG 1 of the Act?(b) Did the Commissioner correctly counteract the tax advantage unders GB 1 of the Act? Frucor argues there was no tax advantage even ifthis was a tax avoidance arrangement. Muir J did not need to deal with5 Frucor Suntory New Zealand Ltd v Commissioner of Inland Revenue [2018] NZHC 2860[High Court judgment].6 At [204].7 At [223].8 At [221]–[222].this issue because of his principal finding.9 Frucor has given noticesupporting the High Court judgment on this additional ground.(c) Did the High Court err in finding that shortfall penalties should not beimposed in any event?[8] Before addressing these issues, we will briefly summarise the key terms ofthe transaction documents comprising the funding arrangement and the context inwhich they were entered. We will say more about the background when we come toaddress the tax avoidance issues in detail. We also summarise the steps taken whenthe transaction closed on 18 March 2003 and at maturity five years later.The funding arrangementContext[9] In January 2002, Deutsche Bank provided a confidential financing proposal toGroupe Danone SA (Groupe Danone or Danone), the ultimate parent company basedin France, in connection with the proposed acquisition of Frucor Beverages Group Ltdand its subsidiaries in New Zealand. The proposal was styled "Efficient FinancingAlternatives for Danone in New Zealand". Two structures were proposed,a convertible note structure and an alternative structure based on the sale and leaseback of registered trademarks.[10] The convertible note structure, which was the genesis of the eventual fundingarrangement, anticipated that Deutsche Bank would pay the New Zealand Danonespecial purpose vehicle (SPV) up to $300 million to subscribe for a five-yearconvertible note. This would be backed by a contemporaneous forward purchaseagreement with "Danone UK" under which Deutsche Bank would deliver theSPV shares to Danone UK on conversion at the end of the arrangement in five years'time in return for an unspecified pre-paid amount as follows:9 At [212].[11] Deutsche Bank summarised the tax treatment as being that the coupons paidby the New Zealand SPV on the convertible note would be fully deductible,the funding costs of Danone UK should also be fully deductible, and there should beno capital gains tax on the acquisition of the SPV shares purchased by the Danone UKsubsidiary (provided the shares were not sold). Deutsche Bank noted that the 75per cent thin capitalisation rules applicable in New Zealand would need to be takenaccount of "in order to determine the size of the transaction".[12] Frucor was formed on 17 January 2002 as the acquisition vehicle. As ittranspired, the convertible note funding arrangement was not formalised until overa year later, in March 2003. In the meantime, the purchase price of approximately$297 million for the acquisition of Frucor Beverages Group Ltd was funded as to$150 million by DAP subscribing for 1,000 ordinary shares in Frucor at $150,000 pershare. The balance of $147 million was funded by an inter-company loan fromDanone Finance, a subsidiary of Groupe Danone also based in France.[13] In July 2002, Groupe Danone entered into a mandate agreement appointingDeutsche Bank as the exclusive and sole arranger of the proposed convertible note.Its services were to include structuring the issue of the convertible note and assistingGroupe Danone and the issuer to prepare appropriate documentation forthe transaction. A structuring fee of EUR 100,000 was to be paid to Deutsche Bankbut this would be credited against arrangement fees (subsequently agreed atUSD 1 million) charged by Deutsche Bank on the closing of the transaction.[14] On 14 March 2003, Frucor, DAP, Groupe Danone, Compagnie Gervais Danone(another France-based Danone company) and Deutsche Bank entered into a series oftransactions, together comprising the funding arrangement, as follows.Convertible note deed[15] A convertible note deed between Frucor and Deutsche Bank with a face valueof $204,421,565 and coupon interest of 6.5 per cent per annum payable bi-annually— a total of $66.51 million payable over the five-year period. At maturity infive years, the principal amount of $204,421,565 was to be repaid unlessDeutsche Bank exercised its option to take 1,025 non-voting shares in Frucor insatisfaction of the loan. It is common ground that Deutsche Bank would elect to haverepayment of the principal amount satisfied by the issue of the shares in all but adoomsday scenario. However, if, for whatever reason including incapacity,impossibility or illegality, Frucor failed to issue the shares on the redemption date,Frucor was obliged to pay the redemption amount in cash.10Forward purchase deed[16] A forward purchase deed between Deutsche Bank (as seller), DAP (as buyer)and Compagnie Gervais Danone (as novation counterparty) for the purchase by DAPof the 1,025 non-voting shares in Frucor to be issued to Deutsche Bank pursuant tothe convertible note deed. The forward purchase deed was conditional upon the issueof the convertible note and the execution of the side letter referred to below. In termsof the forward purchase deed, DAP was required to make an upfront payment of$149 million to Deutsche Bank on the issue date of the convertible note (18 March10 Under the convertible note deed, the redemption amount was equal to the aggregate ofthe principal amount and all accrued, unpaid interest owing at the redemption date.2003) in return for the transfer of the shares in five years' time (upon receipt byDeutsche Bank on maturity of the note).[17] Again, it is common ground that this is how the forward purchase agreementwould be completed in all but a doomsday scenario. However, two other possibilitieswere provided for. First, in the event the shares were not issued by Frucor as requiredunder the convertible note deed despite notice of share election having been given byDeutsche Bank, then Deutsche Bank would satisfy its obligations under the forwardpurchase deed by paying the novation amount to Compagnie Gervais Danone asthe novation counterparty. This obligation was conditional on Deutsche Bank havingreceived the redemption amount. Secondly, in the extremely unlikely eventDeutsche Bank did not give notice to Frucor requiring its obligations to be satisfiedby issuing the shares on the maturity date, then, subject to Deutsche Bank receivingthe redemption amount, it was required to pay that amount to DAP grossed up to coverDAP's liability to pay tax in Singapore on the difference between the redemptionamount ($204,421,565) and the purchase price ($149 million). The evidence was thatthis tax liability would be approximately $14 million.Side letter[18] A side letter in terms of which Deutsche Bank, DAP and Compagnie GervaisDanone agreed for the purposes of s EH 48(3)(a) of the Income Tax Act 1994(then applicable) that $204,421,565 was the lowest price the parties would haveagreed on the date of the forward purchase agreement if payment was required in fullat the time the shares were transferred.Convertible note guarantee[19] A guarantee between Groupe Danone and Deutsche Bank wherebyGroupe Danone guaranteed Frucor's payment obligations to Deutsche Bank underthe convertible note deed up to a maximum of $250 million. Deutsche Bank paida guarantee fee of 0.1 per cent per annum on the $204 million principal amount, withpayment of this fee being made bi-annually on the same dates as interest was payableon the convertible note.Forward purchase guarantee[20] A guarantee between Groupe Danone and Deutsche Bank in terms of whichGroupe Danone guaranteed DAP's payment obligations to Deutsche Bank underthe forward purchase agreement up to a maximum of $67 million. DAP's solepayment obligation under the forward purchase agreement was the upfront paymentof $149 million. The figure of $67 million covered Deutsche Bank's exposure tothe note, being the amount of $55 million (plus interest) it contributed over and abovethe purchase price of $149 million paid by DAP. There was no fee payable toGroupe Danone in connection with this guarantee.Steps at inception — 18 March 2003[21] On the issue date, 18 March 2003, DAP paid $149 million under the forwardpurchase agreement to Deutsche Bank. This payment was funded by a loan of$89 million from a third party lender, BNP Paribas (based in Singapore). The balanceof $60 million was funded by a payment from Frucor to DAP to re-purchase 400 of itsshares at the issue price of $150,000 per share.[22] Deutsche Bank borrowed $55,534,000 from Deutsche Bank Treasury inSingapore. Of this, $55,421,565 was added to the $149 million received from DAP tomake up the advance of $204,421,565 paid to Frucor under the note.[23] As noted, Frucor applied $60 million of the borrowing to pay DAP forthe re-purchase and cancellation of 400 of its shares. The balance of $144 million wasused to repay the loan from Danone Finance mentioned at [1]. Frucor also paidDeutsche Bank's fee of USD 1 million (NZD 1,816,860) for organising the fundingarrangement.Steps at maturity — 18 March 2008[24] On 20 February 2008, Deutsche Bank duly gave notice to Frucor in accordancewith the convertible note deed requiring it to satisfy its obligations to repaythe principal amount outstanding by issuing shares on the maturity date. At maturityon 18 March 2008, Frucor issued 1,025 new non-voting shares to Deutsche Bankwhich immediately transferred those shares to DAP pursuant to the forward purchaseagreement.Subsequent return of capital[25] We note for completeness that later in the year, on 22 December 2008, Frucorre-purchased from DAP 747 non-voting shares and 307 ordinary shares therebyreturning $204,421,565 of surplus capital to DAP. This followed DAP's sale inOctober 2008 of 100 per cent of the shares in Frucor to Suntory (NZ) Ltd, a subsidiaryof a Japanese beverage manufacturer and distributor.Legal principles[26] Section BG 1 of the Act provides that a tax avoidance arrangement is void asagainst the Commissioner for income tax purposes. Tax avoidance is defined bys OB 1 of the Act to include directly or indirectly altering the incidence of any incometax. Income tax means New Zealand income tax imposed under the Act.11A tax avoidance arrangement is an arrangement that directly or indirectly has taxavoidance as its purpose or effect, or has tax avoidance as one of its purposes or effectsif the purpose or effect is not merely incidental. An arrangement means an agreement,contract, plan or understanding (whether enforceable or unenforceable), including allsteps and transactions by which it is carried into effect.[27] The leading authority on tax avoidance in New Zealand is the Supreme Court'sdecision in Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue.12The majority (Tipping, McGrath and Gault JJ) considered that the specific taxprovisions and the general anti-avoidance provision should be construed so as to giveappropriate effect to each.13 An arrangement includes all steps and transactions bywhich it is carried out. Even if all the steps are unobjectionable in themselves, taxavoidance may be found in their combination.14 A two-step approach is required.First, it must be determined whether the use made of the specific provision is within11 Income Tax Act 2004, s OB 6.12 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue [2008] NZSC 115, [2009] 2NZLR 289.13 At [103].14 At [105].its intended scope. If so, the second question is whether the taxpayer has usedthe specific provision to alter the incidence of income tax in a way that cannot havebeen within the contemplation of Parliament when enacting the provision.15Relevant factors in this assessment may include the manner in which the arrangementis carried out, the role of all relevant parties and their relationship with the taxpayer,the economic and commercial effect of the transactions, the duration of thearrangement and the nature and extent of the financial consequences for the taxpayer.A classic indicator of the use of a specific provision outside Parliament'scontemplation is where an arrangement is structured to enable the taxpayer to gain thebenefit of a specific provision in an artificial or contrived way.16[28] The court must look beyond purely legal considerations and have regard tothe use of the specific provision in the light of the commercial reality and economiceffect of that use. The majority summarised the ultimate enquiry in these terms:17The ultimate question is whether the impugned arrangement, viewed ina commercially and economically realistic way, makes use of the specificprovision in a manner that is consistent with Parliament's purpose. If that isso, the arrangement will not, by reason of that use, be a tax avoidancearrangement. If the use of the specific provision is beyond parliamentarycontemplation, its use in that way will result in the arrangement being a taxavoidance arrangement.High Court judgment[29] There was no contest on the first step of the Ben Nevis enquiry. It is commonground that in terms of the specific provisions Frucor was entitled to claim a deductionfor the $66 million paid to Deutsche Bank as interest on the $204 million advance.18[30] Turning to the second question, the Judge assessed the arrangement in the lightof the factors identified in Ben Nevis under four headings: the manner in whichthe arrangement was carried out; the role of all relevant parties and their relationshipto the taxpayer; the economic and commercial effect of the documents; and whetherthere was artificiality and contrivance.15 At [107].16 At [108].17 At [109].18 High Court judgment, above n 5, at [89].[31] The Judge commenced by noting that the transaction involved real moneyflows. DAP borrowed $89 million from BNP Paribas. DAP paid $149 million toDeutsche Bank. Deutsche Bank paid $204 million to Frucor. Frucor paid $144 millionto Danone Finance and $60 million to DAP for the share buyback. Frucor madebi-annual payments of interest at the agreed rate of 6.5 per cent per annum on the facevalue of the note over the five-year term. There was no dispute that all of this involved"real money".19The manner in which the arrangement was carried out[32] The Judge observed that there was a degree of circularity because ofthe contemporaneous re-purchase of share capital from DAP and DAP's forwardpurchase of share capital.20[33] The Judge accepted that the manner in which the face value of the note wasfixed was "unusual". The "very particular sum" ($204,421,565) was a "strongindicator" that the company's medium term financing requirements did not drivethe face value of the note.21 The Judge found that the amount of the note was fixed byadding to the sum of $149 million payable under the forward purchase agreementthe present value of five years' worth of coupons calculated by reference tothe five-year New Zealand dollar swap rate.22 The price did not reflect any share pricevolatility as would normally be the case where funding is provided using a convertiblenote instrument.23[34] However, the Judge considered that because this was an off-market transactionin the context of "a related party refinancing or debt-equity adjustment", this was not"a significant indicator of avoidance".24 Although "the pricing may have beenunorthodox in an open market context", the rate was not "artificially increased tomaximise deductions". The factors driving the price in this off-market transaction did19 At [141(a)].20 At [141(b)].21 At [141(c)].22 At [141(d)].23 At [141(e)].24 At [141(f)].not "predicate avoidance". To find otherwise "would be to place convertible noteswithin a straightjacket of orthodoxy".25[35] The Judge considered it was useful to benchmark the arrangement againstalternative structures identified by Frucor in its submissions. These included:Frucor borrowing an additional $60 million from Danone Finance to achieve itsdesired debt/equity ratio; DAP or Danone Finance lending $204 million to Frucor forfive years at 6.5 per cent by interest bearing debt or convertible note; and Frucorissuing a convertible note to Deutsche Bank on the same terms but withDeutsche Bank funding the $149 million forward purchase amount by way of a loanfrom DAP, Danone Finance or some other third party.26 There could be no questionof tax avoidance under any of these alternative arrangements.27 The Judge acceptedthat the distinguishing feature of these alternative arrangements was that they wouldgive rise to assessable interest in the hands of the relevant offshore Danone entitywhereas the present funding arrangement negated foreign assessable income.The Judge observed that the avoidance of foreign tax is not tax avoidance forthe purposes of s BG 1.28[36] The Judge accepted Frucor's submission that full deductibility for interest paidby it was "an entirely normative New Zealand taxation outcome of related party orthird-party debt funding" and that this outcome was not attributable to any feature ofthe arrangement that might be described as unorthodox, artificial or contrived.29The role of all relevant parties and their relationship to Frucor[37] The Judge observed that all the parties were related apart from Deutsche Bankand BNP Paribas.30 However, this was unremarkable in the context of a refinancingand equity reduction.31 The Judge accepted that it is unlikely the funding arrangementwould have been entered into without DAP's participation and its relationship toFrucor. Deutsche Bank was not in the business of acquiring equity holdings in groups25 At [141(g)].26 At [141(j)].27 At [141(k)].28 At [141(l)].29 At [141(m)].30 At [142].31 At [143].such as Danone, the shares were non-voting, and there was no history of Frucordeclaring dividends. The forward purchase agreement ensured that the ownership ofFrucor would remain unchanged. DAP intended that Deutsche Bank would simply bea conduit of the shares.32[38] Deutsche Bank's role was seen to be pivotal. It was the architect of the schemeand it received a fee of $1.8 million for its role. The Judge accepted thatDeutsche Bank's lending was not intended to generate any return and the only benefitto Deutsche Bank beyond the fee was the anticipated enhancement of its relationshipwith Groupe Danone.33The economic and commercial effect of the documents[39] The Judge summarised the Commissioner's position that the commercial andeconomic reality was that Deutsche Bank provided funding of $55 million on whichFrucor paid $11 million in interest.34 The balance of $149 million was paid to Frucorby DAP with Deutsche Bank merely acting as a conduit in what was a "costlessexercise".35 The Judge said it was "correct that on a Danone Group basis this is exactlyas the transaction was understood, including for accounting purposes". It was alsocorrect that Deutsche Bank "regarded itself as introducing $55.4 million of net fundingfor which its return of $11.09 million was largely offset by its funding costs, guaranteefees and the cost of the credit default swap it entered into".36[40] However, the Judge expressed reservations about the Commissioner'sapproach on this aspect of the analysis. Mr Smith QC, for the Commissioner, wasparticularly critical of this part of the Judge's reasoning, so we set out the relevantpassage in full:[153] The difficulty from an analytical point of view is that if it is notpossible to undertake the s BG 1 inquiry by inference to an economicallyequivalent arrangement (which I accept), why should it nevertheless bepossible, under the pretext of considering the economic and commercial effectof the transaction to, in this case, regard DAP's $149 million forward purchase32 At [144].33 At [145]–[147].34 At [150(a)].35 At [150(b)].36 At [155].from [Deutsche Bank] as a contemporaneous $149 million capital injectioninto its subsidiary at the commencement of the term? The prohibition onidentification of an economically equivalent arrangement becomes, in thatcontext, almost meaningless — a mere checkpoint for the Commissioner todivert around, all the while maintaining the same recharacterisation argument.I have difficulty with that approach.[41] The Judge continued:[156] However, the Commissioner's approach presupposes, in the contextof attempts first to divine parliamentary intention and then to benchmarkagainst it, two propositions which are contentious. They are:(a) The Arrangement is assessed in terms of its overall impact ata group or consolidated level looking (to the exclusion ofthe monies unarguably received and expended by [Frucor]) atthe net external position of entities under common control;and(b) [Frucor] does not incur a cost requiring tax recognition whenit issues shares to satisfy its debt liability.Artificiality and contrivance[42] The Judge turned to consider whether Frucor gained the benefit ofthe specific provision in an artificial and contrived way, cautioning that this was"not simply whether, compared to arm's length norms, aspects of the transactionmight be described as unorthodox or even artificial".37[43] The Judge accepted there was an element of circularity as identified bythe Commissioner but he considered this did not materially advance her case becausethe payment by DAP to Deutsche Bank ($149 million) discharged a genuinecontractual liability and Frucor's payment of part of Deutsche Bank's investment toDAP ($60 million) had both a legitimate commercial purpose and resulted ina "real change to Frucor's funding structure". The Judge did not see the circularity asbeing in the "offensive" category.38[44] The Judge accepted that the note was "unorthodox" given its "unusuallyprecise face value" and that it "was priced as if it was a non-convertible instrument".37 At [158].38 At [163].However, the Judge did not see this as evidence of artificiality and contrivance.39The Judge also accepted that the commercial relationship between Groupe Danoneand Deutsche Bank "assumed a share 'pass through' and DAP's ongoing 100 per centownership of its subsidiary" but said that "does not establish artificiality".40 The Judgeconsidered that whether the convertible note was effectively mandatory rather thanoptional was "irrelevant to the core issue of deductibility" and "takes the matter littlefurther".41[45] The Commissioner argued that there could be no non-tax reasons for usinga convertible note backed by a forward purchase agreement in circumstances whereDeutsche Bank could not participate in any equity uplift and DAP already owned allthe shares in Frucor. The Judge answered this submission by saying that it ignored orunderstated tax reasons "which featured in the calculus but are, in fact, legitimate aimsthat are not indicative of New Zealand tax avoidance".42 Here, the Judge was referringto the non-taxable gain to DAP in Singapore for the difference between the$149 million paid under the forward purchase agreement and the pre-agreed value ofthe shares in five years' time ($204,421,565).[46] The Judge rejected the Commissioner's submission that the shares issued byFrucor to Deutsche Bank in satisfaction of the note came at no cost to Frucor.43He considered that "a focus on 'cost' is capable of misdirecting the requiredanalysis".44 The Judge ultimately saw the issue as being a simple one:45Either the issuance of shares is regarded by Parliament as sufficientlycommercially and economically real to discharge debt liabilities or it is not.And all the pointers to parliamentary contemplation are that such commercialand economic reality is well recognised.[47] The Judge was satisfied the shares not only constituted good consideration,they had real value. Even with the restriction on voting rights, the shares would haveachieved a price if offered on the open market. There was therefore an opportunity39 At [164].40 At [170]–[171].41 At [172].42 At [166].43 At [173]–[193].44 At [177].45 At [190].cost to Frucor in issuing the shares to Deutsche Bank. There was also somecommercial risk, however well-managed, in issuing shares to an unrelated thirdparty.46Overall assessment[48] Having addressed these various factors, the Judge turned to his overallassessment of whether this was a tax avoidance arrangement.47 He commenced bystating that he found the test difficult to apply, noting that the exercise "can bean elusive quest".48 The starting point was that Parliament can be assumed to haveintended that a taxpayer could take a deduction for interest economically incurred,deduct financial arrangements expenditure deemed to be incurred over the life ofa financial arrangement, account for tax on a separate entity basis if a member ofa multi-national group and issue shares to satisfy a liability to a third party, includingits parent.49 Parliament contemplated the use of optional convertible notes and thatcoupons on them calculated at an arm's length rate would ordinarily be deductible.The Judge considered Parliament was "agnostic" about the use of convertible notestructures between parent and subsidiary.50 He considered it relevant that other debtstructures could have been used to deliver the same tax benefits to Frucor withoutprospect of challenge under s BG 1.51[49] The Judge re-stated that Frucor received $204 million in cash fromDeutsche Bank. He said this could not be "gainsaid". He emphasised that this was"real money" and it was "expended". The interest was incurred and paid.52[50] The Judge considered that "the grouped 'economic' approach" said to havebeen adopted by the Commissioner was inconsistent with New Zealand's internationaltax regime and also selective because it ignores that $89 million ofthe forward purchase payment was funded outside the Danone group by46 At [193].47 At [194]–[204].48 At [194].49 At [195].50 At [197].51 At [198].52 At [199].BNP Paribas.53 Further, applying the Commissioner's analysis, the fundingarrangement involved principal payment deductibility even if satisfaction of the noteand forward purchase agreement occurred by way of cash settlement or novation.54The Judge considered that the funding arrangement had "legitimate economic drivers,primary among them offshore tax minimisation".55 The Judge concluded that theCommissioner had not appropriately invoked s BG 1:56Interest was incurred by [Frucor] both legally and, at a single-entity level,economically. And it was actually paid. The deduction did not depend onthe taxpayer reverse engineering a deduction by application of the financialarrangement rules. Nor did the transaction involve back-to-backarrangements, each akin to the other, in the manner now typically assumed toinfringe s BG 1.Submissions on appeal[51] As noted, Mr Smith acknowledges that the legal form of the arrangementsatisfies the relevant deduction provisions — s DB 7 of the Act (allowing a deductionfor interest incurred) and the financial arrangements rules in subpt EW of the Act(together the specific provisions). However, he submits that in economic terms,Frucor effectively received $149 million from its 100 per cent parent in return for1,025 shares which it issued to its parent five years later. He contends the issue ofthose shares came at no cost to Frucor and Deutsche Bank was merely a conduit forboth transactions. Mr Smith argues that Frucor has claimed deductions as if it hadmade interest payments of $66 million whereas, in reality, this was the amount ofprincipal and interest required to discharge the loan of $55 million by Deutsche Bank.[52] Mr Smith claims the Judge did not carry out the second stage of the Ben Nevisenquiry, instead adopting a "threshold" approach, in which there is no room for s BG 1if the specific provisions are met. This approach was doubted by this Court and firmlyrejected on appeal in the Supreme Court.57 Mr Smith argues that the Judge placedimproper emphasis on the legal form of the transactions and their "black letter" law53 At [196].54 At [200].55 At [203].56 At [203].57 Accent Management Ltd v Commissioner of Inland Revenue [2007] NZCA 230, (2007) 23 NZTC21,323 at [116]– [118] and Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue,above n 12, at [104] n 113.compliance. In doing so, he contends that the Judge failed to examine the economicsubstance of the arrangement, wrongly concluding that to do so would involvetaxation by economic equivalence.58 Further, he says the Judge's statement that"a focus on 'cost' is capable of misdirecting the required analysis" was incorrect.59Mr Smith submits that, on the contrary, the enquiry under s BG 1 requiresconsideration of the commercial and economic reality of the $204 million fundingamount. He says Parliament cannot have intended that a forward purchase of equityby a 100 per cent parent at a pre-agreed higher future value should entitle the issuer toa tax deduction for interest expenditure in the amount represented by the pre-agreedvalue increase. Mr Smith also submits the Judge was wrong to find that theunorthodox and unusual features of the transaction were not significant or indicativeof tax avoidance. Finally, he contends that the Judge misapplied the "merelyincidental" test in the definition of "tax avoidance arrangement" in s OB 1 of the Act.[53] Mr L McKay, for Frucor, submits that Muir J was not only correct to find thats BG 1 had no application to the arrangement, but that all steps in his reasoning werealso correct. This reflects the Judge's acceptance of Frucor's arguments in theirentirety.[54] Mr McKay says the "significant error" in the Commissioner's position is totreat the Danone group exposure to Deutsche Bank as the basis for carrying outthe second stage of the Ben Nevis enquiry. He says that is fundamentally contrary toParliament's intention that the tax position of a New Zealand subsidiary ofan international group must be determined as a single economic entity, not ona consolidated group basis. The Commissioner's "net loan" or "group" approach isinconsistent with Parliament's intention that transactions between New Zealandresident taxpayers and offshore group members should be taxed on an independent,arm's length basis. An interest payment is not to be disregarded because it is made toan offshore group member and would be ignored by both entities under financialreporting consolidation. So, for example, the initial loan from Danone Finance ofaround $150 million, which attracted an arm's length margin of interest above58 High Court judgment, above n 5, at [149]–[154]. Mr Smith refers particularly to [153] which wehave quoted at [40].59 At [177].the floating rate, would be disregarded on consolidation but would be fully recognisedin determining Frucor's deductible interest expenditure and taxable income.[55] Mr McKay submits that the Commissioner's "economically costless"proposition is based on the same flawed analysis advanced by her experts in supportof the "group" approach. He points out that the issuance of equity is disregardedapplying this approach even under the cash and novation redemption alternativesprovided for in the forward purchase agreement. Mr McKay submits thatthe Commissioner's "no cost" argument is wrong in any event. Parliament plainlycontemplated that a debt discharged through the issuance of shares would not preventfull interest deductibility for the debt. It is well established that shares issued for aconsideration other than cash must be treated as at least equal in value to the par valueof those shares. There is no distinction in this context between shares issued to a parentor to a third party. He says there is no reference in any relevant determinationssuggesting that debt remission income arises to a debtor/issuer on the basis ofthe absence of economic cost in the share issue.60 Further, he argues that the "costless"proposition conflates as a one-step transaction what could equally be two, namely apayment for shares and the use of the proceeds to repay the debt. Mr McKay submitsthat Parliament must be taken to have contemplated that the discharge of a debtliability through share issuance would have no impact on the issuer's entitlement tointerest deductions otherwise available on the debt.[56] Mr McKay argues that even if the proper analysis is to view Frucor as receiving$149 million from DAP in return for the issue of shares in five years, this would bea financial arrangement entitling Frucor to a $55 million deduction for the differencebetween the $149 million (assumed) receipt and the $204 million tax value ofthe shares at the end of the five-year period.[57] In summary, Mr McKay submits that the economic and commercial reality ofFrucor's position was that it borrowed $204 million. It used this money to repayborrowing from Danone Finance (as to $144 million) and to fund the share buyback(as to $60 million). In terms of International Financial Reporting Standards (IFRS),60 See at [108]–[114] and [183]–[193] for a discussion on Determination G22/G22A (optionalconvertible notes) and Determination G5C (mandatory convertible notes).and in particular IFRS 10, Frucor was required to recognise a liability of $204 millionand an interest cost of $66 million. All Deutsche Bank and Danone documentsconfirmed these liabilities of Frucor. Even on a group basis, the Danone group liabilityto unrelated parties was higher than $55 million ($89 million having been borrowedfrom BNP Paribas).Tax avoidance[58] There is no doubt that, as a matter of legal form, Frucor was able to make useof the relevant specific provisions to claim a full deduction for the interest expenditureon the sum of $204,421,565. As the Judge found, this sum was advanced to Frucorand expended by it. There is also no question that Frucor paid approximately$66 million in interest calculated on this sum at the agreed rate over the five-year term.[59] Nevertheless, for the reasons set out below, we have reached the conclusionthat Frucor used the specific provisions to claim deductions for interest in an artificialand contrived manner that cannot have been within Parliament's contemplation.We consider that when the economic and commercial effect of the fundingarrangement is examined in its context, it becomes clear that tax avoidance was itsprincipal purpose or effect or, at least, tax avoidance was not merely an incidentalpurpose or effect of the arrangement. In summary, we accept the Commissioner'ssubmission that by entering into the funding arrangement Frucor achieved a$66 million interest deduction without incurring a corresponding economic cost forwhich Parliament intended deductions would be available. As a matter of commercialand economic reality, $55 million of the claimed interest represented the repayment ofprincipal borrowed from Deutsche Bank and was not an interest cost. We havetherefore concluded that the Commissioner was entitled to invoke s BG 1.Evidence in the High Court[60] There is no dispute about the relevant background. The funding arrangementwas based on a generic tax driven convertible note funding structure developed byDeutsche Bank at some stage prior to 2002 for promotion to its clients. By 2002,Deutsche Bank had executed the structure in various different jurisdictions, includingNew Zealand, and claimed to have received "positive rulings" from tax advisors.Danone Groupe was familiar with the structure, having considered using it inconjunction with Deutsche Bank for an earlier proposed transaction in Argentina.[61] In late 2001, Deutsche Bank discussed with Danone the possibility of usingthe convertible note structure as a means of financing the then proposed acquisition ofFrucor Beverages Ltd in New Zealand. In January 2002, Deutsche Bank presentedtwo "Efficient Financing Alternatives for Danone in New Zealand". We referred tothis at [9] above. This presentation was prepared prior to the purchase. It records thatDanone was currently looking at various financing alternatives "in connection with its[$294 million] take-over offer". The figure of $294 million compares with the priceagreed on 14 January 2002 of $297,522,000. The proposal also assumes that therewill be no minority shareholders, recording that "Danone has obtained 90% of Frucorand is therefore in a position to claim the remaining 10%". However, in the eventminority shareholders remain whose approval would be required to issue the note, aworkaround is suggested.[62] The so-called efficient financing alternatives presented by Deutsche Bank werethe convertible note structure and an alternative structure styled "TrademarkFinancing". It is clear that the perceived 'efficiency' lay in the tax benefits.[63] The convertible note structure was addressed under four headings — Structure,Tax Treatment, Advantages and Constraints. Although the transaction was describedas a "5-year convertible bond", the underlying premise was that repayment ofthe advance would inevitably be satisfied by the issue of shares. So, for example, itstated that the note "will convert into a fixed number of shares" and "Deutsche Bankwill deliver NZ SPV shares to Danone UK in 5-year[s'] time" (emphasis added).At that stage it was expected (based on discussions in late 2001) that Danone UKwould provide the funding. However, Deutsche Bank stated that other Danone entitiesin "countries such as Germany or Luxembourg could be considered".[64] After the brief outline of the structure, Deutsche Bank addressed the taxtreatment by stating: the coupons payable by the New Zealand entity onthe convertible note would be fully deductible, there should be no capital gains tax onthe acquisition of the shares purchased by the Danone subsidiary; and the fundingcosts of Danone UK should also be fully deductible. We note in passing that on12 March 2003, shortly prior to the transaction closing, Deutsche Bank calculated thatthe "pre-tax equivalent benefit from the transaction" was approximately $24 million.[65] The advantages of the proposal were said to be that the structure was familiarto Danone and there would be no VAT or GST issues. The single constraint mentionedwas that a "75% thin capitalisation rule applies in New Zealand and should be takeninto account in order to determine the size of the transaction". Assuminga $300 million acquisition, the note could not exceed $225 million.[66] Danone advised Deutsche Bank in early February 2002 that it wished to goahead with the convertible note structure and suggested the fee that should be paid toDeutsche Bank for its role. This was confirmed in an internal Deutsche Bank emailon 4 February 2002 which set out the next steps stipulated by Danone:Actually Yes!They've now confirmed they want to go ahead with the convertible structure.Next steps they've asked for are (i) New Zealand memorandum/opinionconfirming deductibility of coupons; (ii) UK memorandum/opinion relatingto forward purchase; and (iii) termsheet.The UK side of this I had prepared before when we looked at the Argentiniandeal. Can you get something from an [sic] NZ lawyer for them? Onthe termsheet I'll start a draft and send it over to you.Concerning fees they have suggested upfront arrangement fee of $1mio pluscredit spread and costs (the idea would be that the credit spread is set byCorporate Bank in Paris who provide risk weighted assets and take the creditrisk in return for earning the credit spread. Accordingly SCM [Deutsche BankStructured Capital Markets] just keeps the upfront fee but has no credit risketc). Danone's justification for this level of fee is:1. Fees for these transactions in Europe are generally 1% of the principal.Here the principal on the notes is only about $80mio;2. We had agreed to execute the Argentinian transaction for this pricing(although this is because it would have been a ground-breaking transaction forEmerging Markets in Argentina. Also we expected to earn more by sellingthe notes to a tax sparing investor);3. They have (apparently) been inundated by other banks willing toexecute this structure with them in New Zealand (they have a moralcommitment to us arising out of Argentina).Accordingly we should probably accept this but let me know what you think(there is also a lot of glory in this with DCM who have been trying to developthe relationship with Danone).[67] Three points may be noted about this email. The first is that full deductibilityof the coupons payable by the New Zealand entity (Frucor) was critical; confirmationof this was the first required step. Secondly, the "principal" that Deutsche Bank wouldlend on the convertible note was estimated to be about $80 million. This compareswith the eventual figure of $55 million. This is consistent with the Commissioner'scontention that, as a matter of economic reality, the principal was $55 million andthe $66 million claimed as an interest expense represented the repayment of thisprincipal plus interest on it. Thirdly, this email shows that this was an unusual lendingtransaction, purposely structured to achieve tax benefits. For example, the lender doesnot normally have zero credit risk and stand to profit from the transaction only byreceipt of an upfront fee. Nor is it usual for the borrower to suggest the fee. The focusis on the shares, with no serious consideration given to the prospect of the loan beingrepaid in cash.[68] By 24 May 2002, the expected face value of the note was $225 million andthe forward purchase payment $154 million. The $225 million equated to 75 per centof $300 million, thus complying with the thin capitalisation rules. The calculation ofthe $154 million was explained in a document distributed on that date headed"Project Falcon", the project name ascribed to the transaction by Deutsche Bank.The purchase price payable by DAP "on day one will be calculated as the face valueof the convertible note less the present value of the convertible note coupon paymentsdiscounted at the applicable zero coupon swap rate plus credit margin (0.35%)".By way of illustration, if the face value of the note was $225 million, then the purchaseprice payable under the forward purchase agreement would be $154 million, being$225 million less $71 million (the present value of semi-annual coupons of$8.7 million at the then applicable interest rate of 7.736 per cent per annum).Deutsche Bank would fund the "net investment" (approximately $71 million) from itsnormal market sources for New Zealand dollars "swapped to an amortising flow thatmatches the profile of the net investment". There is a brief explanation of what willhappen on termination in five years — "the convertible note will be cancelled anda fixed number of ordinary shares will be issued by [Frucor] to [Deutsche Bank] underthe conversion terms of the note. [Deutsche Bank] will deliver a completed transferin respect of those shares to [DAP]." The purpose of the arrangement was set outunder a heading "Summary" — "[the] structure provides term funding to [Frucor] atan after tax cost that is significantly below the Group's normal cost of funds(ie. pre-tax equivalent of approximately minus 1.50%)".[69] This document was used as a template and updated from time to time asthe transaction progressed towards completion. By 18 September 2002, the figureshad changed somewhat, including because of interest rate fluctuations. The face valueof the note was now expected to be $215 million and the forward purchase price$151 million, being $215 million less $64 million (the present value of semi-annualcoupons of $7.69 million or 7.15 per cent per annum). By this time, there was someadditional protection for Danone in that the shares to be issued by Frucor would benon-voting (the word "ordinary" before "shares" has been struck through onthis revision).[70] The net funding figure of $64 million had dropped to $61 million by29 November 2002. An internal Deutsche Bank email sent on that date explainedthe net effect of the transaction — "Danone raises approx NZD61m for [five] years onamortising basis". Again, this is consistent with the Commissioner's contention thatFrucor claimed interest deductions for what were, as a matter of commercial reality,repayments of principal and interest over five years.[71] An internal Deutsche Bank approval document prepared based on data as at2 December 2002 provides further confirmation of the purpose of the five-yearstructured transaction — it "is designed to provide cheaper, tax efficient funding to[Frucor]". The difference between the face value of the note (then $225 million) andthe forward purchase payment ($154 million), being $71 million, "will be amortisedfrom the convertible coupons (nominal payments estimated at NZD 87mn)". It can beseen that the payments to be made by Frucor represented repayment of principal andinterest over the five-year term on an amortising basis. This was how the tax efficiencywas to be achieved — Frucor would claim interest deductions for what were describedas "nominal payments" of interest of $87 million on the face value of the note($225 million) but, in effect, paying principal and interest on the net funding amountof $71 million.[72] A closing agenda was prepared in the lead up to signing. This anticipated thatexecution versions of the documents would be circulated on 3 March 2003.Rate setting would occur on 6 March 2003 at 8 pm New Zealand time. This woulddetermine the final amounts to be written in to the documents. Execution ofthe transaction documents and formal issue of the required professional opinions(in the relevant jurisdictions) would follow in sequence half an hour later:6 March 2003 Rate Setting:8.00am (Paris time)/ 8.00pm (NZ time)/ 3.00pm (Singaporetime):1. [Deutsche Bank] calculate forward purchase priceand convertible coupon rate2. [Groupe Danone] agrees forward purchase price andcoupon rate3. Russell McVeagh inserts forward purchase price andcoupon rate into final documents and faxes relevantpages to [Groupe Danone]Execution of documents:8.30 am (Paris time)[73] By 3 March 2003, the forward purchase amount was fixed at $149 million.Instead of this figure being derived from the face value of the note using the applicablediscount rate, the reverse position was adopted. The face value of the note becamea function of the forward purchase amount. At that stage it was anticipated thatthe rate would be set at 9 pm New Zealand time with the designated person atDeutsche Bank advising his counterpart at Danone of the five-year swap rate andthe consequent "net funding amount", both to be confirmed by Danone:Rate set Thurs 6 Mar at 9.00 am Paris time/ 9.00 pm NZ time/7.00 pmSydney:1. [Deutsche Bank representative] advise [Danone representative] 5 yrswap rate2. [Deutsche Bank] calculate net funding amount and advise [Danonerepresentative].3. Convertible Principal Amount is total of NZD149m (ie ForwardPurchase Price) + net funding amount.4. [Danone representative] to confirm that he is happy with 1,2 &3above.[74] One of the few available Danone documents is an internal memorandum senton 11 March 2003 by Pierre-André Terisse, the Danone representative referred to inthe email quoted above and the person responsible for agreeing to the "net fundingamount" and the final amount of the note. Mr Terisse explained that his memorandumwas "intended to give a brief description of the transaction for signatories".His memorandum included the following summary:The structure, established by Deutsche Bank, works as follows:- issuance by [Frucor] of 215 m NZD convertible bonds, subscribed byDeutsche Bank- Deutsche Bank keeps the principal amount, which gets reimbursed over5 years- But sells the conversion rights to [DAP] for an amount of 149 m NZD- At the end of the 5 years, shares issued in repayment of the bonds aretransferred to [DAP], or, as a fallback, to Compagnie Gervais Danone.Benefits obtained- Financing cost: extremely attractive for NZD financing.- NZD financing: putting a debt in the same currency as cash-flows of thecompany acquired provides us with a natural hedging; furthermore,interest [is] located in the same country as operating income.Issues- Legal / tax issues have been checked by France Hasselman, tax opinionshave been obtained[75] The rate setting and final calculation of the face value of the note did not occuruntil 14 March 2003. An internal Deutsche Bank email sent that day followingexecution of the documents confirms: For your info, the rates/amounts agreed with Danone today are as follows:Convertible Note Principal NZD204,421,565Interest rate 6.50% pa payable 18 Sept/18 MarIssue Date 18 Mar 2003Maturity Date 18 Mar 2008Forward Purchase Price NZD149,000,000Therefore net funding amount is NZD55,421,565[76] A Project Falcon summary document prepared by Deutsche Bankpost-execution confirmed how the note issue price and the net funding amount werederived and how the net funding amount was to be serviced:The net funding requirement is therefore the difference between theconvertible note issue price and the share forward purchase price.This funding will be serviced by the convertible note interest payments. The funding for the net amount (i.e. note subscription less prepaid forwardpurchase price) was provided by [Deutsche Bank Treasury] to [Deutsche BankStructured Capital Markets] by way of a 5 yr NZD amortising loan, to be fullyserviced by the note interest payments. [77] This understanding was shared by Danone. In a document prepared on15 October 2003 concerning the Frucor funding arrangement, under a heading"Purpose and 'débouclage' of the operation", it is stated:During the 5 years, [Frucor] pays coupons to Deutsche Bank. Those couponsare analyzed differently according to tax/statutory and consolidated accounts:• For statutory, coupons considered as interest expenses deductible for taxpurposes. They amount to a total of some [$66 million] The necessarycash is provided by dividends received from Frucor.• For consolidation, coupons paid are analyzed in two separate elements 1.Reimbursement of Deutsche Bank loan for [$54 million] and 2. interestexpense on this loan for the difference, i.e. [$12 million]. As this isa permanent difference, no deferred tax shall be recorded in consolidatedaccounts.At maturity date:• [Frucor] reimburses the remaining [$150 million] loan from DeutscheBank by delivering its 40% own shares previously bought back from[DAP]• Deutsche Bank delivers those shares to [DAP], without receiving anycash, as [$150 million] were paid in advance in 2003• [DAP] holds 100% of [Frucor] shares, as it was prior to the [fundingarrangement].[78] We refer to one more Danone document confirming the nature and purpose ofthe arrangement. This document, which is not dated, includes the following section:What was the point of the scheme?The scheme allowed [Frucor] to finance the purchase of Frucor in a way thatwould entitle it to tax credits for the life of the scheme.Under the arrangement [Frucor] made two coupon payments to[Deutsche Bank] each year. The coupon payments were approximately $7mper payment and were funded by payment of a fully imputed dividend to[Frucor]. These coupon payments were treated differently for Managementand Statutory purposes.For Stat (and Tax) purposes, the whole payment was treated as an interestexpense. The interest payment was 100% deductible. Total payments overthe life of the scheme added up to $66m, which equated to $21.8m of taxcredits (approx $4.4m for each year of the scheme's life).For Management purposes, part of the payment was treated as an interestexpense, and part was treated as repayment of the principal of the convertiblenote loan.[79] Professor Moorad Choudhry was one of the expert witnesses called bythe Commissioner.61 Professor Choudhry has specialist expertise in debt capitalmarkets, bond and fixed income instruments and convertible bonds. His assessmentof the Frucor convertible note (which we accept) was as follows:75. The [Frucor] bond is a [convertible bond] or note in name only. It wasissued not to enable a growing company to offer shares to outside investorswho were prepared to lend it money at a lower rate because they wanted tobenefit from the rise in value of said shares: the seller was already whollyowned by a company that entered into a legal agreement to own these sharesultimately. The lender had no interest in acquiring shares in [Frucor], whichwere not offered in any case, and simply structured a transaction that generated61 Professor Choudhry, who lives in Surrey, England, is a Fellow of the Chartered Institute forSecurities and Investment and the London Institute of Banking and Finance. He has a PhD infinancial economics from the University of London and is an Honorary Professor at University ofKent Business School. He is currently a partner in Moorad Choudhry Financial Ltd. In hisprofessional career spanning over 30 years, he has held senior positions at major investment banksand other financial institutions. Professor Choudhry has published numerous books and articles,including on debt capital markets, bond and fixed income instruments and convertible bonds.tax benefits for [Frucor] in return for a fee. [Deutsche Bank NZ] exposeditself to no credit risk to [Frucor], and its exposure to Danone Group duringthe life of the convertible note was transferred to [Deutsche Bank Paris].76. It may well be that [Frucor] entered into the transaction, and appliedfor tax relief on the convertible note debt interest, in good faith and inthe understanding that tax treatment of its debt interest would be as expected.That said, there is no doubt that this is not a conventional [convertible bond]but rather a "pretend" construct of a [convertible bond], which has the effectof generating a tax benefit.77. Critically, without the advice and solutions presented by theinvestment bank in the first instance, it is highly unlikely that the treasurydepartment of a corporate entity would propose the use of a convertible bondissued by a subsidiary it already owned, in this way. In any other context[,]other than the New Zealand tax relief one[,] this transaction would bedescribed by a neutral observer as having no purpose.[80] Stanley Marcello Jr., the Senior Director of Tax for Danone North America,was the only witness to give evidence for Frucor. He was the Senior Regional TaxManager of DAP from 1 April 2015 to 27 November 2016. His first role withthe Danone group of companies commenced in February 2006, three years afterthe funding arrangement was implemented. Mr Marcello provided a summary ofthe transaction documents and their context. Although he had no personalinvolvement in the funding arrangement, Mr Marcello suggested several reasons whyit may have been entered into (apart from the New Zealand tax benefit). These werecash accumulation/retention benefits, future expanded capital base, Singaporean taxtreatment, lower fixed interest rate funding for Frucor, local currency funding andimproved debt/equity ratio for Frucor.[81] However, we accept Mr Smith's submission based on Professor Choudhry'sevidence that these outcomes were readily achievable simply by borrowing the sameamount from a bank in New Zealand over the same term at the same interest rate.At the end of the five-year period, Frucor could then have issued shares to DAP inexchange for the principal amount required to repay the bank. No tax would bepayable by DAP in Singapore in respect of the receipt of these shares. No fee of$1.8 million would need to be paid to a third party. Mr Marcello's evidence thereforedoes not assist in explaining why this convertible note structure would have beenadopted, if it was not for a tax-driven purpose.Assessment[82] It seems to us to be reasonably plain that the funding arrangement hadNew Zealand tax avoidance as one of its purposes or effects and this was not merelyincidental to some other purpose. The primary purpose of the funding arrangementwas the provision of tax efficient funding to Frucor. That was its stated goal. The taxadvantage was gained in New Zealand through the interest deductions Frucor claimed.DAP (in effect) paid $149 million to Frucor for the shares on day one but with thepayment being structured to enable Frucor to claim interest deductions on it overa five-year term. This tax beneficial outcome was achieved by calculating the amountthat needed to be added to the $149 million to enable interest payments on thatgrossed-up sum over five years to match the amount required to repay over the sameperiod the amount of the gross-up plus interest (the funds introduced byDeutsche Bank). Frucor was thereby able to repay the $55 million advanced byDeutsche Bank plus interest over the five-year term of $11 million but claim the entire$66 million as an interest deduction.[83] DAP's subscription for equity was effectively repackaged as a loan fromDeutsche Bank to achieve the intended tax benefits for Frucor. DAP's equitysubscription was bundled with an amortising loan from Deutsche Bank in an artificialand contrived manner to enable Frucor to claim interest deductions on the loan whichwere, in substance, repayments of principal and interest payable to Deutsche Bank inrespect of the funds it introduced to facilitate the arrangement.[84] The Judge was persuaded that the purpose of the funding arrangement was tonegate foreign assessable income, such as the taxable receipts of interest paid toDanone Finance under the initial funding arrangement.62 We agree that avoidingoffshore tax was an important consideration. The funding arrangement gave rise tothe prospect of generating an unwelcome offshore taxable gain because of the notionalincrease in the value of the non-voting shares over the five-year period from$149 million to $204,421,565 (or whatever other figure happened to be generated bythe formula at the date of closing). This potential problem needed to be managed forthe funding arrangement to succeed. However, we view the need to avoid capital gains62 High Court judgment, above n 5, at [141(1)].tax on the notional share value growth as a condition precedent to the intended fundingarrangement rather than being its object. The condition was always understood to bereadily satisfied simply by choosing a Danone entity resident for tax purposes ina jurisdiction that would not impose capital gains tax on the inferred uplift in the valueof the shares represented by the difference between the forward purchase amount andthe face value of the convertible note. Thus, this condition had to be ticked off beforethe funding arrangement could proceed but that was never going to be a problem.This consideration does not detract from our assessment that a more than incidentalpurpose and effect of the funding arrangement was to engineer tax deductions forinterest expenses claimable by Frucor in New Zealand of sufficient magnitude to repayDeutche Bank. That purpose was not to come at the expense of creating tax problemselsewhere.[85] We consider the funding arrangement fits within the Supreme Court'sformulation in Ben Nevis as one enabling the taxpayer to gain the benefit of the specificprovision in an artificial and contrived way. In our view, this transaction was in manyrespects artificial and it was clearly contrived for the very purpose of enabling Frucorto gain the benefit of the specific provision allowing interest deductions. The artificialand contrived features of the funding arrangement are not seriously in dispute andmost were accepted by the Judge. Taken together, they reveal that the purpose ofthe arrangement was to dress up a subscription for equity as an interest only loan toachieve a tax advantage. It is hard to discern any rational commercial explanation forthe artificial and contrived features of the arrangement, other than tax avoidance.[86] Deutsche Bank made no profit from its participation as the notional lender of$204 million and it plainly had no interest in acquiring 1,025 non-voting shares inFrucor, a company that had never declared a dividend. The benefits to Deutsche Bankwere its fee of $1.8 million for the design and implementation of the arrangement andto enhance its relationship with Groupe Danone. Those benefits aside,Deutsche Bank's interest was in recovering the money it contributed to facilitatethe arrangement together with interest. This would be accomplished by the interestpayments to be made by Frucor over the five-year period, all of which were securedby the guarantee from Groupe Danone (mentioned at [19] above). As to the remainingbalance of $149 million funded by DAP, this would be satisfied by Deutsche Bankexercising its option to call for the shares from Frucor and passing them immediatelyto DAP under the forward purchase agreement.[87] In the extremely unlikely event Deutsche Bank chose not to call for the sharesand Frucor redeemed the loan by paying $204 million in cash, Deutsche Bank wasrequired to gross-up this redemption payment upon receipt in order to make DAPwhole for its consequent tax liability. This would have required Deutsche Bank tomake an additional payment of some $14 million from its own resources.Plainly, Deutsche Bank would ensure that did not happen. In the equally unlikelyevent of Frucor paying Deutsche Bank $204 million rather than issuing 1,025non-voting shares (despite Deutsche Bank calling for the shares), Deutsche Bankwould not be entitled to enjoy that receipt and face down any claim by DAP that it hadsuffered a loss as a result of not receiving these further (non-voting) shares ina company it already wholly owned. Instead, Deutsche Bank would be required topay the $204 million to the novation counterparty, Compagnie Gervais Danone.While technically an optional convertible note, it was to all intents and purposesmandatory.[88] The convertible note issue price of $204,421,565 was itself a contrived figure.Despite what was stated in the side letter, the figure had nothing to do with the likelyvalue of 1,025 non-voting shares in Frucor in five years' time. Deutsche Bank had nointerest in acquiring these shares and DAP already owned all the shares in Frucor.Additional, non-voting, shares would have no value to it. Nor did the note issue pricematch Frucor's funding requirement of approximately $147 million to repay the loanfrom Danone Finance. We know that because Frucor contemporaneously paid$60 million of the $204 million advance straight back to DAP.[89] Rather, as we have seen, the very precise figure of $204,421,565 was derivedfrom other inputs, being the sum to be contributed by DAP for the purchase ofthe shares, the term of the arrangement, the agreed interest rate and bi-annual paymentdates. The figure was mathematically derived by grossing up the amount Frucorrequired ($147 million to repay Danone Finance and $2 million for Deutsche Bank'sfee) such that interest on the grossed-up total paid bi-annually at the agreed rate overfive years would be sufficient to repay the amount of the gross-up plus interest on thatamount if paid bi-annually at the same rate over the same period. This can beexpressed more simply using the following formula:P1 ($149 million) + P2 = P3Where interest on P3 = P2 + interest on P2Thus, P2 (and consequently P3) are wholly derived from P1($149 million contributedby DAP) and the interest calculation.Therefore:$149 million + $55 million = $204 millionWhere interest on $204 million = $55 million + interest on $55 million ($11 million)[90] As a matter of commercial and economic reality, the payment of $149 millionmade by DAP did not carry any liability for Frucor (or Deutsche Bank) to pay interest.The only amount that did attract interest was the $55,421,565 independently advancedby Deutsche Bank.[91] It is not relevant that Frucor could have borrowed the $204 million fromDanone Finance at an arm's length rate of interest and be entitled to claim the sameinterest deductions. The focus must be on the arrangement that was entered into, notone that might have been entered into but was not. We therefore agree with the Judge'sfirst proposition in [153] of his judgment (quoted at [40] above).However, this prohibition does not preclude consideration of the economic andcommercial effect of the transaction under scrutiny. Such consideration, focusingentirely on the funding arrangement in question, is central to the second stage ofthe Ben Nevis analysis. It is by no means "almost meaningless" or a "mere checkpointfor the Commissioner to divert around" as the Judge suggested.[92] Mr McKay emphasised that it is necessary to examine Frucor's position ona standalone basis rather than considering the position of the Danone group onconsolidation. We agree with this, although, as he acknowledges, it is necessary toconsider all the transaction documents comprising the funding arrangement andthe steps taken to implement them when assessing the tax avoidance issue. To thatextent, the involvement of other relevant members of the Danone group must beconsidered.[93] Mr McKay contends that the Commissioner has wrongly taken a groupapproach in suggesting that the loan was in effect only $55 million, not $204 million.Mr McKay points out that the references in the accounts to the $55 million as beinga net loan reflect the group position on consolidation. By contrast, Frucor's annualaccounts consistently show a liability of $204 million and an interest expense of$66 million.[94] This argument found favour with the Judge.63 However, it seems to us thatthe financial statements merely reflect the correct legal and accounting position.They confirm the correctness of the conceded position in terms of step one ofthe Ben Nevis enquiry, but they cannot be dispositive at step two. Otherwise, therewould be no room for a tax avoidance argument based on the commercial andeconomic reality of the payment. So long as it could be shown that expenses weretreated correctly from an accounting perspective and in accordance with the legal formof the underlying transactions, that would be the end of the matter. Mr McKayacknowledged that the financial statements cannot be conclusive, but he commendedthem as a good starting point.[95] In any case we are not persuaded that the Commissioner focused on the groupposition at the expense of considering Frucor's individual position as the New Zealandtaxpayer whose income was being assessed. The Commissioner's assessment ofthe transaction from a tax avoidance perspective did not depend on the consolidatedaccounts for the group. Rather, her focus was on the economic and commercial realityof the payments claimed by Frucor as an interest expense, contending theserepresented payments of principal and interest to Deutsche Bank. That is preciselyhow they were calculated — the interest payments on the grossed-up loan had to equalprincipal and interest on the Deutsche Bank advance. This assessment is notdependent on the group consolidated accounting position, although the consolidatedposition may coincide with the effective commercial and economic position of anindividual group member.63 At [78] and [196].[96] It is well-established that a debt can be discharged by the issue of shares.Further, where shares are issued for a consideration other than cash, this must betreated as being at least equal to the par value of the shares.64 We therefore readilyaccept Mr McKay's submission that Parliament must have contemplated that a debtdischarged by the issuance of shares would not prevent full interest deductibility onthe debt. We would not get past step one of the Ben Nevis analysis if we did not agreewith that uncontroversial proposition. However, Mr McKay's submission assumesthere is otherwise full interest deductibility on the debt. That in turn assumesthe payments are properly viewed as interest payments, not just as a matter of "blackletter" legal and accounting form, but also as a matter of commercial and economicreality. That comes back to the central issue in the case. We respectfully disagree withthe Judge to the extent he suggested it would suffice at step two of the enquiry toaccept that shares may be issued to discharge a debt and any further consideration ofunderlying "cost" would be misdirected.65[97] Mr McKay's fall-back position is that even if it can be said that Frucoreffectively received $149 million from DAP in return for the issue of shares infive years' time, this would be a financial arrangement entitling Frucor to a $55 milliondeduction based on the difference between the amount paid and the agreed value ofthe shares at the end of the period. The difficulty with this proposition is that the figureof $204,421,565 was an artificially contrived figure and had nothing to do withthe value of the shares. The capital requirement was $147 million (plus the fee).That was the amount DAP subscribed for the additional non-voting shares. Theseadditional shares conferred no additional rights on DAP and their "value" to DAPwould not grow over the five-year period. In reality, these shares had no value to DAP(as the 100 per cent parent) so long as they did not end up with a third party.The funding arrangement was designed to ensure that would not happen.64 Osborne v Steel Barrel Co Ltd [1942] 1 All ER 634 (CA) at 637–638, Craddock v Zevo FinanceCo Ltd [1944] 1 All ER 566 (CA) at 569, and Stanton (Inspector of Taxes) v Drayton CommercialInvestment Co Ltd [1983] 1 AC 501 (HL) at 517.65 High Court judgment, above n 5, at [177] and [190] (quoted in part at [46] above).Tax advantage[98] Section GB 1 of the Act provides that where an arrangement is void inaccordance with s BG 1, the taxpayer's deductions and assessable income may beadjusted by the Commissioner as she thinks appropriate "to counteract any taxadvantage obtained" by the taxpayer "from or under" the arrangement.[99] The Commissioner counteracted the tax advantage by reducing the deductibleinterest expense claimed by Frucor in 2006 and 2007 from approximately $13 millionper annum (6.5 per cent on $204 million) to around $2.3 million per annum(6.5 per cent on the amortised balance of $55 million).[100] Mr McKay submits that because the Commissioner must only reconstruct tothe extent required "to counteract any tax advantage", it is necessary to identifythe base level of permissible deductions that would have existed in any event. For thisproposition he relies on the following passage from the judgment of McGechan J inBNZ Investments Ltd v Commissioner of Inland Revenue:66 I have no doubt s [GB 1] is intended to counteract tax advantages obtainedout of avoidance, but not otherwise. Where tax advantages are increasedthrough avoidance which would have existed in any event, it is that incrementabove base level which is to be counteracted, not the legitimate base levelitself. That is all the preservation of the tax base — the purpose of the section— requires.[101] Mr McKay points out that the funding arrangement refinanced the initialacquisition funding provided by Danone Finance of $144 million at a comparable rateof interest. If the present arrangement had not been entered into, there is someevidence to indicate that the level of debt to equity would have been increased toaround the same level as achieved by the funding arrangement. Viewed in that way,the funding arrangement yielded no tax advantage and therefore, even if it was atax avoidance arrangement void against the Commissioner, there is no basis to denythe full amount of the interest deductions claimed. Alternatively, Mr McKay submitsthat the appropriate comparison is with the initial funding arrangement withDanone Finance in terms of which incontestable deductions of interest on the debt ofapproximately $144 million were available.66 BNZ Investments Ltd v Commissioner of Inland Revenue (2000) 19 NZTC 15,732 (HC) at [200].[102] Mr McKay also points out that the Commissioner's approach ignores DAP'sexternal liability to BNP Paribas in respect of the $89 million component ofthe funding. He says this liability was undoubtedly incurred as an element ofthe overall funding arrangement with the result that interest legitimately incurred onthis sum should be treated as being deductible on any reconstruction. On this basis,of the $204 million funding provided to Frucor, just over 70 per cent came fromsources external to the group ($55 million from Deutsche Bank plus $89 million fromBNP Paribas). Mr McKay therefore submits that a similarly proportionate part ofthe interest expense — at least $46.5 million — should be deductible ona reconstructed basis.[103] Section GB 1 does not require the Commissioner to consider otherarrangements the taxpayer might have entered into had it not chosen to proceed withthe tax avoidance arrangement under review.67 Further, the tax advantage with whichthe section is concerned is the New Zealand tax advantage achieved bythe New Zealand taxpayer — Frucor. While DAP is a party to the fundingarrangement, its funding costs and tax position are irrelevant to the analysis that mustbe conducted under s GB 1.[104] We have already concluded that the principal driver of the funding arrangementwas the availability of tax relief to Frucor in New Zealand through deductions it wouldclaim on the coupon payments. The benefit it obtained under the arrangement wasthe ability to claim payments totalling $66 million as a fully deductible expense when,as a matter of commercial and economic reality, only $11 million of this sumcomprised interest and the balance of $55 million represented the repayment ofprincipal. The tax advantage gained under the arrangement was therefore notthe whole of the interest deductions, only those that were effectively principalrepayments. We consider the Commissioner was entitled to reconstruct by allowingthe base level deductions totalling $11 million but disallowing the balance. The taxbenefit Frucor obtained "from or under" the arrangement comprised the deductionsclaimed for interest on the balance of $149 million which, as a matter of commercialreality, represented the repayment of principal of $55 million.67 Alesco New Zealand Ltd v Commissioner of Inland Revenue [2013] NZCA 40, [2013] 2 NZLR175 at [122]–[128].Shortfall penalties[105] Section 141B of the Tax Administration Act 1994 provides that a taxpayertakes "an unacceptable tax position" if, viewed objectively, the tax position fails tomeet the standard of being "about as likely as not to be correct". The Commissionercontends that is the position here. In terms of s 141D, taxpayers who have taken anunacceptable tax position are liable to pay shortfall penalties if they enter into or actin respect of arrangements with a dominant purpose of taking or supporting the takingof tax positions that reduce or remove tax liabilities or give tax benefits.The Commissioner accordingly contends that shortfall penalties are applicable here.In short, Frucor has taken an unacceptable tax position viewed objectively and taxavoidance was the dominant purpose of the arrangement. The Commissioneracknowledges that Frucor is entitled to a 50 per cent reduction for previous behaviourin terms of s 141 FB of the Tax Administration Act.[106] Mr M McKay, who dealt with this aspect of the argument for Frucor, submitsthat the "about as likely as not to be correct" enquiry was correctly distilled bythe Judge to "whether there is substantial merit in [the taxpayer's] arguments".68Expressed another way, the question is whether the taxpayer's argument would beseriously considered by a court. On that basis, Mr McKay submits the High Courtjudgment is a complete answer to any question of penalties. Mr McKay relies onthe decision of Kós J in Commissioner of Inland Revenue v John Curtis DevelopmentsLtd as supporting his proposition that, viewed objectively, the taxpayer's position mustbe regarded as one capable of being reasonably adopted and having substantial meritgiven it was found to be correct by the High Court.69[107] We accept Mr McKay's submission. As the Supreme Court made clear inBen Nevis, the inclusion of the word "about" in the test shows that a 50 per centprospect of success is not the standard. Rather, the question is whether the merits ofthe arguments supporting the taxpayer's interpretation are substantial.70 While wehave come to a different conclusion from the High Court on the core tax avoidance68 High Court judgment, above n 5, at [221].69 Commissioner of Inland Revenue v John Curtis Developments Ltd [2014] NZHC 3034, (2014) 26NZTC 21-113 at [107].70 Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue, above n 12, at [184].issue, we are not persuaded that Frucor's arguments could be dismissed as lacking insubstantial merit. Muir J, an experienced commercial Judge, not only regardedFrucor's argument as deserving of serious consideration, he explained in a careful,closely reasoned and comprehensive judgment why he was persuaded it was bothfactually and legally correct.[108] Accordingly, we consider the Judge was correct to find that shortfall penaltiesshould not have been imposed in this case.Result[109] The appeal is allowed.[110] The orders made in the High Court are set aside. The interest assessments arereinstated. Shortfall penalties do not apply.[111] The appellant is entitled to costs for a complex appeal on a band B basis andusual disbursements. We certify for second counsel.[112] Costs in the High Court are to be determined by that Court in accordance withthis judgment.Solicitors:Crown Law Office, Wellington for AppellantBell Gully, Auckland for RespondentAppendixDanoneFinanceSABNP ParibasFrucorDeutsche BankTreasury$89m repaidplus interest1,025 Frucorshares transferredDAP$204m advancedDeutsche Bank$89madvanced$144m to repayadvances under CashManagement Agreement$149m paidRepayment of$60m capital byrepurchase of 400shares1,025 shares issued$55m principal$11m interest paid$55madvanced$66m paidFranceSingaporeNew ZealandSteps in Green: Occurred at commencement of funding arrangement in March—April 2003Steps in Blue: Occurred over the term of the funding arrangementSteps in Red: Occurred at maturity of funding arrangement in March 2008