DT UNITED KINGDOM LTD V THE COMMISSIONER OF INLAND REVENUE HC AK CIV-2009-404-005580

DT UNITED KINGDOM LTD V THE COMMISSIONER OF INLAND REVENUE HC AK CIV-2009-404- 005580 9 July 2010IN THE HIGH COURT OF NEW ZEALAND AUCKLAND REGISTRY CIV-2009-404-005580IN THE MATTER OF the Tax Administration Act 1994 BETWEEN DT UNITED KINGDOM LTD Plaintiff AND THE COMMISSIONER OF INLAND REVENUE Defendant Hearing: 9 July 2010 Appearances: K Gould for Plaintiff H Ebersohn and T Lamb for Defendant Judgment: 9 July 2010ORAL JUDGMENT OF ASSOCIATE JUDGE BELLSolicitors/Counsel: Christopher Taylor, PO Box 37772, Parnell, Auckland Crown Law, PO Box 2858, Wellington K F Gould, PO Box 1011, Shortland Street, Auckland[1] This is an application for security for costs and for a stay under r 5.45 of the High Court Rules. [2] The substantive proceeding is a challenge under s 138B of the Tax Administration Act 1994 to the Inland Revenue's income tax assessment for the 2002 income year, and a shortfall penalty imposed for an unacceptable tax position. The plaintiff's 2002 income year tax return showed a loss of $386,861,323. The Commissioner has reversed a claimed deduction of $387 million, leaving an amended taxable income of $138,677. The Commissioner has also imposed a shortfall penalty of $12,771,000 under s 141B of the Tax Administration Act, incorporating a 50% reduction under s 141FB. [3] The background to the matter is that Digi-Tech (Communications) Ltd owned intellectual property rights in three products called Freerider, Terminal Adapter and DFS DBUSS. Digi-Tech (Communications) Ltd sold its intellectual property rights in these products to a number of its subsidiaries, including DT United Kingdom Ltd. DT United Kingdom Ltd bought the intellectual property rights for the territories of the United Kingdom and Europe for $395,100,000. Digi-Tech (Communications) Ltd made an advance to DT United Kingdom Ltd so that the purchase price was payable only at a later date. DT United Kingdom Ltd tried to market the intellectual property rights in Europe and the United Kingdom, but without success. Later, DT United Kingdom sold the intellectual property rights to Fifth Investments Ltd, a related company for $8,100,000. That sale was made on 25 January 2002. [4] The sale of the intellectual property rights by Digi-Tech (Communications) Ltd to DT United Kingdom Ltd was a capital receipt in the hands of Digi-Tech (Communications) Ltd and was not taxable. DT United Kingdom Ltd bought the intellectual property rights from Digi-Tech (Communications) Ltd with the purpose of reselling those rights. Accordingly, the purchase price was deductible as expenditure on revenue account. [5] The Commissioner has received advice that the value of the intellectual property rights was in the order of $500,000, rather than $395,100,000. He has taken the position that this is tax avoidance under s BG1 of the Income Tax Act 1994, andhas made an adjustment under s GB1 of the Income Tax Act 1994. He has also issued shortfall penalties for taking an unacceptable tax position. The assessments made by the Commissioner are the subject of challenge in this proceeding. [6] I make it clear at the outset that on an application such as this, the Court is required to come to some view as to the relative strength of the parties' positions. Anything said in this judgment is not a final determination of the merits. That will come with the hearing of the substantive case. [7] Rule 5.45(1)(1)-(3) provides:(1) Subclause (2) applies if a Judge is satisfied, on the application of a defendant,— (a) that a plaintiff— (i) is resident out of New Zealand; or (ii) is a corporation incorporated outside New Zealand; or (iii) is a subsidiary (within the meaning of section 5 of the Companies Act 1993) of a corporation incorporated outside New Zealand; or (b) that there is reason to believe that a plaintiff will be unable to pay the costs of the defendant if the plaintiff is unsuccessful in the plaintiff's proceeding. (2) A Judge may, if the Judge thinks it is just in all the circumstances, order the giving of security for costs. (3) An order under subclause (2)— (a) requires the plaintiff or plaintiffs against whom the order is made to give security for costs as directed for a sum that the Judge considers sufficient— (i) by paying that sum into court; or (ii) by giving, to the satisfaction of the Judge or the Registrar, security for that sum; and (b) may stay the proceeding until the sum is paid or the security given.[8] Sub-clauses (4), (5) and (6) are not relevant. [9] An application under r 5.45 follows these steps:a) Has the applicant satisfied the Court of the threshold under r 5.45(1)? b) The exercise of the discretion under r 5.45(2)? c) What amount should security for costs be fixed at? d) Should a stay be ordered?The threshold[10] In this case, there is no dispute that the threshold has been established. It is not disputed that under r 5.45(1)(b) there is good reason to believe that the plaintiff will be unable to pay the defendant's costs if the plaintiff is unsuccessful in its challenge. The Commissioner notes that DT United Kingdom Ltd filed nil returns for the 31 March 2005 and 31 March 2006 income tax years, except for claiming a loss carried forward of $389 odd million, and did not file tax returns for the March 2007, March 2008 and March 2009 income years. The plaintiff's statement of claim says that it previously carried on business as a buyer and seller of intellectual property rights. So the plaintiff is not presently trading. This information provided by the Commissioner is sufficient to persuade me, in the absence of any evidence from the plaintiff, that the plaintiff would be unable to pay the defendant's costs. As it is, the plaintiff has conceded the point. The plaintiff's director, Mr Reid, says in his affidavit:The plaintiff accepts that due to its financial position it is unable to pay costs if it is unsuccessful in this proceeding.[11] I also note a point which is not a threshold test. In Reefdale Investments Ltd v Commissioner of Inland Revenue (2004) 17 PRNZ 229, McKenzie J heard argument that the Commissioner could not apply for security for costs under r 60 of the former High Court Rules, the counterpart to r 5.45. McKenzie J held against that submission.Exercise of the Discretion[12] On the exercise of the discretion, the decision of the Court of Appeal inA S McLachan v MEL Network Ltd (2002) 16 PRNZ 747, provides useful guidance:[13] Rule 60(1)(b) High Court Rules provides that where the Court is satisfied, on the application of a defendant, that there is reason to believe that the plaintiff will be unable to pay costs if unsuccessful, "the Court may, if it thinks fit in all the circumstances, order the giving of security for costs". Whether or not to order security and, if so, the quantum are discretionary. They are matters for the Judge if he or she thinks fit in all the circumstances. The discretion is not to be fettered by constructing "principles" from the facts of previous cases. [14] While collections of authorities such as that in the judgment of Master Williams in Nikau Holdings Ltd v BNZ (1992) 5 PRNZ 430, can be of assistance, they cannot substitute for a careful assessment of the circumstances of the particular case. It is not a matter of going through a checklist of so-called principles. That creates a risk that a factor accorded weight in a particular case will be given disproportionate weight, or even treated as a requirement for the making or refusing of an order, in quite different circumstances. [15] The rule itself contemplates an order for security where the plaintiff will be unable to meet an adverse award of costs. That must be taken as contemplating also that an order for substantial security may, in effect, prevent the plaintiff from pursuing the claim. An order having that effect should be made only after careful consideration and in a case in which the claim has little chance of success. Access to the Courts for a genuine plaintiff is not lightly to be denied. [16] Of course, the interests of defendants must also be weighed. They must be protected against being drawn into unjustified litigation, particularly where it is over-complicated and unnecessarily protracted.The merits[13] Associate Judge Sargisson directed the parties to file a joint memorandum identifying the issues in this case. The defendant filed a memorandum listing the issues, as follows:2. The primary issue in the proceeding is whether the plaintiff has entered into a tax avoidance arrangement under s BG 1 of the Income Tax Act 1994 (ITA). 3. The sub-issues relevant to the determination of the primary issue are:3.1 (a) What is the scope of the arrangement? (b) Has the defendant assessed the plaintiff on a ground that was not identified and known to the plaintiff and the defendant before the time at which the time-bar would have applied? – s 108(1B) of the Tax Administration Act 1994. (c) Has the defendant assessed the plaintiff on facts and evidence and issues arising from them and propositions of law that are not disclosed in the plaintiff's or defendant's Statement of Position? – s 138G of the Tax Administration Act 1994. 3.2 Was the purchase price for the intellectual property rights acquired by the plaintiff under the arrangement excessive? 3.3 Was the Deloitte October 1997 valuation unreliable? Were the Content Factory valuation of 14 March 2008 and the Grant Thornton valuation of 10 September 2008 valuations and were they reliable? 3.4 Did the plaintiff suffer any real economic consequences from the purchase of the intellectual property rights? 3.5 Was the plaintiff ever likely to be able to repay the loan it received from Digi-Tech Communications Limited to purchase the intellectual property rights? 3.6 Was the sale of the intellectual property rights by the plaintiff to Fifth Investments Limited artificial? 3.7 Was the arrangement artificial and contrived: 3.8 Would Parliament have contemplated that a deduction of $395.1 million would be available to the plaintiff for the purchase of the intellectual property rights? 3.9 Was the tax avoidance effect of the arrangement merely incidental? 3.10 Is the defendant bound by the views expressed in the defendant's Adjudication Report? 3.11 Does the deed of settlement concluded between the defendant, the plaintiff and Digi-Tech (Australia) Limited, dated 9 September 2005, preclude the defendant from making the assessment challenged by the plaintiff? 4. If the arrangement constitutes tax avoidance, the further issues that arise are: 4.1 What is the correct reconstruction of the plaintiff's income tax affairs, under s GB 1 of the ITA, so as to remove the taxadvantage obtained under the arrangement?4.2 What shortfall penalty under the Tax Administration Act 1994 (TAA) should be imposed on the plaintiff as a result of the tax shortfall created by entering into the tax avoidance arrangement?[14] The plaintiff did not disagree that this document adequately recorded the issues. [15] I also record the following technical points raised by the plaintiff: a) The plaintiff says that the Commissioner's assessment is not open to it, because of the terms of a settlement agreement; b) It says that the Commissioner is caught by the time bar under ss 108 and 108B of the Tax Administration Act; and c) It says that the case the Commissioner is running is not open to him because of findings by the Adjudication Unit of the Inland Revenue Department. [16] On the major issue, whether there is a tax avoidance arrangement under s BG1 of the Income Tax Act 1994, I make a preliminary general observation. At present, the tide is running strongly in favour of the Commissioner of Inland Revenue on tax avoidance litigation. The tax team in the Crown Law Office has had such success in its tax avoidance cases as to have a significant effect on the Government's financial position. [17] Next, the courts have had occasion to consider whether other transactions entered into by other Digi-Tech companies have amounted to tax avoidance. In this regard, Mr Ebersohn's written submissions referred to the comments of Fogarty J inR v Connolly (2004) 21 NZTC 18, 844. [18] Mr Ebersohn's written submissions set out the test for tax avoidance established by the leading cases: Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue, [2008] NZSC 115 [2009] 2 NZLR 289, and subsequent decisions such as BNZ Investments Ltd v Commissioner of Inland Revenue (2009) 24 NZTC23,582, Westpac Banking Corporation v Commissioner of Inland Revenue (2009) 24 NZTC 23,834, and Commissioner of Inland Revenue v Penny & Ors [2010] NZCA 231. Without detracting from his submissions, I note that in Inland Revenue Commissioners v Willoughby [1997] 1 WLR 1071 (HL) 1079, Lord Nolan said:The hallmark of tax avoidance is that the taxpayer reduces his liability to tax without incurring the economic consequences that Parliament intended to be suffered by any tax payer qualifying for such reduction in his tax liability.[19] In this case, the Commissioner points to its valuation evidence as to the value of the intellectual property rights, and says that the inflated values given under the agreement for the purchase of the rights from Digi-Tech (Communications) Ltd, the absence of any payment to Digi-Tech (Communications) Ltd, and the dealings between related parties are redolent of contrivance and artificiality. It says that the taxpayer has not undergone the economic consequences intended by Parliament. [20] On the other hand, the plaintiff contests the valuation evidence the Commissioner relies on. It has an argument to put the arrangements in context and refers to the Dot Com Bubble of the late 1990s. [21] At this stage, my judgment is that the Commissioner has the stronger case. [22] There are also secondary issues. The plaintiff relies on an agreement between the Commissioner, Digi-Tech (Australia) Ltd, and the plaintiff, dated 9 September 2005. That agreement was made after the plaintiff had filed its tax returns for the March 2002 income year. The recitals to the deed of September 2005 included this:DT UK acquired the rights, title and interest in the IP from DT CL in an agreement dated 5 June 1997. DT UK incurred expenses in attempting to sell the IP rights to European investors. DT UK claimed a deduction against its gross income for these expenses and its income tax returns for the income years ended 31 March 1998 and 31 March 1999. The Commissioner subsequently issued amended assessments disallowing these deductions for the amounts of $798,765 in respect of the 1998 income tax year and $611,122 in respect of the 1999 income tax year.[23] The deed provided that the Commissioner made assessments of the plaintiff allowing additional deductions for the amounts of $798,765 in respect of the 1998income year and $611,122 in respect of the 1999 income tax year, being expenses incurred in attempting to sell the IP rights to European investors. [24] Paragraph D of the deed of settlement said:This settlement is in full and final settlement of all disputes between the parties relating to the assessment disallowing the deductions and the resultant challenges.[25] Paragraph G said:Both parties acknowledge that this deed and the agreement which it records relate to the matters set out in the recital. This resolution does not provide a precedent for how similar or identical issues will be treated by any of the parties in the future.[26] The Commissioner's argument is that so far as this case is concerned, that deed of settlement is confined to deductions claimed in the March 1998 and March 1999 years, and has nothing to do with the assessment of income tax for the year ending March 2002. It also points to paragraph G as reserving its rights in respect of future income years. [27] At this stage, without having the benefit of any further evidence putting that deed into context, I accept that the Commissioner's argument as to the interpretation of the deed appears sound. [28] DT United Kingdom also argued that the Commissioner's case was confined by the determinations of the Commissioner's adjudication unit dated 1 July 2009. It submitted that determinations made by the Commissioner's adjudication unit recast the Commissioner's case so as to stop the Commissioner being able to rely on his statement of position. [29] The Commissioner submitted that this argument was misconceived because the parties' statements of position are determinative under s 138G of the Tax Administration Act, especially when read with s 89M(4) and (6) of that Act. In any event, the Commissioner's submissions went on to analyse the particular issues raised by Mr Reid in paragraph 5.4.(b).(iv) of his affidavit, and identified howparticular issues had been addressed in the Commissioner's notice of proposed adjustment, statement of position and adjudication report. [30] DT United Kingdom Ltd also argued that the Commissioner was time-barred in making assessments, because of the time-bar under s 108, and a waiver given under s 108B(1b) of the Tax Administration Act. The Commissioner's position was that it had given a notice of proposed adjustment on 26 September 2007. That was within the four year period allowed under s 108. It was entitled to refine its assessment after that date. Again, the Commissioner appears to have the better hand on these issues. [31] Having said that, I do need to make it clear that while I believe that the plaintiff's case is weak, I do not regard it as frivolous or vexatious. It does have an arguable case.Balancing[32] The exercise of the discretion requires a balancing, as was recognised by the Court of Appeal in McLachlan v MEL Network Ltd. That is as applicable in tax litigation as in other litigation. The balancing required here is, on the one hand, to protect the Inland Revenue against being left out of pocket when the plaintiff turns out to be penniless, and, on the other hand, to ensure that the tax payer who disputes their tax assessment has access to the courts to challenge it. In this regard, I note that McKenzie J in Reefdale held that an application for security is to be dealt with by applying the usual principles. I also note that the plaintiff did have the option of applying the Taxation Review Authority under s 16 of the Taxation Review Authorities Act 1994. When an authority hears an objection, it does not award costs, except in the particular circumstances where s 22 of Taxation Review Authorities Act applies. In other words, a tax payer who challenges an assessment before a Taxation Review Authority may do so generally without running any risk of costs. That means that a tax payer who brings a challenge in this Court does so on the basis that it submits to the rules of this Court, including the power to award costs. Such a tax payer cannot complain if the Court uses its powers under the rules to ensure that any costs order will be effective.[33] Here, the plaintiff does not have the assets to conduct the litigation, and seems to be relying on outside funding. Presumably those who are providing the plaintiff with its funding for the tax litigation would also be in a position to provide security for costs as well. If they are not willing to do so, then there is no reason why the Commissioner should be subjected to this proceeding continuing without being protected as to costs. [34] Overall, this is a proper case to exercise the discretion to require the plaintiff to provide security for costs.Amount of security[35] The Commissioner provided a schedule setting out a possible costs award on the basis of a two week hearing, using second counsel, with expert witnesses costing $90,000. The Commissioner's calculations were that a potential costs order could be in the order of $190,000. The plaintiff, instead, submitted that the case could be heard in a week, did not require two counsel, and submitted that a likely order for costs would be about $70,000. I discussed the matter with counsel and was able to narrow the issues. In oral submissions, Mr Ebersohn advised that the plaintiff will in fact call four expert witnesses, in addition to a departmental investigative officer. The plaintiff is likely to call three witnesses, two of them experts. Mr Gould indicated that there could well be hot-tubbing of witnesses, and certainly this is a case where some conferral between witnesses ahead of the hearing could be useful. He indicates that cross-examination could well be confined. [36] On this basis, I regard the plaintiff's assessment that this case will require no more than five working days, as a better estimate. In this area the propositions of law are now well established, and what will really be in contention will be the application of those principles to the particular facts. Again, the way that matters unfolded does not seem to be largely in issue. The matters of contention will be what inferences are to be drawn from undisputed facts and questions of valuation of intellectual property rights. Evidential matters in issue will be primarily the matters of valuation of the plaintiff's intellectual property rights. The Commissioner didinclude a doubling of amounts under both paragraph 7 and paragraph 8 of Schedule 3. In fact, paragraph 7 and paragraph 8 are alternatives. [37] At this stage, I do not see the need for a second counsel. It may be that if the case develops the plaintiff may be able to demonstrate that need, but it is not apparent to me at the moment. [38] There was also discussion as to the costs of expert witnesses. The sum of $90,000, at the outset, seemed to me to be on the high side. Looking at the matter overall, I believe that a likely order for costs, if the matter goes to a full hearing that lasted five days, would be in the order of about $135,000, including witnesses' expenses, travel and accommodation costs, and any disbursements. [39] The next inquiry is whether there should be any discounting from that figure. It is not normal in security for costs awards to award a defendant 100% of a potential costs award, unless the case is so lacking in merit that the Court regards the claim as entirely frivolous and vexatious. I do not take that view. There should be some discounting because of the fact that it would be improper to raise insurmountable hurdles in the face of a tax payer seeking to challenge the correctness of income tax assessments. Some reduction from the sum of $135,000 is appropriate. In my view, an appropriate sum to fix for security for costs would be $90,000. After discussion with counsel, it was agreed that a staged approach would be appropriate. [40] The orders are: a) the plaintiff is to provide security for costs now in the sum of $45,000; and b) the plaintiff is to provide a further sum by way of security for costs of $45,000 to be paid on this matter being set down for hearing.Stay[41] Finally, there will be a stay pending payment of security.Costs[42] I asked the parties to confer as to costs. They agreed that on a 2B basis the amount of costs and the filing fee on the application for security for costs would come to $3,408. The parties were not able to agree on the defendant's claim for travel expenses. I accept that there are cases where the Crown Law Office does need to send their own team out of town to conduct cases outside Wellington. This was simply an application for security for costs, which could conveniently have been briefed out. I note, in particular, that the Crown Solicitor in Auckland has lawyers competent in tax law, and civil litigation, who would be able to master an application for security for costs. In these circumstances, I do not allow the disbursements for travel and accommodation. [43] The order for costs in favour of the defendant is accordingly $3,408. __________________________ R M Bell Associate Judge