GOVIND PRASAD SAHA V THE COMMISSIONER OF INLAND REVENUE HC WN CIV 2007-485-701

GOVIND PRASAD SAHA V THE COMMISSIONER OF INLAND REVENUE HC WN CIV 2007-485-701 23 September 2008IN THE HIGH COURT OF NEW ZEALAND WELLINGTON REGISTRY CIV 2007-485-701BETWEEN GOVIND PRASAD SAHA Plaintiff AND THE COMMISSIONER OF INLAND REVENUE Defendant Hearing: 4 August 2008 Counsel: G J Harley & R P Harley for the Plaintiff M T Lennard & H Ryburn for the Defendant Judgment: 23 September 2008JUDGMENT OF SIMON FRANCE JThis judgment was delivered by Justice Simon France on 23 September 2008 pursuant to r540(4) of the High Court Rules 1985 .[1] Dr Saha was a partner in Ernst & Young (EYNZ). In 2000, EYNZ sold a portion of its business to an overseas company, Cap Gemini. The then partners in EYNZ were paid by means of an allocation of shares in Cap Gemini. [2] Part of the sale arrangements was that some EY partners, including Dr Saha, would work for Cap Gemini for 5 years. Agreements were entered into to give effect to this commitment. The agreements included a share forfeiture regime, which was to apply if the partner stopped working for Cap Gemini before the 5 years was up. This is what happened with Dr Saha, and he was required to return some of the shares he had received. [3] Under successive Income Tax Acts since 1993, when a New Zealand tax resident owns shares in an overseas company, there is a process for assessing annually the tax implications of that ownership. The relevant rules are the Foreign Investment Fund Rules (FIF). The FIF Rules give a tax payer four options as to how to bring the share ownership to tax. Dr Saha chose what is known as the "comparative value" method. Very broadly speaking, under that system if the value of a person's holding has increased during the course of a tax year, that increase will be treated as income, and if it has decreased it will be treated as a deductible loss. There is a prescribed formula to be applied, which determines if the year's events have produced an increase or decrease in the value of the taxpayer's holding. [4] These proceedings concern how that formula applies to Dr Saha's forfeiture of some of his shareholding when he terminated early his employment with Cap Gemini.Evidence[5] Dr Saha called evidence from himself, and from 3 persons involved in the original sale transaction. They were Mr John Judge, who was CEO of EYNZ at the time, and the two solicitors primarily involved in the transaction, Ms Sarah Roberts and Mr Peter Lowe. The purpose of this evidence was to explain the history of thesale, the concerns of the parties to the transaction, and how those concerns were reflected in the documents. [6] The Commissioner called evidence from Mr Peter Frawley, a solicitor within IRD with particular expertise in the area of the FIF rules, and the controlled foreign company regime. [7] The scope of the evidence was the subject of a preliminary oral ruling by me, and then further exploration shortly after the trial started. The consequence of those events was that the briefs were all accepted without cross-examination being required. Those events are detailed in a separate evidence ruling issued at the same time as this judgment.History of the Sale[8] As is well known, Ernst & Young is a large international accountancy firm. One of its services was a consultancy business. For EYNZ that consultancy business in 2000 accounted for 40% of its total business. [9] Sometime in the late 1990's EY International entered into negotiations to sell the consultancy functions to Cap Gemini. The method ultimately agreed upon was that Cap Gemini would pay a fixed figure to purchase EY's consultancy business world-wide. However, individual national firms would have a choice to opt into the agreement or not. Once those choices were made, the fixed global sum would be divided amongst the EY firms that had joined in the sale. [10] In late March 2000, EYNZ decided to join the international agreement. The New Zealand decision making process had been managed by Mr Judge, assisted by Ms Roberts. Mr Judge identified, and EYNZ adopted, a minimum value for its consultancy business. It agreed to sell the business to Cap Gemini if the number of shares in Cap Gemini that EYNZ would receive was valued at more than the minimum value of the business as assessed by Mr Judge. EYNZ's allocation was 191,495 Cap Gemini shares and, at the then value of the shares, EYNZ's expectations were met.[11] Mr Judge advises that goodwill accounted for 90% of the value EYNZ had put on its consultancy business. The primary source of that goodwill was the partners in EYNZ who worked for the consultancy division, and who would as a consequence of the sale transfer to Cap Gemini to work. [12] Cap Gemini was obviously concerned to preserve the goodwill it had bought. This was achieved first by EYNZ entering into agreements to provide on-going support and to not re-establish a consultancy business for 5 years, as well as anti-solicitation and anti-poaching contracts. Second, the transferring partners entered into an employment contract, a deed of covenant in restraint of trade, and an escrow agreement. This last agreement was a mechanism by which Cap Gemini maintained the capacity to enforce the forfeiture penalties within the parent agreement. Shares were allocated to a partner's name, but the capacity to deal with them was limited. In effect shares were released to a partner to deal with as he or she wanted in converse proportion to the sliding scale forfeiture penalties. If permission was given to sell shares early, the cash equivalent was also to be held in the escrow account, and released on the same basis. [13] Obviously, the proportion of the global sum EYNZ was to receive was of importance to the EYNZ partners when it came to approving the sale. So too, was the method of apportionment within those partners. Ms Roberts explained that Cap Gemini was also interested in the internal apportionment both between remaining partners and transferring consultancy partners on the one hand, and within the group of transferring consultancy partners on the other. Cap Gemini's concern was that it wanted the transferring partners to have done sufficiently well out of the sale to provide an incentive for them to see out their 5 year employment agreement. [14] Dr Saha commenced work with Cap Gemini, but it proved unsatisfactory and eventually he left. The sliding scale forfeiture penalties meant that he forfeited 2095 of the original 7566 shares he had received.The various documents[15] The Individual Employment Contract signed by Dr Saha is employment specific and does not address the background issues concerning his acquisition of shares. Those matters are addressed in the Deed of Covenant. Paragraph 1.4 of Schedule 1 of the Deed of Covenant concerns restrictions on competition. Paragraph 1.4(b) provides:(b) The Accredited Consulting Partner agrees and acknowledges that liquidated damages shall be payable and, in settlement thereof, Transaction Shares allocated to him or her (and any proceeds of their sale) shall be subject to forfeiture or payment to Cap Gemini to the extent and on the terms and subject to the conditions set out in Schedule 2 in the event of any breach by him or her of the Consulting Partner Restrictive Covenants and in the other circumstances envisaged in Schedule 2.[16] Schedule 2 concerns the "Release/Forfeiture of the Transaction Shares of a Consulting Partner". Paragraph 1 provides:1. Acknowledgement of ImportanceThe Accredited Consulting Partner agrees that the goodwill and going concern value of the Ernst & Young New Zealand Consulting Business is essential to Cap Gemini and acknowledges that the Consulting Partner Restrictive Covenants are necessary to preserve for Cap Gemini such goodwill and going concern value. The Accredited Consulting Partner further acknowledges that his or her services are of great importance to the Ernst & Young New Zealand Consulting Business and Cap Gemini is acquiring such business on the basis that he/she will become and remain an employee of Newco or Cap Gemini or one of its subsidiaries, and properly perform his or her and their duties.[17] Paragraph 2 involves an undertaking by the Consulting Partner to pay a sum by way of liquidated damages in accordance with the forfeiture provisions of paragraph 6. One of the named circumstances is voluntary cessation of employment. [18] Paragraphs 4 and 5 of the Schedule contain tables which set out what percentage of shares will be released at what point in time. Paragraph 6 is the forfeiture provision, which applies for a period of 5 years. It provides that in the event that nominated events occur: all of the Unreleased Transaction Shares and the full amount of Unreleased Cash held in the Consultants' Share Account and Consultant's Deposit Account at the Final Determination Date or Departure Date shall be released from the Consultants' Share Account and Consultant's Deposit Account pursuant to the Escrow Release Procedure and transferred as follows: (a) 50% of the Unreleased Transaction Shares and 50% of the full amount of Unreleased Cash shall be transferred to Cap Gemini or as it shall direct; (b) 50% to Newco, such shares and cash being destined for allocation to other employees of Newco as Cap Gemini shall decide.[19] The Deed of Settlement entered into when Dr Saha left Cap Gemini agreed that 50% of his Unreleased Transaction Shares, being 2095, would be returned by Dr Saha and 50% would be transferred to Cap Gemini or as Cap Gemini directed.Dr Saha's tax treatment of his shareholding[20] The origins of the FIF rules were explained by Mr Frawley. The FIF rules were introduced to address what was perceived to be a taxation gap that existed as regards foreign entities. Prior to the FIF regime, New Zealand tax residents were taxed on foreign income earned directly. Mr Frawley cites interest on foreign bank accounts as an example. However, if the foreign entity did not distribute its income, tax was avoided if the New Zealand resident taxpayer sold the shares, thereby effectively converting the non-distributed but tax liable income into a non-taxable capital gain. [21] The FIF rules are designed to operate by attributing a pro-rata share of the foreign entity's income to the taxpayer. The value of the taxpayer's share in the FIF may be assessed by one of four methods – accounting profits, branch equivalent, comparative value and deemed rate of return. [22] Dr Saha chose the comparative value method as the route by which his interest was to be valued. The Income Tax Act 1994 was in force at the relevant time, and sCG18 set out the applicable formula for the comparative value method. A person's income or loss was to be calculated by this formula:(a+b) minus (c+d) where – a is the market value of the interest as at the end of the income year (which value shall be nil to the extent that the interest is not then still held by the person as an interest subject to the comparative value method); and b is the aggregate of all the gains derived by the person during the income year with respect to the interest; and c is the market value of the interest as at the end of the preceding income year (which value shall be nil to the extent that the interest was not then held by the person as an interest subject to the comparative value method); and d is the aggregate of all expenditure incurred by or on behalf of the person in acquiring the whole or any part of the interest during the income year.[23] For the first relevant tax year ending March 2001, Dr Saha applied the formula this way –a the market value of his holding at the end of the tax year was $1,438,192; b during that tax year, Dr Saha had sold 2301 shares for $848,709, so this was added to "a"; c the market value as at the start of the tax year was nil since he did not own the shares at that point; d the cost of his acquisition of the 7566 shares during the tax year was calculated to be $3,497,552.[24] Thus applying the formula:($1,438,192 plus 848,709) minus ($0 plus $3,497,552)gave a loss of $1,210,651, which was claimed by Dr Saha and accepted by the Commissioner. [25] In the following year, Dr Saha forfeited 2095 shares. Dr Saha's tax return calculated his year's transactions this way:a 2403 remaining shares worth $418,962; b 767 shares sold realising $124,280;c $1,438,192 carried forward from (a) of the preceding year; d nil because no shares acquired during year.[26] Applying the formula:($418,962 plus $124,280) minus ($1,438,192 plus $0)gave a loss of $894,950, which Dr Saha claimed but which was not accepted by the Commissioner. [27] The Commissioner assessed figure (b) as being different. He treated the disposal of the forfeiture shares as a gain at market value to Dr Saha derived during the year. Thus his calculation, and what has become the disputed assessment, is:($418,962 plus $727,218) minus ($1,438,192 plus $0)which gives a loss of $292,012. [28] The difference, therefore, is whether the loss for the 2002 tax year should be $292,012 as the Commissioner has assessed, or $894,950 as the taxpayer claimed.The Court's summation of the issue[29] The starting point is that the Act brings to tax the holdings of a New Zealand tax resident in an overseas investment fund. That is common ground between the parties. Also common ground is that Dr Saha elected to have that process calculated by the comparative value method. [30] In the tax year ending 2001, Dr Saha declared his initial holding in the foreign investment fund to be 7566 shares (in Cap Gemini). That seems to me to be the key factor in the dispute: a) the Commissioner says that thereafter every dealing with those 7566 shares has a tax implication in the year in which that dealing occurs;b) the taxpayer says that the dealing represented by the forfeiture of the 2095 shares should not be regarded as having any direct tax implication in that year. It will inevitably have some consequence because he will own less shares and the market value of his holding will be affected, but the disposal itself is tax neutral; or alternatively, the true tax implication is for the initial 2001 year because it meant Dr Saha did not acquire 7566 shares, but rather 5471 shares. That might mean Dr Saha claimed too big a "cost" in his 2001 return, but that return cannot be re-opened because it is too late, and the return for the year in issue is correct because the tax implication of the forfeiture does not arise in the tax year in dispute. [31] In order for the Commissioner to give effect to his analysis of the scheme, it is necessary to bring the disposal of the 2095 shares within "b" of the formula, which in its relevant parts reads:is the aggregate of all gains derived by the person during the income year with respect to the interest.[32] I consider the best way to approach the balance of the judgment is to first set out how it is that the Commissioner says the disposal of 2095 shares was a gain derived by Dr Saha in the income tax year. If that explanation seems available, then the onus is on the taxpayer to show it is wrong.The Commissioner's argument on why it is a gain[33] Mr Lennard said it is obvious that the disposal of 2095 shares has not produced an actual gain. No-one is suggesting it did. What is being said is that within the comparative value method, and having brought to tax 7566 shares at a cost of $3,497,552, disposal of any of those shares will always, for tax purposes, be treated as having been done either at market value, or at the actual sale price, whichever is the higher.[34] His starting point was that the arrangements entered into for the sale of the EYNZ Consultancy had tax implications. Had the partners such as Dr Saha received cash, that cash would have been proceeds of the sale of a capital asset and generally not taxable. However, the chosen method of payment, namely by shares in a foreign company, engaged the FIF rules. It was as if EYNZ had received cash and Dr Saha then immediately had invested his cash proceeds into a foreign fund. Hence, Dr Saha could claim a purchase cost of $3.497 million even though he had actually paid no cash for it. [35] Turning to the dispute, the key provision from the Commissioner's viewpoint is CG23(5) which provides:(5) For the purposes of this Act, where at any time in an income year a person disposes of any property which is, with respect to the period immediately before disposition, an interest of the person in a fund with respect to which the person uses the comparative value method or the deemed rate of return method, for no consideration or for consideration which is less than the market value of the property at the time, the person shall be deemed to have derived from the disposition consideration equal to the market value of the property at the time. (emphasis added)[36] The Commissioner's position is that: a) the return of the shares to Cap Gemini is a disposal of an interest in a fund in respect of which Dr Saha uses the comparative value method; b) the disposal was either at market value or at less than market value or for no consideration. It did not matter to the Commissioner which of those options was applied. The Commissioner was not suggesting the disposal was at greater than market value, so the effect of CG23(5) is to regard the disposal as being at market value. [37] Concerning disposal, Mr Lennard notes that it is not disputed by the taxpayer that the forfeiture of the shares amounted to a disposal by Dr Saha. In any event, in ordinary language the transaction was a disposal.[38] Concerning which consideration option of CG23(5) is applicable, the Commissioner's position is that it is a situation of "nil consideration" because the taxpayer was not paid by Cap Gemini for the shares. If that is wrong then as noted the position is that whatever the taxpayer was paid, in whatever form, the Act deems it to be at market value. It is also noted that CG14(2) deems a gain received "in kind" to be equal to the market value of the gain. [39] In policy terms the Commissioner submits there is symmetry in the assessment because the tax treatment adopted by the Commissioner in 2002 reflects the tax treatment adopted by the taxpayer in 2001. On the other hand, if the taxpayer were correct asymmetry results because it allows a one-way deduction. If, for example, in year two the contract had been cancelled altogether, on the taxpayer's approach there would be no tax consequence attaching even though having claimed a loss on the purchase of shares in year one, all the shares were transferred back in year two. [40] The Commissioner's essential position is that transactions in the fund need to be accounted for in tax terms, and under the comparative valuation method this transaction is a deemed gain by virtue of CG23(5).Taxpayer's response[41] It probably does injustice to Mr Harley's argument, but I would describe the essence of it as being that each tax year must be taken as a discrete entity. If there are deficiencies in the system that mean, for example, it is not possible to go back to the 2001 year and adjust that in light of later developments, then that does not justify altering the 2002 return from its proper analysis. [42] With that starting point Mr Harley argued that it cannot be said that Dr Saha made a gain in relation to the 2095 shares:The forfeiture remedy was inextricably linked to the purchase goodwill Cap Gemini had paid in share numbers, and operates to adjust the share numbers allocated [to Dr Saha] by reference to that sliding scale.[43] Mr Harley continued:There was no lack of consideration for the share number adjustment which the documents record. The documents had been agreed between person's at arms length. There is no gift – no element of bounty – from Dr Saha to Cap Gemini. Rather, there is a partial recovery by Cap Gemini of what it had originally paid out on certain terms, measured in share numbers.[44] Underlying the taxpayer's submission was the proposition that the documents were to be taken as setting up the arrangement that they set up. The tax implications then flow from those arms length arrangements. One does not deny the true meaning of the bargain just because it has unexpected favourable tax implications. [45] Apparently recognising the need to show consideration in 2002 for the disposal of shares so as to avoid CG23(5), Mr Harley argued that the consideration for the disposal of 2095 shares was an agreement to reduce the price measured in share numbers, in that second year, because Dr Saha did not complete the earlier bargain as a whole over its full term. [46] Mr Harley submitted that the Commissioner's concern about a taxpayer cancelling the contract in year two, having gained a one-off loss in year one, was invalid. First, there is no cancellation here; second, in that example the taxpayer obtains a gain, namely the return of his share of the consultancy business. [47] In summary, Mr Harley's position is that the forfeiture reflected a prior agreement for a purchase price adjustment in the event of certain things happening. Those things happened and in accordance with that prior agreement the shares had to be returned. That returning of shares was a disposal but it was not for gain; rather it reflected a reduction in benefit from Dr Saha's viewpoint. What he had sold to Cap Gemini in 2001 became less valuable to the purchaser when there was a breach of the complementary employment contract. The parties had agreed that in such circumstances the price would be reduced, and that is what happened.Decision[48] In my view, there is no doubt that what occurred is properly seen as a purchase price reduction. The agreed purchase price, and Dr Saha's share, was at risk of adjustment for a period of 5 years. The parties identified in advance what circumstances might cause such an adjustment of the price, and how the price would be adjusted if such circumstances came into being. The label attributed by the documents to the agreed reduction does not seem important. The substance of the agreement is clear. [49] The key question is whether that arrangement matters in terms of the FIF rules. The Commissioner says it does not, and I agree. [50] In tax year 2001 Dr Saha declared his interest in a foreign investment fund to be 7566 shares, such shares having been acquired by him at a cost of $3,497,552. For tax purposes, Dr Saha therefore had that degree of interest in the foreign company. Thereafter, any adjustments in the number of shares had to be reflected in the relevant tax year. Acquisition of further shares would be treated as a deductible cost, but of course the year end value would also reflect the greater number of shares. Disposition of shares would be treated as an assessable gain, but again the year end value would reflect the lesser number of shares now owned. [51] It seems to me that the Act covers the situation whether the correct analysis of the disposal is that it was for no consideration, or consideration in kind. However, in my view, there was no fresh consideration for the forfeiture. In tax year 2002 Cap Gemini has not paid anything for the shares. No consideration at the time of the disposal has passed from Cap Gemini to Dr Saha. Rather, it is, as the taxpayer contended, an adjustment to the original purchase price. That bargain had been struck before Dr Saha acquired the shares, and before he made his tax choices. Accordingly, I would see CG23(5) as directly engaged, as the Commissioner contends. There was a disposal in tax year 2002 of 2095 shares for nil consideration. CG23(5) deems that disposal to be at market value.[52] The taxpayer's case did not identify any valid route by which CG23(5) could be viewed as not applicable. Further, there appears to me no policy reason, to the extent that is relevant, why Dr Saha's position should be correct. I do not see the Commissioner's approach as effecting any injustice since Dr Saha took a tax position in 2001 that provided to him the full tax benefit available from acquiring 7566 shares in Cap Gemini. [53] At the time Dr Saha ended his employment with Cap Gemini, a Deed of Settlement was entered into. One of its terms was the forfeiture of the shares. In other provisions of that agreement, Dr Saha received a cash settlement, and the date of termination of employment was fixed. The Deed of Covenant remained "in full force and effect". There was little focus by the parties on this Deed of Settlement, and it was not suggested that the forfeiture did other than record the existing bargain as set out in the Deed of Covenant. [54] The only other analysis of Dr Saha's tax position that I considered available was the argument that the taxpayer's 2002 return is correct, and what should happen is that the 2001 return is adjusted. If that cannot be done by reason of time limits, then that is not a basis to alter what is a correct 2002 return. In other words, if it was wrong to claim 7566 shares in 2001, that error is not to be corrected by the 2002 return. [55] I am of the view that that approach is not ultimately correct because it has insufficient regard to the FIF scheme, as applied to this contractual arrangement. The better analysis under that approach would be to say that Dr Saha had a choice in tax year 2001 to say that under the contract arrangements his interest in the overseas fund was less than 7566 shares. In other words he might have sought to bring to tax in year one only that percentage of his allocated shares that were not at risk of forfeiture. I do not know what the Commissioner's response would have been to that. There are counter arguments in the documents. For example, in the way in which a partner's interest in the escrow account is established, and what appears to be crediting to the partner of returns on all 7566 shares or their cash equivalent. Further, the partner was regarded in the documents as being the beneficial owner of all the shares for purposes of voting rights.[56] Whatever the response might have been, Dr Saha chose for tax purposes in 2001 to treat himself as having bought the whole package of 7566 shares for $3.4m. That done, the Act says the subsequent disposal of those shares is deemed to be at market value or higher (where more than market value is actually received).Conclusion[57] The parties indicated there was no dispute as to the market value of the 2095 shares, which is as recorded in the Commissioner's assessment. I accordingly decline the application and confirm the Commissioner's assessment. [58] The Commissioner is entitled to costs. If agreement cannot be reached, memoranda are to be filed. ____________________________ Simon France JSolicitors: G J Harley & R P Harley, Barristers, PO Box 5241, Wellington, email: gjharley@harleychambers.com / rpharley@harleychambers.com M T Lennard, Barrister, PO Box 5616, Wellington, email: mike.lennard@xtra.co.nz