‘Safe Harbour’ provisions almost up
I’ll sneak it in here, because while not directly tax related, firstly I am short on content this week with the tax front line being rather quiet last week (unless you were excited to hear that Family First had won its charitable status claim in the Court of Appeal), and secondly, because arguably indirectly it is tax related. Because without the safe harbour provision, directors could be potentially exposed to the Inland Revenue for having allowed their ships to continue sailing whilst in the midst of a liquidity storm.
The Covid-19 Response (Further Management Measures) Legislation Act 2020 introduced with effect from April 3rd 2020, a ‘safe harbour’ from sections 135 and 136 of the Companies Act 1993, which would provide potential relief to company directors facing insolvency as a result of Covid-19.
Section 135 is the reckless trading duty that directors owe to creditors, and section 136, the duty in relation to a director not agreeing to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so. Naturally, in a Covid-19 environment, these two provisions come to the fore, putting pressure on directors to seriously considering winding up the business or otherwise face a personal liability exposure.
Under the ‘safe harbour’ provision, directors’ decisions to keep on trading, as well as decisions to take on new obligations, over the coming six months would not result in a breach of duties if:
- In the good faith opinion of the directors, the company is facing or is likely to face significant liquidity problems in the next six months as a result of the impact of the Covid-19 pandemic on them or their creditors.
- The company was able to pay its debts as they fell due on 31 December 2019 (or the company was incorporated between 1 Jan and 3 April).
- The directors consider in good faith that it is more likely than not that the company will be able to pay its debts as they fall due within 18 months (for example, because trading conditions are likely to improve or they are likely to able to reach an accommodation with their creditors).
It is important to note that the safe harbour provisions are not designed to support an entity that has no realistic prospect of continuing to trade by deferring a decision about liquidation to the detriment of its creditors.
Directors must also be aware that these temporary safeguards do not release them from their other obligations and duties under the Companies Act 1993. These include acting in the best interests of the company, and their duty of good faith, and that directors can still be held accountable for a serious breach of these duties, and for dishonestly incurring debts.
The ‘safe harbour’ provision is due to expire on 30th September 2020
Frucor loses on appeal
Some of you may have been following the tax avoidance case between IR and Frucor Suntory New Zealand Ltd (‘Frucor’), which Frucor had won in the High Court.
Just to give you the flavour:
“Frucor was advanced $204m by Deutsche Bank in exchange for a fee of $1.8m and a convertible note (the note) redeemable at maturity in five years’ time at Deutsche Bank’s election by the issue of 1,025 non-voting shares in Frucor. The bulk of Deutsche Bank’s advance of $204m was funded by a contemporaneous payment of $149m by Frucor’s then Singapore-based parent, Danome Asia Pty Ltd (DAP), for the purchase of the shares from Deutsche Bank in five years’ time at a pre-agreed price matching the face value of the note (the forward purchase agreement). The balance of $55m was contributed by Deutsche Bank. Upon receipt of the $204m from Deutsche Bank, Frucor immediately returned $60m of capital to DAP in a share buyback and the balance $144m was paid in satisfaction of an existing loan from another Danome entity, Danome Finance SA in France.”
Frucor claimed $66m in interest deductions over the five year period, computed on the full $204m advance, which made IR sad, who claimed that the $66m was in effect $55m of principal and $11m of interest, and Frucor had used our tax legislation in a way that Parliament would never have contemplated (a statement now made famous by the Ben Nevis Forestry case – one which enables the taxpayer to gain the benefit of the specific provision in an artificial and contrived way).
Having lost in the High Court (Muir J comfortable the arrangement was not tax avoidance), IR threw all its toys out of the cot and appealed. The Court of Appeal reinserted a pacifier in IR’s mouth to quieten her down, by allowing the appeal, with a finding that:
- When the economic / commercial effect of the funding arrangement was examined in its context, it became clear that tax avoidance was its principal purpose or effect or, at least, tax avoidance was not merely an incidental purpose or effect.
- By entering into the funding arrangement, Frucor achieved a $66m interest deduction without incurring a corresponding economic cost for which Parliament intended deductions would be available. As a matter of commercial and economic reality, $55m of the claimed interest represented the repayment of principal borrowed from Deutsche Bank and was not an interest cost.
- The primary purpose of the funding arrangement was the provision of tax efficient funding to Frucor.
- The transaction was in many respects artificial and it was clearly contrived for the very purpose of enabling Frucor to gain the benefit of the specific provision allowing interest deductions. Taken together, the features of the arrangement revealed that its purpose was to dress up a subscription for equity as an interest-only loan to achieve a tax advantage. It was hard to discern any rational commercial explanation for the artificial and contrived features of the arrangement, other than tax avoidance.
- The principal driver of the funding arrangement was the availability of tax relief to Frucor in New Zealand through deductions it would claim on the coupon payments. The benefit it obtained under the arrangement was the ability to claim payments totalling $66m as a fully deductible expense when, as a matter of commercial and economic reality, only $11m of this sum comprised interest and the balance of $55m represented the repayment of principal.
- The Commissioner was entitled to reconstruct by allowing the base level deductions totalling $11m but disallowing the balance.
It was not all lose / lose for Frucor however, the Court of Appeal agreeing with the High Court that shortfall penalties should not be imposed in the case. While the Court came to a different conclusion from the High Court on the core tax avoidance issue, it said that Frucor’s arguments could not be dismissed as lacking in substantial merit. The Court acknowledged that Muir J was an experienced commercial Judge, who had not only regarded Frucor’s argument as deserving serious consideration, but he had also explained in a careful, closely reasoned and comprehensive judgment, as to why he was persuaded it was both factually and legally correct.