A Post-Hart Landscape:Avoiding The Broad Brush Of Part IVA

The Federal Court's decision in Macquarie Finance Limited v Commissioner of Taxation [2004] FCA 1170 was handed down on 14 September 2004. Although the case turned on the Court's finding that 'interest' deductions claimed by Macquarie Finance Limited (MFL) were not deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA97), Hill J's comments on the applicability of Part IVA of the Income Tax Assessment Act 1936 (ITAA36), the general anti-avoidance provision, illustrate the difficulties taxpayers may face in seeking to avoid the broad brush of Part IVA.

The case discusses the application of the principles espoused by the High Court in Hart v Commissioner of Taxation (Hart's case) and the approach to weighting commercial purposes and tax purposes in determining the tax payer's dominant purpose in entering the relevant scheme.

The dispute related to two issues of stapled income securities each of $200 million, being preference shares in the capital of Macquarie Bank Limited (MBL), MFL's parent company, and a beneficial interest in notes issued by MFL to a trustee (Trust Company of Australia Limited). The income securities essentially were to bear interest at a floating rate payable quarterly in arrears.

MFL claimed a deduction of $27,833,226.00 for interest payable on the notes. The Commissioner disallowed the claim on the basis that the interest was not deductible under section 8-1 of the ITAA97–which requires the amount to be incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for that purpose, and to not be capital in nature. Alternatively, the Commissioner determined that Part IVA of the ITAA36 applied to deny the deduction.

The aim of the proposal was to provide sufficient capital to allow MBL to acquire the Australian investment banking business and assets of Banker's Trust from Deutsche Bank AG (Deutsche) by way of a debt instrument which would qualify as Tier 1 capital under bank regulatory criteria. A number of proposals were considered by the MBL group with the third structure proposed being ultimately adopted. It involved MBL issuing fully paid preference shares in MBL and the issue of notes by MFL secured by a debenture trust deed, issued first to Deutsche as underwriter who would then on sell to MBL the right to require (in limited circumstances) the trustee to pay interest and principal amounts due to MBL rather than to note holders (referred to as the 'payment direction'). Investors would purchase the holder's right in the debenture subject to the payment direction and would purchase the preference shares from Deutsche.

MFL was to pay all moneys due under the notes (the 'interest') to investors unless there was a payment direction event; MBL guaranteed MFL's obligation to pay the 'interest'. Another key component of the structure was a 'procurement agreement' whereby MBL was to pay Deutsche an amount equal to the face value of the notes; Deutsche would then give a payment direction requiring that all moneys payable under the notes be paid to MBL. The payment direction, coupled with the payment by MBL meant that MBL reimbursed Deutsche for the money subscribed for either the preference shares or the notes. As a result, the preference shares would become dividend paying, investors would still hold the holder's interest but moneys owing would be paid to MBL. As the holder's interests in notes and preference shares were stapled, they could not be transferred individually.

The proceeds of the public offer were lent to Macquarie Leasing at interest to be used in its leasing business. The margin charged by MFL to Macquarie Leasing was greater than the margin MFL was required to pay note holders (the 'interest') via the trustee. It is that interest which was the subject of the dispute regarding deductibility.

In the normal course, interest will be an allowable deduction under section 8-1 if incurred as part of an income producing activity. Characterisation of an amount as interest is not determinative of deductibility, nor is it necessary for there to be a borrowing before what is termed 'interest' may be deducted. The important point is to demonstrate a sufficient nexus between the outgoing and the gaining or producing of assessable income or business.

The Court was convinced MFL was carrying on a business, and insofar as the notes were concerned, it could be said MFL entered the transaction intending to use the 'borrowed' funds in its business of lending at interest to companies within the MBL group, such as Macquarie Leasing. However, the Court indicated the proper analysis did not allow for the notes to be divorced from the MBL preference shares.

The stapling of the notes to preference shares, coupled with the fact that MBL could ensure the loan was never repayable, led the Court to conclude that the 'interest' was in effect the cost of a capital raising to secure an enduring benefit for MBL, and therefore capital in nature. While this finding meant that no part of the interest payable on notes is deductible to MFL, the Court considered the applicability of Part IVA in the event the interest was deductible under section 8-1 of the ITAA97.

A more detailed analysis of the interest deductibility issue will be provided in a separate article.

The Court considered the relevant scheme under section 177A(1) of the ITAA36 was the whole of the steps entered by MBL and MFL in issuing the notes and preference shares, including the giving of the payment direction under the procurement agreement. Hill J confirmed that Part IVA dictates that the scheme be properly identified before there can be any finding of a tax benefit in connection with such a scheme, and further, that the High Court's judgment in Hart's case meant any conclusion as to purpose must be addressed by reference to the whole of the scheme and not some isolated event, although a scheme could be narrowly defined.

Part IVA requires consideration of the eight matters under section 177D(b) in drawing any conclusion on dominant purpose. Hill J referred to the diminished role that commercial purpose was given by the High Court in Hart's case and sought to explain why the High Court considered little weight should be placed on the applicant's commercial reasons for entering the scheme in determining the predominant or prevailing purpose. His Honour suggested two bases for this rational:

• that the focus need be on the way the borrowing was structured and not the purpose for the borrowing itself, and that the former inevitably led to the conclusion the dominant purpose was to obtain the tax benefit; and

• that section 177D(b) did not allow for consideration of subjective motives.

Applying these principles to the present case, Hill J considered he was bound to look to the particular form of the capital raising employed by MFL and MBL, being the agreements relating to the preference shares and notes. His Honour found the procurement agreement and payment direction were only explicable by reference to the dual aims of obtaining the benefit of a share capital raising and an allowable interest deduction. Alternate options for pursuing the capital raising without the need for MFL's participation and without a tax deduction were evident, although His Honour acknowledged the stapled securities presented possibly the cheapest and most flexible commercial option. The Court concluded the inclusion of MFL in the scheme clearly served to ensure a tax deduction for an entity in the MBL group and highlighted the importance of the interest deduction in determining the final shape and form of the capital raising proposal adopted.

In assessing substance and form, His Honour noted the substance of the transaction was a raising of share capital by MBL and the form was a combination of debt and equity capital raising. Further, he noted that in substance MBL really incurred a liability to pay dividends commensurate with MFL's liability to pay 'interest'. He concluded the scheme took the form it did to allow MFL to obtain the tax deduction.

In balancing the importance of competing purposes, Hill J placed considerable emphasis on MBL's goal of obtaining Tier 1 capital (the commercial purpose), but found ultimately that the interest deduction to MFL (the tax purpose) was marginally predominant. In justifying this conclusion, the Court also referred to the taxation result considered from MBL and MFL's perspectives. Hill J also noted that unlike the Spotless case and perhaps Hart's case, the present case was not one where achieving the commercial purpose is dependant on achieving the tax purpose.

However, Hill J's reluctance to find that Part IVA would apply to deny the deduction sought, had that been necessary, is evident from his concluding remarks:

'It follows, therefore, that if, contrary to my view, the "interest" payable on the notes was an allowable deduction to MFL in the year of income, then that deduction constituted a tax benefit which MFL obtained from a scheme to which the provisions of Part IVA applied in respect of which the Commissioner was entitled to make a determination under section 177F, disallowing to MFL the deduction. I might add that I reach this conclusion with some reluctance. I doubt if the legislature would have regarded the present "scheme" as involving the application of Part IVA when the Part was enacted in 1981. However, it seems to me that the approach of the High Court in Hart requires me to reach the conclusion I have.'

This case demonstrates the difficulty in balancing commercial purposes and tax purposes to determine the predominant purpose for which the taxpayer has entered the scheme. Even where a strong commercial justification for a particular scheme can be objectively demonstrated, competing tax purposes will often tip the scales in favour of Part IVA applying to deny the deduction sought.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.