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Chasing tax across countries: A test case

Complex legal structures between countries, known as “hybrid” tax, legally minimise tax but represent a significant challenge for governments. Image sourced from

There has been a lot in the news lately about the low tax paid by some multinational corporations, including Starbucks and Google. These multinationals say that they are complying with the tax laws of all countries.

A recent Australian High Court case reveals the challenge facing national governments in trying to fix the international tax system to capture profits earned by multinationals around the world.

In this test case involving complex and technical Australian company tax rules, the High Court was asked to consider how these rules applied to the Commonwealth Bank of Australia’s controversial $2 billion capital raising in 2009.

The outcome was that CBA was legally able to reduce the cost of its capital raising - while both the Australian and New Zealand governments lost out on tax revenue.

PERLS V securities

At the time, most media attention around CBA’s capital raising centred around allegations it failed to disclose price sensitive material to the market, leading to a $100,000 fine by ASIC.

But the securities on offer, PERLS V securities were also notable for their complex “stapled” structure, comprising a preference share issued by the CBA, and a note issued by the bank’s New Zealand branch.

Under the issue, an investor was entitled to quarterly distributions of interest on the notes, plus a franking credit on the preference share. The interest was paid by the New Zealand branch of the CBA, which issued the notes. The franking credit reflected underlying Australian company tax paid by the bank as an Australian taxpayer.

A major reason for this structure was tax. The securities were treated differently in Australian tax law, compared to New Zealand tax law – we sometimes call this “hybrid” tax treatment and as the OECD identifies, it’s a challenge for tax systems.

Under Australian tax law, the PERLS V securities are treated as equity not debt, so although the return on the security was called “interest”, distributions were treated like a ordinary share dividend for tax purposes and carried a franking credit.

But under New Zealand income tax law, the note that formed part of the PERLS V securities was analysed on its own, separately from the preference share, and it was treated as debt.

This meant that in New Zealand, when the CBA branch paid interest on the note, that interest was deductible against profits of the New Zealand branch. As a result, the New Zealand branch paid less tax to the New Zealand government.

The CBA’s use of a hybrid structure for securities has been deemed legal - but presents challenges for governments worried about maximising tax revenues. AAP

Cheap capital for the Bank

The economic advantage of this complicated structure is that the CBA was able to obtain high quality capital at a cheap price. The cost of raising capital using the PERLS V security was estimated by the bank as 5.86%. This compared to the economic cost of an ordinary issue of shares of 14.2%. That’s quite a saving.

For investors, it’s the franking credit combined with the higher rate of the “interest” return – which was above basic interest rates – that is really attractive, allowing them to reduce tax on their income.

Applying the tax anti-avoidance rule

The full bench of the Federal Court at first ruled in favour of Australia’s Tax Commissioner, finding that a tax anti-avoidance rule directed at franking credit schemes to avoid tax, could be applied.

Justice Jessup concluded the Bank had a “non-incidental purpose” of enabling its investors in the PERLS V securities to get the franking credits which were central to the scheme - and the fact the bank received a deduction in New Zealand was relevant. So, the anti-avoidance rule applied – to deny the investors the benefit of the franking credits.

But on appeal, the High Court found instead that the CBA was able to issue the securities with tax advantages, carrying a franking credit for the investor. Justice Gageler, in the High Court, accepted that the deduction in New Zealand was relevant to the Australian tax rules, but concluded that even though the franking credits were crucial for investors, the main purpose was the capital-raising.

Why should Australian taxpayers care?

Don’t get me wrong, the Commonwealth Bank pays quite a lot of tax. It reported about $2.1 billion in 2012 on a profit of more than $7 billion.

The result of this case confirms the CBA was operating absolutely within the income tax rules of Australia and New Zealand. Many will say the case is a straightforward and sensible approach to company tax rules in a situation where there was a genuine commercial capital-raising by one of Australia’s major banks.

But the bank’s cheap capital comes at a cost to the revenue and we all bear some of this cost (although the investors go home happy). On $2 billion of capital, the Bank saved about $170 million, most of which is the result of reduced tax paid in Australia and New Zealand. If the Tax Commissioner had won this case, the Commonwealth Bank estimated the cost of capital as rising to about 7.8%, still much cheaper than ordinary shares. The main reason for the cheaper capital is the deduction for the interest paid out of the New Zealand branch.

Why, if franking credits reflect company tax paid, should Australians care if the CBA could distribute them to its investors in the PERLS V securities? There actually has been, at some stage, company tax paid by the Bank.

The reason is that the Commonwealth Bank was in what is called an “excess credit” position. Some of the Bank’s shareholders are not Australian residents, and those shareholders cannot use franking credits to reduce their tax.

This means the Bank does not want to distribute franking credits to foreign investors and it builds up a stock of credits it cannot use. The PERLS V securities enabled the Bank to distribute some of those excess franking credits to Australian investors – who can use them - without paying any more company tax on the underlying profit that supported the return on the securities.

The OECD has agreed to prepare new global guidelines on tax to address issues such as profit-shifting. AAP

Tax cooperation needed in the global era

If anything, it’s New Zealand taxpayers who might care that they are not getting their full share of company tax from the CBA. Should Australians care about New Zealand’s tax revenue, if its tax law does not solve the problem?

I think the answer has to be “yes”. In the old days, the tax system of one country really had no connection to another country. But today, capital is increasingly mobile as a result of globalisation. International tax arbitrage by multinationals – for example, by using securities or other arrangements that have hybrid tax treatment across borders – is one way in which the global tax burden of the multinational is lowered.

In the CBA case, the Tax Commissioner argued that the bank had got “the best of both worlds” in its PERLS V securities. Indeed, the Bank has got the best out of our globalised world. All countries would benefit if we were able to achieve increased transparency and a new approach to multinational taxation that would address hybrid tax treatment across borders, as well as other concerns about profit shifting such as that alleged for Google and Starbucks.

There are some positive developments. The federal Treasury Working Group has issued a Discussion Paper on this issue, while the OECD has agreed to prepare new rules about tax avoidance before the G20 meeting in July.

National governments cannot succeed in taxing multinational corporations that can plan their tax and business affairs across a multitude of countries each with different tax and regulatory regimes, unless governments begin to cooperate in designing the tax laws that apply to multinational corporations.

Even countries as closely connected as Australia and New Zealand can miss out if we do not cooperate in designing our tax systems.

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