IRD wins in massive tax case against BNZ; ominous sign for other big 3 banks (Update 5)

The Bank of New Zealand (BNZ) has lost its High Court case against the Inland Revenue Department over years of structured finance transactions, which means the BNZ may have to pay the IRD as much as NZ$654 million in back taxes and interest. (First published July 16 at 12.05pm. Updated with full High Court judgment in Scribd browser on July 20 at 3.50pm) The BNZ said it was likely to appeal, but would make a final decision within 20 working days. BNZ, ASB, ANZ, National, and Westpac face a combined tax bill of over NZ$2 billion if they all lose their cases over structured finance transactions that the IRD has said were designed to avoid paying tax. The BNZ decision is the first one and is likely to set a precedent. It will surprise many, particularly given the banks have expressed confidence that they would not need to provide for losses in the case. Here's BNZ's statement below.

As previously disclosed, the New Zealand Inland Revenue Department (IRD) is carrying out a review of certain structured finance transactions undertaken by some New Zealand banks. As part of this, BNZ received amended tax assessments for the 1998 to 2005 years which BNZ challenged in the New Zealand High Court. The High Court judgment released today in relation to the Structured Finance Tax Case found against BNZ. The case involved six structured finance transactions with offshore counterparties. The tax in dispute for all transactions is NZ$416 million. In addition, as at 30 June 2009, BNZ is liable to use of money interest of NZ$238 million (net of tax). The possible application of penalties has yet to be considered by the IRD. BNZ CEO Andrew Thorburn said: "Clearly we are disappointed by the outcome. We will review the judgment which spans 179 pages, and make a decision within twenty working days on whether we will appeal. At this time it is our expectation that we will do so." It's important to clarify that the judgment will have no impact on BNZ's ability to meet any debt and / or equity obligations (including those related to BNZ Income Securities Ltd and BNZ Income Securities 2 Ltd). BNZ has a capital base well in excess of Reserve Bank of New Zealand capital ratio requirements.

Here is the full statement from IRD on the court decision. They're happy, it's fair to say.

The Commissioner of Inland Revenue, Robert Russell, has welcomed the High Court ruling that BNZ must pay NZ$416 million in back taxes. Justice Wild rejected BNZ's challenge to Inland Revenue's tax assessments. The ruling followed a thirteen-week hearing in the Wellington High Court, which finished last month. The case revolved around a particular kind of transaction known as "˜structured finance.' The BNZ made an equity investment in an overseas entity on terms requiring the overseas entity to buy back that investment when the transaction finished. The transactions were structured to allow the BNZ to deduct its expenses of earning the income gained on the investment, while receiving that income free of tax. The six transactions in issue spanned eight income tax years between 1998 and 2005. Justice Wild said, "Putting aside the tax benefits they generated, these transactions had no commercial rationale, logic or purpose for the BNZ.'' Mr Russell said that Inland Revenue considered these types of transactions to be tax avoidance. "The High Court has agreed, and we are pleased with this outcome.'' The decision is open to appeal.

Later, Standard and Poor's affirmed its AA ratings for Australia's big four banks and their subsidiaries because they could cope with paying the back taxes and interest. It said there was an increased probability the banks would have to pay.

Standard & Poor's Ratings Services today said that it affirmed the "˜AA/Stable/A-1+' ratings on the four major Australian banks"”Australia and New Zealand Banking Group Ltd. (ANZ), Commonwealth Bank of Australia (CBA), National Australia Bank Ltd. (NAB), and Westpac Banking Corp. (WBC)"”despite the recent New Zealand High Court judgement on tax liabilities in relation to certain transactions of Bank of New Zealand (BNZ, which is a wholly owned subsidiary of NAB). At the same time, Standard & Poor's affirmed the "˜AA/Stable/A-1+' ratings on the major Australian banks' core subsidiaries, including the four major New Zealand banks: ANZ National Bank Ltd. (ANZ National), ASB Bank Ltd. (ASB), Bank of New Zealand, and Westpac New Zealand Ltd. (WNZL). Standard & Poor's notes that all the four major banks have significant contingent liabilities over similar disputes with the New Zealand Inland Revenue Department (IRD). Although the impact of the IRD disputes on the major New Zealand banks' earnings could be material, the affirmation on the major New Zealand banks' ratings reflects their core status within the parent bank groups. The IRD has been carrying out a review of certain transactions undertaken by the New Zealand major banks. As part of the review, the banks received amended tax assessments for income tax payments and overdue interest payments of various amounts. A High Court judgement, released yesterday, found against BNZ, and has held BNZ liable for a NZ$416 million income tax payment and NZ$238 million in interest. Additionally, we understand there could be penalty payments that are yet to be considered by the IRD. We believe that there is an increased probability that the four major banks will need to make significant payments to the IRD in relation to these disputes. However, we consider that these banks could make such payments without putting pressure on their ratings, because of four factors: -- These payments would be one-off items, and we expect them to be significantly smaller than the Australian major banks' expected earnings and equity bases at the consolidated group levels. -- We believe that the Australian and New Zealand banks' shareholders are likely to show forbearance for any resulting cut in earnings or dividend payments. -- We expect that the banks would be topping up their equity positions in the unlikely scenario that a resultant loss caused a significant reduction in their equity bases at the group level. -- The payments are unlikely to pose any significant liquidity challenges. Nevertheless, Standard & Poor's considers that the increased probability of these payments reduces the buffer for further unfavorable developments in the major banks' ratings. We note that the penalty amount has not yet been determined, and that a materially punitive penalty could put pressure on the consolidated group earnings or equity bases. The contingent liabilities due to the IRD dispute are a materially larger proportion of the New Zealand banks' earnings and equity bases compared with those at the consolidated group level. Nevertheless, the liabilities do not impact the ratings on the New Zealand major banks because we believe these liabilities do not change the "core" status of the major Australian banks' New Zealand subsidiaries within their parent bank groups. We expect that funding or capital support from the parents would be forthcoming, if required.

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