Share and insurance deal brings $100M IRD tax sting

Friday 23rd February 2001

GOSLING CHAPMAN: Promoted the tax-loss scheme along with Milloy Reid Wong

THE DIGI-TECH DOSSIER

In the biggest clawback of tax since the winebox inquiry, a group of sophisticated investors who poured millions into tiny Wellington company Digi-Tech is now being asked to pay $100 million to Inland Revenue. NICHOLAS BRYANT investigates

SPECIAL REPORT

In 1995 when 110 investors signed up for $225 million worth of shares in Digi-Tech Communications, a company with an annual turnover of only about $1 million, Inland Revenue smelled a rat.

Now, after a three-year investigation, it wants about $100 million from those investors.

The taxman has also referred information surrounding the purchase of an offshore insurance policy to the Serious Fraud Office to investigate.

The policy involved a guarantee that the investors' $75 million investment in $1 Digi-Tech shares would be worth three times that much in 2005.

The SFO was due to have completed a preliminary examination of the case on February 8 It would not comment on the investigation this week.

In the biggest IRD clawback of tax since the winebox inquiry, where 60 companies were found to owe about $140 million, prominent lawyers, accountants, property developers and others are being stung for unpaid tax, interest and penalties.

Their predicament arose from a complex deal over the sale of the Digi-Tech shares, a transaction that involved the intended transfer of money between local investors, a Hong Kong accounting firm, a British Virgin Islands trust company, a Swiss bank and a Dutch insurer.

The deal was promoted by Auckland merchant banking firm Milloy Reid Wong (then known as Milloy Reid Tong) and Auckland accountants Gosling Chapman.

In 1994 investors were asked to consider investing in Digi-Tech by way of a long-term sale and purchase agreement, which allowed them to invest in the "explosive growth" technology sector without the immediate need for fronting up with the required investment funds.

Two investments were required.

For the first, the investors, most of whom were clients of Gosling Chapman, would buy a minimum of 500,000 $1 shares in Digi-Tech.

Each investor would be a director of a loss attributing qualifying company (LAQC).

One hundred and ten investors (forming 74 LAQCs) entered into the share purchase contract in March 1995 with a company called n-Tech.

Milloy Reid Tong owned n-Tech, which in turn owned all 100 million Digi-Tech shares,

The number of shares bought by the 74 companies varied from 500,000 to six million.

Each of the LAQC's contracts specifically included a 10-year delayed settlement date of March 31, 2005.

The shares were not to be transferred to the 110 directors of the 74 companies until the 2005 settlement date.

A deposit of 9.5% of the total value of the shares was paid by each LAQC upon signing the purchase contract and a further 1% of the ordinary share price's $1 value was to be made each subsequent year until settlement date.

On the 10-year settlement date the remaining 81.5% of the $75 million share deal was due.

The second investment was the purchase of a $75 million insurance policy linked to a range of foreign institutions.

Each LAQC, excluding one, bought the insurance policy which ensured the future value of the shares in a "loss of profits" policy.

AP Underwriters Trust, a subsidiary of Epicharmus Vastgoed BV, based in Amsterdam, issued a certificate of insurance to the LAQC companies. The value of cover for each LAQC company's shares was limited to $3 a share.

The insurance policy insured the future value of the Digi-Tech shares to be not less than $3 a share, a total payout of $225 million. The period of cover was June 30, 2005, to September 30, 2005.

It was this policy that interested the IRD. In correspondence to investors obtained by The National Business Review the IRD takes issue with the full insurance premium having been claimed as a lump sum deduction against the nil assessable income of each LAQC in the year it entered into the contract, 1995.

"Each LAQC has therefore incurred a loss approximating three times the number of ordinary shares purchased.

"Typically, this is one million shares with a $3 million loss incurred.

"The effect of that is that the shareholders have claimed their individual share of the LAQC loss in their personal income tax returns," IRD correspondence says.

This is where the Swiss bank comes in.

To enable the LAQCs to purchase the insurance policy a $72 million term loan agreement was taken out with Bank of New York-Intermaritime Bank Geneva, an institution notable for having been sued by the US Justice Department in 1998 in its effort to stamp out secret tax havens.

A year later the bank denied accusations in Russian newspaper reports that it was linked to money laundering for criminals in Eastern Europe.

In the case of an LAQC wishing to buy 500,000 Digi-Tech shares, an application was made to the bank for a loan of $US307,200, its share of the $72 million.

Security available for the transaction was in the form of a mortgage of personal property and the liability of the LAQC was limited to the value of the security provided, in this case the Dutch insurance policy and the Digi-Tech share acquisition agreement.

Transactions involving the loan also attracted the IRD's attention.

It says each LAQC claimed a deduction for the interest incurred on the loan, despite it not being due to be repaid until March 31, 2005.

"Arranging the loan documents in this way has enabled LAQCs to claim a further deduction for interest on the term loan in subsequent years. A further loss will therefore be available in subsequent years to offset against the income of individual shareholders of each LAQC."

The IRD's final view was strongly worded.

"The expenditure incurred by the parties who purchased shares in Digi-Tech Communications are not expenses incurred in carrying on a business or deriving gross income ... It is also considered that the transactions entered into by the various LAQCs are tax avoidance arrangements," the IRD said.

Whether either of the New Zealand parties involved in the scheme was its "mastermind" is the subject of a bitter dispute.

Milloy Reid Wong director John Reid said he was confident of the legitimacy of his firm's role in the deal.

"I am co-operating with the Serious Fraud Office's investigation ... there seems to be a lot of confusion in relation to people's understanding of [the deal]," Mr Reid said.

Gosling Chapman partner Rowan Chapman would not comment other than to say Gosling Chapman had itself made a complaint to the SFO.

"I'm happy to comment after it makes its findings," Mr Chapman said.

The IRD's view was: "The department contends that this is a scheme organised ... as a tax-driven investment."

The offering investors rushed to buy

BIG DEAL: But lawyers are on the case

Digi-Tech Communications was started in 1976 and specialises in modems, multiplexers, cabling and ISDN products, and transmission systems with what it calls a "broad feature range and flexible technology."

It has some high-profile clients including Telecom, the New Zealand Stock Exchange and WestpacTrust.

Since the early 1990s it has been controlled by Auckland merchant banking firm Milloy Reid Wong, formerly Milloy Reid Tong.

A Digi-Tech Communications document dated December 1994, offering an opportunity to invest in the data communications industry, projected year-one revenues would be $3 million with a gross profit of $1.5 million.

Year-five revenues would be $30 million with gross profit of $15 million.

And growth was not due to have slowed by year 10, 2005, with revenues of $138 million trumpeted alongside a gross profit of $69 million.

The company's returns have been unexceptional except for one standout year - the 12 months to March 31, 1998.

Between 1992 and 1997 the company made some net losses, in a range between about $120,000 and $430,000, and some net profits, in a range between $23,000 and $145,000.

Then, in 1998 the growth strategy started to show through. The financial statements to March 31, 1998, show group revenue of $58.6 million and an after-tax profit of $23.8 million.

The growth strategy was based on the sale of manufacturing and product distribution rights for Digi-Tech products. In the second half of 1997, 20 Australian investors bought manufacturing and distribution rights for $79.6 million payable over a 3.25-year term.

Companies office records show the creation of 15 Digi-Tech subsidiary companies, including in Latin America, Africa, the Middle East and the UK, most of which were set up in preparation for the granting of similar licenses to the Australian one.

But the Australian deal turned sour and is the subject of two cases filed by investment partnerships in the New South Wales Supreme Court.

John Reid of Milloy Reid Wong said he cancelled the Australian agreement because the investors failed to meet aspects of the deal.

In doing so Mr Reid made a call for all the money owed.

The Australian party has hired heavy-hitting Sydney law firm Atanaskovic Hartnell to put its case.

Both sets of proceedings are at an interlocutory stage so no judgements have been delivered. Neither of the proceedings has yet been listed for trial.

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