The wacky world of tax, trusts and Digi-Tech

By Deborah Hill Cone

Friday 1st October 2004

It is hard to decide what is wackiest about the Digi-Tech fraud case. Half a day was spent hearing evidence about how an accountant didn't go and visit the non-existent offices of a non-existent insurance company in Amsterdam. Or did he?

The lawyer for John Reid, the main defendant, did a Rumpole-like job of getting investors to concede they basically knew the Digi-Tech scheme was a tax dodge. But hang on a second; isn't he supposed to be defending it?

And the Serious Fraud Office took four days to explain a summary of its case but even then it was hard to find any real victims. An eclectic bunch of well-to-do Aucklanders, including wild-child property developer Mark Lyon, cricket boss Martin Snedden and top silk Paul Davison, not people you would normally see in the same room together, may have "unwittingly" filed false tax returns, apparently.

And get your head around this investors bought an insurance policy worth $3 million but they had to spend $3.6 million to claim it. Call me old-fashioned but that doesn't seem to make stunning financial sense.

Then there are the usual elements in any tax case missing spreadsheets, lost passports, overworked paper shredders, widespread memory loss "I cannot recall" was a frequent response to cross-examination in the Auckland High Court's courtroom 12, maybe echoes of the 1996 Equiticorp case for which it was specially fitted out. Those proceedings were complicated too but I doubt they involved a special sort of trust ideal for maintaining the grave of a much-loved pet another wacky Digi-Tech feature.

Finally there's the fact the case is being heard before a judge alone odd for a criminal trial, which would normally be presented to a jury. Will the judge, Christchurch import John Fogarty, simply pronounce the four defendants guilty or not guilty, or will he write a full judgment, which is unusual for a criminal case? A full judgment, the SFO expects. Just a verdict, the defence speculates, although with a case this complicated that's hard to imagine. It is hard to know what to believe.

But I should back up the truck, because you can be forgiven for losing the plot on this ear-buzzingly complex story, which dates back 10 years.

In one of the SFO's most complex and high-stake prosecutions, four defendants John Reid, John Currie, Peter Russel and Peter Connolly are accused of conspiracy to defraud investors over a 1995 structured investment in a Wellington company called Digi-Tech.

There are big bikkies involved; the investment was worth $75 million on paper, and the IRD estimates the amount of tax at stake in the scheme at $137 million, while the SFO claims investors lost hard cash of $16 million.

Reid ran a self-styled merchant bank called Milloy Reid Wong, which promoted the investment. Russel was a partner in accounting firm Gosling Chapman, which signed up its clients and pocketed a $1.3 million fee. Connolly seems to be a bit of a marginal figure, but is described as an intermediary who helped set up the structure, while offshore accountant Currie looked after the companies which were based in Hong Kong, the Netherlands and Bermuda.

The key figure who came up with the structure, former Rudd Watts partner Paul Darvell, was there only in spirit. He died in November 1995, just nine months after the first investors signed up.

His creation was a deal in which 75 investors each bought $1 million worth of $1 shares in Digi-Tech under a sale and purchase agreement where they paid the bulk of the price, a balloon payment, 10 years in the future in 2005.

At the same time they took out an insurance policy guaranteeing the $1 shares could be sold for $3 when the time came to pay and they took out a loan to pay for almost the entire $1 million insurance premium.

It was at the start of the high- tech boom and Digi-Tech was supposedly on the cusp of a breakthrough with its switching product Freerider, which may have been just what was needed to allow internet users to free up their phone lines. In the event, only 33 of the gizmos were ever produced.

But regardless of the success of the product, investors using loss attributing qualifying companies (LAQCs) got an immediate payoff, claiming the entire $1 million insurance premium as a tax deduction in the first year.

That meant a punter signing up for a $1 million investment could get a cash saving of $330,000 in 1995 for an outlay of only $135,000 (made up of a $95,000 deposit on shares and a $40,000 deposit on the insurance premium.)

Investors were under the impression the $3 per share insurance payout would cover their obligations in ten years time if Digi-Tech failed to perform, an assumption which turned out to be wrong.

And although they were plainly warned in a 1995 tax opinion from barrister Denham Martin that there must be no circular aspect to the insurance and loan set up, the investors made little or no attempt to check whether this was the case.

Their tax deductions were eventually disallowed and the investors were caught up in years of tedious negotiations with the IRD over back taxes and penalties eventually conceding they were unable to prove the transaction was commercial.

Most of them now wish they had never heard of the darned thing.

But the IRD issues are separate from the SFO's case, which is essentially that the investors were duped into putting money into a bogus insurance and loan set-up.

"What might have been a legitimate if marginal tax structure was rendered a fraud on the investors by the fact the insurance and loan transactions were entirely fictional, and the transactions comprising them were circular. The so-called financier who was purportedly providing the funds ... was controlled by Reid, Currie and Connolly," Crown prosecutor Mike Ruffin said.

Three of the men are also facing money-laundering charges the SFO claims they made off with the $40,000 per investor in insurance premium deposits which came back to New Zealand in a number of guises including being used in bond trades and an investment in a winery called Whitehaven.

Another provision in the investor contract seemingly gave them an "out" in which they could get most of their money back and scrap the contract if Digi-Tech didn't report a tax-paid profit of more than $595,000 in the 15 months to June 1996.

But the Crown claims Reid engineered the accounts to push them over this threshold and deny investors the chance to back out.

As to the nitty gritty of how the structure worked: the strangely- named Bank of New York Inter-Maritime Bank Geneva provided a $960,000 "loan" for each investor to pay the $1 million insurance premium, but the Crown claims this was simply a money-go-round from Milloy Reid Wong using what is known as a BNZ daylight overdraft facility, where the funds had to be deposited the same day or the next day.

Milloy Reid Wong disguised these transactions as bond trades, the SFO's case goes, and used transferable certificates of deposit (TCD) an opaque financial instrument, rather than hard cash.

The insurance company Epicharmus Vastgoed BV trading as AP Underwriters Trust, was administered by professional trustee company Insinger de Beaufort (now Equity Trust and part of giant finance group Candover), and later handed its liability to a special purpose trust. Purpose trusts are unusual entities which don't have a beneficiary and are created in only a handful of jurisdictions including Lichtenstein, Bermuda and Jersey.

Insinger de Beaufort's promotional material explains purpose trusts are used to support worthy causes (but not charities) or for sentimental purposes such as looking after the grave of a much-loved pet.

In the Digi-Tech case, the use of a purpose trust meant investors had no claim against the insurance company if it didn't pay up the contract was unenforceable.

"The nature of purpose trusts is there are no beneficiaries and nobody has any rights as against the trustee of a purpose trust of any kind," a 1994 Simpson Grierson tax opinion on a similar scheme explained, while Denham Martin's opinion noted investors had no rights against the entity.

But that is neither here nor there, according to the defence's case. The investors only put their money in to get a tax deduction and didn't care if the insurance company could pay out or not, they say.

And the numbers didn't stack up for them to claim it anyway.

"Were you aware there was no commercial benefit for an investor taking out the insurance, quite irrespective of the strength of the insurer?" Reid's Lawyer, Murray Gilbert, asked another Gosling Chapman partner Martin Richardson.

"No," Richardson replied.

Was there any misunderstanding because Gosling Chapman did not make the point sufficiently clear to their clients?

Richardson: "Possibly."

A typical investor signing up for $1 million worth of shares would have to pay out $2.9 million to the so-called "bank" at the end of 10 years the $960,000 it borrowed plus accrued interest. It would also have to pay the balance for the shares ($835,000 left from the $1 million purchase price after the initial deposit of $95,000 and seven years of yearly $10,000 deposits were deducted) making a total of $3.6 million. Before cashing in the insurance policy the investor would have to wait for about six months before the purpose trust would pay the investor at 8% interest a further loss of about $117,000.

The investor who took out insurance would not get into profit unless Digi-Tech was worth more than $400 million at the end of the 10-year period, whereas without the insurance they could break even if the company was worth $100 million.

A Gosling Chapman spreadsheet setting out the breakeven point for investors $5.60 rather than $3 had been "lost," the court heard.

"I viewed this [investment] as either being worth absolutely nothing or an absolute winner," one of the key figures in the case, Gosling Chapman partner Rowan Chapman said.

Chapman has cast himself as the whistleblower, having laid the original complaint with the SFO.

But Gilbert did his best to paint Chapman as someone who was far from a naive party in the affair, pointing out the accountancy firm had a reputation for advising its clients to invest in structured tax schemes, such as the mirror-image Salisbury forestry transaction. (This deal, which used the jurisdiction of Niue, is the subject of a separate SFO case against a defendant who has name suppression, as NBR reported on July 30.)

"The essence of your complaint was that the investors, of which you are one, were deceived into believing that they were dealing with a substantial lender and a substantial insurer with no link between them and no circularity of funding, is that fair?"

Chapman: "That's correct."

He travelled with tax lawyer Geoff Clews, acting for the investors, to Melbourne to visit Currie because "I was concerned with the lack of information we were getting on behalf of investors to assist with the tax investigation."

Gilbert: Did you ask him [Currie] any questions about the strength of the insurer, Epicharmus Vastgoed?

Chapman: I can't recall.

Gilbert: Did you ask him anything about the Swiss reinsurer?

Chapman: I can't recall.

Another Gosling Chapman partner, Terence McGrath, now running global photography business Kel Geddes Management, had visited the offices of the insurer, Epicharmus, at trust company Insinger de Beaufort in the Netherlands while on other business in February 1995, Chapman told the court.

"Epicharmus was more than a post-box but not a fully fledged office. He told me there was an address with a plaque on the wall and there were stairs leading to an office."

"Were you comforted by that report in believing Epicharmus was a substantial insurer?"

"No, I wasn't."

In his evidence McGrath told the Crown's Ruffin he had not been to Epicharmus' office and then later, under cross-examination by Gilbert, admitted he had.

Justice Fogarty stepped in to try to clarify the contradictory accounts apparently coming no closer to a definitive answer.

McGrath had taken 88 overseas trips since 1996 and had racked his brains on this question: "I have no recollection of being in Holland at that time."

By some accounts this is quite a simple case turning on whether the insurance and loan transactions actually took place.

But the defence might get home by showing there had been no deception because the investors knew what they were getting themselves into.

Even if the conspiracy charges were upheld, it would be hard for a judge to award high damages if no one had been shown to have been duped.

One investor, Paul Davison QC, admitted he hadn't read the Digi-Tech documents with "a degree of care or analysis at the time."

He had been interested in finding some form of investment that could provide an opportunity of using funds "that I was otherwise paying to the government by way of tax, to produce an investment that was tax effective and likely to produce a return for me because I was on what I thought was a fairly straight line of meeting my tax obligations with no relief.

"I don't want the court to get the impression that Mr Russel was forcing these things down my throat or anything of that nature."

Davison said he had not wanted to get into a transaction that had any paper parties in it but admitted he had put great reliance on Gosling Chapman's judgment and the fact the partners there had invested and should have been more careful in reading the documents.

Asked whether he gave the documents the same careful analysis he would have if he had been acting for a client, Davison admitted that as with the builder's house and the plumber's drains he hadn't.

Gilbert: "Looking at it now, would you be prepared to accept that there could be no good commercial reason for paying $1 million premium for a policy expected to confer unenforceable rights against an unspecified purpose trust in an unspecified jurisdiction?'

Davison: "Put like that, I agree."

The defence has yet to fully show its hand but it is not clear the foursome's separate counsel Gilbert for Reid, Hugh Fulton for Connolly, John Haigh QC for Currie and John Billington QC for Russell will be arguing any co-ordinated case.

There is certainly no love lost between the defendants.

The court heard how Russel believed Reid had "fitted him up" by paying him an extra $600,000 as a secret personal commission, which he later confessed to Chapman.

The case is set down for a further three weeks with a key witness being the SFO's forensic accountant David Tanner but in the world of structured tax deals, don't expect things to get any less wacky.

[Proceeding]

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