Inland Revenue shows no mercy to investors in Digi-Tech scheme

By Deborah Hill Cone

Friday 5th April 2002

John Reid

The taxman moved a step closer to investors in the Digi-Tech and NZIL tax schemes this week, with no concessions to the fact the scheme's promoters are being prosecuted for fraud.

Last month four figures linked to the scheme - John Reid, Michael Connolly and two others who have name suppression - were charged by the Serious Fraud Office with conspiracy to defraud and money laundering (NBR, Mar 15).

But even if the investors they signed up are found by the courts to have been victims of a fraud it will cut no ice with the commissioner of Inland Revenue.

IRD director of litigation management Michael Lennard said the outcome of the fraud prosecution would not affect an investor's tax situation, for a number of reasons including different standards of proof.

"Fraud or no fraud, it's still tax avoidance," Mr Lennard said.

Investors received 600-page notices of proposed adjustment from the IRD this week, part of a $100 million clawback to reclaim tax deductions linked to the schemes.

It is the first step in the department's complex dispute resolution procedure, which gives the 110 well-connected investors involved in the scheme two months to respond or be deemed to have accepted the IRD's assessment.

The commissioner's position is that the arrangement was a sham, set up to avoid tax, and that the deductions, which related to an insurance premium that was part of the scheme, were not allowable.

The IRD wants the amount deducted repaid and has also reserved its right to charge shortfall penalties, which could amount to 20% of the deduction or even 100% if the tax position taken was deemed to be "abusive."

But the shortfall penalty regime only came into force on April 1, 1997, so would not apply to deductions investors made in years after 1998.

The structures of the NZIL and Digi-Tech schemes are similar - investors enter a long-term purchase agreement to buy shares years in the future.

Each investor uses a loss-attributing qualifying company (LAQC) for the sale and purchase agreement and at the time of the transaction takes out a "loss of profits insurance policy" with obscure Dutch insurance company Epicharmus Vastgoed as a hedge against the shares not being worth what they are claimed to be at purchase date.

To finance the premium each participating LAQC took out a limited recourse loan with an overseas bank for 96% of the premium and the amount of the premium was then claimed in full as a tax deduction.

There is a question mark over whether the insurance policy did, in fact, exist.

Digi-Tech is a Wellington technology company while NZIL was a company that packaged up various assets linked to John Reid, including stakes in marketing startup Escalator Advertising, trailer manufacturer Fruehauf Pacific and a company, Euston Holdings, said to have the rights to develop the "thinking battery."

"They were trying to make a silk purse out of a sow's ear - all I can tell you is the companies were dogs to start with," one source close to the scheme said.

Also at issue in the IRD's case is whether investors took reasonable care to gather information about the scheme before they signed up for it.

If an investor leaves it for others to provide the information and they were dishonest, the investor may have failed to fulfil their legal obligation.

For example, the investor may have been expected to make inquiries about the so-called Dutch insurance company Epicharmus Vastgoed, such as finding out its credit-rating or checking its annual report.

There are also a number of issues about shortfall penalties, which may be tested through the courts, such as whether the LAQCs should be treated as "look through" partnerships.

Specialist tax barrister Geoff Clews is acting for some of the investors while others have retained their own representation.

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