Forfeiture of shares taxable under FIF regime
2008 case note – Judge held that the forfeiture of shares operated as a purchase price adjustment but did not matter for the Foreign Investment Fund Rules.
The Commissioner treated the forfeiture of shares as a disposal at market value. The plaintiff maintained that the shares were not disposed of for gain; rather there was an adjustment to the original purchase price. His Honour held that the forfeiture operated as a purchase price adjustment; however, he did not consider that the arrangement mattered in terms of the Foreign Investment Fund Rules (FIF).
In 2000, Ernst and Young (E&Y) sold the consultancy arm of its business to Cap Gemini, an international company. After a parent agreement was reached, the partners of E&Y in each country where the business offered the consultancy service in issue had the option of joining the sale. The New Zealand office chose to do so. The sale involved the transfer of the relevant E&Y staff to the new business. Those staff members entered into employment agreements with the new company. In the case of partners such as the plaintiff, the agreements included a penalty formula if the partner left the new company within the term of the five-year employment agreement. The penalty formula involved the return of some shares which the partner had received as his or her share of the sale proceeds. It was a sliding scale formula where the amount liable to be returned decreased as the years went by. Rules were also put in place to prevent diminution of the share holdings during the five-year period. The plaintiff left the new company within the five-year term of his contract, and the sliding scale formula was applied. This meant he forfeited a number of shares he had received.
The share allocations and disposals were caught by the Foreign Investment Fund Rules (FIF). The FIF rules are designed to operate by attributing a pro-rata share of the foreign identity's income to the taxpayer. The value of the taxpayer's share in the FIF may be assessed by one of four methods - accounting profits, branch equivalent, comparative method and deemed rate of return.
The plaintiff elected to use the comparative value method in section CG 18 of the Income Tax Act 1994 as the route to which his interest was to be valued. Under this method, if the value of a person's holding has increased during the course of a tax year, that increase will be treated as income, and if it has decreased it will be treated as a deductible loss.
During the 2002 year, the plaintiff forfeited 2095 shares as he had left the employment of Cap Gemini. The Commissioner and the plaintiff disagreed as to the treatment of these shares in the CG 18 formula. The Commissioner treated the forfeiture of shares as a disposal of an interest in a fund which is deemed by section CG23(5) to be at market value. The plaintiff maintained that the shares were not disposed of for gain; rather there was an adjustment to the original purchase price reflecting that what the plaintiff had sold to Cap Gemini in 2001 had become less valuable. The plaintiff further argued that if it was too late to visit the 2001 assessment, then each income tax year should be treated separately.
Simon France J set out the provisions of CG 23(5), regarding them as the crux of this dispute:
For the purposes of this Act, where at any time in an income year a Person disposes of any property which is, with respect to the period immediately before disposition, an interest of the person in a fund with respect to which the person uses the comparative value method or the deemed rate of return method, for no consideration or for consideration which is less than the market value of the property at the time, the person shall be deemed to have derived from the disposition consideration equal to the market value of the property at the time. (Emphasis added.)
His Honour held that the forfeiture operates as a purchase price adjustment. However he did not consider that the arrangement mattered in terms of the FIF rules; and stated:
 In tax year 2001 Dr Saha declared his interest in a foreign investment fund to be 7566 shares, such shares having been acquired by him at a cost of $3,497,552. For tax purposes, Dr Saha therefore had that degree of interest in the foreign company. Thereafter, any adjustments in the number of shares had to be reflected in the relevant tax year. Acquisition of further shares would be treated as a deductible cost but of course, the year end value would also reflect the greater number of shares. Disposition of shares would be treated as an assessable gain, but again the year end value would reflect the lesser number of shares now owned.
His Honour considered that there was no consideration for the disposal and it was therefore deemed by section CG23 (5) to amount to a disposal at market value:
 In tax year 2002 Cap Gemini has not paid anything for the shares. No consideration at the time of the disposal has passed from Cap Gemini to Dr Saha. Rather, it is, as the taxpayer contended, an adjustment to the original purchase price. Accordingly, I would see CG23 (5) as directly engaged, as the Commissioner contends.
Income Tax Act 1994, FIF rules