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Less to the Fairfax tax deal than meets the eye

By Shoeshine

Friday 30th May 2003

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With an irresistible cast of big business, big dollars, financial engineering and "winebox-type deals," the story of Finance Minister Michael Cullen's intervention in John Fairfax Holdings' takeover of Independent Newspapers was bound to attract major press coverage.

Cullen has already drawn fire, from no less an authority than Big Four accountant KPMG, for using "very emotive language" to justify a change in tax law.

What's more, the beancounter reckons, what amounts to a retrospective law change could scare off foreign investors.

The impression given by news coverage is that Cullen's move was a knee-jerk reaction to the announcement of the financing arrangements for the Fairfax deal.

It wasn't. Inland Revenue has in fact been investigating for some time the Wilson & Horton masthead transaction of late 2001, a deal essentially the same as the one Fairfax wanted put together.

As W&H's parent, Tony O'Reilly's INM, notes, "given the size of this transaction and the publicity given to it at the relevant time," that's hardly surprising. But, it says, its legal and tax advice was that the deal complied with the law.

To get to the bottom of this you have to go back to 1993 when the then-National government changed the law to allow the depreciation of intangible assets.

Neither New Zealand nor Australia, however, allow companies to deduct the depreciation from their taxable income. The US does.

When INM bought W&H in 1996 it revalued the group's newspaper mastheads from $82 million to $794 million.

When W&H was sold to Australia's APN, itself owned 44% by INM, it sold the mastheads to JP Morgan of the US for $1.1 billion and leased them back for $104 million a year, with a lease term of seven years and renewal rights.

The $1.1 billion went back to INM, which agreed to pay JP Morgan $601 million for the reversionary rights ­ the right to use the mastheads after the seven years.

Until Cullen's law change W&H was able to claim the lease payments against tax while JP Morgan got to claim depreciation on the right to use the mastheads, an undeniably tax-effective arrangement.

The law change will mean Wilson & Horton loses its tax benefit for the last five years of the arrangement. The loss will be to INM shareholders but not to APN's minorities because INM indemnified APN against a range of risks including a tax law change.

Fairfax's proposed scheme was to work essentially the same way.

INL revalued its mastheads in 1997, from $228 million to $673 million.

These were to be sold to a US bank and leased back. Fairfax estimated the INL acquisition on its own would add 10% to its earnings a share immediately. The sale and leaseback transaction would add a further 10%.

Those who imagine such deals are examples of "big business" playing games with the country's tax laws winebox-style are being naive.

Both W&H and Fairfax were up-front about the sale and leasebacks and their effects. That a law change, and not an IRD assessment, is being used to plug the loophole indicates the arrangements were perfectly legal.

Whether Cullen can fairly be accused of using emotive language to justify a move that will drive away foreign investors is open to debate.

The term KPMG objects to is "loophole" which, according to the Shorter Oxford English Dictionary, is "an ambiguity or omission in a statute, contract, etc, which affords opportunity for escaping its intention."

Cullen no doubt took the view Parliament could hardly have intended, back in 1993, for companies to revalue intangible assets by 1000%, sell them to Wall Street investment banks and lease them back, for no obvious commercial purpose. It's hard to argue with him on that one.

The issue of investor certainty is trickier.

Cullen claims the "plug" isn't retrospective but it undoubtedly is as far as INM is concerned ­ its shareholders will feel this in their pockets.

"Taxpayers can feel rightly aggrieved," KPMG reckons, "at the government's decision to pull the rug from under existing arrangements. Certainty of the tax law is a key ingredient in a developed country's tax system."

While that's undoubtedly true, both INM and Fairfax clearly recognised the danger the government would realise sooner or later it was being unduly generous.

If INM thought this type of arrangement was an unchallengeable and immutable feature of our tax system it would not have indemnified APN against tax law changes.

"Of course we realised it wasn't a slam dunk," Fairfax corporate affairs manager Bruce Wolpe told Shoeshine. "Governments can always change their minds on tax."

INM's complicated structures and its big debt burden make it hard to guess whether it would have gone ahead with its W&H deal if tax benefits weren't available. But Cullen's law change hasn't put Fairfax off its deal, which is a good one for its shareholders regardless.

Maybe the retrospective nature of the change will put foreign investors off.

But we don't have any newspaper groups left to sell. And competing for capital with other countries by trying to stay one step ahead in the tax benefits league isn't a game we're likely to win.

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