How a Major Bank Succeeded in International Tax Planning, Got Cheap Capital and Paid Less Tax: Mills v Commissioner of Taxation

By Professor Miranda Stewart

Mills v Commissioner of Taxation Case Page

There has been a lot in the news lately about the low tax paid by some multinational corporations, including Starbucks and Google. But these multinationals say that they are complying with the tax law of all countries. How do they do it?

The recent Australian High Court case of Mills v Commissioner of Taxation [2012] HCA 51 is an example of successful international tax planning by a major multinational bank. It concerned a financial transaction by the Commonwealth Bank, one of Australia’s ‘big four’ banks and the second largest corporate group listed on the Australian Securities Exchange.

Don’t get me wrong, the Commonwealth Bank pays quite a lot of tax. It reports about $2.1 billion in tax in 2012 on a profit of more than $7 billion. But the Mills case reveals the challenge for national governments in trying to fix the international tax system so as to capture profits earned by multinationals around the world.

Mills was the first judgment written solely by Justice Stephen Gageler, after his appointment to the Court in October 2012. (Justice Gageler had joined in the majority judgment in Montevento Holdings Pty Ltd v Scaffidi [2012] HCA 48 on 7 November.) In what seems to be an informal tradition for new arrivals on the bench, Justice Gageler wrote the judgment and Chief Justice French and Justices Hayne, Kiefel and Bell each simply said ‘I agree’.

Mr Mills Has His Day in Court — and Wins!
Commonwealth Bank shares are widely held by Australian investors and regularly pay franked dividends that carry a tax credit — called a franking credit reflecting the company tax paid by the Bank — that shareholders can use to reduce their own tax obligations. The Mills case concerned the income tax treatment of securities issued by the Commonwealth Bank in the hands of the investor.

Mills was a test case. The Commissioner of Taxation agreed with the Bank that they would take the case to court, to test if the tax law applied in a particular way. Mr Mills, a senior director of specialist tax firm Greenwoods & Freehills, was an investor in the securities, along with 30,000 other Australian shareholders. He was the test litigator for the Bank.

The Commissioner won at first, but High Court overruled the Full Federal Court (and the single judge in the first hearing) to find that the Commonwealth Bank was able to issue the PERLS V securities with tax advantages, and carrying a franking credit for the benefit of the investor.

A Pearl of a Security: PERLS V Perpetual Exchangeable Resaleable Listed Securities
The Mills case involved complex and technical Australian company tax rules and how they applied to a particular kind of security issued by the Commonwealth Bank. In particular the High Court ruled that a tax anti-avoidance rule in s 177EA of the Income Tax Assessment Act 1936 (Cth) could not apply.

In 2009, the managers of the Commonwealth Bank identified a need for more ‘Tier 1 Capital’. This includes ordinary shares and cash reserves and can also include some other kinds of capital, such as preference shares. All banks are required by Australian law (and by global regulation in the Basel Accords) to maintain minimum capital ratios, to ensure that account holders are protected from risky investments. These capital requirements are intended to prevent the problems that occurred in the Global Financial Crisis.

To meet its need for capital, the Bank issued securities to investors called Perpetual Exchangeable Resaleable Listed Securities or PERLS. This was the fifth issue of this kind by the Bank, hence PERLS V. The PERLS V issue in 2009 raised over $2 billion in capital for the Bank.

Each PERLS V security comprised:

  • a preference share issued by the Commonwealth Bank of Australia, and
  • a note issued by the New Zealand branch of the Commonwealth Bank.

The preference share and the note (which is a debt instrument, or an ‘IOU’) were ‘stapled’ together. They could not be issued or traded separately, but had to be dealt with together (on stapled securities, see here and here).

An investor who purchased a PERLS V security from the Bank or on the ASX was entitled to quarterly distributions of interest on the notes, plus a franking credit on the preference share. The interest was paid by the New Zealand branch of the Commonwealth Bank, which issued the notes. The franking credit reflected underlying Australian company tax paid by the Bank as an Australian taxpayer.

Why Such a Complex Security? Mostly for Tax Reasons
A major reason why the Commonwealth Bank issued the PERLS V securities as a complex ‘stapled’ security was because of tax. The securities were treated differently in Australian tax law, compared to New Zealand tax law — we sometimes call this ‘hybrid’ tax treatment and as the OECD identifies, it’s a challenge for tax systems.

Under Australian tax law, the PERLS V securities are treated as equity not debt. What does this mean? The stapled debt instrument (the note) and equity instrument (the preference share) were treated, together, overall, just like an ordinary share for tax purposes under Australia’s tax rules in div 974 of the Income Tax Assessment Act 1997 (Cth). Any distribution paid to a PERLS V investor is treated like a dividend for tax purposes and can carry a franking credit. This was instead of treating the stapled security like debt. So, although the return on the security was called ‘interest’, it was treated like a dividend for Australian income tax.

But under New Zealand income tax law, the note that formed part of the PERLS securities was analysed on its own, separately from the preference share, and it was treated as debt. This meant that in New Zealand, when the Commonwealth Bank branch paid interest on the note, that interest was deductible against profits of the New Zealand branch. As a result, the New Zealand branch paid less tax to the New Zealand government.

The overall consequence of this hybrid tax treatment is that:

  • a deduction was obtained for the return on the security, in New Zealand, meaning that no tax was paid on that return by the Commonwealth Bank; and
  • at the same time, the return on the security was treated like a dividend for Australian tax, and so a franking credit was distributed to the holder of the security, as if the return came out of Australian taxed profits of the Bank.

Cheap Capital for the Bank
The economic advantage of this complicated structure for the PERLS V securities is that the Commonwealth Bank was able to obtain high quality (Tier 1) capital at a cheap price.

The economic cost of raising capital using the PERLS V security was estimated by the Bank, after tax and after taking account of the franking credits that had to be paid out, as 5.86 per cent. This compared to the economic cost of an ordinary issue of shares being 14.2 per cent. You can think of this like the percentage interest rate on a mortgage. A 5.86 per cent rate is much cheaper than 14.2 per cent!

For investors, it’s the franking credit combined with the higher rate of the ‘interest’ return — which was above basic interest rates — that is really attractive. All of the big Australian superannuation funds, managed funds and mum and dad investors in the Commonwealth Bank can use the franking credit to reduce the tax on their income — and so they love securities that carry franking credits.

Applying the Tax Anti-Avoidance Rule
The High Court had to consider whether s 177EA, which is directed at franking credit schemes to avoid tax, could apply to the PERLS V securities. Justice Gageler, and the Court, held that it could not apply.

In Mills, it was accepted that there was a ‘scheme’ which is any arrangement or course of action (it’s defined very broadly in the tax law in s 177EA). It was also accepted that there were franking credits delivered to investors and that there was an issue of membership interests, which were the stapled security including the preference shares. The main point of the PERLS V securities from the investor perspective was the franking credits.

The issue for the Court was whether the scheme was entered into for the purpose of enabling the investors to get the franking credits, having regard to all the relevant circumstances. The purpose did not have to be the dominant purpose, but it could not be just an incidental purpose of enabling the investor to get a franking credit. The purpose is identified objectively — that is, the subjective motive of a taxpayer (eg, the taxpayer wants to pay less tax) is not relevant.

The ‘relevant circumstances’ are defined in s 177EA by a long list that includes the profit or gain that could be got from the securities, the extent of the franking credit benefit, the form and substance and manner in which the scheme was carried out, any change in financial position of the taxpayer or the Bank, and any other relevant factors.

In the Full Federal Court, the majority held that the anti-avoidance rule did apply. Justice Jessup concluded that the Bank had a ‘non-incidental purpose’ of enabling its investors in the PERLS V securities to get a franking credit. He concluded that the franking credits were central to the scheme and the fact that the Bank got a deduction in New Zealand was relevant. So, the anti-avoidance rule applied — to deny the investors the benefit of the franking credits.

Justice Edmonds concluded, on the other hand, that the deduction in New Zealand law was not relevant to the application of the Australian tax law: [13]. He said, ‘Without drilling down too far, I do not understand why the fact that the Bank obtained a deduction in New Zealand against its New Zealand branch earnings has anything to do with this circumstance’: [72].

The High Court finds no abusive purpose
Justice Gageler accepted that the deduction in New Zealand was a relevant circumstance in deciding the purpose of the Commonwealth Bank in issuing the PERLS V securities. But taking all the circumstances into account, he concluded that there was only an incidental purpose of getting the franking credits to the investors. This was so, even though it was of central importance that the investors would get the franking credits. Justice Gageler said, at [66]:

[A] purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose. Indeed, the centrality of a purpose to the design of a scheme directed to the achievement of another purpose may be the very thing that gives it a quality of subsidiarity and therefore incidentality.

Because the franking credits ‘serves no purpose other than to facilitate the capital raising then the purpose is an incidental purpose’: [67]. Justice Gageler contrasted the Commonwealth Bank’s issue of PERLS V, which was a genuine commercial capital raising, with schemes to trade or stream franking credits where the issue of the shares is incidental to getting the franking credits. Those kinds of schemes would be prevented by the anti-avoidance rule.

Why Should Australian Taxpayers Care?
The result of Mills confirms that the Commonwealth Bank was operating absolutely within the income tax rules of Australia and New Zealand. Many will say that Mills is a straightforward and sensible approach to company tax rules in a situation where there was a genuine commercial capital-raising by one of Australia’s major banks.

But the Bank’s cheap capital comes at a cost to the revenue and we all bear some of this cost (although the investors go home happy). On $2 billion of capital, the Bank saved about $170 million, most of which is the result of reduced tax paid in Australia and New Zealand. If the Commissioner had won this case, the Commonwealth Bank estimated the cost of capital as rising to about 7.8 per cent, still much cheaper than ordinary shares. The main reason for the cheaper capital is the deduction for the interest paid out of the New Zealand branch.

Why, if franking credits reflect company tax paid, should Australians care if the Commonwealth Bank could distribute them to its investors in the PERLS V securities? There actually has been, at some stage, company tax paid by the Bank.

The reason is that the Commonwealth Bank was in what is called an ‘excess credit’ position. Some of the Bank’s shareholders are not Australian residents (for example, foreign individuals or pension funds), and those shareholders cannot use franking credits to reduce their tax. This means that the Bank does not want to distribute franking credits to foreign investors and it builds up a stock of credits it cannot use. The PERLS V securities enabled the Bank to distribute some of those excess franking credits to Australian investors – who can use them – without paying any more company tax on the underlying profit that supported the return on the securities.

Tax Cooperation Needed in the Global Era
If anything, it’s New Zealand taxpayers who might care that they are not getting their full share of company tax from the Commonwealth Bank. Should Australian taxpayers care about New Zealand’s tax revenue, if its tax law does not solve the problem?

I think the answer has to be ‘Yes’. In the old days, the tax system of one country really had no connection and was not thought to be any business of the tax system of another country. But today, capital can be raised and invested across borders. Capital is increasingly mobile as a result of globalisation. International tax arbitrage by multinationals — for example, by using securities or other arrangements that have hybrid tax treatment across borders — is one way in which the global tax burden of the multinational is lowered.

In Mills, the Tax Commissioner argued that the Commonwealth Bank had got ‘the best of both worlds’ in its PERLS V securities. Indeed, the Bank has got the best out of our globalised world. All countries would benefit if we were able to achieve increased transparency and a new approach to multinational taxation that would address hybrid tax treatment across borders, as well as other concerns about profit shifting such as that alleged for Google and Starbucks.

There are some positive developments. The federal Treasury Working Group has issued a Discussion Paper on this issue and the G20 is expressing concern about it.

National governments cannot succeed in taxing multinational corporations that can plan their tax and business affairs across a multitude of countries each with different tax and regulatory regimes, unless governments begin to cooperate in designing the tax laws that apply to multinational corporations. Mills reveals the challenges that arise when one country’s tax treatment of a financial transaction is different from the approach taken by another country. Even countries as closely connected as Australia and New Zealand can miss out if we do not cooperate in designing our tax systems.

AGLC3 Citation: Miranda Stewart, ‘How a Major Bank Succeeded in International Tax Planning, Got Cheap Capital and Paid Less Tax: Mills v Commissioner of Taxation’ on Opinions on High (8 February 2013) <>.

Professor Miranda Stewart is Director of Tax Studies and Associate Dean (Engagement) at the Melbourne Law School.