Ernst & Young Advice re Registry 01/02/02

30 November 2001

Mr Steven Heath

Dear Steven

Restructuring of New Zealand Internet Registry Limited ("NZIRL")

As discussed, please find enclosed our final report and board paper on the restructure of NZIRL, trading as Domainz.

Should have any further questions regarding the implementation of our advice, please do not hesitate to call Russell Hayes or Brian Johnstone.

Yours sincerely
ERNST & YOUNG
Craig Riddle
Partner

1. Background

1.1 The Internet Society of New Zealand Inc. ("InternetNZ") is an independent, incorporated society established in 1995 to foster co-ordinated development of the internet in New Zealand and both work towards and safeguard the internet philosophy of open and uncensored exchange of information.

1.2 InternetNZ is also the holder of the delegation of the ".nz" name space and ultimately responsible to the New Zealand public and international internet community for the sound operation of the Domain Name System ("DNS") within New Zealand. Currently, InternetNZ holds all the shares in New Zealand Internet Registry Limited, trading as Domainz. Domainz acts as both the "registry" and "registrar" of all domain names issued in New Zealand.

1.3 The "registry" is the function that holds and operates the central database holding all information required by the DNS and is the authoritative source for the creation of the primary zone files for ".nz". The "registrar" is the function that registers names with the registry on behalf of registrants (i.e., name holders with ".nz" in their name).

1.4 We understand InternetNZ's functions are broadly divided into two categories. However, the dominant function is the office of the country code Top Level Domain ("ccTLD") manager. In essence, the ccTLD manager's role is supervisory and, to some extent, regulatory in terms of the allocation and proper use of the ".nz" domain name. With the implementation of the shared registry service ("SRS"), the ccTLD management function will be established as a separate, identifiable function within InternetNZ.

1.5 We understand InternetNZ is taxed as a non-profit organisation and, subject to the standard $1,000 deduction, is taxable only on its non-member transactions. InternetNZ has traditionally derived income from the following sources:

• Dividends from Domainz;

• Subscriptions from its approximately 15 corporate and 300 individual members;

• Domainz Management Fee.

1.6 We further understand this income is applied largely to performing the functions of the ".nz" ccTLD manager. The remainder of InternetNZ's income is used to operate the other functions of InternetNZ.

1.7 Following from a consultative report, it has been recommended, and it is now proposed, to remove the registration function currently performed by Domainz and establish it in a separate entity whose sole activity will be the performance of the registry function. It is envisaged that:

• A separate entity will be established to operate the SRS, which will solely perform the registry function;

• This entity will be held 100% by InternetNZ;

• Providers to the SRS will be independent entities that wish to provide registrar services and have received accreditation from InternetNZ ("Authorised Registrars"). It is envisaged there will be many registrars and the registration of domain names will seldom be the core business of a registrar (i.e., they will include telecommunications organisations but not exclusively so). Any organisation that manages domain names in the ".nz" register as part of its business will be a registrar;

• Domainz (or a related entity) will initially participate in the registrar market (i.e., be an Authorised Registrar) until the industry becomes sufficiently mature at which point either it or its assets will be sold, or its operations will be simply discontinued;

• While the registrant or name holder will be the ultimate customer of the SRS, they will not interface directly with it. Instead they will transact directly with an authorised registrar;

• The role of the ccTLD manager will be to assume responsibility for the correct and efficient operation of the domain name registration process within ".nz". The ccTLD manager will also develop and maintain policies for domain names, manage contracts with the registrars and the registry, and may facilitate a dispute resolution process to an extent to be determined.

1.8 The newly created SRS will be run at a break-even position, after allowing for a contribution to a capital reserve (i.e., "memorandum account") to provide for:

• Income fluctuations in registration activity; and

• Ongoing investment in technical infrastructure, particularly to ensure future proofing of the DNS within NZ.

1.9 We understand any surplus proceeds will be distributed to InternetNZ to the extent necessary to fund the "public good" activities of the Office of the ccTLD function and continued development of the infrastructure required to support the internet within New Zealand. Any remaining surplus will ultimately be used to reduce prices charged to the registrars.

1.10 The ccTLD Manager will receive further (but limited) income from the single application fee payable by entities applying to become authorised registrars. As such, the registry fees will be established to cover both the costs of running the registry and the Office of the ccTLD Manager.

1.11 Domainz currently holds all the assets used to provide the current service. However, it is anticipated that the DNS assets will be transferred into the SRS. In addition, Domainz currently holds $2.37M in retained earnings which, it is proposed, will be used to develop the new software system used to operate the SRS.

1.12 We understand that these retained earnings will be sufficient to fund development of the SRS software system and therefore we have not considered any strategies for reducing the after tax cost of external borrowing, which may have otherwise been required.

1.13 All statutory references are to the Income Tax Act 1994 ("the Act").

1.14 Any proposal to distribute funds from Domainz, establish a new entity and dispose of assets, necessarily has tax consequences. Accordingly, in the absence of information to the contrary, we have made the following assumptions for the purposes of our report:

• Dividends paid by Domainz to InternetNZ in the current year ended 31 March 2002 (if any) have been fully imputed;

• InternetNZ is a mutual association and therefore not taxable in respect of member related transactions under current Inland Revenue Department policy;

• The SRS entity will not be a corporate member of InternetNZ;

• Work has not commenced on development of the SRS software system;

• Domainz has available imputation credits to enable payment of a fully imputed dividend equal to its retained earnings. Based on reserves of $2.3M, this will require imputation credits of approximately $1.2m);

• InternetNZ has losses brought forward of approximately $150,000;

• The existing Domain Registry System ("DRS") will no longer be used following development of the SRS software;

• InternetNZ and Domainz have 31 March balance dates;

• Payments will be made from the registry to the ccTLD Manager for services performed by the Manager;

• Domainz would be able to pay a dividend from a company law perspective, including solvency requirements being met.

2. Issue

2.1 You have asked us to advise the most tax efficient means for implementing a restructure of Domainz in order to achieve the objective of establishing the separate SRS registry function with the funds currently held by Domainz.

3. Executive Summary

3.1 Following existing Inland Revenue Department ("IRD") policy, InternetNZ will be taxable and entitled to claim deductions relating to transactions with non-members only.

3.2 We have considered the following two options in regard to the proposed restructure of the registry and registrar functions.

• Under Option One, InternetNZ incorporates a new subsidiary to develop and hold the SRS software and perform the registry function. After receiving a fully imputed dividend from Domainz, InternetNZ would subscribe for shares in the new subsidiary. Domainz would then compete as a registrar with other Authorised Registrars until the desired market maturity levels are achieved.

• Under Option Two the existing Domainz is used as the SRS vehicle. In order to achieve the required operational separation, the DRS and existing customer list would be transferred to another company (NewCo), incorporated and owned 100% by InternetNZ for that purpose. The consideration for the transfer would be in the nature of debt owing to Domainz from NewCo. While this option may potentially result in less transaction and compliance costs compared to Option One, a significant issue will be the valuation of the customer base. Any capital gain from the ultimate sale of the customer list by NewCo will be taxable if NewCo acquires it for the dominant purpose of resale. Therefore, the price at which NewCo acquires the customer base will be important to minimise any such liability.

3.3 We have not reviewed the constitutional status of InternetNZ. However, on the basis it meets the definition of "company" for income tax purposes, any dividend paid by Domainz would be exempt under the inter-company dividend exemption provisions. However, if InternetNZ and Domainz do not satisfy the "wholly-owned group" exemption, Option One is fully dependent on Domainz being able to pay a fully imputed dividend, and also that it has that ability from a company law perspective. On the basis that this is possible, and based on the issues surrounding the transfer of the customer base, we recommend Option One be adopted.

4. Tax Status of InternetNZ

4.1 For the purposes of the following, we have relied on your advice that InternetNZ is a mutual association. On this basis, after the $1,000 deduction available for not-for-profit organisations, the tax position of InternetNZ is as follows.

Treatment of Mutual Associations Under the Act

4.2 Despite the mutual character of transactions between an organisation and its members, the Act specifically provides that where an organisation receives consideration for certain goods and services supplied in transacting with its members, such income is taxable. Related expenditure incurred in deriving that income is generally deductible.

4.3 However, membership subscriptions are not taxable as they in the nature of a capital contribution. Similarly, subscription related expenditure is not deductible.

Inland Revenue Department ("IRD") Approach

4.4 In contravention to the provisions of the Act, current IRD policy is that transactions entered into by an organisation within the "circle of membership" do not have the character of income. Applying this policy to InternetNZ generally results in only non-member transactions being subject to tax and related expenditure deductible.

5. Option One - Incorporation of Special Purpose Registry

Assumptions

1. Incorporate new entity (SRS Limited) to develop and own SRS software and administer registry function.

2. Domainz provides funding necessary to develop SRS software through dividend payment to InternetNZ.

3. Transfer any staff or other assets required to conduct registry function.

4. Authorised Registrar enters into contract with ccTLD Manager that sets out Authorised Registrar's obligations.

5. The ccTLD Manager contracts with the SRS to provide a regulatory function in respect of the registrars and the SRS agrees to certain restrictions and obligations.

6. SRS then contracts with Authorised Registrars.

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Outcomes

• Funds are transferred from Domainz to the new entity free of any tax impost.

• The objective of establishing a separate registry is achieved immediately.

• On the basis the DRS is of nil value, alternatives for the remainder of Domainz are that its assets would be sold and Domainz either retained (for name purposes) or liquidated, or Domainz itself could be sold.

5.1 Step One- Incorporate SRS Limited

5.1.1 We have considered the use of a partnership or a trading trust to hold the registry but recommend a corporate entity for the following reasons:
• Limited liability;
• Non-existence of a natural counter-party with which to form a partnership;
• Imputation credit regime to prevent double taxation;
• Ability to form a consolidate group with Domainz for tax purposes (if required);
• Capitalisation without gift duty implications.

5.1.2 We envisage no advantages in using a partnership (even if there were a natural co-partner available) given aspects of joint and several liability for the partnership's obligations, tax issues arising on potential changes in the composition of the partnership, determining individual partner equity contributions and governance issues. Similarly, adopting a trust structure would involve determination of who would comprise the beneficiaries and again raises governance issues.

5.1.3 For ease of capitalisation and repatriating profits, and in order to give viable exit options, we consider InternetNZ should hold the shares in SRS Limited directly as opposed to through a holding company.

5.2 Step Two - Funding Development of SRS Software

5.2.1 InternetNZ obtains funds from Domainz by the latter paying a dividend, the proceeds from which InternetNZ uses to subscribe for shares in SRS Limited.

Payment of a Dividend

5.2.2 The funds required for the development of the SRS software system are currently held in Domainz as part of shareholder's equity of $2,376,462, which we have assumed is supported by imputation credits of approximately $1.2 million.

5.2.3 Where InternetNZ/Domainz can take advantage of the wholly-owned group intercompany dividend exemption then any dividend will be exempt from tax. To the extent that this exemption is not available, InternetNZ will have a tax liability calculated at the rate of 33% on any dividend it receives from Domainz. Imputation credits attached to a fully imputed dividend paid by Domainz will meet this liability. To the extent the dividend is not fully imputed, Domainz would be required to deduct resident withholding tax at the rate of 33% thereby effectively meeting any residual tax cost on behalf of InternetNZ. To illustrate, assume a dividend of $200 is paid with maximum imputation credits of $98 attached.

The tax treatment would be as follows:

Dividend paid by Domainz 200

Plus Imputation Credits attached 98

Taxable Income to InternetNZ 298

Tax @ 33% 98

Less Imputation Credits attached (98 )

Further tax to pay Nil

Cash received 200

5.2.4 Therefore, if the intercompany dividend exemption is not available and provided sufficient imputation credits exist, we recommend that the proceeds necessary to develop the SRS software system be transferred from Domainz by payment of a fully imputed dividend via InternetNZ.

5.2.5 In any event, even if the intercompany dividend exemption were available, we would still recommend payment of a fully imputed dividend to transfer imputation credits to InternetNZ. This is because any imputation credits unutilised due to the available losses in InternetNZ can be grossed up at 33% and converted to tax losses available to be carried forward or offset against the taxable income in NewCo.

Funding SRS Limited

5.2.6 We recommend that the SRS funding (i.e., proceeds from the Domainz dividend) be introduced into SRS Limited in the form of an equity investment for the following reasons.

5.2.7 Unlike a debt instrument, which will give rise to accrual income to SRS Limited if the debt is remitted or left to become irrecoverable through the lapse of time, there is no requirement for an ordinary equity investment to either:
• be returned by a fixed date by way of a capital payment; or
• pay dividends.

However, an equity investment can be returned to InternetNZ (tax free in certain circumstances) through a repurchase of shares without the need to liquidate the company.

5.2.8 If a later return of the capital invested in SRS Limited is contemplated, consideration should be given to investing that portion of the contribution by way of a non-voting redeemable preference share issue. While such instruments possess some characteristics of debt instruments they are treated as equity investments for income tax purposes.

5.2.9 As discussed, an alternative may be to use a mixture of debt and equity. This would enable funds to be repatriated to InternetNZ by way of interest payments. In addition, you may wish to consider the opportunity (if any) for InternetNZ to become a tax exempt entity under the "public benefit" test for charitable status in which case the interest (and other income) received would be tax exempt. However, SRS Limited would continue to be entitled to a deduction for interest paid to InternetNZ.

5.3 Step Three - Transfer of Assets

5.3.1 We understand the DNS will be transferred to SRS Limited. This could be achieved by either

Domainz selling the assets and leaving the purchase price outstanding as a debt owed by SRS Limited, or

SRS Limited using some of the proceeds received on capitalisation to acquire the assets. Domainz could ultimately return these proceeds to InternetNZ on winding up or through a share repurchase. InternetNZ could then advance these funds back to SRS Limited or use them to subscribe for further shares in the company.

5.3.2 As Domainz and SRS limited will be associated persons for tax purposes, the tax depreciation cost base for SRS Limited may be limited to that used originally by Domainz. However, an increase in the tax depreciation cost base may be achieved for SRS Limited should this be reflected by the assets' market value provided Domainz accounts for any depreciation recovered and the property being transferred is not intangible property.

5.3.3 In any event, you have indicated that the transferring assets may be substantially depreciated by the time they are transferred. To the extent their tax book value is greater than their market value at the time of disposal, Domainz should be entitled to a deductible loss on disposal. The price at which the assets are transferred would then become their cost base for tax depreciation purposes. Any resulting loss on disposal incurred by Domainz could be offset against income derived by SRS Limited providing the companies are group companies when the loss arises. Therefore, we suggest SRS Limited be incorporated as soon as possible.

5.3.4 In respect of the remaining DRS depreciable assets, you have indicated these have a negative value. Therefore, if they are not fully written off for tax purposes Domainz could consider crystallising any potential loss on disposal by either discarding them or seeking a determination from IRD to write the assets off.

Consolidation

5.3.5 The consolidation regime allows group companies to be treated as if they were a single entity and therefore effectively disregards intra-group transactions for income tax and gift duty purposes. While we have discussed the consolidation regime with you, there appears to be little advantage in utilising the regime in the current circumstances. This is particularly so given there appears to be little likelihood (if any) of there being depreciation recovered on transferring assets.

Employee Transfer Issues

5.3.6 Where Domainz employees are to be transferred to SRS Limited, it will be necessary to consider the deductibility of annual leave and other employee remuneration accruals, particularly where the consideration paid by SRS Limited for the DNS is reduced by the value of employee remuneration accruals to be assumed by SRS Limited. Where this occurs, the employee remuneration liabilities assumed by SRS Limited may not be deductible.

5.3.7 While this matter may be subject to forthcoming legislative changes, we suggest, for certainty, any employee remuneration accruals are either paid out by Domainz prior to transfer or they remain with Domainz and reduced when (for example) annual leave and bonuses are paid out.

Goods and Services Tax ("GST") Issues

5.3.8 On the basis that both SRS Limited and Domainz are "registered persons" for GST purposes, Domainz will have a GST output tax liability on the sale price of assets while SRS Limited will be entitled to a corresponding input tax credit provided the assets are acquired for the principal purpose of making taxable supplies (i.e., registry services).

5.3.9 To alleviate any cash flow implications, we would recommend Domainz and SRS Limited become GST group registered. This GST grouping could also be extended to include InternetNZ, the companies' shareholder. As transactions between GST group members are effectively ignored for GST purposes no GST would need to be accounted for on intra-group transactions

5.4 Steps Four - Agreement between ccTLD Manager and Authorised Registrar

5.4.1 We are not aware of any adverse taxation consequences associated with the ccTLD Manager function of InternetNZ entering into a regulatory relationship, and accompanying legal documentation, with the Authorised Registrars. Unless structured as a membership subscription (which we believe is unlikely), any receipts arising from the arrangement would be taxable to SRS Limited although the matter would be clouded if the Authorised Registrar was also a member of InternetNZ. In this regard we refer to IRD's distinction of taxing only non-member transactions.

5.5 Step Five- Agreement between ccTLD Manager and SRS Limited

5.5.1 A payment will be made from SRS Limited to the ccTLD Manager under the terms of an agreement for the ccTLD Manager to provide services.

5.5.2 In order to avoid any adverse tax consequences, specifically dividend and non-deductible expenditure issues, we recommend a written agreement be executed between the companies for the services to be provided.

5.6 Step Six- SRS Limited Transacts with Authorised Registrars

5.6.1 The registrar fees paid to SRS Limited by Authorised Registrars would constitute gross income to SRS Limited. However, expenditure incurred on revenue account to derive those fees will generally be deductible.

5.6.2 Expenditure not directly incurred in deriving gross income but incurred as a necessary incident of SRS Limited's activities of carrying on business will generally be deductible to the extent incurred on revenue account. A possible issue is whether SRS Limited's activities have the requisite profit making intention to constitute a "business" (as defined under the Act).

5.6.3 We consider the better view to be that SRS Limited intends to make the profits necessary to fund non-profitable activities and therefore has a profit making intention (the profit motive or otherwise of its shareholders is not relevant).
5.6.4 The cost of developing the SRS software will be depreciable once (and while) the system is being used in producing gross income.

GST

5.6.5 GST output tax will be payable by SRS Limited on the registry fees it receives while a GST input tax deduction will be available in respect of GST paid on acquiring goods and services for the principal purpose of making its taxable supplies (i.e., registry services).

5.7 Step Seven - Distributions to InternetNZ

Inter Company Charges

• You have advised that inter-company charges between SRS Limited and InternetNZ will be limited to a management fee to cover InternetNZ's strategic and policy direction contribution to the registry. On the basis that SRS Limited is not a member of InternetNZ, these payments will be fully taxable to InternetNZ and will likely be fully deductible to the payer if incurred in producing gross income (again subject to the normal rules of deductibility).
• It may be possible for any loans from InternetNZ to SRS Limited to be interest bearing in order to repatriate profits (if required). SRS Limited would not need to deduct resident withholding tax from any gross interest paid due to their wholly owned group status.

Dividends

5.7.3 Again, under the wholly-owned group exemption, InternetNZ would suffer no tax liability on any dividend received from SRS Limited. However, we would recommend dividends be imputed to ensure InternetNZ receives the tax benefit of those credits.

6. Option Two - Developing NZIRL into the SRS

Assumptions

1. InternetNZ incorporates a name protection company (NewCo) to protect the trading name "Domainz".

2. Domainz sells its customer list and non DNS assets to NewCo.

3. Domainz uses retained earnings to develop SRS software.

4. Domainz acts as SRS (under a new name) and contracts with ccTLD Manager.

5. Domainz contracts with Authorised Registrars.

6. If the customer list and non DNS assets are not sold to NewCo immediately, Domainz continues as a registrar in the short-term (until market matures) before discontinuing its registrar function.

7. The registrar function of Domainz could then be transferred to a new entity (if desired).

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Outcomes

• No requirement to transfer Domainz existing funds.

• May not be immediate separation of registry/registrar function.

• Purchase of the customer list by NewCo for the dominant purpose of resale will give rise to any gain on sale received by NewCo being taxable. Therefore it will be important to determine an appropriate value at which the customer list is transferred.

Advantages of Option Two

6.1.3 The advantage of Option Two is that, apart from the customer list, no transfer of staff or assets of value will be required.

6.1.4 Similarly, under Option Two, there is no requirement to transfer funds to a new entity for the development of the SRS software system and this may reduce transaction costs.

Disadvantages of Option Two

6.1.5 A disadvantage of Option Two is the potential for any gain on sale received by NewCo from a sale of the customer list to be taxable although flexibility could be retained in the Domainz/NewCo transfer price enabling it to be increased in direct proportion to the amount ultimately received by NewCo from third parties. Also, the consideration payable for the customer list would likely be a debt outstanding to Domainz. We envisage this debt would ultimately be repaid once the customer list is sold to a third party although the ultimate sale price could be less than that paid initially by NewCo. If the purchase price is less than that paid initially by NewCo, then there could be adverse debt forgiveness issues for NewCo.

6.1.6 A further disadvantage is that the registrar aspect of Domainz may not be separated from the registry until such time as the registrar market matures sufficiently. This means Domainz cannot participate in the Authorised Registrar market as a separate entity distinct from the registry.

ERNST & YOUNG
30 November 2001