Changes to Part IVA of the Income Tax Assessment Act

Articles Written by Jane Trethewey

Introduction

The Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Sharing) Bill 2012 (Cth) (Bill) was introduced into the House of Representatives on 13 February 2013. The Bill contains amendments to the general anti-avoidance provision in Part IVA of the Income Tax Assessment Act 1936 (Cth) (1936 Act) (together with the Income Tax Assessment Act 1997 (Cth), the Act), as well as new transfer pricing provisions.

This article discusses the changes to Part IVA. The proposed new transfer pricing rules are discussed in a separate article.

Background to the Part IVA amendments

Background to the Part IVA amendments

The Government announced on 1 March 2012 that it would amend Part IVA. This was in response to some Federal Court decisions adverse to the Commissioner of Taxation,1 which, according to the Explanatory Memorandum (EM) to the Bill, 'revealed a weakness in the capacity of Part IVA to effectively counter arrangements that, objectively viewed, have been carried out with a relevant tax avoidance purpose'.

If enacted, the amendments will apply to schemes entered into or commenced to be carried out on or after 16 November 2012, being the date on which the exposure draft (ED) legislation for the amendments was released.2

The Bill provisions are slightly different from (and a slight improvement on) the provisions in the ED but the thrust remains the same.

As well as the usual public consultation, confidential consultations were held with a round table of experts from the legal and accounting professions. However, as their role was notto revisit the Government's policy decisions as announced on 1 March 2012, those experts should not be taken to have approved the amendments in the Bill.

The current provisions

Part IVA has been in operation since 27 May 1981, with relatively few amendments to date.3 In its current form, it applies (pursuant to current section 177D) where:

  • The taxpayer has obtained a 'tax benefit' in connection with a 'scheme'4; and
  • Having regard to the 8 matters listed in s 177D, it would be concluded that any person or persons who entered into or carried out the scheme, or any part of it, did so for the sole or dominant purpose of enabling the taxpayer (or the taxpayer and another or other taxpayers) to obtain a tax benefit in connection with the scheme. The dominant purpose test is an objective test and does not require inquiry into the subjective intentions of the taxpayer or any other person.

Pursuant to current s 177C, a taxpayer obtains a 'tax benefit' in connection with a scheme if:

  • an amount is not included in the taxpayer's assessable income of an income year (income benefit);
  • a deduction is allowable to the taxpayer in relation to an income year (deduction benefit);
  • a capital loss is incurred by the taxpayer during an income year;
  • a foreign income tax offset (FITO) is allowable to the taxpayer; or
  • the taxpayer is not liable for an amount of withholding tax,

where the amount of assessable income, allowable deduction etc. would have been, or might reasonably be expected to have been, so included in assessable income, not so allowable etc. if the scheme had not been entered into or carried out.

The case law in relation to Part IVA has established that the process of determining whether there is a tax benefit under s 177C involves consideration of an 'alternative postulate' (sometimes referred to as the 'counter-factual') - that is, what would, or might reasonably be expected to, have occurred in the absence of the scheme in question.

The 'weaknesses' perceived to have been revealed by the recent Federal Court decisions relates to the process of identifying a tax benefit. In some of the decisions in question, the Court held there was no 'tax benefit' but said (in obiter) that, if there had been a tax benefit, the Court would have concluded under s 177D that the dominant purpose was to obtain the tax benefit.

A key perceived weakness relates to the so-called 'do nothing' alternative. In the case of an income benefit, this alternative means there is no tax benefit, as in the 'do nothing' scenario there would be no amount of assessable income. This is not the case for a deduction benefit as there would of course be no deduction in the do nothing scenario (which presumably is not cause for concern to the Government or the Commissioner of Taxation).

Summary of changes

The proposed amendments in the Bill deal with the process of identifying the tax benefit and are also intended (according to the EM) to deal with the inter-relation between that process and the dominant purpose test and ensure that the dominant purpose test is the 'critical test' or the 'fulcrum upon which Part IVA turns'.

The Bill will insert new section 177CB, dealing with the basis for deciding the alternative postulate to identify a tax benefit (i.e. the basis for deciding what would, or might reasonably be expected to, have happened if the scheme had not been entered into or carried out).

Section 177CB will provide as follows:

  • The postulate on which a decision that a 'tax effect'5 would have occurred if the scheme had not been entered into or carried out is based must comprise only the events or circumstances that actually happened or existed (other than those forming part of the scheme);
  • The postulate on which a decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based must be a reasonable alternative to the scheme;
  • In determining whether a postulate is a reasonable alternative to the scheme, it is necessary to:

a) have particular regard to:

  • the substance of the scheme; and
  • any non-tax result or consequence (i.e. that is not a result or consequence under the Act) for the taxpayer that is or would be achieved by the scheme;

b) disregard any tax result (i.e. under the Act) that would be achieved by the postulate for any person (including a non-party to the scheme).

In addition, the current s 177D (the dominant purpose test) will be replaced by a new s 177D, which will contain the same terms as the current section but slightly re-configured, as follows:

  • subsection 177D(1) will provide that Part IVA applies if it would be concluded that a person who entered into the scheme did so for the dominant purpose of enabling a taxpayer to obtain a tax benefit; and
  • subsection 177D(2) will provide that, despite subsection 177D(1), Part IVA applies only if the relevant taxpayer has obtained a tax benefit in connection with the scheme.

According to the EM, this re-arrangement of s 177D (along with a change to the introductory wording of s 177F)6 is intended to ensure that the dominant purpose test is paramount (the 'fulcrum' or 'pivot' around which Part IVA operates) and that the question of whether there is a tax benefit forms part of a single inquiry with the question of dominant purpose, ensuring that the examination of the tax benefit happens in the context of examining a participant's purpose.7

The proposed provisions are discussed further below.

What the EM says

What the EM says

Tax benefit

Proposed s 177CB in the Bill is apparently based on the proposition that the tax benefit test in s 177C consists of 2 limbs that embody separate and different tests, as follows:8

  • The first limb requires a comparison between the tax consequences of the scheme and what 'would' have been the tax consequences if the scheme had not occurred - this limb is satisfied where the relevant tax advantage would not exist if the scheme had simply not happened. This is described in the EM as an 'annihilation approach'.9
  • The second limb requires comparison of the tax consequences of the scheme and what 'might reasonably be expected' to have resulted if the scheme had not occurred. According to the EM, this limb applies where the mere deletion of the scheme would not necessarily leave a coherent state of affairs for the tax laws to apply to (e.g. where a prediction is required about facts not in existence or about facts that are in existence not being in existence). This is described in the EM as a 'reconstruction approach' and is said to apply where a 'first limb benefit', based on simple annihilation of the scheme, would be 'inconsistent with the non-tax results and consequences sought for the taxpayer' under the scheme.10

The EM rejects the alternative view (which it says 'has become evident in a number of recent decisions') that the tax benefit test in s 177C is a composite test, requiring in every case a postulate about what would or might reasonably be expected to have happened in lieu of the scheme.

On this view, according to the EM, 'would have' and 'might reasonably be expected to have' represent 'ends of a spectrum of uncertainty within which acceptable postulates must lie' and it assumes that 'all acceptable postulates will involve a prediction about events or circumstances, as opposed to a mere deletion of the scheme'.11

The EM says the amendments are intended to put it beyond doubt that the 2 limbs represent 'separate and distinct' bases for demonstrating the existence of a tax benefit. The EM says it is desirable from a policy perspective for the anti-avoidance provision to have both a reconstruction power and an annihilation power,12 with the former being directed (for example) to schemes to avoid assessable income and the latter to schemes directed (for example) to obtaining tax deductions.

The EM also rejects the notion that the second limb test should permit a broad-ranging, unconstrained inquiry into what might reasonably be expected to have happened, or what the taxpayer might reasonably have done, in the absence of the scheme. Rather, it says, the matters that can be taken into this account should not be unlimited and, for example, regard to evidence from the taxpayer as to what it would have done in the absence of the scheme should not be permissible. The EM also says that a 'do nothing' or deferral alternative, based on the tax cost of the transaction, should not be permitted.

From a policy perspective, the EM says the inquiry should:

  • be based on the same objective matters that must be taken into account in determining the dominant purpose under s 177D; and
  • be focused on whether or not there were other ways in which the taxpayer might reasonably have achieved the substance and effect (tax implications aside) that it achieved from or in connection with the scheme, saying this would 'assist in exposing the purposes of participants in the scheme' and 'prevent taxpayers who achieve substantive non-tax effects from a scheme from avoiding the normal tax consequences of what they have actually done by arguing that they would have done something completely different, or nothing at all'. The tax consequences of the alternative postulate should not, according to the EM, be a basis for disregarding it as unreasonable.
  • Proposed new s 177CB presumably implements these concepts by providing that:
  • under the so-called first limb of the tax benefit inquiry - only the actual events or circumstances (other than those forming part of the scheme) happened or existed; and
  • under the so-called second limb of the tax benefit inquiry - any tax effects of the scheme must be disregarded in determining the alternative postulate and regard must only be had to the substance and the non-tax results and consequences of the scheme.

Dominant purpose

Under the current law (as acknowledged in the EM),13 determining whether Part IVA applies is a 2-step process, as follows:

  1. The first question is whether the taxpayer has obtained a tax benefit; and
  2. It is only if the answer to that question is 'yes' that the question of whether there was the requisite dominant purpose of enabling the taxpayer to obtain a tax benefit.

The EM says that a better approach from a policy perspective is for the analysis to start with the s 177D inquiry as to dominant purpose.

While the relevant purpose must be about a tax benefit, the EM says it is nevertheless a single inquiry, which 'looks at how the scheme was implemented, what it achieved as a matter of substance or reality (that is, its end effect) and the nature of the connection between the taxpayer and other parties', and that a consideration of alternative possibilities should form a part of this inquiry. In short, the same considerations that are required to be taken into account in determining dominant purpose should also apply in determining whether there is a tax benefit.14

In support of this approach, the EM cites certain comments of Gummow and Hayne JJ and Callinan J in Hart.15 Their Honours' comments are, however, taken out of context and it is difficult to see how they could be said to support the approach of treating the tax benefit inquiry as simply a part of the dominant purpose inquiry.

Comments

It is submitted that the approaches adopted in relation to the tax benefit and dominant purpose inquiries in the measures under the Bill and the analysis in the EM are misdirected.

In particular:

  • The '2-limb' analysis of s 177C as providing 2 separate, alternative tests for determining whether there is a tax benefit is, with respect, simply wrong and not justified by the language of the provisions or the decided cases.
  • The proposition that the dominant purpose test is to be undertaken as part of a single inquiry with (or effectively before) the tax benefit inquiry is illogical and circular - it is effectively saying that the question of whether there is a tax benefit depends on whether it would be concluded that there was a dominant purpose of obtaining a tax benefit. This would seem to be a case of 'putting the cart before the horse'. In any event, it is not entirely clear that the proposed amendments actually have this effect, notwithstanding that, under proposed s 177CB, some of the same criteria as apply in determining dominant purpose under s 177D will apply in determining whether there is a tax benefit (i.e. the substance and non-tax consequences of the scheme).
  • The justification for applying the same criteria in determining whether there is a tax benefit as apply in determining the dominant purpose (a significant change from the current law) is questionable.
  • The direction that the alternative postulate under the so-called first limb tax benefit test must comprise only the events and circumstances that actually happened, other than those forming part of the scheme, would seem to require a much more precise (and narrow) formulation of what constitutes the 'scheme' (a broadly defined term) than has been regarded as necessary in much of the case law to date.
  • The direction to disregard the tax consequences in deciding the alternative postulate under the second limb of the tax benefit test makes the inquiry artificial and unduly constrained. As recognised in the decided cases, tax cost is clearly a relevant (and often significant) factor in most business and commercial decisions and, as the EM also acknowledges, Part IVA is not intended to apply to all arrangements of a tax planning nature. To prohibit regard being had to the tax consequences in the tax benefit inquiry is contrary to the original policy and intent of Part IVA.
  • The '2-limb' approach to the tax benefit test and the limitations in s 177CB would seem to unduly favour the Commissioner in that, under the amendments in the Bill, it would seem that, as a general rule, a deduction benefit will easily be found under the first limb and an income benefit more readily found under the second limb.

The amendments under the Bill are substantial and will render nugatory much of the existing case law on Part IVA that has been built up over the last 20 or so years. This is undesirable in the absence clear and compelling policy reasons for making the changes. No such compelling reasons are apparent.

It is not at all clear that the handful of recent decisions said to have caused the concerns given as justification for the proposed changes demonstrate that Part IVA (which as noted has been in operation since 1981) is not working as it was intended. In fact, the decided cases have largely and consistently upheld the application of Part IVA against the most blatant and artificial tax schemes, especially those involving the creation of tax deductions with no or limited substantive commercial benefits and those blatantly or artificially avoiding tax on a commercial gain that would clearly still have been commercially beneficial notwithstanding the tax cost.16

This justification in the EM focuses on cases the Commissioner has lost and does not have regard to the many cases he has won. The old adage that 'bad cases make bad law' may be apt here. Perhaps the Commissioner took on the wrong cases. In any event, just because the Commissioner loses does not necessarily make it bad law. No doubt there are cases that the Commissioner won that perhaps he shouldn't have. It does not mean that the law should be fundamentally changed and 20 years of jurisprudence discarded.

Conclusion

The amendments under the Bill will fundamentally change Part IVA and have attracted widespread criticism.

The premise and stated justification for the changes is questionable. What doesseem clear, however, is that the changes will cause uncertainty and complexity, for taxpayers and the Commissioner alike. The changes may even prove to be a 'double-edged sword' for the Commissioner. For taxpayers required to complete a 'Reportable Tax Positions' schedule, the uncertainty created under the proposed changes will make this even more difficult.17

Nor is it clear that the changes will necessarily result in additional revenue - they may simply discourage taxpayers from undertaking commercial transactions because of the associated tax costs. It is by no means certain that the uncertainty and complexity that the changes will inevitably create will prove to be worth it.


1 The cases in question include: FC of T v Futuris Corporation Ltd (2012) 205 FCR 274 (Futuris); RCI Pty Ltd v FC of T2011 ATC 20-275 (RCI); FC of T v Axa Asia Pacific Holdings Ltd (2010) 189 FCR 204.

2 The changes were originally proposed to apply from the date of the announcement (i.e. 1 March 2012), which did not contain any detail as to what the amendments would be.

3 For example to extend the provisions to withholding tax, capital losses and foreign income tax offsets.

4 'Scheme' is very broadly defined in Part IVA.

5 This is a new term, meaning an amount being included in assessable income, a deduction or FITO not being allowable, a capital loss not being incurred or a taxpayer being liable to pay withholding tax.

6 Under the Bill, the opening words to s 177F (which provides for the Commissioner to determine to cancel a tax benefit) will now read 'Where this Part applies to a scheme in connection with which a tax benefit has been obtained, or would but for this section be obtained …'.

7 EM paragraph 1.71.

8 See EM paragraphs 1.31-1.41.

9 For example, as applied in cases such as Puzey v FC of T (2004) (2003) 131 FCR 244 and Sleight v FC of T (2003) 136 FCR 211 (both of which are deduction cases). See EM paragraphs 1.77-1.84.

10 For example, as applied in cases such as FC of T v Spotless Services Ltd (1996) 186 CLR 404 and FC of T v Hart (2004) 217 CLR 216 (Hart) (both of which are income cases). See EM paragraphs 1.41, 1.85-1.97.

11 EM paragraphs 1.42-1.43.

12 As the EM notes (paragraphs 1.45-1.46), the previous general anti-avoidance provision in s 260 of the 1936 Act was considered defective as it did not have a reconstruction power.

13 EM paragraph 1.56.

14 EM paragraphs 1.58-1.59.

15 See EM paragraph 1.17, citing Callinan J's comment that, under the 'form and substance' criterion in s 177D, it is necessary to consider 'whether the substance of the transaction (tax implications apart) could more conveniently or commercially, or frugally have been achieved by a different transaction or form of transaction') and EM paragraph 1.23, citing the comments of Gummow and Hayne JJ that 'each of the concepts of "tax benefit", "scheme" and "scheme to which this Part applies" have their part to play … and each of them must be given operation in the interrelated way in which section 177F requires' and that 'although it will often be convenient to begin any consideration of the application of the Part by attending to the operation of these elucidating and definitional provisions [that is sections 177A and 177C], approaching a particular case in this way must not be allowed to obscure the way in which the Part as a whole is evidently intended to operate.'

16 Arguably in contrast to RCI, which involved an internal restructure, in which the Court found that the tax cost that would have been involved if the scheme in question (a series of transactions which had the result of substantially reducing a large capital gain that otherwise would have arisen under the restructure) had not been undertaken outweighed the commercial benefits of the restructure, such that it was not reasonable to expect that the restructure would have been undertaken without the scheme. This is quite different from a 'do nothing' alternative in the case of, say, an external sale of an asset, where it would generally be easier to find that the sale would, or might reasonably be expected to, have occurred anyway.

17 See http://www.ato.gov.au/content/00322539.htmfor further information on 'Reportable Tax Positions'.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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