The Government is proposing significant amendments to the income tax general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (Part IVA).
It has introduced a new bill into the House of Representatives, the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (Bill),which follows exposure draft legislation (ED) released in November 2012 and considered by Corrs at http://www.corrs.com.au/publications/corrs-in-brief/the-part-iva-changes/.
The ED was heavily criticised when it was released and the Government seems to have taken on board some of this criticism. The result is a Bill which is markedly different to the ED. Below we identify what has changed and what has remained the same, and the practical implications of the Bill for taxpayers.
What has changed
The most significant difference between the changes proposed in the ED and in the Bill relates to the formulation of the alternative postulate under s177C of the Income Tax Assessment Act 1936.
Section 177C defines the circumstances in which taxpayers are taken to have secured a “tax benefit” for the purposes of Part IVA. Broadly, a tax benefit has been received where, but for the scheme, the taxpayer would not have, or might reasonably be expected to not have, received the particular tax advantage obtained under the scheme.
The explanatory memorandum which accompanied the ED (EM to the ED) stated the ED was intended to cure what it saw as a “blurring” of the “would not have” and “might reasonably be expected to not have” limbs in s177C(1) and confirmed that the limbs should be treated as alternatives. However, the ED itself included no specific changes to this effect and this led to criticisms that there was a disconnect between the ED and the accompanying EM to the ED.
Under the Bill, new s177CB confirms that the two limbs of s177C(1) represent alternative bases upon which the existence of a tax benefit can be demonstrated:
- the first limb, called the “Annihilation Approach”, involves considering an alternative postulate which consists solely of the events or circumstances that happened or existed other than those that formed part of the scheme (in s177CB(2)). This limb will be relevant in some cases where the tax benefit in question is a tax deduction or capital loss which would not arise if the steps of the scheme were ignored. The explanatory memorandum accompanying the Bill (EM to the Bill) refers to two Full Federal Court decisions which deal with income tax deductions and which the EM to the Bill says appear to have been decided based on the Annihilation Approach;1 and
- the second limb, called the “Reconstruction Approach”, involves considering an alternative postulate which is based on a reasonable reconstruction of what the taxpayer might have done if the scheme was not entered into (in s177CB(3)).
Under the Bill, the intention is clear - each limb of s177C(1) needs to be considered separately. The EM to the Bill notes that no court has directly considered the competing constructions of s177C(1) and acknowledges that there have been a number of cases where the Annihilation Approach and the Reconstruction Approach have been considered as a single, composite test,2 but explains that the Bill puts beyond doubt that the section should be construed in the way preferred by the Government.
The Annihilation Approach would typically be used where the scheme in question does not produce any material non-tax results for the taxpayers or the scheme shelters economic gains already in existence. The EM to the Bill uses the example of a scheme by which a taxpayer secures a large, up-front, tax deduction which is structured so as to provide a highly contingent right to income payable some years in the future.3
The Reconstruction Approach, on the other hand, would be used where the scheme achieves substantive non-tax results; typically, where the scheme both produces and shelters economic gains. The EM to the Bill uses the example of a couple borrowing to acquire both a family home and holiday house that they plan to rent to holidaymakers.4 Under the borrowing arrangement, the repayments are applied exclusively to the borrowings in relation to the family home, so that the deductible interest payments are increased for the holiday home borrowing and the non-deductible interest payments for the family home are minimised. According to the EM to the Bill, annihilating the scheme would not leave a sensible result as there would be no borrowing at all, so reconstruction is necessary. In this case, the EM to the Bill suggests that a reasonable alternative could be for the couple to take out a separate loan for each house they wish to acquire.
It is also worth noting that the EM to the Bill recognises the Commissioner is entitled to put his case in alternative ways and it is expected that the Commissioner will continue his current approach of arguing both limbs of s177C as alternatives.
What has stayed the same
There are two main changes to the operation of Part IVA common to the ED and the Bill, albeit the changes are dealt with in slightly different ways in each set of draft provisions.
Restoration of the purpose test to its central role in the application of Part IVA
One of the changes is the restoration of the purpose test to its central role in the application of Part IVA (on the assumption that this had been lost as a result of the way the Courts have interpreted Part IVA).
According to the EM to the ED and the EM to the Bill, the question of whether Part IVA applies to a scheme should not start with a consideration of whether a taxpayer has obtained a tax benefit under a scheme. Rather, it should involve a single, holistic inquiry into whether a person participated in the scheme with a sole or dominant purpose of securing a particular tax benefit for the taxpayer in connection with the scheme.
It appeared that the ED sought to make this change through subtle redrafting and reordering of existing provisions (ss177D and 177F(1)) and the introduction of new provisions (ss177AA and 177CB(2)) which change slightly the emphasis of the provisions and the scheme of Part IVA.
It appears that the Bill seeks to make this change solely through the redrafting and reordering of ss177D and 177F(1). Section 177AA of the ED, which contained an objects clause, and s177CB(2) of the ED, which required regard to be had to the eight factors in s177D(2) when considering other ways in which the taxpayer could reasonably be expected to achieve the same non-tax effects of the scheme, are not replicated in the Bill.
Nature of inquiry permitted in constructing an alternative postulate
Each of the ED and the Bill includes measures designed to ensure that, in constructing an alternative postulate, certain arguments adopted by taxpayers in recent Federal Court cases about what is and isn’t reasonable are no longer available.
The ED proposed a number of constraints on how the alternative postulate could be formulated (in s177CB). This change was intended to address specific concerns that the Government had about taxpayers successfully arguing that the scheme in question did not produce a tax benefit. Under this argument, no tax benefit is produced because the reasonable alternative postulate to the scheme, formulated having regard to tax outcomes for the taxpayer and non-tax objectives for others, would have produced a tax outcome at least as beneficial as the one obtained under the scheme.
The specific constraints on the formulation of the alternative postulate that were included in the ED are not included in the Bill. However, under s177CB(4) of the Bill, in determining whether a postulate is a reasonable alternative to the scheme:
- regard must be had to the substance of the scheme and any result or consequence for the taxpayer that is or would be achieved by the scheme other than a result under the Income Tax Assessment Acts (s177CB(4)(a)). This essentially means that the alternative postulate that is formulated must achieve the same commercial outcome for the taxpayer as the scheme; and
- the results under the Income Tax Assessment Acts achieved by the scheme for any person are disregarded (s177CB(4)(b)). This means taxpayers will not be able to argue that the alternative postulate is not reasonable because of the potential Australian income tax costs of that postulate.
Practical implications of the Bill for taxpayers
The Bill was referred to the House Committee on Economics (House Committee), which has recommended that the Bill be passed unamended (with opposition members of the House Committee providing a dissenting report). Once enacted, the Bill will apply retrospectively to schemes entered into or carried out on or after the date of the release of the ED, 16 November 2012.
Some of the practical implications of the Bill for taxpayers are as follows:
- for schemes involving income tax deductions or capital losses, an application of the “Annihilation Approach” will necessarily lead to the identification of a tax benefit. However, it will still be necessary to take the “Reconstruction Approach” in deduction or capital loss cases where the annihilation of the scheme would produce a postulate that does not achieve the non-tax results or consequences for the taxpayer achieved by the scheme;
- in a significant number of cases, taxpayers will still need to consider whether the scheme in question gave rise to a “tax benefit” by reference to what might reasonably have occurred but for the scheme (i.e. the “Reconstruction Approach”). This may not be an easy or straightforward exercise. The alternative postulate might not be what is most reasonable or realistic because factors that would inevitably impact upon what would or would not occur but for the scheme (Australian income tax consequences for the taxpayer and both tax and non-tax consequences for others) must be ignored;
- in addition, in determining whether a postulate is a reasonable alternative to the scheme, you need to have regard to the “substance of the scheme” and “any result or consequence for the taxpayer” of the scheme (other than an Australian income tax result). This would seem to add to the difficulty, uncertainty and potential for argument over whether or not a particular postulate is a reasonable alternative to the scheme;
- the range of taxpayer defences to an application of Part IVA has been narrowed in a limited number of cases. The arguments that proved successful for taxpayers in recent cases, namely, that tax outcomes for the taxpayer and non-tax objectives for others are relevant in formulating the alternative postulate, are no longer available;
- as is currently the case, in most Part IVA cases in which the new rules will apply, there will be a scheme and an identifiable tax benefit. The main focus will be on whether it is possible to identify a person who has the sole or dominant purpose in entering into the scheme of obtaining the tax benefit for the taxpayer; and
- that said, the reasonable alternative postulate to the scheme retains an important role in the Part IVA analysis. It will still be necessary to determine whether the taxpayer has obtained a tax benefit in connection with the scheme (s177D(3)). In most cases this will involve an application of the Reconstruction Approach. As noted above, this may involve a difficult exercise of identifying a reasonable alternative to the scheme having regard to its “substance” and non-tax “results” and “consequences” for the taxpayer. The alternative postulate also plays an important part in assessing purpose under s177D(2). As such, in many cases it may still be necessary for the taxpayer to undertake a detailed forensic exercise to identify the reasonable alternative postulate having regard to the requirements of s177CB(4).