Michael D'Ascenzo, Chief Tax Counsel, Australian Taxation Office
The case concerned a financial arrangement under which the taxpayers had claimed that the source of interest earned from an investment was located in the Cook Islands and, as some withholding tax had been paid there (5%), the interest in the 1987 tax year was exempt from Australian tax under the former subsection 23(q) of the Income Tax Assessment Act 1936.
The relevant facts for present purposes are as follows:
- Spotless was desirous of investing $40m which had been received as a result of a public float and was surplus to its requirements for the year ended 30 June 1987.
- In the interim the funds were invested in Australia on the short term money market for a period of 195 days (a point not appreciated until the High court hearing).
- The arrangement was a scheme to take advantage of S23(q) which exempted foreign sourced income from Australian tax provided withholding tax was paid in the country of source subsection 23(q) ceased to apply to income derived on or after 1 July 1987 with the introduction of the foreign tax credits system.
- To give effect to the arrangement the following transactions took place:
- Spotless opened two accounts: one with Midland Bank (Singapore), the other with European Pacific Banking Corporation (EPBC), Cook Islands.
- Spotless deposited the funds with Midland and instructed the bank to transfer those funds to EPBC.
- Midland provided Spotless with a letter of credit as security for the repayment of principal and interest.
- Spotless' attorney travelled to Cook Islands, drew a cheque on its EPBC account in favour of European Pacific Banking Co Limited (EPBCL) a subsidiary of EPBC.
- EPBCL issued a Certificate of Deposit.
- The rate of interest was some 4.5% less than the Australian bank bill buying rate.
- EPBC reinvested the $40m with Bankers Trust Hong Kong subject to a charge on the deposit in favour of Midland.
- On maturity the principal and interest net of the 5% Cook Island Withholding Tax was paid to Spotless' account in Brisbane.
The ATO assessed Spotless on the interest it received from the arrangement on the basis that it was Australian sourced. Part IVA was used as an alternative argument.
The case came before Luckhart J. at first instance. He took the view that the __ entering into the Certificate of Deposit was the crucial transaction giving the income. As this was made in the Cook Islands by delivery by Mr Levy to Mr Kuegler of the cheque, the interest income had a Cook island source. As for Part IVA, he took the view that the Commissioner had identified the scheme too narrowly and as he was bound by the Full Federal Court decision in Jackson 89 ATC 4429, 90 ATC 4990 and Peabody 93 ATC 4104 Part IVA could not apply.
The Commissioner appealed to the Full Federal Court on the grounds that Lockhart J. had given insufficient weight to the activities carried out in Australia and had erred in funding a Cook Island source. Also, as Lockhart's decision was delivered before the High court's judgment in Peabody 94 ATC 4563, he had been incorrect in not considering the Part IVA issue because the erroneous identification by the Commissioner of a scheme "will not ordinarily result in the wrongful exercise of the discretion conferred by section 177F(1): Peabody at 4669-70.
(a) The Decision
The Full Court 95 ATC 4775 unanimously decided that the source of the interest payments was the Cook Islands and not Australia, although in Beaumont J's view the case was "on the borderline".
Cooper with whom Northrop J. agreed found that:
(a) there was a scheme;
(b) there was a tax benefit because it could reasonably be expected that but for the scheme the taxpayer would have invested the funds to earn interest in Australia; but
(c) that the dominant purpose of the taxpayers was to obtain the best after-tax return and not to obtain a tax benefit.
In his dissenting judgment Beaumont J. also found that there was a "scheme" and a "tax benefit" and decided that the scheme was tax driven and that the Cook Island investment had no other commercial reason.
(b) The Impact of the Decision if Unchallenged.
On one reading of the case the difference between Cooper J. and Beaumont J. comes down to a difference of judgment on the particular facts of the case. On the other hand, the facts of the Case put into sharp focus the application o f Part IVA to a transaction which produces a commercial result by means which may perhaps be said to have been "driven by tax considerations".
You will recall that Hill J. in Peabody 25 ATR 32 at p47 made a similar comment: "Part IVA would seldom, if ever, operate to permit the Commissioner to make a determination, carrying with it as it does an automatic penalty upon a taxpayer assessed, where the overall transaction is in everyway commercial, although containing some element which has been selected to reduce the tax payable."
So quite apart from other cases which had taken advantage of the s23(q) exemption, the concern is that such an interpretation of Part IVA would give it a very narrow field of application. On the otherhand, even though we gained more than we lost in Peabody, we had a bad loss in Wills case (a case where on the facts before the court Part IVA should not have been applied) and could highten adverse perceptions about the effectiveness of Part IVA.
We had to think long and hard about whether we should seek leave to appeal. In Spotless there is no evidence that the funds found their way back to the company, and it would be open to the court to conclude that all the company did was to invest funds which it had on hand in "a way that gave it the best Commercial return."
Also many of the features of the arrangements which one might take into account in determining source were relevant to the application of Part IVA and yet four judges had already concluded that the source was the Cook Islands.
In the end we decided to press on with the Part IVA ground but not source. We believe that the case exhibits the beadges of tax avoidance.
Goudron, McHugh and Kirby heard the Special leave Application on 16 April 1996 and granted leave. The potentially broad application of the reasoning of Cooper J. was noted by McHugh J:
"the facts of this case are so special that the case seems to have a ratio decidendi of some general application, and is not the ratio fo the case simply this, that where a taxpayer lends money at a rate of interest lower than rates that are commercially available simply because the after-tax benefits of the investment scheme make it more profitable than the lending of money at ordinary commercial rates, it cannot be concluded that the taxpayer entered into the scheme for the purpose of obtaining a tax benefit."
(a) The Commissioner's Arguments
The Commissioners argument proceeded on the basis that the interest on the deposit had a Cook Island source but although the form of the scheme provided for the investment of funds in the Cook Islands by handing over a cheque drawn on a bank there, the substance of the scheme was that the funds were invested in Australia dollars (by the handing over to Midland by Spotless of its bank cheque, in exchange for the Letter of Credit which provided for payment in Australia in the case the funds were not repatriated from the Cook Islands) and were repaid in Australia together with interest in Australian dollars. The manner in which the scheme was entered into shows that it was central to Spotless' concerns to obtain absolutely safe Australian security for a short term foreign investment and that the formalities to be performed in the Cook Islands had no commercial significance to Spotless except of the extent that they secured an exemption from Australian tax.
We submitted that the scheme was contrived and blatant as Beaumont J. found in the sense of sending Mr Levy to the Cook Islands and having regard to the steps which for Spotless had no commercial justification except for the purpose of securing a s23(q) exemption.
We submitted that the investment was not an ordinary commercial dealing in contradistinction to Cooper J's comment at p4811, that "where the activity under consideration is a bona fide investment of capital funds the tax payable on the interest earned is, for the purpose of deciding whether or not to undertake any particular investment, a relevant consideration." We argued that the transactions involved many unusual elements - including the adoption in substance of the elaborate plan set out in the Information memorandum, including sending an attorney to the Cook Islands to carry out necessary formalities; and the insistence of security free of foreign elements.
We accepted that, in adopting the scheme Spotless hoped to obtain a better after tax return than it would otherwise have obtained. But we submitted that this of itself cannot be an answer to the suggested application of section 177D, because no-one will ever carry out a scheme in connection with which there is a "tax benefit" as defined in section 177C unless they are to gain an advantage by obtaining it. We submitted that the intention of Part IVA was that it would be sufficient to deal with modern day schemes to avoid tax, and not limited as McHuge J. suggested to the 1970's paper schemes, Curran and the like.
We put to the Court that the $40m had been invested in Australia and that only two things have changed; the interest rate is lower and Australin tax is not being paid. There was a scheme, and the reasonable expectation was that the moneys would have continued to be invested in Australia. In looking at the eight matters udner section 177D questins of artificiality and commerciality arise and that the dominant purpose of one of in this case was to avoid tax.
We submitted that the taxpayer had the onus of showing why this was not so.
(b) The Taxpayer's Arguments
In short, the taxpayer's submission was that the dominant purpose of the investment was to invest a very large amount of money for the required time for a satisfactory rate of return. This is a single purpose and it does not make sense to analysis it into several 'purposes' and treat each of these as if they were independent.
(a) Possible Outcomes
It is possible that the Court could come to the following conclusions:
(i) Decision in favour of the Commissioner because:
(1) But for the tax benefit the scheme will not have been entered into;
(2) The scheme exhibits the badges of tax avoidance such that the dominant purpose was to avoid tax; or
(3) The taxpayer has not discharged the onus that Part IVA should not have applied in this case.
(ii) Decision for the taxpayer
(1) The taxpayers purpose was to obtain the best after tax return.
(b) How might the Judges Decide
This section of my paper is pure speculation; as McHugh comments at p43 of Transcript, "All my views are tentative." However, I am reasonably confident that the Commissioner will succeed in this case, and probably on the grounds that the scheme exhibited the badges of tax avoidance (i.e. the 'half way house' referred to by McHugh J. in the transcript p34). Both McHugh and Kirby JJ. were attracted to the notion that the case involved a one-off windfall provision of capital that was put our to the best advantage of the taxpayer (see transcript - Kirby J. at p10, 43, 70, 76; and McHughe J. at p10, 34, 63, 71, 73-74, 77, 149). McHugh J's. concern is that Part IVA might have too wide an application. For example, at p34 he says:
"I would have thought the answer was that they are going to make more profit. I mean, you want to have a half way house here. It does not seem to me at the moment at this stage of your argument that - you certainly have not convinced me that there is a halfway house here. It seems to me either there is always a tax benefit in any sort of situation where a person takes advantage of some exemption or other provision of the Act or in a commercial setting there is never a tax benefit, that it is done for profit, to increase the profit, and that is it."
The Commissioner's response to this was that it depended on the facts (see for example p 10-11, 13, 32-33, 34, 43, 63, 69, 71-72, 76-77).
Kirby J. on the other hand saw the evaluation of the factors in s177D as "problematical" such that Parliament had given the task of evaluation to the Commissioner. It was then for the taxpayer to displace that view. See transcript at p39, 52, 109. McHugh also agreed that the onus of proof was on the taxpayer (transcript p41).
At p100 of transcript Kirby notes the Commissioner's half way house - "you look at all the facts."
Dawson J. seemed to have no doubts that the scheme was artificial and contrived and that its sole purpose was to obtain the s23(q) exemption: see transcript at p32, 70, 81, 85, 104, 107-108, 137. In Dawson J's. view "you cannot set out to get a tax benefit." (transcript at p35).
Gandran Toohey and Gummon JJ. played less of an active part in the proceedings so it is difficult to determine their views. However, Gandran J. noted that the Act "dictates that you consider the artificiality of the transaction because it requires you to look at the form and substance of the scheme" (p 75 of Transcript and see p 199) and that there were a number of participants in this arrangment (p 92 of Transcript).
Gummar J. in responding to arguments in favour of the taxpayer's position notes that phrases like "choice principle" are not in the Act (p 126 of Transcript), and earlier noted a similarity between Newton's case and this case (p 70 of Transcript). It may be that his questioning on the requirements of a section 14C Certificate (Taxation Administration Act) would also add to the "colour" of the scheme.
I also think that Brennan CJ. is likely to lean in the Commissioner's favour. For example, at p 111 of the Transcript he asks:
"Now, if you look at the terms of the offer that was made to them, one funds that there is an offer which is made at 4½ per cent under the Australian Bank Bill buying rate. So, looking at the form and substance of the arrangements into which your clients entered, compare the prospect of buying Australian bank bills, which, of course, would be in Australian dollars with bank security, at 4½ per cent above the raw interest rate which was on offer, is there any distinction between that and what was acquired, other than the tax differential?"
See also p 112 and p 130 of the Transcript.
So there you have it, hopefully a good result!
Last Modified: Friday, 25 January 2002
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