The comments in these minutes are general in nature and should not be taken to indicate that the Australian Taxation Office (ATO) has a particular view or practice in relation to the application of Part IVA to particular fact situations. Each matter will turn on its particular facts. Taxpayers should be encouraged to carefully consider the application of Part IVA in their particular circumstances; it would not be prudent to determine the tax treatment of particular arrangements solely by reference to the comments in these minutes.
1. Opening Remarks
Participants were informed that the purpose of the workshop was to assist the ATO understand where guidance may be warranted to aid taxpayers in applying the amendments of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936).1
Participants understood that Part IVA is inherently fact driven and that the outcomes suggested during the workshop are subject to an examination of the particular facts and circumstances of each particular case. Further, it was acknowledged that the conversations would not be binding on the ATO.
The ATO noted that a range of existing ATO guidance in relation to Part IVA will need to be updated to accommodate the amendments, with the Practice Statement PS LA 2005/24 a priority. Further, the examples discussed during the workshop may be used as a basis for discussion in the revised documents.
The ICAA, opened with some comments on the examples that were to be discussed. (These examples are included as an attachment to these minutes.) The scenarios contain minimum facts and were designed to stimulate discussion about the application of Part IVA. It was assumed for purposes of the discussion that the tax outcomes of the scenarios (excluding the application of Part IVA) were achieved.
The workshop allowed for discussion of the effect of the amendments as well as the general application of Part IVA to the arrangements identified. However, in practice most of the examples fairly clearly disclosed a tax benefit (whether under the old law or the new) and so the discussion tended to centre on the application of the purpose test in section 177D.
Outlined below is a summary of the key points raised during the workshop. A more detailed discussion in relation to the examples is included following this overview.
Matters concerning the amendments to Part IVA
Two key points specifically focused on the amendments to Part IVA:
- the circumstances in which the Commissioner would seek to rely on the different limbs of subsection 177C(1), as elaborated upon in section 177CB, and;
- what constitutes a reasonable alternative in the context of the second limb.
Guidance would be useful in relation to these 2 points.
- The reconstruction and annihilation limbs: which limb should be applied?
Section 177CB provides an elaboration of how the ‘would have been’ limb (see subsection 177CB(2)) and the ‘might reasonably be expected to have been’ limb (see subsection 177CB(3)) in each of the subsection 177C(1) paragraphs is to be applied. Specifically, subsection 177CB(2) makes it clear that the ‘would have been’ limb operates on the basis of an annihilation approach and subsections 177CB(3) and (4) make it clear that the ‘might reasonably be expected’ limb operates on the basis of a reconstruction approach.
The two limbs offer two distinct routes for identifying tax benefits in respect of which Part IVA might apply. The ATO said that it is open to the Commissioner to mount arguments, in the alternative, under both the annihilation limb and the reconstruction limb.
- The reconstruction limb: what constitutes a reasonable alternative?
Previously, the courts have interpreted the ‘might reasonably be expected to have been’ limb in each of the subsection 177C(1) paragraphs as requiring a prediction as to what the parties might reasonably be expected to have done if they hadn’t entered into the scheme. Different views exist as to whether, to be ‘reasonable’, a prediction had to be the ‘most reliable’ prediction or whether it would suffice if it were merely a ‘reasonable’ prediction (observations in recent Federal Court decisions appear to favour the former view).
The reconstruction approach in subsections 177CB(3) and (4) demands a different inquiry. It asks whether there were any other ways in which the substance of the scheme and its non-tax effects for the taxpayer could have been achieved. Put differently, the search is for an alternative postulate that could reasonably take the place of the scheme. This is a much narrower inquiry than the previous inquiry and does not require any predictions about what the parties would have done if they hadn’t entered into the scheme.
As to whether there could be cases in which the Commissioner would be at liberty to choose between two or more reasonable alternatives – that is a theoretical possibility that will only arise if, having regard to the subsection 177CB(4) factors, there are a number of alternatives to a scheme, each of which is equally ‘reasonable’ or, if a court were to accept a postulate as a ‘reasonable alternative’ to a scheme notwithstanding the existence of another postulate that would be a ‘more reasonable alternative’ to the scheme.
The ATO noted that the amendments do not expressly deal with this issue. Further, the issue does not appear to have been addressed in the Explanatory Memorandum. The ATO understands that Treasury did not have a particular view on the issue.
Matters concerning Part IVA more generally
- Changing plans
Many of the examples suggested several possible schemes that might be identified in each example. Some of these schemes consisted of or included steps taken in the design and formulation of the arrangement subsequently implemented. In general however, the scheme that the Commissioner is likely to examine under Part IVA is the transaction, or series of transactions, that is actually implemented, as opposed to any planning and design that might have led up to the transaction.
Sometimes, elements of the planning and formulation of a scheme may cast some light on the objective features of the scheme actually implemented. On the other hand, merely taking tax advice, or altering a proposed scheme as a result of receiving tax advice, will not normally itself be a scheme to which Part IVA may apply.
- Substance of the scheme
The ATO noted that subparagraphs 177CB(4)(a)(i) and (ii) direct attention to the substance of the scheme and to the non-tax effects that it produces for the taxpayer. To be a reasonable alternative to a scheme it would be expected that a postulate could take the place of the scheme having regard to the commercial (or other) objectives sought for the taxpayer by the participants in the scheme.
The substance and non-tax effects of the scheme must also be taken into account, together with other factors, when undertaking the section 177D inquiry into the purposes of those that participated in the scheme.
- Can Part IVA apply where an arrangement falls within comprehensive regimes within the tax law such as the rules dealing with thin capitalisation in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Part IVA applies with paramount force according to its terms. The ATO’s long-held position is that the mere fact that a taxpayer satisfies the requirements of some specific regime (including one that might be described as a specific anti-avoidance rule) does not somehow immunise the taxpayer from Part IVA.
- Is it open to the Commissioner to ignore the application of Part IVA where a structure has been implemented to deal with an outcome that a taxpayer perceives to have been unintended by Parliament?
To the extent that an entity puts in place a structure to ‘work around’ an apparent problem and that structure delivers a tax benefit, then, depending on the facts, Part IVA could apply.
Nothing in the legislation immunises a taxpayer from the application of Part IVA on the basis that the purpose of a scheme was to circumvent a legislative rule that might be thought to be undesirable or unintended.
3.Discussion of the particular examples
Representatives presented a range of examples on which guidance was sought. (These examples are included as an attachment to these minutes.) Participants understood that Part IVA is inherently fact driven and that the outcomes suggested during the workshop are subject to a full examination of the particular facts and circumstances of each case.
Example 1 – Issuing of Redeemable Preference Shares (RPS)
Examples 1.1 to 1.4 presented a number of variations on a structure that employs the issue of an RPS to raise funding for an Australian company.
The examples sought to identify particular potential schemes (such as changing the terms of the RPS prior to issue of the RPS) within a broader scheme of raising finance. Steps taken in the design and formulation of an arrangement may cast light on the substance of a particular arrangement. However, what the Commissioner is generally examining is the arrangement that is ultimately implemented.
To fall within Part IVA, it must be possible to conclude that the sole or dominant purpose of one or more of the persons who interfered into or carried out a scheme was to enable a taxpayer to obtain a tax benefit in connection with the scheme. In these examples, on the limited facts, the factors in subsection 177D(2) appear to point decisively away from such a conclusion.
When one compares the issue of RPS with other possible means of raising the relevant finance, one cannot, having regard to the 8 factors in subsection 177D(2), conclude that the particular means chosen is explicable only by tax considerations. RPS of a conventional nature are a standard and common means of raising finance which of themselves could not be said to be contrived or artificial in this context. They differ in commercial substance from ordinary shares and represent a legitimate commercial choice available to a company.
In these examples, nothing about the manner in which the finance is raised suggests a tax avoidance purpose. The form and the substance are congruent. The only point to note about timing is that term of the RPS at 9 years is just a little shorter than the relevant threshold under the debt/equity rules in Division 974 (10 years), but that fact alone would not be sufficient in this context to found the relevant conclusion of a tax avoidance purpose.
The fact that the company might have changed the proposed term from 12 years to 9 years in light of its tax advice does not significantly alter the analysis here. That change in the term is a genuine alteration to the commercial substance of the transaction. It might be different if the term were ostensibly changed to 9 years, but by some additional contrivance the economic substance of the arrangement was that the funds were in fact committed for 12 years. (But any such arrangement would have to withstand scrutiny under Division 974 before Part IVA came into play in any case.)
End of example
Example 2 – Investment structured as debt to preserve tax losses
The arrangement in example 2 attempts to preserve tax losses through the issue of a debt instrument rather than an equity instrument, while entitling the holder of the instrument to a percentage of future profits along with control of the company.
The facts presented were rather scant. As with many of the examples, the issue of form and substance is important for the purpose analysis. The analysis would depend, at least in part, on the extent to which the purported debt instrument replicated some or all of the features of ordinary shares in a way that might be seen as an artificial means of issuing disguised equity. But it was not possible to form a firm conclusion on the limited facts presented.
End of example
Example 3 – Person accepts lower consideration to take advantage of rollover
In this example, the owner of a business enters into an arrangement to sell the business at a price that is below the small business rollover relief threshold, despite an alternative offer in excess of the threshold.
It was noted that the example as presented may not work as the market value could be suggested to be in excess of the threshold set under the small business rollover relief rules in Division 152 of the ITAA 1997, despite the actual price struck.
Workshop participants presented two variations on this example to test the application of subsection 177D(2). The first was that instead of accepting the lower price, the business made a donation out of cash at bank which reduced its net assets below the $6m maximum net asset threshold. Or, as a further alternative, instead of making a donation, the business used cash at bank to purchase a house for Hermes.
Contrasting these two additional alternatives: in the first case the beneficiary of the small business rollover relief concessions genuinely gives up value, (as apposed to a circumstance where the ultimate recipient maintains an interest in that value). This assumes the donation is truly charitable in that there is no circular arrangement or side-deal with associates etc. In these circumstances it would be relatively difficult to conclude that the dominant purpose of the charitable gift was to obtain a tax benefit in the form of the small business rollover.
Objectively, by contrast, there seemed to be little commercial rationale behind the later arrangement other then to obtain a tax benefit. When the eight factors in subsection 177D(2) are considered, it may be possible to conclude that the purchase of a house for Hermes was principally directed at the obtaining of a tax benefit. An important point of distinction is that there is no overall change in the financial position of Hermes’ interests under this scheme; merely a pre-sale value shift from the company to him.
Post-meeting note: the use of a private company’s funds to buy assets for the personal benefit of shareholders or their associates might in any case attract the specific anti-avoidance rules in Division 7A of Part III of the ITAA 1936.
End of example
Examples 4 – Contract change to ensure income not personal services income (PSI)
The effect of the arrangements described in examples 4.1 and 4.2 is to ensure that the income derived by the interposed entity will not be characterised as PSI under Division 84 of the ITAA 1997. The PSI rules will not apply where the interposed entity was conducting a personal services business under Division 86 and 87 of the ITAA 1997.
These examples raise the question of whether Part IVA can apply if the primary provisions within the law are satisfied, especially where those provisions are themselves directed, at least in part, at preventing certain avoidance arrangements. The ATO reiterated that Part IVA can in principle apply in these circumstances.
Applying the purpose test in section 177D to the two examples, there seems to be relatively little to support a finding that Part IVA would apply. Assuming that, on close examination of the facts, the contracts are genuinely a result based contract, such that their form and substance are congruent, that would point in favour of the taxpayer. Similarly, the changed arrangements appear in each case to have genuinely different commercial impacts on both parties to the contract compared with the pre-scheme position: see factors in paragraph 177D(2)(e) and (f). No particular feature of the new arrangements appears to lack a commercial explanation. Nor is there any particular complexity or contrivance, or any aspect of the timing, which might be explicable only by tax considerations.
Meeting participants pointed to two ATO rulings, IT 2121 and IT 2639, in relation to income splitting arrangements and the potential application of Part IVA. Whilst examples 4.1 and 4.2 do not reflect income splitting as described in IT 2121, the ruling is nonetheless illustrative of the matters the Commissioner would inquire into to establish the substance of the arrangements, such as whether there is any outward sign of change in the method by which income is derived. This is particularly pertinent in example 4.2 where there is a change in the arrangements post entering into the initial contract to shift the arrangement from a time based to results based contract.
End of example
Example 5 – Arrangements pursued to obtain the benefit of the R&D tax credit
Absent Part IVA, the arrangement described in this example benefits from the R&D credit in Division 355 of the ITAA 1997. The ATO noted that notwithstanding that the entity might not have entered into the arrangement but for the credit, this was nonetheless in line with the intended operation of the R&D credit. That is, the object of the credit, as stated in section 355-5, is to encourage industry to conduct research and development activities that might otherwise not be conducted because of an uncertain return from the activities. Based on those facts, having regard to the eight factors in section 177D, it seemed unlikely that a conclusion of a dominant tax avoidance purpose could be reached.
In particular, nothing about the manner in which the scheme was carried out, the substance and form of it, or the timing seems to indicate a tax avoidance purpose. Provided that the research and development efforts and the commercial aspects of the arrangement were genuine, and in the absence of any contrivance or commercially inexplicable features such as a side-agreement reversing the cash flows or some such, the entity seems to be doing no more than engaging in conduct that the Act specifically contemplates and encourages. The mere fact that it is only the availability of the credit that might make the activity commercially viable does not, by itself, trigger Part IVA.
End of example
Example 6 – Pre-disposal dividend from realised profits
It was noted that examples 6.1 to 6.6 share similarities with the facts of RCI Pty Limited v Commissioner of Taxation.2
On the question of tax benefit, the argument successfully put by the taxpayer in RCI was that there was no tax benefit under Part IVA (as the Part stood before the recent amendments), in that it would not be reasonable to expect that the taxpayer’s group would have proceeded with the wider restructure of its affairs if in doing so it would have incurred such a large capital gains tax liability as to eliminate any commercial benefit from the restructure.
Following the amendments, that particular argument is unlikely to be available to taxpayers in similar cases: paragraph 177CB(4)(b).
On the question of purpose, the ATO said it would re-examine its submissions in RCI to determine the basis on which the Commissioner’s case had been put. On reflection however, the ATO thought that a better way to appreciate the competing arguments is to compare the reasoning of Stone J at first instance on the purpose question3 with the reasoning of the Full Federal Court on appeal.4
In any event, the Commissioner recognises that the Full Federal Court in that case did not consider there to be a dominant purpose of obtaining a tax benefit on the facts of the case. In the unlikely event that a case with facts that are materially indistinguishable from those of RCI were to arise, presumably the result would be the same. All other cases would need to be judged on their own merits.
The examples presented both internal reorganisations and external sales. The ATO did not see the distinction between an internal reorganisation and an external sale as particularly decisive in this context. That a dividend was paid from unrealised profits is similarly not decisive of the issue. All of the facts need to be taken into account and weighed in terms of the eight factors in subsection 177D(2).
End of example
Example 7 – Acquisition via a consolidated group to ensure no L5 gain
Absent the application of Part IVA, the arrangements in example 7 illustrate how companies might prevent the application of CGT Event L5 when an acquirer purchases an existing tax consolidated group. Event L5 applies where a subsidiary ceases to be a member of a consolidated group and the leaving allocable cost calculation under section 711-20 of the ITAA 1997 produces a negative result at step 4 of the calculation. Where a single entity acquires an existing tax consolidated group, that acquisition triggers a deconsolidation of the existing consolidated group5, which in turn may trigger Event L5. On the other hand, as a result of subdivision 705-C where a consolidated group is acquired by another consolidated group, the acquired group is not taken to have been broken up, and Event L5 would be taken not to have occurred. In other words, the law applies differently depending on whether a single entity or a tax consolidated group acquires another tax consolidated group. Participants noted that this issue has been the subject of ongoing discussions at the NTLG and with Treasury for some time.
In the examples presented, the particular entity was inserted into the corporate group for the purpose of ensuring that the target tax consolidated group could be acquired by an existing tax consolidated group, with Event L5 being avoided.
Two key points were raised during this discussion. Firstly, in general if the interposition of new entities into a structure lacks a commercial rationale, questions under Part IVA will tend to arise. There needs to be substance behind the rationale for the vehicle, as opposed to a superficial shroud used merely to suggest that the vehicle has substance. For example, a shell company that simply purchases a few paper clips might not sufficiently demonstrate a commercial purpose. Similarly, a shell company set up for a potential future divestment is unlikely to substantiate a commercial purpose, depending perhaps on how remote and uncertain such a prospect is.
Secondly, participants queried whether, assuming the entity was simply inserted to overcome the operation of Event L5, is there any scope in the administration of the law for the Commissioner to overlook such a structure, especially having regard to the permissive words in section 177F. The ATO noted that where the Commissioner is presented with an area in the law that might be said to operate inappropriately, that does not in and of itself, absolve the Commissioner from applying the law as the law stands. There is no over-arching or final discretion to be exercised independently under section 177F: Cumins v. Federal Commissioner of Taxation.6
End of example
Example 8 – Double transfer through partnership to ensure no gain on sale of stock
Example 8 involves the interposition of a partnership to allow a transfer of trading stock between companies, while avoiding assessable income arising from the transfer. Participants referred to previous Interpretative Decision ATO ID 2003/203 and Taxation Determination TD 96/3 to support the view that Part IVA would not apply in the circumstances outlined in this example.
Pursuant to section 70-100 of the ITAA 1997, an election can be made to treat trading stock as having been disposed of for effectively its cost, with the transferee deemed to purchase the trading stock for the same value. In other words, these provisions allow the transfer of trading stock from one entity to another entity via a partnership without any assessable income arising from the transfer.
On examination of the TD and ATO ID following the workshop it appears that the TD is silent on the application of Part IVA to this arrangement. However, the ATO ID concludes that,
The interposition of the partnership to enable the election to be made will not prevent the operation of the exclusion in paragraph 177C(2)(a) of the ITAA 1936. As there is no tax benefit, Part IVA of the ITAA 1936 will not apply.
The legal basis for the conclusion reached in the ATO ID is not readily apparent.
End of example
Example 9 – Ensuring a grant to purchase equipment is not assessable upfront
Example 9 involves the provision of a grant by a state government to a private sector entity to construct an environmental project. By assumption, the final form of the arrangement ensures that the financial support afforded by the state government is not assessable income. The funding may take the form of a loan for example.
Consistent with other examples, the mere fact that the design of the arrangement was changed fairly late in the process to avoid an adverse tax result would not of itself normally be a scheme that attracts Part IVA. Beyond making that point, it was felt that insufficient facts were provided to undertake even an indicative analysis for the purposes of subsection 177D(2). For example, one would need to understand the exact terms of the scheme as they bear on such matters as the manner in which the scheme was implemented, whether its form and substance were congruent and the timing.
End of example
Example 10 – Negative gearing
Example 10 and its two variants present various negative gearing scenarios, firstly involving the taxpayer choosing in effect to pay off a non-deductible home loan by depositing available funds in a loan offset account, while making interest-only payments on a deductible investment loan; secondly a prepayment of interest on an investment loan; and finally, the use of a line of credit to facilitate the prepayment of an investment loan (allowing other available funds to pay down the home loan).
It was noted that the ATO has previously issued Taxation Ruling TR 93/6 and Taxation Determination TD 2012/1 on the operation of Part IVA in the context of loan account offset arrangements. The ATO will review these and the other relevant ATO views in the context of the amendments. That said, we would not expect a different result to ensue under the amended law.
TR 93/6 was considered further after the workshop. The ruling concludes that loan account offset arrangements that align with the description in paragraphs 3 to 7 of the ruling will not be seen to have the dominant purpose of obtaining a tax benefit. The basis for the calculation of interest under the arrangements described in example 10 is unclear, so it is difficult to categorically rule out the operation of Part IVA to example 10, on the basis of TR 93/6. The ATO also noted the presence of a number of other ATO views in relation to loan structuring including: Taxation Ruling TR 98/22 and its addendums, Taxation Determination TD 1999/42, Taxation Ruling TR 2000/2, Taxation Determination TD 2005/33, and Interpretative Decision ATO ID 2006/297. As noted, the ATO will review these products in the context of the amendments.
Moving on from the question of the loan offset account, the ATO noted that simply choosing to pay off one loan before, or more quickly than, another loan because of tax considerations would not normally be a Part IVA scheme, unless there were features that took the case closer to the facts in Federal Commissioner of Taxation v. Hart7, for example, if the loans were linked together in the manner found in that case and additional interest is being incurred on the investment account. The ATO view on Part IVA and certain linked or split loan facilities is contained in Taxation Ruling TR 98/22.
In relation to the first variation of example 10, where there has been a pre-payment on the loan, it would be expected that the pre-payment would attract a lower interest rate, such that a clear commercial benefit is obtained in pre-paying the interest. Absent this discount it could potentially be concluded that the dominant purpose of the scheme was to bring forward deductions, thereby giving rise to a tax benefit. Normally, absent some cogent commercial reason to do otherwise, a bank receiving a pre-payment against an outstanding loan balance might be expected to apply the payment in reduction of currently outstanding principal rather than as an advance against a future liability to pay interest on that principal.
Regarding the second variation to example 10, the circumstances of this example are similar to those described in TD 2012/1 which discusses the application of the former Part IVA to an investment loan interest payment arrangement that involves a line of credit.
End of example
4. Restructures post repeal of section 25-90
Questions arose in relation to the restructure of funding arrangements of corporate groups in anticipation of the repeal of section 25-90. The ATO noted that as there is a separate consultation process in relation to these changes, those discussions would be better had as part of that process.
5. Closing Remarks
Participants were thanked for their contribution to the day’s discussions. Participants agreed that they would report back to their members that they had an open conversation with the ATO.
The ATO undertook to reflect on the discussions to determine the most appropriate way forward. The ATO also undertook to continue to review existing ATO views that discuss Part IVA.
Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013.