ATO Round Table
Summary of the discussion held at The Tax Institute's National Convention, March 2017.
The ATO Round Table was a question and answer session. The ATO was represented by Andrew Mills, Second Commissioner, Law Design and Practice, and Kirsten Fish, Chief Tax Counsel. The Round Table also included Gordon Cooper, Cooper & Co, and Peter Godber, Grant Thornton.
TOPIC 1: Family partnerships that derive personal services income
The issue: The taxation treatment of family partnerships (also known as husband and wife partnerships) that derive personal services income where, typically, only one partner provides the personal services that generates the income.
In brief: Where a family partnership is subject to the personal services income (PSI) rules, the income is attributed to the partner that generates the personal services income. Where a family partnership is not subject to the PSI rules, the Commissioner will generally respect the profit/loss split determined by the parties, including a 50/50 split provided the partnership is a genuine common law partnership.
What is personal services income (PSI)?
PSI is income that is mainly a reward for an individuals personal efforts or skills. It is distinct from income generated by the use of assets or property, the sale of goods or the business structure of an entity.
How do the PSI rules apply in taxing personal services income?
If the PSI rules apply in a partnership situation, the rules attribute the personal services income wholly to the partner providing the personal services. The partner can deduct certain amounts, but not amounts paid to the spouse as a partner even if the spouse contributes administrative support to the partnership.
How is the partnership taxed if the PSI rules dont apply?
If the PSI rules dont apply, including where the income is derived through a personal services business (PSB), the tax treatment of the income depends on whether the partnership is a genuine common law partnership.
If it is a genuine partnership, the net income of the partnership is taxed in accordance with the partnership rules under Division 5 of the Income Tax Assessment Act 1936 (ITAA 1936).
If the partnership is not genuine, then the income is the income of the individual who derived it.
In what circumstances does a genuine common law partnership exist?
TR 94/8 Income tax: whether business is carried on in partnership (including 'husband and wife' partnerships sets out factors we take into account when determining whether a partnership is in fact being carried on. This ruling applies to husband and wife partnerships.
Under partnership law, two or more parties must carry on a business in common, with a view to profit. Mutual intention to act as partners is essential and must be demonstrated through their conduct. Factors we look at include:
- the extent to which the parties are involved in the conduct of the business
- joint ownership of business assets
- exposure of the personal property of both parties to partnership debt
- extent of capital contributions
- administrative arrangements, such as a separate partnership bank account to which both partners have access, and invoices issued in the name of both partners.
This list is not exhaustive, and no single factor is decisive. It is possible for a partnership to exist even if one party does the bulk of, or even all of the work, depending on the circumstances.
How does Part IVA apply in family partnership arrangements?
If the partnership is caught by the PSI rules, then Part IVA of the ITAA 1936 would not apply.
If a partnership does not exist at common law, Part IVA is not required to dismantle the arrangement, as the income is taxed in the hands of the individual who derived it under ordinary principles.
If a genuine partnership exists with both spouses genuinely exposed to loss and risk, and the PSI rules dont apply, the ATO respects the profit and loss split determined by the partners. The ATO does this even if this is a 50/50 split but one spouse is the main or exclusive generator of the income and Part IVA generally does not apply to disturb this treatment.
Our guidance document (Part IVA: the general anti-avoidance rule for income tax) states that Part IVA would only apply in a family partnership arrangement if there were unusual features: for example, if there was a regulatory prohibition to that business being carried on in a partnership. The document is not a safe harbour, and does not prevent Part IVA from applying to a family partnership arrangement, but the occasions where it is applied will be rare.
Part IVA can also apply to other entities such as companies, trusts and professional partnerships that are PSBs or otherwise earn non-PSI income where factors clearly indicate that the dominant purpose of the arrangement is income splitting or diversion of income.
TOPIC 2: Meeting the $1.6m transfer balance cap
The issue: With the introduction of the $1.6 million transfer balance cap on 1 July 2017, individuals can take steps to bring within the cap the amount they have in the retirement phase by:
- commuting amounts in their accounts that are paying a pension and take it out of superannuation entirely
- transferring the excess above the $1.6 million transfer balance cap to an accumulation account.
Can a trustee of a self-managed super fund (SMSF) make a resolution by 30 June 2017 that the balance of the pension account will not exceed the $1.6 million transfer balance cap?
The ATO accepts that a trustee can make such a resolution where an individual has an interest in a single SMSF. It may not be possible to do so if an individual has interests in multiple SMSFs.
Similarly, where an individual has an interest in a single SMSF, a resolution can be made by a trustee following a members instruction to transfer amounts from their accumulation to pension account, if their pension account balance is under $1.6 million. The concessions are intended to ensure that individuals have a maximum of $1.6 million in their transfer balance account in the 2017-18 financial year.
Advisors should be talking to their clients about implementing these resolutions prior to 30 June 2017.
The ATO has issued guidance on the content of these resolutions in the context of the transition to the new measures in particular, resolutions undertaken in order to satisfy meeting the $1.6 million transfer balance cap.
What date is used to determine the value of the asset being transferred from the retirement account if the transitional rules are being used?
The relevant valuation date is 30 June 2017.
The transitional $100,000 provides a buffer where a mistake has been made. It allows six months for an individual to reduce their pension balance in order to satisfy the $1.6 million transfer balance cap.
Do balances need to be reduced by 30 June 2017 or 1 July 2017 in order to meet the $1.6 million transfer balance cap?
Practically, balances should be under $1.6 million by 30 June 2017 to ensure the transfer balance cap is not exceeded on 1 July 2017.
The transitional $100,000 provides a buffer where a mistake has been made. It allows six months for an individual to reduce their pension balance in order to satisfy the $1.6 million transfer balance cap.
Resolutions should be made, and take effect by, 30 June 2017.
TOPIC 3: Planning associated with the superannuation tax reforms
The issue: If a husband has $2.1million in his retirement account and his wife has $1 million in her accumulation account, is it possible for the husband to reduce his pension account by $500,000 and give it to his wife to contribute to superannuation?
This is possible provided the wife has the ability to make non-concessional contributions and it is done by 30 June 2017.
Prior to 30 June 2017, the maximum for non-concessional contributions is $540,000, provided the bring-forward non-concessional cap has not been triggered in the previous two years. On 1 July 2017, provided the bring-forward has not been triggered in the three financial years before 1 July 2017, the maximum non-concessional contributions that can be made reduces to $300,000.
If the bring-forward cap is triggered in either the 2015-16 or the 2016-17 financial year, but the non-concessional contributions totalling $540,000 has not been made, in the 2017-18 financial year, the non-concessional cap will reduce to either $460,000 or $380,000.
Information is available on the ATO's website in regards to this.
Is it possible to borrow in order to make a non-concessional contribution?
It is possible to borrow to make a non-concessional contribution, provided the borrowing is not from the superannuation fund and it is the right financial decision for an individual.
The interest on loans to make a contribution to superannuation is not deductible (section 26-80 of the Income Tax Assessment Act 1997 (ITAA 1997)).
TOPIC 4: Corporate residency
The issue: The principles of central management and control and corporate residency following the High Court decision in Bywater Investments Ltd v Federal Commissioner of Taxation  HCA 45; 2016 ATC 20-589 (Bywater).
In this case, the High Court considered the central management and control (CM&C) test of corporate residency in subsection 6(1) of the ITAA 1936. In Bywater, the companies were incorporated overseas and had overseas directors. The companies created board minutes to give the impression that their directors were the decision makers. This contrasted with their real role which was to rubberstamp decisions made in Australia by their ultimate owner. The directors, in fact, had no knowledge of the companies businesses to be able to recognise whether decisions they purported to make were unlawful or improper. The court found that CM&C was exercised by the ultimate owner who was the real decision maker.
The Bywater decision confirms three principles about the CM&C test of residency, outlined below.
- Where CM&C is located is a question of fact, and you must consider the reality of what happens in practice, rather than the legal requirements of what should happen or the legal form of what has happened.
- CM&C of a company is about where a companys operations are controlled and directed, and is exercised by those who make a companys decisions as a matter of fact. Esquire Nominees Ltd v Federal Commissioner of Taxation (1972) 129 CLR 177;  HCA 67 is not authority for the proposition that a foreign incorporated company has its CM&C outside Australia and is non-resident if it has a local board, even if it merely rubberstamps and implements decisions made in Australia. The rubberstamping of decisions is not decision making for the purpose of the CM&C test of residency.
- The decision inMalayan Shipping Co Ltd v Federal Commissioner of Taxation (1946) 71 CLR 156;  HCA 7 (Malayan Shipping) means that a company that carries on business operations outside Australia will be considered to carry on business in Australia if it has its CM&C located in Australia.
Withdrawal of TR 2004/15 and new TR 2017/D2
As former TR 2004/15 Income tax: residence of companies not incorporated in Australia - carrying on business in Australia and central management and control took a view contrary to the decision in Malayan Shipping, it could not remain unchanged. Rather than updating the existing ruling, we withdrew TR 2004/15 and issued new TR 2017/D2 Income tax: Foreign Incorporated Companies: Central Management and Control test of residency on 15 March 2017. The new ruling provides public advice and guidance in a new way, setting out principles relevant to the CM&C test in a very direct and simple way.
How do local directors show they exercise CM&C when there are recommendations or directions coming from an Australian parent?
There must be evidence to show that foreign directors of a company exercise its CM&C. This must show that the foreign directors actually make the high-level decisions about the control and direction of the company, rather than merely rubberstamping decisions made by others. In this regard, the decision in Bywater has caused some concern for Australian groups with foreign incorporated subsidiaries. This outcome in the case needs to be considered in light of the extreme and artificial nature of the arrangements considered in Bywater. The Bywater decision is not expected to affect most taxpayers. It deals with artificial arrangements designed to disguise where CM&C is located.
To establish that directors have actually made decisions, it must be shown that they have actively considered and decided matters based on the best interests of the company. This may be established even if the directors receive recommendations and directions from their parent company. Mere rubberstamping of decisions made by others is not sufficient.
The minutes of board meetings are evidence of decision making. However, if, as was the case in Bywater, they are false and do not reflect what the evidence shows happened in reality, they are disregarded.
If minutes recording decisions to be made are sent to the local board with a direction or recommendation that they be signed, and they are, it may be difficult to establish that the local directors are doing anything more than rubberstamping decisions made by others. This can be contrasted to a situation where the local board prepares its own minutes, recording its meetings and their decision-making process to consider recommendations or directions from their parent company.
The discharge of the obligations and duties imposed on directors by company law are relevant to distinguish whether directors are engaged in decision making or are merely rubberstamping decisions made by a parent. Directors of a company need to know and understand its business if they are to exercise its CM&C. If a director is not in position to evaluate whether recommendations or directions coming from a parent company are unlawful or improper, it will weigh strongly against any conclusion that they are exercising CM&C of the company. Conversely, if the directors could show they were concerned with whether recommendations or directions were proper, and sought independent advice about whether implementing them would breach a foreign law before they made a decision to do so, this would clearly demonstrate the exercise of CM&C.
Do the principles in TR 2017/D2 apply for treaty tie-breaker purposes?
No, they are relevant only to the test of residency in subsection 6(1) of the ITAA 1936. Treaties use a variety of tests as tie-breakers to determine taxing rights. The OECD Model Treaty and many of Australias treaties use place of effective management (POEM) as a tie-breaker. There is little jurisprudence on the meaning of POEM, and its precise meaning is not clear. While it has similarities with CM&C, it is not the same. One particular point of difference is that you can only have one POEM as a matter of necessary implication, whereas the courts have recognised that CM&C may be split between two places.
TOPIC 5: Private groups demergers section 45B of the ITAA 1936
The issue: Private groups and their advisors express ongoing concern that there is a difference in the treatment of public groups and private groups in tax law administration on access to demerger relief. They argue that:
- section 45B of the ITAA 1936 is applied unfavourably to private group demergers
- applying the relatively low threshold for the tax benefit test within section 45B (that is, it cant be more than an incidental purpose) is always of a concern for private groups where there is a potential sale of shares in the demerged entity
- there is a reluctance by the ATO to issue private rulings for private groups.
Given this, should private groups apply for private rulings seeking demerger relief?
In brief: The criteria for judging demerger arrangements are exactly the same for private and public groups. Private groups can approach the ATO to discuss their proposals and see if demerger relief is available. The ATO encourages discussion on the issue of safe harbours in the context of private group demergers.
The panel noted that the purpose of the demerger relief provisions is to encourage the economic growth of companies and ensure that tax was not a barrier to that growth. The provisions were originally designed so that relief applied only to listed entities, but this was broadened as the law was developed, before it went to parliament. One concern was that it could be seen as a vehicle for changing economic interests, so there are criteria for judging the genuineness of the restructure.
The view that section 45B of the ITAA 1936 does not apply if all criteria in Division 125 of the ITAA 1997 are satisfied was dispelled. Section 45B should be considered after Division 125 is satisfied.
The criteria for judging the genuineness of the restructure is exactly the same for private and public groups. However, where people are trying to progress a transaction with a view to intergenerational transfer of wealth, or to access the wealth of the company in a tax free way, the ATO may conclude that 45B applies. The panel made specific observations relevant to each group.
- The division between shareholders and management is generally more clearly shown when contrasted with private groups and other considerations are at play. This allows the ATO to more easily determine the applicability of demerger relief. This doesnt mean that that the ATO does not give negative rulings where section 45B applies in the circumstances. The panel noted that the ATO has issued 2 class rulings concerning public group arrangements that were ineligible for demerger relief.
- Public companies usually request advice under early engagement for their proposed demergers, allowing applicants to approach the ATO to initiate conversations about the transaction. Through those conversations the ATO has seen examples of transactions that are not about economic growth which is what the legislation is designed to support. Rather, the transactions are about moving wealth into the hands of shareholders.
- Another possible concern when looking at the purpose of the restructure is the presence of a significant shareholder. Traditionally, this is the original family that started the business and floated it subsequently.
- The ATO has seen some private group demergers that have not raised section 45B concerns, but the ATO has also denied relief in some cases (as is evident from the Register of private binding rulings).
- Private groups traditionally did not have access to early engagement advice. The ATO now offers early engagement services across sectors. If a private group seeks assurance on their proposed demerger arrangement, they can approach the ATO under the early engagement process.
- A key issue that seems to be holding private groups back from obtaining demerger relief is the temporal link between the demerger event and the inevitable succession events that happen for private groups. The closer the link in time, the more it is scrutinised by the ATO.
- It is suggested that demerger relief is more likely if there isnt a temporal connection with a succession event, and evidence shows that the demerger is for the purpose of growing separate core aspects of the business.
The ATO will further consider the issue of providing advice and guidance on safe harbours for private group demergers, and encourages discussions in this context.
TOPIC 6: Small business restructure roll-over Subdivision 328-G of the ITAA 1997
The issue: Broadly, the roll-over refers to the transfer of assets under a transaction which is, or is part of, a genuine restructure of an ongoing business, and the transaction does not have the effect of materially changing the ultimate economic ownership of the assets.
If a number of assets are transferred, can you make a choice for roll-over on an asset-by-asset basis?
Yes. The choice can be made on an asset-by-asset basis. Roll-over does not have to be chosen for all assets transferred.
How does the genuine restructure test interact with the ultimate economic ownership test, and how is this brought out in Examples 2 and 3 of LCG 2016/3?
LCG 2016/3 Small Business Restructure Roll-over: genuine restructure of an ongoing business and related matters is intended to assist taxpayers determine whether a transaction is, or is a part of, a genuine restructure. In Examples 2 and 3 of LCG 2016/3, various transactions occur over a period of time involving changes in both business structure and ownership.
Both examples highlight that conduct after the transfer of assets may be taken into account when determining whether a restructure was a genuine restructure of an ongoing business. They raise the question of when a restructure begins and ends.
The premise in Example 3 is that Steves capital contribution occurs after the restructure from partnership to company. Provided Steves capital contribution does not occur as a part of the restructure, and is an additional equity contribution to an ongoing business (and does not facilitate a partial divestment of its ownership by the existing individuals Melvin and Jenny), the arrangements can qualify as a genuine restructure.
The exact interaction between the genuine restructure test and the ultimate economic ownership test is not clear. Our preliminary thinking is that there is a distinction in section 328-430 of the ITAA 1997 between the transfer, the transaction, and the genuine restructure. The transfer of an asset is the narrowest of these concepts. The genuine restructure is the broadest. Transactions under which assets are transferred may form part of a genuine restructure.
The ultimate economic ownership test applies at the level of the transaction. So, for the purposes of this test, we are considering whether the transaction that is a part of the genuine restructure has the effect of changing the ultimate economic ownership of the assets.
Where, as in the example, Steves capital contribution is not a part of the restructure, it will also not be considered a part of the transaction which transfers the assets from the partnership to the company. As a consequence, while Steves investment may have a subsequent impact on the ultimate economic ownership of the business assets, that change in economic ownership does not occur as a result of the restructure transaction, and should not prevent the rollover conditions from being satisfied.
The outcome may be different if the genuine restructure is considered to include the investment by Steve in the capital of the company. If so, it would be relevant to consider whether the investment was part of the transaction under which the assets were transferred.
Example 2 raises similar issues, including whether the employee share issue is part of the genuine restructure, and if so, whether it is part of the same transaction under which the assets transfer occurred.
If a discretionary trust wants to transfer assets to another discretionary trust, do they have to comply with section 320-440 of the ITAA 1997 (about making a family trust election) to satisfy the ultimate economic ownership test, or can principles from IT 2340 be applied?
The ultimate economic ownership test is new to the law. A purely discretionary trust could not, on our current thinking, satisfy the ultimate economic ownership test without relying on the special rule in section 320-440 of the ITAA 1997. This is because the economic interests that the objects of such a trust have in an asset are not fixed in proportion, and would depend on the trustee exercising their discretion.
In the case of a transfer between two purely discretionary trusts, and even if each had the same objects, our preliminary but considered view is that each would need to make a family trust election nominating the same test individual. Note that the special rule only helps where the trust is the transferor and/or transferee.
Do entities that are not members of the family group have to be excluded as potential trust beneficiaries (even though distributions to them would attract family trust distribution tax)?
Our preliminary thinking is that individuals not within the family group, and entities with underlying individuals who are not within the family group, would have to be removed as potential beneficiaries. Because the legislation refers to interests of individuals, we do not think charities or interposed entities that are part of the family group or wholly owned by the family group need be removed.
What happens if a transferred asset ceases to be an active asset within 3 years?
If the initial transaction was in fact a genuine restructure of an ongoing business, the rollover remains available. There is no J event because the asset ceases to be active, unlike the way the small business CGT roll-over works.
If the initial restructure did not qualify as a genuine restructure of an ongoing business, then the conditions for rollover will not have been satisfied. This means that the transferors assessment for the transfer year may need to be amended.
TOPIC 7: Division 7A - Unpaid present entitlements (UPEs) under sub-trust arrangements
The issue: PS LA 2010/4 Division 7A: trust entitlements sets out options for trustees to place a UPE in a sub-trust arrangement and include investing the funds into the head trust as 7- or 10-year interest-only loans. The 7-year loans will soon mature and require repayment. There is concern around what happens where the trustee has not taken any action to reduce the loan amount, and is considering how to address repayment at the end of the 7-year period. If the loan is not repaid, the questions arising include:
- what is the ATO going to do?
- will the non-repayment give rise to the provision of financial accommodation, and therefore a Division 7A (of Part III of the ITAA 1936) loan?
The practice statement was released at the same time as TR 2010/3 Income tax: Division 7A loans: trust entitlements, which deals with unpaid present entitlements. In particular, where the trustee confers an entitlement to the income of the trust to a private company beneficiary, but retains the funds for use within the trust, it is considered the provision of financial accommodation by the private company and, therefore, a Division 7A loan. The practice statement sets out the circumstances where the ATO accepts that the UPE is held solely for the benefit of the private company beneficiary and will therefore not be considered as the provision of financial accommodation.
The practice statement also makes it clear that the trustee must repay the loan at the end of the investment period. If the loan is not repaid, it will be considered the provision of financial accommodation at that time and therefore a Division 7A loan.
Where there is no intention of repaying the loan, considerations of sham, fraud or evasion will be brought in.
We have commenced consultation to understand practical issues and address concerns we have been hearing. The ATO view of the law has not changed, and our consultation has confirmed our view of the law. For loans that are maturing and are required to be repaid in the 2017 or 2018 income years, we will allow the trustee to enter into complying loans for a further seven years. We are continuing to consult on the approach for loans maturing in these income years and the approach for loans maturing in subsequent income years.
There is a question of fairness between trustees that have repaid the loans on or prior to the seven years expiring, and those that have not (but now have a further seven years under a complying loan). To address this, we indicated that the trustee had a number of options available to them when the UPE first arose. This included entering into complying loans and availing themselves of the investment options under PS LA 2010/4. Some may have looked to enter into complying loans to avoid exposure to Subdivision EA of Division 7A. The consultation on our approach aims to bring these arrangements back to parity. This will include reviewing the availability of the investment options set out in the PS LA into the future. We are looking first at loans that are maturing and are required to be repaid in the 2017 or 2018 income years, then those maturing in subsequent income years. Any changes we make to the PS LA for those subsequent income years will align with the proposed commencement of the targeted amendments to Division 7A announced in the 2016 Budget, being 1 July 2018. The ATO intends to issue a Practical Compliance Guideline outlining the Division 7A consequences for loans maturing in the 2017 and 2018 income years prior to 30 June 2017.