Part IVA: the empire strikes back!
Tax Telegraph, December 2012
Recent times have seen the Commissioner of Taxation lose some battles in the Full Federal and High Courts whilst fighting the Part IVA war.
Taxpayers may have won some small battles… but the war is not yet over!
The Treasury has struck back with the introduction of the exposure draft legislation to amend Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) taking into account the Commissioner’s arguments in recent court decisions.
The amendments will apply to arrangements entered into on or after16 November 2012.
The release of the exposure draft follows the Treasury’s announcement on 1 March 2012 that amendments would be made to the ITAA 1936 so that Part IVA “continues to be effective in countering tax avoidance schemes that are carried out as part of broader commercial transactions”.
Before we get into the features of the amendments, let’s take a brief look at how the Commissioner applies Part IVA.
Part IVA: the basics
Broadly speaking, Part IVA applies where a taxpayer obtains a tax benefit in connection with a scheme and it can be concluded (having regard to a number of factors) that a person who entered into or carried out the scheme or any part of it did so for sole or dominant purpose of obtaining a tax benefit in connection with that scheme.
Generally speaking, this tax benefit was determined by reference to what “would or might reasonably be expected to have happened” if the scheme had not been entered into or carried out. This basically requires a “comparison between the scheme in question and an alternative postulate” (per Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at ). This comparison between the tax consequences arising out of a scheme and the tax consequences arising out of the alternative postulate achieves the following purposes:
- It provides a basis for identifying (and quantifying) any tax advantages (of the relevant kind) that may have been obtained from the scheme; and
- A consideration of alternative postulates may provide a basis upon which a conclusion about the purposes of the participants in the scheme can be drawn — a consideration of whether there were other ways that the participants in the scheme could have achieved their non-tax purposes facilitates a weighing of those purposes against any tax purposes that can be identified.
Features of the amendments
The crux of the amendments are the definition of the term “tax benefit” in section 177C and the way this interacts with other provisions of Part IVA (in particular, the “schemes” to which Part IVA applies).
Historically, the words “would… or might reasonably be expected” in the definition of “tax benefit” have been interpreted as a complete phrase, i.e. one test. However, the explanatory memorandum accompanying the new laws (EM) states that the words "would... or might reasonably be expected" in the definition of "tax benefit" allow two separate “limbs” of working out whether a tax benefit has been obtained. That is:
- The word “would” creates a test which looks at whether the alleged tax benefit would have been obtained if all events had taken place except those forming part of the scheme
- The words "might reasonably be expected" is a test (and one which is currently followed by Courts) which requires the existence of a tax benefit to be determined by reference to the identification of an alternative or hypothetical “postulate” and what would have been expected to result if the scheme had not occurred.
Although the wordings of the actual provision remain the same, this interpretation of the test by dividing it into two separate limbs is a new approach adopted in the EM. This new interpretation will not only increase the Commissioner’s ability to apply Part IVA, but is likely to create significant confusion going forward.
Insertion of “assumptions”
The amendments propose to insert a new section (177CB) into Part IVA which essentially requires that the alternate postulate to be made subject to certain assumptions.
Assumption 1 – assume that tax costs would be disregarded
The first assumption requires that no potential tax liabilities are taken into account in assessing the likelihood or reasonableness of any alternative postulate (section 177CB(1)(a)).
According to the EM, the amendment shows that alternative postulates should not be rejected as unreasonable on the grounds that the tax costs involved in undertaking those postulates would have caused the parties to either abandon or indefinitely defer the schemes and/or the wider transactions of which they were a part. This assumption directly counteracts the decisions in RCI Pty Ltd v Federal Commissioner of Taxation  FCAFC 104 and Commissioner of Taxation v Futuris Corporation Limited  FCAFC 32.
This assumption will have direct impact on internal group restructures. For example, let’s consider the RCI case and apply the new law to its facts.
RCI, was a member of an international group of companies. It owned shares in a US subsidiary, which it sold to a foreign resident member of the group. Prior to the sale however, the US subsidiary re-valued its assets and paid a dividend to RCI, which reduced the value of the shares and therefore also reduced the capital gain made by RCI upon the sale of the shares. The dividend was held to be non-assessable non-exempt income of RCI under section 23AJ of the ITAA 1936.
The Commissioner argued in the Full Federal Court that this dividend was paid by the US subsidiary to reduce the market value of its shares. He applied an alternative postulate under which the shares were sold without the prior payment of the dividend. Under the alternative postulate, the taxpayer would have had an additional tax cost of approximately $172 million.
The Full Federal Court rejected the Commissioner arguments on the basis that it was reasonably expected that the parties in question would have abandoned, deferred or altered the sale of shares to avoid the tax cost of $172 million. Therefore it was found that there was no tax benefit and thus no application of Part IVA.
Under the new law, the Courts would have to assume that RCI would have acted without regard to its potential liability to tax. That is, the expected tax cost of $172 million would not have been a consideration in determining what RCI would otherwise have done.
This is seems to be a strange assumption to apply given that taxpayers commonly structure their affairs after considering any tax liabilities.
Generally, taxpayers can achieve commercial results for their business with reduced tax liabilities whilst adhering to the law.
The introduction of this assumption seems unfair on taxpayers who make commercial decisions which comply with the law. Furthermore, the fact that the taxpayers change their steps to minimise their tax liability should not, logically speaking, trigger Part IVA! For example, if a taxpayer applies a series of rollovers to achieve a restructure would this present an issue under the new law?
Assumption 2 - to be made where the scheme achieves one or more non-tax effects
This assumption applies where a scheme achieves (or would achieve) one or more non-tax effects for the taxpayer. This basically means that if the scheme has any non-tax consequences, the alternative postulate must achieve those same consequences.
What this provision is designed to ensure is that the comparison between tax consequences of the scheme and the tax consequences of the alternate postulate involves a comparison between the scheme and a postulate that is a “true alternative” for the scheme.
This assumption counteracts decisions such as Commissioner of Taxation v Axa Asia Pacific Holdings Ltd  FCAFC 134 and Futuris.
In Futuris, the taxpayer entered into a scheme that essentially involved the sale of assets by one of its subsidiaries (Bristile) to another of its subsidiaries (Walshville) and the subsequent public float of Walshville. The sale of the assets took place for less than market value with the result that the value shifting provisions in former Division 19A of Part IIIA of ITAA 1936 applied to increase the cost base of the taxpayer’s shares in Walshville by around $82m, thereby reducing the capital gain made by the taxpayer on the sale of its shares in Walshville (under the public float) by the same amount.
The taxpayer outlined alternatives as to what it might reasonably be expected to have done if it had not entered into or carried out the scheme. Under the two alternative counterfactuals set out by the taxpayer, capital gains on the sale of the assets would still have been realised by other members of the group, not the taxpayer. In this case, it was held by the Full Federal Court that there was no tax benefit and therefore Part IVA did not apply
Pursuant to the new law you cannot argue that there was no tax benefit because any gain made would have been made by a different taxpayer.
Interestingly, this outcome is basically the outcome which would have been reached had the Commissioner’s argument been successful in the Full Federal Court.
Assumption 3 – to be made where the scheme did not achieve any non-tax effects
The third assumption is that if the scheme does not have any non-tax consequences, it should be assumed that all events or circumstances that actually happened or existed but which did not form part of the scheme would still have happened or existed.
What this means is that the taxpayers must compare the events which actually took place with those same events without the steps which make up the scheme. This provision is designed to ensure that the alternative postulate does not involve a reconstruction of the state of affairs that existed apart from the scheme.
The example provided in the EM to illustrate this assumption is of an individual who does not secure any non-tax effects from a scheme in which he obtains a large, up-front, tax deduction. Under this assumption, a hypothesis about what might have happened in the absence of the scheme cannot involve speculation about circumstances that did not exist, e.g. that the individual would have secured a tax deduction another way.
The introduction of a new Part IVA which addresses many of the arguments seen by the Commissioner in the courts in recent times is not surprising. The amendments have broadened the Commissioner’s reach and give the Tax Office greater power in applying Part IVA to transactions
The amendments have received some criticism and much scrutiny. Whilst still draft in nature, as the amendments will apply from 16 November 2012, no matter when they are finalised, we recommend that taxpayers review their commercial transactions (and in particular any restructures) and identify how the proposed amendments may impact them.
If you have any questions, please contact your local Deloitte Private tax advisor.
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