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Amendments to the general anti-avoidance rule

The Government introduced the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 into Parliament on 13 February 2013. The bill contains, amongst other things, amendments to the general anti-avoidance rule in Part IVA of the Income Tax Assessment Act 1936.

These amendments, which the Government expects to prevent losses to the revenue of over $1 billion per year, were originally foreshadowed in an announcement by the Assistant Treasurer on 1 March 2012, who stated that they would confirm that Part IVA was always intended to apply to commercial arrangements which have been implemented in a particular way to avoid tax. The announcement followed a number of recent court decisions that revealed what the government perceived to be weaknesses with Part IVA, and which reduced its effectiveness in countering tax avoidance arrangements.

The announcement was followed by the release of exposure draft legislation on 16 November 2012. The prevailing sentiment amongst tax advisers, and industry and professional bodies, was that the exposure draft legislation went beyond the policy intent evinced in the Assistant Treasurer’s announcement, and also contained various drafting deficiencies.

The Government has taken these concerns on board and the amendments contained in the bill differ in a number of respects to those contained in the exposure draft.

This alert summarises the proposed amendments and how they are expected to change the operation of Part IVA as it is currently drafted. The amendments, if passed, would apply to schemes entered into, or commenced to be carried out, from 16 November 2012.

The proposed amendments should further strengthen Part IVA. However, the amendments come at a time when there is arguably a sufficient body of case law on Part IVA as it is currently drafted to allow taxpayers to robustly interpret and apply the general anti-avoidance rules. These amendments are expected to reintroduce uncertainty as to how certain aspects of Part IVA apply, and differences in interpretation between the Australian Taxation Office (ATO) and taxpayers will no doubt lead to further litigation down the track.

Please also refer to our earlier alert for further information.

Overview of Part IVA

Part IVA applies where the following requirements are met:

1. There must be a scheme
2. A taxpayer must obtain a tax benefit in connection with that scheme
3. One or more of the persons who participated in the scheme (or part of the scheme) did so for the sole or dominant purpose, objectively ascertained, of enabling the taxpayer to obtain the tax benefit in connection with the scheme.

Examples of tax benefits include an amount not being included in assessable income, an amount not being subjected to withholding tax, a deduction being allowed, or a foreign income tax offset being allowed. The courts have found that, in order to determine whether a tax benefit has been obtained, it is necessary to compare the tax consequences of the scheme in question with the tax consequences that either would have arisen, or might reasonably be expected to have arisen, if the scheme had not been entered into or carried out (known as the alternative postulate).

Where the three requirements for Part IVA to apply are met, the Commissioner can cancel the tax benefit. For example, if the scheme resulted in a deduction for a taxpayer, the Commissioner could deny the deduction.

Summary of the amendments

The amendments are, for the most part, targeted at addressing weaknesses in the concept of tax benefit as highlighted by recent court decisions.

The bases for identifying tax benefits

As highlighted earlier, the determination of a tax benefit requires a comparison between the scheme itself and an alternative postulate. There are two limbs upon which the existence of a tax benefit can be demonstrated:

1. The first limb requires a comparison of the tax consequences of the scheme with the tax consequences that “would have” resulted if the scheme had not occurred (the annihilation approach). That is, the alternative postulate involves the deletion of the scheme
2. The second limb requires a comparison of the tax consequences of the scheme with the tax consequences that “might reasonably be expected to have” resulted if the scheme had not occurred (the reconstruction approach). The alternative postulate under this limb requires speculation about the state of affairs that would have existed if the scheme had not been entered into or carried out.

The Government’s difficulty is that recent case law has blurred the distinction between the two limbs of tax benefit. The proposed amendments seek to rectify this uncertainty by legislatively codifying the annihilation and reconstruction approaches, and making it clear that they are separate and distinct bases for determining the existence of a tax benefit.

There are no specific rules in the bill as to which approach should be applied in practice; rather, the explanatory memorandum (EM) accompanying the bill suggests that this will hinge on the non-tax consequences achieved under the scheme in question. That is, the annihilation approach would be expected to apply where there are no material non-tax results or consequences under the scheme. However, the reconstruction approach would be applied in cases where the mere deletion of the scheme would leave no coherent state of affairs for the tax law to apply to.

An example of where the reconstruction approach was applied is the decision in FCT v Hart [2004] HCA 26. In that case, the taxpayers took out a split loan which partly funded the acquisition of a principal place of residence, and partly refinanced a loan over an investment property. The loan agreement provided for the taxpayers, as borrowers, to direct the application of the whole of the periodical payments required under the loan agreement to the satisfaction of that part of the loan used for private or domestic purposes. Interest on the balance of the loan was allowed to accrue and be capitalised and compounded. This had the effect that the deductible interest on the loan was increased and the non-deductible interest on that part of the borrowing for the principal place of residence was minimised.

In identifying the alternative postulate, it would not make sense to annihilate the scheme as there would be no borrowing at all. Accordingly, the reconstruction approach would be applied. It would be reasonable to expect that, if the scheme had not been entered into, the taxpayers would have taken out two loans – one for the principal place of residence and one for the investment property.

Applying the reconstruction approach

When applying the reconstruction approach, the provisions make it clear that, in determining whether a postulate is a reasonable alternative, it is necessary to:

  • Have regard to the substance of the scheme
  • Have regard to any result or consequence for the taxpayer that is, or would be achieved by, the scheme (other than tax results)
  • Disregard any tax results that would be achieved by the postulate for any person (whether or not a party to the scheme).

The first matter requires that the substance of the alternative postulate and the scheme be the same. The EM gives the example of a company placing $1 million on deposit for 12 months with highly contingent returns that are treated as exempt for tax purposes. From the company’s perspective, the substance of the transaction is considered to be an investment for a fixed term carrying a right to a non-contingent return. The EM states that a reasonable alternative to this transaction would be an investment of the same amount, for the same period at a comparable risk and for a comparable return. An investment in ordinary shares would not represent a reasonable alternative postulate.

The second matter requires a consideration of any financial or other consequences for the taxpayer that would be achieved as a result of the scheme having been entered into. Such matters include changes in the taxpayer’s financial position resulting from the scheme including the impact of transaction costs, non-financial considerations such as the effect that the scheme has on personal or family relationships, and whether the scheme satisfied certain regulatory requirements. The EM states that it would be expected that a postulate that is a reasonable alternative to the scheme would achieve for the taxpayer non-tax results and consequences that are comparable to those achieved by the scheme.

Note that the focus is on the non-tax results and consequences achieved under the scheme by the taxpayer, not those of other participants in the scheme.

The requirement to have regard to the above two matters will narrow the range of alternative postulates that can be developed.

Finally, in determining whether a postulate is a reasonable alternative, regard should not be had to any tax costs that are generated for the taxpayer or any other person. That is, a taxpayer cannot argue that an alternative postulate is unreasonable on the basis that it would have attracted a higher tax cost in comparison to the scheme. However, the term “tax costs” is not used in the bill; rather, the provisions require one to “disregard any result in relation to the operation of this Act that would be achieved by the postulate for any person”. For example, if an alternative postulate would result in a greater deduction than that obtained under the scheme, it seems that this would also be disregarded in assessing the reasonableness of that postulate.

Part IVA operating as an integrated whole

Amendments will confirm that the application of Part IVA starts with a consideration of whether a person participated in the scheme for the sole or dominant purpose of securing for the taxpayer a particular tax benefit in connection with the scheme. The amendments are intended to emphasise the purpose test in section 177D as the ‘fulcrum’ or ‘pivot’ around which Part IVA operates. This is the response to recent case law where the courts have found that Part IVA did not apply on the basis that there was no tax benefit, obviating the need to consider the purpose test in section 177D.

Application

The amendments will apply to schemes entered into, or commenced to be carried out, from 16 November 2012, which was the date when the draft legislation was released.

Next steps

Taxpayers should review transactions entered into, or commenced to be carried out, from 16 November 2012. The proposed amendments to Part IVA, if enacted, will mean that, in determining whether or not there is a tax benefit, taxpayers should now focus on:

  • The non-tax results and consequences of the transaction. This will be relevant to determining whether the annihilation or reconstruction approach applies in determining whether there is a tax benefit
  • Where the reconstruction approach applies, whether the transaction could have been undertaken in another way, which corresponds in substance to the scheme, and whereby the same non-tax results and consequences could have been achieved for the taxpayer (disregarding any tax outcomes).

Furthermore, establishing the purpose of the taxpayer or parties to the scheme will also be of greater importance since the amendments would require the determination of purpose and whether or not there is a tax benefit to be considered together.

Given the importance of evidence in tax disputes and the increasing focus of the ATO on more detailed forensic analysis of possible counterfactuals, it will be important for taxpayers to document their positions.

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