Briefing note. Hidden Part IVA treasure. Background. Tim Kyle, March 2014

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1 Briefing note Hidden Part IVA treasure Tim Kyle, March 2014 Background There is precious little to indicate the current state of curial or administrative play on Part IVA: despite a barrage of articles, there is no recent case law or Australian Taxation Office (ATO) rulings/practice statements on point. However, there is one notable development: the ATO released the minutes of a 18 July 2013 National Tax Liaison Group (NTLG) consultative workshop on Part IVA. The Minutes contain important insights into the current ATO thinking on Part IVA and that thinking can reasonably be expected to be reflected in the impending update to the Part IVA practice statement (PS LA 2005/24). Interestingly, few people seem to be aware of the Minutes: they were released during the holiday period and are hidden in the bowels of the ATO website at For these reasons, the Minutes are a hidden Part IVA treasure. This article sets out the background to the Minutes as well as the more significant big picture and more specific gems that emerge. The forum for this article precludes a detailed analysis of each fact pattern and the ATO response. The consultative workshop on Part IVA amendments was held on 18 July 2013 to discuss specific fact patterns which were provided to the ATO in advance (and are appended to the Minutes). It was attended by the most senior ATO technical officers. The express purpose of the workshop was for the ATO to understand whether guidance on the 2013 amendments is warranted. Despite this stated purpose, the Minutes contain scant discussion on the 2013 amendments and the tax benefit element. Rather, their focus is overwhelmingly on the purpose element principally because of the ATO approach to this element, discussed below. While it is unfortunate that our understanding of the ATO view on the tax benefit element is not greatly improved, the discussion of the ATO view of the purpose element provides valuable insight. In terms of outcomes, it was concluded that: guidance on the 2013 amendments specifically is necessary; the existing ATO guidance in relation to Part IVA generally needs updating - in particular, updating PS LA 2005/24 is a priority; and the specific fact patterns discussed may be reflected in the updated ATO guidance. This article was written by Tim Kyle, a Director of Greenwoods & Freehills, and published in Thomson Reuters Weekly Tax Bulletin 10 on 7 March The ATO should be applauded for providing the insights in the Minutes. However, the ATO has an understandable aversion to issuing views other than in ruling format and so readers should be aware that the Minutes contain an array of disclaimers. Obviously the Minutes should not be treated like case law. Nevertheless, the Minutes are of significant utility because they represent the considered views of the most senior ATO technical personnel ie, those who will ultimately determine the ATO's actions on Part IVA matters. Moreover, it can reasonably be expected that those views will trickle down and shape the approach of front line ATO officers even in the period before the views expressed are reflected in updated PS LA 2005/ March

2 Big picture gems The core ATO approach to Part IVA The most valuable gem is an understanding of the core ATO approach to Part IVA. Element ATO approach Observations Scheme Purpose Tax benefit The relevant scheme for Part IVA purposes is what the participants actually did. Anything else the participants considered (but ultimately didn't do) does not form part of the scheme. The taxpayer's subjective purpose is not the slightest bit relevant in determining whether the requisite purpose is present. In determining whether the requisite objective purpose is present (ie, why the transaction was done), the ATO approach is that the s 177D(2) factors focus on how the scheme was implemented ie, whether any artificiality or contrivance is revealed, and cannot be explained on a commercial basis. Identifying the counterfactual is a dispassionate, relatively mechanical exercise with no prediction required as was the case before the 2013 amendments. The principal role of the counterfactual is to discern the amount of the tax benefit that is to be cancelled. This approach is welcome. See further the discussion on change of plans below. The ATO conclusions on the fact patterns go a long way towards dispelling any residual doubts about the exclusive focus on objective purpose This approach makes sense given the new mantra that purpose is determined before tax benefit. However, it does not sit well with certain case law observations that consideration of the s 177D(2) factors involves comparing the scheme with the counterfactual: see para 92 and following of PS LA 2005/24. Accordingly, there is uncertainty as to the precise role (if any) of the counterfactual in the ATO approach to the purpose element. There are still unresolved issues around whether there can be more than one counterfactual and whether prediction still has any role to play. Relationship between the two counterfactual limbs Background Each head of s 177C tax benefit is expressed on the basis of what would have happened or might reasonably have been expected to have happened. The composite phrase was considered by many to identify different points on the spectrum of certainty in which an acceptable counterfactual must lie. The 2013 amendments split the composite phrase into 2 separate limbs: s 177CB(2) and (3). However, the circumstances under which one limb rather than the other is engaged are not clear on the face of the legislation and the accompanying explanatory memorandum (EM) only confuses the issue. The ATO position The ATO makes no attempt to clarify the issue. Rather, it appears that the ATO sees a tactical advantage for itself in the bifurcation of the composite phrase - although the precise advantage is not specified. Accordingly, the ATO reserves its right to argue both limbs in the alternative. This would seem to have two practical consequences for taxpayers: first, it will increase the work involved in contesting a Part IVA determination; and second, taxpayers must keep both limbs firmly in mind when considering the Part IVA risk associated with a potential transaction. Change of plans Many of the examples considered in the workshop dealt with a change of plans eg, fact patterns 1 to 5, 7 and 9. For example, a taxpayer initially considered entering into scheme A, they then sought tax advice, acting on that advice they changed their plans and actually entered into scheme B in circumstances where scheme A gives rise to a greater tax cost than scheme B. This happens all the time and taxpayers live in fear of the ATO discovering the smoking gun on the (mistaken) assumption that it will render the application of Part IVA a laydown misere because it establishes both the tax benefit and purpose elements. However, the ATO approach revealed in the Minutes attaches very little significance to the impact of changes of 12 March 2014, page 2

3 plans on the relevant scheme, the taxpayer's objective purpose and the counterfactual. No impact on scheme The ATO view is that the relevant scheme is confined to just B as actually implemented. Restated, the ATO does not consider the relevant scheme to comprise all of consideration of scheme A, obtaining tax advice, changing plans to scheme B and implementing scheme B. It follows that any artificiality or contrivance in changing from scheme A to scheme B is not, of itself, relevant to the purpose element. Only potential impact on purpose The emphatic ATO view is that merely changing schemes to produce a better tax result will not normally activate Part IVA - on the basis that the taxpayer's subjective purpose is not relevant to the purpose element. However, the ATO warns that changing schemes may introduce elements of complexity and contrivance which can activate s 177D(2) factors. Presumably an example would be if scheme B involved inserting additional steps into scheme A for no readily identifiable commercial reason. Technically no impact on counterfactual The taxpayer's subjective purpose is, strictly speaking, irrelevant to the formulation of the objectively determined counterfactual. That is, it will not automatically follow that scheme A is the counterfactual. However, it would be difficult for ATO officers (and judges) to be so disciplined as to completely disregard scheme A in formulating the counterfactual for scheme B and so, as a practical matter, it will still have some relevance to the counterfactual analysis. Conclusion The fact that a taxpayer has changed plans to (subjectively) produce a better income tax result is not fatal but obviously caution should still be exercised. Is there only one reconstruction counterfactual? Background Case law on s 177C strongly suggested (although without conclusively determining the issue) that the counterfactual was the single most reliable prediction of what the relevant actor(s) would have done absent the scheme. It would follow that any other less reliable prediction was incapable of qualifying as the counterfactual. However, s 177CB(3) provides that: A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme. [Emphasis added] That is, the use of the indefinite article leaves open the possibility that the reconstruction approach mandated by s 177CB(3) can be satisfied by any number of alternative courses of action so long as the alternative satisfies the reasonableness threshold. This is a significant issue where: there are 10 alternatives that satisfy the reasonable test; the most likely of them produces a tax benefit of $100; and the least likely of them produces a tax benefit of $1,000. Can the ATO pick the alternative that produces the highest tax benefit? If so, the ATO would certainly have a significant tactical advantage. This issue is unclear, not being addressed in either the 2013 amendments or the EM. ATO approach In short, the ATO ducks this issue. It is acknowledged as a possibility - but no concluded view is provided. Multiple counterfactuals are seen as possible in the (unlikely) circumstance that there are multiple equally reasonable counterfactuals otherwise, the issue is left to the courts. ATO positions the argument The ATO ventilates a view of the interaction between s 177C and s 177CB that, if accepted, would more easily allow a court to find that multiple counterfactuals are possible. However, there are some issues with that view. The EM indicates a dissatisfaction with certain case law outcomes produced under the existing counterfactual test. Different outcomes are clearly intended. However, the legislature chose to effect this change by: retaining the existing s 177C tax benefit text; and introducing a new s 177CB. Accordingly, a legitimate issue arises as to whether the effect of introducing s 177CB is to: merely expand the range of potential counterfactuals by reference to the matters identified in s 177CB(3) and (4) ie, by putting some constraints on the s 177C inquiry; or completely replace the s 177C heads of tax benefit. 12 March 2014, page 3

4 The competing theories on the effect of s 177CB produce different consequences: the expansion theory would mean that existing case law is still relevant suggesting that the reconstruction limb still involves a prediction of the (single) counterfactual; and Does this mean that legitimate commercial choice is a panacea? This justification can potentially be argued in a wide array of different circumstances but, as a practical matter, the ATO will likely be forced to draw an arbitrary line. Where exactly that line is to be drawn is unclear. Pre-sale dividends the replacement theory would render otiose existing case law on s 177C in which case the issue would fall to be determined based only on a statutory construction of s 177CB. Pre-sale dividends were addressed in the RCI litigation (Full Federal Court decision in RCI Pty Ltd v FCT (2011) 84 ATR 785) where, in the circumstances, the ATO lost on both the tax benefit and purpose elements. The ATO position The ATO vigorously believes in the replacement theory - the stated ATO view is that s 177CB(3)/(4) now require an entirely different inquiry to that undertaken before the 2013 amendments. However, no reasoning is given for this conclusion and there are valid arguments in support of the expansion theory so watch this space. More specific gems RPS and gaming the debt/equity borderline Redeemable preference shares (RPS) have long been a source of speculation in relation to Part IVA, as small differences in their term can determine on which side of the tax debt/equity borderline they fall. That is, it is very easy to manipulate the tax outcomes that flow from issuing and holding RPS. Fact patterns 1.1 to 1.4 in the Minutes deal with changes to the term of RPS in order to achieve the desired debt/equity outcomes. The stated ATO position on changes of mind is applied to these fact patterns. However, the ATO goes further - and all but gives a get out of jail free card to such changes made to conventional RPS on the basis that the requisite dominant purpose is unlikely to be present. More specifically, the ATO sees nothing offensive from a purpose element perspective in manipulating the term of RPS so as to fall on one side or the other of the debt/equity borderline. This is on the basis that differences in the term are differences of commercial substance ie, the issuer has the funds for a shorter or longer period and that affects their overall funding position. The justification for the ATO position is as follows: 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 obviously from debt] and represent a legitimate commercial choice available to a company. The 2013 amendments clearly overcome the successful argument in RCI that no tax benefit arises in an internal restructure because of the excessive tax cost of the sale absent a pre-sale dividend But what is the current state of play regarding the purpose element? Fact patterns 6.1 to 6.6 deal with a foreign subsidiary paying a dividend before the Australian parent disposes of it in circumstances where, absent the dividend, the Australian parent would have made a taxable capital gain (ie, the capital gain would not be completely disregarded by operation of Subdivision 768-G). The variations in the fact patterns deal with: internal reorganisation as opposed to (direct and indirect) sale to an external purchaser; and dividends paid out of realised as opposed to unrealised profits. Initial observations Clearly, paying a dividend before a sale involves an extra step in comparison with a sale alone. This is potentially (unless perhaps explicable on a genuinely commercial basis) an artificiality or contrivance of the type that activates the s 177D(2) factors. However, it is difficult to see any coherent policy basis for Part IVA being activated in circumstances where a pre-sale dividend is paid out of profits (whether realised or unrealised) that accrued on the Australian parent's watch. Moreover, there are already existing specific s 177E dividend stripping provisions directed towards unacceptable pre-sale dividends paid out of profits that accrued before the Australian parent's watch. Ideally, the ATO would have taken the opportunity in the Minutes to conclude that a pre-sale dividend only activates Part IVA if s 177E dividend stripping is involved. Or, failing that, give some guidance as to what particular features they consider incline for or against activation of the s 177D(2) factors. ATO approach The ATO view is that Part IVA is potentially capable of applying to any pre-sale dividend and one can perhaps identify a willingness to test the issue in the future when the 12 March 2014, page 4

5 ATO expresses the view that the finding in RCI (ie, that the requisite dominant purpose was not present) is confined to its facts. Yet unfortunately no meaningful guidance is provided. Instead, the (rather unhelpful) ATO view is that distinctions between internal restructures and external sales and between realised and unrealised profits are not particularly decisive. the relevant scheme is (only) a sale of the business at a particular price (ie, under the threshold); the initial offer would not form part of the relevant scheme; and a sale at a particular price is a very simple scheme and does not reveal artificial or contrived features of the kind that would activate the s 177D(2) factors. Consequently, caution should be exercised when considering any pre-sale dividend. Accessing intended benefits In example 5, a taxpayer changes plans and incurs expenditure that is eligible for the R&D credit. More specifically, an employee of the taxpayer proposes developing software for extra money. Initially, the proposal is rejected on a cost/benefit basis. However, tax advisers advise that the R&D credit will be available if the product is provided to external users (ie, the software is made generic). The taxpayer changes its plans and proceeds with the software development on that basis. The ATO appears to take a very relaxed approach to schemes involving access to (certain) concessional tax treatment: 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. Curiously, this approach leaves little room for the s 177D(2) factors and so, although the precise reasoning is unclear, it seems that underlying policy considerations trump any artificiality or contrivance, at least in this scenario. However, the ATO ducks the change of plan issue entirely on the spurious basis that, despite the lower sale price, the market value of the assets could nevertheless exceed the $6m threshold. This reason for not addressing the issue directly contradicts the express ATO assumption - to be applied to all the fact patterns - that the tax outcomes (other than Part IVA) are achieved: see the opening remarks section of the Minutes. Avoiding unintended outcomes The ATO approach is that there is no get out of jail free card if a taxpayer engages in an artificial or contrived scheme in order to avoid an unintended or capricious outcome. More specifically, the ATO approach is that Part IVA can be activated even without any demonstrated abuse of the tax system. Further, the ATO position is that, where the elements of Part IVA are present, it does not have an overarching discretion as to whether or not to apply Part IVA. So, if a taxpayer takes steps to work around an outcome that is undesirable or unintended, the ATO will just mechanically apply the s 177D(2) factors. Keen readers will note the lack of consistency in the ATO approach: the underlying policy of the relevant provisions is asserted to be irrelevant to the application of Part IVA in this scenario yet underlying policy is asserted to be critical to the (non-) application of Part IVA in circumstances where a taxpayer accesses intended benefits (being the fact pattern discussed in the section immediately above). These 2 different approaches are not easily reconciled. Also, inevitably, there are limits to this approach. For example, the ATO does not apply this relaxed approach in fact pattern 3 where the concessional tax treatment is the small business rollover. There, a business owner selling his business rejects an offer above the $6m threshold for the small business rollover concession and instead makes a counter offer to the purchaser for a sale price just below $6m. It could be that the ATO does not consider the rollover to be a concessional tax treatment although, if so, where the dividing falls is unclear. Moreover, despite it clearly involving a change of plans, the ATO does not analyse it as a change of plans fact pattern. In that regard, if the ATO was to consistently apply its stated position on changes of plan, one would have thought that: For further information, please speak to: Sydney Melbourne Perth Tim Kyle tim.kyle@gf.com.au Cameron Rider cameron.rider@gf.com.au Nick Heggart hick.heggart@gf.com.au March 2014, page 5

6 These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation. G&F document ID _17.docx Greenwoods & Freehills Pty Limited (ABN ) 12 March 2014, page 6