Keith Kendall FTIA Senior Lecturer, School of Law La Trobe University Most discussion and debate relating to the legal means of combating tax avoidance in Australia centres, understandably, on Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936). This focus is understandable due to the far-reaching nature of Australia s general anti-avoidance provision, especially since the High Court s decision in FCT v Hart, 1 which most commentators have regarded as creating a great deal of confusion. 2 Any uncertainty regarding legislation with consequences as important as those attaching to Part IVA will always draw a great deal of comment. This far-reaching nature also provides a temptation for practitioners to focus virtually exclusively on Part IVA when providing tax planning advice. However, such an approach, as well as being fraught with danger, ignores the fact that Part IVA is only a measure of last resort, rather than a front-line defence in the ATO s ongoing battle with the more aggressive members of the tax planning community. It is also an opportune time to consider Part IVA s role in dealing with tax avoidance in Australia, with Treasury announcing a review of Australia s anti-avoidance provisions (including specific anti-avoidance provisions) last November. 3 This article aims to outline the progressive structure by which the feasibility of a tax planning arrangement should be assessed under the present state of Australian tax law. In doing so, it will be demonstrated, amongst other matters, that Part IVA, while perhaps the most high profile aspect of this structure, should not be the sole or, in many matters, the central focus of any anti-avoidance risk assessment. Part IVA A Measure of Last Resort Section 177B sets out the scope of the operation of Part IVA. The combination of ss 177B(3) and (4) indicate that Part IVA operates subject to the specific anti-avoidance provisions of the tax legislation. 4 Subsection 177B(3) states, Where a provision of this Act other than this Part is expressed to have effect where a deduction would be allowable to a taxpayer but for or apart from a provision or provisions of this Act, the reference to that provision or to those provisions, as the case may be, shall be read as including a reference to subsection 177F(1). Subsection 177B(4) goes on to state, Where a provision of this Act other than this Part is expressed to have effect where a deduction would otherwise be allowable to a taxpayer, that provision shall be deemed to be expressed to have effect where a deduction would, but for subsection 177F(1), be otherwise allowable to the taxpayer. The then Federal Treasurer, Mr John Howard, explained when introducing the bill that incorporated Part IVA into the ITAA 1936 that these provisions are reflective of the last resort nature of Part IVA. 5 This may be seen from the references in both 1 P a g e
provisions to the effective inclusion of s 177F(1) (which allows the Commissioner to cancel the tax benefit 6 associated with the relevant scheme) in the relevant specific anti-avoidance provision. This is done in s 177B(3) by deeming a reference to the anti-avoidance provision as including a reference to s 177F(1). Subsection 177B(4) achieves the same effect by ignoring the operation of s 177F(1) through the use of the phrase but for subsection 177F(1) when deeming the operation of the specific antiavoidance provision. An interesting feature of s 177B is that it appears only to affect the operation of Part IVA in relation to specific anti-avoidance provisions that deny deductions, a feature also noted elsewhere. 7 Both ss 177B(3) and (4) explicitly refer to provisions where a deduction would otherwise be allowable. Due to the apparent exhaustive nature of the language used in these provisions, these explicit references would implicitly appear to exclude other forms of specific anti-avoidance provisions, such as those that deny reductions in assessable income. Notwithstanding this feature of s 177B, it would appear that the substantive aspect of Part IVA, namely the Commissioner s power to cancel a tax benefit under s 177F(1), operates subject to the specific anti-avoidance provisions contained in the tax legislation. This conclusion is derived from the opening sentence to s 177F(1), which states, Where a tax benefit has been obtained, or would but for this section be obtained. This statement outlines the scope of the Commissioner s powers to cancel a tax benefit. In essence, s 177F(1) indicates that the Commissioner has the opportunity to cancel a tax benefit under the auspices of Part IVA once the arrangement is found to be effective against all other provisions contained in the tax legislation. This becomes clear if the operation of the tax legislation is considered in isolation of any effect Part IVA may have in relation to a contemplated arrangement. For the arrangement to be effective, or, to use the language of Part IVA, a tax benefit is to be obtained, the arrangement must pass any applicable specific anti-avoidance rule. Regardless of any other feature of the tax legislation, an arrangement cannot be considered effective if it falls foul of at least one specific anti-avoidance rule. By this standard, a tax benefit can only be achieved if the arrangement is effective as against the various specific anti-avoidance rules in the tax legislation. Conversely, if the arrangement is rendered ineffective and the sought after tax benefit denied under a specific anti-avoidance provision, then the tax benefit has not been obtained. The wording of s 177F(1) establishes that the obtaining of a tax benefit in the absence of Part IVA is a prerequisite for attracting the Commissioner s power to deny a tax benefit (which may be regarded as attracting the operation of Part IVA generally). Since a tax benefit would not have been obtained if the arrangement attracted the operation of a specific anti-avoidance provision, then Part IVA has no application. Consequently, it may be seen that Part IVA generally operates subject to the application of the various specific anti-avoidance provisions in the tax legislation. Specific Anti-Avoidance Provisions The Australian tax legislation is replete with a myriad of provisions referred to as specific anti-avoidance measures. The reason for the label is that these measures are 2 P a g e
designed to address the tax consequences arising from specific form/s of transactions or arrangements. This may be contrasted with the nature and scope of the general anti-avoidance provision in Part IVA, which are expressed in vague terms designed to catch arrangements that are undesirable yet are not negated by some other provision. A number of commentators attribute the proliferation of specific anti-avoidance rules to the heyday of the tax avoidance industry in the 1970s, where the Barwick High Court regarded many blatant avoidance schemes as effective. 8 The specific anti-avoidance provisions in the tax legislation are as varied as the avoidance schemes upon which they focus. Some seek to deny a deduction for expenditure actually incurred, such as s 82KJ of the ITAA 1936, which denies a deduction for certain prepaid expenditure. Others deny an attempted reduction in assessable income, such as Division 6A of the ITAA 1936, which deals with arrangements to alienate income. Still others attribute assessable income to another entity through the non-recognition (for tax purposes) of legal structures put in place, such as the alienation of personal services income rules in Part 2-42 of the ITAA 1997. Further, others quarantine deductions so as not to deny a deduction altogether, but only allow its use in circumstances deemed appropriate. Examples of this last category include s 79D of the ITAA 1936, which quarantines deductions for expenditure incurred in deriving foreign-sourced income and Division 35 of the ITAA 1997, which quarantines losses for certain non-commercial business activities against profits derived from those activities (until certain criteria are satisfied). Note that provisions that preserve the integrity of the revenue by adding additional qualifying criteria, such as Division 165 (which requires a corporate entity to pass either the continuity of ownership test or the same business test before it may claim a deduction for a prior year tax loss or a deduction for a bad debt) are not dealt with under this analysis as specific anti-avoidance measures. As these measures affect the application of the tax legislation in the first instance (which will be referred to from here on as, for lack of a better term, the substantive tax legislation), they are distinct from the specific anti-avoidance provisions considered in this section. These measures are dealt with in the next section. A common feature of all these specific anti-avoidance provisions is that their application is premised upon the arrangement being effective other than for the operation of that provision. This relationship between the specific anti-avoidance provisions and the general deduction provision (as part of the substantive tax legislation) has become somewhat blurred since the 1997 rewrite. Subsection 8-1(2) of the ITAA 1936 includes a fourth negative limb, being you cannot deduct a loss or outgoing under this section to the extent that: (d) a provision of this Act prevents you from deducting it. This limb was a new addition as part of the 1997 rewrite, since there was no equivalent in the forerunner to s 8-1, being s 51(1) of the ITAA 1936. This blurring occurs since this relatively new limb effectively incorporates provisions that deny a deduction for expenditure that would otherwise satisfy the other requirements of s 8-1, such as the provisions in Division 26 of the ITAA 1997, into s 8-1 itself. Consequently, such denial provisions may be considered to be part of the substantive tax legislation. However, this characterisation is not total, since this incorporation tends not to occur with most specific deduction 9 provisions, such as those contained in Division 25 of the ITAA 1997. 3 P a g e
The requirement for an otherwise effectiveness arrangement (in terms of achieving the desired tax treatment) based on the substantive tax legislation is apparent from the use of language in the specific anti-avoidance provisions. For example, s 82KJ begins by setting out that it is only operative where a loss or outgoing in respect of which a deduction would, but for this Subdivision, be allowable (emphasis added). 10 Section 82KK(c), dealing with schemes designed to postpone a tax liability, uses a similar but for test with respect to disallowing certain deductions. Such language infers that, but for the operation of the specific anti-avoidance provision, the relevant deduction would be allowed. Other provisions are structured in a similar fashion. Section 82KL discusses benefits in terms of tax savings obtained from certain expenditure. These tax savings would not be available if the expenditure contemplated by the provision did not give rise to a deduction under the substantive tax legislation. A more recently enacted example of a specific anti-avoidance measure is Division 35 of the ITAA 1997, which contains the non-commercial losses rules. These provisions are premised on the general principle that losses from a business activity (as opposed to a hobby) may be utilised as an allowable deduction against other forms of assessable income (such as salary and wages). Such losses have generally been allowed under the second positive limb of s 8-1 (and its predecessor) as a loss from the carrying on a business. The measures in Division 35 are designed to ensure that only a loss from genuinely commercial activities is regarded as an allowable deduction. 11 A series of tests is set out to determine whether the activity is to be generally regarded as a commercial or non-commercial activity. 12 The effect of these provisions is that such losses are not disregarded entirely, but rather are quarantined until either the tests are passed or the activity earns sufficient assessable income in its own right to offset the losses. For the purposes of the discussion here, the general rule set out in s 35-10(2) provides the link between the operation of the substantive tax legislation and the application of these specific anti-avoidance provisions. This provision states, If the amounts attributable to the *business activity for that income year that you could otherwise deduct under this Act for that year exceed your assessable income (if any) from the business activity for that year, or your share of it, this Act applies to you as if the excess (emphases added) The references to the substantive tax legislation and the use of the deeming phrase as if provide this connection between the application of Division 35 and the substantive tax legislation. If the loss would not otherwise be allowable on the substantive tax legislation, then the rule in s 35-10(2) would not become operative and, therefore, Division 35 generally would not be applicable to the arrangement. These examples are representative of the proposition that the specific anti-avoidances provisions are set up on the presumption that the substantive tax legislation allows for the purported tax treatment of the arrangement. 4 P a g e
Operation of Substantive Tax Legislation When determining the appropriate taxation treatment of an arrangement, primacy must be given to the operation of the substantive tax legislation. The provisions that constitute the substantive tax legislation, as described here, are those that set out the prerequisites for the desired tax treatment. For example, for expenditure to be deductible, it must either satisfy the criteria set out in s 8-1 of the ITAA 1997 or the criteria in one of the specific deduction provisions (as described in s 8-5 of the ITAA 1997). This primacy was illustrated in the approach adopted by the Full Federal Court in Vincent v FCT. 13 While no specific anti-avoidance provisions were raised in argument (due to none being applicable to the arrangement involved), the application of Part IVA was one of the core issues, not least of which due to this being the basis for the court at first instance denying the deduction claimed by the taxpayer. The Full Federal Court adopted an approach that required an analysis of the substantive tax legislation before considering the application of Part IVA. This was made clear when the court indicated that if the expenditure was found to be not deductible (due to being capital or of a capital nature), then the inquiry should stop there. 14 The relationship to Part IVA was further enunciated when the court went on to state after finding that the expenditure was not deductible Once it is clear that no amount was ever an allowable deduction it is clear that Part IVA could never operate on the facts of the present case. 15 The primacy that the Full Federal Court attributed to the substantive tax legislation in Vincent is just as applicable to the specific anti-avoidance rules discussed in the previous section. This is because the entire basis for determining the tax treatment of a particular arrangement must first of all be determined before that treatment can be denied. As indicated by the court in Vincent, if the purported tax treatment does not stand up on the face of the substantive tax legislation, then the anti-avoidance provisions have no application. It is the substantive tax legislation that sets out the criteria by which the tax treatment at first instance is determined. The simplest illustrations of this principle are ss 6-5 and 8-1 of the ITAA 1997, setting out the prerequisites for receipts and expenditure to be ordinary income or general deductions respectively. In Vincent, the substantive tax legislation that was applied was s 51(1) of the ITAA 1936 (as forerunner to s 8-1). As discussed above, consideration of Part IVA was rendered obiter by the finding that the expenditure had failed to meet the requirements of s 51(1). An illustration of the substantive tax legislation that deals with specific deductions is s 25-35, which allows a deduction for bad debts. Section 25-35 states that a bad debt written off during an income year may be allowed as a deduction against assessable income (for taxpayers not in the business of lending money) if the amount had been included in assessable income in the current or an earlier income year. The operation of this may be illustrated in the case of a taxpayer carrying on a business who utilises accrual accounting for their internal reporting purposes, but qualifies for the use of cash accounting for tax purposes. While the internal accounting system would recognise debtors accrued, such recognition is not afforded by the tax accounting 5 P a g e
method employed. Consequently, accrued revenue earned would never be returned as income under this tax accounting system, therefore, any debt raised in the internal accounting system that is later written off as bad would not be allowed as a deduction under s 25-35, since it does not meet the criteria for deductibility. It would not be necessary to consider the application of any specific anti-avoidance provision nor Part IVA. For companies, s 25-35(5) imports additional criteria from Subdivision 165-C that must be satisfied before a deduction for a bad debt can be claimed. These requirements are that the same persons must control more than 50% of the voting power, rights to dividends and rights to capital distributions in the company during the relevant testing time. If the company fails these requirements, then it may pass the same business test as set out in Subdivision 165-E in the alternative. 16 Since a company will be denied a deduction for a bad debt if it does not meet any of these criteria, these provisions form the substantive tax legislation with respect to the deduction of bad debts. Sham Transactions A sham transaction is essentially a transaction of one form masquerading as another form. For example, a gift from individual A to individual B may be presented as a payment for services provided, in order to generate a deduction for the amount of the gift in A s tax return. 17 Such transactions typically generate relevant legal documents that purport to create substantive legal rights and obligations with the intention that such evidence would effectively counter any characterisation of the transaction on the part of the Commissioner as a sham. Critical to any finding that a transaction is a sham is the requirement that the parties to the arrangement do not, in fact, intend to give effect to the purported effect of the arrangement. 18 The High Court clarified this principle in Equuscorp Pty Ltd v Glengallen Investments Pty Ltd, 19 where it was held that a sham does not have the apparent or legal consequences set out in the arrangement. 20 The focus of the inquiry needs to be upon the legal effect of the arrangement, rather than any difference between the purported and substantive economic effects. 21 Due to the generally sophisticated nature of tax planning, most tax structuring arrangements are rarely so blatant as to constitute a sham. At a minimum, the nature of the structuring tends to be sufficiently opaque so that the Commissioner would have a great deal of difficulty meeting their evidentiary burden in litigation, leading to a situation where the Commissioner rarely challenges tax planning arrangements on this ground. In particular, the legal rights and obligations created in the documentation often give rise to substantive matters that the parties do, in fact, intend to give effect to, which should be sufficient to defeat any argument that the transaction is a sham. 22 The Federal Court had a rare opportunity to consider the definition of a sham earlier this year in Raftland. 23 There, Kiefel J cited with approval 24 the following passage from Lockard J s judgment in Sharrment Pty Ltd v Official Trustee in Bankruptcy, 25 6 P a g e
A sham is therefore for the purposes of Australian law, something that is intended to be mistaken for something else or that is not really what it purports to be. It is a spurious imitation, a counterfeit, a disguise or a false front. It is not genuine or true, but something made in imitation of something else or made to appear to be something which it is not. It is something which is false or deceptive. A finding that a transaction is a sham means that [the transaction] may be ignored and regard had to the real transaction. 26 In terms of the need for any statutory provisions to deal with shams, the lack of legal recognition for such structures obviates any requirement for legislation to deal with the issue. As stated by Isaacs J in Jacques v FCT, 27 A sham transaction is inherently worthless, and needs no enactment to nullify it. As a result, any tax consequences arising from the transaction in its purported form are not examined. Inquiry as to the tax outcome of the dealings between the parties needs to centre on the real transaction, as identified by the court. The position that sham transactions have no legal effect and, therefore, do not give rise to tax consequences, has been a feature of Australian tax law since well before the enactment of Part IVA. In addition to Isaacs J s holding quoted previously, 28 the courts have continued to hold that shams are ineffective from a tax perspective without any aid at least from the anti-avoidance provisions. In relation to the predecessor of Part IVA, s 260 of the ITAA 1936, Windeyer J stated, 29 In a case under s 260 one starts with the position that the arrangement that is void as against the Commissioner is valid as between the parties that is to say that it is a legal reality and not a sham, because, if it were a sham, it would fall in any event, and without the aid of s 260. The judicial comments relating to the lack of legal effect that a sham has justifies a conclusion that, not only is it unnecessary to have a general anti-avoidance rule to render such a transaction ineffective, but the arrangement is ineffective against all aspects of the tax legislation. Doctrine of Fiscal Nullity For the sake of completeness, the doctrine of fiscal nullity as established in the United Kingdom is briefly discussed here. This doctrine is a judicial response to artificial or contrived arrangements designed purely to reduce tax liabilities and has its origins in the decisions of the House of Lords in WT Ramsay Ltd v IRC, 30 IRC v Burmah Oil Co Ltd 31 and Furniss v Dawson. 32 Essentially, the doctrine firstly requires a pre-ordained series of transactions or a single composite transaction, which may have a legitimate commercial objective as the desired end result. Secondly, there must be some intervening steps that have no objective commercial or business purpose, other than tax avoidance. If these two requirements are met, the court may disregard the inserted steps and determine the ultimate tax outcome on the end result of the essentially reconstructed transaction. 33 Around the same time as Furniss v Dawson, the Federal Court held in the decision of Oakey Abattoir Pty Ltd v FCT 34 that the doctrine of fiscal nullity was only 7 P a g e
appropriately applied in jurisdictions that did not have a general anti-avoidance rule, such as s 260 or Part IVA. Despite subsequent attempts by the Commissioner to apply the doctrine in Australia, 35 the Federal Court s position was confirmed by the High Court in John v FCT. 36 Australian Structural Approach to Tax Avoidance The analysis and descriptions presented above demonstrate that there are distinct elements in determining the effectiveness of a tax minimisation arrangement under Australian law. The following discussion will establish that the appropriate steps to adopt under Australian law, in order, are, 1. Establish whether the transaction is a sham. 2. Establish whether the transaction is effective on the face of the substantive tax legislation. 3. Establish whether any specific anti-avoidance provisions apply to the arrangement. 4. Establish whether the proposed tax benefit can be cancelled out under Part IVA. 1 (2004) 217 CLR 216. 2 See, for example, M. Cashmere, Part IVA After Hart (2004) 33 Australian Tax Review 131. For an alternative interpretation of the effect of the Hart decision on the application of Part IVA, see D. Carbone and J. Tretola, FCT v Hart: An Analysis of the Impact of the High Court Decision on the Application of Part IVA (2005) 34 Australian Tax Review 196. 3 Department of Treasury, Improving the Operation of the Anti-Avoidance Provisions in the Income Tax Law (Discussion Paper) available at http://www.treasury.gov.au/contentitem.asp?navid=037&contentid=1901. 4 The tax legislation will be used here to collectively refer to the ITAA 1936 and ITAA 1997. 5 N. Challoner and R. Richardson, Tax Avoidance: Implications of 1981 General Provisions (Part IVA) (1981) CCH Australia, North Ryde, [302]. 6 As defined in s 177C. 7 G. Lehmann and C. Coleman, Taxation Law in Australia (5 th ed, 1998) Australian Tax Practice, North Ryde, [20.20]. 8 See ibid, [20.240] - [20.250]; G. Lehmann, The Income Tax Judgments of Sir Garfield Barwick: A Study in the Failure of the New Legalism (1983) 9 Monash University Law Review 115; for examples of such judicial support for avoidance schemes, see Curran v FCT (1974) 131 CLR 409 and FCT v South Australian Battery Makers (1978) 140 CLR 645. 9 As defined in s 8-5 of the ITAA 1997. 10 Sec 82KJ(a) of the ITAA 1936. 11 Sec 35-5(1); Treasurer s Press Release, No 74, 11 November 1999, Attachment A. 12 Sections 35-30 to 35-45 of the ITAA 1997. 8 P a g e
13 2002 ATC 4742. 14 Ibid, 4755. 15 Ibid, 4760. 16 Sec 165-126 of the ITAA 1997. 17 An advantage would accrue overall if B is subject to a lower marginal tax rate. Since such transactions would most likely take place between related parties, it could reasonably be expected that the benefits from this arrangement would be informally shared between A and B. 18 Scott v FCT (No 2) (1966) 40 ALJR 265, 279, as cited by Kiefel J in Raftland Pty Ltd v FCT 2006 ATC 4189, 4204 ( Raftland ). 19 (2004) 218 CLR 471. 20 Ibid, 486 21 Ibid, 486-487. 22 See further G. Cooper, R. Krever, R. Vann and C. Rider, Cooper, Krever & Vann s Income Taxation: Commentary and Materials (5 th ed, 2005) Thomson, Sydney, 949. 23 Above n 17. 24 Ibid, 4204. 25 (1988) 18 FCR 449, 454. 26 Raftland, above n 17, 4206. 27 (1924) 34 CLR 328, 358. 28 Ibid. 29 Hancock v FCT (1961) 108 CLR 258, 301. 30 [1982] AC 300. 31 [1982] STC 30. 32 [1984] AC 474. 33 See Lehmann and Coleman, above n 6, [20.290], paraphrasing Lord Brightman in Furniss v Dawson, ibid, 527. 34 84 ATC 4718. 35 Relevant tax rulings from CKV? 36 (1989) 166 CLR 417. 9 P a g e