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[Insert Client Name]
[Insert Client Position]
[Insert Company Name]
[Insert Client Address]
[Suburb State Post Code]
Dear [Insert Client Name]
Re: Income Tax General Anti Avoidance Rules
The general anti-avoidance rules contained in Part IVA of the Income Tax Assessment Act 1936 (Cth) (“Part IVA”) may be applied by the Australian Taxation Office (ATO) to deny a taxpayer the tax benefit of a scheme they have entered into.
The key features of Part IVA include the following:
Is there a scheme?
Has a tax benefit been obtained?
What was the taxpayer’s sole or dominant purpose?
What happens when Part IVA is applied?
Each of these issues is explored below.
Is there a scheme?
It is important to identify the scheme as it sets the framework for determining if a taxpayer has obtained a tax benefit in connection with the scheme, and whether the dominant purpose of the taxpayer of entering into the scheme was to obtain the tax benefit.
Part IVA provides a broad definition of “scheme”, which includes any agreement, arrangement, promise or undertaking, whether express or implied and whether or not enforceable or intended to be enforceable by legal proceedings. It also includes any unilateral scheme, plan, proposal, course of action or course of conduct.
As a scheme includes any unilateral action, it is not difficult to establish the existence of a scheme however this must be based on fact and reality and not determined by reference to a desired outcome1.
What is the tax benefit?
A ‘tax benefit’ is defined in section 177C as one of the following amounts:
an amount not included in assessable income
a deduction being claimed
incurring a capital loss
claiming a foreign income tax offset.
Furthermore, section 177C specifies that a taxpayer will have obtained a tax benefit in connection with a scheme if the tax benefit would not have arisen if the scheme did not occur, or would reasonably not have arisen if the scheme did not occur.
In June 2013, the Federal Government implemented amending legislation2 to tighten the rules applicable to determining whether a tax benefit has been obtained. These changes have a retrospective application to schemes entered into from 16 November 2012, and may have significant impact on you and your business.
Schemes entered into before 16 November 2012
In making a determination of tax benefit and purpose, the Commissioner was required to make a comparison of the tax consequences between the scheme in question and an alternative postulate3. Whilst the alternative postulate was not codified in the statute, it had been determined by the judiciary to be the most appropriate analysis used in order to reach a conclusion about the purpose(s) of the participants in the scheme and whether tax benefit has arisen in connection with the scheme.
In light of an increasing trend in court decisions in favour of the taxpayer, the Government became concerned that the ‘tax benefit’ test was too easily undermined by an alternative postulate that without the tax benefit the scheme would not have been implemented at all, i.e. the “do nothing” argument. As a consequence, revised legislative provisions were introduced to remedy the perceived shortcomings of the law.
Schemes entered into after 16 November 2012
The legislative amendments remodel the working of Part IVA, and amongst other things, codify alternative postulate used to determine if there is a tax benefit in connection with scheme under two limbs. Satisfaction of either limb (together with the other requirements of Part IVA) can trigger the application of the new Part IVA to deny a tax benefit obtained by a taxpayer. Furthermore, these changes effectively eliminate the ability of a taxpayer to mount a successful Part IVA defence that relies on an argument which is a “do nothing” alternative postulate.
The first limb is satisfied if the tax effect (e.g. a deduction denied or inclusion of income) would not have occurred under the scheme. This is determined based on a postulate that comprises only of the events and/or circumstances that actually happened or existed (excluding those that form part of the scheme). The first limb is described as the annihilation approach as it requires a postulate that considers what would have occurred in the absence of the scheme, i.e. the scheme must be assumed not to have happened and is annihilated.
Example4 – ‘annihilation approach’
Junie, a foreign resident, enters into an arrangement under which her assessable income, which she would otherwise derive from Australian sources, is instead derived from foreign sources. The result of the arrangement is that the income is not assessable to her in Australia. In this regard, the tax benefit is the reduction in Junie’s assessable income. If the arrangement had not been entered into, the income ‘would have’ been included in Junie’s assessable income because the only operation of the scheme was to change the source of income for taxation purposes.
The first limb is expected to be relied upon by the Commissioner in relation to tax benefits arising out of mass marketed tax schemes, i.e. where the scheme in question does not produce any material non-tax results or consequences for the taxpayer.
The second limb is satisfied if the tax effect might reasonably be expected to have occurred if the scheme had not been carried out. This is determined based on a postulate that is a reasonable alternative??? carrying out the scheme. The second limb is described as a reconstructive approach as it requires a postulate that could reasonably take the place of the scheme (i.e. this will involve a reconstruction the state of affairs that would have existed if the scheme had not been entered into or carried out, such as theoretical modifications of a transaction). Of particular relevance is the requirement that the reasonable alternative must disregard any tax impact; as such, it will no longer be possible for a taxpayer to put forward a “do nothing” postulate to avoid the application of Part IVA.
Example5 – ‘reconstruction approach’
Chloe borrows money to acquire a family home and a property using in her business. Chloe enters into a borrowing arrangement whereby the repayments are applied exclusively to the borrowings in relation to the family home, so that the deductible interest payments are increased for the business property borrowing and the non-deductible interest payments for the family home borrowing are minimised. If the annihilation approach is applied, this would not leave a sensible result as there would be no borrowing at all. Therefore, it is necessary to apply the reconstruction approach to consider what might reasonably be expected to have happened if the scheme had not been entered into. In this regard a reasonable alternative for Chloe is that she could have taken out a separate loan for each property under normal commercial terms.
The sole or dominant purpose test
If obtaining a tax benefit is only an incidental purpose of a taxpayer entering into a scheme, then this is not sufficient for Part IVA to apply. The purpose motivating the scheme must be determined on a strictly objective basis, taking into consideration the eight factors listed in subsection 177D(2).
It is worth noting that the relevant purpose does not have to be attributed to the taxpayer who obtained the tax benefit but that of any person who has entered into or carried out the scheme or any part of the scheme. This means that the purpose of a tax adviser involved in the implementation of a scheme can be taken into account in determining whether Part IVA is applicable6.
Whilst a transaction may be entered into based on a rational commercial decision, this does not necessarily mean that the dominant purpose has not been established. A decision to enter into a transaction can be both commercially and tax driven, but the relevant purpose will be the one that is the most influential, ruling or prevailing purpose. Therefore it is very important to have proper documentary evidence to a taxpayer’s defence of Part IVA.
When considering any proposed transactions, you must carefully consider the transaction’s commercial and economic substance. In particular, you should ensure that this substance can be clearly demonstrated in a reasonable alternative scheme.
Apart from the impact of Part IVA applying to “reverse” the impact of any scheme, if it is applied, the ATO can also impose penalties of up to 50% of the tax payable.
The practical application of these new rules can be difficult and there is little guidance currently available because the amendments are so recent. As such, if you require assistance with considering and preparing properly documented and reasonably considered alternative postulates (for a proposed transaction), or have any queries, please contact me on [insert telephone number of partner].
[Insert name of Partner]