"Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Act is less than it otherwise would be."
In recent times in Australia, the sentiments expressed in the above dictum of Lord Tomlin have undergone relentless assault and may even be said that is awaiting the coup de grace in the not too distant future. It appears that the pendulum has swung against tax planning and has sadly lost its momentum to swing back.
A series of successes scored by the Australian taxation Office in the Courts, not only in establishing avoidance by the taxpayers but also in excluding the application of legal professional privilege in a recent related case is a significant pointer to an uncertain future for tax planning in Australia.
The early years
The early attitude of the Australian courts is reflected in the words of Sir William Deane in the case of Federal Commissioner of Taxation v. Westraders Pty Ltd.2
"If there be, in truth, contrariety or unfairness, the fault lies with the form of the legislation of the relevant time and not with the courts whose duty it is to apply the words which the Parliament has enacted. For the court to arrogate to itself, without legislative warrant, the function of overriding the plain words of the Act in any case where it considers that overall considerations of fairness or some general policy of the Act would be best served by a decision against the taxpayer would be to substitute arbitrary taxation for taxation under the rule of law itself."
The anti-avoidance provision in Australia was contained in section 260 of the Income Tax Assessment Act 1936, which read as follows:
"Every contract, agreement or arrangement made or entered into, orally or in writing, whether before or after the commencement of this Act, shall so far as it has or purports to have the purpose or effect of in any way, directly or indirectly –
- altering the incidence of any income tax;
- relieving any person from liability to pay any income tax or make any return;
- defeating, evading or avoiding any duty or liability imposed on any person by this Act; or
- preventing the operation of this Act in any respect,
be absolutely void, as against the Commissioner or in regard to any proceeding under this Act, but without prejudice to such validity as it may have in any other respect or for any other purpose."
The wide sweep of the section was highlighted in the following statement by Knox CJ in Deputy Commissioner of Taxation v. Purcell3:
"The section, if construed literally, would extend to every transaction whether voluntary or for value which had the effect of reducing the income of any taxpayer".
Further on the question of interpreting " purpose or effect’, Fullagar J in FCT v. Newton4 said:
"the purposes or effect, which will attract its operation are stated vaguely. If we interpret it literally, it would seem to apply to cases in which it is hardly conceivable that the legislature should have had in mind."
The advent of Part IVA (General anti-avoidance rule)
There were two significant problems identified in section 260 resulting in its substitution by Part IVA:
- The interpretative rule called the "choice principle". This principle excluded the application of section 260 if the Act allowed the kind of transactions entered into in order to attract the operation of a particular provision of the Act and thus achieve a reduction in tax liability; and
- Section 260 did not require a consideration of the purpose or motive of the person entering into the transaction in determining whether there was tax avoidance.
Part IVA which is the general anti-avoidance provision is in addition to other specific anti-avoidance provisions included in the Act.
For the application of Part IVA there must have been a scheme into which the taxpayer entered into that resulted in the taxpayer gaining a tax benefit. The Part also requires that the sole or dominant purpose of entering into the scheme was to gain the tax benefit.
In order to determine the purpose of the scheme the Part lays down the following eight matters to be considered:
- The manner in which the scheme was entered into or carried out;
- The form and substance of the scheme;
- The time at which the scheme was entered into and period for which the scheme was carried out;
- The result that would have been achieved by the scheme as if the Part did not apply;
- Any changes in the financial position of the taxpayer resulting from the operation of the scheme;
- Any change in the financial position of any person connected with the taxpayer;
- Any other consequences for the taxpayer or any other person connected with the taxpayer; and
- The nature of the connection between the taxpayer and the person contemplated by (vi) above.
In determining the purpose behind the scheme regard can only be had to the above eight matters and to none other.
"Scheme" is any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforced. Unilateral arrangements are also included in schemes.
"Tax benefit" is any amount excluded from the income or a deduction allowed in an year that would not have been so if not for the scheme. This definition is wide and would in reality include almost all benefits derived in any commercial undertaking. The question whether the benefit derived is a tax benefit for the purposes of Part IVA or merely a commercial advantage has caused difficulties in the application of the Part.
There had been subsequent amendments to the definition of tax benefit broadening it. The definition now includes reduction of withholding taxes, capital losses and foreign tax credits.
The decision by the High Court in the case of FCT v. Spotless Services Ltd5 was a landmark decision in the application of the anti-avoidance provision contained in Part IVA.
The taxpayer invested excess funds in Cook Islands instead of Australia. The interest rate in the former was less than that in Australia. However the tax rate in Cook Islands was lower and there was no tax on receipt of the interest in Australia. The decision was that there was tax avoidance. The most notable conclusion by the court was that there was no need to distinguish between commercial transactions and tax avoidance. The presence of commercial reasons for the arrangement does not automatically mean that there was no tax avoidance.
In FC of T v. Consolidated Press Holdings Ltd & Anor6 , both the Federal and the High Courts agreed that the purpose of the advisers of the scheme can be attributed to the taxpayer in determining whether the taxpayer had the requisite purpose. There were two issues to be decided in that case: interest deductibility and dividend stripping.
The following emerged from the decision:
- One or more transactions in a series of transactions may form a scheme:
- Although a series of transactions has a dominant commercial purpose, some of the transactions in the series may have the tax avoidance as the dominant purpose, in which case those transactions could be declared subject to Part IVA;
- The test for the purpose is an objective test; and
- Although the Act restricts factors to be considered to the eight matters listed in the Act, the context and the surrounding circumstances may be considered.
The first two are very significant.
In the midst of judicial reprimand of tax planning schemes there were two cases in which the taxpayer position was upheld. Both were decided by the Federal Court and are on appeal to the High Court by the Commissioner.
In Eastern Nitrogen v.FCT7 and Commissioner of Taxation v. Metal Manufacturers8, the facts involved sale and lease back of industrial plant. In both cases the Federal Court held that Part IVA did not apply.
The sale and lease back arrangements of capital equipment were entered into and the taxpayer claimed the lease payments as deductions. In the case of Eastern Nitrogen, it was argued on behalf of the tax commissioner that even if the payments were deductible under another provision of the Act, Part IVA applied to the arrangement. In the lower court it was concluded that the dominant purpose of the arrangement was to gain a tax advantage. The court applied a subjective test to determine the purpose of the arrangement. The full Federal court on appeal rejected the application of the subjective test. The court reiterated the correct position as the use of an objective test for the determination whether gaining of a tax advantage was the dominant purpose in entering into the arrangement.
On appeal the full Federal court also reached the same conclusion in the case of Metal Manufacturers.
A significant factor distinguishes the facts of these cases from that of the case of Spotless Services. The arrangements in these cases were entered into in order to raise working capital to help run the businesses of the taxpayers. In the case of Spotless Services excess funds were invested in order to earn additional investment income for the business.
It is hoped that the forthcoming High Court decision will give some helpful directions.
Budplan cases and Australian Taxation Office
A series of tax planning schemes, popularly known as Budplan schemes have come under severe scrutiny by the Australian Taxation Office in recent days.
The essential steps in the plan are:
- Investors in the scheme are allowed to borrow funds for the scheme from associates of the promoters of the schemes. The loans are generally non-recourse loans. Non-recourse loan would mean that the lender of the funds will not be able to reclaim the loan by attaching the assets of the borrower.
- The terms of the loan would require that the borrower pay some principle and interest in the early years. Remaining payments to be made upon the scheme making profits
- The outlay by the investor is the amount of interest and principle repaid during the initial years. The deductions will be the outlays plus the management fee paid to the promoters of the scheme, which would be nearly equivalent to the loan amount.
Most investors were convinced that the projects would produce profits in the future years. The results of these schemes was that the participant taxpayers were able to claim amounts far in excess of the cash outlay made by them to the schemes.
A typical budplan case, Howland Rose v. Commissioner of Taxation9 was decided by the Federal court in favour of the Commissioner. The investors in the scheme invested funds using non-recourse loans. The question for decision was whether the initial investment was deductible.
On the effect of Part IVA the court said:
" ……… the Applicants acquired their respective syndicate participations objectively for the dominant purpose of obtaining the benefit of the taxation deductibility opportunities so predominantly featured in the prospectus. The Applicants participated in the process of research and development at no, or virtually no, ultimate cash shortfall, by reason of the excess or likely excess of the monetary benefits flowing in principle from the incidents of taxation deductibility over the cost of participation outlaid in cash."
Following the decision the Commissioner of Taxation has given the budplan taxpayers an opportunity to settle the matter with the tax office.
A more recent case that has buttressed the position of the Commissioner is the recently decided case of Vincent v. Commissioner of Taxation10  FCA 656.
In this case the court denied deduction for expenses incurred in a cattle breeding scheme although it was found that the taxpayer’s dominant purpose in entering into the scheme was not to gain a tax benefit. The court said:
"In my opinion, whatever the subjective purpose of (the taxpayer) and her state of knowledge about the true nature of the scheme into which she entered, a reasonable person would conclude, having regard to the eight listed factors, that those taxpayers who entered into the project did so with the dominant purpose of obtaining a tax benefit in connection with it. From an objective point of view there was little other benefit to be derived."
Access to documents and legal professional privilege
The question of legal professional privilege in taxation matters came to a head in the recent case of Clements Dunne and Bell Pty Ltd v. Commissioner of Australian Federal Police11.
Under the Act, the Commissioner has powers to refer matters for investigation by the Australian Federal Police. The police may be authorised under the Crimes Act to search premises and seize documents. These are in addition to the powers of access available to the Commissioner.
The case related to documents exchanged between accountants of the taxpayer and their legal advisers, which were seized by the Police. The accountants were the plaintiffs in the case.
Referring to the communication included in crime/fraud exception to privilege, the court said:
" …….. the communications are not limited to those in pursuit of a crime or fraud, but extend to communications in pursuit of an illegal or improper object."
This is a wide interpretation of the crime/fraud exception to privilege and in cases involving tax schemes could very well exclude privilege.
Addressing the weight of evidence required for excluding privilege under the crime/fraud exclusion, the court set the following standard:
"It is most important to explain that this case does not involve determining whether the parties have committed criminal offences. In order to find that legal client privilege does not apply, the court must be satisfied that there is evidence which gives colour to the charge, or, in other words, there is prima facie evidence that the allegation has a foundation in fact."
Read in conjunction with the earlier statement of the Court it appears that for the exclusion of the privilege prima facie evidence of illegal or improper object by the taxpayer in entering into a arrangement would be sufficient.
Ralph Reforms and Part IVA
Now for a few comments on tax reform.
Ralph Business Tax Reform Committee which was appointed to review and report on business taxation laws of Australia, among many others, recommended the following changes to Part IVA:
1. An improved "reasonable hypothesis" test
The review recommended that changes be made to the reasonable hypothesis test so that the counterfactual to a purported tax avoidance scheme reflect the commercial substance of the arrangement.
Under the current Part IVA, in order to establish that there is a tax benefit the Commissioner is required to construct a reasonable alternative transaction (counterfactual) which when compared against the arrangement entered into results in a tax benefit to the taxpayer. . If the Commissioner could not create such an alternative it will be impossible to establish a tax benefit.
The Report said this :
"Currently in order to demonstrate the existence of a tax avoidance scheme, the Commissioner of Taxation is required to construct a reasonable alternative transaction or counterfactual which does not give rise to the tax benefit. In some tax avoidance cases promoters of the schemes have argued that the reasonable alternative to the scheme may be that the taxpayer would not have done anything. The recommendation will confirm that this is not the case. For example, if the sale of property had an attached tax benefit , the alternative transaction would be construed on the basis that the sale of property, without the tax benefit, would have taken place."
According to the recommendation the taxpayer will not be able to argue that the "reasonable hypothesis" is that the taxpayer would not have done anything at all.
Australia introduced a Goods and Services tax ("GST") in July 2000. The anti-avoidance provision in relation to GST is in Division 165 of A New Tax System (Goods and Services Tax ) Act 1999. Like in the case of Part IVA the corresponding provision will apply only if the taxpayer has a GST benefit.
Section 165-10(3) states that an entity (entities are the taxable units for GST) can get a GST benefit from a scheme even if the entity or entities that entered into or carried out the scheme, or a part of the scheme could not have engaged economically in any activities that would produce an effect equivalent to the effect of the scheme.
2. An expanded "tax benefit"
The recommendation was that the current definition be expanded to include anti- reduction or deferral of tax payable, irrespective of the method used by the taxpayer in the arrangement. Benefits from arrangements to obtain rebates, credits, losses and advantages through treaty shopping would be included in the expanded definition of "tax benefit".
3. Dominant purpose test
The Review recommended the continued use of the "dominant" purpose test rather than the introduction of the "principle effect" test.
4. Single determination under Part IVA
Under this recommendation the Commissioner will be able to issue a single determination about the tax avoidance scheme without the need to issue determinations for each of the participants in the scheme.
In the evolving unfavourable climate for tax planning it is interesting to be reminded of the circumstances surrounding the introduction of Part IVA into the Act.
The explanatory memorandum that accompanied the introduction had this to say about tax avoidance and the purpose of Part IVA:
"The proposed new Part IVA, which this Bill would insert into the Principal Act, is designed to overcome these difficulties and provide - with paramount force in the income tax law- an effective general measure against those tax avoidance arrangements that - in exact though the words be in legal terms- are blatant, artificial or contrived."
Strong and clear words showing the purpose for which the legislators thought fit to introduce Part IVA.
Again the Treasurer speaking in Parliament on the Bill said:
" One possibility considered was to adopt the language of the Privy Council in the well-known decision in Newton’s case and, positive tests of inclusion having expressed, make the new provisions inapplicable to schemes entered into in the course of ordinary business or family dealings. It has been decided, however, that the better test of what is blatant, contrived or artificial is the positive one that has been adopted. That test seems best to capture the essence of the views expressed by the Privy Council which, in fact, characterised an ordinary business or family dealing as representing a situation other than one in which it can be predicated that it was implemented in the particular way so as to avoid tax."
The purpose was only to target arrangements that are blatant, contrived or artificial.
On the question of interpretation of statute law section 15 AA of the Acts Interpretation Act 1901 is relevant. It reads as follows:
"15AA Regard to be had to purpose or object of Act
In the interpretation of a provision of an Act, a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object."
It cannot however be safely argued that all business and family arrangements must be excluded from the application of Part IVA. Tax planning strategies have markedly changed and various innovative methods are being adopted to gain tax advantage. All concerned in tax administration need to act realistically so as to steer clear of extremes in dealing with tax planning. A balance must be struck that will allow taxpayers to take part in investment schemes without very little detriment to the tax base of the country.1 House of Lords  AC1
2 79 ATC 4089
3 (1921) 29CLR 464
4 (1956) 96 CLR 577
5 (1996) 34ATR 183
6 (1999) 42 ATR 575
7 (2001) 46 ATR 474
8 (2001) 46 ATR 497
9  FCA 246 (18 March 2002)
10  FCA 656
11  FCA 1858
The content of this article does not in any way constitute legal advice by the author and should not be relied on in that way. Specific professional advice should be sought about your specific circumstances.