On Friday 16 November, the Assistant Treasurer released the much-anticipated draft of legislation to amend Part IVA. These changes follow a number of defeats for the ATO which, the ATO said, demonstrated fundamental flaws in the existing design. Assuming they are enacted in their proposed form, the amendments will change several features of Part IVA but it remains to be seen whether the Courts will agree that they have the effects the government seeks. This Tax Brief examines what the new provisions change and how they are meant to work.
The operative provision of Part IVA permits the Commissioner of Taxation to undertake various remedial actions, 'where a tax benefit has been obtained ... by a taxpayer in connection with a scheme to which this Part applies ... ' Typically, the most contentious part of any dispute involving Part IVA is the argument about whether a scheme was implemented with the sole or dominant purpose of avoiding tax, but every general anti-avoidance rule must also contain a second step – the part of the rule which describes what is to be taxed instead of the transaction which the taxpayer undertook, termed the 'counterfactual' or 'alternate postulate.'
Until recently, this second issue was rarely litigated but it has recently become one of the critical questions in a number of Part IVA cases.
The way that the substitute transaction is conceived under Part IVA as currently drafted is to impose tax on a substitute – referred to in the Act as the 'tax benefit' – that seems sufficiently likely. For example, in a case where an amount of income is omitted as a result of an impugned scheme, the substitute is the –
amount [that] would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out.
In other words, the mechanism in the current Pt IVA is to identify a sufficiently likely substitute transaction and impose on the taxpayer the tax outcome that it would have generated. This is obviously a very fraught process because it involves speculating about what the taxpayer might have done. The range of things that a taxpayer might have done – but didn't – is almost unbounded, and yet it is a vital step in the operation of Part IVA.
Until recently, ascertaining the counterfactual had not been an especially contentious step. Courts appear not to have been troubled by counsel for either side with detailed arguments about the shape of the relevant analogy. That naïve world came to an end during the AXA litigation where counsel for the Commissioner initially relied on the counterfactual set out in the appeal statement and then sought to add three additional counterfactuals, arguing that at least one of these must reasonably be expected to have taken place in the absence of the scheme. The procedural skirmishes in the case ultimately proved futile but they highlighted the importance that might follow from correctly or incorrectly identifying one or more counterfactuals.
Subsequent decisions in Futuris and RCI took the matter further. A great deal of time and effort went into trying to establish that there was no reasonable counterfactual – the alternatives being argued about were simply unreasonable or failed to accomplish the same commercial outcome.
2 The Press Release of 1 March 2012
It was against this background that the outgoing Assistant Treasurer, Senator Mark Arbib, announced on 1 March 2012 that Part IVA would be revised.
The main concern in the Press Release was about the way that the jurisprudence on the meaning of 'tax benefit' had developed:
In recent cases, some taxpayers have argued successfully that they did not get a 'tax benefit' because, without the scheme, they would not have entered into an arrangement that attracted tax, Senator Arbib said.
For example, they could have entered into another scheme that also avoided tax, deferred their arrangements indefinitely or done nothing at all.
The concern was that a taxpayer, found to have acted with a purpose of avoiding tax, could nevertheless escape the operation of Part IVA by relying on the tax benefit portion of the test. The Press Release was alluding to RCI where the 'do nothing' hypothesis was the basis of the Full Court's judgment:
... in our view, if the scheme in either of its manifestations had not been entered into or carried out, the reasonable expectation is that the relevant parties would have either abandoned the proposal, indefinitely deferred it, altered it so that it did not involve the transfer by RCI of its shares in [a subsidiary] to [another group company] or pursued one or more of the other alternatives referred to in the Information Memorandum; but they would not have proceeded to have RCI transfer its shares ... to [another group company] at a tax cost of $172 million.
On this view, RCI did not obtain the tax benefit it was alleged by the Commissioner to have obtained in connection with the scheme.
The other concern expressed in the Press Release was the idea that there is a defect in how Part IVA operates when examining abusive steps within a larger non-abusive transaction:
The Government amendments will confirm that Part IVA always intended to apply to commercial arrangements which have been implemented in a particular way to avoid tax. This also includes steps within broader commercial arrangements.
It seems to be the ATO view that its failure in RCI demonstrates this problem.
3 The package of amendments
It is against this background that an Exposure Draft of amendments to Part IVA was released.
The Exposure Draft is disarmingly simple and, at the same time, inscrutably cryptic.
3.1 Re-ordering etc
The disarmingly simple parts of the draft involve the re-location, consolidation and renumbering of several parts of the existing text. For example,
- some provisions (such as dates and rules about geography) which currently appear early in Part IVA are moved to the middle;
- the rules dealing with withholding tax avoidance which had previously been isolated in a specific section are now consolidated with the other types and amounts of tax benefit;
- one of the main provisions (s 177F) in the current law is divided into a number of subsections; and one of the main provisions (s 177F) in the current law is divided into a number of subsections; and
- cross-references appearing elsewhere in the Act have to be adjusted as a consequence.
3.2 Objects clause
Another change which looks like it should be in the disarmingly simple category is the decision to add an 'objects' clause into the text to articulate its intended scope. Part IVA will now begin with the statement:
The object of this Part is to counter schemes (including schemes that are steps within or towards other schemes) that are entered into or carried out with an objectively ascertainable purpose of reducing the liability of a taxpayer to tax or withholding tax.
This passage explicitly addresses the concern in the Press Release about the need to ensure that Part IVA applies to 'steps within broader commercial arrangements.'
3.3 Influencing the speculation
The main substantive change to Part IVA effected by the draft is the insertion of a new provision the purpose of which is to intervene into the speculation into what might have happened, but didn't.
The new provision requires that the speculation be done under three new constraints.
Ignore tax considerations. First, in deciding what might have happened, the court is required to 'assume that each person ... would have acted ... without regard to any person's liability (or potential liability) to tax ... in any year of income.'
This provision is aimed squarely at the 'do nothing' problem. The logic behind this amendment is straightforward. One of the concerns with the existing drafting is that a problem arises when the size of the tax triggered by any alternatives is so large that they are, therefore, unlikely. If they are unlikely because they are potentially so expensive, under the existing provisions they cannot be the substitute to be taxed; only a substitute which is 'reasonably likely' is open. The draft amendment tries to exclude this argument by excluding the liability to tax from consideration when speculating about what might have happened but didn't. The speculation now has to be done 'without regard' to the amount of tax involved. It may still turn out to be the case that a person would not have done anything or would not have done anything yet, but that conclusion would have to be demonstrated by pointing to facts and circumstances other than the amount of tax involved.
Sometimes, excise the scheme. The draft requires a second interference with the speculation. The precise adjustment that is required varies depending upon whether or not the scheme achieves any 'non-tax effects for the taxpayer.'
Where the scheme achieves no 'non-tax effects' the court is required to 'assume that all events or circumstances that actually happened or existed but did not form part of the scheme would still have happened or existed.' This amendment appears to be directed at so-called 'paper schemes' or self-cancelling arrangements which involve no commercial outcome beyond the triggering of, say, a tax deduction or the omission of an amount of income. They are the most obvious category of avoidance – transactions which achieve only a tax consequence for the parties.
Construct a scheme with the same commercial goals. Where the scheme does achieve some 'non-tax effect' for the taxpayer, the court is instead required to assume that the relevant actors 'would have acted ... to achieve for the taxpayer the same non-tax effects' that were achieved by the scheme.
Both of these amendments attempt to constrain the speculation. In the blatant case, the court must assume that all the steps other than the contrived aspects still occurred. In the less blatant, but still apparently abusive, situation the court must instead assume that people tried to accomplish the same commercial outcomes as those that occurred. In short, in both cases, the draft is trying to insist that the speculation result in an outcome which looks substantially the same as the events that actually happened. It is likely that this will be a new area for dispute – identifying which of the commercial outcomes that actually happened have to appear in the substitute, and what is to happen when there is no other way of achieving the important commercial effects that the impugned scheme accomplished.
3.4 Completing the conceptual loop
The third adjustment to the speculation made by these amendments is an attempt to create a formal and structural link between the aspect of Part IVA which examines the relevant 'purpose' and this element which sets out the alternative that is to be taxed.
The thinking behind this adjustment points to the part of the rule which requires a finding to be made that –
... the person, or one of the persons, who entered into or carried out the scheme ... did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme ...
That finding must be based upon an analysis of the eight factors, listed in the legislation, that are indicative of artifice or contrivance. It is intuitively appealing to read this process as implicitly involving a finding about the substitute in coming to a conclusion about the taxpayer's purpose. The logic is this: there can only be a finding of a purpose of avoiding tax if the court has identified the tax position being avoided. And so when the court has concluded that a person had a purpose of avoiding tax, the court must implicitly also have identified what that avoided tax position was.
The draft inserts a provision which articulates this argument, though, interestingly, only in a case where the scheme achieves some 'non-tax effect' for the taxpayer – that is, in the less contrived class of cases. For these cases, the court must have regard to 'the [eight] matters to which regard must be had ... in deciding whether this Part applies to the scheme.'
This is perhaps the most cryptic of the amendments being proposed but it is intended to work as follows: the taxpayer is to be taxed on a substitute transaction, but that substitute now has to be constructed by examining the factors that are relevant in deciding whether an offensive purpose exists or which detract from that conclusion. These factors will show both the taxpayer's objective purpose and the alternate form in which the scheme could have been implemented and thus the transaction which is to be taxed instead.
4 Next steps
The exposure draft is being released for comment and will inevitably attract much attention. Part IVA is extremely contentious and any changes to it will be seen as only adding to the difficulties it presents for taxpayers and their advisers. That impression can only be heightened by the awareness that the Government is acting principally to stem the run of losses being sustained by the ATO in the courts. Any amendment designed to ensure that the ATO wins more Part IVA cases will automatically attract much criticism.
Interestingly, the Government has decided to try to pacify some complainants and has abandoned one feature of its March announcement which had caused much consternation – that the new provision would start from 1 March 2012. In the Press Release of 16 November, the Assistant Treasurer announced that 'the amendments will apply to arrangements that are entered into or commenced from today ... rather than from the original date of announcement, in recognition of the unique role that Part IVA plays in the income tax laws ...'
The government is seeking comments on the draft by Wednesday, 19 December 2012 and has announced that a formal Bill will be introduced into Parliament in early-to-mid 2013.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Greenwoods & Freehills are the winners of the 2011 BRW Client Choice Awards.