Income Taxation : Commentary and Materials [Eighth edition.] 9780864608345, 0864608349

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INCOME TAXATION Commentary and Materials

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INCOME TAXATION Commentary and Materials

GRAEME S COOPER Professor of Taxation Law, University of Sydney

MICHAEL DIRKIS Professor of Taxation Law, University of Sydney

MIRANDA STEWART Professor of Law, University of Melbourne and Australian National University

RICHARD J VANN Challis Professor of Law, University of Sydney

EIGHTH EDITION

LAWBOOK CO. 2017

Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668, 19 Harris Street, Pyrmont, NSW First edition 1989 Second edition 1993 Third edition 1999 Fourth edition 2002 Fifth edition 2005 Sixth edition 2009 Seventh edition 2012 Eighth edition 2017 National Library of Australia Cataloguing-in-Publication entry Creator: Cooper, Graeme S., author. Income taxation : commentary and materials / Graeme S. Cooper, Miranda Stewart, Richard J. Vann, Michael Dirkis. 8th edition Includes index ISBN 9780864608345 (pbk) Income tax – Law and legislation – Australia. Income tax – Law and legislation – Australia – Cases. Other Authors/Contributors: Stewart, Miranda, author. Vann, Richard J., author. Dirkis, M. J. (Michael J.) author. © 2017 Thomson Reuters (Professional) Australia Ltd This publication is copyright. Other than for the purposes of and subject to the conditions under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. All legislative material herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing. Requests should be submited online at www.ag.gov.au/cca, faxed to (02) 6250 5989 or mailed to Commonwealth Copyright Administration, Attorney-General’s Department, Robert Garran Offices, National Circuit, Barton ACT 2600. This edition is up to date as of 15 December 2016. Editor: Lalitha Vyamajala Product Developer: Lucas Fredrick Publisher: Robert Wilson Printed by Ligare Pty Ltd, Riverwood, NSW This book has been printed on paper certified by the Programme for the Endorsement of Forest Certification (PEFC). PEFC is committed to sustainable forest management through third party forest certification of responsibly managed forests. For more info see www.pefc.org

PREFACE This is the 8th edition of this book. We have used the preface to each edition to tell a common story – about rapid and extensive change in the tax world, the impermanence of tax law and the brief life expectancy of any book that aspires to being current. And we have made the point that tinkering with the tax system seems to be the inevitable output of frustrated and powerless politicians whose influence over the real economy and the lives of citizens is at best tangential. For this edition we can add to our customary lament, the increasing influence of external actors, especially the OECD, as a force driving rapid change to Australian tax law – no country is island when it comes to tax law. Given that stability in the tax system is never going to be the norm, we remain firmly of the view that the object of a work such as this should be about preparing readers for the future, not simply understanding the present. In the past, we have put it this way, and we continue to think the original sentiment got it just about right: … to provide students with an understanding of the dialectics of tax law, not an historical snapshot of its status at a given point in time. Tax students must learn how to understand the technical rules of legislation and how to apply judicial precedents to given hypothetical situations, but these skills are not to be acquired as ends in themselves. The technical formulae are merely examples of how Treasury and the Commissioner’s Office have chosen to implement policy decisions and the pedagogic objective of the exercise is to provide students with the ability to read, analyse and work their way through whatever rules are adopted in response to changed policy objectives. We persevere in the view that, while students must learn how to understand, manipulate and apply obscure legislative directions, case law precedents and the dictates of the tax administration, they must also know how to evaluate their conclusions critically in terms of external policy considerations then to and predict, first for their examiners and later for their clients, the likely response of the Australian Taxation Office and Treasury to their decisions. Only then can a professional properly advise on the course of action most appropriate for a taxpayer. Once again cases and articles in this edition have been heavily edited by us. While large omissions have sometimes been identified by ellipses, some less significant jumps in the text have not been explicitly marked. We have taken liberties with texts but always with the hope of ensuring that in an abbreviated form, each extract is still a clear and accurate reflection of the author’s point. We are grateful for the assistance provided by generations of students and research assistants who have helped in the preparation of this book. We also wish to thank Alexandra Mills, Sandie Vann, Kristen Walker and Helen Dirkis. We also greatly appreciate the support and contributions of the staff at Thomson Reuters, especially Lucas Frederick and Lalitha Vyamajala. This book incorporates research that was originally funded by the Australian Research Council. The law is not stated exhaustively but what there is, is stated as at an indeterminate time in mid-2016. Graeme Cooper, University of Sydney Michael Dirkis, University of Sydney Miranda Stewart, University of Melbourne and Australian National University Richard Vann, University of Sydney February 2017

v

TABLE OF CONTENTS

Preface .............................................................................................................................................. v

Abbreviations .................................................................. ......................................................................... ix Table of Cases .................................................................................................................................. xi Table of Statutes ........................................................................................................................... xxv Table of Rulings ............................................................................................................................ xlvii

Part 1. Income Tax in Context 1. Tax Policy and Process ............................................................................................ 3 2. Fundamental Principles of the Income Tax System ......................................... 35

Part 2. The Tax Base – Income and Exemptions 3. Income from Property .......................................................................................... 75 4. Income from the Provision of Services ............................................................ 139 5. Business Income .................................................................................................. 259 6. Compensation Receipts and Periodic Receipts ............................................... 351

Part 3. The Tax Base – Deductions 7. The Positive Limbs – Nexus Issues .................................................................... 395 8. Personal and Non-personal Expenses ............................................................... 455 9. Current and Capital Expenses ........................................................................... 487 10. Specific Deductions and Restrictions on Deductions .................................. 519

Part 4. Allocating Income and Deductions to Periods – Timing 11. Tax Accounting .................................................................................................. 557 12. Statutory Accounting Regimes ....................................................................... 609

Part 5. Income Derived Through Intermediaries 13. Partnerships, Trusts and Income Splitting ................................................... 691 14. Taxation of Companies and Shareholders .................................................... 747 vii

Income Taxation

15. Special Topics in Company Tax ..................................................................... .. 809

Part 6. Income Derived From International Transactions 16. Principles for Taxing International Transactions ...................................... .. 863 17. Taxation of Residents ..................................................................................... .. 909 18. Taxation of Non-residents ............................................................................. .. 921

Part 7. Tax Administration 19. Administering the Tax Regime ..................................................................... .. 949 20. Containing Tax Avoidance and Evasion ..................................................... .. 1011 Index........................................................................................................................... 1051

viii

ABBREVIATIONS AAT ABN ACOSS ADF ADJR ATO ATR BAS CAA CGT COT CTBR DCT ETP FBT FBTAA 1986 FCT FDT FIFO GST HECS IRC IT ITAA 1936 ITAA 1997 JCPA LIFO MT OECD OSSA PAYE PAYG PE PPS PR RBL RPS RSA SBT

Administrative Appeals Tribunal Australian Business Number Australian Council of Social Securities Approved Deposit Fund Administrative Decisions (Judicial Review) Act 1977 Australian Tax Office Australian Tax Reports Business Activity Statement Civil Aviation Authority Capital gains tax Continuing of ownership test Commonwealth Taxation Board of Review Deputy Commissioner of Taxation Eligible termination payment Fringe benefits tax Fringe Benefits Tax Administration Act 1986 Federal Commissioner of Taxation Franking deficit tax First-in first-out Goods and Services Tax Higher Education and Education Contribution Scheme Inland Revenue Commissioner Income Tax Ruling Income Tax Assessment Act 1936 Income Tax Assessment Act 1997 Joint Committee of Public Accounts Last-in first-out Miscellaneous Taxation Ruling Organisation for Economic Co-operation and Development Occupational Superannuation Standards Act 1987 Pay As You Earn Pay As You Go Permanent Establishment Prescribed Payments System Product Ruling Reasonable benefit limit Reporting Payments System Retirement Savings Accounts Same business test ix

Income Taxation

SIS Act SIS Regulations Syd LR TAA 1953 TBRD TD TFN TLIP TR UWALR VAT WHT

Superannuation Industry (Supervision) Act 1993 Superannuation Industry (Supervision) Regulations Sydney Law Review Taxation Administration Act 1953 Taxation Board of Review Decisions Taxation Determination Tax File Number Taxation Laws Improvement Project Taxation Ruling University of Western Australia Law Review Value added tax Withholding tax

x

TABLE OF CASES [Where an extract from a case is reproduced, the name of the case and its paragraph number appear in bold type.] A AAT Case [2006] AATA 100; (2006) 61 ATR 1192 ....................................................................... 8.185 AAT Case 10,267 (1995) 31 ATR 1027 .................................................................................... 10.225 AAT Case 10,475 (1995) 31 ATR 1328 ...................................................................................... 7.315 AAT Case 10,700 (1996) 31 ATR 1375 ...................................................................................... 8.225 AAT Case 11,523 (1996) 34 ATR 1165 ..................................................................................... 11.225 AAT Case 12 (1987) 18 ATR 3056 ........................................................................................... 10.105 AAT Case 4611 (1988) 19 ATR 3895 ........................................................................................ 11.225 AAT Case 4708 (1988) 19 ATR 4040 ....................................................................................... 20.180 AAT Case 4880 (1989) 20 ATR 3255 ......................................................................................... 3.440 AAT Case 5181 (1989) 20 ATR 3694 ........................................................................... 11.365, 11.585 AAT Case 5219 (1988) 20 ATR 3777 ....................................................................................... 20.110 AAT Case 5593 (1989) 20 ATR 3140 ......................................................................................... 5.180 AAT Case 6253 (1990) 21 ATR 3703 ......................................................................................... 3.285 AAT Case 9451 (1994) 28 ATR 1108 ......................................................................................... 3.285 AAT Case 9605 (1994) 30 ATR 1001 ......................................................................................... 7.395 AAT Case 9824 (1994) 29 ATR 1246 ......................................................................................... 4.440 AGC (Advances) Ltd v FCT (1975) 132 CLR 175 ................................................... 2.500, 7.370 AGC (Investments) Pty Ltd v FCT (1992) 92 ATC 4239 ....................................... 5.750, 5.760 ANZ Bank v FCT (1993) 25 ATR 369 ....................................................................................... 12.710 ARM Constructions v FCT (1987) 19 ATR 337 ......................................................................... 13.135 Abbott v Philbin [1961] AC 352 ............................................................................. 2.260, 4.660 Aktiebolaget Volvo v FCT (1978) 8 ATR 747; 78 ATC 4316 ........................................................ 3.610 All States Frozen Food Pty Ltd v FCT (1990) 20 ATR 1874; 90 ATC 4175 ................................... 12.50 Allen, Allen & Hemsley v DFCT [1989] FCA 125 ...................................................................... 19.440 Alliance Holdings Ltd v FCT (1981) 21 ATR 509; 81 ATC 4637 ................................................ 12.490 Allied Mills v FCT (1989) 20 ATR 457 .................................................................... 5.570, 5.580 Allsop v FCT (1965) 113 CLR 341; 39 ALJR 201 ......................................... 6.120, 6.230, 6.240 Amalgamated Society of Engineers v Adelaide Steamship Co Ltd (1920) 28 CLR 129 ............... 20.70 Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295 .................................... 7.350 Archer Brothers Pty Ltd v FCT [1953] HCA 23; (1953) 90 CLR 140 ........ 14.1020, 14.1030, 14.1040 Armco (Australia) Ltd (1948) 76 CLR 584 ................................................................................. 5.770 Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673; 14 ATD 98 .... 11.350 AusNet Transmission Group Pty Ltd v FCT [2015] HCA 25; 2015 ATC 20-521 ..... 9.25, 9.30 Australasian Catholic Assurance Co v FCT (1959) 100 CLR 502 ........................ 5.700, 5.710 Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566; 10 ATD 217 ...... 12.110, 12.120, 12.130 Automatic Totalisators Ltd v FCT (1968) 119 CLR 666 .............................................................. 6.285 Avco Financial Services v FCT (1982) 150 CLR 510 ................................................................... 5.770 Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97 ........................... 15.450, 15.460 Ayrshire Pullman Motor Services v IRC (1929) 14 TC 754 ......................................................... 20.40

B BHP-Billiton Petroleum (Bass Strait) [2002] FCAFC 433; 51 ATR 520 ........................................ 11.335 BHP Billiton Finance Ltd v FCT [2010] FCAFC 25 ............................................. 10.340, 10.350 BP Australia Ltd v FCT (1965) 112 CLR 386 ........................................... 9.130, 11.460, 11.465 BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65 ....................................... 10.105, 10.225 Babka v FCT (1989) 20 ATR 1251 ............................................................................................... 5.60 Bailey v FCT (1977) 136 CLR 214 ........................................................................................... 19.510 Baker v Campbell (1983) 153 CLR 52 ............................................................... 19.450, 19.460 xi

Income Taxation

Ballarat Brewing Co v FCT (1951) 82 CLR 364; 5 AITR 151; 9 ATD 254 .................... 11.320 Balnaves v DFCT (1985) 85 ATC 4429 .................................................................................... 19.400 Barclays Mercantile Finance Ltd v Mawson [2004] UKHL 51 ................................................... 20.190 Barnett v FCT (1999) 99 ATC 2444 ............................................................................................. 6.75 Barratt v FCT (1992) 36 FCR 222; 23 ATR 339; 92 ATC 4275 ...................................... 11.175, 11.335 Barrett v FCT (1968) 118 CLR 666 ............................................................................................ 3.585 Bellinz Pty Ltd v FCT (1998) 84 FCR 154; 98 ATC 4634 ............................................................. 19.20 Bellinz Pty Ltd v FCT 39 ATR 198 .............................................................................................. 19.50 Bennett v FCT (1947) 75 CLR 480; 4 AITR 12 .................................................................. 4.810 Bernard Elsey Pty Ltd v FCT (1969) 121 CLR 119; 1 ATR 403; 69 ATC 4126 ................ 11.590, 12.440 Beville v FCT (1953) 10 AITR 458 ............................................................................................ 13.155 Bidencope (1978) 140 CLR 533 ............................................................................................... 5.240 Binetter v DCT [2012] FCAFC 126 .......................................................................................... 19.500 Blank v FCT [2015] FCAFC 154 ................................................................................................. 4.670 Bluebottle UK Ltd v DCT (2007) 232 CLR 598; [2007] HCA 54 .......... 14.310, 14.320, 18.10 Bonnell v DCT (No 5) [2008] FCA 991 .................................................................................... 19.420 Booth v Commissioner of Taxation (1987) 164 CLR 159 ............................... 13.570, 13.580 Boulder Perseverance Ltd v Taxation, Commissioner of (WA) (1937) 4 ATD 389 ...................... 14.755 Brackenreg and FCT, Re (2003) ATC 2196 .................................................................................. 6.75 Brajkovich v FCT (1989) 89 ATC 5227 ........................................................................................ 5.60 Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195 .... 2.170, 4.730, 4.1220, 11.210, 19.200 Briggs v DFCT (1985) 85 ATC 4569 ........................................................................................ 19.400 British American Tobacco Australia Services Ltd v FCT [2010] FCAFC 130 ............................... 20.280 British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 .............................................. 9.20 British Mexican Petroleum Co Ltd v Jackson (1931) 16 TC 530 ................................................. 5.770 British South Africa Co v Varty [1965] 2 All ER 395 .................................................................... 15.50 Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 ................................................... 9.70 Brooks v FCT (2000) 44 ATR 352 .............................................................................................. 3.295 Brookton Co-operative Society Ltd v FCT [1981] HCA 28; (1981) 147 CLR 441 ...... 14.310, 14.330, 14.340 Brown v FCT (1998) 39 ATR 226 ............................................................................................... 7.395 Brown v FCT [2002] FCAFC 318 ............................................................................................... 4.205 Burrill v FCT (1996) 67 FCR 519; 33 ATR 133; 96 ATC 4629 ........................................... 2.245, 3.470 Bywater Investments Ltd v FCT [2016] HCA 45 .......................................................... 16.200, 16.215

C C of T v Consolidated Press Holdings Ltd (2001) 207 CLR 235 ............................................... 15.170 C of T v Consolidated Press Holdings Ltd (No. 1) (1999) 91 FCR 524 ..................................... 15.170 C of T (NSW) v Ash (1938) 61 CLR 263 ............................................................................ 7.210 C of T (Vic) v Phillips (1936) 55 CLR 144 ....................................................... 6.10, 6.20, 6.320 CC (NSW) Pty Ltd v FCT (1997) 34 ATR 604 ........................................................................... 20.400 CMI Services Pty Ltd v FCT (1990) 90 ATC 4428; 21 ATR 445 ........................................ 5.230, 5.750 CPH Property Pty Ltd v Commissioner of Taxation [1998] FCA 1276 ....................................... 20.310 CPT Custodian v Commissioner of State Revenue (2005) 224 CLR 98 ..................................... 13.490 CTC Resources NL v FCT 27 ATR 403 ........................................................................................ 19.60 Californian Copper Syndicate v Harris (1904) 5 TC 159 ............................................................ 5.470 Californian Oil Products v FCT (1934) 52 CLR 28 ................................................ 5.510, 5.520 Caltex Ltd (1960) 106 CLR 205 ................................................................................................ 5.770 Cameron Brae v FCT (2006) 63 ATR 488; [2006] FCA 918 ........................................................ 4.920 Campbell v CIR (NZ) (1967) 14 ATD 551 ................................................................................ 14.130 Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321 ...................................................................................................................... 13.250 Carapark Holdings Ltd v FCT (1967) 115 CLR 653 .................................................. 6.80, 6.90 Carlaw and FCT, Re (1995) 31 ATR 1190 .................................................................................. 8.225 Case 1/97 (1997) 97 ATC 101 ................................................................................................ 11.225 Case 10/94 (1994) 94 ATC 168 ................................................................................................ 8.185 Case 110 (1955) 5 CTBR (NS) 656 ........................................................................................... 18.55 Case 111 (1981) 24 CTBR(NS) 898 ........................................................................................ 20.180 xii

Table of Cases

Case 16 (1993) 93 ATC 208 ...................................................................................................... 8.185 Case 17/93 (1993) 93 ATC 214 ................................................................................................ 7.315 Case 23 (1944) 12 CTBR 379 ................................................................................................... 8.185 Case 23/94 (1994) 94 ATC 234 ................................................................................................ 7.545 Case 24/94 (1994) 94 ATC 239 ................................................................................................ 3.285 Case 26/94 (1994) ATC 258 ..................................................................................................... 7.315 Case 29/94 (1994) 94 ATC 280 ................................................................................................ 8.225 Case 41/95 (1995) 95 ATC 361 ................................................................................................ 8.105 Case 48/93 (1993) 93 ATC 520 ................................................................................................ 8.105 Case 49/95 (1995) 95 ATC 422 ................................................................................................ 7.315 Case 51/93 (1993) 93 ATC 542 ................................................................................................ 8.245 Case 58/94 (1994) 94 ATC 498 ................................................................................................ 4.440 Case 61 (1979) 23 CTBR (NS) 537 ........................................................................................... 2.175 Case 68 (1967) 13 CTBR (NS) 463 ........................................................................................... 2.205 Case 8145 (1992) 23 ATR 1243 ................................................................................................ 4.815 Case 8775 (1993) 26 ATR 1056 ................................................................................................ 18.55 Case B9 (1970) 70 ATC 42 .......................................................................................................... 8.45 Case F43 (1974) 74 ATC 245 ...................................................................................................... 8.45 Case J53 (1977) 77 ATC 468 ..................................................................................................... 8.125 Case K89 (1959) 10 TBRD 477 ................................................................................................. 8.125 Case L54 (1979) 79 ATC 399 .................................................................................................... 2.175 Case N97 (1981) 81 ATC 521 ................................................................................................... 8.185 Case R50 16 TBRD .................................................................................................................... 2.205 Case S65 (1985) 85 ATC 469 .................................................................................................... 8.125 Case S80 (1985) 85 ATC 589 .................................................................................................... 8.125 Case V142 (1988) 88 ATC 891 ................................................................................................ 11.225 Case V15 (1988) 88 ATC 177 .................................................................................................... 8.125 Case V52 (1988) 88 ATC 402 .................................................................................................... 8.185 Case V6 (1987) 87 ATC 140 ...................................................................................................... 5.305 Case V95 (1988) 88 ATC 631 .................................................................................................. 11.585 Case W27 (1989) 89 ATC 4946; AAT Case 4946; 20 ATR 3340 .................................................. 5.350 Case W57 (1989) 89 ATC 517 .................................................................................................. 3.440 Case W58 (1989) 89 ATC 524 ................................................................................................. 20.110 Case W61 89 ATC 558 ............................................................................................... 11.365, 11.585 Case X81 90 ATC 594 ............................................................................................................... 3.285 Case Z1 (1992) 92 ATC 101 ..................................................................................................... 8.105 Case Z21 (1992) 92 ATC 218 ................................................................................................... 5.595 Case Z28 (1992) 92 ATC 264 ................................................................................................. 19.290 Case Z42 (1992) 92 ATC 381 ........................................................................................ 8.105, 8.265 Case Z9 92 ATC 267 ................................................................................................................. 4.815 Cecil Bros Pty Ltd v FCT (1962) 8 AITR 523 ..................................................................... 7.450 Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430; 8 AITR 523; 13 ATD 261 ........... 7.460, 12.240, 20.120 Chamber Of Manufacturers Insurance Ltd v FCT (1984) 84 ATC 4315 ...................................... 5.720 Channel Pastoral Holdings Pty Ltd v Commissioner of Taxation [2015] FCAFC 57 ................... 20.290 Charles v FCT (1954) 90 CLR 598 ................................................................................ 5.730, 13.530 Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 ............................... 7.190, 8.10 Chevron Australia v FCT [2015] FCA 1092 .............................................................................. 16.300 Citibank v FCT (1989) 20 FCR 403; 89 ATC 4268 .......................................................... 19.480 Citibank v FCT [1989] FCA 126 .............................................................................................. 19.440 Clarke and Kann v DFCT (1983) 83 ATC 4764 ........................................................................ 19.400 Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059 ............. 2.540, 9.270 Clough Engineering Ltd and DCT, Re (1997) 35 ATR 1164 ...................................................... 20.400 Coal Developments (German Creek) Pty Ltd v FCT (2008) 71 ATR 96; [2008] FCAFC 27 ........ 15.510 Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214 ............ 3.440, 11.450 Colonial Mutual Life Assurance Society v FCT (1946) 73 CLR 604 ............................................. 6.430 Colonial Mutual Life Assurance Society Ptd Ltd v FCT (1953) 89 CLR 428 ................ 9.240 Commercial Union Australia Mortgage Insurance Co Ltd v FCT (1996) 69 FCR 331; 33 ATR 509; 96 ATC 4854 .............................................................................................................. 11.505 xiii

Income Taxation

Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373 ....................................... 5.770 Commissioner v Glenshaw Glass Co (1955) 348 US 426 ............................................................ 2.60 Condell v FCT (2007) 66 ATR 100; [2007] FCAFC 44 .......................... 14.130, 14.260, 14.270 Constable v FCT (1952) 86 CLR 402; 5 AITR 371; 10 ATD 93 ........................................ 2.190 Cooper Brookes (Wollongong) Pty Ltd v FCT (1981) 147 CLR 297 ................ 20.50, 20.100 Countess of Bective v FCT [1932] HCA 22; (1932) 47 CLR 417; 2 ATD 80 ........................ 2.70, 2.215 Country Magazine Pty Ltd v FCT (1968) 117 CLR 162; 10 AITR 573; 15 ATD 86 ....... 6.315, 11.500 Coward v FCT (1999) 99 ATC 2166 ............................................................................................ 6.75 Craven v White (1988) 62 TC 1 .............................................................................................. 20.190 Creer v FCT (1985) 16 ATR 246; 85 ATC 4104 ........................................................................ 11.460 Crommelin v DCT (1998) 39 ATR 377 .................................................................................... 13.240 Cumins [2007] FCAFC 21 ........................................................................................................... 3.30 Curran v FCT (1974) 131 CLR 409 .................................................................. 11.590, 12.445, 20.50 Cyprus Mines Corp v FCT (1978) 78 ATC 4468 ........................................................................ 8.250

D DCT v Broadbeach Properties [2008] HCA 41; (2008) 69 ATR 357 .......................................... 19.420 DCT v de Vonk (1995) 31 ATR 481 .......................................................................................... 19.500 DFC of T v Black (1990) 25 FCR 274; 101 ALR 535; 90 ATC 4699 ................ 14.130, 14.400, 14.410 DFCT v Trustees of Wheat Pool of Western Australia (1932) 48 CLR 5 ..................................... 13.305 Daihatsu Australia Ltd v FCT (2000) 46 ATR 129; [2000] FCA 1658 ......................................... 19.440 Danmark Pty Ltd v FCT (1944) 7 ATD 333 .............................................................................. 19.290 David Jones Finance and Investments Pty Ltd v FCT (1991) 21 ATR 1506; 91 ATC 4315 ........................................................................................................ 19.40, 19.260, 19.270 Dawson v IRC (1978) 78 ATC 6012 .......................................................................................... 2.245 Dean and McLean v FCT (1997) 37 ATR 52; 97 ATC 4762 ......................................................... 4.155 Delacy v FCT [2006] AATA 198 .................................................................................................. 8.230 Deloitte Touche Tohmatsu v DFCT (1998) 40 ATR 435 ............................................................ 19.490 Denlay v Commissioner of Taxation [2011] FCAFC 63 ............................................................ 19.440 Denver Chemical Manufacturing Co v FCT (1949) 79 CLR 296 .............................................. 19.220 Dibb v FCT (2004) 136 FCR 388; [2004] FCAFC 126 .............................................................. 4.1120 Dickenson v FCT (1958) 98 CLR 460 ........................................................... 4.840, 5.420, 5.430 Dingwall v FCT (1995) 30 ATR 498 ........................................................................................... 15.40 Dolby v FCT 2002 ATC 2325 .................................................................................................... 15.40 Donaldson v FCT [1974] 1 NSWLR 627; (1974) 4 ATR 530; 74 ATC 4192 ...................... 2.250, 4.270 Donoghue v FCT [2015] FCA 235 ........................................................................................... 19.280 Donovan v DFCT (1992) 92 ATC 4114 .................................................................................... 19.500 Dormer [2002] FCAFC 385; (2002) 51 ATR 353 ...................................................................... 11.490 Dwight v FCT (1992) 37 FCR 178; 23 ATR 236; 92 ATC 4192 ................................................. 13.375

E EHL Burgess Pty Ltd v FCT (1988) 88 ATC 4517 ........................................................................ 7.225 Eastern Nitrogen v FCT (2001) 45 ATR 474; 108 FCR 27; [2001] FCA 366 ..... 10.187, 9.320 Egerton-Warburton v Deputy FCT (1934) 51 CLR 568 ...... 6.370, 6.410, 6.420, 6.430, 9.210 Eisner v Macomber 252 US 189 (1920) ......................................................................... 2.50, 14.350 Elberg v FCT (1998) 38 ATR 623 ............................................................................................... 7.165 Electricity Supply Industry Superannuation (Qld) Ltd v DFCT (2003) 53 ATR 120; [2003] FCAFC 138 ........................................................................................................................ 14.950 Elmslie v FCT (1993) 46 FCR 576; 26 ATR 611; 93 ATC 4964 .................................................... 3.285 Employers Mutual Indemnity Association Ltd v FCT (1991) 91 ATC 4850 .................................. 5.750 Emu Bay Railway Co Ltd v FCT (1944) 71 CLR 596 ................................................................. 14.690 Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226 ............................................................ 20.190 Erdelyi v FCT (2007) 60 ATR 872 .............................................................................................. 3.390 Esquire Nominees v FCT (1973) 129 CLR 177 ........................................................... 16.215, 18.100 Essenbourne v FCT (2002) 51 ATR 629; [2002] FCA 1577 ......................................................... 4.640 Esso v FCT (1998) 40 ATR 76 ...................................................................................................... 8.75 xiv

Table of Cases

Esso Australia Ltd v FCT (1998) 40 ATR 76 ................................................................................ 4.560 Esso Australia Resources Ltd v FCT (1999) 43 ATR 506 ............................................................ 19.470 Europa Oil (NZ) Ltd (No 2) v IRC (1976) 5 ATR 744; 1 WLR 464 .......... 7.470, 20.50, 20.120 Evans v DCT (SA) (1936) 55 CLR 80 ....................................................................................... 14.210 Evans v FCT (1989) 20 ATR 922 .................................................................................................. 5.60 Evenden v FCT [1999] AATA 731 ............................................................................................... 7.395

F F & C Donebus Pty Ltd v FCT (1988) 19 ATR 1521 ................................................................. 10.225 F J Bloemen Pty Ltd v FCT (1981) 147 CLR 360 ...................................................................... 19.260 FCT v AGC Ltd (1984) 2 FCR 483; 15 ATR 982; 84 ATC 4642 ....................................... 11.430 FCT v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 ........................................................... 20.350 FCT v Anstis [2009] HCA 40 ...................................................................................................... 8.105 FCT v Applegate (1979) 9 ATR 899; 79 ATC 4307 ............................................ 16.150, 16.160 FCT v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49 .............................................. 10.340, 20.350 FCT v Australia & New Zealand Savings Bank (1998) 39 ATR 419 ............................................. 7.640 FCT v Australian Gas Light Co (1983) 15 ATR 105; 83 ATC 4800 ............................... 11.300 FCT v Bamford (2010) 240 CLR 481 ....................................................................................... 13.400 FCT v Batagol (1963) 109 CLR 243 ........................................................................................ 19.220 FCT v Blake (1984) 15 ATR 1006; 84 ATC 4661 .............................................................. 4.125, 6.405 FCT v Brand (1995) 31 ATR 326 ..................................................................................... 5.190, 7.315 FCT v Brian Hatch Timber Co (Sales) Pty Ltd (1972) 128 CLR 28 ............................................ 19.510 FCT v Broken Hill Pty Co Ltd (2000) 45 ATR 507 ............................................................ 3.430, 9.355 FCT v CSR Ltd (2000) 104 FCR 44; 45 ATR 559; [2000] FCA 1513 ...................... 2.300, 5.410, 6.120 FCT v Citibank Ltd (1993) 44 FCR 434; 26 ATR 423; 93 ATC 4691 .... 11.550, 11.560, 12.55, 12.710 FCT v Clark (2011) 190 FCR 206 ............................................................................................ 13.500 FCT v Collings (1976) 76 ATC 4254 ............................................................................................ 8.45 FCT v Comber (1986) 10 FCR 88; 17 ATR 413; 86 ATC 4171 .................................................... 4.700 FCT v Commercial Nominees of Australia Ltd (2001) 47 ATR 220 ............................................ 13.500 FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281 ............................................................... 9.100 FCT v Consolidated Media Holdings Ltd [2012] HCA 55 ................................ 14.150, 14.160 FCT v Consolidated Press Holdings Ltd (2001) 207 CLR 235; [2001] HCA 32 ......... 15.180, 20.270, 20.310 FCT v Cooke (2004) 55 ATR 183; [2004] FCAFC 75 .................................................................. 20.20 FCT v Cooke and Sherden (1980) 10 ATR 696; 80 ATC 4140 ......... 1.320, 2.230, 4.30, 5.280 FCT v Cooling (1990) 90 ATC 4472 .......................................................................................... 5.640 FCT v Coombes (1999) 42 ATR 356 ........................................................................................ 19.470 FCT v Cooper (1991) 21 ATR 1616 ................................................................................ 8.190, 8.225 FCT v Creer (1986) 86 ATC 4318 .............................................................................................. 7.630 FCT v Cyclone Scaffolding Pty Ltd (1987) 87 ATC 5083 ............................................................ 5.490 FCT v Dalco (1990) 20 ATR 1370; 90 ATC 4088 ...................................................................... 19.350 FCT v Day (2008) 236 CLR 163; 70 ATR 14; [2008] HCA 53 ........................................... 7.160 FCT v Dixon (1952) 86 CLR 540; 5 AITR 443 ...................................... 4.80, 6.10, 6.330, 6.340 FCT v Donoghue [2015] FCAFC 183 ...................................................... 19.280, 19.285, 19.495 FCT v Dunn (1989) 20 ATR 356; 89 ATC 4141 ........................................................................ 11.175 FCT v Edwards (1994) 28 ATR 87 .............................................................................................. 8.185 FCT v Efstathakis (1979) 9 ATR 867 ......................................................................................... 18.200 FCT v Email Ltd (1999) 42 ATR 698 .......................................................................................... 9.100 FCT v Emmakell Pty Ltd (1990) 21 ATR 346 .............................................................................. 5.190 FCT v Energy Resources of Australia (2003) 135 FCR 346; [2003] FCAFC 314 ........................... 12.50 FCT v Energy Resources of Australia Ltd (1996) 185 CLR 66 ...................................................... 3.440 FCT v Equitable Life & General Insurance Co Ltd (1990) 90 ATC 4438 ...................................... 5.750 FCT v Everett (1980) 143 CLR 440; 80 ATC 4076 .......................................... 13.250, 13.375, 13.570 FCT v Finn (1961) 106 CLR 60 ....................................................................... 7.270, 8.10, 8.120 FCT v Firstenberg [1977] VR 1; (1976) 6 ATR 297; 76 ATC 4141 ................................ 11.150 FCT v Firth (2002) 50 ATR 1 ............................................................................................... 7.520 FCT v Forsyth (1981) 148 CLR 203 .................................................................................... 8.160 FCT v Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278 ................................................................ 5.790 xv

Income Taxation

FCT v Futuris Corporation [2012] FCAFC 32 ........................................................................... 20.320 FCT v Futuris Corporation Ltd (2008) 69 ATR 41; [2008] HCA 32 ............................................ 19.280 FCT v GKN Kwikform Services Pty Ltd (1991) 91 ATC 4336 ...................................................... 5.490 FCT v Guest (2007) 65 ATR 815; [2007] FCA 193 ..................................................................... 7.395 FCT v Gulland, Watson, Pincus (1985) 160 CLR 55; 85 ATC 4765 ................... 4.940, 13.590, 20.240 FCT v Guy (1996) 67 FCR 68; 32 ATR 590; 96 ATC 4520 .......................................................... 3.295 FCT v Gwynvill Properties Pty Ltd (1986) 13 FCR 138 ............................................................... 7.630 FCT v Harris (1980) 10 ATR 869; 80 ATC 4238 ........................................................ 4.70, 4.110 FCT v Hart [2004] HCA 26 ...................................................................................................... 20.260 FCT v Hatchett (1971) 125 CLR 494 .......................................................................... 8.10, 8.90 FCT v Holmes (1995) 58 FCR 151; 31 ATR 71; 95 ATC 4476 .......................................... 4.170 FCT v Hyteco Hiring Pty Ltd (1992) 24 ATR 218; 92 ATC 4694 ....................................... 5.470, 5.490 FCT v Ilbery (1981) 12 ATR 563 ........................................................................ 7.310, 7.630, 20.190 FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579; 10 ATD 240 ................... 11.390 FCT v Janmor Nominees (1987) 19 ATR 254; 87 ATC 4813 ..................................................... 13.395 FCT v Jenkins (1982) 12 ATR 745; 82 ATC 4098 ...................................................................... 16.175 FCT v Kurts Development Pty Ltd (1998) 39 ATR 493 .................................... 12.190, 12.200 FCT v La Rosa (2002) 50 ATR 450 ............................................................................................. 7.170 FCT v La Rosa (2003) 129 FCR 494; 53 ATR 1; [2003] FCAFC 125 ....................... 5.350, 5.355, 7.170 FCT v Lacelles-Smith (1978) 78 ATC 4162 ................................................................................ 8.105 FCT v Lamesa Holdings BV (1997) 36 ATR 589 ........................................................................ 16.100 FCT v Lau (1984) 6 FCR 202; 16 ATR 55; 84 ATC 4929 ...................... 5.190, 11.460, 12.605, 20.230 FCT v Lenzo (2008) FCR 255; [2008] FCAFC 50 ....................................................................... 20.20 FCT v Levy (1961) 106 CLR 448 ............................................................................................... 7.225 FCT v Ludekins [2013] FCAFC 100 ......................................................................................... 20. 210 FCT v M I Roberts (1992) 92 ATC 4781 ..................................................................................... 8.105 FCT v Macquarie Bank Ltd [2013] FCAFC 13 .......................................................................... 20.290 FCT v Maddalena (1971) 2 ATR 541 ......................................................................................... 7.320 FCT v Manchester Unity IOOF (1994) 94 ATC 4235 and 4309 .................................................. 7.425 FCT v McClelland (1969) 118 CLR 353; 1 ATR 31 .................................................................... 11.590 FCT v McDonald (1987) 18 ATR 957 ...................................................................... 13.80, 13.90 FCT v McNeil (2007) 229 CLR 656; [2007] HCA 5 .................. 3.420, 14.130, 14.300, 14.350, 15.50 FCT v McPhail (1968) 117 CLR 111 .......................................................................................... 8.250 FCT v Midland Railway Company of Western Australia Ltd (1952) 85 CLR 306 ........................ 14.690 FCT v Mitchum (1965) 113 CLR 401 ......................................................................... 18.200, 18.240 FCT v Mochkin [2003] FCAFC 15; (2003) 52 ATR 198 ................................................ 13.590, 20.380 FCT v Montgomery (1999) 198 CLR 639 .................................................................................. 5.660 FCT v Murphy (1961) 106 CLR 146 ........................................................................................ 12.430 FCT v Murry (1998) 39 ATR 129; 98 ATC 4585 ......................................................................... 3.285 FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 ...... 2.60, 5.360, 5.370, 6.10 FCT v NF Williams (1972) 127 CLR 226; 3 ATR 283; 72 ATC 4188 ........................................... 11.590 FCT v National Commercial Banking Corp of Australia Ltd (1983) 72 FLR 116 ........................ 10.330 FCT v Orica Ltd (1998) 39 ATR 66; 98 ATC 4494 ............................. 3.50, 3.130, 5.770, 5.780 FCT v Patcorp Investments Ltd (1976) 140 CLR 247 .................. 14.80, 14.90, 19.40, 19.280 FCT v Payne (2001) 46 ATR 228 ....................................................................................... 8.40, 10.30 FCT v Peabody (1994) 123 ALR 451 ....................................................................................... 20.390 FCT v Phillips (1978) 36 FLR 399; 8 ATR 783 ...................................................... 7.560, 20.120 FCT v Pitcher (2005) 146 FCR 344; [2005] FCA 1154 ............................................................. 4.1120 FCT v Prestige Motors Pty Ltd (1998) 38 ATR 568 ................................................................... 13.460 FCT v QANTAS [2014] FCAFC 168 ............................................................................................ 4.450 FCT v Rabinov (1983) 83 ATC 4437 .......................................................................................... 8.250 FCT v Radnor Pty Ltd (1991) 91 ATC 4689 ............................................................................... 5.750 FCT v Ramsden (2005) 58 ATR 485 ......................................................................................... 13.380 FCT v Raymor (1990) 24 FCR 90; 21 ATR 458; 90 ATC 4461 ..................................................... 12.50 FCT v Reynolds (1981) 11 ATR 629; 81 ATC 4131 ............................................ 19.290, 19.300 FCT v Roberts & Smith (1992) 37 FCR 246; 23 ATR 494; 92 ATC 4380 ......... 13.140, 13.150 FCT v Rothmans of Pall Mall (Australia) Ltd (1992) 23 ATR 620 ................................................. 9.185 FCT v Rowe (1997) 187 CLR 266 ................................................................. 4.155, 6.250, 6.260 FCT v Rozman [2010] FCA 324 ............................................................................................... 14.370 xvi

Table of Cases

FCT v Ryan (2000) 201 CLR 109; [2000] HCA 4 ...................................................................... 19.220 FCT v Seven Network [2016] FCAFC 70 .................................................................................. 18.185 FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 7 ATR 726; 77 ATC 4365 ......... 3.610, 18.170 FCT v Slater Holdings Ltd [1984] HCA 78; (1984) 156 CLR 447 .................... 14.190, 14.200 FCT v Slaven (1984) 1 FCR 11 ........................................................................... 6.60, 6.70, 6.320 FCT v Sleight (2004) 136 FCR 211; [2004] FCAFC 94 ......................................... 5.120, 5.180, 20.20 FCT v Smith (1981) 147 CLR 578 ............................................................................ 6.100, 6.110 FCT v Snowden and Willson Pty Ltd (1958) 99 CLR 431 ...................................... 7.70, 7.110 FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645 ............. 7.490, 7.500, 20.50 FCT v Spedley Securities Ltd (1988) 19 ATR 938 ............................................................ 5.380, 6.120 FCT v Spotless Services Ltd [1996] HCA 34 ............................. 20.250, 20.330, 20.340, 20.380 FCT v Squatting Investment Co Ltd (1954) 88 CLR 413 ............................ 4.30, 5.280, 5.290 FCT v St Hubert’s Island Pty Ltd (1978) 138 CLR 210; 8 ATR 452; 78 ATC 4101 ..... 12.260, 12.310 FCT v Star City Pty Ltd [2009] FCAFC 19 .......................................................................... 9.170 FCT v Stone (2005) 222 CLR 289; [2005] HCA 21 ..................................... 4.160, 5.140, 6.365 FCT v Studdert (1991) 91 ATC 5006 .............................................................................. 7.640, 8.105 FCT v Subrahmanyam (2001) 116 FCR 180; 49 ATR 29 .......................................................... 16.170 FCT v Sun Alliance Investments Pty Ltd (in liq) (2005) 222 ALR 286 ........................................ 14.210 FCT v Sydney Refractive Surgery Centre Pty Ltd (2008) 172 FCR 557; [2008] FCAFC 190 .......................................................................................................................... 6.40 FCT v Tasman Group Services Pty Ltd (2009) 180 FCR 128 ..................................................... 10.340 FCT v The Myer Emporium Ltd (1987) 163 CLR 199 .............................................................. 15.715 FCT v Thiel (1990) 171 CLR 338 ................................................................ 18.40, 18.50, 18.280 FCT v Totledge (1982) 12 ATR 8309 ....................................................................................... 13.375 FCT v Tully Co-operative Sugar Milling Association Ltd (1983) 14 ATR 495 ............................. 10.180 FCT v Uther [1965] HCA 42; (1965) 112 CLR 630 ............... 14.280, 14.290, 14.300, 14.1010 FCT v Vogt (1975) 75 ATC 4073 ................................................................................................. 8.40 FCT v Wade (1951) 84 CLR 105 ................................................................................................ 6.140 FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 ................................... 10.70, 10.80 FCT v Westraders Pty Ltd (1980) 144 CLR 55 ...................................................... 20.30, 20.60 FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 ....... 5.210, 5.220, 10.40, 11.530, 11.540, 11.570, 11.590, 12.440, 20.70 FCT v Woite (1982) 31 SASR 223; 13 ATR 579; 82 ATC 4578 ........................................ 4.850 FCT v Woolcombers (1993) 27 ATR 302; 93 ATC 5170 .............................................................. 12.50 Fairway Estates Pty Ltd v FCT (1970) 123 CLR 153 ............................................. 5.160, 5.170 Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255 ............ 2.160, 5.260, 5.270, 15.715 Ferguson v FCT (1979) 9 ATR 873 .............................................................................. 5.60, 5.70 Ferris v FCT (1988) 20 FCR 202; 19 ATR 1705; 88 ATC 4755 ............................ 4.690, 14.440 First Provincial Building Society Ltd v FCT (1995) 30 ATR 207 ......................... 5.330, 5.340 Fletcher v FCT [1991] HCA 42; (1991) 173 CLR 1 .................... 7.640, 20.150, 20.160, 20.170 Fowler v FCT (2008) 167 FCR 425; [2008] FCA 528 ................................................................ 4.1220 Freeman v FCT (1983) 14 ATR 457 .............................................................................. 4.1120, 7.380 French v FCT (1958) 98 CLR 398 ............................................................................................ 18.200 Fullerton v FCT (1991) 91 ATC 4983 ........................................................................................... 8.45 Furniss v Dawson [1984] 2 WLR 226 ...................................................................................... 20.190

G G v CIR (NZ) [1961] NZLR 994 ................................................................................................. 5.155 GE Capital Finance v FCT (2007) 159 FCR 473; 66 ATR 447 ...................................................... 16.80 GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124 ..................... 5.310, 5.320 Gair v FCT (1944) 71 CLR 388; 7 ATD 443 ................................................................... 2.170, 13.585 Gandy Timbers Pty Ltd v FCT (1995) 95 ATC 4167 ................................................................... 7.545 Gas Lighting Improvement Co Ltd v IRC [1923] AC 723 ........................................................... 14.20 Gilbert v FCT [2010] AATA 882 ................................................................................................. 8.230 Gillespie v FCT (2001) 49 ATR 1012; [2001] AATA 1009 .......................................................... 4.1120 Giris Pty Ltd v FCT (1969) 119 CLR 365 ............................................................ 19.370, 19.380 xvii

Income Taxation

Glenboig Union Fireclay Co v IRC (1922) 12 TC 427 ................................ 5.550, 5.560, 6.150 Gray v FCT (1989) 20 ATR 649 ............................................................................................... 20.110 Grollo Nominees Pty Ltd v FCT (1997) 36 ATR 424 .................................................... 13.135, 20.110 Guinea Airways Ltd v FCT (1949) 83 CLR 584; 5 AITR 58; 9 ATD 197 ...................................... 12.380 Gwynvill Properties v FCT (1986) 13 FCR 138; 17 ATR 344; 86 ATC 4512 ............................... 11.460

H HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 .......................................... 6.210, 6.220 HW Coyle Ltd v IRC (NZ) (1980) 11 ATR 122; 80 ATC 6012 .................................................... 11.550 Hallstroms Pty Ltd v FCT (1946) 72 CLR 634; 3 AITR 436 ............................................... 9.50, 11.465 Hance v FCT [2008] FCAFC 196 ............................................................................................... 5.120 Handley v FCT (1981) 148 CLR 182 .................................................................................. 8.140 Haritos v Commissioner of Taxation [2015] FCAFC 92 ............................................................ 19.330 Harris v FCT (2002) 125 FCR 46; [2002] FCAFC 226 ................................................................. 4.920 Hayden v FC of T (1996) 33 ATR 352; 96 ATC 4797 ................................................................ 13.395 Hayes v FCT (1956) 96 CLR 47 .................................................................................... 4.10, 4.40 Heaton v Bell [1970] AC 728 .................................................................................................... 2.175 Heavy Minerals v FCT (1966) 115 CLR 512 ................................................ 5.530, 5.540, 6.150 Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 ...... 6.315, 11.130, 11.270, 11.480, 12.350 Henry Jones (IXL) Ltd v FCT (1991) 91 ATC 4663 ...................................................................... 5.415 Hepples v FCT (1991) 22 ATR 465; 91 ATC 4808 ......................................... 3.150, 3.160, 6.55 Hepples v FCT (No 2) (1992) 173 CLR 492; 22 ATR 852 ................................................ 3.150, 4.860 Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 ......................................... 7.70, 7.90 Higgs v Olivier [1951] 1 Ch 899 ........................................................................... 4.830, 4.1125 Hobart Bridge Co v FCT (1951) 82 CLR 372 ............................................................................. 15.10 Hobbs v FCT (1957) 98 CLR 151; 6 AITR 490 ......................................................................... 13.590 Hochstrasser v Mayes [1960] AC 376 .......................................................................................... 2.80 Howard v FCT [2014] HCA 21 .................................................................................................. 2.215 Howland-Rose v FCT (2002) 118 FCR 61; [2002] FCA 246 .................................. 5.120, 5.180, 20.20 Hunter Douglas Ltd v FCT (1983) 14 ATR 629 .......................................................................... 5.770 Hurley Holdings (1989) 20 ATR 1293 ........................................................................................ 3.440

I ICI Australia v FCT (1994) 29 ATR 233 (Ryan J); (1996) 33 ATR 174 ........................................... 5.770 IRC v Blott [1921] 2 AC 171 ................................................................................................... 14.350 IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482 ............................................................. 9.25 IRC v Burmah Oil Co Ltd [1982] STC 30 ................................................................................. 20.190 IRC v Duke of Westminster [1936] AC 1 ................................... 13.460, 20.50, 20.120, 20.130 IRC v Falkirk Ice Rink (1975) 51 TC 42 ...................................................................................... 5.305 IRC v Forrest (1924) 8 TC 704 .................................................................................................. 15.20 IRC v McGukian [1997] UKHL 22 ............................................................................................ 20.190 IRC v Scottish Provident Institution [2004] UKHL 52 ............................................................... 20.190 IRC v Sir John Oakley (1925) 9 TC 582 ..................................................................................... 15.20 IRC v Warnes & Co [1919] 2 KB 444 ........................................................................................... 7.70 IRC v Wattie [1999] 1 WLR 873 ................................................................................................ 5.660 IRC v von Glehn & Co Ltd [1920] 2 KB 553 ................................................................................ 7.70 IRC (NZ) v Mitsubishi Motors (NZ) Ltd (1995) 31 ATR 350; 95 ATC 4711 ............................... 11.360 IRG Technical Services Pty Ltd v FCT (2007) 165 FCR 57; [2007] FCA 1867 ............................ 4.1220 Idlecroft Pty Ltd v FCT (2004) 56 ATR 699 .............................................................................. 13.460 Ikea Ltd v Canada (1998) 1 SCR 196 ........................................................................................ 5.660 Ilbery’s case [1981] FCA 188 .................................................................................................. 12.540 Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396 .... 10.150, 10.180 Indooroopilly Children Services Qld v FCT (2006) 63 ATR 106; [2006] FCA 734 and on appeal (2007) 158 FCR 325; [2007] FCAFC 16 .................................................................... 4.640 Industrial Equity Ltd v DFCT [1990] HCA 46 ........................................................................... 19.430 xviii

Table of Cases

Inland Revenue, Commissioners of v Burmah Oil Co Ltd (1981) 54 TC 200 .............................. 6.205 International Business Machines v FCT [2011] FCA 335 .......................................................... 18.185 International Nickel Australia Ltd v FCT (1977) 137 CLR 347 .................................................... 5.770 Investment and Merchant Finance Corporation Ltd v FCT (1971) 125 CLR 249 .......... 12.320, 15.10, 15.110, 20.50

J J & G Knowles v FCT (2000) 44 ATR 22 ....................................................................... 4.420, 14.435 J & G Knowles, Re (2000) 45 ATR 1101 ..................................................................................... 4.420 J Rowe & Son Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157 ................ 12.40 James v United States (1961) 366 US 213 ................................................................................ 5.350 John v FCT (1989) 116 CLR 417; 20 ATR 1; 89 ATC 4101 .............................. 11.590, 20.190, 20.200 John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 ................................................................ 9.90 Jones v FCT (2002) 49 ATR 188 ................................................................................................ 7.395 Jones v Leeming [1930] AC 415 ...................................................................................... 3.10, 20.70 Jupiters Ltd v Deputy FCT (2002) 50 ATR 236 ........................................................................... 9.160 Just v FCT (1949) 8 ATD 419 ........................................................................ 6.430, 6.440, 9.230

K Kafataris v FCT (2008) 172 FCR 242; [2008] FCA 1454 ........................................................... 13.490 Kajewski v FCT (2003) 52 ATR 455; [2003] FCA 258 ................................................................. 4.640 Keily v FCT (1983) 83 SASR 494 ............................................................................. 6.380, 6.390 Kelly v FCT (1985) 16 ATR 478; 85 ATC 4283 ........................................................................... 4.160 Kennedy Holdings and Property Management Pty Ltd v FCT (1992) ATR 321 ........................... 9.185 Knight-Ridder Newspapers v United States (1984) 743 F 2d 781 ............................................ 11.100 Knuckey v FCT [1998] FCA 1143 ............................................................................................ 19.430 Kordan Pty Ltd v FCT (2000) 46 ATR 191 ................................................................................ 20.390 Krampel Newman Partners Pty Ltd v FCT (2003) 126 FCR 561; [2003] FCA 123 ....................... 20.20 Kratzmann’s Hardware Pty Ltd v FCT (1985) 16 ATR 274; 85 ATC 4138 .................................. 12.430 Kwikspan Purlin Systems Pty Ltd v FCT (1984) 84 ATC 4282 ............................ 5.620, 5.630

L L’Estrange v FCT (1978) 9 ATR 410; 78 ATC 4744 ................................................................... 19.210 Lamesa Holdings v FCT [1997] FCA 134 ................................................................................. 18.280 Lancey Shipping Co Pty Ltd v FCT (1951) 9 ATD 267 ............................................................. 19.290 Lau v FCT (1984) 84 ATC 4618 ................................................................................................. 7.630 Law Shipping Co v Inland Revenue 1924 SC 74 ..................................................................... 10.105 Lawford v C of T (NSW) (1937) 1 AITR 89 ................................................................................ 5.420 Lawrence v FCT [2009] FCAFC 29 .......................................................................................... 15.190 Le Grand v FCT (2002) 124 FCR 53; [2002] FCA 1258 ............................................................ 4.1120 Leary v FCT (1980) 80 ATC 4438 .............................................................................................. 8.250 Lees & Leach v FCT (1997) 36 ATR 137 .................................................................................... 5.660 Leighton v FCT [2011] FCAFC 96 .............................................................................. 13.300, 13.375 Liftronic Pty Ltd v FCT (1996) 96 FCR 175 ................................................................................ 6.120 Lighthouse Philatelics Pty Ltd v FCT (1991) 22 ATR 707; 91 ATC 4942 .................................... 19.290 Lilyvale Hotel Pty Ltd v FCT [2009] FCAFC 21 .................................................. 15.490, 15.500 Lindsay v FCT (1961) 106 CLR 377 ......................................................................................... 10.105 Lodge v FCT (1972) 128 CLR 171 .............................................................................................. 8.60 Lomax v Peter Dixon (1943) 25 TC 353 ................................................................ 3.440, 3.450 London Australia Investment Co Ltd v FCT (1977) 138 CLR 106 ........... 5.730, 5.740, 15.10 London and Thames Haven Oil Wharves Ltd v Attwooll [1967] Ch 772 .................................... 6.205 Lonsdale Sand and Metal Pty Ltd v FCT (1998) 38 ATR 384 .................................................... 14.130 Lunney v FCT (1958) 100 CLR 478 .................................................................... 8.10, 8.30, 8.60

xix

Income Taxation

M MIM Holdings Ltd v FCT (1997) 36 ATR 108 ........................................................ 5.440, 5.450 MLC Ltd v FCT (2002) 51 ATR 283 ......................................................................... 1.330, 1.340 MNR v Anaconda American Brass Ltd [1956] AC 85 ................................................................ 12.110 MacCormack v FCT [2001] FCA 1700 ..................................................................................... 19.440 MacFarlane v FCT 86 ATC 4477 ................................................................................. 14.130, 14.240 Macniven v Westmoreland Investments Ltd [2001] UKHL 6 .................................................... 20.190 Macquarie Finance Ltd v FCT (2004) 57 ATR 115; [2004] FCA 1170 ........................... 14.680, 20.380 Macquarie Finance Ltd v FCT (2005) 146 FCR 77; 61 ATR 1; [2005] FCAFC 205 ..................... 14.680 Madad (1984) 15 ATR 1118 ........................................................................................................ 7.70 Madad Pty Ltd v FCT (1984) 84 ATC 4115 .................................................................................. 7.70 Magna Alloys & Research Pty Ltd v FCT (1980) 49 FLR 183 ................................ 7.70, 7.130 Malayan Shipping Co Ltd v FCT (1946) 71 CLR 546 ....................................... 16.180, 16.190 Mallalieu v Drummond [1983] BTC 380 ................................................................................... 8.185 Mansfield v FCT (31) ATR 367 ................................................................................................... 8.185 Martin v FCT (1953) 90 CLR 470 ................................................................................ 5.40, 5.50 Martin v FCT (1984) 2 FCR 260 ........................................................................................... 8.60 Martin v FCT (1993) 27 ATR 282 .............................................................................................. 8.265 Martin v Lowry [1927] AC 312 ................................................................................................. 5.210 Mayne Nickless Ltd v FCT (1984) 84 ATC 4458 .......................................................................... 7.70 McCauley v FCT (1944) 69 CLR 235; 3 AITR 67 ........................................................................ 3.580 McClelland (1970) 120 CLR 487 .............................................................................................. 5.240 McCurry v FCT (1998) 39 ATR 121 ........................................................................................... 5.230 McDermott Industries (Aust) Pty Ltd v FCT (2005) 59 ATR 358 ............................................... 18.190 McGrouther v FCT [2015] FCAFC 34 ...................................................................................... 19.310 McIntosh v FCT (1979) 10 ATR 13; 79 ATC 4325 .................................................................... 4.1100 McLaurin v FCT (1961) 104 CLR 381; 8 AITR 180; 1 ATD 273 ...... 2.280, 2.290, 6.120, 6.250 Memorex Pty Ltd v FCT (1987) 87 ATC 5034 ........................................................................... 5.490 Meredith v FCT (2002) 50 ATR 528 ........................................................................................ 20.390 Millar v Commissioner of Taxation [2015] FCA 1104 ............................................................... 20.180 Millar v Commissioner of Taxation [2016] FCAFC 94 .............................................................. 20.180 Mills v FCT [2012] HCA 51 ...................................................................... 14.960, 14.970, 20.310 Modern Permanent Building & Investment Society (in liq) v FCT (1958) 98 CLR 187 ............. 12.320 Moneymen Pty Ltd v FCT (1991) 91 ATC 4019 .................................................... 6.450, 6.460 Montgomery v FCT (1998) 38 ATR 186 .................................................................................... 5.660 Montgomery v FCT (1999) 198 CLR 639; [1999] HCA 34 ..................................... 2.60, 5.670 Moriarty v Evans Medical Supplies [1958] 1 WLR 66 ................................................................. 6.205 Morris v FCT (2002) 50 ATR 104 ............................................................................................... 8.185 Morrison and Commissioner of Taxation, Re [2015] AATA 114 ................................................ 20.180 Murray v Imperial Chemical Industries Ltd [1967] Ch 1038 ............................. 3.590, 3.600 Mutual Acceptance Ltd v FCT (1984) 15 ATR 1238; 84 ATC 4831 .................................. 3.455, 5.770

N NF Williams (1972) 127 CLR 226 ............................................................................................ 13.220 National Australia Bank v FCT (1993) 46 FCR 252; 26 ATR 503; 93 ATC 4914 ........................... 4.520 National Bank of Australasia v FCT (1968) 118 CLR 529 ............................................................ 5.720 National Revenue, Minister of v Olva Diana Eldridge [1964] CTC 545 ........................................ 7.75 Naval, Military & Airforce Club of South Australia (Inc) v FCT (1994) 28 ATR 161 ..................... 3.265 Newton v FCT (1958) 98 CLR 1 ................................................................................................ 20.30 Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031 .......................................................................................................... 11.410 Norman v FCT (1963) 109 CLR 9 ........................................................................................... 13.570

O O’Connell v FCT (2002) 121 FCR 562; [2002] FCA 904 ............................................................ 5.680 xx

Table of Cases

O’Reilly v Commissioners of the State Bank of Victoria (1982) 13 ATR 706; 153 CLR 1; 57 ALJR 130 .................................................................................................... 19.20, 19.450, 19.460 O’Reilly, Re; Ex parte Australena Investments Pty Ltd (1983) 15 ATR 162; 83 ATC 4807 ........... 19.310 Oakey Abbattoir Pty Ltd v FCT (1984) 15 ATR 1059 ................................................................ 20.190 Official Receiver v FCT (case) (1956) 96 CLR 370; 6 AITR 331; 11 ATD 119 ............................. 12.440 Ogilvy & Mather v FCT (1990) 21 ATR 841; 90 ATC 4836 ....................................................... 11.455 Orica v FCT [2001] FCA 1344; (2001) 48 ATR 588 .................................................................... 3.285 Ounsworth v Vickers Ltd [1915] 3 KB 267 ................................................................................... 9.20

P P and P, In the Marriage of (1985) FLC 79,911 ....................................................................... 19.430 PBL Marketing v FCT (1985) 85 ATC 4416 ................................................................................ 9.100 Packer v DFCT (1984) 84 ATC 4666 ........................................................................................ 19.470 Parke Davis & Co v FCT (1959) 101 CLR 521 ......................................................................... 18.100 Patcorp Investments v FCT (1976) 140 CLR 247 ..................................................................... 12.320 Paykel v FCT (1994) 49 FCR 41; 28 ATR 92; 94 ATC 4176 ......................................................... 4.860 Payne v FCT (1994) 28 ATR 58; 94 ATC 4191 ............................................................................ 4.180 Payne v FCT (1996) 66 FCR 299; 32 ATR 516; 96 ATC 4407 ..................... 2.205, 4.180, 4.190 Peabody v FCT (1992) 24 ATR 58 ........................................................................................... 20.110 Peabody v FCT [1993] FCA 74 ................................................................................................ 20.380 Peabody v FCT [1994] HCA 43 .................................................................................. 20.260, 20.290 Pech and Federal Commissioner of Taxation, Re [2001] AATA 573 ............................................. 9.100 Permanent Trustee Co of NSW Ltd v FCT (1940) 2 AITR 109; 6 ATD 5 ......................... 2.170, 11.200 Perron Investments v Deputy Commissioner of Taxation (WA) (1989) 20 ATR 1299 ................ 19.440 Perrott v DCT (1925) 40 CLR 450 ........................................................................................... 11.580 Peterson v FCT (1960) 106 CLR 395 .................................................................. 13.200, 13.210 Philip Morris Ltd v FCT (1979) 10 ATR 44; 79 ATC 4352 ............................................. 12.160 Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 ..................................... 7.390 Point v FCT (1970) 119 CLR 453 ..................................................................................... 10.310 Poole & Dight v FCT (1970) 122 CLR 427 ......................................................... 13.120, 13.130 Pratt Holdings Pty Ltd v FCT (2004) 136 FCR 357; [2004] FCAFC 122 .................................... 19.490 Prebble v FCT (2003) 131 FCR 130; [2003] FCAFC 165 ............................................................ 4.920 Pridecraft and Spotlight Stores v FCT (2004) 55 ATR 745; [2004] FCA 650 and on appeal (2004) 58 ATR 210; [2004] FCAFC 339 ................................................................................ 4.640 Primary Health Care Ltd v Commissioner of Taxation [2010] FCA 419 .................................... 10.175 Princi v FCT (2008) 68 ATR 938; [2008] FCA 441 ...................................................................... 20.20 Puzey v FCT (2002) 51 ATR 616 .............................................................................................. 20.390 Puzey v FCT (2003) 131 FCR 244; [2003] FCAFC 197 ......................................... 5.120, 5.180, 20.20

R RAC Insurance Pty Ltd v FCT (1990) 90 ATC 4737 .................................................................... 5.750 RCI v FCT [2011] FCAFC 104 .................................................................................................... 17.60 RCI Pty Ltd v Commissioner of Taxation [2011] FCAFC 104 ....................................... 20.350, 20.360 Raftland Pty Ltd v FCT (2008) 238 CLR 516; 68 ATR 170; [2008] HCA 21 .................. 13.460, 20.180 Rapistan Canada Limited v MNR (1974) 48 DLR (3d) 613 .......................................................... 3.75 Re Esso Australia Ltd v FCT (1998) 38 ATR 1160; 98 ATC 2085 .................................................. 4.560 Read v Commonwealth (1988) 176 CLR 57 ............................................................................ 13.530 Registrar of the Accident Compensation Tribunal v FCT (1993) 178 CLR 145; 26 ATR 353; 93 ATC 4835 ...................................................................................................................... 13.305 Remuneration Planning Corporation v FCT (2001) 46 ATR 400; [2001] ATC 4130 ..................... 19.20 Reseck v FCT (1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213 ....................................................... 2.550 Reuter v FCT (1993) 27 ATR 256; 93 ATC 5030 ............................................................... 4.790 Roads and Traffic Authority of NSW v FCT (1993) 43 FCR 223; 26 ATR 76; 93 ATC 4508 .................................................................................................................................. 4.360 Roche Products v FCT (2008) 70 ATR 703 ............................................................................... 16.300 Rolls-Royce Ltd v Jeffrey [1962] 1 WLR 425 .............................................. 5.600, 5.610, 6.205 Ronpibon Tin NL v FCT (1949) 78 CLR 47 .................................................... 7.360, 7.420, 8.60 xxi

Income Taxation

Rose v FCT (1951) 84 CLR 118 ............................................................................ 13.170, 13.180 Rotherwood v FCT (1996) 32 ATR 276 ...................................................................................... 5.660 Rowe & Son Pty Ltd v FCT (1971) 124 CLR 421 ....................................................................... 12.30 Russell v FCT (2009) 74 ATR 446 ............................................................................................. 18.215 Rutledge v IRC (1929) 14 TC 490 ............................................................................................. 5.210

S SNF Australia [2011] FCAFC 74 ............................................................................................... 16.300 Saffron v FCT (1991) 22 ATR 131 .............................................................................................. 5.350 Saffron v FCT (No 2) (1991) 22 ATR 307 ................................................................................... 5.350 St George Bank Ltd v FCT [2009] FCAFC 62 ........................................................................... 14.680 Sanctuary Lakes Pty Ltd v FCT [2013] FCAFC 50 ..................................................................... 19.530 Saunders v Vautier (1841) 4 Beav 115; 49 ER 282 ...................................................... 13.375, 13.490 Scanlan v Swan (1983) 83 ATC 4112 ...................................................................................... 19.500 Schokker v FCT (1998) 38 ATR 91 ............................................................................................. 7.165 Scoble v Secretary of State for India [1903] AC 299 .......................................... 3.500, 6.410 Scott v Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215 ......... 2.20, 4.750, 6.10 Scott v FCT (1966) 117 CLR 514 ................................................................................. 4.10, 4.60 Seabright v FCT (1998) 40 ATR 1160; [1998] AATA 985 .......................................................... 4.1120 Selleck v FCT (1997) 36 ATR 558 .............................................................................................. 5.660 Service v FCT [2000] FCA 188 .................................................................................................. 7.575 Sharkey v Wernher [1956] AC 58 ............................................................................................ 12.430 Shepherd v FCT (1965) 113 CLR 385 ..................................................................................... 13.570 Slutzkin v FCT (1977) 140 CLR 314 ................................................................... 15.150, 15.160 Smith v FCT (1987) 164 CLR 513 ............................................................................. 4.10, 4.140 Snook v London West Riding Investments Ltd [1967] 2 QB 786 .............................................. 20.180 Snow v DFCT (1987) 18 ATR 439; 87 ATC 4078 ...................................................................... 19.420 Softex Industries, Re [2002] AATA 1232 .................................................................................... 5.345 Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101 ................................................................. 5.180 Sommer v FCT [2002] FCA 1205 .............................................................................................. 6.125 Southern Estates Pty Ltd v FCT (1967) 117 CLR 481 ................................................................. 5.180 Southwestern Indemnities Ltd v Bank of New South Wales and FCT [1973] HCA 52 ............... 19.440 Spotless Services Ltd v FCT (1993) 25 ATR 334 ............................................... 16.260, 16.270 Spriggs v FCT; Riddell v FCT [2009] HCA 22 ......................................................... 7.320, 7.330 Stanton v FCT (1955) 92 CLR 630; 6 AITR 216 ......................................................................... 3.580 Starrim Pty Ltd v FCT (2000) 44 ATR 487 .................................................................................. 4.420 State Chamber of Commerce and Industry v Commonwealth (1987) 163 CLR 329 .................. 1.300 Steele v Commissioner of Taxation (1996) 31 ATR 510 .................................................. 7.290, 9.340 Steele v DFC of T (1999) 41 ATR 139 ..................................................................... 7.300, 9.350 Steinberg v FCT (1975) 134 CLR 640 ....................................................................................... 5.240 Stergis v FCT (1988) 88 ATC 4442 .......................................................................................... 19.500 Stewart v FCT (1973) 3 ATR 603 ..................................................................................... 10.480 Stone v FCT (2002) 51 ATR 297; [2002] FCA 1492 ........................................................ 5.130, 6.365 Stone v FCT (2003) 130 FCR 299; [2003] FCAFC 145 .................................................... 5.130, 6.365 Stone v FCT (2005) 222 CLR 289; [2005] HCA 21 .................................................................... 5.130 Strick v Regent Oil Co Ltd [1966] AC 295 ....................................................................... 9.150 Strong & Co Ltd v Woodifield [1906] AC 448 ............................................................................. 7.80 Summers [2008] AATA 152 ....................................................................................................... 3.390 Summons (Kenneth A) Pty Ltd v FCT 86 ATC 4979 ................................................................. 14.130 Sun Alliance Investments Pty Ltd (in liq) v FCT (2005) 225 CLR 488; [2005] HCA 70 .............. 15.120 Sun Newspapers Ltd v FCT (1938) 61 CLR 337 ........................................................ 9.20, 9.40 Sunraysia Broadcasters Pty v FCT (1991) 91 ATC 4530 .............................................................. 9.100 Sweetman v CIR (1996) 34 ATR 209 ......................................................................................... 7.220

T TNT Skypak International (Aust) Pty Ltd v FCT (1988) 19 ATR 1067 .......................................... 5.790 Taneja v FCT [2009] AATA 87 .................................................................................................. 4.1230 xxii

Table of Cases

Task Technology v FCT [2014] FCAFC 113 ................................................................. 18.185, 18.280 Taxation, Commissioner of v Consolidated Media Holdings [2012] HCA 55 .............................. 15.80 Taxation, Commissioner of v Sara Lee Household & Body Care (Australia) Pty Ltd [2000] HCA 35; (2000) 201 CLR 520; 44 ATR 370; 2000 ATC 4378 ........ 3.270, 3.280 Taxation (WA), Commissioner of v Boulder Perseverance Ltd (1937) 58 CLR 223 .................... 14.680 Taxation (WA), Commissioner of v Newman (1921) 29 CLR 484 ............................................ 12.250 Taxes (SA), Commissioner of v Executor Trustee & Agency Co of SA Ltd (Carden’s case) (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 ..................................... 11.110 Taxes (Vic), Commissioner of v Phillips (1936) 55 CLR 144 ......................................... 4.770 Taxpayer and Federal Commissioner of Taxation [2013] AATA 3 ................................................ 8.230 Taylor v DFCT (1970) 119 CLR 444 .................................................................... 13.330, 13.340 Tech Mahindra v FCT [2015] FCA 1082 ..................................................................... 16.240, 18.230 [2016] FCAFC 130 .................................................................................................................. 18.230 Tennant v Smith [1892] AC 150 .................................................................................... 2.220, 4.250 Texas Co (Australasia) Ltd (1940) 63 CLR 382 .......................................................................... 5.770 Thiel v FCT (1990) 171 CLR 338; 21 ATR 531 ......................................................................... 16.100 Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834 ..................................... 16.240, 16.250 Tikva Investments Pty Ltd v FCT (1972) 128 CLR 158 .................................... 13.220, 13.230 Tilley v Wales [1943] AC 386 .................................................................................................... 2.295 Tinkler v FCT (1979) 79 ATC 4641 .............................................................................................. 6.75 Traknew Holdings Pty Ltd v FCT (1991) 21 ATR 1478; 91 ATC 4272 ....................................... 13.450 Trautwein v FCT (1936) 56 CLR 63 ............................................................................ 19.200, 19.530 Trevisan v FCT (1991) 21 ATR 1649 ........................................................................................ 20.110 Truesdale v FCT (1970) 120 CLR 353 ..................................................................................... 13.590 Trustees of Estate Mortgage Fighting Fund Trust v FCT (2000) 45 ATR 7 ............... 13.360, 13.370 Trustees of the Lisa Marie Walsh Trust v FCT (1983) 14 ATR 399 ............................................. 13.590 Tubemakers of Australia Ltd v FCT (1993) 25 ATR 183 .............................................................. 4.350 Tyco Australia Pty Ltd v FCT (2007) 67 ATR 63 .......................................................................... 9.175

U Unilever Australia Securities Ltd v FCT (1994) 28 ATR 422 (Spender J); (1995) 30 ATR 134 ........ 5.770 Unisys Corporation v FCT (2002) 51 ATR 386 ......................................................................... 16.100 United Aircraft Corporation v FCT (1943) 68 CLR 525 ............................................................ 18.100 United Dominion Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1 ........................................ 13.65 United Energy v FCT (1997) 78 FCR 169 .................................................................................... 9.60 United States v Kirby Lumber Co (1931) 284 US 1 ................................................................... 5.770 Ure v FCT (1981) 50 FLR 219 ............................................................................................. 7.590

V VBI v Federal Commissioner of Taxation [2005] AATA 683 ......................................................... 8.240 Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 ............................................................... 9.20 Van den Berghs Ltd v Clark [1935] AC 431 .................................................................... 6.150, 6.160 Vestey v IRC [1962] Ch 861 ..................................................................................... 3.520, 6.410 Vincent v FCT (2002) 124 FCR 350; [2002] FCAFC 291 ................................................. 5.120, 5.180 Vincent v FCT (2002) 50 ATR 20 ............................................................................................. 20.390 Virgin Blue v FCT [2010] FCAFC 137 ......................................................................................... 4.450

W W D & H O Wills (Aust) Pty Ltd v FCT (1996) 32 ATR 168 ....................................................... 20.110 W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67 .................................... 7.240, 11.465 W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58 ............................................ 10.90, 10.100 WD & HO Wills (Australia) Pty Ltd v FCT (1996) 32 ATR 168 ................................................... 20.400 WT Ramsay Ltd v IRC [1982] AC 300 ...................................................................................... 20.190 Walsh Bay Developments Pty Ltd v FCT (1995) 31 ATR 15; 95 ATC 4378 ................................ 13.375 Walstern v FCT (2003) 138 FCR 1; [2003] FCA 1428 ................................................................. 4.920 xxiii

Income Taxation

Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1 .................... 10.150, 10.160, 10.170 Warner Music Australia v FCT (1996) 34 ATR 171 ........................................................... 6.285, 6.310 Western Gold Mines NL v C of T (WA) (1938) 59 CLR 729 ........................................................ 5.250 Westfield v FCT (1991) 21 ATR 1398 ......................................................................................... 5.380 Westpac Banking Corporation v FCT (1996) 32 ATR 479; 96 ATC 4366 ..................................... 4.370 Westpac Banking Corporation v FCT (1996) 70 FCR 52; 34 ATR 143; 96 ATC 5021 .... 4.340 Whitaker v FCT (1998) 82 FCR 261; 38 ATR 219; 98 ATC 4285 ................................................... 6.75 White v FCT (1969) 120 CLR 191 ............................................................................................. 3.585 Whitfords Beach Pty Ltd v FCT (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 ...................... 11.585 Wilkins v Rogerson [1961] Ch 133 ............................................................................................ 2.245 Willingale v International Commercial Bank Ltd [1978] AC 834 .............................................. 12.330 Woolcombers Pty Ltd v FCT (1993) 25 ATR 487; 93 ATC 4342 ................................................ 11.460

X XCO Pty Ltd (1971) 124 CLR 343 ............................................................................................. 5.240

Z Zarin v Commissioner (1990) 916 F.2d 110 .............................................................................. 5.795 Zobory v FCT (1995) 64 FCR 86; 30 ATR 412; 95 ATC 4251 .................................. 2.70, 2.215, 5.350

xxiv

TABLE OF STATUTES s 231: 14.80 s 254A: 15.60 s 254K: 15.60 s 254S: 14.800 s 254T: 14.210, 14.220, 14.530 s 254SA: 14.190 s 256B: 14.250

COMMONWEALTH A New Tax System (Australian Business Number) Act 1999: 19.90 s 5: 19.90 s 7: 19.90 s 8(2): 19.90 s 28: 19.90 s 38: 19.90 s 41: 19.90

Crimes Act 1914: 19.440 s 3E: 19.440, 19.450 s 4AA: 20. 210 s 10: 19.450

A New Tax System (Commonwealth–State Financial Arrangements) Act 1999: 1.305

Family Law Act 1975 Pt VIIIA: 3.335

A New Tax System (Goods and Services Tax) Act 1999 Div 129: 12.750 Div 132: 12.750

Federal Court Rules O 52B, r (v): 19.510 Foreign Account Tax Compliance Act: 16.430

Acts Interpretation Act 1901: 1.330, 20.70, 20.90 s 15AA: 16.100, 20.90, 20.110 s 15AB: 16.100, 20.90, 20.110

Freedom of Information Act 1982: 19.40, 19.510 ss 32 to 47: 19.510 s 36: 19.510 s 37(1)(a): 19.510 s 37(1)(b): 19.510 s 37(2): 19.510 s 38: 19.510 s 41: 19.510 s 42: 19.510 s 43(1): 19.510 s 45(1): 19.510

Administrative Appeals Tribunal Act 1975 s 29(7): 19.320 s 33: 19.330 s 37: 19.400, 19.510 s 44: 19.330 Administrative Decisions (Judicial Review) Act 1977: 19.400 s 5: 19.400, 19.420 s 6: 19.400 ss 8 to 10: 19.400 s 13: 19.400 Sch 1: 19.400

Fringe Benefits Tax Act 1986: 1.300, 12.450 Fringe Benefits Tax Assessment Act 1986: 1.300, 4.250, 4.320, 4.330, 4.350, 4.430, 4.440, 4.530, 8.75 s 5B: 4.320 s 5B(1B): 4.600 s 5B(1C): 4.600 s 5C(3): 4.600 s 5C(4): 4.600 s 5E(3): 4.620 s 6: 4.330 s 7(1): 4.440 s 7(2): 4.440 s 7(2A): 4.440 s 7(3): 4.440 s 7(4): 4.370, 4.440 s 8(2): 4.440 s 8(3): 4.440 s 9(1): 4.440 s 9(2)(a): 4.440 s 9(2)(c)(ii): 4.440, 4.445 s 10: 4.440

Bills of Exchange Act 1909: 3.440 Broadcasting Act 1942: 9.100 Commonwealth of Australia Constitution Act 1901: 1.300 s 51(ii): 1.300 s 53: 1.300 s 55: 1.300, 19.530 s 75: 19.260 s 90: 1.305 s 96: 1.305 s 99: 1.300 Convention on Mutual Administrative Assistance in Tax Matters: 16.430 Corporations Act 2001: 5.120, 14.10, 14.30, 14.80, 14.130, 14.210, 14.310 s 44: 14.220 s 202-45(e): 14.530 xxv

Income Taxation

Fringe Benefits Tax Assessment Act 1986 — cont s 10(3): 4.440 ss 10A to 10B: 4.440 s 14: 4.460 s 14ZZM: 19.420 s 14ZZR: 19.420 s 16: 4.460 s 17: 4.460 s 18: 4.460, 4.510 s 19: 4.510, 4.520 s 19(1): 4.510 s 20: 4.155, 4.375, 8.265 s 22: 4.350, 4.555 s 24: 8.265 s 30(1)(b): 4.520 s 39A: 4.450 s 39A(1)(f): 4.450 s 39B: 4.450 s 39C: 4.450 s 39D: 4.450 s 39E: 4.450 s 39AA: 4.450 s 39AB: 4.450 s 39DA: 4.450 s 39FA: 4.450, 4.640 s 39GA: 4.450 s 39GB: 4.450 s 40: 4.155, 4.375 s 41: 4.375, 4.555 s 42: 4.480 s 42(1)(a)(i): 4.480 s 42(1)(a)(ii): 4.480 s 42(1)(a)(iii): 4.480 s 42(1)(b): 4.480 s 42(1)(c): 4.480 s 43: 4.480 s 44: 4.480, 4.520 s 45: 4.155, 4.375 s 47(2): 4.350, 4.560, 8.70 s 47(3): 4.560 s 47(4): 4.560 s 48: 4.490 s 49: 4.490 s 52: 4.490, 4.520 s 58A: 4.500 s 58B: 4.500 s 58C: 4.500, 4.555 s 58D: 4.500 s 58F: 4.500 s 58G: 2.450, 4.450 s 58G(2): 2.450 s 58H: 4.500 s 58P: 4.500 s 58X: 4.525 s 58X(2): 4.525 s 58Z: 4.500 s 58GA: 4.450 s 62: 4.500 s 65J(2A): 4.610

s 65J(1): 4.610 s 66: 2.450, 4.320, 4.590 s 66(1): 4.320, 4.430 s 72: 19.190 s 135M: 4.620 s 135P(2): 4.620 s 136: 4.380, 4.390, 4.440, 4.450, 4.480 s 136(1): 4.45, 4.65, 4.95, 4.125, 4.330, 4.350, 4.370, 4.380, 4.390, 4.450, 4.530, 4.670, 4.705, 4.865, 4.920, 5.300, 12.705 s 136(1)(ha): 4.670 s 148: 4.390 s 148(1): 4.45, 4.390 s 148(3): 4.370 s 150: 4.375 s 158: 4.380 s 159: 4.380 Pt IIA: 4.590, 4.600 Pt III: 4.490, 4.510 Pt III, Divs 2 to 11: 4.330 Pt IVC: 19.420 Div 2: 4.330 Div 3: 4.330 Div 4: 4.330 Div 5: 4.330 Div 6: 4.330 Div 7: 4.330 Div 8: 4.330 Div 9: 4.330 Div 9A: 4.330, 4.470, 8.210 Div 10: 4.330, 4.470 Div 10A: 4.330, 4.450 Div 11: 4.330 Div 12: 4.330 Div 13: 4.500 Div 14: 4.500 Divs 2 to 12: 4.500 Income Tax Act 1986 s 5: 2.310 Income Tax (Arrangements with the States) Act 1978: 1.305 Income Tax Assessment Act 1922: 19.200 s 4(d): 6.430 Income Tax Assessment Act 1936: 2.10, 2.320, 2.330, 2.340, 2.360, 2.370, 2.380, 2.430, 2.470, 2.550, 3.10, 3.40, 3.120, 3.210, 3.255, 3.320, 4.840, 4.920, 5.310, 6.290, 7.460, 8.75, 8.240, 11.10, 11.510, 12.420, 12.530, 13.50, 13.250, 13.260, 13.300, 13.320, 13.450, 15.700, 16.80, 17.110, 18.100, 19.50, 20.30, 20.70, 20.110, 20.240 s 4(2): 18.280 s 6: 12.420, 12.440, 16.230, 19.220 s 6(1): 3.610, 4.10, 5.30, 13.300, 14.50, 14.80, 14.130, 14.135, 14.140, 14.260, 14.280, 14.310, 14.370, xxvi

Table of Statutes

Income Tax Assessment Act 1936 — cont 14.420, 14.535, 15.320, 16.120, 16.130, 16.175, 16.220, 18.40, 18.170, 18.190 s 6(4): 14.820 s 6D: 14.140 s 6BA: 14.350, 14.840 s 6CA: 16.240, 18.20 s 7: 18.40 s 11S(2): 16.240 s 12(1): 2.350 s 14ZU: 19.260 s 16: 19.400 s 17A(4): 18.110 s 19: 2.170, 2.205, 11.200 s 20(1): 2.220 s 21: 2.220, 14.130 s 21A: 1.320, 2.250, 4.380, 5.280, 5.300, 5.305, 5.660, 8.210, 10.510 s 21A(1): 5.300 s 21A(2): 5.300 s 21A(3): 5.300 s 23(1): 7.260 s 23(1)(a): 7.280, 7.340 s 23J: 3.440 s 23L: 4.530 s 23L(1A): 2.450, 4.530 s 23M: 4.530 s 23AH: 16.240, 16.290, 17.40, 17.45, 17.60, 17.100, 17.170, 18.40 s 23AH(15): 16.80 s 23AI: 17.120 s 23AJ: 17.50, 17.60 s 25: 4.160, 4.250, 4.780, 5.570, 5.660, 5.770, 6.60 s 25(1): 2.550, 3.10, 4.30, 4.45, 4.180, 4.250, 4.1080, 5.210, 5.490, 6.60, 6.450, 19.290 s 25A: 2.410, 3.10, 5.240, 5.770, 11.510, 12.30, 12.300, 12.320, 12.430, 12.440 s 25A(1A): 5.240, 5.770 s 25A(1): 5.200 s 26AAAA: 4.250 s 26AAAB: 4.250 s 26: 6.290 s 26(a): 3.10, 5.200, 5.210, 5.240, 5.490, 5.730, 11.590, 19.290, 20.70 s 26(b): 13.450 s 26(d): 2.550, 4.700, 4.890, 4.1080, 4.1190 s 26(e): 2.100, 2.180, 2.240, 2.410, 4.10, 4.30, 4.45, 4.130, 4.150, 4.155, 4.160, 4.180, 4.250, 4.270, 4.660, 4.1080, 5.280, 8.260 s 26(f): 2.410 s 26(g): 5.310 s 26(j): 6.120, 6.290, 6.300 s 26(k): 6.290 s 26(l): 6.290 s 26C: 3.440 s 26BB: 3.470, 11.510, 13.550 xxvii

s 26BB(4): 15.50 s 26BB(5): 15.50 s 26AAA: 2.100, 3.10, 5.200, 19.290 s 26AAA(1A): 5.200 s 26AAB: 4.250, 4.380 s 26AAB(14): 4.380 s 26AAB(15): 4.380 s 26AAC: 4.250, 4.270, 4.660, 4.670 s 27A: 4.125, 4.760, 4.1080 s 27A(1): 6.445, 12.705 s 27H: 3.480, 3.485, 4.120, 4.890, 4.1040, 4.1080, 6.370, 6.405, 6.410, 6.430, 7.640, 11.180, 20.160 s 27H(1): 6.370 s 27H(1)(b): 4.125 s 27H(2): 6.370, 6.445 s 27H(4): 3.480 ss 28 to 37: 12.20 s 31(1): 12.220 s 31C: 7.650, 12.240, 19.390 s 36: 12.250, 13.170 s 36(1): 12.270, 12.430 s 36A: 13.190, 20.50 s 44: 2.410, 3.420, 14.180, 14.210, 14.260, 14.280, 14.330, 14.500, 14.570, 14.620, 14.720, 14.830, 14.1020, 15.20, 15.80, 15.320, 15.330, 17.100 s 44(1): 3.420, 4.680, 4.700, 11.180, 14.130, 14.135, 14.140, 14.370, 16.240, 18.100, 18.120, 18.130 s 44(1)(b): 14.640 s 44(1A): 14.210 s 44(1B): 14.830 s 44(2): 11.590 s 44(2) to (4): 15.330 ss 44(5) and (6): 15.330 s 45: 14.840 s 45A: 14.840, 14.845, 18.130, 20.200 s 45A(5): 14.840 s 45B: 14.840, 14.845, 15.320, 15.330, 18.130 s 45B(8): 14.840 s 45B(9): 14.840 s 45C: 14.840 s 45C(3): 14.840 ss 45 to 45C: 14.535 s 46: 14.450, 15.100, 15.110, 15.120, 19.260 s 46A: 15.120 s 46B: 15.120 s 46FA: 14.650 s 46FB: 14.650 s 47: 14.280, 14.1000, 14.1020, 14.1030 s 48: 2.320 s 51: 8.110 s 51(1): 7.10, 7.140, 7.280, 7.360, 7.410, 7.440, 7.460, 7.550, 7.570, 7.600, 7.630, 7.640, 8.150, 8.175, 9.340, 20.160 s 51(2): 12.30

Income Taxation

s 82KL: 10.580, 12.600, 12.605, 20.200, 20.230 ss 82KZC to 82KZJ: 7.600 s 82KZL: 12.550 s 82KZL(2): 12.550 ss 82KZL to 82KZO: 11.460 s 82KZM: 11.465, 12.450, 12.530, 12.540, 12.550, 12.580, 12.590, 12.595 s 82KZM(1)(ba)(ii): 12.550 s 90: 13.110, 13.390 ss 90 to 92: 13.250 s 91: 13.110 s 92: 13.110, 13.590 s 92(2AA): 13.270, 13.275 s 94: 13.590 s 94(1)(a): 13.590 s 94D(2): 13.270 s 94D(3): 13.270 s 94D(4): 13.270 s 94D(5): 13.270 s 94J: 13.260 s 94K: 13.260 s 94P: 13.265 s 95: 13.390 s 95(2): 16.220 s 95A(1): 13.380 s 95A(2): 13.320, 13.350, 13.360, 13.460, 13.470 s 95B: 13.460 s 95AAD: 13.555 s 96: 2.215, 13.320, 13.375 s 97: 13.320, 13.390, 13.420 s 97(1): 13.400 s 97(2): 13.460 s 98: 13.320, 13.390, 13.420, 13.430, 13.460, 13.555 s 98(1): 13.390 s 98(2): 13.390 s 98(2)(aa): 13.460 s 98(4): 13.460 s 98A: 13.460 s 98B: 13.460 s 99: 13.320, 13.390, 13.395, 13.420, 13.440, 19.370, 19.390 s 99A: 13.320, 13.330, 13.360, 13.390, 13.395, 13.400, 13.420, 13.440, 13.460, 13.590, 19.360, 19.370, 19.390 s 99A(2): 13.440 s 99A(3): 13.440 s 99B: 13.450, 17.150, 17.155 ss 99B to 99D: 13.450 s 100: 13.390 s 100A: 20.180, 20.200 s 100A(6A): 13.460 s 100A(1): 13.460 s 100A(5): 13.460 ss 100A(7) to (12): 13.460 s 100A(13): 13.460 s 100AA: 13.460

Income Tax Assessment Act 1936 — cont ss 51(2) to (2A): 12.20 s 51(4): , 7.650 s 51(4A): 4.590 s 51AE: 4.470 s 51AH: 6.310 s 51AK: 10.550 s 51AAA: 2.540, 7.600 s 51AEA: 4.470 s 52A: 12.320 s 53AA: 6.290 s 54(2): 10.150 s 57AF: 11.550 s 59: 5.490, 13.170 s 59AA: 13.190 s 63: 5.160 s 63(3): 6.290 s 63E: 10.370 s 63E(3)(a): 10.370 s 63E(3)(b): 10.370 s 63F: 10.370 s 64A: 7.140 s 65: 10.470 s 69(2): 6.290 s 70B: 3.470, 13.550 s 70B(4): 12.500 s 72(2): 6.290 s 73B: 10.440 s 74(2): 6.290 s 75: 5.180 s 78(1)(c): 4.700 s 78A: 8.250 s 80: 11.50 s 80B(5): 20.90 s 80E: 15.440 s 82: 2.520, 10.110, 11.510 s 82KZMD: 7.650, 12.530 s 82KZMA: 12.530, 12.560 s 82KZMF: 12.530, 12.540, 12.570 s 82KZME: 12.530, 12.540, 12.570 s 82KZMD(2): 12.560 s 82KZME(2): 12.570 s 82KZMB(3): 12.560 s 82KZME(3): 12.570 s 82KZME(5): 12.570 s 82KZME(9): 12.570 ss 82KZMA to 82KZMD: 12.540 s 82A: 8.100 ss 82A to 82K: 8.250 ss 82C to 82CE: 18.130 s 82AA: 8.250 s 82AF(2)(a): 3.375 s 82KH(1B): 12.600 s 82KH(1D): 12.600 s 82KH(1F): 12.600 s 82KH(1AD): 12.600 s 82KH(1): 12.600 ss 82KH to 82KL: 7.510, 12.580, 20.230 s 82KJ: 10.580, 12.600, 20.200, 20.230 s 82KK: 10.580, 12.590, 12.595, 20.230 xxviii

Table of Statutes

ss 128B(9A) to (9C): 18.160 s 128B(2): 18.140 s 128B(3)(h)(ii): 18.110 s 128B(3)(ga): 14.640, 14.650, 18.130 s 128B(5): 18.140 ss 128B(6) to (9): 18.140 s 128D: 14.650 s 128F: 18.140 s 128AC: 14.745, 18.195 s 128AE: 18.150 s 128FA: 18.140 s 128GB: 18.150 s 136: 7.480 s 159GZZZP: 15.70 s 159GZZZR: 15.70, 15.90 ss 159GZZZQ(1) to (4): 15.95 ss 159H to 159Z: 8.250 s 159J: 2.360 s 159J(1B): 2.365 s 159N: 6.380 s 159P: 2.365, 8.240 s 159T: 8.100 s 159GP(1): 3.480, 12.490 s 159GP(3): 12.490 s 159GP(10): 3.480 s 160AAAA: 6.380 s 160APHM: 14.920 s 160APHT: 14.920 s 160APHD: 14.920 s 160APHE: 14.920 s 160APHU: 14.930 s 160APHL: 14.930 s 160APHR: 14.930 s 160A: 3.50, 3.210 s 160M: 3.120 ss 160M(1) to (5): 3.120 ss 160M(1) to (7): 3.120 s 160M(6): 3.150, 3.210, 4.860 s 160M(7): 3.150, 3.170, 3.210, 4.860 s 160N: 3.120 s 160U: 3.40, 3.270 s 160ZA(4): 12.700 s 160ZI: 3.135 s 160ZO: 2.410 s 160ZS: 20.110 s 160AAA: 6.380 s 161: 19.180 s 161A: 19.35, 19.180 s 161A(2): 19.180 s 161AA: 19.180 s 162: 19.180 s 163: 19.180 s 166: 19.190 s 166A: 19.190, 19.250 s 167: 19.200, 19.210 s 168: 19.200 s 170: 6.315, 11.40, 11.50, 12.50, 19.190, 19.220 s 170(1): 19.220 ss 170(2) to (4): 19.220

Income Tax Assessment Act 1936 — cont s 101: 13.380, 13.450 s 101A: 5.420, 11.100 s 102: 13.500, 13.590 s 102AAZD: 17.140 s 102(1)(a): 13.590 s 102M: 13.540 s 102N: 13.540 s 102P: 13.540 s 102Q: 13.540 s 102R: 13.540 s 102AC: 13.430 s 102AE: 13.430 s 102AG: 13.430 s 102CA: 13.570 ss 102MA to 102MD: 13.545 s 102NA: 13.545 s 102UG: 13.460 s 102UH: 13.460 s 102UK: 13.460 s 102UM: 13.460 s 102UT: 13.460 s 102AAH: 17.150 s 102AAL: 17.145 s 102AAM: 17.155 s 102AAT: 17.140, 17.150 s 102AAT(a)(i)(C): 17.145 s 102AAT(a)(i)(D): 17.145 s 102AAU: 17.140 s 102AAU(2): 17.140 s 102AGA: 13.430 s 103A: 14.40, 14.370 s 108: 4.680, 14.400 s 109: 4.10, 4.210, 4.350, 4.680, 4.700, 4.705, 4.1080, 7.250, 7.540, 7.545, 10.450, 14.420, 14.440 s 109A: 14.370 s 109C: 14.370 s 109D: 14.370 s 109E: 14.380 s 109F: 5.795, 14.370 s 109J: 14.380 s 109K: 14.380 s 109L: 14.370, 14.380 s 109M: 14.380 s 109N: 14.380, 14.420 s 109R: 14.370 s 109Y: 14.390 s 109CA: 14.370 s 109RB: 14.430 s 109RC: 14.430 s 109ZB: 14.435 ss 121F to 121L: 13.460 s 125-55(2): 15.330 s 128A(1AB): 14.720 s 128A(1): 14.720 s 128B: 18.120 s 128B(2B): 18.160 s 128B(3E): 18.110 s 128B(5A): 18.160 xxix

Income Taxation

s 202B: 19.90 s 202C: 19.90 ss 202D to 202DM: 19.90 s 202CB: 19.90 s 221YHAAA: 2.370 s 224: 19.500 s 255: 14.310, 18.10, 18.250, 19.520 s 255(1)(a): 19.420 s 257: 19.520 s 260: 7.440, 7.460, 13.590, 15.150, 15.170, 20.190, 20.230, 20.240, 20.250, 20.390 s 262: 3.490, 3.525 s 262A: 5.30, 19.440, 19.530 s 263: 19.440 s 264: 19.400, 19.440, 19.450, 19.470, 19.490, 19.500 s 264A: 16.410, 19.440 s 266-125: 13.470 s 267-20: 13.470 s 267-20(1)(c): 13.470 s 269-55: 13.470 s 271-105: 13.470 s 272-5: 13.470 s 272-65: 13.470 s 272-70: 13.470 s 272-80: 13.470 s 272-100: 13.470 s 278(2): 4.990 s 318: 13.300 s 340: 17.120 s 361: 17.120 s 456: 17.120 s 461: 17.120 s IVA: 20. 210 Pt IIIA: 2.380, 3.10, 3.120, 3.150 Pt IIIA, Div 1A: 14.920 Pt X: 17.110 Pt X, Div 7: 17.120 Pt X, Div 8: 17.120 Pt IX: 4.990 Pt VA: 19.90 Pt XI: 17.110 Pt III, Div 3, subdiv D: 12.580 Pt III, Div 5: 13.40, 14.600 Pt III, Div 6: 14.610 Pt III, Div 6AAA: 17.110, 17.140 Pt III, Div 9C: 13.460 Pt III, Div 13: 4.350 Pt III, Div 13A: 2.270 Pt III, Div 17 to 19: 2.360 Pt IVA: 1.310, 3.30, 4.640, 4.1220, 7.540, 10.360, 13.590, 14.940, 15.30, 15.170, 16.80, 16.260, 16.290, 18.40, 18.280, 19.220, 20.30, 20.110, 20.150, 20.180, 20.190, 20.230, 20.240, 20.250, 20.260, 20.290, 20.380, 20.390, 20.400 Div 5: 13.320, 18.235 Div 5A: 13.260, 13.270, 13.540

Income Tax Assessment Act 1936 — cont s 170(3): 6.315 s 170(7): 19.330 s 170(9): 11.510 ss 170(9D) to (11): 19.220 s 170A: 19.220 s 170B: 19.220 s 170C(1): 20.300 s 170C(1)(a): 20.300 s 170C(1)(b): 20.300 s 170C(1)(ba): 20.300 s 170C(1)(bb): 20.300 s 170C(1)(bc): 20.290, 20.300 s 175: 19.260 s 175A: 19.250, 19.260 s 177: 19.260 s 177A: 20.250 s 177A(1): 20.260 s 177A(3): 20.260 s 177A(5): 20.260, 20.380 s 177B(3): 20.250 s 177B(4): 20.250 s 177C: 15.170, 20. 210, 20.250, 20.290 s 177C(1): 20.290, 20.300, 20.320, 20.350, 20.370 s 177C(1)(ba): 20.290 s 177C(1)(bb): 20.290 s 177C(2): 20.300 s 177D: 20.250, 20.310, 20.380, 20.390 s 177D(1): 20.250, 20.260, 20.380 s 177D(2): 20.250, 20.290, 20.380 s 177D(3): 20.250 s 177D(4): 20.250 s 177D(b): 20.380 s 177E: 15.130, 15.170, 15.185, 15.190, 20.310 s 177F: 19.360, 20.390 s 177F(1): 20.390 ss 177F(2) to 177F(3): 20.390 s 177F(3): 20.390 s 177G: 19.220 s 177CA: 20.290 s 177CB: 20.250, 20.370 s 177CB(1): 20.370 s 177CB(2): 20.370 s 177CB(3): 20.370 s 177CB(4): 20.370 s 177DA: 18.280, 20.310 s 177EA: 14.940, 14.950, 14.960, 14.990, 18.130, 20.310 s 177EA(3): 14.940 s 177EA(4): 14.940 s 177EA(5): 14.940 s 177EA(13): 14.940 s 177EA(14)): 14.940 s 177EA(17): 14.940 s 177EB: 14.940 s 185: 19.260 s 190: 8.260 s 190(b): 4.660, 19.350 xxx

Table of Statutes

s 8-1(2()c): 7.600 s 3-5(1): 19.95 s 3-5(2): 19.95 s 4-1: 2.310, 14.20 s 4-10: 2.310, 11.20 s 4-10(3): 2.360 s 4-10(3A): 2.360 s 4-15: 2.40, 10.280, 11.20 s 4-15(1): 2.320 s 5-5: 19.190 s 5-10: 19.190 s 6-1: 2.550 s 6-5: 2.10, 2.165, 2.330, 2.370, 2.380, 2.400, 2.550, 3.370, 3.420, 3.455, 3.570, 3.610, 4.10, 4.30, 4.45, 4.130, 4.155, 4.205, 4.210, 4.220, 4.700, 4.865, 4.1080, 5.10, 5.200, 5.230, 5.240, 5.310, 5.480, 5.490, 6.10, 6.60, 6.140, 6.370, 9.360, 12.250, 12.430, 12.440, 12.500, 14.130, 15.50, 16.240, 18.10 s 6-5(1): 5.490 s 6-5(3): 3.30, 16.240, 18.10, 18.70 s 6-5(4): , 2.170, 2.205, 3.30, 4.270, 4.1210, 11.200 s 6-10: 2.10, 2.100, 2.330, 2.550, 4.1080, 12.640, 16.240, 18.10 s 6-10(1): 2.550, 3.20 s 6-10(3): 2.205, 3.30, 4.270, 11.200 s 6-10(5): 3.30, 16.240, 18.10, 18.70 s 6-15: 2.330, 2.420 s 6-20: 2.330, 2.550 s 6-23: 2.330 s 6-25(1): 2.550 s 6-25(2): 2.550 s 8-1: 2.340, 2.370, 2.490, 2.500, 2.540, 3.610, 4.530, 4.640, 4.920, 5.30, 5.190, 7.10, 7.40, 7.50, 7.140, 7.230, 7.260, 7.280, 7.315, 7.395, 7.400, 7.410, 7.430, 7.460, 7.540, 7.545, 7.600, 8.10, 8.40, 8.45, 8.100, 8.130, 8.180, 8.185, 8.210, 8.220, 8.225, 8.265, 8.270, 9.25, 9.260, 9.360, 10.10, 10.20, 10.30, 10.40, 10.50, 10.65, 10.110, 10.120, 10.250, 10.260, 10.290, 10.360, 10.370, 10.490, 10.560, 11.360, 12.30, 12.150, 12.250, 12.340, 12.380, 12.440, 12.470, 12.500, 12.540, 15.50, 17.170, 20.150, 20.160 s 8-1(1): 7.10, 7.60, 7.620, 7.630, 7.640, 10.370, 10.460 s 8-1(1)(a): 4.1230, 7.10, 7.30 s 8-1(1)(b): 4.1230, 7.10, 7.30 s 8-1(2): 8.270, 10.460 s 8-1(2)(a): 7.140, 9.10 s 8-1(2)(b): 8.10, 8.210, 10.460 s 8-1(2)(d): 10.20 s 8-1(3): 10.10 s 8-5: 2.340, 10.10

Income Tax Assessment Act 1936 — cont Div 6: 2.215, 4.990, 12.690, 13.320, 13.350, 13.390, 13.410, 13.420, 13.425, 13.450, 13.490, 13.510, 13.545, 13.550, 13.555, 14.610 Div 6A: 13.570, 13.585 Div 6B: 13.540, 13.545 Div 6C: 13.540, 13.545, 13.550 Div 6D: 13.460 Div 6E: 13.410, 14.610 Div 6AA: 13.430, 13.560, 13.570, 13.590 Div 6AAA: 17.150, 17.155 Div 7A: 4.350, 4.680, 13.590, 14.370, 14.380, 14.390, 14.420, 14.430, 14.435, 14.535 Div 9A: 18.150 Div 10C: 12.660 Div 10D: 12.660 Div 11: 2.330 Div 11A: 16.240, 18.10, 18.110, 19.160 Div 13: 7.480 Div 13A: 4.660, 4.670 Div 14: 4.350 Div 16D: 10.580 Div 16E: 3.120, 3.460, 3.475, 5.770, 6.445, 11.460, 12.490, 12.540, 12.590 Div 16K: 15.70 Div 36: 15.350 Div 70: 12.30 Div 230: 13.550 Div 266: 13.470 Div 267: 13.470 Div 269-B: 13.470 Div 269-D: 13.470 Div 269-E: 13.470 Div 269-F: 13.470 Div 270: 13.470 Div 271: 13.470 Div 272: 13.470 Div 272-D: 13.470 Div 275: 13.555 Div 276: 13.555 Div 815: 16.300 Div 815-B: 16.305 Sch 2C: 3.110, Sch 2E: 12.710 Sch 2F: 13.470, 14.930 Sch 7, Pt I: 2.350 Sch 7, Pt II: 2.350 Income Tax Assessment Act 1997: 2.10, 2.175, 2.205, 2.320, 2.330, 2.360, 2.370, 2.380, 2.430, 2.470, 2.550, 3.10, 3.40, 3.50, 3.100, 3.105, 3.135, 3.255, 3.320, 3.375, 3.540, 4.10, 4.530, 5.310, 6.290, 7.40, 11.10, 12.420, 12.440, 12.740, 13.50, 13.300, 13.470, 15.210, 15.700, 16.80, 19.390 s 1-3(2): 6.290 s 2-15: 13.300 s 2-15(3): 13.40 xxxi

Income Taxation

s 26-10: 5.790, 11.420 s 26-20: 8.105, 10.465 s 26-25: 18.110 s 26-26: 14.680, 14.720 s 26-30: 8.210, 10.465 s 26-30(3): 4.530 s 26-35: 7.540, 10.465, 10.470, 20.200 s 26-35(4): 10.470 s 26-40: 10.465 s 26-45: 8.210, 10.520 s 26-45(3): 4.530 s 26-47: 5.30, 5.125, 10.520 s 26-50: 8.210, 10.520 s 26-52: 10.500 s 26-53: 10.500 s 26-54: 5.355, 7.170, 10.500 s 26-55(1)(ba): 10.60 s 27-5: 7.40, 12.750 s 27-10: 12.750 s 27-15: 7.40, 12.750 s 27-20: 7.40 s 27-80: 7.40, 12.750 s 27-90: 12.750 s 27-95: 12.750 s 30-5: 8.220 s 30-15: 10.60 s 30-15(1): 8.250 s 30-25: 8.250 s 30-45: 8.250 s 32-5: 8.210, 8.220, 8.225, 8.270, 10.530 s 32-10: 8.210, 8.220, 8.265, 10.530 s 32-20: 4.530, 8.210, 8.215, 8.270, 10.530 s 32-30: 8.210, 8.215, 10.530 ss 32-30 to 32-50: 8.215, 8.270 s 32-35: 8.210, 8.225 s 32-40: 8.210 s 32-45: 8.210, 8.215 s 32-50: 8.220, 8.225 s 32-55: 8.215 s 32-65: 8.225 s 35-5: 8.230 s 35-10(1): 5.190 s 35-10(1)(a): 5.190, 8.230 s 35-10(2): 5.190 s 35-10(2E): 5.190, 8.230 s 35-10(3): 5.190, 8.230 s 35-10(4): 8.230 s 35-15(2): 5.190 s 35-20: 5.195 s 35-30: 5.190, 8.230 s 35-35: 5.190, 8.220, 8.230 s 35-40: 5.190, 8.230 s 35-40(4): 5.190 s 35-45: 5.190, 8.230 s 35-55: 5.190, 8.230 s 35-55(1): 5.190 s 35-55(1)(a): 8.230 s 35-55(1)(b): 8.230 s 35-55(1)(c): 8.230 s 36-10(4): 10.280

Income Tax Assessment Act 1997 — cont s 8-5(2): 10.20 s 8-10: 2.500, 2.550, 9.360, 10.20, 10.40 s 10-5: 2.550, 3.20 s 15-2: 2.100, 2.180, 2.240, 2.250, 2.410, 4.10, 4.30, 4.45, 4.220, 4.390, 4.650, 4.670, 4.700, 4.740, 4.760, 4.815, 4.820, 5.300, 11.180 s 15-2(3): 4.670 s 15-2(3)(d): 4.10 s 15-3: 4.210, 12.705 s 15-5: 5.790 s 15-10: 5.30, 5.300, 5.310, 5.330 ss 15-10 to 15-30: 2.550 s 15-15: 2.410, 2.510, 3.10, 4.735, 5.200, 5.235, 5.240, 5.245, 5.490, 5.770, 10.40, 11.510, 12.30, 12.70, 12.300 s 15-15(2)(a): 5.240 s 15-15(2)(b): 5.240, 5.245 s 15-20: 2.410, 3.570, 3.580, 3.585, 3.610 s 15-25: 3.550 s 15-30: 6.10 s 15-50: 13.240 s 15-70: 4.210, 4.555 s 15-80: 4.210 s 17-5: 2.330, 7.40, 12.750 s 17-10: 12.750 s 20-10: 6.10 s 20-20(1): 6.290 s 20-20(2): 6.290, 6.300 s 20-20(3): 6.290 s 20-25: 6.290 s 20-25(4): 6.210, 6.250 s 20-30(1): 6.290 s 20-30(2): 6.290 s 23: 16.420 s 25-5: 7.140, 10.50, 19.420 s 25-10: 3.550, 10.40, 10.50, 10.65, 11.180 s 25-15: 3.550, 3.555, 10.50, 11.180 s 25-20: 10.30 s 25-25: 4.520, 10.50, 12.530, 12.540 s 25-30: 10.50 s 25-35: 2.500, 5.160, 6.310, 10.370, 11.180, 11.335, 11.455 s 25-35(1): s 25-35(1)(a): 10.290, 10.300, 10.320, 10.330 s 25-35(1)(b): 10.330 s 25-40: 5.235, 10.40, 10.110 s 25-45: 7.220, 7.225, 10.50 s 25-47: 7.220 s 25-50: 4.700, 7.250, 10.50 s 25-55: 10.50 s 25-55(1): 10.40 s 25-60: 10.30 s 25-85: 14.720 s 25-90: 12.500, 14.720, 17.170 s 25-95: 13.240 s 25-100: 8.40, 8.45, 10.50 s 26-5: 7.70, 7.75, 7.650, 10.465, 10.500 xxxii

Table of Statutes

s 40-K: 10.230 s 42-18: 10.150 s 42-190: 5.490 s 42-215: 8.210 s 43: 10.140 s 43-20(1): 10.270 s 43-25: 10.270 s 43-30: 10.275 s 43-70(1): 10.270 s 43-70(2): 10.110 s 43-70(2)(e): 10.140, 10.270 s 43-210: 10.270 s 43-230: 10.270 s 43-235: 12.660 s 43-250: 10.270 s 45-40: 10.140, 10.150 s 47(2): 8.75 s 51-10: 6.360, 6.380 s 51-35: 6.360 s 51-50: 6.320, 6.360 s 51-55: 6.75 s 52-10: 6.380 s 52-15: 6.380 s 52-65: 6.380 s 52-65(4): 6.380 s 53-10: 3.30 s 59-40: 14.130, 15.50 s 61-470: 8.70 s 63-10(1): 17.80 s 67-25(1DA): 18.130 s 70-5(1): 5.480 s 70-10: 5.480, 12.290 s 70-15: 12.50, 12.230 s 70-20: 7.460, 7.650, 12.240, 19.390, 20.200 s 70-25: 12.30, 12.470 s 70-30: 12.440 s 70-30(4): 12.440, 12.445 s 70-35: 12.30, 12.60, 12.250, 12.340, 12.440 s 70-35(2): 12.30, 12.470 s 70-35(3): 12.30 s 70-40: 12.30, 12.90 s 70-45: 12.70, 12.80, 12.90, 12.220 s 70-45(1): 12.750 s 70-45(1A): 12.750 s 70-50: 12.80 s 70-55: 12.80 s 70-90: 5.420, 5.470, 5.480, 12.250, 12.300, 12.430, 12.750, 13.170, 13.235 s 70-95: 12.270, 12.750 s 70-100: 12.275, 13.190, 13.195 s 70-105: 12.250, 12.750 s 70-110: 12.430 s 70-115: 5.480, 6.140 s 80-5: 4.1080 s 80-10: 4.1080 s 80-15: 4.1080, 4.1125 s 80-20: 4.1080

Income Tax Assessment Act 1997 — cont s 36-15: 10.280 s 36-17: 14.20, 14.590, 14.595, 15.350 s 40: 10.120 s 40-25: 10.120, 10.180, 10.185, 10.190, 10.200, 10.260 s 40-25(2): 10.210 s 40-30: 10.210 s 40-30(1): 10.130 s 40-30(2): 10.175 s 40-30(3): 10.140 s 40-30(4): 10.180 s 40-35: 13.195 s 40-40: 10.185, 10.187, 12.720, 13.195 s 40-45(2): 10.270 s 40-70: 10.200 s 40-70(1): 10.210 s 40-75: 10.200 s 40-75(1): 10.210 s 40-80(2): 10.140 s 40-85(7): 10.190 s 40-95(3): 10.175 s 40-95(7): 10.190 s 40-100: 10.190 s 40-102: 10.190, 10.210 s 40-105: 10.190 s 40-180: 10.195 s 40-180(2): 10.225, 16.305, 20.200 s 40-190: 10.195 s 40-195: 10.225 s 40-215: 10.110 s 40-230: 10.540, 11.550 s 40-285: 5.490, 6.180, 6.205, 10.220 s 40-285(1): 5.490, 6.180, 10.220 s 40-285(2): 6.180, 10.220 s 40-290: 10.220 s 40-295: 10.225, 13.170 s 40-295(1): 6.180 s 40-295(2): 13.190, 13.235 s 40-300(2): 6.180, 16.305 s 40-305(1)(b): 10.220 s 40-340(1): 15.250, 15.340 s 40-340(2): 13.235 ss 40-340(3) to (7): 13.190 s 40-365: 6.180, 6.205, 10.225 s 40-425(2): 10.410 s 40-440: 10.200 s 40-645: 10.230 s 40-730: 10.230 s 40-735: 7.400 s 40-750: 7.30 s 40-830: 7.310, 9.185, 10.230 s 40-840: , 7.315 s 40-840(2)(d)(i): 10.230 s 40-840(2)(d)(iv): 7.310 s 40-880: 7.310, 7.315, 9.90, 10.250, 10.260, 10.265 s 40-880(2A): 10.410 s 40-880(5): 10.260 s 40-880(6): 10.260 xxxiii

Income Taxation

s 83A-305: 4.670 s 83A-310: 4.670 s 83A-335: 4.670 s 83A30(2): 4.670 s 84-5: 4.1220 s 84-5(1): 4.1220 s 84-5(2): 4.1220 s 85-5: 4.1230 s 85-10: 4.1230, 10.560 s 85-10(1): 4.1230 s 85-10(2): 4.1230, 10.560 s 85-15: 4.1230, 10.560 ss 85-15 to 85-25: 4.1230 s 85-20: 4.1230, 10.560 s 85-25: 4.1230, 10.560 s 85-30: 4.1230 s 85-35: 4.1230 s 86-15: 4.1230 s 86-15(1): 4.1230 s 86-15(2): 4.1230 s 86-15(3): 4.1230 s 86-15(4): 4.1230 s 86-20: 4.1230 s 86-20(1): 4.1230 s 86-30: 4.1230 s 86-35: 4.1230 s 87-5: 4.1230 s 87-15: 4.1230 s 87-15(1): 4.1230 s 87-15(1)(c): 4.1230 s 87-15(2): 4.1230 s 87-15(3): 4.1230 s 87-18: 4.1230 s 87-18(1): 4.1230 s 87-20(1): 4.1230 s 87-25(1): 4.1230 s 87-30: 4.1230 s 100-40(2): 12.660 s 102-5: 2.100, 2.410, 2.470, 3.20, 12.640, 12.690, 13.420 s 102-5(1): 12.640, 12.690 s 102-10: 3.20, 12.640, 15.350 s 102-15: 3.20, 12.640, 15.350 s 102-20: 3.40 s 102-22: 3.40 s 102-25: 3.210, 13.500 s 102-25(3): 3.210 s 102-30: 3.20 s 102-33: 3.40 s 103-5: 3.30 s 103-10: 3.30, 3.530, 12.650 s 103-15: 3.530, 12.660 s 103-25: 3.325 s 104-5: 3.40 s 104-10: 6.190, 13.500 s 104-10(1): 3.40 s 104-10(2): 13.500 s 104-10(3): 3.290, 12.520 s 104-10(4): 3.40, 12.660 s 104-10(5): 3.40

Income Tax Assessment Act 1997 — cont s 82-10(2): 4.1130 s 82-10(3): 4.1130 s 82-10(4): 4.1130 s 82-65(2): 4.1130 s 82-65(3): 4.1130 s 82-130: 4.815, 4.1080 s 82-130(1)(a)(ii): 4.1080, 4.1140 s 82-130(1)(b): 4.1120 s 82-130(2): 4.1080 s 82-130(3): 4.1080 s 82-135: 4.860, 4.865, 4.1080 s 82-135(a): 4.1080 s 82-135(b): 4.1080, 4.1125 s 82-135(c): 4.1080 s 82-135(d): 4.1080 s 82-135(e): 4.1160 s 82-135(h): 4.705, 4.1080 s 82-135(i): 4.1080, 4.1125 s 82-135(j): 4.1080, 4.1125 s 82-140(a): 4.1130 s 82-140(b): 4.1130 s 82-145: 4.1130 s 82-150: 4.1180 s 82-150(1)(d): 4.1180 s 82-150(2): 4.1180 s 82-155: 4.1130 s 82-160: 4.1130 s 83-10(2): 4.1190 s 83-15(a): 4.1190 s 83-80(1): 4.1190 s 83-85: 4.1190 s 83-130: 4.860 s 83-130(1)(b): 4.1120 s 83-135(e): 4.1080 s 83-170: 4.1160 s 83-170(2): 4.1160, 4.1170 s 83-170(3): 4.1160 s 83-180: 4.1160 s 83-180(2): 4.1170 s 83A: 4.670 s 83A-5(b): 4.670 s 83A-5(c): 4.670 s 83A-10(1): 4.670 s 83A-10(2): 4.670 s 83A-20(2): 4.670 s 83A-25: 4.670 s 83A-25(1): 4.670 s 83A-30(1): 4.670 s 83A-33: 4.670 s 83A-35: 4.670 s 83A-35(1): 4.670 s 83A-45: 4.670 s 83A-105: 4.670 s 83A-105(3): 4.670 s 83A-105(4): 4.670 s 83A-110: 4.670 s 83A-115: 4.670 s 83A-120: 4.670 s 83A-125: 4.670 xxxiv

Table of Statutes

s 109-5: 3.290 s 109-10: 3.290 s 110-10: 12.660 s 110-25: 9.100, 12.660 s 110-25(2): 3.530, 9.180, 12.660 s 110-25(2)(a): 9.100 s 110-25(3): 7.140, 12.660 s 110-25(4): 12.660 s 110-25(4)(a): 7.600 s 110-25(5): 9.80, 12.660 s 110-25(6): 7.140, 9.80, 9.90, 12.660 s 110-35: 2.540, 12.660 s 110-35(2): 9.100 s 110-40(2): 12.660 s 110-45: 2.540 s 110-45(1B): 2.540, 12.660 s 110-45(2): 12.660 s 110-45(3A): 12.750 s 110-45(4): 10.110 s 110-55: 2.540, 3.300, 12.660 s 110-55(1): 12.660 s 110-55(3): 12.660 s 110-55(7): 15.120 s 110-55(8): 15.120 s 112-20: 3.270, 16.305 s 112-20(2): 15.40 s 112-20(3): 15.40 s 112-25: 3.260 s 112-30: 3.135 s 112-35: 13.250 s 112-37: 15.50 s 114-1: 12.660 s 114-10: 12.660 s 114-10(1): 3.270, 12.660 s 115-10: 12.690 s 115-15: 12.690 s 115-20: 12.640, 12.690 s 115-20(1): 12.660 s 115-25: 3.40, 12.690 s 115-25(3): 12.690 s 115-30: 3.40 s 115-30(1): 15.300 s 115-40(1): 12.690 s 115-45: 12.690 s 115-100: 12.690 s 115-230: 13.420 s 116-20: 3.540, 6.445, 12.650 s 116-20(1): 3.530 s 116-20(5): 12.750 s 116-25: 3.540 s 116-30: 12.650, 16.305 s 116-30(1): 3.270, 6.190, 12.650 s 116-30(3): 6.190, 12.650 s 116-30(3)(b): 12.650 s 116-30(3A): 6.190, 12.650 s 116-40: 2.300, 12.650 s 116-45: 12.650, 12.660 s 116-50: 9.100, 12.650 s 116-55: 12.650, 13.250 s 116-75: 3.540

Income Tax Assessment Act 1997 — cont s 104-15(3): 3.40 s 104-15(4): 3.40 s 104-20: 3.120, 6.190 s 104-20(3): 3.40 s 104-20(4): 3.40 s 104-25: 3.120, 6.190, 9.180, 12.650, 14.170, 15.50 s 104-25(1): 5.245 s 104-25(3): 3.40, 12.660 s 104-25(5): 3.40 s 104-30: 15.50 s 104-30(1)(c): 15.50 s 104-30(5): 15.50 s 104-35: 3.40, 3.210, 4.860, 15.40 s 104-35(3): 3.40, 12.660 s 104-35(5): 3.40 s 104-35(5)(c): 3.290 s 104-35(5)(d): 3.290, 13.530 s 104-40: 15.40 s 104-40(6): 15.50 s 104-55: 13.490 s 104-60: 13.490 s 104-70: 12.690, 13.450 s 104-71: 13.450 s 104-75(1): 13.440 s 104-135: 14.170 s 104-135(6): 14.1020 s 104-145: 14.1020 s 104-155: 2.165, 3.40, 3.210, 4.860, 5.685, 15.40 s 104-155(3): 3.40, 12.660 s 104-165(2): 18.90 s 104-165(3): 18.90 s 104-175: 15.340 s 104-180: 15.340 s 104-182: 15.340 s 104-220: 12.440 s 104-230: 15.200 s 104-235: 5.490, 10.220 s 106-5: 13.40, 13.110, 13.250, 13.255 s 106-50: 13.490 s 106-60: 3.35 s 108: 3.100 s 108-5: 3.50, 9.80, 9.360, 15.10 s 108-5(1): 3.100 s 108-5(2): 3.105, 13.40 s 108-5(2)(a): 3.100, 3.105 s 108-5(2)(d): 13.255 s 108-7: 3.105, 3.385, 13.255 s 108-10: 3.410 s 108-10(1): 12.670 s 108-10(2): 12.670 s 108-10(4): 12.670 s 108-15: 3.410, 12.670 s 108-20: 3.410 s 108-20(1): 12.670 s 108-20(2): 12.670 s 108-20(3): 12.670 s 108-25: 3.410, 12.670 xxxv

Income Taxation

Income Tax Assessment Act 1997 — cont s 118-5: 2.470, 3.50 s 118-5(b): 3.370 s 118-10(1): 3.410, 12.670 s 118-10(1)(2): 3.410 s 118-10(3): 3.410, 12.670 s 118-20: 2.470, 3.300, 3.570, 5.240, 5.245, 5.470, 9.360, 12.700, 13.250, 14.1020 s 118-20(1): 12.700 s 118-20(4): 12.700 s 118-24: 3.300, 3.610, 5.470, 5.490, 6.205, 10.110, 10.220, 12.700 s 118-25: 3.300, 5.470, 12.315, 12.700 s 118-27: 12.500 s 118-37: 3.370, 5.125, 5.355 s 118-37(1)(a): 6.75 s 118-37(1)(b): 6.75 s 118-37(1)(f): 3.30 s 118-37(1)(g): 3.30 s 118-115: 3.385 s 118-130: 3.385 s 118-145: 3.385 s 118-150: 3.385 s 118-170: 3.385 s 118-185: 3.385 s 118-190: 3.385, 8.175 s 118-195: 3.385 s 118-197: 3.385 s 118-300: 6.190 s 122-15: 15.260 s 122-20: 15.260 s 122-25: 15.260 s 122-35: 15.260 s 122-37: 15.260 s 122-40: 15.270 s 122-45: 15.270 s 122-50: 15.275 s 124-70: 6.190 s 124-70(1)(c): 3.325 s 124-75: 3.325, 15.330 s 124-75(1): 6.190 s 124-75(4): 3.320 s 124-85: 15.330 s 124-85(2): 3.320, 6.190 s 124-85(3): 3.320 s 124-90: 15.330 s 124-780(1): 15.300 s 124-780(2): 15.300 s 124-780(3): 15.300 s 124-783: 15.310 s 124-784A: 15.310 s 124-785: 15.300 s 124-790: 15.300 s 124-795(1): 15.300 s 124-800: 15.300 s 125-65: 15.330 s 125-70(1)(2): 15.320 s 125-70(2): 15.330 s 125-80: 15.330 s 125-155: 15.330 xxxvi

s 125-160: 15.330 s 125-165: 15.330 s 125-170: 15.330 s 126-5: 3.330 s 126-15: 3.330 s 128-15: 3.385 s 128-50: 3.385 s 130-20(4): 13.540 s 130-80: 4.670 s 134-1(4): 15.50 s 149-10: 3.40 s 149-30: 15.200 s 149-70: 15.200 s 152-10: 3.350 s 165-12: 15.390 s 165-12(7): 15.410 s 165-20: 15.390 s 165-37(4): 15.410 ss 165-80 to 165-200: 15.400 s 165-115A(1A): 15.530 s 165-115A(1): 15.530 s 165-115A(1)(b): 15.530 s 165-115A(1)(c): 15.530 s 165-115A(2): 15.530 s 165-115A(3): 15.530 s 165-115B: 15.530 s 165-115B(4): 15.530 s 165-115C(4): 15.410 s 165-115E: 15.530 s 165-115E(2): 15.530 s 165-115BA: 15.530 s 165-115BA(4): 15.530 s 165-115GC(4): 12.450 s 165-123(7): 15.410 s 165-150: 15.400 s 165-155: 15.400 s 165-160: 15.400 s 165-165: 15.410 s 165-208: 15.400 s 165-210: 15.450 s 165-215: 15.400 s 166-15: 15.420 s 166-175: 15.420 s 166-240: 15.420 s 166-272: 15.420 s 170-5: 7.460 s 202-5(a): 14.555, 18.130 s 202-5(c): 14.555 s 202-20: 14.555, 18.130 s 202-30: 14.720 s 202-35: 14.530 s 202-40: 14.530, 14.540 s 202-45: 14.530, 14.535, 15.95 s 202-45(d): 14.720 s 202-45(e): 14.530, 14.830 s 202-45(g): 14.430 s 202-45(g)(iii): 4.705 s 202-45(h): 14.840 s 202-60(2): 14.555 s 202-65: 14.555

Table of Statutes

s 207-145(2)(b): 14.900 s 207-145(2)(c): 14.990, 15.130 s 207-150(1)(a): 14.920 s 207-150(1)(e): 14.610 s 207-155: 14.990, 15.130 s 207-160: 14.610 s 207-165: 14.610 s 207-170: 14.610 s 214-150: 14.550 s 230-15: 12.500 s 230-15(1): 12.500 s 230-15(2): 12.500, 12.510 s 230-15(3): 12.500, 17.170 s 230-20: 12.500 s 230-25: 12.500 s 230-25(1): 12.500 s 230-25(3): 12.500 s 230-45: 12.500 s 230-50: 12.500, 12.520 s 230-100(2): 12.510 s 230-100(2)(b): 12.510 s 230-100(5): 12.510 s 230-105(2)(a): 12.510 s 230-115: 12.510 s 230-115(2): 12.510 s 230-115(4): 12.510 s 230-115(5): 12.510 s 230-125: 12.510 s 230-125(2)(b): 12.510 s 230-125(c): 12.510 s 230-130(1): 12.510 s 230-135: 12.510 s 230-135(4): 12.510 s 230-170: 12.510 s 230-170(2): 12.510 s 230-175: 12.510 s 230-175(1): 12.510 s 230-175(2): 12.510 s 230-185: 12.510 s 230-185(2): 12.510 s 230-190: 12.510 s 230-190(3): 12.510 s 230-190(4): 12.510 s 230-190(5)(b): 12.510 s 230-210(2): 12.520 s 230-220: 12.520 s 230-230: 12.520 s 230-300(3): 12.520 s 230-310: 12.520 s 230-310(4): 12.520 s 230-315: 12.520 s 230-320: 12.500 s 230-325: 12.520 s 230-360: 12.520 s 230-365: 12.520 s 230-435: 12.510 s 230-445: 12.500 s 230-445(1): 12.510 s 230-455: 12.490, 12.500 s 230-455(1)(e): 12.490

Income Tax Assessment Act 1997 — cont s 202-75(2): 14.555 s 202-75(3): 14.555 s 202-80: 14.510, 14.555 s 202-85: 14.555 s 203-20: 14.860 s 203-25: 14.860 s 203-30: 14.860, 14.870 s 203-35: 14.555 s 203-40: 14.860 s 203-45: 14.860 s 203-50(1)(a): 14.870 s 203-50(1)(b): 14.870 s 203-50(2): 14.870 s 203-50(3): 14.870 s 203-50(4): 14.870 s 203-55: 14.860 s 204-30: 14.905 s 204-30(3): 14.900 s 204-30(3)(a): 14.900 s 204-30(3)(c): 14.900 s 204-35: 14.900 s 204-40: 14.900 s 204-45: 14.900 s 204-75: 14.860 s 205-10: 14.540 s 205-15: 14.500, 14.550, 14.555, 14.570, 14.595 s 205-20: 14.550 s 205-25: 14.595, 18.130 s 205-30: 14.500, 14.595, 14.870, 14.900, 15.95 s 205-45(2): 14.550 s 205-50: 14.550 s 205-70: 14.550, 14.555 s 207-20: 14.570, 15.130 s 207-20(1): 14.500, 14.570 s 207-20(2): 14.500, 14.570, 14.650 s 207-35(1): 14.600, 14.610 s 207-35(2): 14.600, 14.610 s 207-35(3): 14.600, 14.610 s 207-35(4): 14.610 s 207-45: 14.600, 14.610 s 207-50(2): 14.600 s 207-50(2)(b): 14.605 s 207-50(3): 14.610 s 207-50(3)(b): 14.615 s 207-55(3): 14.600, 14.610, 14.615 s 207-57: 14.600, 14.610 s 207-70: 18.130 s 207-75(1): 18.130 s 207-75(2): 18.130 s 207-110: 14.520 s 207-120: 14.520 s 207-125: 14.520 s 207-130: 14.520 s 207-135: 14.520 s 207-145(1)(a): 14.920 s 207-145(1)(b): 14.900 s 207-145(1)(c): 14.990, 15.130 xxxvii

Income Taxation

s 292-80: 4.930 s 292-85: 4.930 s 292-85(3): 4.930 s 292-85(4): 4.930 s 292-90(2): 4.930 s 293-15: 4.920 s 295-5(2): 4.970, 4.990 s 295-10: 4.990 s 295-85: 5.690 s 295-85(2): 4.990 s 295-90: 4.990 s 295-95: 16.220 s 295-165: 4.960, 4.990 s 295-170: 4.990 s 295-170(1): 4.950 s 295-190: 4.990, 4.1010 s 295-380: 4.990 s 295-385: 4.990 s 295-550: 4.990 s 301-5: 4.1030 s 301-10: 4.1030 s 301-25: 6.370 s 305-5: 4.1050 s 306-5: 4.1010 s 306-10: 4.1010 s 307-15: 4.1010, 11.200 s 320-355: 12.520 s 328-10: 12.460 s 328-10(1): 12.450 s 328-10(2): 12.450 s 328-50: 12.450 s 328-110: 10.410, 12.460 s 328-110(1)(b): 12.460 s 328-110(1)(b)(i): 12.460 s 328-110(1)(b)(ii): 12.460 s 328-110(3): 12.460 s 328-110(4): 12.460 s 328-110(5): 12.460 s 328-115: 12.460 s 328-120(1): 12.460 s 328-120(2): 12.460 s 328-120(4): 12.460 s 328-125: 12.460 s 328-130: 12.460 s 328-180(1): 10.410 s 328-220: 12.460 s 328-285: 12.470 s 328-295: 12.470 s 328-295(1): 12.470 s 328-295(2): 12.470 s 355-25: 10.440 s 355-25(2): 10.440 s 355-30: 10.440 s 385-100: 6.140 s 395-495: 4.1010, 4.1020 s 700-1: 15.630 s 700-10: 15.730, 15.840 s 701-1(1): 15.680 s 701-1(2): 15.680 s 701-1(3): 15.680

Income Tax Assessment Act 1997 — cont s 230-460(1): 3.480 s 230-460(5): 3.480 s 230-530: 12.500 s 230-530(2): 12.520 s 240-20: 12.720 s 240-25: 12.720 s 240-25(5): 12.720 s 240-35(1): 12.720 s 240-35(2): 12.720 s 240-40: 12.720 s 240-50: 12.720 s 240-55: 12.720 s 240-60: 12.720 s 240-85: 12.720 s 245-10: 5.790 s 245-35: 5.790, 5.795 s 245-40: 5.790, 5.795 s 245-195(1): 5.790 s 250-20: 12.450 s 275-10: 13.550 s 275-10(1)(b): 13.550 s 275-10(3)(a): 13.550 s 275-10(4): 13.550 s 275-15: 13.550 s 275-20: 13.550 s 275-25: 13.550 s 275-30: 13.550 s 275-35: 13.550 s 275-110: 13.550 s 275-115: 13.550 s 275-605: 13.555 s 276-10: 13.550 s 276-15(1): 13.550 s 276-80: 13.555 s 276-105(2): 13.555 s 276-205: 13.555 s 276-210(2): 13.555 s 276-255: 13.555 s 276-260(2): 13.555 s 276-405: 13.555 s 276-410: 13.555 s 276-415: 13.555 s 280-105(1): 19.420 s 280-105(2): 19.420 s 284-150: 20. 210 s 290-10: 4.920 s 290-60: 4.920 s 290-60(3): 4.920 s 290-75: 4.920 s 290-100: 4.920 s 290-130: 4.960 s 290-150: 4.930, 4.940 s 290-155: 4.940 s 290-160: 4.930, 4.940 s 290-165: 4.940 s 290-170: 4.930, 4.940 s 291-15: 4.940 s 291-15(a): 4.920 s 291-15(b): 4.920 xxxviii

Table of Statutes

s 900-55: 8.270 s 900-115: 8.265 s 900-125: 8.265 s 900-150: 8.265 s 900-155: 8.265 s 900-205: 8.265 s 900-215: 8.270 s 960-50: 2.220 s 960-100: 13.300 s 960-120: 14.130, 14.310 s 960-275: 3.10, 12.665 s 960-275(2): 12.660 s 960-275(4): 12.660 s 960-280(1): 12.660 s 974: 14.535 s 974-5(4): 14.730 s 974-15: 14.720, 14.730 s 974-20: 14.720 s 974-20(4): 14.750 s 974-25: 14.740, 14.745 s 974-35: 14.750, 14.770 s 974-40: 14.750, 14.770 s 974-45: 14.750, 14.770 s 974-50: 14.750 s 974-55: 14.750 s 974-60: 14.750 s 974-65: 14.720, 14.740 s 974-70: 14.720, 14.730 s 974-70(1)(b): 14.730 s 974-75: 14.720 s 974-75(4): 14.740, 14.745 s 974-75(6): 14.745 s 974-80: 14.720, 14.740 s 974-85: 14.760 s 974-90: 14.760 s 974-95: 14.760 s 974-100: 14.770 s 974-105: 14.730, 14.750 s 974-130: 14.720 s 974-135: 14.750 s 974-135(5): 14.750 s 974-140: 14.750 s 974-145: 14.750 s 974-150: 14.720, 14.730 s 974-155: 14.730 s 974-165: 14.770 s 975-300: 14.720, 14.810 s 975-300(1)(b): 15.60 s 977-50: 5.470 s 995-1: 4.440, 4.970, 5.30, 8.210, 12.720, 12.750, 14.30, 14.80, 14.390, 16.170 s 995-1(1): 2.330, 2.340, 13.50, 13.260, 13.270, 16.220 Pt IIIA, Divs 1 to 4: 3.40 Pt 2-1: 2.380 Pt 2-15: 2.330 Pt 2-20: 2.360 Pt 3-1: 2.100, 2.380, 2.460, 2.470, 3.10, 3.40, 7.600, 12.30 Pt 3-2: 3.40

Income Tax Assessment Act 1997 — cont s 701-5: 15.690 s 701-10: 15.720 s 701-15: 15.860 s 701-30: 15.810 s 701-40: 15.870 s 701-60: 15.720, 15.860 s 701-85: 15.700 s 703-5(3): 15.650 s 703-30: 15.650 s 703-50: 15.650 s 703-50(2): 15.650 s 705-25: 15.740, 15.750 s 705-35: 15.740, 15.750 s 705-40: 15.750 s 705-60: 15.740, 15.750, 15.760 s 707-145: 15.760, 15.820 s 707-305: 15.830 s 707-335: 15.830 s 709-55: 15.780 s 709-60: 15.780 s 711-15: 15.860 s 711-20: 15.860 s 711-30: 15.860 s 721-15: 15.790 s 721-25: 15.790 s 721-30: 15.790 s 727-470(2): 12.450 s 768-5: 17.50, 17.55, 17.100, 17.170, 18.130 ss 768-905 to 768-980: 17.20 s 770-10: 17.80 s 770-75: 17.80, 17.170 s 770-130: 17.90 s 770-135: 17.120 s 770-140: 17.80 s 775-10: 16.240 s 775-15: 12.740, 17.80 s 775-30: 12.740 s 775-45: 12.740 s 775-55: 12.740 s 775-75: 12.740 s 775-85: 12.740 s 775-95: 12.740 s 775-110: 11.200 s 815-115: 16.290 s 815-120: 16.290 s 815-120(3): 16.290 s 815-125: 16.290, 16.300 s 815-130: 16.290, 16.300 s 815-135: 16.300 s 815-145: 16.290 s 815-215: 16.290, 16.300 ss 815-215 to 815-230: 16.290 s 820-960: 18.60 s 830-45: 13.270 s 830-50: 13.270 s 840-815: 18.20 s 855-35: 18.70 s 900-50: 8.270 xxxix

Income Taxation

Div 108-A: 13.585 Div 109: 3.40, 3.270, 3.290 Div 110: 2.530, 3.40, 12.750 Div 112: 3.40, 12.750 Div 114: 12.660 Div 115: 3.10, 3.20, 3.290, 3.400, 12.690, 13.420, 14.170, 15.20 Div 116: 3.40, 12.750, 13.585 Div 118: 3.40, 3.370 Div 121: 3.40 Div 122: 3.40 Div 124-Q: 13.545 Div 125: 13.530, 15.320, 15.330 Div 126-G: 13.500 Div 128: 3.360, 13.440, 13.525 Div 130: 12.680 Div 130-D: 4.670 Div 132: 3.540, 12.680 Div 134: 3.265, 12.680, 15.50 Div 149: 15.200, 15.770 Div 152: 3.20, 3.350, 3.400, 12.690, 13.420 Div 165: 15.390 Div 166: 15.420 Div 167: 15.400 Div 170: 12.240, 15.590 Div 175: 15.430 Div 197: 14.810 Div 200: 14.450 Div 203: 14.860 Div 204: 18.130 Div 205: 14.650 Div 208: 14.650 Div 214: 14.540 Div 215: 14.720 Div 216: 14.910 Div 220: 17.100, 18.130 Div 230: 6.430, 7.640, 12.490, 12.500 Div 240: 10.580, 12.710, 12.720, 12.730, 14.745 Div 242: 12.730, 14.745 Div 245: 5.790, 5.795, 15.430 Div 247: 7.530 Div 250: 10.580, 14.745 Div 275-A: 13.550 Div 275-B: 13.545 Div 275-L: 13.550 Div 276-B: 13.555 Div 276-C: 13.555 Div 276-D: 13.555 Div 276-E: 13.555 Div 276-F: 13.555 Div 276-G: 13.555 Div 276-H: 13.555 Div 280: 4.900, 19.420 Div 290: 4.900, 4.910 Div 291: 4.920 Div 293: 4.920 Div 294: 4.920 ,4.1040 Div 295: 4.900, 4.970, 4.990 Div 295-190: 4.930

Income Tax Assessment Act 1997 — cont Pt 3-3: 2.100, 2.380, 2.460, 2.470, 3.10, 3.40, 12.30 Pt 3-6: , 14.80, 14.450 Pt 3-90: 10.360, 15.550, 15.630, 15.740, 15.850 Pt III, Div 5A: 16.370 Pt IVA: 18.280 Div 5: 13.40, 13.120 Div 6: 2.370, 2.550 Div 8: 2.340, 2.370, 3.480 Div 13A: 15.50 Div 16E: 12.510 Div 17: 12.750 Div 20: 6.10, 6.290 Div 25: 10.10, 10.30, 10.290 Div 26: 10.20, 10.450 Div 27: 12.750 Div 28: 8.260 Div 30: 8.250, 10.10, 10.60 Div 32: 4.470, 10.450, 10.530 Div 34: 8.180, 10.490 Div 35: 5.30, 5.150, 5.190, 8.230, 8.235, 10.285, 10.450, 12.540, 20.160, 20.220 Div 36: 2.330, 10.10, 10.30, 10.280, 11.50, 13.110, 17.170 Div 40: 3.610, 4.520, 5.490, 6.180, 9.290, 10.10, 10.30, 10.110, 10.140, 10.150, 10.195, 10.220, 10.230, 10.270, 12.540, 12.660, 12.750, 15.250, 15.860 Div 41: 10.420 Div 43: 10.10, 10.30, 10.110, 10.140, 10.150, 10.270, 12.540, 12.660, 12.665 Div 45: 10.140 Div 50: 10.60, 13.115 Div 51: 6.380, 6.405 Div 52: 6.380, 6.405 Div 53: 6.380, 6.405 Div 61: 2.360 Div 65: 2.360 Div 67: 2.360, 14.500 Div 70: 5.30, 9.360, 10.130, 12.20 Div 82: 4.700, 4.705, 4.740, 4.860, 4.1130 Div 82-A: 4.1130 Div 82-B: 4.1130 Div 83: 4.1080 Div 83A: 4.10, 4.45, 4.250, 4.660, 4.670, 18.225 Div 83A-C: 4.670 Div 85: 4.1230, 10.450, 10.560 Div 86: 4.1230 Div 87: 4.1230 Div 100: 3.20, 12.660 Div 102: 3.400 Div 104: 3.40, 3.120, 3.300, 13.585 Div 106: 3.30 Div 108: 3.40 xl

Table of Statutes

Subdiv 124F: 15.50 Subdiv 130-A: 13.530 Subdiv 152-A: 3.400 Subdiv 207-B: 13.410 Subdiv 230-B: 12.520 Subdiv 230-C: 12.520 Subdiv 230-D: 12.520 Subdiv 230-E: 12.520 Subdiv 230-F: 12.520 Subdiv 230-H: 12.500 Subdiv 290-B: 4.910 Subdiv 290-C: 4.910 Subdiv 290-D: 4.960 Subdiv 307-C: 4.1030 Subdiv 328-C: 3.350 Subdiv 855-B: 18.90 Subdiv 900-E: 8.260 Subdiv 900-F: 8.260 subdiv 27-B: 12.750 subdiv 30-B: 10.60 subdiv 36-C: 14.590, 15.350 subdiv 40-C: 10.195 subdiv 40-E: 10.200, 10.230 subdiv 40-F: 10.230 subdiv 40-G: 10.230 subdiv 40-H: 10.230 subdiv 40-I: 10.230 subdiv 40-J: 10.230 subdiv 52-A: 6.380 subdiv 52-B: 6.380 subdiv 61-G: 8.240 subdiv 86-B: 4.1230 subdiv 87-B: 4.1230 subdiv 108-B: 3.410 subdiv 108-C: 3.410 subdiv 108-D: 3.105 subdiv 118-B: 3.40, 3.380 subdiv 122-A: 15.250, 15.260, 15.270, 15.275 subdiv 122-B: 15.250 subdiv 124-B: 3.320, 3.325 subdiv 124-C: 3.340 subdiv 124-G: 15.340 subdiv 124-J: 3.340, 3.545 subdiv 124-L: 3.340 subdiv 124-M: 15.280, 15.300, 15.310 subdiv 124-N: 15.340 subdiv 126-A: 3.330 subdiv 126-B: 15.340, 15.600 subdiv 130-A: 14.350, 15.40 subdiv 130-B: 15.50 subdiv 130-C: 15.50 subdiv 130-D: 15.50 subdiv 130-E: 15.50 subdiv 152-A: 3.350 subdiv 152-B: 3.400 subdiv 152-C: 3.400 subdiv 152-D: 3.400 subdiv 152-E: 3.350, 3.400 subdiv 165-A: 15.390

Income Tax Assessment Act 1997 — cont Div 301: 4.900, 4.1030, 4.1080 Div 302: 4.1030 Div 305: 4.1030 Div 306: 4.1010 Div 328: 10.10, 10.410, 12.450 Div 355: 10.440 Div 385: 12.250 Div 392: 11.50 Div 405: 11.50 Div 700: 15.550 Div 703: 15.650 Div 705: 15.720, 15.740, 15.750, 15.870 Div 707: 15.800, 15.820 Div 709: 15.780, 15.870 Div 711: 15.860 Div 719: 15.670 Div 721: 15.790 Div 725: 15.210, 15.220 Div 727: 15.210, 15.230, 15.600 Div 755: 12.740 Div 768: 15.300 Div 768-A: 16.370 Div 768-G: 17.60 Div 770: 7.30, 17.80 Div 775: 5.770, 12.740 Div 815: 12.240 Div 815-B: 16.290, 16.300, 16.360 Div 815-C: 16.290, 16.300 Div 815-E: 16.430 Div 820: 10.450, 17.170 Div 830: 13.270 Div 840: 18.20 Div 840-M: 13.545 Div 842: 7.30 Div 855: 3.30, 16.240, 18.70, 18.185 Div 900: 8.260, 8.270 Div 974: 10.450, 14.80, 14.535, 14.680, 14.690, 14.700, 14.720, 14.960, 15.650 Divs 4 to 21: 3.40 Divs 80 to 83: 4.210, 4.1070 Divs 84 to 87: 4.1220, 10.560, 18.215 Divs 85 to 87: 13.590 Divs 301 to 307: 4.1030 Divs 723 to 727: 3.255 Divs 815-B to 815-D: 16.290 Subdiv 28-G: 8.260 Subdiv 28-H: 8.260 Subdiv 83-B: 4.1190 Subdiv 83-C: 4.1160, 4.1170 Subdiv 83A: 4.1190 Subdiv 87-A: 4.1230 Subdiv 104-E: 13.440 Subdiv 108-D: 13.445 Subdiv 115-C: 13.420 Subdiv 118-B: 13.395, 13.445 Subdiv 124-H: 13.530 Subdiv 124-M: 13.530 Subdiv 124E: 15.50 xli

Income Taxation

s 13: 13.430 s 14: 13.430 s 18: 16.175 s 23A: 2.350 s 26(1): 4.990 s 26(2): 4.990 s 28(b): 13.460 Sch 7, Pt II: 18.200 Sch 7, Pt III: 18.200 Sch 10, Pt I: 13.320 Sch 11, Pt I: 13.430

Income Tax Assessment Act 1997 — cont subdiv 165-B: 15.390 subdiv 165-C: 15.390 subdiv 165-D: 15.400 subdiv 165-F: 15.400 subdiv 165-CA: 15.390 subdiv 165-CB: 15.390 subdiv 165-CC: 15.530 subdiv 170-D: 15.590 subdiv 202-B: 14.555 subdiv 202-C: 14.530 subdiv 202-E: 14.500, 14.650 subdiv 204-B: 14.880, 14.890, 14.895, 14.900 subdiv 204-C: 14.890 subdiv 204-D: 14.900 subdiv 204-E: 14.860 subdiv 207-B: 14.100, 14.600, 14.610 subdiv 207-E: 14.520 subdiv 230-B: 12.510, 12.520 subdiv 230-E: 12.520 subdiv 230-G: 12.510 subdiv 230-H: 12.500 subdiv 292-B: 4.920, 4.930 subdiv 292-C: 4.930 subdiv 328-C: 12.460 subdiv 328-D: 12.450, 12.480 subdiv 328-E: 12.450 subdiv 328-F: 10.430 subdiv 705-A: 15.740 subdiv 705-B: 15.770 subdiv 705-C: 15.770 subdiv 705-D: 15.770 subdiv 707-A: 15.820 subdiv 707-C: 15.830 subdiv 707-D: 15.870 subdiv 768-G: 17.60 subdiv 802-A: 14.640, 18.130 subdiv 815-B: 20.200 subdivs 815-B to 815-D: 7.480 subdiv 815-C: 20.200 subdiv 855-A: 18.70 subdiv 960-E: 14.30 subdiv 960-F: 14.30 subdiv 960-G: 14.80, 15.650 subdiv 960-M: 12.660 subdiv 974-E: 14.720

Inspector-General of Taxation Act 2003 s 7(1): 19.410 s 7(2): 19.410 s 9: 19.410 s 15: 19.410 s 18: 19.410 International Tax Agreements Act 1953: 16.80 s 3(11A): 18.170 s 4: 16.80 s 20: 16.440 s 24: 16.300 Judiciary Act 1903 s 39B: 19.260, 19.280 Medicare Levy Act 1986: 2.360 s 6(1): 2.365 Model Tax Convention: 16.360 New Business Tax System (Capital Allowances) Act 2001: 5.490 New Business Tax System (Debt and Equity) Bill 2001: 14.710 Ombudsman Act 1976: 19.410 Patents Act 1952: 3.285 Public Governance, Performance and Accountability Act 2013: 19.20 s 63: 19.540 Public Service Act 1999: 19.20 Retirement Savings Accounts Act 1997 s 960-275(3): 15.40

Income Tax Assessment Amendment (Capital Gains) Act 1986: 4.860

Social Security Act 1991: 6.380

Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974: 18.110

Superannuation (Excess Concessional Contributions Charge) Act 2013: 4.920

Income Tax (Managed Investment Fund Withholding Tax) Act 2008 s 4: 18.20

Superannuation (Excess Concessional Contributions Tax) Act 2007: 4.920 Superannuation (Excess Non-concessional Contributions Tax) Act 2007: 4.930

Income Tax Rates Act 1986: 2.310, 2.350, 2.360, 4.1130, 11.50 s 12(1): 13.320 s 12(9): 13.320

Superannuation (Government Co-contribution for Low Income Earners) Act 2003: 4.950 xlii

Table of Statutes

s 14S: 19.520 s 14S(1): 19.420 s 14ZL: 19.250 s 14ZU: 19.250, 19.260 s 14ZW: 19.190, 19.250 s 14ZW(1A): 19.250 s 14ZW(1): 19.250, 19.310 s 14ZW(2): 19.290, 19.310 s 14ZW (3): 19.290 s 14ZW(3): 19.310 s 14ZX(4): 19.310 s 14ZY: 19.310 s 14ZY(3): 19.510 s 14ZZ: 19.310, 19.320 s 14ZZ(1): 19.320 s 14ZVA: 19.250 s 14ZYA: 19.310 s 14ZYA(2): 19.310 s 14ZYA(3): 19.310 s 14ZZC: 19.320 s 14ZZE: 19.330 s 14ZZF: 19.510 s 14ZZK: 4.660, 19.290, 19.340, 19.350 s 14ZZN: 19.320 s 14ZZO: 4.660, 19.290, 19.340, 19.350 s 14ZZQ: 19.330 s 290-60(1): 20. 210 s 353-10: 19.440 s 353-10(1)(b): 19.440 s 353-10(1)(c): 19.440 s 353-15: 19.440 s 353-15(1): 19.440 Pt IIA: 19.420 Pt III: 19.530 Pt IVC: 19.250, 19.290, 19.540 Pt IVC, Div 4: 19.510 Div 12: 4.380 Div 284: 19.530 Div 340: 19.540 Div 360: 19.70 Sch 1: 2.360, 19.35, 19.87 Sch 1, Div 12: 19.100 Sch 1, Div 12-D: 18.70 Sch 1, subdiv 12-E: 19.90 Sch 1, Subdiv 12-F: 18.110 Sch 1, subdiv 12-F: 19.160 Sch 1, Div 12-H: 13.550 Sch 1, Subdiv 12-H: 18.20 Sch 1, subdiv 12-H: 19.160 Sch 1, Subdiv 12-FB: 18.250 Sch 1, subdiv 12-FC: 19.160 Sch 1, Div 45: 19.120 Sch 1, subdiv 45-B: 19.120 Sch 1, subdiv 45-C: 19.120 Sch 1, Div 95: 4.920 Sch 1, Div 96: 4.920 Sch 1, Div 135: 4.920 Sch 1, Div 284: 19.530, 20. 210 Sch 1, Div 290: 20.200, 20. 210 Sch 1, subdiv 290-B: 20. 210

Superannuation Industry (Supervision) Act 1993: 4.900, 4.970, 4.980, 4.1000 s 19: 4.1000 s 34(4): 4.1000 s 42(1A): 4.1000 s 42A: 4.1000 s 45: 4.900 s 52(2): 4.1000 s 58: 4.1000 s 62: 4.1000 s 65: 4.1000 s 67: 4.1000 s 67(4A): 4.1000 Pt 3: 4.1000 Pt 8: 4.1000 Pt 9: 4.1000 Pts 12 to 14: 4.1000 Superannuation Industry (Supervision) Regulations Pt 5: 4.1000 Pt 6: 4.1000 Superannuation (Sustaining the Superannuation Contribution Concession) Imposition Act 2013: 4.920 Tax Administration Act 1953 Div 12-H: 13.545 Tax Agent Services Act 2009: 2.360 Tax Law Improvement Act 1996: 4.10 Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013: 20.360 Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006: 4.10 Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2016 Sch 1, s 38: 19.220 Sch 1, s 39: 19.220 Tax and Superannuation Laws Amendment (2016 Measures No 2) Bill 2016: 19.87 Taxation Administration Act 1953: 5.350, 12.450, 18.60, 19.50, 19.260, 19.520 s 3A: 19.20 s 3B: 19.20 s 3C: 16.430 s 4: 19.20 s 4A: 19.20 s 5: 19.20 s 6D: 19.20 s 8: 19.20 s 8C: 19.500 s 8D: 19.500 s 8ZE: 19.530 s 8AAG(1): 19.420 s 8AAG(2): 19.420 xliii

Income Taxation

Sch 1, s 284-160(a)(i): 19.530 Sch 1, s 284-160(a)(ii): 19.530 Sch 1, s 284-215: 19.530 Sch 1, s 284-220(1)(a): 19.530 Sch 1, s 284-225(1): 19.530 Sch 1, s 284-225(2): 19.530 Sch 1, s 290-50: 20. 210 Sch 1, s 290-60(1)(a): 20. 210 Sch 1, s 290-60(2): 20. 210 Sch 1, s 290-60(3): 20. 210 Sch 1, s 290-65: 20. 210 Sch 1, s 298-20: 19.530 Sch 1, s 298-25: 19.530 Sch 1, s 298-30: 19.530 Sch 1, s 350-10: 19.260 Sch 1, s 353-10: 19.35, 19.440, 19.450, 19.500 Sch 1, s 353-15: 19.35, 19.450, 19.500 Sch 1, s 357-60: 19.50, 19.60 Sch 1, s 359-35(4): 19.510 Sch 1, s 361-5: 19.80 Sch 1, s 370-5(1): 19.87 Sch 1, s 370-5(4): 19.87 Sch 1, s 388-50: 19.35 Sch 1, s 388-55: 19.180 Sch 1, ss 12-80 to 12-90: 19.100 Sch 1, ss 359-60 to 359-70: 19.60 Sch 1, Pt VA: 19.35 DIV 284: 19.530

Taxation Administration Act 1953 — cont Sch 1, Div 340: 19.540 Sch 1, Div 353: 19.440 Sch 1, subdiv 353-B: 19.440 Sch 1, Div 355: 16.420, 19.20 Sch 1, Div 370: 19.87 Sch 1, Div 393: 19.35 Sch 1, Div 396: 16.430 Sch 1, subdiv 396-A: 19.35 Sch 1, subdiv 396-B: 19.35 Sch 1, subdiv 396-C: 19.35 Sch 1, Div 410: 19.35 Sch 1, Divs 357 to 360: 19.40 Sch 1, s 12-1(1): 19.110 Sch 1, s 12-1(2): 19.110 Sch 1, s 12-1(3): 19.110 Sch 1, s 12-35: 19.100 Sch 1, s 12-140: 19.90, 19.120, 19.150 Sch 1, s 12-155: 19.120 Sch 1, s 12-175: 13.460 Sch 1, s 12-180: 13.460 Sch 1, s 12-190: 19.90, 19.130, 19.150 Sch 1, s 12-190(1)(a): 19.150 Sch 1, s 12-190(4)(a): 19.150 Sch 1, s 12-190(4)(b): 19.150 Sch 1, s 12-300: 19.160 Sch 1, s 12-315: 18.60 Sch 1, s 12-325: 18.20 Sch 1, s 12-330: 18.20 Sch 1, s 12-335: 18.20 Sch 1, s 12-383: 13.550 Sch 1, s 14-5(3): 19.110 Sch 1, s 15-10: 19.100, 19.110 Sch 1, s 15-15: 19.110 Sch 1, s 15-25: 19.100, 19.110 Sch 1, s 16-5: 19.100 Sch 1, s 16-25: 19.100 Sch 1, s 16-30: 19.100 Sch 1, s 16-70: 19.100 Sch 1, s 42-325: 19.120 Sch 1, s 45-15: 19.140 Sch 1, s 45-50: 19.120 Sch 1, s 45-70(1): 19.120 Sch 1, s 45-110: 19.120, 19.130, 19.140 Sch 1, s 45-120: 19.140 Sch 1, s 45-120(3): 19.140 Sch 1, s 45-125: 19.120, 19.130 Sch 1, s 45-140: 19.120 Sch 1, s 45-170: 19.120 Sch 1, s 45-205: 19.140 Sch 1, s 55(1): 19.90 Sch 1, s 255-5: 19.190, 19.420, 19.520 Sch 1, s 255-10: 19.420 Sch 1, s 260-5: 19.420, 19.520 Sch 1, s 284-15: 19.530 Sch 1, s 284-75(1): 19.530 Sch 1, s 284-75(2): 19.530 Sch 1, s 284-75(3): 19.530 Sch 1, s 284-80: 19.530 Sch 1, s 284-90: 19.530

Taxation Administration Regulations 1976: 18.120 reg 12F: 19.440 regs 39 to 42: 18.110 reg 40(1)(b): 18.120 reg 44B: 18.250 reg 44C: 18.60 Taxation (Interest on Overpayments and Early Payments) Act 1983: 19.420 Taxation Law Amendment Bill (No 4) 1988 cl 13: 1.320 Taxation Laws Amendment Act (No 4) 1992 Pt IIIA: 4.860 Taxation Laws Amendment Bill (No 2) 1996: 5.790 Taxation Laws Amendment Bill (No 4) 1988: 1.320, 5.300 Taxation Laws Amendment (Self-Assessment) Act 1992: 19.60 The Explanatory Memorandum to Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013: 20.370 Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016: 14.10 xliv

Table of Statutes

Art 10(5): 18.230 Art 11(3)(b): 18.140 Art 11(4): 18.140 Art 11(6): 18.230 Art 11(7): 18.315 Art 12: 18.185 Art 12(3): 18.230 Art 12(4): 18.195 Art 13: 18.185 Art 13(5): 18.90 Art 14: 18.235 Art 15: 18.215, 18.225 Art 16: 18.280, 18.315 Art 17: 18.245 Art 17(2): 18.240 Art 23: 18.320 Art 25(5): 16.440 Art 27: 16.240

Trust Recoupment Tax Assessment Act 1985: 13.460 Veterans’ Entitlements Act 1986: 6.380 Voluntary Tax Transparency Code: 16.430

NEW SOUTH WALES Companies Act 1936: 14.55 Conveyancing Act 1919 s 144: 13.390 Income Tax (Management) Act 1928 s 11(i): 4.740 s 11(j): 4.740 Income Tax (Management) Act 1941: 19.220 Mining Partnership Act 1900: 14.55

UNITED KINGDOM

Trustee Act 1925: 13.290

Income Tax Act: 12.110

QUEENSLAND

Income Tax Assessment Act 1997 Arts 6 to 21: Art 25:

Trusts Act 1973: 13.290

VICTORIA

UK treaty: 16.230, 16.235, 18.65, 18.220, 18.230, 18.280, 18.320, 18.325 Arts 1 to 5: 16.90 Art 2: 18.225 Art 3(1)(m): 18.230 Art 3(2): 16.100, 16.375 Art 3(3): 16.100 Art 4: , 16.230 Art 4(1): 16.235 Art 4(2): 16.235 Art 4(3): 16.230 Art 5: 18.40, 18.230 Art 5(3)(a): 18.195 Art 6: 18.20, 18.55, 18.60 Arts 6 to 8: 16.240 Arts 6 to 21: 16.90 Art 7: , 16.300, 18.40, 18.55, 18.60, 18.170, 18.185, 18.230, 18.245 Art 7(2): 16.300 Art 7(7): 18.60 Art 8: 18.60, 18.195 Art 8(5)(b): 18.60 Art 9: , 16.300, 16.305, 18.55 Art 9(3): 16.300 Art 10(1): 18.120 Art 10(2): 18.120 Art 10(2)(a): 18.130 Art 10(2)(b): 18.120 Art 10(3): 18.130 Art 10(5): 18.110 Art 10(6): 18.120 Art 10(7): 18.280 Arts 10 to 19: 16.240 Art 11(3)(b): 18.140

Electricity Industry Act 1993: 9.25 Motor Accidents Act 1973: 6.60, 6.75

CANADA Income Tax Act, 1985: 12.110

GERMANY German treaty Art 23: 18.280

UNITED STATES Constitution Art 1: 2.40 Internal Revenue Code 1986 s 111(a): 6.310 US Treasury Regulations reg 62, Art 545(1)(c): 5.770 US treaty: 16.230, 18.65, 18.90, 18.215, 18.315, 18.320 Art 1(3): 18.320 Art 1(4): 18.320 Art 2: 18.225 Art 3(2): 16.100 Art 5(4)(b): 18.195 Art 6: 18.90 Art 7: 18.185, 18.245 Art 8: 18.195 xlv

Income Taxation

Art 26(3): 16.465 Art 26(4): 16.465 Art 27: , 16.465 Art 27(2): 16.465 art 4(4): 16.230

UK treaty — cont Art 11(4): 18.140 Art 11(6): 18.110 Art 11(7): 18.140 Art 11(9): 18.280 Art 12: 16.290, 18.185 Art 12(2): 18.160 Art 12(3): 18.170, 18.195 Art 12(4): 18.110 Art 12(7): 18.280 Art 13: 18.185 Art 13(3): 18.60 Art 13(5): 18.90 Art 13(6): 18.80 Art 14: 18.215, 18.225, 18.260 Art 14(3): 18.60 Art 15: 18.225 Art 16: 18.245, 18.260 Art 16(2): 18.240 Art 17: 16.230, 18.260 Art 18: 18.260 Art 19: 18.260 Art 20: 18.260, 18.270 Art 20(5): 18.280 Art 21: 16.240 Art 22: , 16.240, 18.225 Art 23: 16.90, 16.240 Art 23(3): 18.320 Art 24: 16.90, 16.375 Art 25: 16.450, 18.320 Arts 25 to 27: 16.90 Art 26: Art 26(1): 16.465

TREATIES AND CONVENTIONS Australia–UK treaty: 16.80 Australia–US treaty: 16.80 Model Tax Convention: 18.230 Art 1: 16.370 Art 17: 18.240 Art 23: 16.370 Art 27: 16.440 Protocol: 16.80 Switzerland treaty: 18.280 Taxation Administration Act 1953 Sch 1, Div 263: 16.440 Vienna Convention on the Law of Treaties: 16.80 Art 27: 18.280 Arts 31 to 33: 16.100

FIN Finland 2006 treaty Art 13(5): 18.80 Swiss treaty Art 7: 18.245 Art 17: 18.245

xlvi

TABLE OF RULINGS [Where an extract from a ruling is reproduced, the name of the ruling and its paragraph number appear in bold type.] TR 98/9: 8.100 TR 98/11: 16.300 TR 98/16: 16.300 TR 98/17: 16.140 TR 98/21: 16.370, 18.195 TR 98/22: 11.245 TR 99/6: 4.380 TR 1999/1: 16.300 TR 1999/5: 4.640 TR 1999/6: 2.205, 4.200, 4.205 TR 1999/9: 15.480 TR 1999/16: 3.285, 15.200 TR 1999/17: 5.110 TR 2000/4: 4.560 TR 2000/8: 5.120, 5.190, 20.230 TR 2000/16: 16.300 TR 2001/2: 4.600 TR 2001/7: 4.1220 TR 2001/8: 4.1230 TR 2001/10: 2.175, 4.910, 4.1210, 11.225 TR 2001/11: 16.300 TR 2001/13: 16.105, 18.280 TR 2001/14: 5.190 TR 2002/5: 18.55 TR 2002/14: 3.390 TR 2002/18: 13.395 TR 2003/3: 5.190 TR 2003/4: 5.110, 5.125 TR 2003/6: 4.1230 TR 2003/8: 14.130, 14.300, 15.320 TR 2003/10: 4.1230 TR 2003/13: 4.1120 TR 2004/1: 16.300 TR 2004/6: 19.110 TR 2004/7: 15.200 TR 2004/11: 15.700, 15.710 TR 2004/15: 16.200, 16.210 TR 2004/16: 10.140, 10.150 TR 2004/18: 15.200 TR 2005/1: 5.110, 5.190 TR 2005/7: 13.135 TR 2005/12: 13.155, 13.390, 13.395 TR 2005/16: 19.100 TR 2005/20: 12.720

RULINGS Tax Rulings TR 92/3: 5.390, 5.400, 5.410, 5.415 TR 92/4: 5.410 TR 92/8: 7.640 TR 92/15: 4.370 TR 93/2: 4.180, 4.200 TR 93/6: 11.245 TR 93/11: 11.280 TR 93/12: 18.170 TR 93/15: 12.650, 12.660 TR 93/20 12.360, 12.370 TR 93/25: 5.350 TR 93/26: 5.90 TR 93/30: 8.170 TR 93/38: 4.380 TR 94/8: 13.60, 13.65 TR 94/14: 16.300 TR 94/22: 8.185 TR 94/26: 11.460 TR 94/30: 3.80, 3.90, 3.240, 3.250, 3.255, 15.15 TR 95/6: 5.90, 5.190 TR 95/8: 8.240 TR 95/19: 8.240 TR 95/25: 13.155 TR 95/35: 6.190, 6.200, 6.205 TR 96/14: 15.50 TR 96/20: 11.330 TR 96/26: 4.450 TR 96/27: 4.560 TR 97/5: 11.285 TR 97/7: 11.230, 11.240, 11.505 TR 97/11: 5.90, 5.100, 5.110 TR 97/12: 8.180 TR 97/15: 11.360 TR 97/17: 4.470, 8.210, 8.220 TR 97/20: 16.300 TR 97/25: 10.270 TR 98/1: 11.160, 11.170, 11.175 TR 98/3: 3.50, 3.60, 3.220, 3.230, 3.570 TR 98/7: 12.380, 12.390 TR 98/8: 12.380, 12.400, 12.410

xlvii

Income Taxation

Tax Rulings — cont TR 2006/2: 7.570, 13.590 TR 2006/8: 12.190 TR 2006/10: 19.50 TR 2006/14: 13.445 TR 2007/2: 15.820 TR 2007/6: 5.190 TR 2007/8: 5.120 TR 2007/10: 18.195 TR 2008/1: 3.30, 15.30 TR 2008/2: 5.110 TR 2008/5: 15.50 TR 2008/7: 18.170, 18.185 TR 2008/8: 18.195 TR 2009/2: 4.1170 TR 2009/6: 17.90 TR 2011/6: 10.260, 10.265 TR 2012/5: 14.220, 14.230, 14.530 TR 2013/1: 18.215 TR 2014/6: 16.300 TR 2016/1: 10.190 Draft Tax Rulings TR 2004/D25: 13.490, 13.495 TR 2007/D10: 12.650 Income Tax Rulings IT 1: 19.50 IT 54: 8.185, 8.240 IT 333: 12.360, 12.380 IT 360: 5.190 IT 2026: 4.680, 4.690 IT 2162: 11.550 IT 2170: 3.375 IT 2195: 5.190 IT 2329: 13.460 IT 2350: 12.170, 12.180 IT 2402: 12.190 IT 2405: 6.365 IT 2450: 11.550, 11.580 IT 2483: 15.300 IT 2484: 3.285 IT 2485: 3.385 IT 2494: 3.120 IT 2495: 5.240, 5.770 IT 2500: 19.60 IT 2534: 11.455 IT 2540: 13.250 IT 2550: 5.490 IT 2561: 3.215 IT 2582: 13.155 IT 2604: 11.195 IT 2613: 11.40, 11.240 IT 2614: 4.555 IT 2625: 11.455 IT 2627: 15.170 IT 2631: 5.640, 5.650, 5.660 IT 2648: 11.360 IT 2655: 5.60 IT 2660: 18.170 IT 2675: 4.470, 8.215

Class Rulings CR 2001/1: 19.50 CR 2004/51: 13.540 CR 2004/56: 13.540 CR 2014/90: 15.80 CR 2015/27: 15.80

DETERMINATIONS Tax Determinations TD 2: 3.115 TD 46: 3.565 TD 48: 3.565 TD 92/162: 8.215 TD 93/235: 3.215 TD 93/238: 3.250 TD 94/54: 4.450 TD 95/4: 13.590 TD 1999/34: 4.200 TD 1999/43: 3.390 TD 1999/46: 3.335 TD 1999/55: 3.335 TD 1999/58: 3.335 TD 1999/60: 3.335 TD 1999/61: 3.335 TD 1999/67: 3.390 TD 1999/74: 3.390 TD 2000/10: 15.15 TD 2000/13: 3.390 TD 2000/16: 3.390 TD 2000/27: 15.400 TD 2000/31: 3.105 TD 2000/32: 13.530 TD 2000/33: 3.75 TD 2000/34: 3.105 TD 2000/35: 3.415 TD 2000/36: 3.320 TD 2000/37: 3.325 TD 2000/45: 3.320 TD 2000/50: 15.300 TD 2000/51: 15.300 TD 2001/9: 3.325 TD 2001/26: 13.525 TD 2003/1: 3.30 TD 2003/28: 13.455 TD 2004/3: 13.445 TD 2004/33: 15.710, 15.715 TD 2004/83: 15.715 TD 2004/84: 15.715 TD 2004/85: 15.715 TD 2008/23: 17.60 TD 2008/27: 11.245 TD 2008/32: 12.250 TD 2010/20: 18.280 TD 2011/22: 17.55 TD 2014/1: 15.190 TD 2015/14: 19.110 xlviii

Table of Rulings

ATO Interpretative Decisions ATO ID 1009/135: 13.195 ATO ID 2002/775: 8.240 ATO ID 2011/58: 13.425 ATO Law Administrations Practice Statements PS LA 2003/3: 19.50 PS LA 2003/7: 19.310 PS LA 2003/12: 13.525 PS LA 2008/3: 19.60 PS LA 2008/4: 19.80 PS LA 2011/4: 19.420 PS LA 2011/17: 19.540

SUPERANNUATION Superannuation Guarantee Rulings SGR 2009/2: 19.110

COMMONWEALTH INDIRECT TAXES GST Rulings GSTR 2001/3: 4.600 GSTR 2004/2: 13.65 Product Rulings PR 98/2: 19.50

OTHERS

Miscellaneous Tax Rulings MT 2016: 4.380, 4.390, 4.400 MT 2019: 4.380, 4.390, 4.410 MT 2021: 4.440, 4.450

OTHERS 92/201: 11.195 ID 2009/28: 10.180 LCG 2015/1: 19.50

xlix

INCOME TAX IN CONTEXT 1. Tax Policy and Process ......................................................................... .. 3

PART1

2. Fundamental Principles of the Income Tax System ...................... .. 35

1

CHAPTER 1 Tax Policy and Process [1.10]

1. TRADITIONAL APPROACH TO TAX POLICY....................... ............................. 4

[1.20]

(a) Why Do We Need Taxes? ......................................................................................... 4

[1.30]

(b) Criteria for Judging Tax Systems .............................................................................. 5

[1.60] [1.70] [1.80] [1.100] [1.120]

(c) Alternative Tax Bases ................................................................................................ 7 (i) Income ..................................................................................................................... 8 Henry Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy ................................................................................................................ 8 (ii) Consumption ........................................................................................................ 13 (iii) Wealth .................................................................................................................. 14

[1.130] [1.140]

(d) Tax Expenditures ................................................................................................... 14 Reform of the Australian Tax System, Draft White Paper .................................................. 14

[1.160]

2. WELFARE ECONOMICS AND TAX POLICY....................... ............................. 16

[1.170]

(a) Two Theorems of Welfare Economics and Taxes ..................................................... 16

[1.180]

(b) Market Failure ....................................................................................................... 17

[1.190]

(c) Optimal Taxation in a Second-Best World .............................................................. 17

[1.200]

(d) Ramsey Taxes and the Equity–Efficiency Trade-Off ................................................. 18

[1.210]

(e) Haig-Simons Comprehensive Income Revisited ...................................................... 18

[1.220]

(f) Insights and Limitations of Optimal Taxation .......................................................... 19

[1.230]

3. THE HENRY REVIEW ...................................... ................................................ 20

[1.240]

Australia’s Future Tax System, Report to the Treasurer, Pt 1 Ch 2.1 .................................. 20

[1.250]

(a) Progressive Marginal Tax Rates and the Tax-Transfer Unit ....................................... 24

[1.260]

(b) Critique From an Optimal Tax Perspective ............................................................. 25

[1.270]

4. TAX PROCESS........................................... .................................................... 26

[1.280]

(a) Tax Reform and the Democratic Process ................................................................ 26

[1.300]

(b) Constitutional Constraints ..................................................................................... 28

[1.310]

(c) Development of Tax Policy into Legislation ............................................................ 30

[1.320]

(d) Legislation by Press Release ................................................................................... 31

[1.330] [1.340]

(e) Interpretation of Tax Legislation ............................................................................. 33 MLC Ltd v FCT ............................................................................................................. 33

3

Income Tax in Context

1. TRADITIONAL APPROACH TO TAX POLICY It was Alistair who said, on national television, that being a Tax Officer was the most pleasant work imaginable, like turning on a tap to bring water to parched country. It felt wonderful to bring money flowing out of multinational reservoirs into child-care centres and hospitals and social services … He sold taxation as a public good. Peter Carey, The Tax Inspector (Vintage International, 1993, 124) [1.10] It has been traditional to analyse tax policy by first taking the revenue needs of

government as given, then applying criteria of equity, efficiency and simplicity to the tax system and in particular analysing the income tax in terms of the Haig-Simons comprehensive definition of income. This chapter begins with a brief introduction to this method of analysis which was the dominant official (bureaucratic) approach until recently. Much of the public finance literature since the 1970s, however, has departed from this approach and based the analysis of tax and social policy on welfare economics. Accordingly, in the second part of the chapter, we give an introduction to the use of welfare economics for tax policy analysis. The last major tax review, Australia’s Future Tax System (2009), commonly called the Henry Review after the former Secretary of the Treasury Ken Henry who was its chair, applied a mixture of the traditional and modern approach. Major tax reform is contested, difficult and always partial. Australia’s tax system, in particular the income tax which is the main focus of this book, has demonstrated remarkable stability over the last century, while also being the subject of many large and small reforms. Most recently, the Abbott government issued the Re:Think Tax Discussion Paper (March 2015) to start a “national conversation” about tax reform. This goal seems to have been abandoned by the Turnbull government as too politically challenging, although various specific changes are underway to which we refer in later chapters of the book. The chapter concludes with a brief discussion of the process of tax law in Australia: how it is made – the process of putting tax policy into legislation, and how it is interpreted – the process of giving meaning to legislation. Chapter 2 discusses the fundamental concepts that underlie the statutory concept of income. Then the following chapters in Pts 2–6 are a detailed step-by-step analysis of income tax using the various materials available for interpretation. The final step in the tax process – putting legislation into action by the tax administration and taxpayers – is covered in Pt 7 which canvasses the means of dealing with tax avoidance, including a more detailed analysis of interpretation of the legislation.

(a) Why Do We Need Taxes? [1.20] The cost of government is large. The Commonwealth Government estimates

expenditure of about $431 b in the 2016-17 budget, of which 80% is expended directly and about 20% is given to State governments to spend. One justification for the existence of government is to provide public goods. The benefit theory of taxation suggests that we pay taxes in order to fund public goods. The concept of public goods has a long history; for example, Adam Smith, writing 250 years ago, explained public goods as being “in the highest degree advantageous to a great society” but in which no one individual would invest sufficiently and which should be provided for all; for example, Smith included education for children in this category (An Enquiry into the Nature and Causes of the Wealth of Nations (1776) Book V, V.1.69, http://www.econlib.org). In modern economic theory, public goods are those goods and services that either will not be supplied by the market or will be supplied by the market in insufficient quantity. They have two critical 4

[1.10]

Tax Policy and Process

CHAPTER 1

properties. First, it costs nothing for an additional individual to enjoy their benefits. Second, they are non-excludable – it is not possible to exclude anyone from their benefit. National defence is an often cited example. However, today less than 5% of government expenditure in Australia is on defence while about 50% of government expenditure is on health and education which are commonly described as public goods. The other justification for the existence of government and for the raising of taxes is to fund redistribution so as to address economic inequality and poverty. Since the 19th century, redistribution has become a major function of many governments. In Australia, more than one third of Commonwealth government expenditures are on social security and welfare payments including the age pension, family payments, childcare benefits, disability support, Newstart unemployment benefits and youth allowance. These are called “transfer” payments in economic parlance. Governments can finance themselves by a variety of means including commandeering resources from private individuals, creating money, borrowing, user charges or taxation. Adam Smith said that only taxes could provide “That sure, steady, and permanent revenue which can alone give security and dignity to government … defraying the necessary expence of any great and civilized state.” (An Inquiry into the Nature and Causes of Wealth of Nations (1776), Book V, V.2.13, V.2.22, http://www.econlib.org). The size of government has increased massively since Adam Smith’s time, but this statement remains true for most countries today. Taxes account for around 95% of Australian Government revenue. This book focuses on the income tax, which is Australia’s most important tax. Income tax on individuals, companies and other entities generates about 70% of Commonwealth tax receipts and about 60% of all tax revenues in Australia. The income tax has been seen by many as an ideal tax for funding public goods and to achieve the goal of redistribution because payment is based on ability to pay and its rates can be (and almost inevitably are) progressive, so that those with more income pay more in taxes. This was expressed by Attorney General Billy Hughes in his second reading speech on introducing the federal income tax in Australia in 1915 (Hansard, House of Representatives): The Commonwealth has hitherto not resorted to taxation of income but I have always regarded this form of direct taxation as particularly, peculiarly appropriate to the circumstances of a moderate community. Not only as an effective means for raising money for the conduct of government, but serving as an instrument of social reform.

(b) Criteria for Judging Tax Systems [1.30] In traditional policy analysis of taxation, it is usual to take the need for revenue as

given. The focus is on the best way to raise taxes. In order to debate this question it is necessary to have criteria against which to test various tax measures and suggested changes to the tax system. Although there has been discussion of the criteria at least since the time of Adam Smith, in the 1970s it was generally agreed in Australia that the criteria could be reduced to three – equity (fairness), efficiency and simplicity. Equity was seen as having two dimensions: horizontal equity – taxpayers in like situations should be treated alike; and vertical equity – taxpayers in different positions should pay appropriately different amounts of taxes. For example, taxpayers with more income, reflecting greater capacity to pay, would be liable to pay more income tax. Efficiency was essentially interpreted as saying that taxes should not influence individual choices (neutrality). Simplicity means that taxes should be collected with [1.30]

5

Income Tax in Context

the minimum of cost of administration by government, or of compliance by taxpayers. These objectives can obviously conflict and not surprisingly taxation and different, and often controversial, judgments may be made on the trade-offs between them. Surprisingly, there was broad agreement over many years on the general direction of tax reform in Australia – broadening the base of taxes and lowering tax rates. The general idea was that if all income or expenditure was taxed without exclusions or concessions, that produced horizontal equity as well as efficiency and simplicity. In turn, lower tax rates could then produce the same revenue and interfere less with individual choices, contributing to efficiency. Progressive tax rates, especially in the income tax, could be retained to the extent it was desired to differentiate between taxpayers and ensure that taxpayers with more income paid higher income tax, achieving vertical equity. [1.40] There have been several major reviews of the tax system since the 1970s which all

accepted the general tax reform strategy of broadening the base and lowering the rates. In 1975, the Taxation Review Committee presented its Full Report (Asprey Report) (AGPS, Canberra, 1975). Owing to the dismissal of the Whitlam Labor Government in that year, this report never received the full attention of government. Nonetheless the Asprey Report set the tax policy agenda for the following three decades. It proposed a goods and services tax (GST), – called in the Asprey Report a value added tax (VAT); a capital gains tax (CGT); corporate-shareholder imputation; and reform of the taxation of foreign income – to mention some issues which have been current since then. In 1985, the Hawke Labor Government embarked on major tax reform which gave us the fringe benefits tax (FBT), CGT and the imputation system. The debate was commenced by the release of the government’s tax reform options in Reform of the Australian Tax System, Draft White Paper (AGPS, Canberra, 1985). The Draft White Paper proposed broadening the income tax base and introducing a broad-based consumption tax. The latter proposal failed for political reasons at the 1985 Tax Summit but the income tax proposals formed the basis for most of Australia’s tax reform measures in the decade from 1985. At the same time, the base-broadening allowed maximum individual tax rates to decline from around 60% to around 50%. [1.50] In the early 1990s, the Liberal/National Coalition led by John Hewson in Opposition

proposed a major tax reform including a broad based GST and lowering income tax rates (presented in the 630 page Fightback!proposal). The Coalition lost the “unloseable election” and so the package did not proceed. However, led by John Howard, the Coalition won office in 1996 and returned to tax reform in 1998. The Howard government presented in Tax Reform – Not a New Tax, a New Tax System (AGPS, Canberra, 1998) its plans to introduce a GST to deal with federal–State financial relations by passing the revenue from the tax to the States, lowering personal income tax rates and reforming the business income tax. The GST was introduced in 1999 at a rate of 10%, with all revenues going to the States, income tax rates were lowered and family welfare benefits were significantly increased. [1.55] The Howard Coalition government also commenced a Review of Business Taxation

which produced the report, A Tax System Redesigned (AGPS, Canberra, 1999). This report proposed company tax base-broadening changes which were immediately adopted including the abolition of accelerated depreciation so as to fund cutting the company tax rate. It also abolished indexation for CGT and introduced the 50% CGT discount for individuals. Other changes that were proposed and apparently accepted by the government were never enacted, 6

[1.40]

Tax Policy and Process

CHAPTER 1

including a new method of calculating taxable income (the tax value method) and a unified entity tax regime under which, in particular, trusts would be taxed the same way as companies. The tax value method did not proceed because it did not change very much at a substantive level while requiring an entire rewrite of the income tax law and administration systems, while the unified entity regime would have taken away the effectively transparent taxation that trusts achieved for small and privately owned businesses. However, the recommended tax regime for consolidation of corporate groups was introduced in 2002 (see Chapter 15) and changes were made to taxation of financial arrangements (see mainly Chapter 12 and Chapter 14), which took full effect only in 2010.

(c) Alternative Tax Bases [1.60] The three major tax bases available to governments in modern times are income,

consumption and wealth (which are closely related, as we shall see). Most taxes can be classified into one or other of these tax bases. In each case the tax base can be broader or narrower, and tax can be levied on the base in varying ways. No developed country relies on a single tax base to raise government revenue. The combination of taxes is sometimes called the “tax mix”. However, the emphasis on certain bases or types of tax is greater in some countries than in others. Recent tax reform debates in Australia have focused on the balance between income and consumption taxes. It has been argued that, compared with its principal trading partners, Australia relies excessively on the income tax as its major tax base (see, for example, Re:Think Discussion Paper, Treasury, 2015). Comparing tax statistics in different countries is, at best, a risky business. The first problem arises from the different federal systems in various jurisdictions, as the example of income taxation illustrates well. In Australia, a single income tax is levied at the Commonwealth level. In other federal jurisdictions, there are often separate federal and State (or provincial) income taxes. Sometimes, as is the case in the United States, taxpayers may receive a third income tax assessment from their city or municipality. How then does one compare the level or rates of Australian income tax with those of the United States – by looking at United States and Australian federal income taxes only; or by looking at federal, State and municipal income tax in the United States and federal income taxes in Australia? A second problem is the use of different instruments with the same economic effect where one instrument is classified as a tax while the other is not. While at first glance, Australia’s reliance on the income tax appears to be relatively higher than that of other comparable countries, Australia’s income tax is used to fund programs paid for by social security taxes on wages in many other countries. Once these are taken into account, Australia drops towards the bottom in the OECD in terms of reliance on income and social security taxes relative to other forms of taxes. Even this adjustment is misleading, however, as Australia funds an increasingly large amount of retirement income out of superannuation funds. In other countries, retirement pensions are mainly funded out of social security. The superannuation guarantee means that most superannuation saving is compulsory in Australia (as are social security taxes overseas) but contributions to superannuation funds are not treated as taxes in standard OECD revenue statistics A third source of difficulty in comparing tax systems relates to tax expenditures, which are tax concessions that are functionally equivalent to government expenditures (effectively, the government collects the tax and pays out amounts by way of grants to the activity or taxpayer [1.60]

7

Income Tax in Context

that benefits from the concession). There is no internationally agreed method for comparing tax expenditures across countries. Without adjusting tax revenues for tax expenditures, comparisons of tax revenue will miss differences in the tax base, arising where one country taxes and spends revenue on particular activities while other countries use tax expenditures to the same end. (i) Income [1.70] The best-known articulation of the income concept in English is by Henry Simons. The

definition of income in Simons’ analysis is often referred to as the Haig-Simons “comprehensive income” tax base.

Henry Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy [1.80] Henry Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy, University of Chicago Press, Chicago, 1938 [at pp 49–57, 105–106, 122–124, 150–151, 153] Personal income connotes, broadly, the exercise of control over the use of society’s scarce resources. It has to do not with sensations, services, or goods but rather with rights which command prices (or to which prices may be imputed). Its calculation implies estimate: (a) of the amount by which the value of a person’s store of property rights would have increased, as between the beginning and end of the period, if he had consumed (destroyed) nothing, or (b) of the value of rights which he might have exercised in consumption without altering the value of his store of rights. In other words, it implies estimate of consumption and accumulation. Consumption as a quantity denotes the value of rights exercised in a certain way (in destruction of economic goods); accumulation denotes the change in ownership of valuable rights as between the beginning and end of a period.

happen in subsequent periods. All data for the measurement would be found, ideally, within the period analysed.

The relation of the income concept to the specified time interval is fundamental – and neglect of this crucial relation has been responsible for much confusion in the relevant literature. The measurement of income implies allocation of consumption and accumulation to specified periods. In a sense, it implies the possibility of measuring the results of individual participation in economic relations for an assigned interval and without regard for anything which happened before the beginning of that (before the end of the previous) interval or for what may

This position, if tenable, must suggest the folly of describing income as a flow and, more emphatically, of regarding it as a quantity of goods, services, receipts, fruits, etc. To conceive of income in terms of things is to invite all the confusion of the elementary student in accounting who insists upon identifying “surplus” and “cash”. If one views society as a kind of giant partnership, one may conceive of a person’s income as the sum of his withdrawals (consumption) and the change in the value of his equity or interest in the enterprise. The essential

8

[1.70]

Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question. In other words, it is merely the result obtained by adding consumption during the period to “wealth” at the end of the period and then subtracting “wealth” at the beginning. The sine qua non of income is gain, as our courts have recognised in their more lucid moments – and gain to someone during a specified time interval. Moreover, this gain may be measured and defined most easily by positing a dual objective or purpose, consumption and accumulation, each of which may be estimated in a common unit by appeal to market prices.

Tax Policy and Process

CHAPTER 1

Henry Simons, Personal Income Taxation: cont.

income vary with considerable regularity, from one income class to the next, along the income scale.

connotation of income, to repeat, is gain – gain to someone during a specified period and measured according to objective market standards. Let us now note some of the more obvious limitations and ambiguities of this conception of income.

A similar difficulty arises with reference to receipts in the form of compensation in kind. Let us consider here another of Kleinwachter’s conundrums. We are asked to measure the relative income of an ordinary officer servicing with his troops and a flugeladjutant [a military officer] to the sovereign. Both receive the same nominal pay; but the latter receives quarters in the palace, food at the royal table, servants, and horses for sport. He accompanies the prince to theatre and opera, and, in general, lives royally at no expense to himself and is able to save generously from his salary. But suppose, as one possible complication, that the flugeladjutant detests opera and hunting.

In the first place, it raises the unanswerable question as to where or how a line may be drawn between what is and what is not economic activity. If a man raises vegetables in his garden, it seems clearly appropriate to include the value of the product in measuring his income. If he raises flower and shrubs, the case is less clear. If he shaves himself, it is difficult to argue that the value of the shaves must also be accounted for. Most economists recognise housewives’ services as an important item of income. So they are, perhaps; but what becomes of this view as one proceeds to extreme cases? Do families have larger incomes because parents give competent instruction to children instead of paying for institutional training? Does a doctor or an apothecary have relatively large income in years when his family requires and receives an extraordinary amount of his own professional services? Kleinwachter suggests that the poorest families might be shown to have substantial incomes if one went far in accounting for instruction, nursing, cooking, maid service, and other things which the upper classes obtain by purchase. A little reflection along these lines suggests that leisure is itself a major item of consumption; that income per hour of leisure, beyond a certain minimum, might well be imputed to persons according to what they might earn per hour if otherwise engaged. Of course, it is one thing to note that such procedure is appropriate in principle and quite another to propose that it be applied. Such considerations do suggest, however, that the neglect of “earned income in kind” may be substantially offset, for comparative purposes (for measurement of relative incomes), if leisure income is also neglected. For income taxation it is important that these elements of

The problem is clearly hopeless. To neglect all compensation in kind is obviously inappropriate. On the other hand, to include the perquisites as a major addition to the salary implies that all income should be measured with regard for the relative pleasurableness of different activities – which would be the negation of measurement. There is hardly more reason for imputing additional income to the flugeladjutant on account of his luxurious wardrobe than for bringing into account the prestige and social distinction of a (German) university professor. Fortunately, however, such difficulties in satisfactory measurement of relative incomes do not bulk large in modern times; and, again, these elements of unmeasurable psychic income may be presumed to vary in a somewhat continuous manner along the income scale. If difficulties arise in determining what positive items shall be included in calculations of income (in measuring consumption), they are hardly less serious than those involved in determining and defining appropriate deductions. At the outset there appears the necessity of distinguishing between consumption and expense; and here one finds inescapable the unwelcome criterion of intention. A thoroughly precise and objective distinction is inconceivable. Given items will represent business expense in one instance and merely consumption in another, and often the motives will be quite mixed. A commercial artist buys paints and brushes to use in making his living. Another person may buy the same articles [1.80]

9

Income Tax in Context

Henry Simons, Personal Income Taxation: cont.

as playthings for his children, or to cultivate a hobby of his own. Even the professional artist may use some of his material for things he intends or hopes to sell, and some on work done purely for his own pleasure. In another instance, moreover, the same items may represent investment in training for earning activity later on. The latter instance suggests that there is something quite arbitrary even about the distinction between consumption and accumulation. On the face of it, this is not important for the definition of income; but it must be remembered that accumulation or investment provides a basis for expense deductions in the future, while consumption does not. The distinction in question can be made somewhat definite if one adopts the drastic expedient of treating all outlays for augmenting personal earning capacity as consumption. This expedient has little more than empty, formal, legalistic justification. On the other hand, one does well to accept, here as elsewhere a loss of relevance or adequacy as the necessary cost of an essential definiteness. It would require some temerity to propose recognition of depreciation or depletion in the measurement of personalservice incomes – if only because the determination of the base, upon which to apply depreciation rates, presents a simply fantastic problem. It is better simply to recognise the limitations of measurable personal income for purposes of certain comparisons (for example, by granting special credits to personal-service incomes under income taxes). Our definition of income may also be criticised on the ground that it ignores the patent instability of the monetary numeraire [the currency], and it may also be maintained that there is no rigorous, objective method either of measuring or of allowing for this instability. No serious difficulty is involved here for the measurement of consumption – which presumably must be measured in terms of prices at the time goods and services are actually acquired or consumed. In periods of changing price levels, comparisons 10

[1.80]

of incomes would be partially vitiated as between persons who distributed consumption outlays differently over the year. Such difficulties are negligible, however, as against those involved in the measurement of accumulation. This element of annual income would be grossly misrepresented if the price level changed markedly during the year. These limitations of the income concept are real and inescapable; but it must suffice here merely to point them out … Another difficulty with the income concept has to do with the whole problem of valuation. The precise objective measurement of income implies the existence of perfect markets from which one, after ascertaining quantities, may obtain the prices necessary for routine valuation of all possible inventories of commodities, services, and property rights. In actuality there are few approximately perfect markets and few collections of goods or properties which can be valued accurately by recourse to market prices. Thus, every calculation of income depends upon “constructive valuation”, that is, upon highly conjectural estimates made, at best, by persons of wide information and sound judgment: and the results of such calculations have objective validity only in so far as the meager objective market data provide limits beyond which errors of estimates of income, especially upon problems centering around the “realisation criterion”. Our definition of income perhaps does violence to traditional usage in specifying impliedly a calculation which would include gratuitous receipts. To exclude gifts, inheritances, and bequests, however, would be to introduce additional arbitrary distinctions; it would be necessary to distinguish among an individual’s receipts according to the intentions of second parties. Gratuities denote transfers not in the form of exchange – receipts not in the form of “consideration” for something “paid” by the recipient. Here, again, no objective test would be available; and, if the distinctions may be avoided, the income concept will thus be left more precise and more definite … Since the devices of accounting and tax legislation contemplate only very rough approximation to income, it is decisively important to see behind these methods of calculation an ideal income, calculable by

Tax Policy and Process

Henry Simons, Personal Income Taxation: cont.

different and less practicable methods. Only on the basis of some broader conception is it possible to criticize and evaluate merely practicable procedures and to consider fruitfully the problem of bettering the system of presumptions. Indeed, if there be any excuse for a treatise like this, it must lie in the importance of maintaining some broad – and perhaps quite impractical – conception in terms of which existing and proposed practices in income taxation may be examined, tested, and criticized. … Indeed, it may be regarded as a sort of thesis that income, as already described, is essentially identical with that base on which it would be most nearly equitable to levy upon individuals … [W]hen property is employed directly in consumption uses, there is the strongest case for recognising an addition to taxable income. This is widely recognised in criticism of our federal tax for its egregious discrimination between renters and homeowners, and perhaps more strikingly in the almost consistently different practice among income taxes abroad … Receipts in kind may also take the form of compensation for services rendered. Our federal law provides for inclusion of compensation of whatever kind and in whatever form paid … The courts and the treasury distinguish strangely between cases where the taxpayer effects a saving but receives no income and those where the perquisites may be regarded as additional compensation. In England perquisites are taxable as income only in cases where the taxpayer is free to convert them into cash. Such arbitrary rules do invite caustic criticism. Anyone who condemns them hastily, however, will be placed in a most awkward position by a request for constructive proposals. There is here an essential and insuperable difficulty, even in principle. The problem of Kleinwachter’s flugeladjutant is insoluble and certainly is not amenable to reasonable solution on the basis of simple rules which could be administered by revenue agents. Obviously there are many instances where taxpayers are too favorably treated. The sporting-goods salesman, who lives

CHAPTER 1

at the best hotels and clubs and spends much time entertaining good customers “on the company”, might well be taxed on something more than his salary – providing he doesn’t dislike such life, as the flugeladjutant did the operas! Yet, after all, these are merely one kind of perquisite. Other positions may be equally attractive, at the same nominal salary, for prestige, freedom, leisure, or what not. And one must surely hesitate to propose graduation under income taxes according to the pleasurableness of people’s occupations. The taxation of compensation in kind, under our own law, presents another instance of clear discrimination against recipients of personalservice incomes. If one obtains use of one’s residence as part of one’s salary, the rental value must be included for income tax. On the other had, a neighbour, obtaining use of an identical house by virtue of ownership in fee, is quite exempt so far as concerns this item … It does seem thoroughly unsound, as a matter of definition, to set up a category of capital profits outside (or even within) the income concept. Although no satisfactory line can be drawn between these and other gains, and although any separation violates the underlying principle of income taxation, still it is not surprising that an issue should be found here. The case of capital gains reveals most strikingly those shortcomings of income tax which arise from instability of the numeraire. Moreover, such speculative profits invite special attention because of their peculiarly unstable, irregular, and fortuitous character. The irregularity of personal income presents a real problem for equitable taxation and one of special relevance here. Any tax graduated according to income for single years must impose undue burden upon persons with widely fluctuating incomes. Where the fluctuation arises from windfalls and gratuities, the discrimination may be unobjectionable, for heavy levies upon such receipts are generally approved. The same feeling as to capital gains is, however, surely less common, for they have at some flavor of “earnings”. Besides, losses fluctuate as well as gains, thus aggravating the situation. To eliminate both capital gains and losses in computing taxable income, however, would simply prohibit fairness in relative levies among [1.80]

11

Income Tax in Context

Henry Simons, Personal Income Taxation: cont.

persons. To do this, or even to make the more moderate concessions of our federal law, is to undermine the very basis of income taxation … The case in favor of some allowance for the irregularity of taxable income, however, is strong, for prevailing methods of measurement do

[1.85]

aggravate the inequities. The real culprit here is the realisation criterion. Gains and losses from capital transactions are recognised only when the investor “gets out”. One may complain of this practice; but to demand that it be abandoned outright is to display little regard for practical considerations. Escape from it is possible in the case of actively traded securities; but, unfortunately, the realisation criterion must be accepted as a practical necessity.

Questions

1.1

What according to Simons is the relationship between income, consumption and wealth? Can it be argued that a tax system with an income tax, a consumption tax and a wealth tax is taxing the same matter three times over?

1.2

Why is it necessary to choose a period over which to measure income? Would it be possible to operate a system that measures income over a lifetime rather than a year? Is lifetime income a better measure of ability to pay tax than income over one year? (Compare the lifecycle income of a professional sportsperson or a rock star with that of a public servant.)

1.3

Would Simons tax income as it accrues or when it is realised? For example, if a taxpayer buys an asset, holds it for more than a year and sells it at a profit, would the profit be taxed year by year over the period the asset was held as it increased in value, or would the profit only be taxed in the year when the asset is sold?

1.4

Would Simons tax as income benefits in kind from employment and, if so, how would those benefits be valued? Would Simons tax imputed income, for example, the imputed rent an owner-occupier of a house obtains? If imputed rent is taxed, how would expenses relating to the property like mortgage interest, rates, repairs and insurance be treated? Australia in fact taxed imputed rent under income tax from 1916 to 1923. Why do you think this tax was abandoned? Would Simons tax potential income? Take, for example, the case of a person who chooses to work for only three days a week when he can get full-time work, and spends the rest of the week surfing. Should he be taxed on the amount he would have earned if he worked for five (or seven) days a week, rather than the amount actually received for three days’ work?

1.5

1.6

1.7

Simons would levy tax on the basis of net gain rather than gross receipts, that is, receipts are reduced by the costs of earning income. How are costs of earning income and personal consumption expenses to be distinguished?

[1.90] As we shall see throughout this book, the concept of comprehensive income has been

influential in Australia so far as legislative changes to the income tax are concerned, although it has not had any marked impact on the judicial concept of income. When considering the Australian statute and case law in the rest of this book, you should ask yourself two questions. (1)

12

To what extent does Australian law reflect the concept of income elaborated by Simons? [1.85]

Tax Policy and Process

CHAPTER 1

(2)

Where the law departs from Simons’ concept, is the explanation that the law is bad, or that the concept is flawed as a theoretical or practical guide for taxing income? Schedular systems of taxing income are often contrasted to Simons’ comprehensive concept. Under a schedular system, income is divided into categories and each category is taxed separately. Deductions against one category of income are not usually allowed against other categories of income. As will become apparent in the various English cases you will read in this book, the UK system is schedular in origin, although the actual “Schedules” of income that historically existed in the UK tax statute are no longer there. Australia’s system on the other hand, like that of the United States, is apparently comprehensive or “global” in its drafting of the concept of income but not necessarily in operation. In origin, the UK schedular system had to do with preventing tax officials knowing the full extent of any taxpayer’s income (as each schedule was separately administered). It has been maintained not only out of the British respect for tradition and privacy, but also because it prevents tax planning based on using (artificial) deductions against one category of income being used against another. For example, the UK system does not have the same issue that is often discussed in Australia of current interest deductions on money borrowed to finance an investment that exceed the income from the investment being used against employment or business income of an individual taxpayer (so-called negative gearing). (ii) Consumption [1.100] Consumption taxes are generally levied as indirect taxes on businesses which are

passed on to consumers in the price of goods and services supplied – in Australia, the Goods and Services Tax (GST) is a consumption tax of this kind. These taxes are referred to as “indirect” because they are levied on the intermediary (though they could equally be levied as a matter of law on the consumer and collected from business like withholding of income tax on wages). The arguments in favour of indirect consumption taxes generally focus on perceived benefits in terms of complexity, avoidance, evasion and political acceptance. They are generally regarded as problematic in terms of vertical equity (fairness) as they usually have a flat rate and do not tax saving. Economic arguments in favour of indirect consumption taxes focus on horizontal equity and efficiency. During the 1970s and 1980s there was a lot of academic and some policy attention paid to the design of a personal or direct consumption, or expenditure tax. This tax would be levied like income tax directly on the individual rather than indirectly on businesses. Using the relationship between income and consumption noted by Simons, the tax base could be calculated as the individual’s income minus savings in a period. Another way of achieving a similar result is to exempt income derived from capital from tax (a so-called wage tax). For an analysis of consumption taxes see Head, “Alternative tax instruments and tax reform strategies” (1984) 1 Australian Tax Forum 16. [1.110] No country has yet enacted a direct consumption or expenditure tax. . However,

Australia’s income tax is sometimes described as a “hybrid” income-consumption tax because it taxes some forms of saving or capital lightly. In addition, Australia has long had various forms of indirect consumption tax. Until 1998, proposals to enact a broad-based consumption tax by both Labor (in the 1985 Draft White Paper) and the Hewson-led Liberal-National Coalition (in Fightback!) failed to garner support. In 1998, the Howard Government fought and (just) won its second term election giving it a mandate to introduce the GST. However, the GST reform package did not contain such a significant switch in the tax mix from income tax [1.110]

13

Income Tax in Context

to consumption tax as had originally been proposed. The GST was introduced at a rate of 10% with many exemptions in the base and the reform package was replete with compensation measures. The GST commenced on 1 July 2000 (see Cooper and Vann, “Implementing the Goods and Services Tax” (1999) 23 Sydney Law Review 337-436). Today, the GST is Australia’s second most important tax. (iii) Wealth [1.120] Wealth taxes (annual levies on a taxpayer’s wealth) or wealth transfer taxes (taxes on

the transfer of wealth by gift or will) have until very recently played a role in the tax bases of every developed country except two, Australia and Canada. Wealth taxes can be narrowly based (such as land taxes) or broadly based on total wealth; they can be annual levies based on wealth holdings or periodic levies on wealth transfers (such as estate and gift duties). Until the late 1970s Australia had, at the Commonwealth and State levels, a comprehensive system of gift and estate duties. In the mid-1970s the Asprey Report commended the gift and estate taxes as an integral part of the Australian tax system and made detailed proposals to overcome many of the problems in levying the taxes effectively. However, as chronicled by Willard Pedrick in “Oh, to Die Down Under! Abolition of Death and Gift Duties in Australia” (1982) 14 UWALR 438, tax competition between the States and political events at the federal government level led to the demise of these taxes not long after the release of the Asprey Committee’s final report. In recent years, many countries have found it increasingly difficult, whether politically or practically, to retain significant taxation of wealth. The problems of taxing wealth mean that other proposed reforms of the tax system (eg introducing a progressive consumption tax) may not be achievable if they are be premised on the existence of effective wealth taxes. We do not consider wealth taxes further in this book. A good review of the arguments for such taxes and the ways in which they can be constructed is found in Groenewegen, “Options for the Taxation of Wealth” (1985) 2 Australian Tax Forum 305.

(d) Tax Expenditures [1.130] The tax system serves a large number of functions in Australia. For example, it clearly influences behaviour, and the government often utilises this feature of the system to pursue a host of social and economic policy objectives. This phenomenon was noted in the 1985 tax reform debate.

Reform of the Australian Tax System, Draft White Paper [1.140] Reform of the Australian Tax System, Draft White Paper, AGPS, Canberra, 1985 Need to review Government spending programs in tax system 1.14

14

Equity, efficiency and simplicity are criteria that are used to evaluate technical tax provisions. In addition to technical provisions, however, the tax act contains a number of provisions that are functionally equivalent to direct spending programs. [1.120]

1.15

These tax concessions, or tax expenditures as they are sometimes termed, were placed in the act to deliberately influence private decisions and the allocation of resources in favour of particular sectors. A proper assessment of such concessions depends both on whether their resource allocation effects have net benefits for the Australian economy and on whether the tax system is the best method of delivering

Tax Policy and Process

receive the same amount, nontaxpayers – usually low-income individuals – will be excluded from the program.

Draft White Paper cont.

the assistance implicit in them. Judgments on the first point need to be reached on a case-by-case basis, but some general comments can be made about the use of the tax system to deliver government subsidies. 1.16

Once the need for any program of government assistance has been demonstrated, the question becomes what policy instrument should the government use in achieving the program’s objectives? The government has a wide range of possible instruments available to it such as grants, loans, guarantees, interest subsidies, regulation, the use of public institutions and tax concessions. Most of the criteria normally used in selecting the appropriate instrument would suggest that while tax concessions may sometimes be the most appropriate instrument, they should be used sparingly. • Equity – If the tax concession is structured as an exclusion or deduction from income it will be of greatest benefit to taxpayers with high marginal rates. Even if it is structured as a tax rebate so that all qualifying taxpayers

CHAPTER 1

Because tax • Controllability – concessions must necessarily be openended – available to any taxpayer who meets the eligibility requirements – once they are enacted the government generally has no way of controlling the public money spent through them. Consequently, tax concessions can end up costing the government more than anticipated and more than the government, in setting its spending priorities, had intended to spend in encouraging the particular activity or industry. • Accountability – Tax concessions are less visible than direct outlays and may therefore be subject to less public scrutiny. 1.17

Tax expenditures can be less efficient than direct outlays in targeting intended beneficiaries and ensuring their administration, including the control of abuse, by the most appropriate area of the bureaucracy. They also increase the complexity of the tax system and can contribute to the belief that the system is unfair.

[1.150] To calculate the budget cost, let alone the effectiveness, of such measures is not an

easy matter. The Treasury attempts to measure cost in its annual publication, the Tax Expenditures Statement.The Treasury explains that “a tax expenditure arises where the actual tax treatment of an activity or class of taxpayer differs from the benchmark tax treatment” (Tax Expenditures Statement 2015, Chapter 1). The estimate of revenue foregone by a particular measure is determined by measurement against the benchmark, holding all else in the system constant. The list of tax expenditures that this methodology throws up is extensive (the Tax Expenditures Statement 2015 reports 290 tax expenditures) and the measures arise in virtually all policy areas of government. As an estimate of revenue foregone, tax expenditures cannot be summed together as they are estimated on the basis that each exists independently, holding the remaining tax system constant. For the income tax, the tax expenditure benchmark is close to the Haig-Simons comprehensive definition of income (which is an explicit recognition of the underlying policy which Treasury regards as being incorporated in the income tax). Against this comprehensive income benchmark but ignoring imputed rent from living in your own home, the largest estimated tax expenditure in the income tax is the exemption from CGT of a taxpayer’s main residence (about $50 b revenue foregone in 2015-16). The second largest is the concessional [1.150]

15

Income Tax in Context

tax treatment of superannuation savings (about $30 b revenue foregone in 2015-16). For the GST, the benchmark is a broad-based consumption tax that applies to most goods and services. Against this benchmark, the next largest estimated tax expenditure is the exemption of food from the GST (revenue foregone of $6.8 b in 2015-16). When tax reform is in the air and there is talk of broadening the tax base and lowering tax rates, the estimates of tax expenditures assume particular significance as they identify candidates for base broadening. For example, the revenue estimates in the 1998 business tax reform were significantly based on eliminating accelerated depreciation so as to fund the reduction of the company tax rate from 36% to 30% (Review of Business Taxation, A Tax System Redesigned, pp 28-31). Accelerated depreciation has crept back into the system since that reform but the Tax Expenditure Statement 2015 states that it is unable to estimate revenue foregone from “caps” on depreciation as “unquantifiable” (but potentially large).

2. WELFARE ECONOMICS AND TAX POLICY [1.160] In recent years much attention has been given by economists to the application of

welfare economics to tax policy questions.1 This work started in the 1970s. Drawing on developments in the economics of information, the new models recognised from the outset that a government cannot tax what it cannot observe, and therefore cannot tax income comprehensively. For example, it is usually not possible to observe an individual’s gain from activities outside the market place. The tax literature of the 1970s instead showed that, without full information, it was necessary for governments to levy differential taxation and take account of behavioural responses of individuals to this differential taxation in deriving rules for an ideal tax system. This result led to the rejection of the Haig-Simons approach in public economics.

(a) Two Theorems of Welfare Economics and Taxes [1.170] Welfare economics starts with the question of why we need taxes, or more

fundamentally why we need government. The key to the answer is provided by what are referred to as the two fundamental theorems of welfare economics. The first theorem states that under certain conditions, competitive markets lead to an allocation of resources in which there is no change in the allocation that can make someone better off without making someone else worse off. This is called a Pareto efficient allocation. This does not mean that there is only one distribution of resources among individuals that is Pareto efficient; there are a number of such possible distributions. The second theorem states that every Pareto efficient allocation of resources can be attained by a competitive economy, provided we begin with a particular distribution of resources among individuals. Hence by taking resources from one individual and giving them to another, it is still possible to have a Pareto efficient outcome. This has the important consequence that if we do not like the distribution of income generated by a competitive market economy, the government can carry out a redistribution and we need not abandon the use of the competitive price mechanism. If the ideal conditions for the first and second welfare theorems hold, then government has the simple but important role of setting lump sum taxes on individuals to achieve the socially 1

16

We are indebted to Professor Patricia Apps for most of this section, which is extracted and summarised from unpublished material written by her. [1.160]

Tax Policy and Process

CHAPTER 1

desired distribution of income. This is known as the “first-best” solution to the tax problem. A lump sum tax does not distort competitive prices by making one kind of goods relatively more or less expensive than another. Lump sum taxes change behaviour in one way only, called an “income effect”. Those individuals whose incomes fall under application of the redistributive tax will reduce at least some of their purchases and those whose income rises as a result of redistribution, will increase them. But the outcome is still Pareto efficient. In contrast to a lump sum tax, a differential tax (most taxes in reality) does distort prices. For example, if a tax is levied on one particular kind of good but not on other goods, this will increase the price of the taxed good. This tax produces both an “income effect” and a “substitution effect” on behaviour of individuals. The substitution effect is a behavioural response to the fall in the relative price of the untaxed goods. The individual in the presence of the differential tax is likely to buy less of the taxed goods and will substitute a purchase of more of the untaxed goods than otherwise would be the case. This contrasts to the lump sum tax, where the individual buys less goods in total but does not change the mix of the goods purchased. This outcome of the differential tax is not Pareto efficient. The resulting efficiency loss is referred to as the deadweight loss or excess burden of the tax. It is measured by the difference between the amount of tax that an equivalent lump sum tax would produce and the lesser amount that the differential tax produces. An equivalent lump sum tax is one that leaves the individual at the same level of wellbeing as the differential tax (but with a different mix of goods purchased). The deadweight loss is entirely due to the substitution effect.

(b) Market Failure [1.180] There are many assumptions required for the ideal competitive market which

underlies the two theorems of welfare economics such as perfect information, no collusion between firms in setting prices and no risks of adverse events for which full insurance is not available at fair premiums. The assumptions cannot be achieved in the real world. This does not mean the formulation of a competitive model is a pointless exercise. The competitive model, and the assumptions on which it is constructed, provide the theoretical framework for defining market failure as the rationale for government intervention in almost all areas of the economy. The literature on different types of market failure is vast and is not covered here. It provides the economic justification for many of the activities undertaken by governments today, including the provision of public goods and the levying of particular kinds of taxes, such as taxes on pollution, tobacco or road congestion, sometimes called Pigouvian taxes.

(c) Optimal Taxation in a Second-Best World [1.190] Optimal tax models assume that the pre-tax economy satisfied all the conditions

necessary for Pareto efficiency, that society has well-defined preferences regarding the distribution of individual welfares and that lump sum taxes cannot be used to achieve that distribution. The innovative step was to combine distributional concerns with recognition that lump sum taxes are not possible, so that the second theorem of welfare economics does not hold. It was recognised that lump sum taxes were not feasible because individual endowments cannot be directly observed due to an information asymmetry. The government does not know the endowment (or potential income) of each individual, and is therefore limited to taxing proxies or surrogate measures of endowment. Examples of such proxies are the individual’s [1.190]

17

Income Tax in Context

observed income from work in the market place or their expenditure on market consumption goods. In both cases, the gains from time allocated to activities outside the market or household production are untaxed. Taxes on proxies imply differential taxation, which distorts relative prices. A tax on wage income reduces the net wage and therefore the implicit price of non-market activities. A tax on market consumption raises the price of market goods relative to that of goods or services produced outside the market. Given that the policy instrument for a first-best solution is not available, the aim of optimal tax theory has been to derive rules for tax design in a second-best setting. The literature of the 1970s combined, in a formal model, the government’s concern for redistribution taking account of efficiency loss due to differential taxation.

(d) Ramsey Taxes and the Equity–Efficiency Trade-Off [1.200] Much earlier, in 1927, Frank Ramsey presented an analysis of the tax problem for an

economy in which he assumed that all individuals were identical. He asked the question: what taxes should the government impose on different commodities, assuming it could not levy lump sum taxes? In other words, what is the least distortionary pattern of tax rates? Should, for instance, every commodity be taxed at the same rate in order to minimise distortions, as was widely believed at the time? Ramsey not only showed that this was wrong, but also derived a formula for the optimal rate of tax on each commodity. Differential taxes that minimise the excess burden are now called Ramsey taxes. Ramsey’s basic insight was to observe that commodities with a low elasticity of demand (that is, commodities for which the demand does not change greatly with the price) have a lower deadweight loss and thus should face higher tax rates. A disturbing feature of this result is that it suggests that high tax rates should be imposed on commodities with low price elasticities, such as food, with the result that the poor will bear a larger burden than the rich. The approach was thus largely dismissed when it was published. The approach was, however, accepted in the 1970s because the new models extended Ramsey’s original analysis to include redistributive goals. Where only indirect taxation is feasible, the extent to which one chooses between taxing necessities that are inelastic, as opposed to luxuries that are elastic, depends on the concern for income distribution. Optimal tax theory shows that the optimal policy, on the one hand, minimises the efficiency cost of achieving a particular distributional outcome and, on the other, attains the outcome which appropriately balances the social gain from redistributing income against the social cost of using distortionary taxes. This balancing of the social gain against the social loss at the optimum is the equity–efficiency trade-off. The optimal point is where the marginal social gain from the government giving an extra dollar to an individual is just equal to the marginal social loss caused by raising an additional dollar of tax revenue.

(e) Haig-Simons Comprehensive Income Revisited [1.210] A central motivation of Simons’ treatise was to find an ideal measure of income as a

reference for identifying shortcomings in the tax policy and law of the time. In common with the optimal tax theorists, Simons was concerned with redistribution and he recognised that an ideal measure of income could not be taxed in practice. He identified many of the same information problems that are of concern in optimal tax theory. In discussing inevitable exclusions from the tax base, he acknowledged that gains from the allocation of time to leisure and home production cannot be taxed. In economics, the gain from the allocation of time to 18

[1.200]

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both market and non-market activity is defined as full income, computed as the product of the wage and total time available where the wage measures earning power. Optimal tax models which assume that only wage income and/or consumption can be taxed, derive results for optimal tax rates taking account of the disincentive effect of not taxing the gains from non-market time. From this perspective, the Haig-Simons approach is internally inconsistent because Simons ignores disincentive effects. For the income tax, the relevant elasticity is about a decision to work in the market or the household (in traditional literature called the work-leisure choice) and the levying of a tax on (market) work may be a disincentive to do that work. Although Simons recognised that it was not possible to tax a comprehensive measure of income, he recommended that “practices in income taxation” be “examined, tested and criticised” in terms of departures from such a measure. Thus he ruled out the possibility of a gain in social welfare from not taxing a particular source of income, which is contrary to the Ramsey insight in relation to differential taxation. It could turn out to be true that, ideally, the income tax base should be as broad as possible, but this is not the point. The optimal tax base and rate scale can be determined only on the basis of empirical evidence on behavioural responses of individuals to differential taxation. In regard to neglected sources of gain, such as “earned income in kind” and “leisure”, it is interesting to note Simons’ comment that that these “vary with considerable regularity from one income class to the next, along the income scale”. In making this point, Simons is concerned here, as elsewhere, with equity. However, empirical evidence shows that this might not be correct. For example, two-parent families with the same observed market (“earned”) income actually make very different choices between market work and “leisure” (or work from home). These families may have one parent who does not work in the market or only works part-time and takes primary responsibility for childcare and work in the home (a “homemaker/breadwinner” household model), which contrasts with a family with two parents working full-time in the market, who must pay for childcare and home services.

(f) Insights and Limitations of Optimal Taxation [1.220] Under optimal tax theory, debates about society’s ethical views on distribution can, in

principle, be differentiated from arguments about the efficiency cost of distortionary taxation. Optimal tax theory for the first time recognised that cash welfare payments, or social security, known as “transfers” in the economic literature, can be analysed as “negative taxes”. The revenue from positive taxes on individuals with higher incomes finances negative taxes (or transfers) for those on lower incomes. In today’s world, where more than one third of Commonwealth government expenditures fund transfers, it makes no sense to analyse income taxes independently of these transfer or social security payments. The idea of an equity–efficiency trade-off in tax design has strongly influenced the way many economists think about taxation. It is often accepted without question that a tax reform designed to redistribute income necessarily involves such a trade-off – that there is no possibility of a gain in both equity and efficiency. This assumes that the first welfare theorem holds in the pre-tax world and there is no market failure. The assumption implies an “initial endowments” theory of inequality, which implicitly attributes inequality in observed income to differences in innate earning power. However, casual observation as well as extensive empirical research suggests that income inequality is to a large extent the result of market failure. [1.220]

19

Income Tax in Context

The idea of an inevitable equity–efficiency trade-off also ignores discrimination in the market on the basis of race, gender and other characteristics which are not related to innate ability. In these circumstances, redistributive policies may increase efficiency as well as equity. The models also fail to give direction on the problems of taxing two-parent households and market failure. Because they compare a tax change with a pre-tax equilibrium, they are of limited relevance to real-world tax changes which involve changes in the existing tax system.

3. THE HENRY REVIEW [1.230] The Henry Review signalled a shift in the official approach to tax reform. The Review

adopted an analysis of the tax and transfer system as a whole and drew on both comprehensive income concepts and optimal tax theory. The Review was intended to provide strategic direction for the tax system for many years ahead, rather than to present a package that would develop all the recommended policy changes in detail. However, for political reasons, two issues were off-limits: the rate and base of the GST and the exemption from income tax of superannuation payments that had been enacted in 2007. As the Rudd government which initiated the Review had come to government on a platform of enacting a carbon emissions trading scheme (carbon tax), the Review also did not deal with this topic in any detail. The Henry Review reported just after the Global Financial Crisis, at the end of the commodities boom and start of the current period of slow economic and wage growth and what has turned out to be a long period of fiscal deficits for Australia (now in its eighth year). Tax reform has proved difficult and contested in this period. The immediate response of the Rudd government on release of the Henry Review was a limited range of announcements but including one of great economic and political significance, the adoption of a Minerals Resource Rent Tax (MRRT). The way this issue was handled politically was partly responsible for the demise of Prime Minister Rudd. The Gillard government won the next election and succeeded in enacting the MRRT and the carbon emissions trading scheme. However, it subsequently lost office and the Abbott Liberal/National Coalition government came to government on a platform of “scrap the tax”. It repealed both the MRRT and the carbon emissions trading scheme.

Australia’s Future Tax System, Report to the Treasurer, Pt 1 Ch 2.1 [1.240] Australia’s Future Tax System, Report to the Treasurer, Pt 1 Ch 2.1 (2009) New insights about the design of taxes and transfers In redesigning the tax and transfer system, the Review has taken advantage of better and stronger understandings developed recently about the way taxes and transfers affect people’s

20

[1.230]

behaviour and the economy. The international consensus on these matters has moved some way since the last major reviews of the tax and transfer systems, the Asprey review of the tax system in 1975 and the Social Security Review initiated in 1986.

Tax Policy and Process

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Australia’s Future Tax System, Report to the Treasurer, Pt 1 Ch 2.1 cont.

Box 2.1: Design principles for the tax and transfer system Equity The tax and transfer system should treat individuals with similar economic capacity in the same way, while those with greater capacity should bear a greater net burden, or benefit less in the case of net transfers. This burden should change more than in proportion to the change in capacity. That is, the overall system should be progressive. Considerations about the equity of the system also need to take into account exposure to complexity and the distribution of compliance costs and risk. Efficiency The tax and transfer system should raise and redistribute revenue at the least possible cost to economic efficiency and with minimal administration and compliance costs. All taxes and transfers affect the choices people and businesses make by altering their incentives to work, save, invest or consume things of value to them. The size of these efficiency costs varies from tax to tax … and from transfer to transfer, reflecting, in part, the extent to which they affect behaviour. Instability in policy settings can reduce economic efficiency by increasing uncertainty about the expected payoffs to long-term decisions such as investing in education, choosing retirement products, investing in long-lived productive assets and the choice of business structure. These costs represent a net loss to society as a whole, whereas revenue raised through a tax is redistributed among members of society through government expenditure, including transfer payments. Simplicity The tax and transfer system should be easy to understand and simple to comply with. A simple and transparent system makes it easier for people to understand their obligations and entitlements. People and businesses will be more likely to make the most beneficial choices for themselves and respond to intended policy signals. A simple and transparent system may also involve lower compliance costs for taxpayers and transfer recipients. Sustainability A principal objective of the tax system is to raise revenue to fund government programs, including transfer payments. The tax system should have the capacity to meet the changing revenue needs of government on an ongoing basis without recourse to inefficient taxes. To be sustainable the tax system, together with the transfer system, must contribute to a fair and equitable society. The cost of the transfer system needs to be predictable and affordable in the light of demographic change. Sustainability also means that the structural features of the system should be durable in a changing policy context, yet flexible enough to allow governments to respond as required. Legal and administrative institutions and frameworks should also be robust to maintain the effectiveness of the system and underpin the legitimacy of the system. Policy settings should also contribute to environmental outcomes that are sustainable. Policy consistency Tax and transfer policy should be internally consistent. Rules in one part of the system should not contradict those in another part of the system. To the extent possible, tax and transfer policy should also be consistent with the broader policy objectives of government. However, the primary objectives of the tax and transfer system, to raise revenue and provide assistance to those in need, should not be compromised by other policy objectives.

The impact of taxes and transfers on economic growth Encouraging strong economic growth is one of the most effective ways of dealing with the fiscal pressures that are likely to be associated with the ageing of Australia’s population. Recent empirical studies suggest that economic growth is affected by the structure of the tax system. Company income tax has been found to have the

largest adverse effects on economic growth, followed in rank order by taxes on personal income, consumption and land (assuming all these taxes are on suitably broad bases) … This ranking reflects the higher efficiency costs of a tax levied on a base that can be moved or changed. For this reason, there should be a lighter tax burden on more mobile bases, particularly investment. [1.240]

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Income Tax in Context

Report to the Treasurer, Pt 1 Ch 2.1 cont. Tax and transfer policy should support productivity through the efficient allocation of investment and productive resources to their most highly valued uses. When products are taxed at the same rate, relative prices will be unaffected and there will be less impact on the decisions of individuals and businesses. A broad base also enables a lower rate of tax for a given revenue objective, which results in smaller distortions to people’s and businesses’ choices. Broadly-based taxes are, therefore, more consistent with an allocation of resources in the economy that supports a high rate of economic growth and individual satisfaction. Narrowlybased taxes can, however, improve resource allocation where they address cases of market failure or support improved social outcomes. People’s choices about participating in the workforce are affected by both taxes and transfer payments. International and Australian research has highlighted the different ways in which tax and transfer rules impact on the workforce participation of men, single and partnered women and women with children. In particular, partnered mothers and single parents are quite sensitive to the impact of taxes, transfer withdrawal rates and the level of transfer payments in deciding whether to undertake paid work. Associated with increased female workforce participation and the growth of two-income households, there is now also a greater awareness of the importance of policies that enable primary carers of children to make workforce participation choices that are in the best interests of their children and themselves. Studies generally confirm that in the period immediately following childbirth, both the mother and the baby benefit from the mother being at home. However, extended absences from the labour market tend to affect a person’s longer-term labour market prospects, with detrimental effects on longer term outcomes for both children and their parents, especially women. However, the potential for improved family wellbeing as a consequence of the primary caring parent returning to work while children are young depends on the availability of high quality affordable child care. 22

[1.240]

The tax and transfer system also affects people’s choices to save and invest. Recent theoretical and empirical research has brought a new perspective to the long-standing debate about the relative merits of comprehensive income taxation, under which savings income is taxed at a taxpayer’s marginal rate, and expenditure taxes, under which savings income is exempt. This work strengthens the argument that while there are potential benefits from taxing savings income, it should be taxed at a lower rate than labour income. Designing transfers to improve lifetime wellbeing In framing policies to alleviate disadvantage, a simple focus on the adequacy of income, judged against criteria such as the Henderson Poverty Line, has been replaced by broader goals that focus on lifetime income and the capacity of people to engage in work and other social activities. [The Henderson poverty line defines the amount of income below which a particular household would be considered to be in poverty. The benchmark level relating to 1973 was established by the Henderson Commission of Inquiry. This level is adjusted by per capita household income and is therefore a relative, rather than absolute, measure of poverty (Henderson 1975).] In particular, there is greater awareness that assistance should not encourage short-term choices which compromise the development of capabilities that offer potential medium to long-term improvements in a person’s wellbeing. For example, government assistance, and its interaction with taxation, should not lock people into welfare dependency by discouraging them from working, working longer hours, studying or retraining. This has seen increased emphasis on requiring people to work, actively seek employment or participate in training. Similarly, housing assistance should not lock people into geographical disadvantage. The distributional implications of taxes All taxes ultimately bear on or benefit people, not businesses or other entities. It is the distribution of the economic burden of taxes that is important for equity, not who remits a tax. Different community perspectives about the

Tax Policy and Process

Report to the Treasurer, Pt 1 Ch 2.1 cont. merits of a specific tax setting often reflect a difference of view about who ultimately bears the burden of a tax. It has long been understood that the person or entity legally obliged to remit a tax may not be the person, or the only person, whose income or consumption opportunities are altered. For example, taxes are shifted from businesses to households through higher prices for products or through lower returns to the use of domestic factors of production such as reduced wages, reduced rent or reduced prices for the use of natural resources (see Chart 2.2). The distribution of the burden of a tax can also vary over time as markets adjust. It is generally accepted that the burden of a tax will fall to a greater extent on: • a person consuming a product or owning a factor of production for which the demand or supply is unresponsive to a change in its price; • a person consuming a product with no ready substitutes; or • a person owning a factor of production that is relatively immobile. There has been less agreement about the extent to which tax shifting occurs in practice and where the burden of most taxes ultimately rests. It follows, however, that in a small open economy like Australia’s, where capital and products can move relatively freely between Australian and overseas markets, the burden of most taxes ultimately is likely to fall largely on Australian residents. It also follows that the extent to which this occurs is likely to be higher in the longer term, as there is greater capacity for resources to be reallocated across the economy in response to changes in prices or the return to investment. Recent empirical work using economic models is shedding greater light on this issue. At least some of the burden of company income tax is shifted onto labour. This is because investors can avoid the tax by moving their capital abroad. Less capital in the economy means lower productivity of labour and land and this means lower wages and lower rents for the owners of land. These effects are less pronounced where a tax is levied on profits that arise because of the specific location of an investment, as is often the case with non-renewable resources.

CHAPTER 1

Taxes (such as payroll tax, insurance tax and GST) on the factors of production and other business inputs tend to be shifted to households through lower returns to those factors or higher product prices. Taxes that appear to be borne by the business owner end up being borne by them either as a supplier of labour or as an owner of specific capital. In contrast, the burden of a broad-based uniform tax on land will fall primarily on existing landowners. The fixed supply of land limits the ability of landowners to pass the tax onto others. Instead, the price of land would adjust to restore the market rate of return to holding land as an asset. Policy measures that compensate people for the indirect impacts of taxes, such as changes to the rates of transfer payments by indexation or other compensation measures and increases to first home owner grants, effectively shelter the recipients from the burden of those taxes. A consequence of such indexation is that it adds a degree of progressivity, even to broadly based indirect taxes that are fully passed on through consumer prices. The principle underlying compensation measures in this context is that where taxpayers have arranged their affairs on the basis of the existing arrangements or are poorly placed to rearrange their financial affairs (either because they are not able to do so, or because it would be unreasonable to expect them to absorb the cost of doing so), it is necessary to effectively shelter them from the burden of those taxes. Compensation measures have also reflected judgements about the distributional impact of taxation changes. However, compensation measures can be complex. Grandfathering arrangements can result in service delivery agencies administering two sets of rules. Measures to insulate income support and family assistance recipients from the price changes of major shifts in the tax base can also result in complex arrangements. A payment indexed only to the CPI will automatically adjust to changes in prices (though in some circumstances special measures will be needed to bring forward the payment of the CPI increase). However, if it is important that payments benchmarked to community living standards do not reduce in real value, other changes in addition to normal indexation are necessary. [1.240]

23

Income Tax in Context

Report to the Treasurer, Pt 1 Ch 2.1 cont. The Report does not outline specific compensation measures for the recommended changes to taxation. The design of any such measures will depend on government decisions about policy reform packages. However, in this context it should be noted that if payment or taxation rates are effectively adjusted to compensate low and middle income households for changes that are often regarded as regressive (such as flat rate taxes and consumption taxes), such taxes can have an overall progressive effect. Consistent with the principles articulated in Part Two, the personal income tax and transfer system is the most appropriate mechanism for compensating lowand middle-income households for major tax changes. The costs of complexity The complexity of the tax system and the costs of complying with it are perennial concerns, particularly of the business community. Recent research suggests a range of costs associated with this complexity. It reduces transparency, impeding optimal decision making by businesses and individuals and their ability to respond to intended policy signals. It can cause people inadvertently to pay the wrong amount of tax or claim more or less than they are entitled in

transfer payments. It is regressive in its impact, affecting mostly those people with the least capacity to deal with complexity and the least access to professional help. Significant among the causes of complexity are the pursuit of finely calibrated equity and efficiency outcomes, instability in policy settings and people’s incentives to maximise their aftertax and transfer incomes or after-tax business profits. The provision of choice in determining a tax liability can increase complexity and result in higher compliance costs where taxpayers seek to discover the best tax outcome. Complexity may also be compounded where policy settings within the system do not draw on “natural” taxpayer systems or are inconsistent with broader policy objectives of government. Related to the issue of complexity are the costs of administering and complying with the tax and transfer system. These costs represent a net loss to the economy, because the resources engaged in these activities could otherwise be put to more highly valued uses. Recent research suggests there is an optimal level of system complexity and operating costs, one that balances administration and compliance costs with improved efficiency and distributional outcomes.

(a) Progressive Marginal Tax Rates and the Tax-Transfer Unit [1.250] Australia’s income tax has always applied progressive marginal tax rates to an

individual tax unit. However, the transfer (social security or welfare) system has mostly been targeted based on a joint spouse or family unit, in particular since the establishment of substantial “family tax benefits” (cash transfers) for low and middle income families with children by the Howard government in the 1990s. Australia also provides childcare benefits for children in paid childcare that are means-tested and withdrawn based on family income. One recommendation of the Henry Review for the individual income tax was a restructuring of the tax rate scale with a large tax-free threshold or zero bracket of $25,000, a tax rate of 35% on income in the range $25,000–$180,000 and of 45% above that range. While continuing to support the individual tax unit, in the transfer system, the Henry Review recommended keeping the family tax benefit means-tested by withdrawing the benefit based on family (couple) income. The tax rate reforms have been partly enacted by Labor and Liberal/National Coalition governments, while joint testing of family and childcare benefits remains. The zero tax bracket was expanded from $6,000 to $18,200 in 2012 (about $20,000 for low income earners or pensioners, as a result of the Low Income Tax Offset and Seniors and 24

[1.250]

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Pensioners Tax offsets). The remaining marginal tax rates are 19%, 32.5% (up to $80,000), 37% (up to $180,000) and 45% above that. In addition, most individuals pay the Medicare Levy, now 2% of taxable income. Top marginal taxpayers have for the last three years been subject to an additional 2% Temporary Budget Deficit Repair Levy. The Henry Review also suggested that a standard deduction be given to each individual taxpayer which would eliminate the need for the large majority of individuals to claim (and keep records for) specific deductions for income-related expenses. The Review further recommended that investment income and capital gains of individuals be calculated separately, net of related expenses and with a general 40% discount for net investment income to take account of inflation. These recommendations have not been implemented by governments to date.

(b) Critique From an Optimal Tax Perspective [1.260] The tax and transfer system recommendations of the Henry Review, and adopted by

governments, have been subject to considerable criticism led by Professors Apps and Rees, Why the Henry Review Fails on Family Tax Reform and Rees, “A New Perspective on Capital Income Taxation” in Evans, Krever & Mellor (eds), Australia’s Future Tax System: The Prospects After Henry (2010) 103, 129. Apps and Rees observe that these tax rate changes and targeted family benefits continue a trend of recent decades that shifts tax burdens on labour income from upper income taxpayers to lower and middle income taxpayers. The current system also taxes secondary earners (largely women) at significantly higher effective marginal and average tax rates than primary income earners (largely men). These effects are caused by flattening marginal tax rates and targeting or means-testing various transfer (welfare) payments which in the past were universal. The targeting limits the transfer to persons below a certain income and then withdraws it as their income from other sources (such as wages) increases. Viewing the tax and transfer systems as a single system, this generates high “effective marginal tax rates”, as the withdrawal rate operates as an additional implicit tax on the earned income, on top of the regular income tax rate applicable to the income. The saving from limiting the previously universal benefit is then returned to all taxpayers in the form of a tax cut. Those above the limit for the transfer payment will benefit from the tax cut, whereas those below the limit keep the benefit and have a tax cut plus an additional implicit tax. In a zero sum (revenue neutral) game there will be winners and losers from the change. The highest income taxpayers get more benefit from the tax cut (whose value is greater the higher the income) than they lose from forgoing a universal benefit. In addition, such a change inevitably produces a crazy pattern of effective marginal tax rates where the highest effective marginal rates fall on middle income earners. The withdrawal of most family and childcare benefits based on family (couple) income, not individual income, means that if an extra dollar of income comes from the second member of the household getting a job, the withdrawal mechanism for the benefit will apply and it acts as an implicit additional tax on that income. Primary earners in families (typically, men) who keep working and earning a similar level of income over many years are not generally affected by this. Consequently, the high effective marginal tax rate typically impacts on women as secondary earners, who get taxed more than men earning similar incomes. The alternative for many women in such cases is to work in the home, providing untaxed household production particularly in the form of childcare. There is a very significant economic inefficiency created by this higher effective tax on a group (women with children) whose labour supply is very [1.260]

25

Income Tax in Context

responsive to tax because of the untaxed production choices available to them. The empirical evidence also shows that the effect of discouraging secondary earners with young children from market work has persistent effects across their working life, caused by the degradation of workplace skills (loss of human capital) from choosing household production over paid employment. It is argued by economists that saving is “double taxed” under the income tax (because the return to saving is taxed). This has been linked to low saving rates. Common solutions suggested have been a progressive direct expenditure (consumption) tax (as discussed above) or a lower rate of tax on income from capital. The general impression from this analysis is that most saving comes from the highest income earners and that it is the high rates of tax on their investment income under a progressive income tax that are the cause of the low level of saving. However, impressions can be deceiving. The data on which such statements are based relate to family, not individual, incomes. What they disguise is that most of the saving in volume terms is done by dual-earner households with average incomes. Critically, the amount of saving in the household is closely related to the income of the secondary earner. Hence the deleterious effect of the current tax system on labour supply of women carries over to the amount of saving that occurs in Australia. It is this which is the major adverse impact of the tax system on saving, not the tax treatment of income from saving directly. In this context, reducing the effective marginal tax rates on the second earner in the household would produce a double benefit, including both higher saving in households and increased productivity of the workforce.

4. TAX PROCESS [1.270] The process of turning tax policy into legislation has attracted criticism for many

years because all interested groups – politicians, bureaucrats, tax professionals and taxpayers – are dissatisfied with the length and complexity of tax legislation and the ongoing requirement to continually amend it to overcome policy or technical deficiencies. Various experiments have been tried over the years and new processes have often been put into place, but it remains to be seen whether the product is any better. As you proceed through this book you should consider the particular vintage of tax legislation you are analysing to judge for yourself whether legislation has improved or not.

(a) Tax Reform and the Democratic Process [1.280] There are many players in the tax reform process and their goals are undoubtedly

diverse. Leaving to one side the role of the judiciary, institutional players in the reform process include the politicians in the government and opposition parties and public servants in Treasury and the Australian Tax Office. These participants are constantly addressed by pressure groups representing particular interests, such as business and industry, unions, community or welfare representatives, tax and financial law and accounting advisers and more specialised interests. All of these groups regularly call for particular changes, make comments on proposed changes and today, are almost always consulted prior to change. Political scientists, sociologists, economists and psychologists have developed a bewildering variety of theories about how and where special interest groups exercise their influence on government policy, and many of these theories could be applied to studying the formation of tax policy. They range from the highly theoretical to the entertaining – for example, the 26

[1.270]

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CHAPTER 1

account of the US reforms in J Birnbaum and A S Murray, Showdown at Gucci Gulf – Lawmakers, Lobbyists and the Unlikely Triumph of Tax Reform (New York, Vintage, 1988). In this discussion we can do no more than highlight a few of the theories about a few of the players. Broadly, the theories about how government policy is formed tend to align themselves into two groups: those which emphasise the interactions between policymakers and private groups; and those which emphasise the goals of policymakers within the apparatus of the state. A concise summary of one interactive explanation of the behaviour of politicians is given in S Ross and P Burgess, Income Tax: A Critical Analysis (2nd ed, Law Book Co Ltd, Sydney, 1996), p 205: Politics is the realm of power and ideas, but in a democracy, politics can be viewed as a market where the traded commodity is votes. Politicians seek votes by promising public expenditures on areas favoured by a sufficient section of the electorate to ensure them office. To fund that expenditure they must raise taxes, preferably from that part of the electorate which did not vote for them. In practice, taxes are raised from both relatively small groups (for example, as with land tax, now paid by a small number of non-farming landowners) and from virtually everybody (for example, as with income tax). But it remains true that, other things being equal, the government of the day will tend to tax more lightly its supporters and will tend to be less mindful of the interests of its opponents.

This description sees politicians as captured to a greater or lesser degree by the social groups on which they depend for their existence. In fact, as the system develops, the influence of the interest groups would not even need to be exercised openly – their views would be anticipated by the policymaker without the need for consultation, often because the policymaker came from the same background and was aware of their views. Many examples could be marshalled to support this theory, but contradictory examples would also soon appear. Why, for example, did the Labor government abolish a form of subsidy to business in the investment allowance in 1985 and then reintroduce a version of it in 1992? Why did the Howard Government take the benefit of accelerated depreciation away from business in 1999 and the Rudd Government introduce another investment allowance beneficial to business in 2008? While anomalies might be explained as examples of diffusion of power or choices between competing interest groups within a pluralist system, other theories explain inconsistencies by arguing that policymakers may have independent goals. Their goals may be for advancement within a party or bureaucracy, or strengthening the power of their particular faction or group. In other words, the goals of policymakers might not come from their need to address the concerns of particular interest groups, but rather be generated from within the structure of the state. So, a politician might seek to be a more important politician, rather than a politician who is more responsive to electors. Policymakers might then seek to achieve these goals by forming transient coalitions on particular issues and on particular occasions. Like all good theories, these competing views of the goals of policymakers may both be “right” or “wrong” for different policymakers, on different occasions and on different issues. It should also be stressed that there are serious constraints on the ability of policymakers, even willing policymakers, to effect some reforms. For example international competition between nations for capital (including human capital) and investment, as well as the substantial network of international bilateral treaties allocating shares of tax revenue to each state, may prevent countries from making some kinds of tax changes unilaterally. [1.290] More complete and convincing answers to questions such as these would also have to

take into account the roles and goals of senior policymakers within the public service. They [1.290]

27

Income Tax in Context

must undoubtedly be viewed as active players in the process of public policy formation, rather than the mere administrators of the policies of the government of the day they were once conceived to be. In a rather grand description of senior bureaucrats, M Pusey, Economic Rationalism In Canberra (Sydney, Cambridge UP, 1991), p 2: Nothing remains of the old positivist distinction … which says that politicians choose the values of public policy and public servants the neutral means for its implementation. Along with elected politicians and some types of intellectuals, top public servants are the “switchmen” of history; when they change their minds, the destiny of nations takes a different course.

Pusey’s sociological analysis of the elite echelons of the Canberra bureaucrats described a group who, for the most part, were young, almost exclusively male, came from privileged family backgrounds, were educated in private schools, concentrated their tertiary study in economics, and “far more conservative than they say or believe” (p 74). He observed: The central agency officers [in the departments Treasury, Finance, and Prime Minister and Cabinet] did not seek to hide the enjoyment of their power. … The central agency people were nearly four times more likely to mention the satisfactions of political influence than were their counterparts in [other] departments. The central agency people were more inclined to stress the private ego satisfactions of personal achievement. Over and over again the interviews were suddenly charged with a certain intensity as the respondents warmed to their own phrases about “the challenge” of the work and to their own feelings of “success” and personal achievement. … The stress that central agency people set on power, political nous and intellectual acumen tells us a good deal about the nature of their work and their place within the state apparatus. For the most part they are not “client-oriented”. It is true that in their role as brokers between Ministers and a great variety of powerful outside interest groupings, they do indeed have relationships with a variety of influential “outside” organisations. But they are not primarily oriented to delivering services to these outsiders.

Pusey’s analysis of 25 years ago may be less applicable today. Rather, the analysis by Laura Tingle of politicians and a public service which has lost its “memory” and, by implication, its analytical capability and its power to make policy, may be more apposite for contemporary times. (See Laura Tingle, Political Amnesia: How We Forgot How to Govern, Quarterly Essay 60, Black Inc Press, 2015).

(b) Constitutional Constraints [1.300] Australian governments are not entirely free to change the tax system as they want. The Australian Constitution provides some constraints, particularly for the States and Territories. Section 51(ii) empowers the Commonwealth Parliament to make laws with respect to taxation. The main issue that has arisen under this provision is whether a particular law amounts to a tax or a user charge or financial penalty. While the distinctions can be difficult to draw in various situations, no one doubts that the income tax is a tax under this provision. The section also provides that tax law must not discriminate between States or parts of States, which is reinforced by s 99 forbidding the Commonwealth giving “preference” to any State in a revenue law. Again this is the source of little controversy in the income tax. Other constraints upon the imposition of taxation are contained in s 55 of the Constitution. This section dictates a formal, rather than substantive, limitation on the Commonwealth’s powers, requiring the Parliament to deal only with tax matters in taxation laws and to deal with only one matter in each tax law. The operation of the section thus contains two separate elements: one ensures but limits the superiority of the House of Representatives over the Senate in financial matters by limiting tax Acts (which under s 53 of the Constitution can only 28

[1.300]

Tax Policy and Process

CHAPTER 1

originate in the House of Representatives and cannot be amended by the Senate) to deal only with tax. The second element limits the House to enacting one tax per Act. The first element has led to the process of separating the Tax (Imposition) Act from the Tax Assessment Act which is apparent throughout the income tax system, though whether this is required may be doubted. There is an Income Tax Act and an Income Tax Assessment Act; a Fringe Benefits Tax Act 1986 and a Fringe Benefits Tax Assessment Act 1986. It was apparently thought prudent to isolate the fringe benefits tax from the rest of the income tax system by including it in separate Acts but it was not thought necessary to separate the capital gains tax, nor the withholding tax for payments of dividends, interest and royalties to non-residents, although there is a separate imposition Act for the latter. As to the second element, occasionally what appears to be simply a formal requirement can become a potential impediment to governments. It was argued in State Chamber of Commerce and Industry v Commonwealth (1987) 163 CLR 329 that the fringe benefits tax dealt with more than one subject of taxation. The various subjects were said to flow from the anti-avoidance provisions of the Act: it taxed fringe benefits paid to employees, but it also caught a benefit paid to an associate of the employee; it taxed a fringe benefit paid by an employer, but it also caught a payment by an associate of the employer; and it caught a payment connected to the employment, but it also caught a payment only indirectly connected to the employment. The Court observed: clearly enough the legislation has been framed on the footing that there is but a single subject of taxation, formulated according to a broad conception of what constitutes fringe benefits. The conception embraces benefits, not being salary or wages, referable to the employment relationship, whether provided by the employer or not and whether received by the employee or not. So understood, the legislation presented for the consideration of each House of the Parliament [has] a unity of subject matter rather than distinct and separate subjects of taxation. [1.305] In Australia’s federal system, the allocation of taxing and spending power between

the Commonwealth and State governments has been controversial over the last century. In any federal system, there are problems of allocating jurisdictional responsibilities and resolving overlaps of authority. Some matters may be reserved exclusively for the central government, some for the regional government, and power over some matters may be shared. An example of the first class is the power of levying customs duties and excise taxes, which is specifically reserved for the Commonwealth by s 90 of the Constitution. This provision has been interpreted broadly by the High Court so that it effectively precludes the States from levying sales taxes on goods. The power to levy income tax is concurrent for the federal and State governments. After Federation, income tax was originally imposed only by State governments in Australia, with the Commonwealth relying until 1915 upon customs duties for most of its revenue. From 1915 until 1942 both State and Commonwealth governments shared this tax, each imposing their own income tax. The Commonwealth assumed exclusive control of the income tax in 1942, a procedure which was twice validated by the High Court, including a decision that the “grants” power in s 96 of the Constitution permitted grants from the Commonwealth to the States on conditions. The States were formally permitted to re-introduce income taxes from 1978 to 1989 by the now repealed Income Tax (Arrangements with the States) Act 1978, no State did so. The Commonwealth’s superior economic position effectively permits it to control the manner in which the States can raise revenue, and any move to impose a State income tax would almost certainly be met by a corresponding reduction in Commonwealth grants to that State. [1.305]

29

Income Tax in Context

The exclusion of States from taxing income or goods creates a problem usually referred to as vertical fiscal imbalance. The problem is simply that the States are expected by citizens to provide a level of public goods which costs far more than the States can raise from their available revenue sources – principally payroll tax, land tax, stamp duties and miscellaneous transaction taxes. In short, the Commonwealth collects most of the revenue but the States spend much of it. As noted above, 20% of the Commonwealth revenues are distributed to the States and Territories and these grants make up 45% of their budgets. The introduction of the GST and its allocation in full to the States under the Intergovernmental Agreement of 1998 has probably given the States greater financial independence, although this is declining as the GST revenues grow more slowly than originally anticipated while State expenditure demands, especially in health expenditures, are increasing significantly as the population ages. In return for the GST revenue, the State governments agreed to repeal many of their business transaction taxes such as stamp duty on leases, conveyances of shares, business assets and various instruments executed for borrowing money, financial institutions duties and bank accounts debits tax. After originally promising much, the States were reluctant to proceed and in the end less was achieved than promised. The Inter-Governmental Agreement on the Reform of Commonwealth–State Financial Relations is enacted in A New Tax System (Commonwealth–State Financial Arrangements) Act 1999. The Henry Review returned to the theme of reforming the more inefficient state taxes, however, the politics are challenging and it seems unlikely that major reform will be achieved in the near future.

(c) Development of Tax Policy into Legislation [1.310] In 1990, Canadian tax academic Brian Arnold asserted (“The Process of Tax Policy

Formulation in Australia, Canada and New Zealand” (1990) 7 Australian Tax Forum 379, p 393): [T]here is no question that … all governments should consult with the public, including tax professionals, concerning major tax reform proposals. This public consultation is one of the most important features of modern tax reform, since previously the making of tax policy was often shrouded in secrecy. The issue, however, is not whether consultation is desirable, but what form it should take.

Arnold’s comment refers specifically to “major” tax reform. For example, the Asprey Committee inquiry of 1975 received 600 submissions. At the other end of the spectrum, consultation on some important reforms has sometimes been targeted and confidential, as when the government obtained the advice of Mr G Hill QC (subsequently Justice Hill of the Federal Court) and Mr M Gleeson QC (subsequently Justice Gleeson of the High Court) in respect of the introduction of the General Anti Avoidance Rule in Part IVA of the Income Tax Assessment Act 1936 (see Chapter 20). The Review of Business Taxation in 1998 paid attention to improving and integrating tax policy and legislation processes and consultation in tax reform. On 1 July 2002, responsibility for the detailed the development of tax legislation was transferred from the Australian Taxation Office (ATO) to Treasury. It recommended establishment of a Board of Taxation, which continues with quasi-independent status within the Treasury, including representatives of business and the tax profession. The Board often reviews policy areas before government makes announcements and conducts post-implementation reviews to test whether tax legislation has achieved its purpose. More generally, consultation is now a matter of course for 30

[1.310]

Tax Policy and Process

CHAPTER 1

most tax reforms, whether large or small, including through inquiries, discussion papers, the release of exposure draft bills and, once a Bill is in Parliament, through mechanisms such as Parliamentary Inquiries. Today, the ATO has re-established a Policy and Law Design branch which works closely with the Treasury on tax reforms. [1.315]

1.8

Question

Can issues of complexity in legislation be solved by different bureaucratic arrangements and increased consultation? Is there something peculiar to taxation that makes tax legislation the most complicated in the land?

(d) Legislation by Press Release [1.320] One of the causes of concern to practising tax advisers that emerged in the mid-1980s

was the practice of the Treasurer to amend the Act by issuing a press release. For example, the capital gains tax was introduced effective 19 September 1985, but legislation was not enacted until 1986. Retrospectivity was again in the news in recent reforms to superannuation tax concessions, in the 2016-17 Budget. A good example of this process is the introduction of s 21A into the ITAA 1936. The section was foreshadowed in a press release issued on 4 February 1985 after the decision by the Federal Court in FCT v Cooke and Sherden (1980) 80 ATC 4140 (which is discussed in Chapter 5). The decision in that case held that a “fringe benefit” (that is, a non-cash benefit) paid to the owners of a business would not, in certain circumstances, be included in the assessable income of the recipients. The press release indicated that from February 1985, business fringe benefits would be included in the recipient’s assessable income. No legislation was produced until s 21A was released in Taxation Laws Amendment Bill (No 4) 1988. In the meantime, however, taxpayers had been informed that, despite the law as it stood in Cooke and Sherden, the ATO would nevertheless treat a business fringe benefit as assessable income. During those three years, of course, the Act had not been changed, nor had Cooke and Sherden been overruled by a court. The ATO might nevertheless have assessed individuals on the basis of the law as it would become, confident that the section, when it was eventually released, would be backdated to February 1985. Clause 13 of the Taxation Law Amendment Bill (No 4) 1988 did make the section apply to benefits provided after 4 February 1985. In fact the procedure was even more complicated than this, because before the Bill was enacted the government announced that s 21A would be amended in three material ways which would differ from the press release issued in February 1985. Here, therefore, was a press release and a Bill being amended by a further press release. When the amendments to overcome the Cooke and Sherden decision were introduced into Parliament, after pressure from the opposition parties in the Senate, the legislation was eventually expressed to apply from the date of its introduction into the House of Representatives – 31 August 1988, not 4 February 1985. You might care to ponder the position of taxpayers who paid tax on business fringe benefits in the intervening years after the first press release. The virtue of legislation by press release is that whenever a defect in revenue legislation is exposed by a court decision or otherwise, the government can immediately announce that it will enact legislation to overcome the defect before too many schemes are mounted to exploit the loophole. It can also be used for a distinct purpose of announcing major policy changes even though legislation may not have been completed if it is feared that details will leak or some urgent announcement is necessary. The process can also prevent major economic [1.320]

31

Income Tax in Context

dislocation that would arise if tax changes were signalled. For example, when the capital gains tax on shares was introduced in Canada, the valuation day nominated was some days before the announcement to prevent any dramatic changes in the market by a rush of trades. However, it is a fundamental principle of our legal system that (leaving aside the role of the courts) the law can only be changed by Parliament and until Parliament does so (or the case is overturned on appeal) it is inappropriate for the ATO to assess individuals except on the basis of the law as it stands. The ATO has no express power to assess an individual on the law as it might be and certainly would not be able to collect assessed tax on the basis of anticipated law. But the reality of court delays means that if the ATO wanted to assess tax on the basis of the law as it would become, by the time it sought to collect the tax the law will usually have been amended to support the assessment that he has raised. The issuing of an assessment on the basis of a press release does also assume the complete acquiescence of Parliament in the will of the ATO or Treasurer which the events in the Cooke and Sherden episode show might not always be accurate. Apart from questions as to legal validity, legislation by press release can create uncertainty in the tax system. Whether uncertainty is necessarily bad was discussed by H Reicher in “Legislation By Press Release” (1978) 7 Australian Tax Review 31. He noted that a degree of uncertainty might be exactly what a government would prefer. He suggested that: the effect of using the technique of legislation by press release – of merely threatening future retrospective legislation – is, it is suggested, far more potent from the government’s point of view than the actual legislation itself … When … a practitioner is faced with no more than an amorphous threat of retrospective legislation, he is placed in an unenviable dilemma. It is impossible to offer an informed opinion, as it is not known which particular provisions of existing legislation will be altered, what form the amendments will take and what may be their precise ramifications. … If taken to its logical extreme, governments may use legislation by press release to threaten retroactive amendments to revenue legislation and then, as a matter of deliberate policy, refrain from drafting amendments on the basis that the threat will be more effective than the deed itself.

Some other commentators have suggested that this response is exaggerated. The role of the tax adviser is to give advice on the law as it now stands, on the law as it may stand if proposed changes are enacted and on the law as it could stand if political or social pressures change. Some practitioners cautioned clients on the probability of a capital gains tax many months before it was introduced. After all, it had been actively discussed at the Tax Summit more than two months before the official announcement in September 1985. Similarly, some practitioners advised corporate clients to defer the realisation of income until the next year – anticipating a fall in the company tax rate in 1988. Concern about the process of legislation by press release provoked a response from the Senate in November 1988. The Senate’s resolution (reported in Hansard, Australia, Senate, Debates 1988, Vol 17, p 2220) announced that where the government “has announced by press release its intention to introduce a Bill to amend taxation law and that Bill has not been introduced into Parliament or made available by way of a publication of a draft Bill within six calendar months of the date of that announcement, the Senate shall, subject to any further resolution, amend the Bill to provide that the commencement date of the Bill shall be a date that is no earlier than either the date of introduction of the Bill to Parliament or the date of publication of the draft Bill as the case may be”. The 2008 review of tax policy and legislative process referred to above also suggested limits on retrospective tax legislation and the matter 32

[1.320]

Tax Policy and Process

CHAPTER 1

seems to have provoked less contention in recent times. The ATO has a process for dealing with unenacted announcements that will apply from the day of announcement or other time prior to the passage of legislation. [1.325]

1.9

Question

Is legislation by press release contrary to the rule of law?

(e) Interpretation of Tax Legislation [1.330] The interpretation of tax legislation by judges has been a vexed topic over the years.

Influenced by English decisions, the Australian courts tended to take the view that tax legislation was to be strictly construed in favour of the taxpayer. If the taxpayer could structure a transaction to fall within (or without) the terms of particular provisions in the tax law, then the tax result followed accordingly whether or not this seemed in accord with the intent of the legislation. Beginning in the 1980s, the judges moved to a more purposive interpretation of the law partly of their own accord and partly as a result of changes to the Acts Interpretation Act 1901. The current approach to interpretation was summarised as follows by Hill J in MLC Ltd v FCT (2002) 51 ATR 283 at 291-292:

MLC Ltd v FCT [1.340] MLC Ltd v FCT (2002) 51 ATR 283 It is now clear, if it ever was in dispute, that the task of construction is not one simply of taking each word used in a statute and applying the dictionary meaning of that word to arrive at a conclusion. The task is not as mechanical as that. While it is clear that the construction of a statute will commence with the words used and that it is a good start to assume that the words mean what they say, that is only a start to the process. As Gibbs CJ said in Cooper Brookes at 305: if the language of a statutory provision is clear and unambiguous, and is consistent and harmonious with the other provisions of the enactment, and can be intelligibly applied to the subject matter with which it deals, it must be given its ordinary and grammatical meaning, even if it leads to a result that may seem inconvenient or unjust. However, the English language is seldom so clear and unambiguous that only one construction is open. It is for that reason that in judicial decisions in recent times which have discussed the process of construction great importance has been attached to “context”. Perhaps the most famous and often cited passage to this effect is to be found in the judgment of the

High Court in CIC Insurance Ltd v Bankstown Football Club Limited (1997) 187 CLR 38 at 408 where Brennan CJ, Dawson, Toohey and Gummow JJ in a joint judgment wrote: It is well settled that at common law, apart from any reliance upon s 15AB of the Acts Interpretation Act 1901 (Cth), the court may have regard to reports of law reform bodies to ascertain the mischief which a statute is intended to cure. Moreover, the modern approach to statutory interpretation (a) insists that the context be considered in the first instance, not merely at some later stage when ambiguity might be thought to arise, and (b) uses “context” in its widest sense to include such things as the existing state of the law and the mischief which, by legitimate means such as those just mentioned, one may discern the statute was intended to remedy. Instances of general words in a statute being so constrained by their context are numerous. In particular, as McHugh JA pointed out in Isherwood v Butler Pollnow Pty Ltd, if the apparently plain words of a provision are read in the light of the mischief which the statute [1.340]

33

Income Tax in Context

MLC Ltd v FCT cont. was designed to overcome and of the objects of the legislation, they may wear a very different appearance. Further, inconvenience or improbability of result

may assist the court in preferring to the literal meaning an alternative construction which, by the steps identified above, is reasonably open and more closely conforms to the legislative intent.

[1.350] As you proceed through this book, you should consider to what extent this approach

is followed by the judges in the cases and by the ATO in public Rulings. Even in the most recent cases it is hard to find complete consistency in approach. We return to interpretation of tax legislation in more detail in Chapter 20.

34

[1.350]

CHAPTER 2 Fundamental Principles of the Income Tax System [2.10]

1. AUSTRALIAN TAX LAW CONCEPTS OF INCOME .................. ........................ 36

[2.20] [2.30] [2.40] [2.50]

(a) Income According to Ordinary Concepts ............................................................... (i) Influence of trust law .............................................................................................. (ii) Influence of other jurisdictions ............................................................................... Eisner v Macomber .......................................................................................................

[2.70] [2.80]

(b) Contrasting Judicial and Economic Concepts of Income: Income as Gain .............. 41 Hochstrasser v Mayes ................................................................................................... 42

[2.100]

(c) Statutory Modifications to Ordinary Income and the 1985 Tax Reforms ................. 43

[2.110]

2. ELEMENTS OF THE JUDICIAL CONCEPT OF INCOME .............. ................... 45

[2.120] [2.130]

(a) Realisation – Income as a Flow ............................................................................... 45 R W Parsons, Income Taxation: An Institution in Decay? ................................................. 45

[2.150] [2.160] [2.170] [2.180] [2.190] [2.215]

(b) Identifying the Taxpayer and the Taxable Event ..................................................... Federal Coke Co Pty Ltd v FCT ....................................................................................... (i) Constructive receipt ............................................................................................... (ii) Benefits received from intermediaries ..................................................................... Constable v FCT ........................................................................................................... (iii) Amounts received but for the benefit of others .....................................................

[2.220] [2.230] [2.260]

(c) Valuation ............................................................................................................... 54 FCT v Cooke and Sherden ............................................................................................. 55 Abbott v Philbin ........................................................................................................... 58

[2.280] [2.290]

(d) Apportionment ...................................................................................................... 59 McLaurin v FCT ............................................................................................................ 59

[2.310]

3. STATUTORY FRAMEWORK FOR TAXING INCOME ................. ....................... 61

[2.320]

(a) Taxable Income ..................................................................................................... 61

[2.330]

(b) Assessable Income ................................................................................................. 61

[2.340]

(c) Deductions ............................................................................................................ 62

[2.350]

(d) Rate Scales ............................................................................................................ 62

[2.360]

(e) Tax Offsets ............................................................................................................. 62

[2.370]

4. STRUCTURE OF THE AUSTRALIAN INCOME TAX SYSTEM ........... ................ 64

[2.370]

(a) Volume and Numbering of Legislation ................................................................... 64

[2.380] [2.390] [2.480]

(b) Integrating Elements of the Income Tax System .................................................... 65 (i) Method for inclusions in tax base ........................................................................... 65 (ii) Method for cost and outlays .................................................................................. 68

[2.550]

(c) Overlapping Assessment Sections .......................................................................... 70

37 38 38 39

47 48 49 50 50 53

35

Income Tax in Context

Principal Sections ITAA 1936 s 17

ITAA 1997 ss 4-1, 4-10

s 19

ss 6-5(4), 6-10(3)

s 21

s 25

Div 6

Effect These sections are the principal charging provisions in the Act. They bring into the charge to tax the taxable income of any person, resident or non-resident. These sections deem a person to have derived income realised indirectly by way of constructive receipt. This section applies to all non-cash transactions and values the consideration in such circumstances as its money value. These are the principal assessing provisions in the Act. They encompass all gains which fall within the judicial concept of income and in the 1997 Act statutory income.

1. AUSTRALIAN TAX LAW CONCEPTS OF INCOME [2.10] What is income for the purposes of Australian tax law? If you look at the ITAA 1997

for an answer, you will see that s 6-5 covers “income according to ordinary concepts which is called ordinary income.” The legislation offers little guidance on what is “ordinary income” and we have to turn to case law for assistance. Section 6-10 adds that assessable income also includes amounts covered by other sections that are not ordinary income, which are called statutory income. So, for income tax law, the meaning of income thus comes from two sources: the opinions of judges and the elaborations in the ITAAs. Sometimes in this book we will use the term “income” in a broad sense to encompass gains subject to taxation, including fringe benefits taxed under the fringe benefits tax (FBT) and capital gains taxed under the capital gains tax (CGT). At other times we use the term income (tax) in contradistinction to fringe benefits (tax) and capital gains (tax), that is, to identify the taxing provisions that apply, with some significant enhancement, to income according to ordinary concepts. Students will quickly and intuitively learn to distinguish the usages. The term “income” is qualified where it is used in the ITAAs by epithets such as “ordinary”, “statutory”, “taxable” or “assessable”. There are important consequences attached to these epithets and distinctions between the various meanings need to be kept in mind. One major difference between the ITAA 1936 and the ITAA 1997 is that the term “income” is intended not to be used unadorned. This has important implications for the structure of the legislation which is discussed at the end of this chapter. Finally, although we might think of the term “income” as relevant principally for tax law, in fact the concept is important (and has its own meaning) in other areas of law as well. For example, in trust law it is necessary to determine the income of the trust, as the beneficiaries are often divided into two categories with one entitled to the income of the trust and the other entitled to the capital of the trust. Similarly, under social security law, the entitlement to a pension is often reduced where the pensioner is in receipt of income as defined in the relevant legislation. Our concern is with tax law, but it will be seen that other areas of law where the 36

[2.10]

Fundamental Principles of the Income Tax System

CHAPTER 2

concept of income is important are not unrelated to tax law. In some situations, you will see the movement of definitions or concepts from one context to another.

(a) Income According to Ordinary Concepts [2.20] Despite the large accretions to the income tax legislation in recent years, most income

which is taxed in Australia enters the statutory calculation as income according to ordinary concepts, that is, what the judges say is income in case law. It was never likely that judges reared in the common law which elaborates concepts on a case-by-case basis, reasoning by common understanding, common sense and analogy, would depart from their traditions in the taxation area and state an overriding concept of income applicable to all cases. Indeed it is difficult to find any Australian cases conceptualising the matter and the High Court has rejected any such approach (see below). When making general statements about the law on the meaning of income for income tax purposes, many judges content themselves with a repetition of the words of Jordan CJ in Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215; 3 ATD 142: The word “income” is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts.

On the basis of this passage, the judicial elaboration of income was often referred to as the “ordinary concepts” notion of income, and this label was simply appropriated by the drafter and given statutory force in s 6-5 of the ITAA 1997. In deciding particular cases, the judges rely on decided cases with similar facts and apply or distinguish them in the normal common law way. It has been largely left to text writers to try to classify these cases and see what common ideas arise. There is general agreement in dividing the judicial concept of income into three broad areas: • income from services; • income from business; and • income from property. It is not possible to fit all decided cases into this framework, however, and some wider search for a conceptual framework has been attempted. For example, Professor Ross Parsons in Income Taxation in Australia, Law Book Co, Sydney, 1985 seeks to relate the law to Simons’ concept of income (Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (1938)) by insisting that gain is an essential element in the judicial concept of income and delineating five categories of gain that are within it: • rewards for services; • profits from carrying on a business; • return from property; • receipts in compensation for income or allowable deductions; and • periodical receipts. Others seize on the distinction between intended and unintended receipts in trying to elaborate the concept. Thus gifts and profits on the sale of property not bought with a profit-making [2.20]

37

Income Tax in Context

purpose are excluded from income, while receipts from services, business and property are included as they are cases where the taxpayer set out to obtain the receipt. As with most areas of judge-developed law, there will always be disagreements as to the precise classification of the judicial pronouncements on the meaning of income. For the purposes of this book we have adopted the traditional classification with some modification based on Parsons’ framework. Although the Australian judges have created most of the law on what constitutes income for Australian income tax purposes, they have not worked in a vacuum, for concepts of income were available in other areas of the law and in overseas jurisdictions. We will briefly look at two other influences on the meaning of income. (i) Influence of trust law [2.30] It has already been noted that trust law for many centuries has had to elaborate a

meaning for income to divide trust property among beneficiaries with differing rights in the trust. It is clear in a number of areas that trust concepts of income have been influential in developing the tax law concept of income. The failure of the judicial concept of income to include capital gains can be attributed to the influence of trust law concepts of income. The division of trust property between beneficiaries is usually effected by the income–capital distinction, that is, there will be income beneficiaries and capital beneficiaries of the trust. For example, if property is left by a will on trust to the spouse of the deceased for life and the remainder to the children of the deceased after the death of the spouse, the life tenant (the spouse) will be entitled to the income from the property for life and then the property will pass to the capital beneficiaries (the children) on the spouse’s death. If the property increases in value and is sold by the trustees pursuant to a power in the will of the deceased to be replaced by other property, any increase in value of the property sold will inure to the capital beneficiaries and hence may be described as a capital gain (in contrast to the income, such as rent from the property, which belongs to the life tenant). This explanation of the income capital distinction and the influence of trust law are not always accepted; see Ault and Arnold, Comparative Tax Law (2nd ed) pp 25 26, 116, 198; Prebble, “Income Taxation: A Structure Built on Sand” (2002) 24 Sydney Law Review 301. (ii) Influence of other jurisdictions [2.40] So far as the influence of overseas jurisdictions is concerned, it should be noted that

Australia is not a “colony” of the United Kingdom in the income tax area, in contrast to many other areas of the law. The United Kingdom income tax is based on the schedular system introduced in the early 19th century, that is, income is by legislation divided into various categories (schedules in the original legislation) and separate rules as to deductions, etc are enacted for each category. The schedular system and the reasons for it are described in Chapter 1. The Australian income tax system by contrast was based, from its earliest expressions, on a more global concept of income. Although income is now split into ordinary and statutory income, generally the two categories are added together as assessable income and deductions of all kinds are similarly aggregated and deducted from assessable income: see s 4-15 of the ITAA 1997. There is no need, for example, to subtract deductions relating to income from property only from that income. This has meant that the Australian courts have adopted a take 38

[2.30]

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it or leave it attitude to United Kingdom cases in the income tax area. Sometimes the United Kingdom case law is distinguished as being based on different legislation, while at other times it is accepted as relevant to the Australian statute without question. Students should observe for themselves in the Australian cases extracted in this book which approach is adopted to United Kingdom case law in the particular instance in question. Like Australia, the United States adopts a global approach to income in its statute and leaves it largely to the courts to elaborate the concept. Unlike Australia, the United States courts have accepted the challenge to state a general concept of income. In Eisner v Macomber, the United States Supreme Court was concerned with the constitutional validity of taxation of a stock dividend (or in Australian parlance, a bonus share issue) whereby the company capitalised its retained profits and issued to shareholders new shares in the company in proportion to their existing shareholdings. Under the United States Constitution Art 1, direct taxes are required to be apportioned among the states in accordance with population, but the Sixteenth Amendment creates an exception to this rule in the case of taxes on incomes. The taxpayer argued the stock dividends were not income and hence the tax levied on them was unconstitutional. Pitney J delivered the judgment of the court, as follows.

Eisner v Macomber [2.50] Eisner v Macomber 252 US 189 (1920) In order, therefore, that the clause cited from Article I of the Constitution may have proper force and effect, save only as modified by the Amendment, and that the latter also may have proper effect, it becomes essential to distinguish between what is and what is not income, as the term is there used; and to apply the distinction, as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which alone it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised. The fundamental relation of capital to income has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time. For the present purpose we require only a clear definition of the term income, as used in common speech, in order to determine its meaning in the Amendment; and, having formed also a correct judgment as to the nature of a stock dividend, we shall find it easy to decide the matter at issue.

After examining dictionaries in common use … we find little to add to the succinct definition adopted in two cases … “Income may be defined as the gain derived from capital, from labour, or from both combined”, provided it be understood to include profit gained through a sale or conversion of capital assets … Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy. The Government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word “gain”, which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. “Derived-fromcapital”; “the gain-derived-from-capital”, etc. Here we have the essential matter: not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being “derived”, that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal; that is income derived from property. Nothing else answers the description. [2.50]

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Income Tax in Context

Eisner v Macomber cont. The same fundamental conception is clearly set forth in the Sixteenth Amendment – “incomes, from whatever source derived” – the essential thought being expressed with a conciseness and lucidity entirely in harmony with the form and style of the Constitution. Can a stock dividend, considering its essential character, be brought within the definition? To answer this, regard must be had to the nature of a corporation and the stockholder’s relation to it. We refer, of course, to a corporation such as the one in the case at bar, organised for profit, and having a capital stock dividend into shares to which a nominal or par value is attributed … The dividend normally is payable in money, under exceptional circumstances in some other divisible property; and when so paid, then only (excluding, of course, a possible advantageous sale of his stock or winding-up of the company) does the stockholder realise a profit or gain which becomes his separate property, and thus derive income from the capital that he or his predecessor has invested … We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent

accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realised or received any income in the transaction. It is said that a stockholder may sell the new shares acquired in the stock dividend; and so he may, if he can find a buyer. It is equally true that if he does sell, and in doing so realises a profit, such profit, like any other, is income, and so far as it may have arisen since the Sixteenth Amendment is taxable by Congress without apportionment. The same would be true were he to sell some of his original shares at a profit. But if a shareholder sells dividend stock he necessarily disposes of a part of his capital interest, just as if he should sell a part of his old stock, either before or after the dividend. What he retains no longer entitles him to the same proportion of future dividends as before the sale. His part in the control of the company likewise is diminished … Yet, without selling, the shareholder, unless possessed of other resources, has not the wherewithal to pay an income tax upon the dividend stock. Nothing could more clearly show that to tax a stock dividend is to tax a capital increase, and not income, than this demonstration that in the nature of things it requires conversion of capital in order to pay the tax.

[2.60] With its emphasis on the nexus between gain and its source (“Income may be defined

as the gain derived from capital, from labour, or from both combined”), the income concept adopted by the United States Supreme Court in Eisner v Macomber is quite close to the Australian concept that arises out of, but is not articulated in, the Australian cases, apart from the fact that the United States concept clearly included capital gains (in the phrase “provided it be understood to include profit gained through a sale or conversion of capital assets”). Subsequent to Eisner v Macomber the United States judicial concept of income moved away from a particularised notion in which income could be divided into various categories depending on its source to a more global (and correspondingly broader) concept. In Commissioner v Glenshaw Glass Co (1955) 348 US 426, the United States Supreme Court said the definition of income in Eisner v Macomber served a useful purpose but was not meant to provide a touchstone to all future gross income questions. Instead, the Court adopted an income concept based on “instances of undeniable accessions to wealth, clearly realised, and over which the taxpayers have complete dominion”. The judicial concept of income expressed in Glenshaw Glass is not greatly different from the economic concept set out by Simons. The case exemplifies a judicial approach to the 40

[2.60]

Fundamental Principles of the Income Tax System

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income concept that goes far beyond anything to be found in the Australian cases. Although United States authorities have been quoted from time to time in Australia, the broad and conceptual style of formulating an income definition has generally not been followed in this country. However, many commentators have suggested the High Court adopted a more comprehensive approach to the income concept in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 18 ATR 693; 87 ATC 4363 (extracted in Chapter 5). This issue was considered by the High Court of Australia in Montgomery v FCT (1999) 198 CLR 639; [1999] HCA 34, a case concerning a lease incentive paid by a landlord to induce a tenant to sign a lease (see Chapter 5). The majority judgment states: As was noted in FCT v Myer Emporium Ltd, both the “ordinary usage meaning” of income and the “flow” concept of income derived from trust law have been criticised. But both the ordinary usage meaning and the flow concept of income are deeply entrenched in Australian taxation law (Parsons, “Income Taxation: An Institution in Decay?” (1986) 12 Monash University Law Review 77) and it was not suggested by either party that there should be any reconsideration of them. Nor was it suggested that they should be replaced by concepts of gain or realised gain, concepts that some economists consider preferable (Simons H C, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (1938)). [2.65]

Questions

2.1

Should the legislature spell out in detail what is to be treated as income rather than leaving the question to the courts? What advantages does the judicial approach have over the legislative solution?

2.2

Is it better to tax income under a schedular system or under a global system?

(b) Contrasting Judicial and Economic Concepts of Income: Income as Gain [2.70] You will recall from Chapter 1 the comprehensive definition of income which emerges

from the economic literature in the Haig-Simons tradition. The relationship between the legal definition of income for tax purposes and the economists’ comprehensive concept has been mentioned at a number of points above, and the impression may have been conveyed that the judicial concept is always smaller than economic notions. In fact ordinary income is both under-inclusive and over-inclusive when compared with the economic definition. In addition to the lack of a capital gains tax, ordinary income does not generally include gifts, and gambling and lottery winnings. On the other hand, ordinary income includes the gross amount of annuities and royalties paid to a person even though the payments include some recovery of the purchase price or property involved in the transaction and do not represent pure gain. Ordinary income also involves a defective valuation principle as discussed below. On the other hand, the law on income according to ordinary concepts in some areas seems to follow the logic of Simons’ concept of income by regarding a receipt as not being income on the basis that there is no gain in the particular situation. For example, generally a person will not be treated as deriving income for tax purposes where he or she is not beneficially entitled to the receipt. The classic case is the trustee, but as the legislation has express provisions to deal with the trust, the principle does not often have to be relied on. Nonetheless, where the trust provisions seem likely to produce taxation on a person in her or his personal capacity on income to which he or she has no beneficial entitlement, the courts will seek to prevent this result. A very good example of this process is the judgment of Dixon J in Countess of Bective v [2.70]

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Income Tax in Context

FCT (1932) 47 CLR 417; 2 ATD 80. The issue in the case was whether the Countess was taxable on amounts paid to her under a trust but which she was obliged to spend on the maintenance of her daughter. Dixon J said: The question is whether the payments to her form part of her assessable income. [They] appear to have been included in the taxpayer’s assessment upon the view that she took [them] beneficially, the statement of the purpose contained in the provision for maintenance amounting to no more than an expression of the donor’s motive, or of his expectation. [Their] inclusion in her assessable income could be supported if the statement of the purpose were understood as annexing to a gift to her a condition which she was bound to perform. Possibly, it might be supported also if the condition were construed as a gift of income to the taxpayer subject to a charge for maintenance. But if either of these two constructions were adopted, a corresponding deduction should be allowed for expenditure upon maintenance, a deduction which would not, of course, necessarily amount to the same sum. On the other hand, if she is not an object intended to be benefited at all by the provision for maintenance, the payments ought not, in my opinion, to be included as assessable income of the taxpayer, although if it appeared she had appropriated to her own use an unexpended surplus after discharging her duty of maintaining her daughter, the surplus would be taxable as part of her income.

More recently (and doubtfully), the courts have held that an embezzler is not taxable on interest earned on amounts embezzled because it is subject to a trust in favour of the true owner of the money: Zobory v FCT (1995) 64 FCR 86; 30 ATR 412; 95 ATC 4251. Another way of reinforcing the gain idea is to identify a rule that an amount received by a taxpayer must belong to that taxpayer absolutely if it is to be taxed on it. Parsons expresses a rule that “there is no gain [and therefore no income] unless an item is derived by the taxpayer beneficially”: see R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, p 36. A similar idea explains why a person may not be taxable where an amount is received which he or she is obliged to expend in benefiting another or which compensates for a detriment suffered in serving another, although there is not strictly a trust involved as regards the amount. For example, in Hochstrasser v Mayes, the taxpayer was an employee of a company which had a scheme whereby employees were compensated for any loss they made on the sale of their homes when being transferred from one location to another by the company. The taxpayer was assessed on an amount received under this scheme but the House of Lords held that the receipt was not taxable. Lord Denning explained the conclusion as follows.

Hochstrasser v Mayes [2.80] Hochstrasser v Mayes [1960] AC 376 My Lords, tried by the touchstone of common sense – which is, perhaps, rather a rash test to take in a revenue matter – I regard this as a plain case. No one coming fresh to it, untrammelled by cases, could regard this £350 as a profit from the employment. Mr Mayes did not make a profit on the resale of the house. He made a loss. And even if he had made a profit, it would not have been taxable. How, then, can his loss be taxable, simply because he has been indemnified against it? I can readily appreciate the case which was put in argument – namely, that if an employer, by 42

[2.80]

way of reward for services, agrees to indemnify his employee against his losses on the Stock Exchange, the payments which the employee received under the indemnity would be taxable. But that would be because the losses were his own affair and nothing to do with his employment: the payments of indemnity would there be a straight reward for services. This payment of £350 was nothing of that kind. It was a loss which Mr Mayes incurred in consequence of his employment and his employers indemnified him against it. I cannot see that he gets any profit

Fundamental Principles of the Income Tax System

Hochstrasser v Mayes cont. therefrom. If Mr Mayes had been injured at work and received money compensation for his injuries, no one would suggest that it was a profit from his employment. Nor so here, where all he receives is compensation for his loss. Why, then, if this case is as plain as I think it is, has it got so far as to reach your Lordships’ House? Only, I suggest, because of a broad proposition which the Crown advanced about “profits”. This proposition was put forward almost as if it were a definition of what the law regards as the “profits” of an employment. It was supported with quite a show of authority. So much so that the Court of Appeal were induced to accept it as correct – though the majority, to be sure, refused to hold that it applied in this case. I need hardly say that, if there were available to your Lordships a definition of “profits”, it would be a pearl of great price. But I am afraid that this pearl turned out to be cultivated and not real. It was culled

CHAPTER 2

from the cases and not from the statute. It did not survive the critical examination of your Lordships. When subjected to close scrutiny, it was found to be studded with ambiguities and defaced by exceptions. It would, if accepted, put a greater burden on the taxpayer than ever the statute warrants, and it would introduce more confusion into a subject where enough already exists. I would ask your Lordships, therefore, to put on one side the proposition submitted by the Crown and to go back to the words of the statute. I do not find much help in any of the previous decisions: and the speeches in them cannot rule the day. They show the way in which judges look at cases, and in that sense are useful and suggestive, but in the last resort each case must be brought back to the test of the statutory words. So tested the question simply is: was this £350 received by Mr Mayes a “profit” from his employment? I think not, for the simple reason that it was not a remuneration or reward or return for his services in any sense of the word.

[2.90] The fringe benefits tax and capital gains tax may now affect the outcome in both the

case and analogous situations (though not always clearly so). The reasoning of the remainder of the House of Lords in Hochstrasser v Mayes was different from Lord Denning. They held that the payment was not taxable as it was the equivalent of a gift by the employer to the employee unrelated to the employee’s services. There are many cases dealing with gifts to employees, some of which are extracted in Chapter 4. It may be doubted whether the reasoning of the majority of the House of Lords in this case is consistent with the principles emerging from those cases.

(c) Statutory Modifications to Ordinary Income and the 1985 Tax Reforms [2.100] Although the judicial concept of income has moved over time in Australia, the speed of change has been too slow for the legislature which has intervened increasingly from the 1980s to correct perceived aberrations in the law. Until 1985, much of the legislative intervention was simple repair of the law, but since then the interventions have changed the face of Australian income tax law so as to reduce greatly the practical significance of the concept of ordinary income in the sense that many gains falling outside ordinary income are now usually subject to tax. The reforms in the area of the income tax announced on 19 September 1985 are often described as “base broadening” measures by which is meant the reforms bring the income tax base as it operates under the law closer to the comprehensive tax base of Simons. Although the changes were many, two stand out: the capital gains tax and the fringe benefits tax. It has [2.100]

43

Income Tax in Context

already been explained that the judicial concept of income did not generally include profits made on the sale of capital assets (capital gains). Some statutory changes had been made to the judicial rules before 1985, for example, profits on property purchased and sold within 12 months had been taxable under s 26AAA of the ITAA 1936 (which was repealed with effect for sales occurring after 25 May 1988), but now generally all assets acquired after 19 September 1985 are subject to tax as capital gains under Pts 3-1 and 3-3 of the ITAA 1997. Although it is common to speak of the capital gains tax as if it were separate from the income tax, in fact the tax works by an inclusion of net capital gains in assessable income as statutory income under s 6-10 by the effect of s 102-5 of the ITAA 1997. Nonetheless the calculation of the tax payable on capital gains is the subject of many special rules and calculations and the capital gains tax is often for convenience spoken of as if it were separate from the income tax. In general terms, the capital gains tax operates to tax a profit made on the happening of a CGT event, most commonly the disposal of an asset that was acquired on or after 20 September 1985. Capital gains will be studied in greater detail in Chapter 3. It will then become apparent that the so-called capital gains tax not only applies to profits made on the sale of assets, but also catches a number of other gains that escaped the income tax prior to 1985. The other major base-broadening initiative of 19 September 1985 was the fringe benefits tax. Here the problem under the previous system was of a different kind to that dealt with by the capital gains tax. Fringe benefits are benefits, usually in kind, given by employers to employees in addition to salary or wages, such as the use of a company car for private use by the employee. There had long been in the income tax a provision designed to tax such benefits to employees, namely s 26(e) of the ITAA 1936, now s 15-2 of the ITAA 1997, but because the provision did not provide any specific guidance on the valuation for tax purposes of the various kinds of benefits to which it could apply, it was not generally enforced at the administrative level. As a result, the use of fringe benefits, especially in the case of high-income employees such as company executives, grew enormously in the 1970s and early 1980s. The fringe benefits tax is designed to provide the concrete valuation rules and collection mechanism to ensure that tax is collected on fringe benefits. Partly for administrative convenience and partly for political reasons, the tax is levied on the employer and not the employee, but nonetheless the tax should be considered as part of the income tax in the comprehensive sense. Although the structural changes to the tax legislation in the capital gains tax and the fringe benefits tax are fundamental to the income tax system, in general they build on the existing edifice of ordinary income rather than demolishing it. An understanding of the current legislation and the impact of the 1985 tax reforms is therefore best obtained by starting with ordinary income. Hence in most chapters of this book the materials will begin with the legislation and cases on the pre-1985 law, and then the impact of the 1985 tax reform measures on that law will be assessed. Coincidentally Parsons’ text on the income tax referred to above was published in 1985 and thus encapsulates the income tax system as it was just before the 1985 tax reform. The text is now often quoted by judges as the authoritative text on income according to ordinary concepts. It is available online at http:// www.setis.library.usyd.edu.au/oztexts/parsons.html. 44

[2.100]

Fundamental Principles of the Income Tax System

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2. ELEMENTS OF THE JUDICIAL CONCEPT OF INCOME [2.110] The following four chapters explore in detail the boundaries of the judicial concept of

income as it applies to different categories of cases. Some fundamental features which characterise ordinary income generally will arise time and again throughout those materials. This section of this chapter explores these basic foundations. You should try to keep these materials in mind as you read the next chapters and identify how each concept is applied in the particular instances looked at in those chapters. The income tax is levied on particular taxpayers at particular times in particular Australian dollar amounts, but it is not always easy to identify who is the relevant taxpayer, what is the relevant time for taxing the income, and what is the amount of the income. For example, if a landlord rents premises for 10 years to a tenant on the basis that the tenant pays the rent to the landlord’s spouse, who is to be taxed on the rent, the landlord or the spouse? If the rent is to consist of the transfer every two years to the spouse of certain company shares owned by the tenant, when is the rental income derived? And if the shares will probably have different values every two years, how much income is there?

(a) Realisation – Income as a Flow [2.120] We saw above that Simons was of the view that whatever the theoretical ideal, in most

cases practical considerations will mean income can only be taxed when it is realised, that is, severed from its source, and not as it accrues. This realisation principle for a time achieved quasi-constitutional status in the United States in Eisner v Macomber (extracted above). The realisation requirement provides a general timing rule for the taxation of income which is implicitly accepted as part of Australian income tax law (though there are many more specific statutory rules which express the general concept of realisation and even a few which contradict this requirement). An example of the realisation requirement is that tax is not collected from the owner of a share in a company which has just earned substantial profits until either the profits are distributed to the shareholder as dividends or the shareholder sells the shares and collects the value of the profits from the purchaser. In other words, the requirement of realisation before an amount can be defined to be income postpones the time at which accretions to economic power are taxed until the time when the appropriate event “releasing” the gain occurs. But does the realisation requirement have a deeper significance? On occasions, the realisation notion seems to be used to justify a corollary – that an amount which is realised must be income, without the need to find any real accretion to economic power. The proposition that an amount is not income until realised becomes confused with a proposition that an amount which is realised must be income. R W Parsons takes up this point and argues that realisation is inextricably tied to a concept of income other than gain, that is, income as a flow.

R W Parsons, “Income Taxation: An Institution in Decay?” [2.130] R W Parsons, “Income Taxation: An Institution in Decay?” (1986) 3 Australian Tax Forum 233 The trust law concept of income is built on the idea of flows, which Simons rejects. The flows that are income are commonly identified, in judicial statements about the concept of income,

as dividends, interest, rent and royalties and proceeds of a business. There is another flow, that from human capital, which is the judicial explanation of how it is that rewards for services [2.130]

45

Income Tax in Context

R W Parsons, “Income Taxation: An Institution in Decay?” cont.

royalty receipts. There will be no accretion to economic power if the proceeds of sale of goods do not exceed their cost.

are income, without regard for the costs of human capital consumed in performing those services. To describe these as flows is to call on a metaphor. Metaphors and Latin are used by lawyers as substitutes for, and not aids to analysis. It may be more helpful to say that a flow is the consequence of some act or event in relation to property that is seen as capital, which triggers a receipt by the owner which is not a receipt in realisation of that property. The act or event may be the declaration of a dividend, or the coming of a day when interest is due, or the grant of a lease or licence, or the sale of goods in the course of business operations. The flow may be an accretion to economic power, a phrase that Simons made his own as a description of a gain, but often it will not be. In the case of a dividend on a share, there will not generally be an accretion to economic power if the dividend is received immediately after the acquisition of a share purchased cum dividend or the share has fallen in value since it was acquired. In the case of interest on debentures, there will not generally be a realised accretion to economic power if the debenture was purchased immediately before the due date for payment of interest, or if, as a result of an increase in interest rates, the debenture has fallen in value since it was acquired. Nor will there generally be an accretion to economic power if the new owner of property not yet leased, immediately leases the property and takes rent in advance, or a premium. There has been only a conversion to cash of some part of the new owner’s property rights – the right to possession – which one might expect to be reflected in a decline in the value of his property rights that remain following the conversion. The allowing by the owner of the use of an asset may generate flows in the form of royalties, but there will be no gain to the owner if use will cause a diminution of the value of his property below its cost, and that diminution equals or exceeds the amount of the

The lawyer’s response to Simons is to say that, however inspiring Simons may be, his ideas belong in some other world and are beyond achievement on earth. Simons sought to answer that challenge by conceding that (at 207): The proper underlying conception of income cannot be directly and fully applied in the determination of year-toyear assessments. Outright abandonment of the realisation criterion would be utter folly; no workable scheme can require that taxpayers reappraise and report all their assets annually; and, while this procedure is implied by the underlying definition of income, it is quite unnecessary to effective application of that definition … The recognition of capital gains and losses may wisely be postponed while the property remains in an owner’s possession. The concession goes far towards destroying Simons’ revelation. If “appraisals” of value are to be avoided, the gains in the value of property that will be included in the base of the income tax will be confined to gains realised on disposal. And flows will continue to be included whether or not they reflect gains. If flows that are income are to be confined to gains, there will be need of a valuation of the shares on which dividends have been received; of the debenture on which interest has been received; of the property on which a lease premium has been received; and of the property in respect of which royalties have been received. That valuation must be made after the receipt of the dividends, interest, premium or royalties. If, for example, the payment of a dividend has reduced the value of the shares below their cost to the taxpayer who receives the dividend there is gain only to the extent that the dividend exceeds the reduction in value below cost.

[2.140] You will see many examples in the next four chapters of the constant tension between

the competing gain and flow notions of income. Unfortunately, despite the efforts of Simons to 46

[2.140]

Fundamental Principles of the Income Tax System

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tie the economic meaning of income exclusively to the gain notion, it is clear that tax law tries to embrace both notions simultaneously even though they may be in fundamental conflict. [2.145]

Questions

2.3

Do you agree with Parsons that the realisation requirement contradicts the notion of income as economic gain?

2.4

Is the notion of income as a flow a better explanation of the current law on what is income than the concept of gain? (You may wish to reconsider this question after more detailed study of Chapters 3 to 6.)

2.5

Are the United States cases of Eisner v Macomber (extracted above) and Commissioner v Glenshaw Glass Co (referred to above) more consistent with a flow concept of income or a gain concept? The realisation requirement is expressed in Australian law in the timing rules covered in Chapters 11 and 12. In brief, a taxpayer is required to account for tax purposes on one of two bases: a cash/receipts basis (that is, when an item is actually received); or on an accruals/ earnings basis (that is, generally when a right to receive an item arises). Generally speaking, employees will be on a cash basis and businesses on an earnings basis. (Beware the word “accruals” in income tax law. Sometimes it is used to refer to mere increases in value without any realisation having occurred, while at other times it is used to describe the particular case of realisation in the form of a right to receive a payment having arisen.) A realisation will give rise to assessable income if it has an income nature within the many rules on that topic: see Chapters 3 to 6.

(b) Identifying the Taxpayer and the Taxable Event [2.150] The rules referred to in the previous paragraph do not serve to identify the taxpayer in ambiguous cases. Rather, they assume that the taxpayer is identified. Although the correct taxpayer usually is self-evident, the Australian Taxation Office (ATO) found to its cost in Federal Coke Co Pty Ltd v FCT that the self-evident taxpayer is not always the correct taxpayer. Bellambi Coal Company Pty Ltd (Bellambi) was a coal mining company and the parent of coke-producing subsidiaries, one of which was Federal Coke. The arrangement between the companies was for Bellambi to supply coal to Federal Coke who would convert it to coke for a fee (ownership of the coal/coke remained at all times with Bellambi). In April 1970 Bellambi contracted to supply coke to Le Nickel SA, a French nickel processing company, and proposed to upgrade Federal Coke’s coking works to meet the contract. After a downturn in world demand for nickel, Le Nickel sought variation of the contract. Le Nickel agreed to pay $1 m to Bellambi for the variation in two equal instalments and forwarded the first instalment to Bellambi. Having sought tax advice, Bellambi refused the payment and under a renegotiated agreement Le Nickel agreed to pay the $1 m to Federal Coke in consideration of the closure of the company’s coking works necessitated by the change to the supply contract between Bellambi and Le Nickel. The ATO assessed the sums in the years they were received as income to Federal Coke. He argued that if the sums had been received by Bellambi they would have been assessable and therefore they were equally assessable to Federal Coke. Bowen CJ considered that the sums may well have been income if received by Bellambi, on a number of possible bases. [2.150]

47

Income Tax in Context

Federal Coke Co Pty Ltd v FCT [2.160] Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519; 77 ATC 4255 Had an assessment then been raised against Bellambi, it might perhaps have been argued that the $500,000 which Bellambi refused to accept had accrued due to Bellambi as income and had been paid by Le Nickel to a subsidiary of Bellambi in accordance with the order and directions of Bellambi … In the result, none of these bases of assessment were adopted by the Commissioner. He assessed Federal upon the receipts so that the question for determination by the court is not what would have been the character of the receipts in the hands of Bellambi, but what, for the purposes of income tax, is the character of the receipts in the hands of Federal … Counsel for the Commissioner further submitted that the payments were to compensate Bellambi for loss of profits and for this reason acquired an income character and that they retained this character and did not lose it when the deed was interposed whereby the arrangement was altered and the payments were made to Federal. Nothing had been done, so it was argued, which would indicate that the character of the payments was altered … But under the deed of 22 March 1972, they were not received by Bellambi. A consequence of this is that one of the factors, which would have

[2.165]

impressed them with the character of income, disappears. One is left only with the method of formulation and the original purpose of Bellambi and Le Nickel. It appears to me that this is insufficient to impress upon the sum an essential and unchangeable character of income. Indeed, it appears to me that the starting point of this argument for the Commissioner is wrong. When one is considering the character of an amount received by a taxpayer, the inquiry must start with the question: what is the character of the receipt in the hands of the taxpayer? It appears to me to be wrong to ask: what would have been the character of the amounts had they been received by Bellambi? And then to pose the question: has their character been changed by the fact that they were paid to Federal Coke? One must, I think, pose the essential question and start from that question: what is the nature of the receipts in the hands of Federal? It then becomes less than decisive to observe that, in their origin, and if they had been received by Bellambi, they may have been of an income character. Each receipt in the hands of Federal is broadly in the nature of a gift, being a sum received without consideration. [He went on to hold that the gift was not assessable to Federal Coke: see Chapter 6.]

Questions

2.6

Why did Federal Coke escape taxation? For what fundamental principle of income taxation is the case authority?

2.7

Section 6-5 of the ITAA 1997 speaks of “income … derived” by a person and so suggests that a receipt may have an income character independent of its derivation (receipt) by the person. Is this reasoning consistent with Federal Coke?

2.8

If a business person assigns receivables arising from the business to a family member before the debts are due for payment, will the family member receive income? Would it make any difference if the business person did not assign the receivables but directed payment to a family member?

2.9

Would Federal Coke nowadays be taxed under capital gains provisions, especially CGT event H2, s 104-155 of the ITAA 1997? (See Chapter 3.)

48

[2.160]

Fundamental Principles of the Income Tax System

CHAPTER 2

(i) Constructive receipt [2.170] The result in Federal Coke (above) may suggest that virtually all taxpayers may be

able to avoid income tax simply by directing payment of the income to a related party. For example, all wage earners could direct their employer to pay their wages to their spouse or their mortgagee. The case, however, left open the question of whether Bellambi was taxable on the payment. This is a real possibility because of s 6-5(4) of the ITAA 1997 (formerly s 19 of the ITAA 1936) which is directed to this kind of situation, that may be conveniently referred to as constructive receipt. Under the constructive receipt concept, a payment received by one party is treated as having been first (constructively) received by another party and then paid over to the actual recipient. Indeed, as Bellambi was a business taxpayer it presumably was accounting for tax purposes on an earnings basis and so the full $1 m could be treated as having been derived by Bellambi when it entered into the original agreement with Le Nickel. In order to prevent the income tax being subverted by payments directed in all manners to other parties, it would seem that a very extensive doctrine of constructive receipt is necessary; however, surprisingly there is little authority for it. Indeed the authorities may be thought to restrict the operation of the doctrine, for example, Permanent Trustee Co of NSW Ltd v FCT (1940) 2 AITR 109 at pp 110-11 and Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195: see further Chapter 11. A more encouraging view is found in the following dicta of Latham CJ in Gair v FCT (1944) 71 CLR 388; 7 ATD 443: If X, not being a dealer in houses and land, sells his home to Y upon terms, and Y pays an instalment of the purchase money by transferring to X a right which he (X) has to receive, a sum due to him by way of salary, then, though, if Y had received the salary, the money would have been part of his income, when it is received by X in part payment for the house which he has sold, it is certainly not part of the income of X. He would receive merely part of the consideration for the sale of a capital asset. If Y were to deal with his salary in this way, he would be liable to tax upon the amount of the salary with which he had so dealt, because the Income Tax Assessment Act, s 19, provides that “income shall be deemed to have been derived by a person although it is not actually paid over to him but is … dealt with on his behalf or as he directs”. Accordingly, the amount of salary would have been part of Y’s assessable income, but it would not have been part of X’s assessable income. Thus the same sum of money may be income in relation to one person and capital in relation to another. [2.175]

2.10

2.11

2.12

2.13

Questions

Consider the position of Bellambi Coal Company Pty Ltd in Federal Coke Pty Ltd v FCT in light of the doctrine of constructive receipt. Should the assessment have been issued to Bellambi? What happens (apart from FBT) when an employer pays an employee’s child’s private school fees? (See Case 61 (1979) 23 CTBR (NS) 537; Case L54 (1979) 79 ATC 399.) Does it matter whether the employee previously paid the fees or whether the employee is under a contractual liability to pay the fees? In Heaton v Bell [1970] AC 728, the House of Lords held that an employee was taxable on a constructive receipt basis when the employee accepted a reduction in salary in exchange for the use of a car (the employee being able to cancel the deal at any time and revert to the previous salary). What does this suggest is required for salary packaging in order to avoid the employee being treated as having in effect received salary which is then used to purchase a benefit? See the Ruling on salary sacrifice, TR 2001/10. Do the changes in wording in the ITAA 1997 in relation to constructive receipt represent any change in the former law? Do they affect salary packaging? [2.175]

49

Income Tax in Context

2.14

Would the result in Federal Coke under current law be that Bellambi would be subject to income tax and Federal Coke to CGT? (See Question 2.9 above in relation to CGT.)

2.15

The Court in Federal Coke did not consider the significance of the fact that Bellambi was an earnings basis taxpayer, in which case it would have possibly derived the settlement amount when it became entitled to the amount. This occurred on the making of the original deed, prior to the alteration under which the money was paid to Federal Coke. Does this make a difference to your answer to Question 2.10?

(ii) Benefits received from intermediaries [2.180] Even where the taxpayer and the basis on which the taxpayer is accounting (cash or

accruals) are clear, there may be a question of the appropriate event to treat as a realisation, and whether the necessary income characteristics are present at that time. This type of problem is typified by Constable v FCT. The taxpayer was an employee of Shell Co of Australia Ltd, an oil company. Both the taxpayer and his employer were contributing members to a superannuation trust fund, the taxpayer (employee) contributing 10% of his salary, which was recoverable in certain events. The employer contributed equal amounts to the fund, but the taxpayer’s entitlement to these contributions was contingent. For example, if the member retired before a certain period of service or before a certain age, he was not entitled to the employer’s contributions. Under Art 23 of the trust deed, if the fund altered the regulations so that the rights or obligations of the members were changed in various ways, then any member was entitled to withdraw the amount credited to the member’s account in the fund, including the member’s own contributions, employer contributions and interest on both. As a result of changes to superannuation arrangements in the oil industry, the rules were changed to prevent any new members being admitted to the fund. This was an event within Art 23 of the trust deed and the taxpayer withdrew £403 in the 1947–1948 year of income. The Commissioner assessed the taxpayer under s 26(e) of the ITAA 1936 (s 15-2 of the ITAA 1997) to tax on the amounts representing: 1. the employer contributions; 2. interest on employer contributions; and 3. interest on employee contributions. It was assumed that the employee’s contributions were paid out of income which had already been derived by the employee at the time of the payment of salary, even though the amounts of contributions were never actually received by the employee (since they were withheld from the employee’s salary and sent directly by the employer to the fund). This is an example of constructive receipt. This element of the payout sum was not in issue. All members of the High Court held that the remaining elements of the payout were not assessable to the taxpayer, though there were different reasons given by the majority Dixon CJ, McTiernan, Williams and Fullagar JJ, on the one hand, and Webb J, on the other. The majority reasoned as follows.

Constable v FCT [2.190] Constable v FCT (1952) 86 CLR 402; 5 AITR 371; 10 ATD 93 Section 26(e) provides that:

50

[2.180]

The assessable income of a taxpayer shall include the value to him of all allowances, gratuities, compensation,

Fundamental Principles of the Income Tax System

Constable v FCT cont. benefits, bonuses and premiums allowed, given or granted to him in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him, whether so allowed, given or granted in money, goods, land, meals, sustenance, the use of premises or quarters or otherwise … Upon the text of the paragraph it would seem that the liability of the sum, or any part of the sum, received by the present taxpayer during the year of income to inclusion in his assessable income must depend upon the answers to one or other or all of the following questions. Can that sum or any part of it be described as an allowance, gratuity, compensation, benefit, bonus or premium? If so, can it be said of it that it was “allowed, given or granted to him” during that year? If an affirmative answer is given to these two questions, then is it correct to say of the amount or any part of it that it was so allowed, given or granted to him “in respect of, or for or in relation directly or indirectly, to any employment of him or services rendered by him”? The employment or services must be employment by, or services rendered to, the Shell Company of Australia Ltd. It is evident that it is enough for the taxpayer if any of the foregoing questions is answered in the negative … On these facts we are of opinion that, whether or not the payment or any part of it may be described as an allowance, gratuity, compensation, benefit, bonus or premium in respect of or for or in relation to the taxpayer’s employment or services rendered by him, it cannot correctly be said it was such an allowance, etc “allowed given or granted to him” during the year of income under assessment. It appears to us that the taxpayer became entitled to a payment out of the fund by reason of a contingency (viz: an alteration of the regulations curtailing the rights of members)

CHAPTER 2

which occurred in that year enabling him to call for the amount shown by his account. It was a contingent right that became absolute. The happening of the event which made it absolute did not, and could not, amount to an allowing giving or granting to him of any allowance, gratuity, compensation, benefit, bonus or premium. The fund existed as one to a share in which he had a contractual, if not a proprietary, title. His title was future, and indeed contingent or, at all events, conditional. All that occurred in the year of income with respect to the sum in question was that the future and contingent or conditional right became a right to present payment and payment was made accordingly. This, in our opinion, cannot bring the amount or any part of it within s 26(e). The amount received by the taxpayer from the fund is a capital sum, and, unless it or some part of it falls under s 26(e) (there being no other applicable imposition of liability), it is not part of the assessable income. While we prefer to place our decision of the case upon the simple ground stated, that does not mean that we think that the actual payments by the company to the fund in respect of the taxpayer formed, in the year in which they were so paid, any part of his assessable income. It is not, of course, a matter that arises for decision in the present case, but, to avoid misunderstanding, it is, we think, desirable to say that on the frame of the regulations we find it by no means easy to see how the sums so contributed can be regarded as allowed, granted or given to the employee when they are paid to the administrators of the fund. It is only after the administrators have exercised their discretion that any moneys paid to the special account are reflected in the member’s (employee’s) account, and even then that does not mean that the member becomes presently entitled to the moneys credited to that account. We do not think that s 19 can be used to eke out s 26(e) and extend its operation or application.

The difference in the judgment of Webb J concerns the treatment of contributions to the fund at the time of contribution. He said:

[2.190]

51

Income Tax in Context

[2.200] I think that the moneys paid into the fund by the company were, as counsel for the Commissioner submitted, really part of the remuneration of the appellant, or in any event were a “benefit … given or granted to him in respect of, or for or in relation directly or indirectly to” his employment, within s 26(e). Moreover, I think they became a benefit to the appellant as from the time when the company paid them into the fund. Upon such payment into the fund they ceased to be the property of the company and the payment then enured for the benefit of the appellant, although contingently on his serving for the necessary period to qualify to receive them (Article 16), which the appellant did in 1941. But I do not think that because the moneys in fact paid out of the fund to the appellant purported to be identified, in the yearly accounts given to him under Article 10 and in the receipts which he gave for these moneys, with moneys paid in by the company and interest thereon, that the moneys when paid out of the fund to the appellant still retained their identity as remuneration of the appellant and interest thereon. By Article 12 moneys of the fund, which included foundation moneys, were to be invested and earnings allocated to the members’ accounts among other accounts. Investment in the manner indicated in Article 12 would, I think, cause the moneys paid into the fund to lose their identity as remuneration of the employees. They were

[2.205]

invested, but a record was kept showing the exact amount of each contribution and interest earned thereon. The regulations required this to be done, as in certain cases they permitted payments to be made to an employee before his retirement of the amounts paid in by him and interest thereon; and also in some cases of the amounts paid in by his company. If the money received by the appellant from the fund had been paid to him without purporting to show how it was made up it could not, I think, have been held to be taxable as remuneration of the appellant in respect of his employment. But this requirement of the regulations was merely one of keeping a record and did not, I think, have the effect of preserving the identity of the moneys in the fund as employers’ and employees’ contributions and interest thereon, so that when they were paid out of the fund to the appellant under Article 23 they still retained that character. In my opinion, then, the moneys paid out of the fund to the appellant were not moneys paid for or in respect of his employment; nor were they in the events that happened a retiring allowance. Moreover, they were of a capital nature. That applies also to the appellant’s contributions and interest thereon. For these reasons I think that none of the amounts in question was assessable income of the appellant.

Questions

2.16

What was the view of the majority concerning payments into the fund in Constable? Why was s 19 of the ITAA 1936 of no assistance? How does Webb J differ on this issue? What was the view of the majority concerning payments out of the fund? How, if at all, does Webb J differ on this issue?

2.17

The ITAA 1997 includes an additional provision for constructive receipt in s 6-10(3). Why is it expressed differently from s 6-5(4) of the ITAA 1997? Would it make any difference to the result in Constable? The result in Constable may have been complicated by the fact that a superannuation fund was involved and that special tax rules apply to such funds (see Chapter 4). The reasoning in the case gives no sign of this, however, and the case is still regarded as the basis in Australia for not taxing employees on employer contributions to superannuation funds at the time of contribution. Nowadays, most employer contributions to superannuation funds on behalf of employees are required by law to be vested from the outset. What, if anything, does this mean for the tax treatment of such employer contributions in the light of Constable?

2.18

52

[2.200]

Fundamental Principles of the Income Tax System

2.19

2.20

CHAPTER 2

An employer with 10 employees pays $1,000 per week to a trustee under a discretionary trust. The beneficiaries under the trust are the employees and their relations. Each week the trustee distributes varying amounts to the beneficiaries amounting in total to $1,000. Are the receipts of the employees or their relations under the trust, income? See Case 68 (1967) 13 CTBR (NS) 463; Case R50 16 TBRD. What is the effect of Constable on air tickets received under frequent flyer schemes? Does it matter if the tickets are received by the member of the scheme or a relation of the member? Does it matter if the miles were from flights paid for by the member’s employer or if the employer paid any membership fee? See Payne v FCT (1996) 66 FCR 299; 32 ATR 516; 96 ATC 4407 (extracted in Chapter 6), and Ruling TR 1999/6.

[2.210] If Constable is to be accepted at face value, it stands for a further fundamental

proposition that income characteristics have to be judged at the time when a receipt is claimed to be taxable by the ATO. The fact that at an earlier or later event it may have the relevant income characteristics is not to the point, just as it was not to the point in Federal Coke that the receipt may have had an income character in the hands of Bellambi. Thus, on the reasoning of the majority in Constable, the fact that the employer contribution may have had an income character when paid into the fund did not matter, as it was not constructively received then by the employee, and when actually received by the employee it no longer had the necessary income characteristics. Similar problems involving employee benefit trusts have recently attracted a great deal of media attention and been litigated in the courts: see Chapter 4. (iii) Amounts received but for the benefit of others [2.215] It was noted above [2.70] that the case law in Australia has also offered some

instances where the income tax problem is exactly the reverse – an amount has been received by someone but the person argues that the amount is not their income because it is being held by them for the benefit of someone else. Section 96 of the ITAA 1936 sets out the proposition that a trustee is not liable to tax on amounts they collect, except in the circumstances set out in the Act. Other provisions in Div 6 of the ITAA 1936 will then allocate the income tax liabilities among various parties involved in the trust, but this section probably captures an idea that already exists as part of the judicial notion of income. The High Court decision in Countess of Bective v FCT [1932] HCA 22 discussed above is an example of this idea. The Commissioner assessed the Countess on money received from the estate of her late husband which she received, as the guardian of their daughter, to pay for the daughter’s living expenses. Dixon J observed that, “the income of the trust fund appears to have been included in [the Countess’] assessment upon the view that she took it beneficially …” but, he observed, “if she is not an object intended to be benefited at all by the provision for maintenance, the payments ought not, in my opinion, to be included as assessable income of the taxpayer …”. The decision in Zobory v FCT (1995) 64 FCR 86; 30 ATR 412; 95 ATC 4251 is another example where this idea was successfully employed by a recipient but the argument is not always successful. The High Court decision in Howard v FCT [2014] HCA 21 is a recent example of a case where a taxpayer tried to invoke this principle, in order to avoid being assessed on money he had received. The taxpayer had been a participant in a joint venture which ultimately ended in an acrimonious and protracted legal dispute with some of the other joint venturers. Eventually the taxpayer was awarded damages but the taxpayer argued that [2.215]

53

Income Tax in Context

the amounts he received were not his income because he had been involved in the joint venture on behalf of his company and, in bringing the action, he was acting to vindicate the rights of the company. If anyone had to pay tax on the amount, it was the company for whom he was a trustee, and not him. Ultimately the High Court disagreed that the taxpayer owed any fiduciary duties to the company as a matter of law, and the Commissioner’s assessment of Howard personally was upheld. It is thus not always obvious whether a person is receiving money which properly belongs to another, or whether the person is receiving money in their own right, and thereafter becomes subject to various obligations. In the first case, the recipient is not deriving income, while in the second, the recipient is assessable on the amounts received and must therefore look to some explicit provision in the legislation to allow a deduction for the amounts which must then be disbursed.

(c) Valuation [2.220] Having identified the relevant taxpayer and the relevant time of income derivation, it

remains to assign a number of Australian dollars to the amount of assessable income: s 960-50 of the ITAA 1997 (until 2003, s 20(1) of the ITAA 1936). If the income is a cash amount, the valuation problem would seem to solve itself, but if the income is in another form, then it is necessary to provide a valuation test. Several possibilities suggest themselves: the amount that the provider spent to provide the benefit; the amount that the recipient would have had to spend to acquire the benefit; or the market value of the benefit, for example. At first sight, s 21 of the ITAA 1936 would seem to solve the problem and to indicate a simple market value test. Valuation has proved, however, not to be such a straightforward problem. First, the cases seem to ignore s 21 in favour of an English judicial test deriving from Tennant v Smith [1892] AC 150, which held that for the purposes of the relevant Schedule of the United Kingdom tax legislation, income had to be cash or convertible to cash. In that case, the taxpayer was a bank employee who was required as a condition of his employment to live in a flat above the bank, which was provided rent-free to him. He was specifically prohibited from subletting the flat and would have to leave the flat when he left the bank’s employment. The Revenue claimed that occupying the flat rent-free provided income of £50 to the taxpayer – why the Revenue decided upon £50 is not clear from the case – but, when combined with his salary, it had the effect of putting the taxpayer’s total income above an income threshold. The result of the case was that the employee’s total income fell below the threshold. But the exact principle for which Tennant v Smith is authority is not absolutely clear, as we shall see. Second, there is a subtlety present of the Federal Coke and Constable kind – what exactly is it that is being valued? For example, even in the simple case of a cash payment, if the payment is not due until well into the future, the present value of the right to the payment will be less than its face value: is the amount of income the face value of the payment or its present value? (You will see in later chapters that the treatment of the present value of future payments is a considerable problem under the income tax.) The basic valuation test that is applied under the income tax is exemplified in FCT v Cooke and Sherden. The taxpayers were engaged in selling home delivery soft drinks. The product, the areas to be covered, the trucks used and generally the whole infrastructure of the operation were supplied by the soft drink manufacturers, but the taxpayers were able to choose their own times for canvassing in the designated areas and acted as independent contractors. The taxpayers were provided with “free” holidays under a holiday scheme operated by the soft 54

[2.220]

Fundamental Principles of the Income Tax System

CHAPTER 2

drink manufacturers on the basis of satisfactory performance during the year. It was not possible to take a cash payment in lieu of the holidays and the tickets, accommodation, etc could not be transferred or sold. The ATO sought to tax the taxpayers on the amounts paid by the soft drink manufacturers for the holidays taken by the taxpayers under the scheme. The Full Federal Court held that the taxpayers were not taxable. Brennan, Deane and Toohey JJ (subsequently all members of the High Court) reasoned as follows.

FCT v Cooke and Sherden [2.230] FCT v Cooke and Sherden (1980) 10 ATR 696; 80 ATC 4140 It is convenient first to look at the concept of income, to which the Act frequently refers but which it does not define. Whether a receipt is to be treated as income or not is determined according to “the ordinary concepts and usages of mankind” … except where statute sweeps in particular receipts or amounts which would not ordinarily be taken to fall within the concept. There are other provisions which indicate the nature of an income receipt. By s 25, the gross income of a taxpayer is divided into assessable income and exempt income; by the definition of taxable income in … s 17 income tax at the rates declared by the Parliament is levied upon taxable income. The operation of this complex of provisions requires that taxable income must be, or be expressed as, a pecuniary amount. An item of income which could not be reckoned as money could not find its way into taxable income so as to be subjected to tax at a rate declared by the Parliament. And s 20 requires that income wherever derived and expenses wherever incurred be expressed in terms of Australian currency. So the Act sufficiently shows that the items of income are to be money or to be reckoned as money. Consistently with this notion, the Act makes particular provision for some nonpecuniary receipts by including within assessable income the value to the taxpayer of those receipts (see s 26(e) and (ea)), and thus brings a pecuniary amount to tax. The notion that the items of income are money or are to be reckoned as money accords with the ordinary concepts of income as “what comes into (the) pocket” to adapt Lord Macnaghten’s phrase in Tennant v Smith [1892] AC 150 at 164. That is not to say that income must be received as money; it is sufficient if what is received is in the form of money’s worth … Nor is it necessary that an item

of income be paid over to the taxpayer; it is sufficient, according to ordinary concepts and usages, that it be dealt with on his behalf or as he directs, as s 19 of the Act recognises. Although Tennant v Smith was concerned with the operation of legislation different in structure from the Income Tax Assessment Act 1936, some parts of their Lordships’ speeches applied ordinary conceptions to the construction of the terms of the Act there under consideration. Thus Lord Halsbury LC said (at 157): I come to the conclusion that the Act refers to money payments made to the person who receives them, though, of course, I do not deny that if substantial things of money value were capable of being turned into money they might for that purpose represent money’s worth and be therefore taxable. If a taxpayer receives a benefit which cannot be turned to pecuniary account, he has not received income as that term is understood according to ordinary concepts and usages. The conversion of an item into money may occur, of course, in a variety of ways. It is not desirable (even if it be possible) to define in advance the ways in which conversion may possibly occur in order that a non-pecuniary item of receipt might be treated as an item of income. However, it will not often occur that a benefit to be enjoyed by a taxpayer cannot be turned to pecuniary account if the benefit be given up, or if it be employed in the acquisition of some other right or commodity. If one were so to vary the facts of the present case that the tickets with which the taxpayers were provided could be surrendered by them for cash, the benefit which, on that hypothesis, the taxpayers would have received would have been [2.230]

55

Income Tax in Context

FCT v Cooke and Sherden cont. converted into money, and would have constituted income if the origins of the receipt gave that character to it. Indeed, as the authorities show, it is not necessary that the pecuniary alternative be available by way of direct conversion of the benefit received: Heaton v Bell [1970] AC 728; Abbott v Philbin [1961] AC 352. In Heaton v Bell the taxpayer was an employee of a company which had introduced a voluntary car loan scheme for certain employees. Under the scheme the company bought cars, insured them, paid road fund tax and lent them to employees from whose weekly wages money was deducted according to the type of car on loan. If an employee cancelled the arrangement, as he was free to do on notice, the deduction from his pay ceased. By a majority it was held that on the true interpretation of the arrangement between company and employee, the monetary wage remained unaltered and that accordingly the respondent’s emoluments, taxable under Schedule E of the Income Tax Act 1952 were his gross wage before deduction. On that footing, of course, the relevant receipt was the monetary wage, part of which was applied to the hire of the car. But an alternative basis of assessment was upheld by a majority of their Lordships who held that the free hire of the car was a “perquisite” of the taxpayer’s employment because he could have surrendered the free hire of the car and become entitled to a higher monetary wage than he was receiving … [T]he respondents in the present cases could not have turned the benefits in fact received by

them to pecuniary account. It is immaterial that the respondents would have had to expend money themselves had they wished to provide holidays for themselves. If the receipt of an item saves a taxpayer from incurring expenditure, the saving is not income; income is what comes in, it is not what is saved from going out. A nonpecuniary receipt can be income if it can be converted into money; but if it be inconvertible, it does not become income merely because it saves expenditure. The holidays which were enjoyed by the taxpayers in the present case provided them, at a cost to the manufacturers, with a non-convertible benefit. It seems curious that a benefit which has cost money is not convertible into money, either by sale or by some less direct mode of realisation, and it may be that cases of this kind are to be found only where the benefit is gratuitously provided. If this be so, the inconvertible benefit falls outside the revenue net not because it is a gratuity, for a taxpayer may receive as income a benefit gratuitously provided … it falls outside the revenue net because it is not money or money’s worth, and there is no statutory provision which widens the net to catch it. In particular, it falls outside s 20 which brings to tax the money value of consideration which is paid or given upon any transaction otherwise than in cash. In the present case, the Commissioner disavowed any reliance on that section … The benefit not being convertible into money or money’s worth, there was no receipt of income according to ordinary concepts, and the assessments are not supported by s 25(1). The alternative foundation is s 26(e).

[2.240] The Court held that s 26(e) of the ITAA 1936 (s 15-2 of the ITAA 1997) was not

applicable, as the taxpayers were not employees of the soft drink manufacturers nor were the taxpayers rendering services to them; rather the taxpayers were engaged in the business of buying the soft drinks from the manufacturers and selling the products on their own account. [2.245]

2.21

2.22

56

Questions

How is income not in cash or its equivalent brought to account for tax purposes in a money sum? Why does a non-convertible benefit in kind go untaxed on ordinary income concepts? What conditions are required to make a benefit non-convertible? Can the distinction between cash and accruals tax accounting produce any difference in the amount

[2.240]

Fundamental Principles of the Income Tax System

CHAPTER 2

brought to tax as ordinary income (because the time of taxation arises in the latter case before the payment is received)? Consider, for example, Burrill v FCT (1996) 67 FCR 519; 33 ATR 133; 96 ATC 4629. 2.23

A taxpayer invests $5,000 with a finance company in debentures that do not pay interest but provide the taxpayer with the rent-free personal use of a colour television set. Is the taxpayer taxable on the use of the set? See Dawson v IRC (1978) 78 ATC 6012.

2.24

What if the finance company in Question 2.23 provided, instead of the television set, a suit which cost $500 and which the taxpayer could sell for $200 (second-hand value)? See Wilkins v Rogerson [1961] Ch 133.

2.25

If the holidays had been held to be taxable in Cooke and Sherden, what amount should have been brought to tax? Should it make any difference that the taxpayers were engaged in business and presumably on an earnings basis of tax accounting?

[2.250] The actual decision in Cooke and Sherden was reversed some years later by s 21A of

the ITAA 1936 in the business context (see Chapter 5) but the principle that it espouses remains the general principle. There is a significant issue about the relationship between the valuation rules and the meaning of income in the judicial concept of income arising out of Cooke and Sherden, and it is important to be clear about the exact principle that emerges from cases such as Tennant v Smith. The case may be trying to say one of two things: either, that because the value of the flat could not be turned into cash, the employee did not derive income; or, because the value of the flat could not be turned into cash, the employee derived income of zero. In other words, the case may be stating a principle that what the employee has is not income or that the employee does have income but its value is to be recorded at zero. The difference is important because some sections of the income tax legislation such as s 15-2 of the ITAA 1997 set out a different valuation rule from this “realisable value” test. Those sections will be effective to change the zero value to something else but that may not be enough to make the amount taxable. In other words, all that they may achieve is to give a non-income amount a different value, not to turn it into an income amount. While the language of Tennant v Smith is less than clear about which principle it is stating, it is suggested that the correct principle that emerges from Tennant v Smith is simply the valuation rule: that a benefit which cannot be turned into cash is (or is not) income with a zero value. You may wish to reread the extract from Cooke and Sherden above to decide which view it is expressing. Share options given to employees as part of their salary raise both valuation and derivation issues. The problems are well displayed in Abbott v Philbin and the later Australian decision in Donaldson v FCT [1974] 1 NSWLR 627; 4 ATR 530; 74 ATC 4192 (extracted in Chapter 4). In 1954 Abbott paid £20 for an option to purchase 2,000 shares in the company which employed him. The option was exercisable at any time over the next 10 years at the price of 68s 6d, which was the market price of the shares at the time the option was granted. By 1956 the value of the shares had risen to 82s and he exercised his option in respect of 250 shares, paying the agreed price of 68s 6d and retaining the shares. The Revenue included £166 in his assessable income in 1956, being the difference between the option price and current market price. The House of Lords by a majority held expressly that no amount could be included as income in 1956. Their Lordships also implied that any tax consequences arose only in 1954 when the option had been granted. [2.250]

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In finding against the Revenue, the House of Lords had to contend with the rule in Tennant v Smith. The possible application of this rule arose because the terms of the grant of the option prevented the taxpayer from assigning the option. This was probably the reason that the Revenue had waited until some convertible benefit was generated in 1956 before assessing the taxpayer. So in this case it was the Revenue rather than the taxpayer who relied upon Tennant v Smith because it aided their argument that there was no income in 1954, but only in 1956. Viscount Simonds observed:

Abbott v Philbin [2.260] Abbott v Philbin [1961] AC 352 How, then, can it be said that an option to take up shares at a certain price is not a valuable or at least a potentially valuable right? Its genesis is in the desire of the company to give a benefit to its employees and at the same time, no doubt, to enhance their interest in its prosperity. It is something which the employee thinks it worth his while to pay for: not a large sum truly, but £20 deserves a second thought. And it is something which can assuredly be turned to pecuniary account. This was challenged because the option was itself not transferable, but this objection is without substance. There was no bar, express or implied, to a sale of the shares as soon as the option was exercised and there could be no difficulty in the grantee arranging with a third party that he would exercise the option and transfer the shares to him … I have little doubt that, if the Revenue authorities had addressed their minds to the proper question, they could have ascertained whether it had any and what value. But … I must say that it is really irrelevant whether a value could be ascribed to it or not. If it had no ascertainable value then it was a perquisite of no value – a conclusion difficult to reach since

£20 was paid for it. In my opinion, the Crown cannot succeed in this essential aspect of the case unless it is established as a general proposition that an option to acquire shares at a fixed price in such circumstances as those of the present case is not a perquisite of office. It must be shown that, even if at the date of the option being granted the market price is higher than the option price, the option is not a perquisite which falls within the Schedule. This appears to me an impossible proposition. What distinguishes such a right from that commonly given to a shareholder in a commercial company, when upon an issue of shares he is given in the form of a provisional allotment letter the right to take up new shares at a certain price? He can exercise his right and take up the shares or he can sell his right to do so, or he can do neither and let the offer go by default. But from the moment he has the letter he has a right of more or less value according to the circumstances. So, too, the grantee of such an option as that which we are considering has a right which is of its nature valuable and can be turned to pecuniary account. He has something at once assessable to tax.

[2.270] There are now specific provisions dealing with employee share schemes in Pt III

Div 13A of the ITAA 1936 which are discussed in Chapter 4. Although the principle in Tennant v Smith has been reversed in a number of specific contexts, it is mystifying why the legislature simply does not reverse the principle generally. A related question to valuation is how the tax system handles cases where amounts change after the tax relevant event or transaction occurs, for example, a person repays an amount because the price was wrongly calculated. In Australia it has been established that there are no general principles which simply reverse the original tax treatment to the necessary extent to give effect to the change. In dealing with ordinary income it is necessary to analyse the subsequent events or transaction giving rise to the change to decide whether they give rise 58

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independently to ordinary income (or a deduction). This result, which is analysed in detail in Chapter 6, is consistent with the approach to the issues considered in this chapter. As a result, there are many statutory provisions dealing with the issue that are referred to throughout this book, but again there is still no broad statutory enactment of a general principle.

(d) Apportionment [2.280] The final issue that may arise in deciding the income character of a receipt or of

determining the amount of assessable income in a receipt is apportionment. It is possible that a taxpayer may receive a payment in respect of a number of matters, some of which are clearly of an income character and some of which are clearly not of an income nature. In such a case the ATO will seek to apportion the amount into its income and non-income elements but the tax authority’s power to do so in Australia seems to be very circumscribed and if apportionment is not possible the payment is treated as not being income at all. The leading authority on apportionment is McLaurin v FCT (1961) 104 CLR 381; 8 AITR 180; 1 ATD 273. The taxpayer was a grazier whose land, fixtures, chattels and stock were extensively damaged by a fire which commenced on an adjoining property owned by the Commissioner of Railways. The taxpayer commenced an action against the Commissioner of Railways and claimed that losses to the value of £30,000 were incurred. The valuation was the sum of the items on a list of expenses compiled for the action. A lump sum of £12,350 was paid out of court in full settlement of the taxpayer’s claim. This figure was recommended by a valuer for the Commissioner of Railways and was based on a list of particular items of damage. However, the taxpayer was never informed of the means by which the lump sum was calculated. The Commissioner of Taxation sought to assess the taxpayer to £10,640 of the sum on the basis that this represented the compensation for damage to items on income account on the basis of the Commissioner of Railway’s list. It was contended that where a sum had capital and income components, then it must be dissected. (The excluded component related to compensation for damage to capital items.) The High Court held that none of the payment was assessable.

McLaurin v FCT [2.290] McLaurin v FCT (1961) 104 CLR 381; 8 AITR 180; 1 ATD 273 It is difficult in these circumstances to see how the dissection which the respondent has made can possibly be justified. All that has been urged in support of it is that the Commissioner for Railways should be considered to have paid the £12,350 as the total of the separate amounts which were allowed in [the valuer’s] list, and that each of those amounts must be separately included in or excluded from the appellant’s assessable income upon consideration of the nature of the item to which it related in the list. The submission neither accords with fact nor squares with legal principle. It does not accord with fact, for an account of the manner in which [the valuer] reached his total is only an account of his reasons for the

recommendation he made to the Assistant Solicitor for Railways; and even though those reasons may have been adopted by that officer, or even by the Commissioner for Railways himself, the offer that was made was not of a total of itemised amounts, but was a single undissected amount. And in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of the recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it. It is true that in a proper case a single payment or receipt of a mixed nature may be apportioned amongst the several heads to which it relates and [2.290]

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McLaurin v FCT cont. an income or non-income nature attributed to portions of it accordingly … But while it may be appropriate to follow such a course where the payment or receipt is in settlement of distinct claims of which some at least are liquidated (cf Carter v Wadman (1946) 28 Tax Cas 41) or are otherwise ascertainable by calculation (cf Tilley v Wales [1943] AC 386) it cannot be appropriate where the payment or receipt is in respect of a claim or claims for unliquidated damages only and is made or accepted under a compromise which treats it as a single, undissected amount of damages. In such a case the amount must be considered as a whole: Du Cros v Ryall (1935) 19 Tax Cas 444 at 453 …

[2.295]

But it is impossible to see a basis in fact for the contention that the £12,350 which the appellant accepted in settlement of his claims for every kind of damage which the fire had caused him was in truth of the nature of compensation for loss of profits. The fire caused him losses of sheep and cattle, and damage to wool on surviving sheep; it put him to expense for the eradication of rabbits to the incursion of which the destruction of fences had exposed the property, it also caused losses of or damage to capital assets such as pastures, fencing and buildings. But the whole of the damage which it did, whether covered by the appellant’s list of particulars or not, was compensated for by the one entire sum; and it is simply not true that that sum took the place in the appellant’s hands of assessable income.

Questions

2.26

What is meant by claims being ascertainable by calculation if the basis adopted by one party is not able to be used? Would it have made any difference if the taxpayer in McLaurin was aware of the calculations of the valuer for the Commissioner of Railways but had not accepted them, though agreeing to accept the total sum offered?

2.27

In Tilley v Wales [1943] AC 386, the taxpayer was assessed on a payment that consisted of an amount for the reduction of the taxpayer’s pension rights and an amount for a reduction in future salary. In the Court of Appeal both amounts were held taxable and in the House of Lords the Revenue conceded that if the amount in respect of the pension rights were held not to be of an income nature, then it could be apportioned out and escape taxation. What does this imply as to the tax treatment of an undissected amount where part of the amount is admittedly attributable to income? For what proposition has the High Court used the case as authority?

2.28

Would it make any difference in apportionment cases if the settlement payment clearly exceeded the “capital” amount claimed by the taxpayer?

2.29

How (if at all and apart from FBT) is apportionment relevant to the following items: • a car provided by an employer for use by an employee for both the employer’s purposes and the employee’s private purposes; • the provision of an airline ticket by an employer for an employee to spend two weeks in Hong Kong, one week on the employer’s business and one week on holiday; and • a Christmas gift given at work by an employer to an employee who is the employer’s best friend?

[2.300] The Taxation Review Committee (Asprey Committee) in its Full Report (AGPS,

Canberra, 1975), recommended the adoption of a general apportionment power (paras 7.101–7.102) but this has yet to occur. There is a power of apportionment in the capital gains tax under s 116-40 of the ITAA 1997, but how far this provision resolves the problem 60

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under the income tax is unclear. The ATO recently sought to litigate the matter again before the High Court but the Court refused leave to appeal the decision in FCT v CSR Ltd (2000) 104 FCR 44; [2000] FCA 1513. The principles outlined here in relation to identifying the taxpayer and the taxable event, valuation and apportionment have generally been analysed in the context of ordinary income. However, it is possible to use them (along with the issue of income character) as a general tool for thinking about all forms of taxes – who is taxable, when, on what characteristics, and on how much?

3. STATUTORY FRAMEWORK FOR TAXING INCOME [2.310] This section describes the mechanics of the various processes and calculations that

have to be undertaken in order to calculate the annual amount of a taxpayer’s liability under the income tax system. Formally, the income tax is imposed upon an amount referred to as the taxable income of the taxpayer. The tax is levied under s 5 of the Income Tax Act 1986 at the rates declared by the Income Tax Rates Act 1986 (see also ss 4-1, 4-10 of the ITAA 1997). So the first step in calculating a tax liability is to identify the taxpayer’s taxable income.

(a) Taxable Income [2.320] The taxable income of the taxpayer is calculated under the ITAA 1997 which, with

the ITAA 1936, is by far the most important legislation in the process: the use of separate assessment and taxing Acts is a result of constitutional issues. Section 4-15(1) (equivalent to s 48 of the ITAA 1936) says the calculation of taxable income requires the subtraction from all the taxpayer’s assessable income of all the taxpayer’s deductions. In brief then: Assessable income – deductions = Taxable income

(b) Assessable Income [2.330] The assessable income of a taxpayer is defined in s 995-1(1) of the ITAA 1997 to have

the meaning given by ss 6-5, 6-10 and 6-15. The first encompasses ordinary income, the second statutory income and the third exempt income and non-assessable non-exempt income, which both are excluded from amounts which would otherwise be assessable income. Statutory income includes all amounts included in assessable income under the ITAA 1997 and ITAA 1936, putting aside ordinary income. Thus, it includes the increasingly fewer survivals in the ITAA 1936 and the many statutory inclusions under the ITAA 1997, including net capital gains. Exempt income is defined in s 995-1(1) to have the meaning given by s 6-20 which has slightly different rules for ordinary income and statutory income. Various provisions of the Act then exempt from income tax certain types of income or certain types of taxpayers – see the lists located in Div 11 and the operative provisions in Pt 2-15. In 2003 another category of income was introduced, non-assessable non-exempt income, which s 6-15 makes clear also is not part of assessable income even if it is ordinary or statutory income. Section 6-23 provides that non-assessable non-exempt income is an amount that the Act provides is not assessable income and not exempt income. For example, the part of the price collected by a seller in respect of a sale of trading stock that represents GST is non-assessable non-exempt income: see [2.330]

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Income Tax in Context

s 17-5. The main significance of this category of income is that carry-forward tax losses are reduced by exempt income but not by non-assessable non-exempt income: see Div 36 of the ITAA 1997.

(c) Deductions [2.340] Deductions (defined in s 995-1(1) not very helpfully to mean “amounts you can

deduct”) are provided for primarily in Div 8 of the ITAA 1997. They were formerly called allowable deductions under the ITAA 1936 and this terminology is still commonly used in practice. The most important provision is s 8-1, which provides deductions for any loss or outgoing incurred in the gaining or producing of assessable income, for example, rent paid on a factory in which the taxpayer conducts its business. These deductions are called general deductions. Section 8-5 also provides for deductions allowed by specific provisions elsewhere in the Act (of which there are many). These are called specific deductions.

(d) Rate Scales [2.350] When taxable income has been calculated, it is then necessary to decide which is the

appropriate rate scale to apply to that taxable income in order to determine income tax liability. The Income Tax Rates Act 1986 has many different rate scales for different types of taxpayers. Most of us will have experience with the rate scale in s 12(1) and Sch 7 Pt I applicable to most resident individual adult taxpayers, with a zero bracket for taxable income up to $6,000, and tax rates ranging from 15% to a maximum of 45% where income exceeds $180,000. But if the taxpayer is not a resident individual, a different rate scale will be applicable. For example, a company’s taxable income is taxed at the rates in s 23A of the Income Tax Rates Act 1986 (currently 30% but scheduled to decline to 29%) and a non-resident individual’s taxable income at the rates in s 12(1) and Sch 7 Pt II. These rates are, of course, subject to fairly frequent changes – for example, there is a temporary 1% “flood levy” in 2011–12 and further changes will happen to the rate schedule and thresholds with the government’s “carbon tax” measures.

(e) Tax Offsets [2.360] This calculation of tax payable under the rate scale is not the end of the story. It remains to take into account any tax offsets (previously called tax rebates or tax credits) to which the taxpayer is entitled: s 4-10(3) of the ITAA 1997. These provide direct subtractions from the income tax liability of the taxpayer in order to produce finally the income tax payable by the taxpayer. Tax offsets are granted to taxpayers for a variety of purposes such as to correct overtaxation that would otherwise occur, to modify tax rate scales or to grant subsidies to taxpayers. Tax offsets are granted directly by the ITAA 1936 and ITAA 1997 rather than through the Income Tax Rates Act 1986. See, for example, the spouse rebate under s 159J of the ITAA 1936. Most tax offsets are located in Pt III Divs 17–19 of the ITAA 1936 and Divs 61, 65 and 67 of the ITAA 1997. Hence, the full calculation of income tax payable is: (Taxable income × Rate scale) – Tax offsets = Income tax payable

The treatment of tax offsets needs to be distinguished from refunds to taxpayers of excess tax payments. Until recently, if the amount of a tax offset exceeded the income tax liability of 62

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a taxpayer there was no refund of the excess. For example, if a taxpayer was entitled to a spouse rebate that exceeded tax payable (a not very likely event), the excess was not refundable to the taxpayer. This treatment should be contrasted with that under the Pay-As-You-Go (or PAYG) system for taxing salary income. Under this system, the employer withholds tax and pays it to the ATO on behalf of the employee and the employee is entitled to have this amount subtracted from her or his eventual tax liability. If it is found that the amount paid by the employer exceeds the amount of tax payable by the employee, the overpayment is refundable. More recently, refundable tax offsets have been created, most notably imputation tax rebates from 1 July 2000. So it is important now to distinguish tax offsets that do not give rise to a refund right and those that do. Refundable tax offsets are similar to PAYG deductions, while non-refundable tax offsets are similar to the treatment of the spouse rebate. The calculation and ordering of tax offsets is found in s 4-10(3A) and Pt 2-20 of the ITAA 1997. The concept of taxable income is also used to levy other taxes besides the income tax, notably the Medicare Levy under the Medicare Levy Act 1986 and the Higher Education Contribution Scheme (HECS). Many would regard the former as simply a 1.5% surcharge on taxable income and as indistinguishable from the income tax, but there is one important difference, namely income tax offsets cannot be used to reduce the levy. Thus for most students using this book, the full calculation of tax payments arising on taxable income will be: Taxable income × Tax rate scale – Tax offsets + Taxable income × Medicare levy rate scale + Taxable income × HECS rate scale = Total tax payable

The collection of tax in most cases proceeds relatively independently of these calculations. The government does not trust us to turn up at the Australian Taxation Office with a cheque for a whole year’s tax after it has issued tax assessment! Thus there are various withholding mechanisms to collect tax from the payer of income rather than the recipient, and advance payment procedures. One major element of the recent tax reform has been a revamp and rewrite of these provisions, which are now found in Sch 1 of the Taxation Administration Act 1953: see Chapter 19. An assessment is issued to the taxpayer with the previous payments credited against the tax payable. The taxpayer is obliged to pay any deficit on the assessment and (in some cases) is entitled to receive a refund for any surplus of tax paid in advance over final tax liability. (In the case of non-residents, the withholding tax system usually operates as a final tax for interest, dividends and royalties.) The income tax system has become so complex that fewer and fewer taxpayers are preparing and submitting their own tax returns. Increasingly, tax returns are submitted on behalf of taxpayers by tax agents registered to provide tax services. It is not permitted to charge for professional services in relation to preparation of a return unless the preparer is so registered. Many readers of this book may one day become a tax agent and profit from the complexity of the income tax law. The regulation of the tax profession is governed by the Tax Agent Services Act 2009, which sets up a comprehensive regulatory system, overseen by the Tax Practitioners Board, to govern those who, for a fee, assist taxpayers to meet their tax obligations. [2.360]

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[2.365]

Questions

2.30

A and B are resident adult individuals and each has assessable income of $180,000. A has a dependent spouse with no income but no deductions, while B has deductions of $2,000. Who pays more income tax? Who pays more income tax and Medicare Levy combined? See s 159J(1B) of the ITAA 1936 and s 6(1) of the Medicare Levy Act 1986.

2.31

Some tax offsets are calculated by applying a fixed rate to the amount of expenditure that qualifies for the offset, for example, s 159P for medical expenses above a certain threshold. What is the difference between granting an offset in this way and granting a deduction for the same expenditure?

4. STRUCTURE OF THE AUSTRALIAN INCOME TAX SYSTEM (a) Volume and Numbering of Legislation [2.370] The ITAA 1936 passed the dubious milestone of one million words, making it by far

the largest piece of legislation in Australia. Action to try to get this under control began with the Tax Law Improvement Project (TLIP). While the ITAA 1997, which has replaced parts of the ITAA 1936, is shorter and generally easier to read, we are currently caught in an uncomfortable halfway house between the two Acts. The TLIP has been abandoned and the promise in 1998 of a unified tax code now seems unlikely to be fulfilled, so we do not know if or when the law will be reunited in one Act. The Board of Taxation took the first step through recommending the formal repeal of the many inoperative provisions in the tax legislation, especially in ITAA 1936, which occurred in 2006, but the process of moving legislation in to the 1997 Act is still occurring on a piecemeal basis as various areas of the income tax are reformed. It is a forbidding prospect for a student to be faced with legislation that, when placed on the desk at the commencement of the course, is some 25 cm thick, printed on wafer-thin paper, and out of date almost as soon as it is purchased (the income tax legislation has grown at the rate of hundreds of pages each year for the last decade). Do not despair! We (and your lecturer) will be selective. Indeed, to stave off student panic, your lecturer may have kindly prescribed one of the abridged versions of the legislation which is a mere 5 cm thick though still bigger than this book. It is a healthy exercise to become accustomed to reading the inimitable “styles” in which the legislation is drafted, so pick the legislation up off the desk and browse at random when you have finished your current reading assignment. It may assist if we explain the method of numbering the legislation. In the ITAA 1936, apart from the fact that the numbers are in sequence (1 before 2 etc), and that this applies no matter how many letters follow the number (s 221YHAAA enacted in 1986 had the honour of being the first five letter “number” in the Act – can you find a six letter number?), there was no fixed system to the way in which the letters crowd around the number. Generally the lettered sections come after the section with the same commencing number. Then AAAAA comes before AAAAB, which comes before AAAA, which comes before AAAB, which comes before AAA, etc, and ZAAAA comes after Z, which comes after YZZZZ etc. These mind-numbing combinations led to a revised system in the ITAA 1997. The ITAA 1997 is broken into divisions and the sections within the divisions numbered with the division number hyphenated with a fresh sequence of numbers. Thus the ordinary income provision is s 6-5 (the second section in Div 6) and the general deduction provision s 8-1 (the first section in Div 8). Gaps are left in the sequences of division numbers and within divisions to allow for 64

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later amendments without the need for the alpha-numeric combinations of the ITAA 1936. Even so, the alphabet has already crept back into the ITAA 1997 at all levels of numbering.

(b) Integrating Elements of the Income Tax System [2.380] It will soon become apparent that the income tax is not a unified and consistent

system. Today it is comprised of many units which are intended to fit together to form one consistent whole, yet often fail to achieve this result. Elements have been grafted onto the original system with less than perfect results. Moreover, the ITAA 1997 has only replaced parts of the ITAA 1936. The “income tax system” now mainly comprises: 1.

The tax on ordinary income contained in s 6-5 of the ITAA 1997.

2.

The statutory additions to ordinary income. Many sections in Pt 2-1 of the ITAA 1997 are examples of statutory additions to the income tax base.

3.

The tax on net capital gains in Pts 3-1 and 3-3 of the ITAA 1997, replacing Pt IIIA of the ITAA 1936. This system, grafted onto the income tax, represents the single largest example of the Parliament stepping in to increase the income tax base.

4.

The fringe benefits tax imposed by the FBTAA 1986. This taxes non-wage benefits paid to employees which, mainly due to the inadequacies of the tax administration, were frequently not taxed.

(i) Method for inclusions in tax base [2.390] Ultimately, the “bottom line” is always how much tax the taxpayer will have to pay

or be entitled to as a refund. The answer to this problem is determined most usually by answering the questions: Is this amount included in assessable income? Or, is this amount a deduction? These questions cannot be answered without considering the effects of other elements in the income tax system – the fringe benefits tax or capital gains tax – whether they apply, and if they do, how overlaps, inconsistencies and omissions are to be reconciled. In order to resolve even the most basic tax problems, it is often necessary to have a detailed knowledge of all of these disparate elements of the tax system, how they function and how they fit together. The purpose of this section is to try to do that: to provide a little information about the pieces that make up the income tax system and how they fit together or fail to fit together. It is, of course, an impossible task to explain the whole of the income tax system in a few pages. We will spend many chapters discussing what is income, what is a fringe benefit and what is a net capital gain, so you need to be aware that the following few pages simplify very complex issues. A methodical and logical way to resolve a tax problem would be to work through each of the elements of the tax system in turn. When faced with a tax problem, one way to answer the problem would be to use a method which asks the questions outlined below. Step 1 – Is the amount included in assessable income as “ordinary income” – the judicial concept of income? [2.400] The first question to ask is whether the amount comes within s 6-5 of the ITAA 1997.

This has to be the first place to start for most problems and it is the subject of Chapters 3 to 6 of this book. The answer to the question will be given in the cases, since the question is really asking in different words, have judges said that the word “income” in s 6-5 of the ITAA 1997 includes this type of amount? [2.400]

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Income Tax in Context

The types of payments, which according to the cases are included as income according to ordinary concepts, can be grouped into five classes. 1.

The first principle is that a gain which is a return from property has the character of income. This is the principle by which dividends, interest, rent and royalties are taxable. It also distinguishes a gain which is a return from property from a gain on the sale of property, which is usually called a capital gain, and does not have an income character. This is discussed in Chapter 3.

2.

The next principle (explored in Chapter 4) is that a gain which is a reward for services (eg salary, wages, certain gifts, etc) has the character of income.

3.

A further principle is that a gain which is the product of carrying on a business has the character of income. This is the subject of Chapter 5.

4.

The fourth principle is that a gain which is compensation for an amount that would be income has the character of income. There may also be a corollary that a payment which is reimbursement for an amount that has previously been allowed as a deduction has the character of income. This is explored in Chapter 6.

5.

The fifth principle is that a gain which is derived periodically, such as a pension, scholarship, or annuity, has the character of income. This is also explored in Chapter 6.

Step 2 – Is the amount included in assessable income by some specific statutory provision? [2.410] The next question is to ask whether the payment is included in the taxpayer’s assessable income by some specific statutory provision. Usually these are situations where the government has intervened by inserting a section to make some amount taxable because it is dissatisfied with the position that would apply if ordinary concepts were allowed to operate alone. There are many provisions which have the effect of including payments in the taxpayer’s assessable income such as:

• s 15-15 (previously s 25A): gains from carrying out profit-making schemes; • s 15-20 (previously s 26(f)): royalties; • s 102-5 (previously s 160ZO): a net capital gain; • s 15-2 (previously s 26(e)): allowances from employment and services; and • s 44: company distributions. Some of these statutory provisions merely repeat that an amount which would already be within ordinary income is included in assessable income – they are apparently superfluous. But others clearly change what would be the tax consequences if the concept of ordinary income were allowed to operate alone. For example, a capital gain would not be ordinary income and so would not be included in assessable income and taxed apart from s 102-5. Step 3 – Is the amount excluded from tax by being classified as exempt income or non-assessable non-exempt income? [2.420] There are some types of payments which would have an income character according

to the judicial test of income or under express provisions, but which are effectively excluded from the tax base at this stage. Although they would be included in assessable income, an excluding provision classifies some payments as exempt income or non-assessable non-exempt income, and s 6-15 then excludes any such income from the taxpayer’s assessable income. 66

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Step 4 – How are amounts included as ordinary income and statutory income reconciled? [2.430] If an amount would be ordinary income and is also included in assessable income by a

specific section, is the payment taxed twice? This is an important issue that the courts did not resolve satisfactorily in relation to the ITAA 1936. The ITAA 1997 has attempted a solution which is taken up in more detail below. Step 5 – Does the payment also create a “fringe benefit”? [2.440] The next layer of complexity arises when FBT is introduced. Even though a payment

may be included in assessable income either as ordinary income or statutory income, where the payment is connected to some employment it must next be asked whether the payment also gives rise to a fringe benefit. If it is a fringe benefit, the employer will be taxable on the value of the fringe benefits provided to employees. Step 6 – How are the amounts to be reconciled if the payment would be both included in assessable income and be a fringe benefit? [2.450] If the amount would be both included in assessable income (and so taxed as income to

the employee) and is a fringe benefit (and so taxed to the employer) what reconciliations are possible? There are three mechanisms designed to integrate fringe benefits tax and the income tax, as outlined below. 1.

The payment may not be a “fringe benefit” at all. For example, wages, retirement payments and employee share schemes are not fringe benefits and so the employer is not taxable on them. The FBTAA 1986 has no application and they are dealt with only under the provisions already contained in the ITAAs.

2.

The payment also may not be a taxable “fringe benefit” because it is an exempt benefit. For example, certain employee car parking paid for by the employer is an exempt benefit (under s 58G of the FBTAA 1986). This means that the employer will not be taxed on the specified kind of benefit because it is not a fringe benefit and is not included in the “fringe benefits taxable amount” for s 66 of the FBTAA 1986. The employee also will not be taxed on the benefit if it is an exempt benefit even though it would otherwise be included in assessable income. This is because s 23L(1A) of the ITAA 1936 treats exempt benefits as exempt income and so the employee does not pay tax on them. Your lecturer may be interested in this outcome: see s 58G(2). In effect, there is no tax: there is no FBT because it is an exempt benefit, and no income tax because it is still treated as exempt income.

3.

If the payment is a “fringe benefit” taxable to the employer and would otherwise be included in assessable income, the amount will then be excluded from the employee’s assessable income. This means that only the employer has to pay tax on the benefit – it is no longer included as assessable income of the employee.

Step 7 – Does the payment include an amount in assessable income and also create a net capital gain? [2.460] The capital gains tax contained in Pts 3-1 and 3-3 of the ITAA 1997 is not a separate

tax. In fact, calling it a capital gains tax is a misnomer because it is a tax on the profitable realisation of nearly all assets. It can and does overlap with amounts included in assessable income as ordinary income or other statutory income. [2.460]

67

Income Tax in Context

Step 8 – How are the amounts to be reconciled if the payment would be both included in assessable income outside Pts 3-1 and 3-3 and be a net capital gain under those Parts? [2.470] Obviously some amounts will potentially be included in assessable income in both

ways. For example, every sale of a pair of shoes by a shoe store could be dealt with under capital gains tax, since the shoe store has sold an asset, just as much as it can be dealt with under ordinary concepts as the product of carrying on a business. In the ITAA 1936 there were several mechanisms to obviate double inclusion of the same amount. The ITAA 1997 simplifies the mechanisms down to two: certain capital gains are disregarded (eg exempt assets covered by s 118-5) while other capital gains are reduced by the amount otherwise included in assessable or exempt income: see s 118-20. Note that the treatment for reconciling capital gains tax suggested here is a little misleading on two counts: (1) capital gains tax is really an example of Step 3: amounts being included in assessable income by a specific statutory provision: s 102-5; and (2) the CGT mechanics strictly require that the reconciliation in Step 8 be done before the netting of capital gains and losses in Step 7. In other words, there is no net capital gain derived until s 118-20 has been applied to exclude whatever part of the capital gain has to be excluded because it is also taxed outside Pts 3-1 and 3-3. Nevertheless, the scheme is still helpful even if not absolutely formally accurate. (ii) Method for cost and outlays [2.480] The steps outlined above have attempted to reconcile the various elements of the

income tax system in so far as they operate to include amounts in the tax base. Similar issues arise for the exclusion of sums from the tax base or, at least, the reduction of gross sums to the net sums that will eventually be the subject of the tax. The treatment of costs and outlays raises the same problems and a suggested approach is as follows. Step 1 – Is the outlay deductible from current assessable income? [2.490] Section 8-1 of the ITAA 1997 is the primary section which allows a taxpayer to

deduct a loss or outgoing from assessable income, reducing assessable income to taxable income. Outlays will be deductible if they are incurred in producing assessable income or in carrying on a business to produce assessable income. The section will, however, prevent many overlaps with capital gains tax by excluding capital costs from being deductible from assessable income. In addition to s 8-1, there are many sections which grant specific deductions from assessable income for other revenue expenses. Step 2 – How are deductions reconciled if they are allowed under s 8-1 and under some other section? [2.500] It is clear that some of the specific deduction sections merely confirm the operation of

s 8-1 while some others will vary its effect in some respects. For example, s 25-35 allows a deduction for bad debts which are written off during the year of income and in addition some of these bad debts might be deducted from assessable income under s 8-1, according to the High Court in AGC (Advances) Ltd v FCT (1975) 132 CLR 175. This type of overlap is specifically resolved for all allowable deductions by s 8-10 which allows the deduction under the provision that is most appropriate. 68

[2.470]

Fundamental Principles of the Income Tax System

CHAPTER 2

Step 3 – Is the outlay subtractable from revenue in calculating the profit on a venture? [2.510] Most expenses are deducted from assessable income to produce a net figure of taxable

income on which tax is levied (this operation was discussed above). But some gains from business operations and under s 15-15 are accounted for on the basis that only a net figure is included in the taxpayer’s assessable income. In these circumstances, the costs of deriving the profit are subtracted from the receipts to disclose a profit and it is that profit figure which enters the taxpayer’s accounts as an item of assessable income. Step 4 – If the outlay is both deductible from assessable income and subtractable in calculating a profit, how are the overlaps reconciled? [2.520] If the expense is subtracted in calculating the profit of a business venture, might the

expense also be deducted from assessable income so that it is counted twice? This possibility is partly prevented by s 82 of the ITAA 1936 which provides that where a profit is included in assessable income, any expenditure incurred which has been allowed as a deduction is not to be subtracted in calculating the profit. Step 5 – Is the outlay subtracted from capital gain? [2.530] An outlay incurred by a taxpayer might also be subtracted in the calculation of a

capital gain derived by the taxpayer. The outlay will affect the calculation of a capital gain if it is included in the cost base of the asset. The cost base of an asset is generally set out in Div 110 of the ITAA 1997. One form of integration occurs at this stage by including some costs which were not allowed as deductions from assessable income in the cost base of the asset. Step 6 – How is the overlap reconciled if the outlay is both deductible from current income and is subtracted from capital gain? [2.540] Section 8-1 will prevent many overlaps with CGT from occurring, as it permits

taxpayers to deduct expenses only if they are not of a capital nature. There was originally no general rule under the CGT that any outlay allowed as a deduction from assessable income was automatically excluded from forming part of the cost base of some asset. This meant that it was possible for an outlay to reduce assessable income and to reduce a capital gain. It could happen, therefore, that an expense which is an allowable deduction is included in the cost base of an asset. This possibility probably arose in Cliffs International Inc v FCT (1979) 142 CLR 140; 9 ATR 507; 79 ATC 4059 where the taxpayer paid as part of the price of some shares a periodic royalty payment which was allowed as a deduction. This payment could also have been the money paid in respect of acquiring the asset and so formed part of the cost base of the asset. The taxpayer was allowed to deduct the royalty payment from its assessable income, and when the taxpayer sold the shares it might have been entitled to subtract the royalty to calculate any capital gain. Some specific situations of overlap are provided: • Incidental costs are excluded from forming part of the cost base of the asset if they have been allowed as a deduction from assessable income: s 110-45(1B) of the ITAA 1997. These “incidental costs” are defined in s 110-35 and include certain professional fees, the costs of transferring the property including stamp duty and advertising expenses. • Section 110-55 also integrates some allowable deductions and the cost base of an asset. It provides that the reduced cost base of an asset is to be reduced by any amount that is allowed as a deduction. The reduced cost base is used if the taxpayer will generate a capital [2.540]

69

Income Tax in Context

loss on the sale of the asset. The effect of this is to minimise the sum of the capital loss generated by reducing the size of the reduced cost base and hence reducing the amount by which it falls short of the price originally paid for the asset. This treatment was extended to the calculation of the cost base for calculating capital gains from 1997: see s 110-45. This deals with the Cliffs International situation but has also created problems and complexities of its own. • Section 51AAA provides that where an amount which would be an expense incurred in earning assessable income is allowable only because a net capital gain has been included in assessable income, the amount will not be an allowable deduction.

(c) Overlapping Assessment Sections [2.550] As noted in the previous section, the courts did not conclusively resolve the

relationship between ordinary concepts of income embodied in s 25(1) of the ITAA 1936 and specific sections including amounts in assessable income. As an example of the problem consider Reseck v FCT (1975) 133 CLR 45; 5 ATR 538; 75 ATC 4213. Section 26(d) (repealed in 1983) included in assessable income 5% of amounts some of which would otherwise be assessable in full as ordinary income and some of which would otherwise not be assessable. The ATO sought to assess a taxpayer in full on an amount that was ordinary income, apart from the effect of s 26(d). The High Court held that the taxpayer was only assessable on 5% of the amount. In their view s 26(d) had both an including and an excluding effect. It included 5% of amounts that would otherwise not be assessable and excluded 95% of amounts from assessable income that would otherwise be assessable in full as ordinary income. In effect the High Court held that s 26(d) occupied the field and prevented ordinary concepts of income from operating. While this case settled the matter for s 26(d), it did not provide any guidance for other cases where there was apparently an overlapping but different scope as between ordinary income and specific assessment provisions. Further, the issues at stake in cases like this extended far beyond the relationship of s 25(1) and other assessment provisions, affecting Australia’s international income tax jurisdiction, the concept of exempt income (was the 95% excluded in Reseck exempt income?), issues of double counting, and any provisions in the ITAA 1936 containing the word “income” without any attached epithet such as assessable or exempt. Much intellectual effort has been devoted to these problems. There is no need to dwell here on this effort, as the ITAA 1997 has sought to meet the problems head-on by the following means: • ss 6-5 and 6-10 on ordinary income and statutory income contain equivalent international jurisdiction rules; • s 6-20 on exempt income distinguishes clearly between the treatment of ordinary and statutory income; • the word “income” is intended not to be used on its own; rather sections indicate whether they are dealing with ordinary income, statutory income or both; • an attempt is made to indicate the relationship between ordinary and statutory income for cases such as Reseck; and • an attempt is made to deal with the possibility of double inclusion of an amount in assessable income under more than one provision. 70

[2.550]

Fundamental Principles of the Income Tax System

CHAPTER 2

It is the attempts referred to in the last two points that are of most interest. If an amount can be covered by provisions on both ordinary and statutory income, what is the result? And if more than one provision seems applicable is there any rule against double counting? At the general level it is by no means clear whether ordinary income takes precedence over statutory income under the ITAA 1997 or vice versa. Section 6-10 on statutory income provides in subs (1) that such assessable income includes amounts that are not ordinary income, suggesting a priority for ordinary income. By contrast, s 6-25(2) provides that in the absence of contrary intention, provisions outside Div 6 prevail over the rules about ordinary income. As all the specific rules on statutory income are outside Div 6, this section suggests a contrary view. The notorious diagram in s 6-1 provides no help, as it conveniently does not depict overlapping circles (so infamous is the diagram that it was reduced from operative provision to guide during the debates on the diagram). Other non-operative provisions variously suggest different relationships such as s 10-5. On balance it is likely that a priority for statutory income is intended similar to Reseck. Fortunately, a number of provisions on statutory income such as ss 15-10 to 15-30 are explicit on the issue, making clear that ordinary income prevails (and perhaps suggesting that otherwise the reverse would be true). However, s 6-25(1) seems to indicate that it is possible for provisions on both ordinary income and statutory income to be operative in a particular case (as well as more than one provision on statutory income). The effect of the provision is that where the “same amount” is otherwise included more than once in assessable income, it is to be included only once. How does this apply where different sections produce different amounts for inclusion in assessable income as in Reseck? Does the provision mean that there is no rule against double inclusion if the amounts are different? Or does it mean that there is a rule against double inclusion to the extent of overlap, with the consequence that effectively the higher amount is always included, reversing the result in Reseck? It should be noted that these types of overlap problems are differently structured for deductions. It is clear by s 8-10 that the provisions which allow deductions are intended to operate independently and that overlap is avoided by choosing the provision that is most appropriate. However, the “same amount” terminology also appears there and raises similar questions as for assessable income.

[2.550]

71

THE TAX BASE EXEMPTIONS

–

INCOME

AND

4. Income from the Provision of Services ......................................... .. 139 5. Business Income .................................................................................. 259 6. Compensation Receipts and Periodic Receipts ............................ .. 351 [Pt2.10] This Part starts our examination of the “income” portion of the income tax. As we will see, the base of the income tax starts from amounts that are, and are deemed to be, income. Determining the total of these amounts for a tax year is the first step in calculating the amount of tax that has to be paid. But one reason why this book is over 1,000 pages long is that the answer to the question – is this amount taxable or not? – is straightforward for some amounts, and horribly complex for others.

PART2

3. Income from Property ....................................................................... .. 75

As we noted in Chapter 2, some amounts are income because they are the kind of amounts that people think of when they hear the word, “income”. The following chapters have instances of these kinds of amounts – interest on a bank account, rent paid to a landlord, wages received by employees, the fees earned by a lawyer. These amounts are all taxable and all for the same reason – they are what people include within the meaning of the term “income”. In the following chapters we try to do two more things. First, we try to be more analytical about these examples. We break down these items into constituent groups. Interest and rent may be taxable but they are taxable for reasons that are different from the reasons that are invoked when taxing wages received by employees or the fees earned by a lawyer. Chapters 3 to 6 try to delineate and then coordinate the different jurisprudential theories that the courts have expressed to explain why one receipt is income and another isn’t. In breaking down the examples into groups, we try to define the boundaries of the groups, to see where each starts and stops. The second thing we do is to see how the ordinary meaning of the word “income” is expanded by the tax legislation. That is, defining the limits on the ordinary meaning of the word income uncovered during our exploration doesn’t exhaust our inquiry; we also have to be satisfied that there is no statutory provision which extends the ordinary meaning to capture the kind of transaction we are examining. The most extensive statutory extensions to the income tax are the capital gains tax (CGT) provisions in Pts 3-1 and 3-3 of the ITAA 1997. Because virtually every difficult tax issue nowadays involves consideration of the CGT, we deal with it first in the chapters that follow, and return to it constantly thereafter.

73

CHAPTER 3 Income from Property [3.10]

1. INCOME FROM USE AND SALE OF PROPERTY ................... ......................... 77

[3.20]

2. CAPITAL GAINS TAX ...................................... ............................................... 80

[3.20]

(a) CGT Framework .................................................................................................... 80

[3.50] [3.50] [3.60] [3.90] [3.120] [3.130] [3.150] [3.160] [3.230] [3.250] [3.270] [3.280] [3.300] [3.310] [3.370] [3.410]

(b) Principal CGT Concepts ......................................................................................... 83 (i) CGT asset ............................................................................................................... 83 Ruling TR 98/3 ............................................................................................................ 84 Ruling TR 94/30 .......................................................................................................... 87 (ii) CGT events ............................................................................................................ 91 FCT v Orica Ltd ............................................................................................................ 93 (iii) The terrible twins: CGT events D1 and H2 ............................................................ 96 Hepples v FCT .............................................................................................................. 98 Ruling TR 98/3 .......................................................................................................... 100 Ruling TR 94/30 ........................................................................................................ 102 (iv) Time of acquisition and CGT events .................................................................... 104 Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd ............ 105 (v) Calculation of capital gain or capital loss .............................................................. 109 (vi) Rollovers ............................................................................................................. 109 (vii) Exclusions .......................................................................................................... 114 (viii) Personal use assets ............................................................................................ 116

[3.420]

3. GAINS FROM THE USE OF PROPERTY......................... ................................ 116

[3.430] [3.440] [3.450] [3.460] [3.470] [3.480] [3.500] [3.520]

(a) Interest, Discounts and Premiums ........................................................................ 117 (i) Discounts and premiums ...................................................................................... 118 Lomax v Peter Dixon ................................................................................................... 119 (ii) Deep discount debt securities – Div 16E and TOFA .............................................. 124 (iii) Traditional securities ........................................................................................... 124 (iv) Annuities ............................................................................................................. 125 Scoble v Secretary of State for India ............................................................................. 127 Vestey v IRC ............................................................................................................... 128

[3.540] [3.540] [3.550] [3.560]

(b) Rent, Premiums, Repairs and Leasehold Improvements ........................................ 130 (i) Rent and premiums .............................................................................................. 130 (ii) Repairs ................................................................................................................. 131 (iii) Leasehold improvements .................................................................................... 132

[3.570] [3.580] [3.590] [3.600]

(c) Royalties .............................................................................................................. (i) Payments for natural resources ............................................................................. (ii) Intellectual property and know-how .................................................................... Murray v Imperial Chemical Industries Ltd ...................................................................

132 134 135 136

75

The Tax Base – Income and Exemptions

Principal Sections ITAA 1936 s 25A

ITAA 1997 –

s 26(a)

s 15-15

s 26(f)

s 15-20

s 26(l)

s 15-25

s 26AAA

s 15-15

ss 26BB, 70B

–

s 27H

–

s 160ZO(1)

s 102-5

s 160ZC

ss 102-5 to 102-22

ss 160L, 160M

Div 104

s 160ZS s 160U ss 160B, 160ZQ s 160ZZQ

Subdiv 118-B

s 104-110 Divs 104, 109 160Z(7), Subdivs 108-B, 108C

ss 160ZZK, 160ZZL

Subdiv 124-B

s 160X

Div 128

76

Effect This section replaced s 26(a) and included measures designed to overcome the deficiencies of s 26(a). This section included in a taxpayer’s assessable income profit realised on the sale of property acquired for the purpose of resale and profit realised from a profitmaking scheme. This section includes royalties in a taxpayer’s assessable income. This section includes in a lessor’s assessable income compensation or damages for breach by the lessee of a covenant to repair. This section included in assessable income gains realised on the sale of property acquired within a year of its disposal. These sections deal with traditional securities. This section provides a pro-rata formula for recognising the cost of a purchased annuity. This section includes a net capital gain in assessable income. These sections define a net capital gain as the excess of capital gains realised during the year over capital losses suffered during the year or carried forward from previous years. They also incorporate the CGT discount for individuals and trusts enacted in 1999. These provisions define when a capital gain arises and exclude from CGT gains realised on the disposal of assets acquired prior to 20 September 1985. This section deals with the grant of a lease. These contain the timing rules for CGT. These contain rules on collectables and personal use assets. These contain the CGT exclusion for the main residence. These contain rollovers for assets compulsorily acquired, lost or destroyed. These contain rollovers on death.

Income from Property

ITAA 1936 Pt III Div 16E

ITAA 1997 Div 230

CHAPTER 3

Effect The provisions in this Division provide for the recognition of income gains on deep discount securities as if they were realised as compound interest.

1. INCOME FROM USE AND SALE OF PROPERTY [3.10] Although the ITAA 1936 apparently adopted a global notion of income, the schedular

UK system had a considerable influence in limiting the apparently broad and undefined concept of income. Section 25(1) included gross income in assessable income but the courts limited this (in the absence of specific provisions) to income according to the ordinary concepts and usages of mankind, which were largely based on the schedules in the UK legislation: see Chapters 1 and 2. Nowhere was this limitation more obvious than in relation to income from property. Gains from the use of property (including money) such as rent, royalties, interest and dividends were included in ordinary usage income, but gains (profits) from the sale of property generally speaking were not. We have already noted in Chapter 2 that this result was probably influenced by trust law, which distinguished between income and capital beneficiaries. The major exception to this position was gains made on the sale of (some kinds of) property owned by a business. Profit on the sale of the trading stock (inventory) of a continuing business was clearly income according to ordinary concepts – the very purpose of the business was to trade and make profits on such items. It was also accepted that profits on some non-trading-stock assets sold by a business were income according to ordinary concepts; a common example was the asset portfolios of banks and insurance companies: see Chapters 5 and 11. The most contentious situation arose in respect of gains arising from one-off business-like transactions. The UK legislation imposed tax on profits from an adventure in the nature of trade. This provision was apt to encompass where there was no continuing business if there were “badges of trade” in the transaction, that is, the transaction had a commercial flavour. The House of Lords apparently held in Jones v Leeming [1930] AC 415 that profits on the one-off sale of certain property were not income within these principles, even though the taxpayer had bought the property with the intention of selling it at a profit. While the exact decision in this case came to be much debated in subsequent years, the Australian legislature reacted by enacting a provision that included in assessable income “profit arising from the sale by the taxpayer of any property acquired by him for the purpose of profit-making by sale, or from carrying on or carrying out any profit-making undertaking or scheme” (which came to be s 26(a) of the ITAA 1936). The precise effect of this provision was, in turn, much debated in cases and elsewhere over a 50-year period: did it just restate the law on ordinary usage income or did it extend the type of gains subject to tax? Judicial decisions over the years also revealed technical shortcomings in the first part of the provision relating to property acquired with the intention of resale at a profit and the provision was re-enacted as s 25A in 1984 with amendments to deal with the problems. This history is further elaborated in Chapter 5. The Labor Government of the early 1970s enacted s 26AAA of the ITAA 1936 which brought into assessable income profits on property acquired and sold within 12 months. This provision could be viewed as seeking to overcome evidentiary problems in demonstrating the [3.10]

77

The Tax Base – Income and Exemptions

necessary intention under s 26(a), but equally it was seen as the thin edge of the wedge leading ultimately to a capital gains tax (CGT). The Asprey Committee in its Interim Report of 1974 recommended the introduction of a CGT and the Labor Government promptly announced its adoption of this recommendation. In its Full Report of 1975, the Committee recommended that introduction of the CGT be delayed in view of the high level of inflation at the time (up to 20%) and the momentous political events of that year ensured that nothing further happened on the CGT front for the next 10 years. The Labor Government elected in 1983 quickly identified tax reform as a priority issue. It had undertaken not to introduce a CGT in its first term and contented itself with enacting s 25A of the ITAA 1936. After winning the 1984 election on a platform of consulting about tax reform, it introduced a CGT effective immediately after the announcement date of 19 September 1985. Clearly the comprehensive income tax base discussed in previous chapters includes gains on assets whether as part of a business or not. The equity and efficiency arguments for the comprehensive tax base were hence deployed in justifying the CGT; indeed as noted in Chapters 1 and 2, the tax reform of 1985 can be characterised to some degree as grafting the Simons’ comprehensive income tax base onto ordinary usage income. In order to win the approval of minority parties in the Senate and mindful of the history of CGT in Australia, the government decided only to apply the CGT to assets acquired on or after 20 September 1985, with the amount of gain being adjusted to eliminate the effects of inflation if assets were held for more than 12 months and effectively averaged gains over five years to moderate the effect of the gain all being reported in one tax year. Legislation for CGT was introduced into Parliament on 22 May 1986. The oddity of introducing such a major change in the tax system by government announcement was ameliorated by the existence of s 26AAA – property acquired after 19 September 1985 and sold before 19 September 1986 was covered by this provision, so that the CGT in most cases really bit from 20 September 1986. Having done its transitional work and ironically having become the source of CGT avoidance, s 26AAA was effectively repealed in 1988 and actually deleted from the ITAA 1936 in 1994. The 12 months indexation rule, which has its origin in part in that section, is still with us, though fading as explained below. Section 25A was partly repealed as from 20 September 1985 but is still in part with us (as explained in Chapter 5) as s 15-15 of the ITAA 1997. The CGT was contained in a separate part as an add-on to the income tax (Pt IIIA of the ITAA 1936 is now Pts 3-1 and 3-3 of the ITAA 1997) but was not entirely separate from it. On one hand, the amount included in assessable income under the CGT was capital gains reduced by capital losses (to give a net capital gain each year). On the other hand the CGT could apply to assets subject to the income tax, and if the capital gain amount exceeded the income tax amount, the excess was included in the calculation of net capital gain. The CGT legislation extended far beyond profits from the purchase and sale of property as we would understand that idea. Over the years the courts had held that many amounts were not income according to ordinary concepts. These amounts were often referred to as “capital gains” as a shorthand way of saying they were not subject to income tax, even though they had nothing to do with the purchase and sale of property; for example, the premium received on granting a lease or a payment received by an employee for agreeing to a restrictive covenants sought by a former employer. The government used the CGT as the means of dealing with these defects in the income tax base as well. The original concept underlying the CGT – the profit arising from the sale of an asset – was designed to reflect the basic transaction: it applied to the disposal of an asset, and the capital gain or loss on the asset was calculated by deducting 78

[3.10]

Income from Property

CHAPTER 3

the indexed or reduced cost base from the consideration in respect of disposal. But the decision to use the CGT to remedy other holes in the income tax base meant that these basic building blocks of the CGT had to be manipulated to accommodate these other amounts which did not arise from selling assets – the provision had to, for example, deem the existence of an asset, deem the disposal of the asset, deem the cost base or deem the consideration in respect of disposal. As we will see below, even this extensive deeming was not sufficient for taxing the employee restrictive covenant. Many of the items which these extensions were directed at were flows rather than gains, but even with the extensive drafting adjustments, the CGT could not reconcile the conflict of the flow and gain concepts of income, discussed in Chapter 2. When the tax legislation came to be rewritten as part of the Tax Law Improvement Project (TLIP), the global concept of income in the ITAA 1936 was partly given up. Income was explicitly divided into ordinary income and statutory income as explained in earlier chapters. Capital gains tax is included as part of statutory income but still retains its essentially separate character in Pts 3-1 and 3-3 of the ITAA 1997 with the special procedure allowing the offset capital losses only against capital gains. The breadth of the tax was recognised by abandoning the disposal of asset concept of the ITAA 1936. Now the tax applies in relation to a CGT event in relation to an asset. Whether this approach is clearer than the ITAA 1936 may be doubted. It would be much simpler to put the additions to the tax base beyond profits on the sale of assets into the income tax and not the CGT (as the UK, for example, has long since done for employee restrictive covenants). Indeed it may be simpler to collapse the CGT and income tax into one so far as the sale of property is concerned. The Ralph Report recommended extensive change to the regime for taxing capital assets in 1999, not all of which were adopted. Indexation was terminated at the end of the September 1999 quarter (s 960-275 of the ITAA 1997) and CGT averaging as from 21 September 1999. As compensation for the loss of indexation, individuals are able (in most cases) to exclude 50% of net capital gains from their assessable income and superannuation funds one-third of net capital gains; these discounts are available for gains on assets held for more than one year (Div 115 of the ITAA 1997). For assets acquired before 21 September 1999, individuals and superannuation funds have the choice of indexation up to September 1999 or the discount, but not both. Companies retain indexation up to 21 September 1999 and had their tax rate reduced to 30% from 36% as a result of Ralph recommendations; they do not, however, benefit from the CGT discount. In addition, the government has enacted Ralph reforms in relation to removing depreciable assets from the CGT net, rollovers for scrip for scrip takeovers and demergers, exemption of certain foreign pension funds from CGT on venture capital investments (since effectively overtaken by much broader measures in the venture capital area), and small business CGT relief. In the following parts of this chapter we consider the CGT and then gains from the use of property. This reverses the usual order of considering ordinary usage income before statutory income, which characterises later chapters. We think the reversal is justified by the all-pervasive nature of the CGT today, which extends far beyond simple sales of property at a profit. Although superseded by the ITAA 1997 provisions in 1998, Pt IIIA of the ITAA 1936 was only finally repealed in 2006. We still refer at various points to the 1936 provisions in what follows to compare how they solved various issues differently from the 1997 Act and in particular in relation to extracts which deal with the ITAA 1936. [3.10]

79

The Tax Base – Income and Exemptions

2. CAPITAL GAINS TAX (a) CGT Framework [3.20] There are two possible ways to enter the capital gains world. One is to go directly to Pt

3 and read Div 100 which contains the guide to capital gains and losses. This guide provides a helpful summary of the CGT and can appropriately be read at this point. Alternatively, we can start with s 6-10(1) of the ITAA 1997, which includes in assessable income some amounts that are not ordinary income (and as we have noted, capital gains are not ordinary income). A note to this provision points to the list of relevant inclusions in s 10-5. One item in the list is capital gains, which in turn points to s 102-5. When we turn to s 102-5 we find that what is included in assessable income is a “net capital gain.” The method statement indicates that the taxpayer calculates separately each capital gain and capital loss for the year, and subtracts the losses from the gains. • If the result for the year is a negative amount, no amount is included in assessable income. Instead, the taxpayer has a net capital loss for the year which may be taken into account in later years; it cannot be deducted from other assessable income of that year: see s 102-10. • If the result is a positive amount, the taxpayer then subtracts any net capital losses of previous years from that amount. Section 102-15 provides that net capital losses are deducted in the order in which they were incurred, that is, the earliest such losses are subtracted first, then the next earliest and so on. If a positive amount remains after taking account of all prior net capital losses, this is the “net capital gain” for the year. Although this is the normal calculation, there are a number of exceptions and modifications for which a list is found in s 102-30. The method statement has been significantly altered to incorporate the Ralph changes relating to the CGT discount for individuals and superannuation funds now provided in Div 115, and the small business CGT relief now found in Div 152. The method statement, along with Div 115, is designed to give the relevant taxpayers the option of calculating capital gains using indexation up to September 1999 or taking the appropriate discount where the asset has been held for more than one year. The discount is only available after capital losses have been offset against capital gains. The calculation of capital gains is discussed briefly below and elaborated further in Chapter 12. [3.25]

3.1

Question

The taxpayer, which is a company, has the following capital gains and losses over a period of five years: Year 1 2 3 4 5

Capital gains 100,000 150,000 100,000 150,000 200,000

Capital losses 50,000 250,000 150,000 75,000 100,000

What is the net capital gain or net capital loss for each year? In which years are the net capital losses of any previous year utilised? [3.30] A number of important consequences flow from the CGT method of calculation. First,

capital losses can only be applied against capital gains, not against other forms of income. This 80

[3.20]

Income from Property

CHAPTER 3

quarantining is used because capital gains are taxed on a realisation basis (when a CGT event occurs) and not as they accrue. Hence, if capital losses could be offset against other types of income, taxpayers would be encouraged to realise their capital losses but not their capital gains and use the loss to reduce tax on other income such as wages or interest. If taxpayers do make a capital gain, however, they can generally realise any capital losses on assets which have fallen in value and reduce or eliminate tax on the capital gain, though it has been held in Cumins [2007] FCAFC 21 that the general anti-avoidance rule in Pt IVA of the ITAA 1936 can apply to manufactured sales, and the ATO has tried to deter sales if the same or a similar asset is immediately repurchased (a “wash sale” – see TR 2008/1). Second, the calculation for capital gains is separate from the calculation employed for other assessable income and deductions. As the same amounts may be entering as positive or negative elements in the calculation under capital gains and elsewhere, there are a number of complex adjustments that may have to be made to avoid double counting. Third, for similar reasons, the CGT contains repetitions of many rules that are found under the income tax. For example, the CGT has its own provisions on identifying the taxpayer, (Div 106), constructive receipt (s 103-10, compare ss 6-5(4), 6-10(3) and see TD 2003/1), valuation (s 103-5), and international jurisdictional rules for non-residents (Div 855, compare ss 6-5(3), 6-10(5)). Moreover, any tax exemptions have to be delivered twice – one rule eliminating tax under the ordinary rules and a further rule eliminating CGT (compare, s 53-10, Items 4B and 4C, which exempt amounts paid under sugar and tobacco industry adjustment schemes from income tax, with s 118-37(1)(f) and (g) which exempt the amounts from CGT.) [3.35]

3.2

3.3

Questions

Why does the CGT have a separate constructive receipt provision? How (if at all) does the constructive receipt provision for CGT differ from those for the income tax? What is the relationship between the income tax and CGT constructive receipt provisions? What is the effect of s 106-60? What happens if a mortgagee takes possession of a mortgaged property because the mortgagor has defaulted on payments under the mortgage, sells the property and uses the proceeds to pay off the mortgage? Would the result be any different under the income tax if the profit on sale was taxable under the income tax? If a mortgagee in possession of a rented property directs the tenant to pay the rent to the mortgagee instead of to the mortgagor landlord, whose income is it?

[3.40] Capital gains and capital losses used in the calculations only arise if a CGT event

happens (s 102-20 of the ITAA 1997). The list of CGT events is contained in Div 104 with a summary in s 104-5. A CGT event is the ITAA 1997 equivalent of the “disposal” of an asset in the CGT provisions of the ITAA 1936. The first and most important CGT event in the ITAA 1997, s 104-10(1), still refers to the case where “you dispose of a CGT asset”. For each event the provisions set out the nature of the event, the time when the event occurs and the calculation of the capital gain or capital loss arising on the event (which is generally done by comparing two different amounts: the disposal proceeds and the cost base (see s 102-22)). The nature of most CGT events involves an asset in one way or another, either through referring to that term directly or to particular kinds of assets. Hence the concept of an asset remains central to the CGT. The basic definition of asset is in Div 108, as well as rules for determining when assets are aggregated or kept separate for CGT purposes. Division 108 also contains special rules for assets of a personal nature (referred to as collectables and personal use assets). [3.40]

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The Tax Base – Income and Exemptions

The time when a CGT event occurs is important, as the calculations of net capital gain and net capital loss require allocating capital gains and capital losses to an income year. In the ITAA 1936 the rules for determining when an asset was disposed of and when it was acquired were found in one place, s 160U. The use of separate CGT events means that the time of each event is now separately stated in every section prescribing an event which can involve some repetition. The time when an asset is acquired – which is important for various purposes including transition, indexation (to a reduced extent following the Ralph changes) and the CGT discount – is set out separately in Div 109, which generally mirrors the event rules. In the discount case there are modifications of the acquisition rules, especially s 115-30, as not all CGT events attract the discount: see s 115-25. The methods used to switch off the CGT are complex. In a number of cases the CGT event sections provide that certain capital gains or losses “are disregarded.” This is the general method adopted for excluding various capital gains or losses from CGT. In the same way, Div 118 of the ITAA 1997 also provides many instances where the gain or loss is “disregarded.” The fact that the gain or loss is excluded from tax calculations does not mean that the CGT event is regarded as not having occurred: see s 102-33. This general method for effecting exclusions is to be contrasted with ITAA 1936 where various methods were used, and is one of the improvements effected in the ITAA 1997. Although the same general method is used, the purpose of the exclusions differs. Some are part of the reconciliation with the income tax, such as the “anti-overlap provisions” in Div 118, some defer taxation to a later time (including, but not limited to, so-called rollovers), while others effectively exclude amounts from taxation altogether such as the main residence exemption in Subdiv 118-B. There are a few situations where the legislation specifically provides that a CGT event does not occur (as opposed to being disregarded) such as s 104-35(5). One of the most important exclusions relates to the transition rule – that CGT does not (usually) apply to assets acquired before 20 September 1985. Due to the CGT event structure of the ITAA 1997 it is necessary to repeat this exclusion for each CGT event to which it is relevant, for example, ss 104-10(5), 104-15(4), 104-20(4), 104-25(5). CGT events do not require this transitional rule if they do not depend on the acquisition of an asset, for example, ss 104-35, 104-155. Assets excluded by this transitional rule are commonly called “pre” assets to distinguish them from “post” assets (acquired after 19 September 1985) which are subject to CGT and this usage continues even though it is not precisely accurate in the structure of the ITAA 1997. Indeed, “pre-CGT asset” is a defined term for one area of the law: see s 149-10. This transitional rule was one of a number of political compromises (others can be seen in the various exclusions) necessary to secure Senate acceptance of the CGT. The common practice in other jurisdictions (such as the UK) which decided to introduce a CGT is to use a “valuation” day at the time the tax comes into effect and to assess gains on all assets, as measured from the value of the property at the time the tax is introduced. This approach avoids the problem of retrospectivity while furthering the aims of equity (all future gains and losses are recognised) and economic efficiency (all assets are treated the same). The consequences of the pre- and post-asset system are serious from both equity and efficiency perspectives. From an equity perspective, it favours existing wealth-holders, who have acquired assets prior to the commencement date, as all future gains realised by them will be exempt from taxation. From an efficiency perspective, it led to an enormous lock-in problem as taxpayers holding pre-assets are reluctant to dispose of them and reinvest in post-assets that would be subject to CGT, even if the post-assets could generate higher rates of return before 82

[3.40]

Income from Property

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tax. From a legal perspective, the most significant consequence of the pre- and post-asset system is the significant degree of complexity it adds to the legislation. In cases where a CGT event occurs and the gain or loss is not going to be disregarded, the next step is to calculate the capital gain or loss. This calculation is specified separately for all events though in many cases it is the same as the single calculation under the ITAA 1936: the disposal proceeds (called consideration in respect of the disposal under the ITAA 1936) less cost base. A capital gain arises if disposal proceeds exceed the cost base and a capital loss arises if the reduced cost base exceeds disposal proceeds, for example, ss 104-10(4), 104-15(3), 104-20(3) and 104-25(3). Surprisingly the CGT event provisions do not specify the precise amount of the capital gain or capital loss. This is left to the second sentence of s 102-22 which indicates that it is the amount of the difference. In those cases where the CGT taxes flows rather than gain, the cost base is not relevant, and the capital gain or capital loss is measured by reference to the disposal proceeds less the transaction costs involved in the event, for example, ss 104-35(3) and 104-155(3). If cost is used in the calculation, then the CGT event sections employ two concepts: cost base for capital gains and reduced cost base for capital losses. In the case of capital gains, later sections indicate that the cost base, in turn, has two alternative calculations. The cost base rules are found in Div 110 with modifications of those rules for special cases indicated in Div 112. Both the cost base and the reduced cost base start with five elements, which effectively are what was paid for the asset, transaction costs of acquisition and of the CGT event, and certain capital and non-capital costs of ownership. The reduced cost base makes adjustments to what was paid to acquire the asset mainly for amounts that have been deducted under other provisions of the income tax legislation. It is, in effect, one of the adjustment mechanisms for reconciling the CGT with other provisions. Similar adjustments effective in 1997 were introduced for the cost base calculation also. The calculation of disposal proceeds is set out in Div 116. Essentially it is the amount paid on the happening of the CGT event. There are several modifications of disposal proceeds similar in many respects to those for the cost base and reduced cost base, for example, where a transaction involves a gift. The final division in Pt 3-1 is Div 121 on record-keeping which completes the general part of the CGT. Part 3-3 starting with Div 122 then covers special CGT topics. (It is odd that a gap has been left in the numbering of the parts but not the divisions here – how will divisions in any future Pt 3-2 be numbered?) The organisation of the CGT into general and specific provisions also occurred in the ITAA 1936 though there was not any formal separation of the two. Divisions 1 to 4 of Pt IIIA were the general provisions, and Divs 4 to 21 the specific provisions.

(b) Principal CGT Concepts (i) CGT asset [3.50] The definition of CGT asset found in s 108-5 has gone through three versions since 1986 (in the ITAA 1936 under s 160A, it was simply an asset and we will often use this term as well). The first version was open to an argument that it only applied to property or rights that were assignable. The second version made clear that rights could be assets even if not regarded as property but otherwise retained the awkward form of the original definition which first said what asset “means”, then what it “includes” and finally excluded motor vehicles. The 1997 [3.50]

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The Tax Base – Income and Exemptions

definition is much cleaner – but not necessarily any clearer. It first states what CGT asset means – any kind of property, and a legal or equitable right that is not property. Then for the avoidance of doubt it states that certain things are CGT assets – goodwill and interests in partnership assets and partnerships (which approximately corresponds to the inclusive part of the former definition). Finally it has a note giving examples of assets, which includes one item that was previously in the inclusive list – foreign currency (the ITAA 1997 is no more forthcoming on the status of Australian currency). The exclusion of motor vehicles has been deleted and replaced by a provision that the disposal of a motor vehicle is disregarded, s 118-5, as part of the general change which seeks to use the same mechanism for all exclusions, as discussed above. In all its forms the definition raises the question whether it will be interpreted expansively or not. After some inconclusive case law in Australia, the High Court recently decided emphatically in favour of an expansive interpretation even for the first version of the definition in FCT v Orica Ltd (1998) 39 ATR 66; 98 ATC 4494 (extracted below). The difficulty is that the broader the definition of asset is cast, the more difficult transactions become to characterise for CGT purposes and the more complex is the CGT analysis; and at the same time the greater becomes the potential application of the CGT, so that it may apply unexpectedly in common situations. Information is an area where the borderline of the asset concept is unclear. The law gives quite formal legal protection to certain kinds of information (or its presentation) by patent and copyright. Confidential information also can be protected by the law. Is information an asset? Are the rights arising from the law protecting confidential information assets? Issues of these kinds are dealt with in Ruling TR 98/3 on mining, quarrying and prospecting information.

Ruling TR 98/3 Nature of mining, quarrying or prospecting information [3.60] 16. Mining, quarrying or prospecting information is not property. Of course, such information can ripen into a form of property such as copyright, trademarks, designs and patents … 17. This Ruling deals with information transactions whose essential character is not the transfer of a “literary work” under copyright law (analogous to the sale of copyrighted works such as books or computer programs). Rather, the transaction’s essential character is the passing across of information about existing or potential mining or quarrying business. To pass across this information it may be necessary to transfer ownership in reports, maps, computer tapes, etc, but the transfer of the recording medium is merely incidental to the character of the transaction.

948; 88 ATC 4190, the Full Court of the Supreme Court of Queensland considered the dutiability of an agreement for the sale of an interest under a mining joint venture including information arising from feasibility studies and exploration work. The court rejected an argument by the Commissioner that the information comprised tangible property on the basis that it related to documents and records. The court said at ATR 950; ATC 4193:

18. In Pancontinental Mining Ltd v Commissioner of Stamp Duties (Qld) (1988) 19 ATR

19. In determining the dutiability of a transaction or instrument the first step taken by

84

[3.60]

I am not persuaded that the information referred to in cl 2.2(c) is necessarily to be found in those documents. But if some of the information does appear in them, the communication of that information is clearly not for that reason converted into a transfer of property. It would be quite wrong to confuse the information with the physical record: Rolls Royce, supra, at p 431. The information itself remains intangible.

Income from Property

Ruling TR 98/3 cont. the court in Pancontinental was to characterise the transaction or instrument having regard to all relevant factors. The mere fact that title to property (eg the physical medium recording information) passed did not determine the outcome of the characterisation. The court decided that the passing of title to property was merely ancillary or incidental to what it regarded as the provision of a service. Therefore, no liability to ad valorem conveyance duty was imposed on that element involving the transfer of property. 20. In circumstances analogous to those in Pancontinental, it is accepted that the transfer of exploration or prospecting information involves the provision of a service, and the transfer of title to any documents and chattels comprising the media upon which the information is stored is incidental and subservient to the passing across of the information. Exploration or prospecting information is akin to know-how, ie technical knowledge that is peculiar and unique to a specific business operation. 21. The term “know-how” is difficult to define with precision. One leading description was given by Lord Radcliffe in Rolls-Royce Ltd v Jeffrey (Inspector of Taxes) (1962) 40 TC 443; 1962 1 All ER 801. This description has been summarised in Strouds Judicial Dictionary of Words and Phrases, 5th Edition, Sweet and Maxwell, at 1.395, as follows: “Know-how” is the fund of technical knowledge and experience acquired by a highly specialised production organisation; although it may be, and usually is, noted down in documents, drawings etc, it is itself an intangible entity whose category may vary according to, and may even be determined by, its use. Like office or factory buildings, patents and trademarks, and goodwill, it may be described as a “capital asset” while it is retained by a manufacturer for his own purposes, but, unlike these, its supply to another is not a transfer of a fixed capital asset because it is not lost to the supplying manufacturer.

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22. Know-how is therefore an intangible asset and, from a practical perspective in relation to exploration or prospecting information, can be viewed as undivulged knowledge or information residing with the supplier that enables, or may enable, a mining or quarrying business to be carried on, eg knowledge about the presence of mineral bearing ore or quarry materials needed to facilitate extraction. In supplying know-how, the seller is passing to the buyer the seller’s special knowledge or information that remains unknown to the public. 23. There is a view expressed by Gummow J in the Federal Court’s decision in Hepples v FCT (1990) 90 ATC 4497; 21 ATR 42 that confidential information has a proprietary character. His Honour said at ATR 69; ATC 4520: … that the degree of legal protection afforded by the legal system (especially in equity) to confidential information (and this would be true particularly of trade secrets) makes it appropriate to describe such confidential information as having a proprietary character, not because this is the basis on which that protection is given, but because this is the effect of that protection. 24. However, the views of Gummow J were not followed when the matter was considered on appeal to the Full High Court. Moreover, they are in direct conflict with the decisions of the High Court in such cases as Victoria Park Racing and Recreation Grounds Company Limited v Taylor and Ors (1937) 58 CLR 479 and FCT v United Aircraft Corporation (1943) 68 CLR 525; 2 AITR 458; 7 ATD 318 where information was held not to be property. 25. In the United Aircraft Corporation case Latham CJ said, at CLR 534: Knowledge is valuable, but knowledge is neither real nor personal property. A man with a richly stored mind is not for that reason a man of property. Authorities which relate to property in compositions, &c, belong to the law of copyright and have no bearing upon the question whether knowledge or information, as such, is property. It is only in a loose metaphorical sense that any knowledge as such can be said to be property. [3.60]

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The Tax Base – Income and Exemptions

Ruling TR 98/3 cont. 26. The decision in the United Aircraft case that information is not property has been confirmed in other cases such as: Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195, Rolls-Royce Ltd v Jeffrey (Inspector of Taxes); Pancontinental Mining Ltd v Commissioner of Stamp Duties (Qld); Nischu Pty Ltd v Commissioner of State Taxation (WA) (1990) 21 ATR 391; 90 ATC 4391; and its subsequent appeal to the Full Supreme Court of Western Australia reported as Commissioner of State Taxation (WA) v Nischu Pty Ltd (1991) 21 ATR 1557; 91 ATC 4371. Unless and until the courts decide otherwise, the better view is that information is not property. 27. Information can be and is dealt with independently from any mining, quarrying or prospecting right. In a situation where the mining information was unavailable, for example, as a result of destruction of technical records by fire, the mining right would remain entirely unaffected. The right would still be in existence and capable of being dealt with and exploited in exactly the same manner. Prospectively, it would still yield the same profit. It is only its value to a potential purchaser that would be diminished without the information. 28. The separateness of “mining information” from the “mining right” to which it relates is highlighted and confirmed in the stamp duty cases of Pancontinental and Nischu. 29. Mining, quarrying or prospecting information is not goodwill. It is separate and distinct from the goodwill of a mining business. It might be a source of the goodwill of the business but it is separate from the goodwill. Goodwill does not attach to mining, quarrying or prospecting information. Rather it attaches to the mining business which uses the information. 30. As the High Court explained in FC of T v. Murry 98 ATC 4585; (1998) 39 ATR 129, it is the legal definition of goodwill, rather than its accounting and business definitions, that applies for capital gains tax purposes. Goodwill has the meaning attributed to it by the High Court in that case. Unlike goodwill (which cannot be dealt with separately from the business with which it is associated) mining, quarrying or prospecting information can be and is often disclosed or dealt 86

[3.60]

with independently of the mining tenement or any other asset of the mining business. Is mining or prospecting information an asset? 63. For something to be an asset within the definition of asset in s 160A, it must be either a form of property or it must be a right which falls within the scope of paragraph (a) of that section. As mining, quarrying or prospecting information itself is not property (for the reasons outlined in paras 16 to 26) and is not otherwise within the scope of para 160A(a), it is not an asset as defined in s 160A. 64. However, the sale of mining, quarrying or prospecting information is often accompanied by the sale of items of property such as core samples, plant and equipment, etc. Consideration received for the disposal of these items of property comes within Pt IIIA. Is the medium containing mining, quarrying or prospecting information an asset? 65. Strictly speaking, the medium in which mining, quarrying or prospecting information is contained (eg paper, computer memory, floppy disk, etc) is an asset for the purposes of Pt IIIA. 66. However, although the medium is an asset, it is not an asset that necessarily carries the value of the information. Generally, the value of the medium is negligible. Unless the facts indicate otherwise, it will be accepted that the medium containing the information has negligible value such that, in practical terms, no amount has to be allocated to the medium under subs 160ZD(4) in transactions where information itself is being disclosed. Are rights in relation to mining, quarrying or prospecting information an asset? 67. A taxpayer agreeing to disclose mining, quarrying or prospecting information brings into existence certain contractual rights by entering into a contract to disclose that information. The right to have information disclosed is a right for the provision of a service. Other rights could also be created, including rights to hold, use, enjoy, disclose or destroy mining, quarrying or prospecting information. These rights in relation to mining, quarrying or prospecting information, considered together, are an asset in terms of Pt IIIA.

Income from Property

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[3.70] The Ruling goes onto consider other CGT issues which are extracted below. Question

[3.75]

3.4

Is know-how an asset? How, if at all, is it different from information and goodwill? (A similar issue is considered in the Canadian decision of Rapistan Canada Limited v MNR (1974) 48 DLR (3d) 613: see TD 2000/33.)

[3.80] The final paragraph of the previous extract considers that the bundle of rights created

by a contract to disclose information is a single asset. Whether a single asset exists in a particular case or a bundle of assets is often an important issue in deciding whether a CGT event has occurred and, if so, under which CGT event provision. The question of whether a share in a company is a single asset, or a bundle of assets consisting of each individual right inherent in the share, is considered in Ruling TR 94/30.

Ruling TR 94/30 Nature of a share [3.90] 18. In examining the capital gains tax (CGT) implications of any variations in the rights which are attached to shares, it is necessary to consider whether a share is one asset or whether a series of assets are contained in the bundle of rights that comprise a share. Furthermore, we need to consider whether a change in rights attaching to a share results in the creation of a new share comprised of a new bundle of rights. 19. The explanation which follows considers the nature of a share and then relates relevant concepts from that discussion to the statutory requirements of Pt IIIA. 20. The precise legal nature of a share has not been made clear by the courts but some assistance can be obtained by turning to company law concepts as well as to death duty cases on the subject. 21. The rights of each shareholder in relation to each class of share are usually contained in the memorandum and articles of association of the company. The rights attaching to a share are not ordinarily thought of as a separate piece of property.

“aliquot” part is part of a total such that, if the total is divided by that part, there is no remainder. For example, 5 is an aliquot part of 15.) Farwell J followed this interpretation when describing the legal nature of a share in Borland’s Trustee v Steele Bros & Co Ltd 1901 1 Ch 279 at 288: The contract contained in the articles of association is one of the original incidents of the share. A share is not a sum of money settled in the way suggested, but is an interest measured by a sum of money and made up of various rights contained in the contract, including the right to a sum of money of a more or less amount. 23. This description was endorsed by Williams J in the High Court decision of Archibald Howie and Others v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 156. Dixon J at 152 also endorsed this approach in the following terms: While a shareholder has not a proprietary right or interest in the assets of an incorporated company, his “share” is after all an aliquot proportion of the company’s share capital with reference to which he has certain rights.

22. An often-used description of a share is that it is an aliquot interest of a shareholder in a company as measured by a sum of money. (An [3.90]

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The Tax Base – Income and Exemptions

Ruling TR 94/30 cont. 24. The Corporations Law defines a share as personal property which is transferable or transmissible and, subject to the articles, able to be devolved (s 1085). 25. The nature of a share was considered in the death duty case of Re Alex Russell, deceased 1968 VR 285. McInerney J of the Supreme Court of Victoria considered the question of whether the right to convert a preference share to an ordinary share could be transferred at death. His Honour found that this right was still “locked up” and it could not be separated out of the actual estate. Also examined was the question of whether the right to convert could be separated out from the preference shares. McInerney J commented at 299-300: It follows that while it is correct to speak of the testator’s preference shares as consisting of a bundle or congeries of rights, it is not correct to speak of a shareholder owning each of those rights as a separate piece of property, or as a separate chose in action … It is not permissible, therefore to separate out the various rights appertaining to the holder of preference shares and to treat some of those rights as “actual estate” and others as “notional estate”. 26. Accordingly while shares are comprised of a bundle of rights, those rights are not separate pieces of property capable of being divided out and held separately. 27. The implications of incidental changes to rights attaching to shares was considered in the decision of the New South Wales Court of Appeal in Rofe & Others v Commissioner of Stamp Duties (NSW) 88 ATC 4865. This was a death duty case where the court had to consider whether the conversion of ordinary shares into cumulative preference shares not long before the death of the testator was a “disposition of property” and so dutiable under the Stamp Duties Act 1920 (NSW) (SDA (NSW)). 28. The special resolution passed by the company in altering the rights and liabilities of the shares set down that the shares after conversion bore the same share numbers but different rights (most notably the new right to a 88

[3.90]

fixed dividend) and privileges than the ordinary shares before conversion. Mahoney JA, in finding that there was a disposition of property, said that the effect of the conversion of ordinary shares to cumulative preference shares was that (at 4874): … The deceased ceased to hold property of one kind and acquired property of another kind … The rights of the two classes of shares were, of course, fundamentally different. 29. The reasoning in this case relies heavily on the provisions of the SDA (NSW). It ultimately was decided in its particular statutory context of the definition of “disposition of property”. The question in this case was not whether there was a “disposition of property” as this point was conceded by the executors of the estate. Rather, the question was whether there was a “disposition of property” because it was a “transaction entered into with intent to diminish the value of the shares”, in the words of this Act. Therefore the question of whether there was a disposition arose only because it fell within the extended definition of “disposition of property” in the SDA (NSW). As such, the analysis is not applicable in the context of the ITAA. 30. The High Court has also looked into the nature of a share in the death duty case of Robertson v FC of T (1952) 86 CLR 463. In that case, the articles of the company had been altered so that upon the testator’s death the shares standing in the register in his name became No 2 class shares with very limited rights. The shares were valued by the Court on the basis of these reduced rights. Williams J at 479-480 commented: The contract between the company and its members created by section 20 of the Companies Act or the contract thereby created between the members inter se, if there be any such contract, could not cause the beneficial interest in the shares of one member to pass or accrue to or devolve upon the shares of another member (perhaps “accrue” is the most apt word for present purposes). The property in the shares is the property that exists in the shares themselves. Shares do not give an aliquot proprietary right in the property of the company. The whole effect of Article 6 upon the

Income from Property

Ruling TR 94/30 cont. death of the deceased was to alter the existing contractual rights of the shareholders against the company inter se. The article did not cause any beneficial interest in any property owned by one person to accrue in any other person. It merely altered the contractual rights upon death of the deceased. It did not alter any proprietary rights. 31. Clearly in this case there was a change in the relative interests of shareholders following the change in rights. For taxation purposes, the issue that needs to be determined is whether the variation in relative interests in a share amounts to a disposal of that share. A disposal of rights attaching to a share (or asset) for the purposes of Pt IIIA of the ITAA, or a part disposal of the share, envisages that the rights be capable of being separated out of the share or assigned. That is, they would need to be regarded as assets in their own right. Whether a right attaching to a share is a CGT asset 32. In considering the nature of a share, it has been the prevailing view of the courts that the rights attaching to shares cannot be dealt with separately from the share itself. It is clear that these rights were not assets under the definition of asset in s 160A as it existed before being amended by the TLAA (No 4) 1992. 33. We also consider that the current extended definition of “asset” in s 160A, which applies to the construction or creation of assets after 25 June 1992, does not alter this position. The expression “any other right” is a general provision which, under the rules of statutory interpretation, does not take precedence over a more specific provision. As a share is a chose in action, subpara 160A(a)(iii) takes precedence over subpara 160A(a)(iv) to the effect that a share itself is the asset and not its constituent rights. The concept of a share as a whole being the relevant asset is also supported by other provisions in Pt IIIA: see, for example, paras 160M(5)(a), 160T(1)(c) and 160T(1)(j). Disposal Full disposal

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34. Section 160M is the provision dealing with disposals for CGT purposes. For a disposal to occur under subs 160M(1), there must be a “change in the ownership” of the asset. Generally, this occurs where there is both a disposal of the asset by the person who owned it immediately before the change and an acquisition of the asset by the person who owned it immediately after the change. However, a variation in share rights may not necessarily result in an acquisition by a person (for example, where shareholders relinquish rights without any other shareholders gaining those rights). 35. Paragraph 160M(3)(c) is the disposal provision which specifically refers to a share. It provides that a change in ownership of an asset, being a share, is deemed to occur where the share is redeemed or cancelled. If there is no redemption or cancellation, no disposal takes place in terms of that paragraph. 36. The terms “cancel” and “redeem” are defined at paras 16 and 17 above. Cancellation of a share certificate does not mean that the share itself is cancelled. Share scrip is of evidentiary value and may be cancelled for a variety of reasons all of which have no CGT consequences. Examples of where a company may cancel a share certificate include where: (a)

the balance of a partly paid share is later paid by the shareholder. A new certificate may issue to show that the share is now fully paid;

(b)

a company changes its name and new certificates are issued;

(c)

a share certificate is lost or damaged and a substitute or replacement or substitute certificate is issued;

(d)

a shareholder having one certificate as evidence of a share holding transfers part of that share holding. The company may cancel the original share certificates and issue two new certificates: one to evidence the new share holding and the other to evidence the shares transferred. The shares transferred will of course be subject to the provisions of Pt IIIA.

37. Of course, a company may specify in the articles that a cancellation of shares is to occur at a particular time or on the happening of an event such as giving up the share scrip. [3.90]

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The Tax Base – Income and Exemptions

Ruling TR 94/30 cont. 38. The administration of the ITAA is not constrained by the usage of terms in the Corporations Law. However, if it is clearly a requirement that a transaction calls for a redemption and cancellation of shares, in terms of the Corporations Law, a disposal has to have taken place for the purposes of the ITAA, by virtue of para 160M(3)(c). 39. A variation in share rights that does not involve a cancellation or redemption of the share does not amount to a disposal of the share for the purposes of subs 160M(1). Part disposal 40. It could be argued that a variation in share rights amounts to a part disposal of the share on the basis that some of the rights are relinquished. Paragraph 160M(3)(c) refers to a redemption of a share in whole or in part. However, the specific section dealing with part disposals is s 160R, which is premised on the basis that Pt IIIA applies to that part of an asset which is capable of disposal. If it cannot in fact and at law be

separately disposed of, the section does not deem it to be capable of being separately disposed of. 41. By way of judicial comment on s 160R is an obiter dictum comment by Deane J in the High Court case of Hepples v FCT (1991) 173 CLR 492; 22 ATR 465; 91 ATC 4808 at 516 (CLR), 480 (ATR), 4821 (ATC): It seems to me that the preferable approach is to treat section 160R as applying to a case where there has been a disposal, in the sense of a change of ownership of any part of the rights involved in the ownership of an asset, those rights themselves constituting an asset for the purposes of Pt IIIA. (emphasis added) 42. His Honour’s view still requires that there be a change of ownership for s 160R to apply. We consider that there is no change in ownership of a share (or part of a share) where a company varies one or more of the rights attaching to the share. This is because there is no redemption of part of a share and the rights attaching to a share are not assets separate from the share.

[3.100] This Ruling also considers further issues which are extracted below. As is evident

from the extract it is difficult to separate out the questions whether there is an asset, what that asset is and whether there is a relevant event in relation to the asset. The concept of part disposal of an asset does not appear in the ITAA 1997. Instead the definition of asset in s 108-5(2)(a) – the avoidance of doubt part – states that “part of, or an interest in, an asset” referred to in s 108-5(1) is an asset. The Explanatory Memorandum states at p 58, “The rewritten provisions will also put beyond doubt that a divided part of a CGT asset and an undivided interest in a CGT asset are also CGT assets”. Division 108 also contains a subdivision titled “Separate CGT assets” which contains rules for particular cases (mainly involving land) which will be treated as involving more than one asset. [3.105]

3.5 3.6

3.7

90

Questions

Does the Ruling still correctly state the law in light of the change in the ITAA 1997 to refer to part of an asset as an asset in s 108-5(2)? When will it be appropriate to treat groups of rights or individual rights as the relevant asset? Does it follow from the change in the ITAA 1997 that groups of assets can themselves be treated as a single asset? (You should revisit these questions after consideration of the material under the next heading, especially the High Court decision in Orica.) If you own an interest in a CGT asset and you acquire another interest in that asset, do the interests remain separate CGT assets for capital gains purposes or do they become a single asset? (See TD 2000/31.) [3.100]

Income from Property

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3.8

Can property or a right, the “market value” of which is nil, be a CGT asset? (See TD 2000/34.)

3.9

Is s 108-7, which states that the interest of a joint tenant is to be treated as an interest as tenant in common, necessary in the ITAA 1997? (The principal difference between joint tenancy and ownership of property in common is that the doctrine of survivorship applies to property owned by joint tenants. Where one joint owner dies, the other joint owner(s) automatically have their interest in the asset increased. On the other hand, property owned by a taxpayer as a tenant in common will pass under the will of the deceased, and does not automatically enure to the benefit of the other co-owner.) What happens if a taxpayer transfers a block of land which she owns to herself and another as joint tenants or tenants in common? For each of the sections in Subdiv 108-D, consider the following matters: • why has the provision been enacted?

3.10 3.11

• is the provision necessary disregarding s 108-5(2)(a)? • is the provision necessary in the light of s 108-5(2)(a)? [3.110] Although the definition of asset extends beyond transferable property, it is evident

from the materials above that it is based on an analysis of legal rights. Accounting has a different concept of asset, namely, anything of future economic benefit. This much wider concept is not reflected in the law. For example, work in progress of a professional firm is not an asset for CGT purposes though it is for accounting purposes. For the income tax treatment of work in progress see Chapter 11. It also follows from the focus on assets that the CGT does not deal directly with gains and losses on liabilities. An often-cited example is gains on “forgiveness of debt” realised by taxpayers who borrow and then have the debts cancelled so they do not have to repay the borrowed funds. As we shall see in Chapter 5, gains from forgiveness of debt are considered ordinary income in some circumstances. Debt forgiveness measures were introduced in 1996 (Sch 2C of the ITAA 1936) to deal with such gains but not by an inclusion in assessable income. [3.115]

3.12

Question

In 1992 the taxpayer borrowed $10,000 from his father. Fourteen months later, in 1993, the father waived the debt (at which time it was cancelled) and the taxpayer was able to keep the $10,000 without an obligation to pay it back. Are there any CGT consequences for the lender or borrower from these events? (See Determination TD 2.)

(ii) CGT events [3.120] Under the ITAA 1936 the CGT revolved around the concept of disposal of an asset. The principal “disposal” provision in Pt IIIA is s 160M. Subsections 160M(1) to (5) dealt with actual disposals and the remaining subsections dealt with “deemed disposals”. One purpose of these latter provisions was to bring into the operation of Pt IIIA capital gains generated in transactions that did not involve actual property dispositions but which gave rise to gains that were labelled by the courts as “capital” receipts as they were not ordinary income. Section 160N made clear that the loss or destruction of assets was a disposal of that asset. There were many other special provisions in Pt IIIA dealing with individual transactions that had to be deemed to generate a “disposal”. All these disposals are now gathered as CGT events in Div 104 of the ITAA 1997. For the purposes of exposition, however, we will track the treatment of the ITAA 1936. In this part of [3.120]

91

The Tax Base – Income and Exemptions

the chapter which covers general CGT concepts, we will deal with the events that correspond to the disposals covered by s 160M(1) to (7) and s 160N of the ITAA 1936. The CGT event rules which relate to special cases will be covered to the extent they are relevant to the subject matter of this book at the points where the special cases are discussed. The CGT event sections also provide the time of the event and the calculation of capital gain or capital loss in relation to that event. We shall also follow the ITAA 1936 treatment by considering timing of events (and acquisitions) and the calculation of capital gain or capital loss together, but separately from CGT events. The main CGT events are A1, B1, C1 and C2. The first two deal with disposals of CGT assets. Event A1 defines disposal as a change of ownership from the taxpayer to another person (putting aside mere changes in legal title). Because it only operates when someone else becomes the owner of the asset, it is necessary to have two further provisions in ss 104-20 and 104-25 (events C1 and C2) to deal with the cessation of assets, respectively the loss or destruction of a tangible asset, and the coming to an end of an intangible asset like a right. The latter provision has the potential to be very far-reaching if a wide range of rights are treated as separate CGT assets or separable parts of a single CGT asset even though bundled together, for example, the variety of rights that arise whenever two parties enter into a contract. A way of limiting this conclusion would be to say that the event constituted by the coming to the end of the right would only apply if a right is terminated by breach of the agreement as opposed to being carried out by the parties to the agreement. These issues were dealt with by the High Court in Orica. The taxpayer had borrowed money from the public using debentures. A trustee for debenture holders represented the interests of the individual debenture holders and as protection for them the trust deed contained many restrictions and ratios which limited the business operations of the taxpayer. As commercial conditions changed, the restrictions and ratios became a barrier to the development of the taxpayer’s business and like many other taxpayers in similar positions, the taxpayer sought ways to satisfy the debentures. Partly because the debentures were widely held it was not practical to buy them all back – and in any event, some debenture holders may simply refuse to sell. Hence the taxpayer entered into what was called an “in-substance debt defeasance” transactions. These were effected by entering into transactions with other parties of substantial creditworthiness (typically banks or government instrumentalities) which, in exchange for payments from the taxpayer, undertook to make payments of interest and principal on the debentures as they fell due. As a result, in a practical, though not a legal, sense the taxpayer was relieved from the obligations under the debentures. The trustee for debenture holders agreed to release the taxpayer from the restrictions and ratios and the company’s auditors agreed to the removal of the liability for the debentures from its balance sheet. In this particular case, under debenture trust deeds of 1966 and 1970, various debentures were issued which had repayments dates (so far as relevant to the case) between 30 November 1986 and 31 January 2000. On 6 June 1986, the taxpayer entered into a principal assumption agreement with the Melbourne and Metropolitan Board of Works (MMBW) and an interest assumption agreement with the State Bank of New South Wales. Under the former, the taxpayer paid the Board $62,309,546 on 1 July 1986, being the present value of the future obligation to pay the principal on the debentures as at that date. The aggregate of the principal amounts payable was $98,662,800. The present values of the several principal amounts payable on their respective maturity dates were calculated by discounting those amounts at a rate equal to the Commonwealth Bond rate for bonds maturing on or reasonably close to the 92

[3.120]

Income from Property

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respective maturity dates less 0.03% per annum. The accounts of the taxpayer dealt with the difference between the two amounts by reporting a profit of $36,353,254. The ATO sought to tax this profit either when it was made (in the 1986 year of income as the taxpayer balanced for tax purposes on 30 September) or over the period of the transaction based on Div 16E of the ITAA 1936, on that basis that the profit was ordinary income. This position was based on a Ruling IT 2494 on debt defeasance in reliance on the Myer Emporium case, which is extracted in Chapter 5. The High Court by majority rejected this basis of assessment: see Chapter 5. An alternative that found acceptance with a majority of the High Court was that each time the Board effected payment of principal, the taxpayer was assessable under the CGT. The difference between the ATO’s approach to the events of July 1986 and the ultimate finding of the Court is really quite fundamental. The ATO saw the transaction as involving something akin to a disposal (the elimination of a liability) while the Court regarded the transaction as a purchase of rights. It is not surprising that the tax treatment which the Court approved looked nothing like the way the ATO had assessed the taxpayer. Gaudron, McHugh, Kirby and Hayne JJ reasoned as follows:

FCT v Orica Ltd [3.130] FCT v Orica Ltd (1998) 39 ATR 66; 98 ATC 4494 Capital gains tax 88. Two issues were debated: whether, by making the Principal Assumption Agreement, the taxpayer acquired an asset and whether, when MMBW performed its obligations under the Principal Assumption Agreement, a change occurred in the ownership of an asset. An asset? 89. Section 160A provides that in Pt IIIA, unless the contrary intention appears, asset: … means any form of property and includes – (a) an option, a debt, a chose in action, any other right, goodwill and any other form of incorporeal property … (Nothing turns on the amendments later made to s 160A by the Taxation Laws Amendment Act (No 4) 1992 (Cth)). 90. We have no doubt that the rights acquired by the taxpayer against MMBW under the Principal Assumption Agreement are an asset for the purposes of Pt IIIA. The contention, accepted by the majority of the Full Court, that the right acquired by the taxpayer “was merely a personal right … which was incapable of being assumed by a third party” (ICI Australia Ltd v FCT (1996) 68 FCR 122; 33 ATR 174; 96 ATC 4650 at 138 (FCR),

188-9 (ATR), 4694 (ATC) per Lockhart J) must be rejected. The conclusion that the taxpayer’s right against MMBW was only a right to compel MMBW to specifically perform its obligations appears to have been founded in the proposition, adopted by the primary judge, that “no conceivable assignee would have any interest in enforcing MMBW’s obligation which was to discharge the taxpayer’s obligation to the debenture holders” … It may be doubted that enquiring whether there is any person who would have a commercial interest in taking an assignment will determine whether something is an item of property capable of assignment … The question is whether the rights are capable of assignment, not whether anyone is interested in taking an assignment. 91. Furthermore, in construing the term “any form of property” in s 160A, it is important to bear in mind the following statement by Kitto J in National Trustees Executors & Agency Co of Australasia Ltd v FCT (1954) 91 CLR 540 at 583: It may be said categorically that alienability is not an indispensible attribute of a right of property according to the general sense which the word “property” bears in the law. Rights may be incapable of assignment, either because assignment is considered incompatible with their nature, as was [3.130]

93

The Tax Base – Income and Exemptions

beneficiary is absolutely entitled to the asset as against the trustee;

FCT v Orica Ltd cont. the case originally with debts (subject to an exception in favour of the King) or because a statute so provides or considerations of public policy so require, as is the case with some salaries and pensions; yet they are all within the conception of “property” as the word is normally understood … In any event, we do not accept that there is “no conceivable assignee” who would have an interest in taking an assignment from the taxpayer of its rights against MMBW. The debenture holders are an obvious class of persons who would have a real and lively commercial interest in having MMBW perform its obligations. It follows that the rights which the taxpayer had against MMBW under the Principal Assumption Agreement are an asset for the purposes of Pt IIIA. Disposal? 92. Section 160M provided in 1986 and 1987: (1)

(2)

(3)

94

Subject to this Part, where a change has occurred in the ownership of an asset, the change shall be deemed, for the purposes of this Part, to have effected a disposal of the asset by the person who owned it immediately before the change and an acquisition of the asset by the person who owned it immediately after the change. A reference in subsection (1) to a change in the ownership of an asset is a reference to a change that has occurred in any way, including any of the following ways: (a)

by the execution of an instrument;

(b)

by the entering transaction;

(c)

by the transmission of the asset by operation of law;

(d)

by the delivery of the asset;

(e)

by the doing of any other act or thing;

(f)

by the occurrence of any event.

into

of

a

Without limiting the generality of subsection (2), a change shall be taken to have occurred in the ownership of an asset by – (a) a declaration of trust in relation to the asset under which the [3.130]

(b)

in the case of an asset being a debt, a chose in action or any other right, or an interest or right in or over property – the cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment, at law or in equity, of the asset;

(c)

in the case of an asset being a share in or debenture of a company – the redemption in whole or in part, or the cancellation, of the share or debenture; …

The ATO submitted that s 160M(3)(b) applied to deem performance by MMBW of its obligations under the Principal Assumption Agreement to be a change in the ownership of the taxpayer’s asset (its rights under that agreement). It was submitted that MMBW’s performance of its obligations was the “discharge” or “satisfaction” of the asset being the “chose in action or any other right” constituted by the taxpayer’s rights under the Principal Assumption Agreement. 93. The Full Court held that “discharge” and “satisfaction”, when used in s 160M(3), were not to “be construed as extending to the performance of obligations under an agreement giving rise to the rights in accordance with the terms of the agreement” (ICI Australia Ltd v FCT (1996) 68 FCR 122; 33 ATR 174 at 139 (FCR), 189 (ATR) per Lockhart J) and were words which “must be confined to cases where the rights are satisfied or discharged otherwise than by performance of the obligations which give rise to the rights by the other party to the contract” ((1996) 68 FCR 122 at 139; 96 ATC 4680 at 4694 per Lockhart J). 94. There is no basis for confining “discharge” or “satisfaction” in this way. First, as a matter of ordinary language, “discharge” can be used in the sense of “the act of clearing off a pecuniary liability; payment” (The Oxford English Dictionary, 2nd ed (1989), “discharge” sense 5) or “fulfilment, performance, execution (of an obligation, duty, function, etc)” (The Oxford English Dictionary, 2nd ed (1989), “discharge” sense 6).

Income from Property

FCT v Orica Ltd cont. 95. Second, it is common for lawyers to speak of a contractual obligation being discharged by performance. No doubt there are other ways in which the obligation can be discharged but performance is one. There is nothing in the ordinary usages in the law of the terms the “discharge” or the “satisfaction” of an obligation which would suggest that the use of the terms in s 160M(3) is to be confined in the manner suggested. 96. Third, when the subsection speaks, as it does, of the “discharge” of a debt it is plainly using the word “discharge” in a way that at least includes payment of the debt according to the terms of the obligation incurred by the debtor. 97. Fourth, far from the other provisions of Pt IIIA (or s 160M in particular) providing a sound basis for reading down the apparent generality of s 160M(3)(b), the context in which the provision sits discloses an intention to give it a very wide operation. Subsections (1) and (2) of s 160M centre upon a change in ownership of an asset. Subsection (1) deems a change in ownership to effect a disposal of an asset by one person to another and subsection (2) amplifies what is meant by a “change in the ownership”. Subsection (3) provides that a change “shall be taken to have occurred in the ownership of an asset” upon the happening of any of several events or transactions. It is clear from the reference to redemption or cancellation of shares or debentures in par (c) that the events that are to be taken to amount to a change in ownership include events where the asset ceases to exist as an item of property. Similarly, subsection (6) demonstrates that there can be a disposal of an asset for the purposes of Pt IIIA where an asset is created by the disposal. 98. It was submitted that unless the provision was read down by confining “discharge” and “satisfaction” to discharge or satisfaction otherwise than by performance of the obligation undertaken, performance of every executory contract would be brought within the reach of the capital gains provisions. No doubt that is so but it does not mean that a party to an executory contract will always be liable to tax. It is necessary

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to recall that tax will be payable only if there is a capital gain, that is, only “if the consideration in respect of the disposal exceeds the indexed cost base to the taxpayer in respect of the asset”, s 160Z(1)(a). If what the taxpayer receives on performance of the obligation undertaken by the other party to an executory contract does exceed the indexed cost base to the taxpayer in respect of the acquisition of the right to have the obligation performed, we see no incongruity in concluding that the taxpayer has made a capital gain. 99. Accordingly, there is no basis for confining the word “discharge” (or, for that matter, the word “satisfaction”) to discharge or satisfaction otherwise than according to the tenor of the obligation incurred. 100. In all these circumstances it follows that for the purposes of Pt IIIA performance by MMBW of its obligations under the Principal Assumption Agreement, and discharge pro tanto of those obligations by performance, is a disposal of part of the taxpayer’s asset (being its rights against MMBW under the Principal Assumption Agreement). (By s 160R “a reference to a disposal of an asset” in Pt IIIA “includes, unless the contrary intention appears, a reference to a disposal of part of an asset”. No contrary intention is to be found in s 160M(3)). 101. The taxpayer contended that if the difference between the amount paid by the taxpayer under the Principal Assumption Agreement and the face value of the debentures was income or profit from a profit-making scheme the Commissioner’s appeal in respect of the 1987 year should nevertheless be dismissed because the taxpayer made no gain until MMBW had paid out more than the $62,309,546 that the taxpayer paid under the Principal Assumption Agreement. Debentures maturing between 30 November 1986 and 31 May 1990 were for principal amounts totalling $61,869,800. Accordingly, not until payment in relation to debentures maturing on 31 July 1990 (which had a face value of $4,275,000) would MMBW pay out more than the taxpayer had paid under the Principal Assumption Agreement. Because we consider that the difference between the two amounts is not income or profit, we need not decide whether this argument is good. It is, however, an argument [3.130]

95

The Tax Base – Income and Exemptions

FCT v Orica Ltd cont. that does not arise under Pt IIIA because where, as here, part of an asset is disposed of, s 160ZI requires apportionment of the cost base attributable to the asset. 102. MMBW having made no payment under the Principal Assumption Agreement during the 1986 year, the Commissioner’s appeal in respect

of that year should be dismissed with costs. MMBW having made payments in the 1987 year, the appeal to this Court in respect of that year of income should be allowed, the orders made by the Full Court set aside, and in lieu it should be ordered that the appeal to that Court should be allowed, the decision of the Commissioner disallowing the taxpayer’s objection set aside and the Commissioner directed to amend the assessment concerned.

[3.135]

3.13

3.14

3.15

Questions

Does the majority of the High Court consider the principal assumption agreement to be a single asset or a bundle of assets? Does it matter if a right is assignable in characterising it as an asset? Were the amendments made to the definition of asset on this issue necessary? Does the different approach to part disposals in the ITAA 1997 make any difference to facts like Orica? How does the majority analyse each payment made by MMBW for CGT purposes? How is the amount of the capital gain to be calculated in relation to each payment? How would the calculation be done under the ITAA 1997? (Section 112-30 is the equivalent provision to s 160ZI.) Do you agree with the view of the majority that their approach is unlikely to give rise to practical problems? Consider a case where a person contracts to buy land for $100,000 which rises in value to $120,000 at the time when the contract is settled a few months later. (The ATO for some years has been developing approaches to deal with cases of this kind, but nothing is yet concluded. The dissent of Gummow J on this point was partly founded on the inconvenience of the majority view.)

[3.140] Event C1 deals with the loss or destruction of a tangible asset. It raises a number of

issues about the correct analysis when compensation is involved (eg an insurance payout). These issues are dealt with in Chapter 6. Event B1 deals with the case where legal and beneficial title do not change immediately, but in economic substance the asset has just been sold. The simplest example is a hire purchase transaction. This is one of a number of cases in the CGT where substance prevails over legal form. The tax legislation overall is still not fully consistent in treating such cases as the equivalent of a sale and a loan, though the trend is to adopt that characterisation in an increasing number of areas of tax law. (iii) The terrible twins: CGT events D1 and H2 [3.150] The most controversial measures in Pt IIIA were the deemed disposal provisions in

s 160M(6) and (7). Labelled the “terrible twins” by many commentators, their form was subject to strong criticism when originally adopted. The criticism was not in respect of their aim – few disputed that gains such as payments for entering into restrictive covenants, payments for agreeing not to enforce contractual rights or to withdraw from a contract, and so forth, should be included in taxable income. Rather, criticism was directed at the execution of the objective through convoluted provisions that relied on artificial deeming. It was suggested that the preferable approach would be to adopt specific inclusion provisions that operated 96

[3.135]

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independently of the CGT. Thus, for example, it was suggested that payments to employees or ex-employees in respect of restrictive covenants could be dealt with as employment income or in the FBT legislation. Predictions that the two deemed disposal provisions would prove inadequate to the task intended for them were proved correct when the High Court finally had an opportunity to consider their scope in the 1991 case of Hepples v FCT (1991) 22 ATR 465; 91 ATC 4808. The case involved a payment to an employee for a restrictive covenant agreement. A majority of the High Court agreed the gain was assessable under s 160M(6) or s 160M(7), but no clear majority emerged for either provision alone – one judge thought the gain was caught under s 160M(6) only, one judge thought it was caught under s 160M(7) only, and two judges thought it was caught under both provisions. So, although four of seven judges thought the gain was assessable under Pt IIIA, only a minority of three could be found in favour of any particular charging provision. The Court invited the parties to make further submissions on the appropriate decision in the circumstances and in Hepples v FCT (No 2) (1992) 173 CLR 492; 22 ATR 852; 92 ATC 4013, the High Court said the gain was not assessable on the basis that two distinct issues were raised and there was a majority against the ATO on each issue. To understand the changes that were subsequently made to s 160M(6) and (7), a brief review of the perceived problems with the original provisions is helpful. Section 160M(6) applied to the disposal of an asset “that did not exist … before the disposal, but was created by the disposal”. Section 160M(7) applied where “an act or transaction has taken place in relation to an asset or an event affecting an asset has occurred”, and “a person has received, or is entitled to receive, money or other consideration by reason of the act, transaction or event”. Two cases when the latter provision could apply were included in the legislation although they were not exhaustive: (i) if the asset was a right, for surrendering the right or agreeing not to exercise the right; or (ii) for use or exploitation of the asset. On their face, the provisions contained problems. One view of the first provision was that it applied where a new asset was carved out of an existing asset (such as granting an easement over land). The problem of this interpretation was to distinguish it from a part disposal. Another view was that it applied to cases such as the grant of an option for consideration where, before the option was granted, it did not exist. On this view, the provision could catch a restrictive covenant agreement. Prior to the agreement, there was no asset but following the agreement there was, namely a contractual undertaking by the taxpayer not to do something such as compete or divulge trade secrets. The contract would be an asset in the hands of the other party and could be used as the basis of a suit for damages if the taxpayer breached the agreement. The problem with this approach was that it meant that a borrower in a loan transaction might be taxed on the amount borrowed (as the same analysis would apply as for the restrictive covenant). The second provision, s 160M(7), some suggested was intended to catch gains for forfeiting existing rights. An example would be a taxpayer with a contract for sale of stock who is approached by the purchaser and offered consideration to forgo the contractual rights (so that the purchaser could buy the goods from another supplier at a lower cost). The problems with s 160M(7) were said to arise out of the relationship between the two paragraphs: (a), which mentioned a transaction, act or event taking place in relation to an asset; and (b), which spoke of a person receiving consideration as a result of the act. The provision did not make clear the connection, if any, needed between the asset in paragraph (a) and the receipt of consideration in paragraph (b). If no direct connection were needed, the scope of the provision would be [3.150]

97

The Tax Base – Income and Exemptions

virtually limitless – some asset to satisfy paragraph (a) could be found in almost every transaction involving the receipt of money, thus technically satisfying the words of the provision. Some advisers suggested a compromise approach in which the provision would be read so that paragraph (b) would be invoked only if the asset mentioned in paragraph (a) were an asset belonging to the taxpayer. The Explanatory Memorandum released with the provisions in Bill form was not of much assistance. It gave the grant of options and leases as examples of cases covered by s 160M(6), even though there were other specific provisions dealing with these cases, and the employee restrictive covenant as covered by s 160M(7) without making clear what was the relevant asset. In the High Court, McHugh J, one of the majority who concluded the provisions would not catch the gain derived by the taxpayer, said the following with respect to s 160M(6).

Hepples v FCT [3.160] Hepples v FCT (1991) 22 ATR 465; 91 ATC 4808 The difficulties in construing the sub-section are very great. One reading is sufficient to confirm the statement of Hill J in Cooling (at p 61) that it “is drafted with such obscurity that even those used to interpreting the utterances of the Delphic oracle might falter in seeking to elicit a sensible meaning from its terms”. How can a person dispose of an asset that did not exist before the disposal even as part of another asset? In his written submissions, counsel for the respondent argued that where the word “disposal” first appears in the sub-section “it is an elliptical description of an act whereby an asset, not before that act in existence, is brought into existence such that it is vested in a person other than the creator”. This construction would mean that a person who had borrowed money and promised to repay it had disposed of an asset (the promise to repay the money) and would be subject to tax under Pt IIIA on the whole amount of the borrowing because that is “the consideration in respect of a disposal” of the asset: see s 160ZD(1)(a) or, alternatively, s 160ZD(2)(a). This result is so absurd that it is difficult to believe that Parliament intended it. If Parliament had intended the creation of rights in another person to constitute a disposal of those rights by the person creating them, it would have been easy enough for it to have said so. Significantly, the explanatory memorandum does not suggest that s 160M(6) was intended to apply to the creation of rights generally... 98

[3.160]

Neither legal parlance nor the ordinary meaning of the words “disposal of an asset” could justify interpreting those words to cover the case where the asset is a personal right to sue the grantor of that right. When a person creates a right in another person to sue him or her, the grantor does not dispose of any asset of his or her own. The personal right to sue is never vested in the grantor, even momentarily. It is only when the right to sue is vested in the grantee, and not before, that it bears the character of a proprietary right. It would require a very strained construction of s 160M(6) to hold that a transaction in which A incurred an obligation giving rise to a correlative right in B constituted a “disposal of an asset” (the right to sue) by A to B. There is nothing to suggest that Parliament intended s 160M(6) to cover such a case: neither the explanatory memorandum nor the language of the subsection supports it. In Cooling and in the present case, the Full Court of the Federal Court held that s 160M(6) operates only where new proprietary rights have been created out of or over an existing asset … The principal argument against the construction which the Full Court placed on s 160M(6) is that to give effect to it contradicts the words in brackets in that sub-section. It is true that the Full Court’s construction requires that the asset be created out of or over an existing asset while s 160M(6) in terms applies only to a case where the asset “did not exist (either by itself

Income from Property

Hepples v FCT cont. or as part of another asset) before the disposal”. But I do not think that there is any conflict between the Full Court’s construction and the words in brackets. Although a lease, an easement and a profit à prendre are created out of land, for

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example, it is not a misuse of language to say that they were not part of the land before their creation. Consequently, I would hold that s 160M(6) applies only where the asset disposed of was created out of or over an existing asset.

[3.170] Not all the judges who concluded s 160M(7) did not apply to the taxpayer’s gain said

that provision only operated where the asset referred to in para (a) of the subsection was an asset of the taxpayer. Deane J did place this restriction on the section. He said: [3.180] I consider … that the provisions of s 160M(7) should be construed as confined to a case where the person who has received the money or other consideration was, immediately before the deemed disposal, the owner of the pre-existing asset referred to in the subsection.

When s 160M(7) is so construed, it is apparent that it is not applicable to the present case where the suggested existing asset for the purposes of the subsection is the goodwill and trade secrets which were owned by the employer and not by the appellant.

[3.190] Brennan J explained the connection between the asset in para (a) and the transactions

in para (b) that a majority of the judges thought necessary in these terms: [3.200] The question then arose as to whether the asset referred to in para (a) had to be an asset of the taxpayer. The majority of the court below gave a negative answer to this question. I forbear from answering the same question because in my respectful opinion there was no connection between the assets of Hunter Douglas the taxpayer’s employer and the appellant’s taxpayer’s entry into the deed containing the covenant which satisfies the requirements of para (a). The only way in which the appellant’s covenant affected these Hunter Douglas assets was to add to them the benefit of the appellant’s covenant. The appellant’s entry into the deed

containing the covenant did not relate to the then existing assets of Hunter Douglas which were wholly unaffected thereby. The asset created by the covenant in no way depended on the enjoyment by Hunter Douglas of its other assets. Ex hypothesi, the benefit of the covenant did not exist before the covenant took effect. As there was no existing asset in relation to which the appellant’s entry into the deed took place (thus no relevant “act or transaction”) nor any asset which was affected by the appellant’s entry into the deed (thus no relevant “event”), I would hold that subs (7) has no application in this case.

[3.210] The legislature reacted to the High Court decision by amending the definition of asset

in s 160A, as noted earlier, and redrafting s 160M(6) and (7). When the provisions were re-enacted in 1997, they were separated by some considerable distance and placed in separate subdivisions as events D1 (s 104-35) and H2 (s 104-155). The special nature of these events and the relationship between them is only revealed by s 102-25 dealing with the order of application of CGT events. This section is dealing with the possibility that more than one CGT event section may be potentially applicable to a particular transaction and states the general order of application (with the not necessarily always helpful rule that the more specific is [3.210]

99

The Tax Base – Income and Exemptions

applied). Subsection (3) makes it clear that all other CGT events apply before D1 and H2 (ie if any other event applies, neither of these apply). Failing the application of any other event, D1 is considered first and then if it is not applicable, H2. The ordering of subs (3) was also present in the ITAA 1936. [3.215]

3.16 3.17

3.18 3.19

Questions

Which of events D1 and H2 would now apply to taxpayers in cases like Hepples? How does the legislation deal with the problem of loans being caught by the provisions? Has the problem of giving a clear operation to both provisions been resolved? What is the analysis of the grant of an easement? (See on easements Ruling IT 2561 and Determination TD 93/235.) What are the consequences of the application of events D1 and H2 in relation to the general transitional rule that assets acquired before 20 September 1985 are not subject to CGT and the rule that a taxpayer recovers the cost in a transaction and so is only taxed on the gain made?

[3.220] In analysing any particular transaction, events D1 and H2 need always to be

considered if it appears that no other events apply. This is exemplified in the rulings on mining and prospecting information, and rights attaching to shares which have been partly extracted above. Ruling TR 98/3 in relation to the former (after the amendments to deal with Hepples) states:

Ruling TR 98/3 [3.230] Application of subsection 160M(6) 68. Subsections 160M(6) to 160M(D) apply to an asset created by a person if: • that asset is not a form of corporeal property; and • on the creation of the asset, it is vested in another person.

new provisions; that a person creates an asset, the asset is not a form of corporeal property, and on its creation the asset is vested in another person. Hence it is to apply in much the same way as subsection 25(1) of the ITAA applies to include “gross income” in assessable income.

69. The reference to an asset that is not a form of corporeal property is a reference to an asset of a non-physical or intangible nature (eg rights under a contract, patents, or goodwill).

71. The amendment made by the Taxation Laws Amendment Bill (No 4) 1992 first applied to any transactions where money or other consideration was received after 25 June 1992.

70. In the explanatory memorandum to the Taxation Laws Amendment Bill (No 4) 1992, which introduced subsection 160M(6) in its present form, the Treasurer stated, at 66-67:

72. If a person, A, agrees to supply mining or prospecting information to another person, B, the transaction gives rise to a provision of a service by A to B. By entering into the agreement, it could be said that A has also created in B a right to require A to supply the mining or prospecting information to B. The agreement might go on to restrict A from further disclosing the mining or prospecting information to other persons and could also confer on B rights to hold, use, enjoy, disclose or even destroy the mining or prospecting information.

The new provisions are intended to apply to a wide range of circumstances where a person receives consideration for creating incorporeal assets in another person. It is not practicable for the legislation to refer specifically to all those circumstances. Rather, the new subsection 160M(6) will provide the general criteria for the application of the 100

[3.215]

Income from Property

Ruling TR 98/3 cont. 73. However, the rights that are created are something separate from the information itself. In FCT v Sherritt Gordon Mines Limited (1977) 7 ATR 726; 77 ATC 4365, Jacobs J recognised rights under a contract as property but, at the same time, recognised “know-how” as not being property when he said, at ATR 736; ATC 4374: A right to put to use know-how as it is defined in the present agreement is not a right in respect of property because the possessor of the know-how has no right in it against the world … However, once he reveals and makes available know-how as defined to another in return for a payment rights are created between him and the payer, rights which are governed by the terms express or implied upon which that “know-how” is revealed. 74. In Pancontinental the court recognised a distinction between the information itself and the rights under which it was obtained, and said, at ATR 950; ATC 4192: Now one readily accepts that the assignment of rights under a contract may amount to a transfer of property. See Danubian Sugar Factories Ltd v IR Commrs (1901) 1 QB 245 at p 257 and Allgas Energy Ltd v Commr of Stamp Duties (Qld) 80 ATC 4020 at 4024 (1979) 10 ATR 593 at 596. The information referred to in cl 2.2(c) of this agreement may not however be characterised as rights under a contract, in this case the joint venture agreement. The information is likewise not to be regarded as part of the benefit of a contract being assigned. The fact that Isa may have acquired the information through exercising rights under the joint venture agreement obviously does not give the information itself the quality of a chose in action, or place it into the category of contractual rights being assigned: it remains mere information. 75. Likewise, in Canada the Federal Court of Appeal has distinguished information, or “knowhow”, from the rights to have that information

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disclosed. In Rapistan Canada Limited v Minister of National Revenue 1974 CTC 495 at 499, the court said: The asset that the appellant acquired in this case was the knowledge of how to commence and carry on the particular manufacturing operation. That was, from the businessman’s point of view, an asset. It was not, however, “property”. It is true that the appellant did, by the “Deed of Gift”, acquire, by implication, a promise that the donor would do certain things and that that promise is a “right” that falls within the definition of the word property. That right is not, however, the “know-how” that is the subject matter of the claim for capital cost allowance. 76. In the light of the above authority, it is accepted that where mining, quarrying or prospecting information is being disclosed for its market value, any consideration received by the “vendor” for its disclosure is not for the creation of rights but rather for the information itself. In these circumstances, subsection 160M(6) does not apply to generate a capital gain as a result of the creation of the rights, because the consideration is received for the information itself and not the created rights. 77. As a practical matter, the “purchaser” pays for, and receives, the information itself. The right of the “purchaser” to require the “vendor” to supply the information on payment of the consideration is only a means to an end of actually getting the information. The consideration received by the “vendor” is not, in terms of paragraph 160ZD(1)(a), consideration in respect of the disposal by the “purchaser” of rights to receive the information. 78. The market value of mining, quarrying or prospecting information is a question of fact. As a general proposition, its value would represent the present day costs of reproducing the information, taking into consideration the losses that would result from the consequential delay in the development of mining, quarrying or prospecting right. From this value it would be appropriate to make deductions for all or some of the following factors: [3.230]

101

The Tax Base – Income and Exemptions

Ruling TR 98/3 cont. (a)

knowledge that some of the information was available from public records, such as reports available from State government authorities;

(b)

general knowledge that certain work need not be duplicated, for example, a purchaser who had a knowledge of the mining information for the purposes of negotiating a price for the tenement would know that some exploration had revealed little or no evidence of mineralisation in particular areas and would know that this work would not need to be repeated; and

(c)

more recent test results that affect the accuracy of the older information.

Application of subsection 160M(7) 79. For subsection 160M(7) to apply, the owner of an asset must have received money or other consideration by reason of an act or transaction taking place in relation to the asset (whether it affects the asset or not), or an event affecting the asset has occurred. It does not matter whether the asset is affected adversely or beneficially or neither adversely nor beneficially.

80. When consideration is received for dealing with or disclosing mining, quarrying or prospecting information, it is difficult to regard it as an act or transaction that takes place in relation to another asset or as an event that affects another asset. It has already been explained in this Ruling that mining, quarrying or prospecting information is something separate from the mining, quarrying or prospecting right and also something separate from the goodwill of a business (see paragraphs 27 to 30). 81. The disclosure of mining, quarrying or prospecting information is an act, transaction or event that relates to, or affects, the information itself. By sharing the information with others, the number of people who have knowledge of the information is increased and thus the information is more widely circulated and its value may be affected. However, mining, quarrying or prospecting information itself is not an asset as defined in section 160A and, therefore, it is not an asset as that term is used in subsection 160M(7). 82. Accordingly, subsection 160M(7) does not apply to the consideration received for the disposal of mining, quarrying or prospecting information.

[3.240] Similarly, the provisions are canvassed in Ruling TR 94/30 on changes to rights

attaching to shares as follows:

Ruling TR 94/30 Subsection 160M(6) [3.250] 44. Before their amendment by the TLAA (No 4) 1992 with effect after 25 June 1992, the previous subsections 160M(6) and 160M(7) operated. The former subsection 160M(6) was interpreted by the Full Federal Court in Hepples v FCT (1990) 21 ATR 42; 90 ATC 4497 to apply only to assets which were created out of or over existing assets. In Reuter v FCT (1993) 24 ATR 527; 93 ATC 4037 at 545 (ATR), 4051 (ATC), the Federal Court (Hill J) observed that this view also represented the majority judgment of the Full High Court in Hepples v FCT (1991) 173 CLR 492; (1991) 22 ATR 465; 91 ATC 4821. We accept that the former subsection 160M(6) applied only to 102

[3.240]

assets created out of or over an existing asset. Accordingly, this subsection did not apply to a variation of share rights during the period of its operation. 45. The present subsection 160M(6) applies to the construction or creation of assets after 25 June 1992. The broad criteria which trigger the new subsections 160M(6) to 160M(6D) are that a person must create an asset, not being corporeal property, which on its creation is vested in another person. As all these requirements are not present when a company resolves to vary the rights attaching to its shares, the subsection will not apply.

Income from Property

Ruling TR 94/30 cont. Subsection 160M(7) 46. The former subsection 160M(7) deemed a disposal of an asset where an act, transaction or event occurred and money or other consideration was received or was entitled to be received as a consequence of the action or event. 47. The same applies for the new subsection 160M(7) which applies only if the other provisions of Pt IIIA do not apply. The present subsection operates where a person who owns an asset has received, or is entitled to receive, consideration by reason of an act or transaction that has taken place in relation to the asset (whether it affects the asset or not) or an event that has affected the asset. It does not

[3.255]

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matter whether the asset is affected adversely or beneficially or neither adversely nor beneficially. Where subsection 160M(7) applies, the person is deemed to have acquired the notional asset created by the disposal immediately before the deemed disposal. There is necessarily a broad spectrum of possible variations to share rights which can be carried out and differing financial implications attached to those situations. However, we consider that the section applies to a variation of share rights where money or other consideration is received or is entitled to be received as a result of the variation. 48. Subsection 160M(7) does not apply to a variation in share rights if the taxpayer does not receive, or is not entitled to receive, money or other consideration in relation to the relevant transaction (see Determination TD 93/238).

Questions

3.20

Do you see the statement in para 48 of Ruling TR 94/30 as a problem? If, so how might it be solved? (Value shifting provisions were introduced into the ITAA 1936 as a result of the conclusion drawn in the ruling: see now Divs 723 to 727 of the ITAA 1997.)

3.21

Do you agree with the analysis in each of the extracts? Would the conclusion be any different under ITAA 1997?

[3.260] The CGT provisions also contemplate that assets can be split, changed or merged

without there being a relevant CGT event and provide for cost base adjustments in such cases in s 112-25. In other cases, for example, options, the CGT provides that while at one stage of an ongoing transaction there may be a CGT event, if a later CGT event occurs, the earlier CGT event is undone and replaced by cost base adjustments. Because of the possible varying analyses available under the CGT which all have different taxing outcomes – disposal of an asset (including part of an asset), termination of an asset; creation of rights; transactions affecting assets; and splitting, changing or merging of assets – in many more complex transactions, courts find it difficult to settle on any particular analysis with certainty. The Hepples case is but one example of such problems. [3.265]

Questions

3.22

Can you think of examples where CGT assets are split, changed or merged without there being a CGT event? How can such cases occur without falling within event H2 if no other event is relevant?

3.23

In the case of an option, how does the CGT deal with the kinds of issues raised by the case of Abbott v Philbin (extracted in Chapter 2)? Consider in particular the CGT position on grant of the option, exercise of the option and sale of property acquired pursuant to the exercise of the option? In answering this question, consider the case of options generally, not the case of employee share options which was covered in that case: see event D2 and Div 134. [3.265]

103

The Tax Base – Income and Exemptions

3.24

The taxpayer owned property, acquired prior to 20 September 1985, in the City of Adelaide. The property was zoned for floor space much larger than that found in the taxpayer’s old building and the value of the land was based, in part, on the floor space that could be incorporated into a building on the site. In 1987, the City of Adelaide declared the property a heritage property. To protect the interests of persons whose property was subject to a heritage order and therefore declined in value to the extent the zoned floor space could not be erected, the heritage legislation allowed taxpayers subject to a heritage order to sell the unused rights to other owners who could add the extra space on to buildings they were constructing. In 1988, the taxpayer sold its transferable floor rights for $338,750. 1. Are the rights an asset for CGT purposes? 2. If not, will the transaction be caught under one of the CGT events not requiring disposal of an asset? See Naval, Military & Airforce Club of South Australia (Inc) v FCT (1994) 28 ATR 161.

(iv) Time of acquisition and CGT events [3.270] As noted above, the time of acquisition of an asset is important for a number of

reasons. One reason is for indexation purposes; a 12-month holding rule applies for getting indexation (s 114-10(1)). With the ceasing of indexation from the end of the September quarter 1999, this factor will fade in significance as years pass. Second, the time of acquisition is important in cases where there is no consideration (as in a gift) or the consideration cannot be valued. As we shall see, in these cases the market value of the property at the time of acquisition becomes the cost base for the property: s 112-20 of the ITAA 1997. Finally, and most importantly of all, the time of acquisition will determine whether the asset is a pre-asset, on which gains are generally exempt from CGT. The time of acquisition rules, previously found in s 160U, are now in Div 109 of the ITAA 1997. Similarly, the time of a CGT event determines in which income year a capital gain or loss arises. This can be very important if a taxpayer is trying to match particular gains and losses – as losses cannot be carried back, only used in the current or future years. It is also relevant to indexation (and accordingly of diminishing significance over time), as the end of the period for the 12-month holding rule is the time of the CGT event. Again, if a CGT event involves an element of gift, then market value at the time of the event may be relevant: see s 116-30(1) of the ITAA 1997. In many large commercial transactions, there will be a series of contracts, variations and related documents created in carrying out the deal. It is not always easy to apply a simple date of contract rule in such cases. A good example is the High Court of Australia decision in Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd [2000] HCA 35; (2000) 201 CLR 520; 44 ATR 370; 2000 ATC 4378. There the taxpayer was a subsidiary of the US multinational, Sara Lee Corporation, which sold its worldwide pharmaceutical and health care business to the Swiss multinational, Roche Holding Ltd. A purchase and sale agreement was entered into on 31 May 1991 between Sara Lee and its subsidiaries on the one side (including the Australian subsidiary) and Roche on the other. Roche had the capacity under section 12.3 of the agreement to nominate subsidiaries or associates to take on various assets and liabilities dealt with in the sale agreement. Roche nominated an Australian subsidiary, Nicholas Products Pty Ltd, as the purchaser of the Australian assets. This company only came into being on 25 June 1991 and Roche took up shares in it only on 28 August 1991. An amendment agreement was executed by Sara Lee and 104

[3.270]

Income from Property

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Roche on 30 August 1991 which changed the price allocated to the Australian assets and the treatment of its employees. Nicholas was named as the purchaser of these assets in this agreement but was not a party to it. The amendment agreement provided in clause 11 that, subject to the changes, the sale agreement of 31 May 1991 remained in force. The transaction was settled on 30 August 1991, with Nicholas for its part entering into a deed of assignment and a deed of assumption of liabilities and contracts. The taxpayer argued that the disposal occurred on 30 August 1991 so that it could offset its capital gains against losses available in that year. The ATO argued that the date of disposal was 31 May 1991. The High Court found in favour of the ATO.

Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd [3.280] Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 201 CLR 520; [2000] HCA 35 37. Both parties to the present appeal argued the case upon the basis that the relevant change in the ownership of assets occurred on 30 August 1991, by the deed of assignment of that date, and that what was effected was a disposal of the assets by the respondent and an acquisition of the assets by Nicholas Products Pty Ltd. The difference between the parties related to the operation of s 160U which, so far as relevant, provides: 160U(1) Subject to the provisions of this Part other than this section, where an asset has been acquired or disposed of, the time of acquisition or disposal for the purposes of this Part shall be ascertained in accordance with this section. 160U(3) Where the asset was acquired or disposed of under a contract, the time of acquisition or disposal shall be taken to have been the time of the making of the contract. 160U(4) Where the asset was acquired or disposed of otherwise than under a contract, the time of acquisition or disposal shall be taken to have been the time when the change in the ownership of the asset that constituted or gave rise to the acquisition or disposal occurred. 38. The present appeal is concerned with the time of disposal of assets. The time of acquisition will be an important matter in relation to the liability of Nicholas Products Pty Ltd to tax in the event of a disposal of the assets, or part of them,

by that company, but it is not determinative of this case. It is to be noted that the section refers to “the time of acquisition or disposal”, not the time of acquisition and disposal. 39. The appellant argued, and North J held, that the case is governed by s 160U(3), and that the time of the making of the relevant contract was 31 May 1991. The respondent argued, and the Full Court held, that the case is governed by s 160U(3), and that the time of the making of the relevant contract was 30 August 1991. Alternatively, the respondent argued that the case is governed by s 160U(4). On that basis, it is agreed that the relevant time would have been 30 August 1991. 40. The Full Court, before coming to the issue to be resolved, made the following observations as to the legislative scheme. There is no reason why the date of disposition and the date of acquisition referred to in s 160U are necessarily the same. The section refers to the time of acquisition or disposal. Other provisions make it clear that disposal and acquisition are not necessarily contemporaneous, and it is not difficult to think of cases where they may be different. In order for there to be a disposal under a contract for the purposes of s 160U(3) it is not necessary that the contract be unconditional or specifically enforceable. What is relevant is the time of the making of the contract, not the time when it became unconditional, or specifically enforceable. Nor is there any reason why an asset [3.280]

105

The Tax Base – Income and Exemptions

Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd cont. cannot be said to be disposed of under a contract even though the transferee of the asset was not a party to the contract. Application of the legislation 41. Taking into account the later ratification of the signature by Mr Patten, on 31 May 1991 the respondent entered into a contract with Roche by which it was bound to transfer to Roche, on completion of the contract, the assets in question, in consideration for the payment of a sum of money and the assumption of certain obligations. The contract gave Roche the capacity, subject to certain conditions, (including the retention by Roche of its own liability under the contract), to assign its rights to a subsidiary. 42. The words “under a contract”, in s 160U(3), direct attention to the source of the obligation which was performed by the transfer of assets which constituted the relevant disposal. From 31 May 1991, until completion on 30 August 1991, there was a contractual obligation upon the respondent to dispose of its assets to Roche, or to an entity of the kind referred to in s 12.3 of the purchase and sale agreement. The content of that obligation did not change. The price was varied, as were certain other terms and conditions of the sale, but the agreement of 31 May 1991 was the source of the obligation which the respondent discharged by performance on 30 August 1991. 43. The Full Court accepted that the respondent’s assets were disposed of under a contract. Subject to one argument, which was advanced for the first time in this Court, that conclusion appears inevitable. The transfer of ownership of the assets in question was, as is usual in such commonplace disposals as conveyances of real estate, effected pursuant to a contractual obligation which the respondent had previously undertaken. The transferor was acting in performance of a preexisting contract. Whether the same was true of the transferee is beside the point. 44. The new argument put by the respondent was to the effect that s 160U(3) can have no application to a case where there is more than 106

[3.280]

one contract to which a disposal is potentially referable, and where there is no compelling reason to relate the disposal to one of those contracts rather than to another. Where s 160U(3) applies, it can only produce one result. The legislation does not countenance the possibility that there can be two different times of disposal. In a case where s 160U(3) cannot produce a single answer to the question as to the time of disposal, then s 160U(4) applies. 45. It is true that s 160U(3) assumes that, in a case to which it applies, there is a single time of disposal which can be established by reference to the contractual background to the change of ownership. Even so, the circumstance that, in a given case, there may be room for doubt about the correct conclusion does not make the task of reaching it impossible. If, in some case, it were impossible to relate a change of ownership to a contract in such a way as to produce a single time of disposal, then it may be necessary to apply s 160U(4). That is not this case. If it were, the practical operation of s 160U(3) would be seriously curtailed. 46. The Full Court emphasised that the legislation operates in relation to particular dispositions and on the basis of the consideration in respect of each particular disposition. Their Honours said: “In the present case the disposition is a disposition from the respondent to Nicholas Products; the consideration in respect of that disposition is US$62,461,000.” That disposition, for that consideration, they held was referable to the amendment agreement. They said: In the context of s 160U(3), the first time that there was a contractual obligation on the part of the respondent to transfer assets for a consideration of US$62,461,000 was in August 1991 and as a result of the Amending Agreement. The contract under which the disposition which brought into play the provisions of Part IIIA of the Act occurred was not the contract which was made in May, but the contract which was made in August and was brought into existence by the Amending Agreement. That contract was, in our view, the contract under which the disposition was made.

Income from Property

Commissioner of Taxation v Sara Lee Household & Body Care (Australia) Pty Ltd cont. 47. It appears that it was the variation in the consideration effected by the amendment agreement that was seen as being of particular significance. As was noted, Nicholas Products Pty Ltd was not a party to the amendment agreement, and although it was identified in a schedule to that agreement as the purchaser of the assets, that was done pursuant to a right given to Roche by s 12.3 of the agreement of 31 May 1991. Insofar as the identity of the disponee can be related to a contract anterior to the deed of assignment of 30 August 1991, there is less reason to relate it to the contract of 30 August, than to relate it to the contract of 31 May, pursuant to which Roche acted in assigning its rights to Nicholas Products Pty Ltd. Both the deed of assignment and the deed of assumption of liabilities and contracts of 30 August 1991 were expressed to be pursuant to the agreement of 31 May, as amended.

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conclusion. It was that the assumption of obligations by Nicholas Products Pty Ltd, by the further deed of 30 August 1991, was an important aspect of the acquisition of the respondent’s Australian business, and that was only effective by reason of the contractual operation of the deed into which Nicholas Products Pty Ltd entered on 30 August. However, that assumption of obligations was referable to s 12.3 of the agreement of 31 May, (the concluding words of that provision having continuing importance), and, as was noted, it was said to be pursuant to the agreement of 31 May, as amended. 49. Where there are two or more contracts which affect the rights and obligations of the parties to a disposal of assets, the identification of the contract under which the assets were disposed of, for the purpose of applying s 160U of the Act, requires a judgment as to which of the contracts is properly to be seen as the source of the obligation to effect the disposal. In the present case, that contract is the purchase and sale agreement of 31 May 1991.

48. There was an additional reason advanced by the respondent in support of the Full Court’s

[3.285]

Questions

3.25

Would the result of the case be the same under the different structure of the 1997 Act?

3.26

When did Nicholas acquire the Australian assets in the Sara Lee case?

3.27

How are transactions involving powers to nominate the purchaser to be analysed under the CGT?

3.28

Did the High Court unwittingly ignore the date of contract rule in the Orica case extracted above? (See Orica v FCT [2001] FCA 1344; (2001) 48 ATR 588.)

3.29

When does a taxpayer acquire an asset subject to hire purchase – at the date of signing the hire-purchase contract, at the date of taking possession of the asset, or at the date of transfer of legal title to the asset at the end of the hire-purchase period?

3.30

In the leasing industry, it is standard practice that leases of equipment do not include options to purchase but the lessee (or an associate of the lessee) is invariably allowed, as a matter of commercial practice, to purchase the equipment on expiry of the lease for the residual value under the lease. Can a lessee rely on this practice to argue under CGT event B1 that the equipment is acquired when the lease is entered into and not on its expiry? (See AAT Case 6253 (1990) 21 ATR 3703; Case X81 90 ATC 594.)

3.31

When does a taxpayer dispose of a business if the contract of sale was expressed to be “subject to finance”? (See AAT Case 9451 (1994) 28 ATR 1108; Case 24/94 (1994) 94 ATC 239.) [3.285]

107

The Tax Base – Income and Exemptions

3.32

A patent is only fully recognised for legal purposes when the patent is registered under the Patents Act 1952 (Cth) or the law of another country recognised by Australia for this purpose, but reliance on this date could create hardship as it may take many years to register a patent. In 1982 the taxpayer began work on a process that led to the granting of a patent in 1986. When did the taxpayer acquire the patent? (See Ruling IT 2484.)

3.33

A taxpayer commenced writing a novel in 1984 and finished it in 1998 when it was published. When did the taxpayer acquire the copyright in the novel?

3.34

The taxpayer started a business in 1983. It grew slowly at first but increased rapidly after 1996. The taxpayer sold the business in 2001. When did the taxpayer acquire the goodwill of the business? (See FCT v Murry (1998) 39 ATR 129; 98 ATC 4585, Ruling TR 1999/16 especially paras 120-123.)

3.35

The taxpayer acquired a supermarket in 1984. In 1996 the taxpayer acquired a liquor outlet and integrated it with the supermarket. The supermarket/liquor outlet was sold in 1997. When was the goodwill in the business acquired? (See references for Question 3.35.)

3.36

The partners in a partnership agreed to sell their business to a company in which they would receive shares. A verbal agreement was entered into in May 1985 and heads of agreement (which contemplated a formal agreement which never eventuated) in July 1985. The partners applied for shares in the company in October and their applications were accepted and the shares allotted in November 1985. When were the shares acquired for CGT purposes? (See Elmslie v FCT (1993) 46 FCR 576; 26 ATR 611; 93 ATC 4964.)

[3.290] Frequently the acquisition and event rules are the mirror image of each other and

most of the acquisition rules in Div 109 are expressed as relating to CGT events: see s 109-5 which starts with the general rule that a taxpayer acquires an asset on becoming its owner. It is possible to have a CGT event without there being an acquisition by another, such as events C1 and C2, or an acquisition by one person without there being a CGT event for another person (such as the grant of an option, an allotment of shares in a company or units in a unit trust: s 104-35(5)(c) and (d)). In the latter type of case, acquisition rules are separately stated in s 109-10. The rules in Div 109 are supplemented by special rules elsewhere which are signposted in Div 109. Division 115 has some special rules for the date of acquisition in relation to the CGT discount. It is possible for an acquisition or CGT event to be regarded as occurring, and then by reason of later events, the acquisition, event or timing is reversed or altered. For example, if a person enters into a contract to sell an asset, this is a CGT event at the time of the contract. If the contract subsequently falls through so that the sale does not proceed, there is no change of ownership of the asset and so no CGT event. If this occurs in a subsequent income year, it may be necessary to amend the original tax assessment for the year when the contract was made: see Note 1 to s 104-10(3). [3.295]

3.37

108

Questions

A buyer enters into a contract to buy a block of land for $250,000 and pays a deposit of $25,000 on 31 December 2008. The seller acquired the land in 1990 for $150,000. The contract is rescinded and the deposit forfeited by the seller on 31 July 2009 because the buyer breaches the contract by not settling the contract on time. What is the CGT [3.290]

Income from Property

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result? (See CGT events A1, H1, H2, FCT v Guy (1996) 67 FCR 68; 32 ATR 590; 96 ATC 4520 overruled in Brooks v FCT (2000) 44 ATR 352.) 3.38

A enters into a hire purchase contract with B for some equipment in 2008. B repossesses the equipment in 2009 because A fails to make the required rental payments under the hire purchase agreement. What is the CGT result?

3.39

X grants an option to Y to purchase land in exchange for $1,000 in July 2008. The land was acquired by X for $100,000 in 1999. The option is to be exercised by 31 December 2009, the exercise price being $200,000 (with the option fee creditable against the purchase price). What happens if Y does not exercise the option? What happens if Y exercises the option in July 2009? What would be the result if X originally purchased the land in 1984?

(v) Calculation of capital gain or capital loss [3.300] The calculation of capital gain or loss is spelt out individually for each CGT event in

Div 104 as explained above. The details of the calculations are considered in Chapter 12. The calculation involves, in effect, two main steps: first, the calculation of the capital gain or loss disregarding the rest of the Act; and second, reconciliation with the rest of the Act to avoid double counting. The two steps are not kept distinct in the legislation and a number of reconciliation devices are employed. For now it should be noted that the disposal of a depreciating asset or trading stock is disregarded for CGT purposes as a result of ss 118-24 and 118-25. If a CGT event also has income tax consequences under other provisions, a subtraction method is provided for capital gains by s 118-20. Capital losses in equivalent situations are dealt with by cost base adjustments under s 110-55. There are also a number of other cost adjustments to prevent double counting of costs. It may not be necessary to perform a calculation of capital gain or capital loss for a CGT event because a rollover or exclusion for CGT is available. Special rules also apply to calculations for collectables and personal use assets. These issues are considered under the next three headings. (vi) Rollovers [3.310] The CGT contains a number of rollover provisions that reflect commonly accepted

tax policy grounds. These fall into three broad groups: rollovers for involuntary CGT events; rollovers for changes in legal ownership where economic interests remain the same; and rollovers for renewable licences. Further rollovers were introduced for small businesses designed to remove obstacles to the expansion of a small business and to provide equivalent retirement income treatment as for employees. These rollovers were expanded following the Ralph Report and were amended again in 2007 in an effort to achieve greater commonality among the various special measures in the income tax legislation dealing with small business. While these addressed a political constituency of the then government, it is undoubted that the current tax system bears heavily on small businesses which seek to comply with their tax obligations. The rollover on death by contrast is a result of political compromise. On the one hand some consider that death should be treated as a normal disposal event like a gift (as in Canada). On the other hand, in some countries death is an event which effectively excludes capital gains arising during life from taxation by giving the beneficiaries a market value cost (as in the UK and the US). [3.310]

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The rollover provisions follow a general pattern. Where there is a CGT event under which an asset is transferred to or created in another person that qualifies for a rollover, the CGT event is disregarded and the tax attributes of the transferred property (its cost base or reduced cost, as the case may be, and – usually but not invariably – its pre-CGT or post-CGT status) continue for the next owner. Where there is a disposal of an asset and acquisition of a replacement asset by the same taxpayer that qualifies for a rollover, the rollover transfers the tax attributes of the original asset to the replacement asset. Rollovers are generally limited to CGT, though some are extended into other parts of the system such as depreciation. The result is that they do not apply to assets which are effectively outside the CGT (such as trading stock). In many other countries similar rollovers apply across the board. Can you think why Australia has so limited its rollovers? Involuntary disposal rollovers [3.320] An involuntary disposal may result from an act of State such as expropriation by the

government or an act of nature or accident, such as destruction in a storm or by fire. These cases are dealt with in Subdiv 124-B of the ITAA 1997 which covers situations where the taxpayer receives cash compensation for the disposal and uses the proceeds to acquire new property, and where the taxpayer receives another asset as compensation for the disposal. The rollover in the case of receipt of money is subject to more restrictions than in the case of receipt of an asset. The restrictions require a qualifying taxpayer to spend at least part of the money to acquire a replacement asset within certain time limits and provide that the taxpayer must use the replacement asset for the same purposes as the original asset: see s 124-75(4). The ITAA 1936 apparently required that all of the expenditure be incurred within the time limits, but this has been changed in the ITAA 1997. In the case of a pre-asset (acquired before 20 September 1985), the expenditure in respect of the acquisition of the replacement asset must not exceed 120% of the market value of the original asset when the event happened: see s 124-85(3). If the original asset was acquired after 20 September 1985, then the complicated provisions of s 124-85(2) come into play. These provide a partial rollover and partial recognition of gain when the amount received in respect of the original asset exceeds the amount paid for the replacement asset. The ATO released a number of determinations in 2000 dealing with involuntary disposal rollovers: see TD 2000/36 – TD 2000/45. [3.325]

Questions

3.40

What is the CGT result in respect of an original asset that was acquired before 20 September 1985 where the cost of the replacement asset exceeds the value of the original asset by more than 20%?

3.41

What is the CGT result in respect of an original asset acquired on or after 20 September 1985 if the original asset has a cost base of $100, and the amount received in respect of the original asset is $200, if the replacement asset costs alternatively $210, $190 or $90?

3.42

What is the purpose of s 124-70(1)(c)?

3.43

Why do you think it has been made more difficult to satisfy the requirements of the rollover where money is received as opposed to another asset?

3.44

Is a choice or an election required to obtain these rollovers? (See s 103-25 on choices.)

110

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3.45

3.46

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For the purposes of Subdiv 124-B, can you purchase a replacement CGT asset before an Australian government agency has given you a formal notice of intention to compulsorily acquire a CGT asset? (See TD 2000/37.) The taxpayer owned a rental house that was destroyed in a fire. He used his insurance proceeds to acquire a replacement investment. Which of the following would qualify for the s 124-75 rollover? 1. the taxpayer used the insurance proceeds to build on the same site a block of units to be used for rental purposes; 2. the taxpayer used the insurance proceeds to build a house to be used for rental purposes on a different site; 3. the taxpayer used the insurance proceeds to acquire an existing house and land to be used for rental purposes; 4. the taxpayer used the insurance proceeds to acquire shares in a public company to be used for income-producing purposes.

3.47

These provisions on involuntary disposals apparently regard any amount received under an insurance policy as being the capital proceeds from the disposal of the asset that is acquired, damaged or destroyed. Is this a correct CGT analysis of the situation?

3.48

If you receive compensation for a compulsory acquisition of part of a CGT asset which you own, how do you treat that compensation – for cost base purposes – to the extent to which it reflects a reduction in value of the remaining part of your asset? (See TD 2001/9.)

Marital breakdown rollovers [3.330] There are a large number of rollover provisions applicable to CGT events which result

legally in a change in ownership but not in the underlying economic interest of the original owner. Most of the rollovers in this category apply to investment or business assets and are considered in other chapters. The exceptions are the marriage breakdown rollovers in Subdiv 126-A of the ITAA 1997. The family law measures that provide for the transfer of assets upon breakdown of a marriage from one spouse to the other spouse (or former spouse) have their origins in trust law. Particularly in the case of assets owned within a family, legal title may not reflect the actual contributions of the parties to the acquisition of the property. In the context of a family, parties to a marriage can make direct contributions to the acquisition of property or indirect contributions by assuming household responsibilities that enable the other spouse to work and acquire assets. In these circumstances, a court can use trust law principles, and now family law provisions, to order a transfer in legal ownership to reflect the recipient spouse’s beneficial or economic interest in the transferred property. The marriage breakdown rollover provisions allow the transferor to avoid realisation of gains when this happens. Despite the use of the term “marriage” in the title of the subdivision, the rollover now extends to many de facto marriage situations. In 2008 under the initiative of the Rudd Labor Government to end many of the discriminations against same-sex couples without, however, conferring the title “marriage” on such relationships, the heading was amended to include relationship breakdowns and the operation of the subdivision now extends rollovers to same-sex couple relationship breakdowns. Section 126-5 applies to transfers directly between the spouses. Section 126-15 applies to transfers of assets from a family company or trust to one of the spouses. Both provisions [3.330]

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employ similar rollover mechanisms with respect to the asset received by the transferee spouse. The latter contains further provisions to adjust the cost base of shares in the company or the interest in the trust from which the asset is transferred. The provisions also adjust the cost of any loans to the company or trust so that the person who owned the transferred asset indirectly through a company or trust is not taxed on any illusory gains or able to recognise any apparent losses resulting from the transfer. [3.335]

Questions

3.49

Is the operation of these rollovers automatic or is a choice required by the relevant taxpayer(s)? (See TD 1999/60.)

3.50

A husband and wife separate and obtain a divorce. They amicably agree to the division of their property, and transfers are effected accordingly without reference to the Family Court or any agreement under family law. Is a rollover available?

3.51

The Family Law Act 1975 Pt VIIIA now permits persons to enter into binding financial agreements before, during or after marriage. The agreements do not require the approval of the Family Court though the parties have to have legal advice. Would transfers under such agreements qualify for rollover?

3.52

A husband and wife separate and obtain a divorce. Pursuant to an agreement approved by the Family Court, property is transferred from a family company controlled by the wife to a family trust controlled by the husband. Is a rollover available? (See TD 1999/46 – TD 1999/55 for this and related questions.)

3.53

A same-sex de facto couple separate and their property is divided pursuant to litigation under state legislation dealing with de facto spouses. Is a rollover available? (See TD 1999/61.)

3.54

How do you calculate the cost base of shares in a family company after an asset has been transferred to a spouse from the company and a rollover obtained? (See TD 1999/58.)

Renewable licences [3.340] The expiry of an asset is treated as a CGT event. There are several types of statutory

licences such as liquor licences or taxi licences that regularly expire but which are normally renewed more or less as of right. To avoid triggering deemed disposals and acquisitions every time a statutory licence expires and is then renewed, taxpayers are granted a rollover in Subdiv 124-C. Note that this rollover is not elective – it occurs automatically if the licence is renewed. Similar concepts are applied to Crown leases under Subdiv 124-J and prospecting and mining entitlements under Subdiv 124-L. Small business [3.350] The provisions of the income tax dealing with small business have proliferated over

the last decade (see the discussion of the Simplified Tax System in Chapters 10 and 12). Included among these are four important CGT regimes in Div 152 which are part rollover, part tax reduction and part exemption. The rollover is covered here and the other parts of Div 152 in relation to CGT exclusions below. There are three main common requirements under s 152-10 for all of the Div 152 benefits: a small business entity test, a maximum net asset value test and an active asset test. The benefits extend beyond sale of a small business directly by an individual owner to cases where the business is owned by a company or trust 112

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and the CGT event relates to interests in the company or trust. In these cases, additional tests about the ownership or control of the company or trust are applicable. The small business entity test is found in Subdiv 328-C which is the new uniform test for small business. The test requires an annual turnover of less than $2 m (taking into account the turnover of businesses operated by associated entities of the taxpayer). The maximum net asset value test is net assets of less than $6 m owned by the taxpayer (disregarding personal use assets and the main residence) and including business assets of associates. The active asset test requires that the asset disposed of be an active asset. An asset is an active asset if it is used in a business or in the case of an intangible asset is inherently connected with a business (like goodwill), but typical investment assets like shares in companies or loans are generally excluded. Shares in companies or interest in trusts can qualify as active if the company or trust has 80% or more of its assets constituted by active assets, loans or cash connected with the business. The rollover is found in Subdiv 152-E but it simply refers back to the qualifying conditions in Subdiv 152-A. The real limitations applicable to the rollover are found in CGT events J2, J5 and J6. The taxpayer has a period of one year before to two years after the CGT event for which the rollover applies to acquire a replacement asset – if not, a separate CGT event occurs to tax the original gain. Even if a replacement asset is acquired, CGT events taxing all or part of the original gain can still occur (eg if the asset stops being an active asset because it is no longer used in a business). Death [3.360] Division 128 of the ITAA 1997 provides that a CGT event arising from death is

disregarded and instead gives a rollover of the cost bases of post-property to the new owners for the purpose of calculating their gains or losses. The new owners are deemed to have acquired pre-assets at their market value on the date of death so that gains on pre-assets up to the time of death are exempt from taxation. This approach was adopted as part of a trade-off that ensured passage of the CGT by the Senate. It is further considered in Chapter 13. The testamentary rollover may be criticised on efficiency grounds. The inefficiency it is said to cause is “lock-in”. Persons old enough to see the prospect of death in the foreseeable future are unlikely to dispose of assets to fund their bequests when they can avoid the tax by holding on to property and giving it directly. Thus, they will retain property that generates a lower rate of return than other possible investments simply to avoid the tax. The problem remains after their death because the recipient beneficiaries will have cost bases inherited from the deceased (or earlier owners if the deceased is bequeathing property that he or she also inherited!) Their cost bases, therefore, will be low and they will face a tax liability on significant accrued gains, much of which accrued before they acquired the property. It is thought that the prospect of the large tax bill will “lock” the new owners into retaining the property when they would have otherwise sold it if the decision were based on market factors only. Over a period of time political pressure is likely to build to free the inherited gain from tax – especially in relation to rural properties, which tend to be willed from one generation of the family to the next. [3.365]

3.55

Question

Can you think of any way the problems with the testamentary rollover can be avoided if the rollover is retained? [3.365]

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(vii) Exclusions [3.370] A number of transactions and gains are excluded from the application of CGT. Some

of these are for technical reasons relating to integration of the CGT with the rest of the Act (see above), some for policy reasons, some for administrative reasons, and some for political reasons. As noted earlier, they are largely gathered together in Div 118 and generally subject to the same device of providing that the capital gain or loss is disregarded. The first exclusion encountered in Div 118 is for motor vehicles. There are two reasons for this exclusion. First, there are a number of special provisions applicable to motor vehicles and these largely cover the field. Second, and more importantly, motor vehicles are more likely to depreciate in value than to appreciate. Excluding motor vehicles from the definition of “asset” ensures that taxpayers will not be able to claim capital losses for depreciation due to personal consumption. This exclusion has been criticised on the basis that some motor vehicles, particularly collectibles and antiques, do appreciate in value, while losses due to personal consumption can be dealt with by other provisions such as the personal-use asset measures described below. The government has not considered changing the treatment of motor vehicles but the ATO has indicated that it believes it will be able to use s 6-5 to catch such gains realised by motor car traders and speculators. The next exclusion in s 118-5(b) is decorations for valour unless they were purchased. In view of the small amount of revenue involved, the social and political cost of taxing heroes on awards or the descendants who inherit them is sensibly avoided. If, however, a Victoria Cross is purchased, the CGT may subsequently apply to any sale by the purchaser. Exempted receipts under s 118-37 include damages for personal injuries, and lottery and gambling winnings. These are discussed in later chapters. [3.375]

3.56

3.57 3.58 3.59

Questions

Is a semi-trailer subject to the CGT? (See the ITAA 1997 definition of “car”, (previously s 82AF(2)(a)), Business Assessing Handbook, para 2.8.30 and Ruling IT 2170 – now withdrawn.) What happens if an athlete wins an Olympic Gold Medal and subsequently sells it? What if the purchaser on-sells it? See further Chapter 5. Why do you think gambling winnings and losses, and some damages claims but not others, have been excluded from the CGT? Is an amount which is effectively excluded from tax by a disregard of the capital gain exempt income, non-assessable non-exempt income or something else?

Main residence [3.380] One of the most important exclusions relates to the taxpayer’s main residence: Subdiv 118-B. Various forms of concession for gains on personal residences are common in overseas tax systems. If the capital gain on a main residence is taxed then consistency suggests that the imputed rent realised while the owner occupies it should also be taxed, and the costs of mortgage, insurance, rates and depreciation for improvements etc deducted: see Chapter 1. This would involve considerable compliance costs for many taxpayers. Further, it is likely that the tax would produce little revenue except from inner Sydney because historically little real gain is made on housing on average, after improvements and inflation are taken into account. On the other hand it has been argued that the exemption has significant equity and economic efficiency implications (both positive and negative). Certainly the main residence exemption raises several problems of definition. 114

[3.370]

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[3.385]

3.60 3.61 3.62 3.63

3.64

3.65

3.66

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Questions

What do you think that the arguments for and against the main residence exclusion are? Does the exclusion apply where a taxpayer holds a leasehold interest in the main residence? (See s 118-130.) A doctor has a surgery attached to her home. To what extent, if at all, does the home qualify for the exclusion? (See ss 118-115, 118-190.) A husband and wife own a house in the city and a country cottage that they use on weekends. The husband seeks to treat the city dwelling as his main residence for CGT purposes while the wife seeks to treat the country cottage as her main residence. What is the result? What would happen if the husband owned outright the city dwelling and the wife the country cottage? (See ss 118-170, 118-185.) A newly married couple buy a block of land and save for four years to build a house on the land while living in rented accommodation. Are they entitled to any exclusion? What would be the result if they lived on the land in a caravan while saving to build their house? Would there be any difference if they lived on the land in a mobile home that was a fixture and thus treated under property law as part of the land? (See ss 118-115, 118-150.) A home is owned jointly by a wife and husband. The husband dies and the wife continues to live in the home until she becomes too frail. She then lets out the home and moves into a nursing home for three years. She then sells it. How does the exclusion operate in this case? (See ss 118-145, 118-195, 118-197, 128-15, 128-50.) The taxpayer and her brother owned (as joint tenants) a house in which the taxpayer lived. The brother lived separately, in another city. The house was acquired by the taxpayer and her brother in 1987 and sold for a considerable profit in 2009. How does the exclusion apply? (See s 108-7 and Ruling IT 2485.)

[3.390] These and other issues arising under the main residence rules have been the subject of

many tax determinations, reflecting the importance of the exemption to many taxpayers: see, for example, TD 1999/43, TD 1999/67 – TD 1999/74, TD 2000/13 – TD 2000/16, TR 2002/14 as well as some case law [2003] AATA 342, Erdelyi v FCT (2007) 60 ATR 872, Summers [2008] AATA 152. Small business [3.400] As noted above under rollovers at [3.350], small business is the subject of a number of special CGT rules. Subdivision 152-B provides an exemption from CGT for sale of assets of a small business that qualify under the Div 152 general conditions outlined above if held for 15 years and the gain occurs in effect in conjunction with retirement or permanent disability. Subdivision 152-D provides an exemption without a retirement condition up to a lifetime maximum of $500,000 but if the taxpayer is less than 55 years old the amount must be rolled into the superannuation system described in Chapter 4. Complex rules seek to replicate the same outcome in both cases if shares in a company or an interest in a trust is sold. The 15-year rule takes priority over the lifetime exemption rule. Both of these rules seek to recognise that small business owners are less likely to be able to provide for themselves through the superannuation system because they tend to plough every spare penny back into the business – their business is their superannuation. Finally Subdiv 152-C provides an additional 50% discount for capital gains if the basic conditions in Subdiv 152-A are satisfied. This may be applied after the general 50% discount [3.400]

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under Divs 102, 115 meaning in such cases a total discount effectively of 75%. The remaining gain may then by election be subject to the benefits in Subdiv 152-D and/or Subdiv 152-E already described. (viii) Personal use assets [3.410] Subdivisions 108-B and 108-C carve out from the general definition of CGT asset two

related categories of property known as “collectables” and “personal-use assets”. These are, as one of the names suggests, assets applied primarily for the personal use and enjoyment of the taxpayer. A combination of policy and administrative concerns explain the separate identification of these assets and the special rules that apply to them in the CGT. The policy concerns relate to the fact that most personal-use assets depreciate in value due to use. To allow a taxpayer to recognise a capital loss on the decline in value of her or his refrigerator, stove, bed, and so forth would be tantamount to allowing a tax deduction for personal consumption, a policy that would violate fundamental principles of income taxation. The administrative concerns arise mostly because of the relatively small cost of many personal assets. Taxpayers are unlikely to retain records of cost or sale price and it is unlikely that any paper trail will be available for auditors; in any case, the amount of tax imposed on the small gains would probably not equal the cost of administering CGT with respect to these assets. A three-part solution to these concerns was adopted. The first has already been mentioned – the dissection of such assets into collectables and personal-use assets. Collectables are assets such as jewellery, coin collections, artwork, and so forth, whose value is more likely to rise or decline in response to market forces, rather than as a result of usage by the owner. Also, for a variety of reasons such as insurance, owners are more likely to retain records for such assets and a paper trail for auditors is more likely to exist. For these reasons, all gains realised on the disposal of these assets are recognised for CGT purposes, provided the cost or market value of the asset at the time of acquisition exceeds $500: s 118-10(1), (2) (a figure that may be in need of upward revision). At the same time, losses suffered on the disposal of collectables will be recognised, but are subject to special provisions which require taxpayers to offset losses on collectables only against gains realised on collectables: s 108-10. The second special rule is the prohibition in s 108-20 on recognition of losses suffered on the disposal of personal-use assets. Finally, s 118-10(3) establishes a minimum floor for calculating gains on personal-use assets; if the cost is $10,000 or less, any capital gain is disregarded. The various provisions involving monetary limits are protected by ss 108-15 and 108-25 which prevent taxpayers from selling separately assets that would normally constitute a set of articles. [3.415]

Questions

3.67

Is an interest in a racing horse acquired by a lawyer who races horses as a hobby subject to the $10,000 floor for personal-use assets?

3.68

Is a capital gain or capital loss made from an antique car, a veteran car or a vintage car disregarded? (See TD 2000/35.)

3. GAINS FROM THE USE OF PROPERTY [3.420] The discussion so far has focussed on rules that were introduced to tax (non-income)

gains made from selling assets (albeit that their scope extends beyond that paradigm case). We now shift to examining the rules which tax gains that are made while holding and using assets. 116

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The “fruit and tree” analogy used to explain the distinction between “income” gains generated by property and “capital” gains realised on the disposal of property was also used to construct judicial doctrines on the characterisation of gains related to the use of property. Severed and periodic gains for the use of property, such as interest for the use of borrowed money, rent for the use of leased property, and royalties for the right to use intellectual property or to exploit resources on real property were all characterised as income gains, analogous to the fruit that could be realised without disposing of the underlying property. But payments for the creation or redemption of legal contracts (loans, leases, royalty agreements, and so forth) that give rise to severed income gains for the use or exploitation of property are generally considered capital amounts, given their direct nexus with the underlying property rather than its actual use. Examples are premiums paid for entry into a lease or on redemption of a loan (in addition to the rent or interest payable). From an economic perspective, the distinction between the two types of gains is quite artificial. And, for that matter, their legal distinction is also somewhat tenuous. Virtually any contract that gives rise to a right to receive income can be restructured to provide an entitlement to less income and a premium or similar consideration for agreeing to enter into the contract. The remainder of this chapter considers three areas where the distinction between income and capital gains in respect of the use or exploitation of property has been subject to litigation and specific legislative provisions. The CGT acts as an overlay on both the judicial and prior and subsequent legislative initiatives. One type of gain from the use of property not considered in this chapter is dividends paid by companies to shareholders for the use of their “capital”. From an early stage in the development of Australian income taxation, dividends have been subject to a special statutory inclusion provision, currently s 44(1) of the ITAA 1936. Because of this, there has been little exploration by the courts of the status of dividends according to the judicial concepts of income, although the High Court decision in FCT v McNeil [2007] HCA 5 is an important reminder that there is room for s 6-5 to operate as well as s 44, when considering the benefits received by shareholders in cash or property from companies. More importantly the taxation of dividends is completely entwined in the imputation system of company taxation that now operates in Australia, and is more properly regarded as an issue of taxing income derived through an intermediary rather than as a separate issue of income from property. Hence dividends are considered in Chapter 14.

(a) Interest, Discounts and Premiums [3.430] Interest on a loan is one of the most commonly encountered types of income from

property. It is a periodic payment by the borrower to the lender for the use of the lender’s money by the borrower and is paid in addition to repayment of the lender’s principal. As it exhibits all the characteristics of ordinary income (severed from the source, periodic, expected by the recipient), interest is characterised as ordinary income for tax purposes. Not all returns for the use of borrowed money are paid as interest, however. Often a lender will realise gain in the form of a discount or premium on a loan in lieu of interest. The characterisation for tax purposes of these related types of gains is less certain. Conversely, what the parties call interest may turn out to be something else such as purchase price on closer analysis: see FCT v Broken Hill Pty Co Ltd (2000) 45 ATR 507. [3.430]

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(i) Discounts and premiums [3.440] Where a loan is made at a discount, the “lender” will provide the “borrower” with

less money than the amount (apart from interest if any) that will actually have to be repaid. Where a “loan” is made at a premium, the “borrower” will be required to repay an amount (again apart from interest, if any) in addition to the amount advanced or will be required to pay an initial sum to have the lender advance the amount. We have put the terms lender, borrower and loan in quotation marks because discount and premium transactions may not involve loans in a legal sense, even though they clearly do in economic substance. A discount arising at the outset of a transaction is commonly called “original issue discount”. Subsequent “market discount” may arise if interest rates rise or the creditworthiness of the borrower weakens. Similar terminology could be used for premiums but is not common. A debt instrument may offer no return apart from a discount. Common forms of these are stripped bonds and zero coupon bonds. The former are ordinary debt instruments that entitle the lender to annual interest payments. The debt notes are issued in “bearer” form, as a single document evidencing a right to repayment of principal, to which are attached coupons evidencing a right to payment of interest each year. A purchaser, usually a financial institution, acquires the debt and then separates the interest coupon from the principal repayment note and markets each part separately. For example, if a company issued 21-year $1,000 debentures or bonds with $100 interest coupons attached, a lender who acquired the bond could sell the right to $1,000 in 21 years to one purchaser for the present value of that payment, the right to $100 in 20 years to another, the right to $100 in 19 years to a third, and so forth. Zero coupon bonds are debt instruments issued by the borrower on the understanding that they will pay no interest so that the lender’s entire return is based on the original issue discount. Traditionally – although zero coupon bonds were sometimes issued by private borrowers – the most frequent users of this method of borrowing were governments. Government-issued zero coupon bonds are often called “T-bills”, meaning Treasury bills. They have a fixed redemption value and date, but the discount is determined by the market at the time they are issued as they are auctioned and sold to the highest bidder (who will, therefore, receive the lowest rate of return). In Australia, for reasons having to do with past regulatory practices in the banking sector, large private markets utilising bills of exchange and promissory notes (as dealt with in the Bills of Exchange Act 1909 (Cth)) issued at a discount became a very common form of private sector financing. Two recent examples in High Court cases are Coles Myer Finance Ltd v FCT (1993) 176 CLR 640 (see Chapter 11) and FCT v Energy Resources of Australia Ltd (1996) 185 CLR 66. While discounts exhibit few of the usual characteristics of ordinary income, it is clear that they substitute for ordinary interest in most cases, particularly where a zero coupon note has been issued and there is no other return paid to the lender. In these cases, as a substitute for an income amount, the discount would ordinarily be held to have acquired an income character. Nevertheless, the government decided to make certain of this result, at least for the purpose of government-issued zero coupon securities, by enacting s 26CITAA 1936. It might be inferred from the adoption of s 26C of the that discounts were not income in the absence of a specific statutory inclusion provision. Further, even if original issue discount is income (as seems fairly clear: see Hurley Holdings (1989) 20 ATR 1293), it is certainly not as clear that market discount is income. When the ATO assessed individual taxpayers on both kinds of discounts, there was an outcry and the government enacted s 23J of the ITAA 1936 that exempted 118

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discounts from assessment provided the instrument was acquired prior to the effective date of the provision, 30 June 1982. The exclusion provision applied to all taxpayers (other than dealers) – not only those who had not expected their gains to be assessable – and, as AAT Case 4880 (1989) 20 ATR 3255; Case W57 (1989) 89 ATC 517 showed, exempted taxpayers who acquired discounted notes only for the purpose of realising a gain and whose gains clearly would have constituted assessable income according to ordinary concepts. There are two strands to the judicial tests used to distinguish discounts that are “income” and those that are “capital” gains. The first is based on the character of the lender. If the lender is a financial institution or regularly acquires discounted securities to generate business profits, the gains will be treated as business income. For other lenders, the character of a discount will depend on whether there is evidence the discount was paid in substitution for interest or whether the taxpayer can establish another plausible explanation for the discount. The leading authority on this issue is Lomax v Peter Dixon (1943) 25 TC 353. The taxpayer company manufactured newsprint and had organised a Finnish company, in which the shareholders were its nominees, to supply wood pulp to it. It had loaned £319,600 to the Finnish company and entered into an agreement for the repayment of the loan. Under the agreement the Finnish company issued 640 notes to the taxpayer with a face value of £500 each (total face value £340,000). The notes were issued at 94% or a discount of 6% and carried interest 1% above the lowest rate charged by the Bank of Finland. The notes were to be redeemed on a regular basis by repayment of £600 each (a premium of 20%). The UK Revenue assessed the taxpayer on the interest, discount and premium on the notes. The Court of Appeal held that only the interest was taxable. Lord Greene MR reasoned as follows.

Lomax v Peter Dixon [3.450] Lomax v Peter Dixon (1943) 25 TC 353 In a Scottish case, CIR v Thomas Nelson & Sons Ltd 22 TC 175, a loan was made to an Indian company repayable in ten years or earlier on the happening of certain specified events, with a power to the company to repay one tenth of the principal on three months’ notice, the rate of interest being 3%. The agreement provided (and this is the important matter) that on payment of the principal sums or any part thereof there should be paid a premium varying with the date on which such principal sums or any part thereof should become payable. From this it appears that the amount to be paid by way of premium must have been calculated by reference, not to any element of capital risk, but to the period of the loan, whatever it might turn out to be, a circumstance, which, prima facie at any rate, stamped the premium with a revenue character. The Lord President in his judgment placed great reliance on the fact that the rate of interest (3%)

was, for a loan of that character, a remarkably low one. He also pointed out that under the power given to the borrower to make yearly repayments, if it had been exercised, the lenders would have received in the form of interest, plus premium, a return varying between 5 and something over 5.5%, and this he said could only be regarded as a reasonable return on the capital lent. He also pointed out that there was no resemblance between the case before him and that of a debenture issued at a discount. The case before him turned on “the specialities of the contract” (22 TC 175 at 180), and forms a good example of a case where the contract itself gives the answer to the question … But in many cases mere interpretation of the contract leads nowhere. If A lends B £100 on the terms that B will pay him £110 at the expiration of two years, interpretation of the contract tells us that B’s obligation is to make this payment; it tells us nothing more. The contract does not explain the nature of the £10. Yet who could doubt that [3.450]

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Lomax v Peter Dixon cont. the £10 represented interest for the two years? The justification for reaching this conclusion may well be that, as the transaction is obviously a commercial one, the lender must be presumed to have acted on ordinary commercial lines and to have stipulated for interest on his money. In the case supposed, the £10, if regarded as interest, is obviously interest at a reasonable commercial rate, a circumstance which helps to stamp it as interest. In Lord Howard de Walden v Beck 23 TC 384, the appellant became entitled to receive sets of promissory notes payable without interest at three monthly intervals. The consideration moving from the appellant was an amount which represented the present value of the promissory notes calculated in the case of one set of notes on a 4% basis, and in the case of the other sets at a rate approximating to 4%. Wrottesley J pointed out that the documents threw no light on the problem whether or not the difference between the present value and the nominal amounts of the notes represented capital or income. Nor did he find any assistance in the surrounding circumstances. He rejected the view that the appellant had purchased an annuity (a view which was not pressed by the Crown), and held that the appellant had stipulated for the return of his capital. This at once stamped the transaction as one of loan, and on that basis it does not seem to have been seriously argued that the difference between the present and the nominal value of the notes ought not to be regarded as interest. It is to be noted (1) that the contracts did not in terms provide for payment of interest; (2) that 4% was a reasonable commercial rate. These facts led really as a matter of common sense to the inference that the 4% was interest. A rather different case is that of a moneylender who stipulates for payment by instalments of a sum very much larger than that which he lends. From a business point of view, the excess, one would have thought, is referable largely, if not mainly, to the capital risk. So long as the moneylender is carrying on his business this is immaterial since he will be assessed. … It is part of his business to take capital risks. But in Bennett 120

[3.450]

v Ogston 15 TC 374, the moneylender had died, and the question arose in relation to instalments collected by his administrator. … It does not seem to have been seriously argued that the difference between the amount of the loan and the amount of the instalments did not represent interest. As Rowlatt J says (at 378): “Each of these instalments is found in the case to contain principal and interest and we know, of course, that it is so, and we are familiar with the way in which these instalments are broken up into principal and interest.” On this basis the insurance against capital risk was provided for by means of a high rate of interest; and, where this is the case, interest it is and not capital. In saying that the case was one of interest, Rowlatt J apparently based himself on the well-known practice of moneylenders; and if the deceased had been alive he would no doubt have admitted that he fixed the amount of instalments by reference to an interest table, a circumstance which would be sufficient to stamp the whole excess as interest … The position is more complicated when A lends £100 to B at a reasonable commercial rate of interest and stipulated for payment of £120 at the maturity of the loan. In such a case it may well be that A requires payment of the £20 as compensation for the capital risk; or it may merely be deferred interest. If it be proved that the former was the case by evidence of what took place during the negotiations, it is difficult to see on what principle the £20 ought to be treated as income. In the absence of such proof, what inference ought to be drawn? Something may, perhaps, depend on the length of time for which the money is lent. If the period is short it is perhaps easier to treat the £20 as deferred interest. The longer the period the greater the element of risk, and if it was, say ten years, the probability that the £20 was not intended to be deferred interest would seem to be greater. A good example of the difficulty is to be found in the contracts of loan which used to be made on a gold basis when the currency had left, or was expected to leave, the gold standard. In such contracts the amount to be repaid was fixed by reference to the price of gold ruling at the repayment date, and if the currency depreciated in terms of gold, there was a corresponding increase in the amount of sterling to be repaid at

Income from Property

Lomax v Peter Dixon cont. the maturity of the loan. It could scarcely be suggested that this excess ought to be treated as income when the whole object of the contract was to ensure that the lender should not suffer a capital loss due to the depreciation of the currency. I refer to these problems, not for the purpose of attempting to solve them, but in order to show that there can be no general rule that any sum which a lender receives over and above the amount which he lends ought to be treated as income. Each case must, in my opinion, depend on its own facts and evidence dehors [outside] the contract must always be admissible in order to explain what the contract itself usually disregards, namely, the quality which ought to be attributed to the sum in question. I will now consider the case of an ordinary issue of debentures by a limited company. If the credit of the company is good and the security an ample one, the issue can be made at par at a normal reasonable rate of interest. If the company’s credit and the security offered are exceptionally good, the issue can be made at a premium. In such a case the calculation of the rate of interest which the subscriber will receive on the capital which he invests is a simple matter. It will be less than the nominal rate; but this does not entitle the subscriber to avoid taxation on the difference between the nominal rate and the actual rate. He is taxed on what he in fact receives. The premium which he pays is capital. He pays it because the security which he is getting is a particularly good one. Here the excellence of the security is expressed in terms of capital. Such a company, however, may prefer to issue its debentures at par at a lower rate of interest. Here the excellence of the security is expressed in terms of interest. The subscriber receives less interest but does not pay a premium. Actuarially the result is the same in both cases; but the subscriber pays less tax in the latter case than he does in the former because his income is less. Now let me take the opposite case where the credit of the company and the security which it offers are not such as to enable it to offer its

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debentures at par at a normal rate of interest applicable to sound securities. The object of the company is to make its issue attractive and various alternatives are open to it. It may make the issue at par but give a high rate of interest. The whole of the interest is unquestionably income and is taxable as such although the high rate of interest is, in part, attributable to the capital risk. Another course which the company may take, and for commercial reasons probably will take, is to fix the rate of interest at a more normal level and make the issue at a discount; or it may make the issue at par and offer a premium on redemption; or it may combine both methods. Here the defect in the security is expressed in terms of capital. I venture to think that no business man would regard the discount or the premium as anything but capital matters. In each case the result is the same – the subscriber is paying for a more or less hazardous investment less than the figure at which it is to be redeemed, and in exchange has to be content with a lower rate of interest. Another way of making good the defect in the security would be for the company to take out a guarantee policy … In such a case the issue might be at par. The subscriber would be paying more for a safer investment than he would have paid if the guarantee policy had not been taken out. No one would suggest that the premiums paid by the company were part of the subscriber’s income. Yet the policy would be playing exactly the same part as would have been played by a reduction in the issue price, or the offer of a premium on redemption, or a combination of the two. The amount by which the issue price falls short of par or the redemption price exceeds par can, of course, as has been done in the present case, be reduced to terms of income if any one chooses to make the calculation; and this is often done by a stockbroker advising a client, particularly when the redemption date is drawing near. But this does not mean that these amounts are income. If they were income and taxable as such when received on redemption, it would appear to follow that in the case of a debenture issued at a premium and redeemable at par, the amount of the premium ought to be treated as an income loss. A premium on redemption and a premium on issue are in their nature precisely the same and [3.450]

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Lomax v Peter Dixon cont. come into existence for the same reason, viz, the desire to express in the former case the greatness, in the latter, the smallness, of the risk in terms of capital rather than in terms of interest. I have for simplicity considered only the case where the variations in issue price and rates of interest are due only to differences in the security offered. This, of course, is not necessarily always the case. The precise terms of an issue may be affected by a variety of other considerations – the taste of the market; the terms of previous issues by the company; the political or international situation; the expectation of changes in money rates; the instability of the currency, etc. But these matters do not affect the principle. It is perfectly true that a company may be able to obtain subscribers by issuing debentures at par at a high rate of interest just as well as it can by issuing them at a lower rate of interest below par or with a premium on redemption. The two methods are, however, essentially different although actuarially they will normally produce the same result. But for income tax purposes the result is, I think, different, according as the company chooses the one method rather than the other. The Crown is, in my opinion, bound by the company’s choice and cannot go behind it. I can find no ground for distinguishing the present case from that of an ordinary issue of debentures by a trading company. If at the date of the agreement the appellants had lent to the Finnish company a sum of £319,600 to be secured by an issue of notes at 94 repayable over 20 years at 120 and bearing interest at a rate fixed by reference to bank rate in the usual way, the Revenue authorities would not have claimed tax on the discount or the premium. The element of capital risk was quite obviously a serious one, and the parties were entitled to express it in the form of capital rather than in the form of interest if they bona fide so chose. It is said, however, that there is a difference between the case of a security issued for a present loan and that of a security issued to cover an existing loan. This argument found favour with Macnaghten J but, with all respect to him, I cannot follow it. The parties to the transaction, faced with an existing 122

[3.450]

debt which the Finnish company was obviously not in a position to repay there and then, did what in effect amounted to writing down the capital value of the debt which by the terms of the agreement was not to be repaid over a long period of years, bearing interest in the meantime at a normal commercial rate. I can see no difference between writing down the capital value of a new debt which is what is done where a company makes an ordinary issue of debentures at a discount or repayable at a premium. Moreover, it is quite common for a company to issue debentures as security for an existing loan. This is often done in the case of a company’s bankers who call for security, and also not infrequently under schemes of arrangement when debentures are issued to existing creditors of the company. In such cases circumstances may well call for a writing down of the value of the debts. An additional argument was presented on behalf of the Crown to the effect that the difference between the price at which the notes were issued and the redemption price, or, at any rate, the difference between the issue price and the nominal par value of the notes, was income from “discounts” within the meaning of para (b) of Rule 1 to Case III. But, in my opinion, the word “discounts” in that paragraph does not cover such a case as the present. I agree with what was said by Rowlatt J, in The National Provident Institution v Brown 8 TC 57 at 66: “It is clear”, he said, “that it is not every difference in amount between a sum payable in future and the same sum represented by cash down which is an annual profit or gain by way of discount, even though popularly the word ‘discount’ may be used to describe it.” It was conceded (and in my opinion rightly) that in the case of a debenture, the difference between issue price and redemption price when received by the holder is not income from “discounts” within the meaning of the paragraph. It is impossible to suppose that the legislature intended to include under the one word “discounts” two such entirely different commercial transactions as the discounting of a bill of exchange or a Treasury Bill (which normally are short-dated and carry no interest) and a subscription for debentures issued at a discount. The issue of debentures or other obligations by companies was unknown in 1805 when profits

Income from Property

Lomax v Peter Dixon cont. on “discounts” were for the first time expressly subjected to income tax … In The National Provident Institution v Brown, Lord Sumner says (8 TC 57 at 96) that there is no restriction of the word “discount” in the statutes to transactions in use in the year 1842 – he might have said 1805 – and that the rule relates to profits on all discounts from whomsoever made. This observation does not, however, throw much light on the question whether any particular transaction is one of “discount” within the meaning of the rule. If the case of the debenture fell under the word “discount”, it would follow from the National Provident case that profits realised by selling debentures on the market would be taxable as income as well as those made by an original subscriber who holds his debenture until maturity. The storm which would be aroused in the city of London if this were found to be the law is perhaps the best proof that it cannot be the law, since it shows at once the fundamental difference from the business point of view between the case of the debenture and the case of the discounted bill. It is conceded that the word would not cover the “discount” in the case of a debenture issued “at a discount” and, as I have already said, for present purposes I can see no difference between that case and this. In the discounting of bills of exchange, Exchequer Bills, etc., the discount is the reward, and in the normal case, since such bills do not as a rule carry interest, the only reward which the person discounting the bill obtains for his money. It may be convenient to sum up my conclusions in a few propositions:

[3.455]

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(1)

Where a loan is made at or above such a reasonable commercial rate of interest as is applicable to a reasonably sound security, there is no presumption that a “discount” at which the loan is made or a premium at which it is payable is in the nature of interest.

(2)

The true nature of the “discount” or the premium, as the case may be, is to be ascertained from all the circumstances of the case …

(3)

In deciding the true nature of the “discount” or premium, in so far as it is not conclusively determined by the contract, the following matters together with any other relevant circumstances are important to be considered, viz, the term of the loan, the rate of interest expressly stipulated for, the nature of the capital risk, the extent to which, if at all, the parties expressly took or may reasonably be supposed to have taken the capital risk into account in fixing the terms of the contract.

In this summary I have purposely confined myself to a case such as the present where a reasonable commercial rate of interest is charged. Where no interest is payable as such, different considerations will, of course, apply. In such a case, a “discount” will normally, if not always, be a discount chargeable under para (b) of Rule 1 to Case III. Similarly, a “premium” will normally, if not always, be interest. But it is not necessary or desirable to do more than to point out the distinction between such cases and the case of a contract similar to that which we are considering.

Questions

3.69

When a transaction involves discounts, premiums and interest as in Peter Dixon what principles are applied in determining which elements in the transaction are taxable apart from the effect of legislation? Is there any inconsistency in suggesting that where the parties choose to express the risk in a transaction in an interest rate, the interest is taxable, while where they choose to express it in a discount or premium, it may not be taxable?

3.70

Would it make any difference in Peter Dixon if the lender were a financial institution? (Compare Mutual Acceptance Ltd v FCT (1984) 15 ATR 1238; 84 ATC 4831.) [3.455]

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3.71

Discounts might now be assessable under CGT. In what circumstances would a taxpayer prefer to be assessed on a discount under CGT rather than under s 6-5?

(ii) Deep discount debt securities – Div 16E and TOFA [3.460] In the absence of any special recognition rules, a fully assessable discount would still

be far more desirable than ordinary interest to most taxpayers. That is because the discount would not be taxable until it is realised upon redemption or sale of the security, while annual interest would be taxable each year, as it is derived. In effect, the taxpayer deriving her or his gain by way of a discount can “reinvest” each year’s gain, since the final discount will be based on a compounding formula, while the taxpayer deriving annual interest will lose up to half of the gain to tax and have far less to reinvest each year. Division 16E of the ITAA 1936 was enacted to eliminate the disparity in treatment between assessable discounts and ordinary interest. Div 16E treated assessable discounts as the equivalent of compound interest and provided for annual assessment of an appropriate part of the gain. Division 16E was not a base-broadening provision, however. It only applied to discounts that would be assessable income; if a discount is not otherwise assessable, it would not be affected by the Division. As we shall see in Chapter 12 (on Statutory Accounting Regimes), Div 16E was replaced by the Taxation of Financial Arrangements (TOFA) regime which was more ambitious – it applies to all discounts on qualifying securities, whether or not the discount would have an income nature. Division 16E, and now TOFA, only apply to securities issued at a deep discount (and other securities where the return is other than by way of normal interest). The legislation uses the term “eligible return” to describe the discount. The formula in the legislation which measures whether the discount is large enough compares the eligible return to a benchmark return calculated as 1.5% of the payments to be made to the lender apart from interest (ie in most cases, simply the nominal principal amount) multiplied by the number of years of the loan. If the eligible return exceeds the benchmark return and other conditions are satisfied (such as the term being more than one year), the security is one to which TOFA will apply. The operation of the formula can be illustrated with two loans, each with a face value of $100 and each with a 10-year term. The first note is issued at $90, while the second is issued at $80. In both cases, the benchmark return will be .015 × 100 × 10 = $15. The eligible return for the first note is $10, while the eligible return for the second is $20. The first is not a qualifying security, while the second is. Notice also that note has to be issued at a discount to fall within TOFA – if discount is pure market discount (a note with a face value of $100 was bought on market for $80), TOFA does not apply. (iii) Traditional securities [3.470] The only inclusion provision explicitly covering non-assessable discounts apart from

the TOFA regime is s 26BB, which applies to “traditional securities” as they are called in the section. Traditional securities are defined as discounted notes with no eligible return (ie they carry only interest), or with an eligible return but less than the benchmark return. Typically this provision will apply to market discount. Like TOFA, s 26BB changes the character of gains and renders assessable discounts and other gains that might not have been assessable as income according to judicial concepts. Although discount and other returns which are not ordinary income would nowadays 124

[3.460]

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generally be caught by the CGT, s 26BB ensures that indexation and the CGT discount are not available to what are essentially interest equivalents. Section 26BB is complemented by s 70B, which allows taxpayers a deduction for losses suffered on the disposal of a traditional security. Section 70B was amended in 1992 in response to the collapse of a number of financial institutions. It was feared that investors in those institutions would be able to utilise s 70B to deduct losses that were not related to ordinary discounts or redemptions (based on fluctuations in interest rates and market conditions) but which were instead the result of financial collapse. Such losses can be recognised as capital losses. The Court held in Burrill v FCT (1996) 67 FCR 519; 33 ATR 133; 96 ATC 4629 that s 70B is based on historical cost and not the time value of money. In the case, a depositor in a failed financial institution received 25% of the amount deposited from the liquidator and the remaining 75% by way of a government note payable in four years without interest. Even though the depositor had clearly made a loss in being kept out of his money for four years, the Court held that no loss arose under s 70B. Nevertheless s 70B has been the source of claims for substantial deductions and it is likely that on balance the government has lost rather than gained revenue from the enactment of ss 26BB and 70B. [3.475]

3.72

Question

In 1999 A acquires a low-interest note, which does not fall within Div 16E, at below its issue price because of market discount. One year later A gifts the note to B when its market price has risen but is still below the issue price. B holds the note to redemption. How are A and B taxed, if at all, with respect to the note?

(iv) Annuities [3.480] Annuities are a regular series of payments received by a person usually for a fixed

term of years, or for life. Originally annuities were created under wills and trusts, but in modern times they are generally paid to a person in return for a single premium provided to the financial institution paying the annuity. Modern annuities are akin to a principal and interest (blended) loan made by the annuitant to the financial institution, one in which the borrower (financial institution) pays interest and principal over the life of the loan through a series of regular payments. (Most home mortgages and consumer loans such as car loans are principal and interest loans, though in these cases it is the financial institution that is making the loan rather than receiving it.) In such loans, the first payments are mostly interest, with a small principal repayment amount, but the principal repayment component increases over the life of the loan as the outstanding principal is reduced and the resulting interest charge lowers. Although purchased annuities are effectively comprised partly of interest and partly of principal, annuity payments are characterised entirely as income according to judicial concepts. The earliest annuities were charges on trusts or estates (usually to provide for a dependant and consequently for the life of the dependant). They were not purchased and payments were treated as “income” payments under the periodical receipts principle: see Chapter 6. English courts applied the same treatment to purchased annuities for UK income tax purposes and, not surprisingly, Australian courts followed the UK approach despite the different basis of our legislation. In the case of purchased annuities, the courts speak of a “capital” amount being transformed to a stream of “income” amounts. Modern annuities are effectively an alternative form of investment. However, the application of old UK doctrines to modern annuity payments is not as irrational as it might [3.480]

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appear to be at first glance. Many modern annuities are “life” annuities, issued by life insurance companies. Payments are calculated as if the annuitant (the person who receives the payment) were to receive them for a fixed period, namely the rest of their life, as determined by the insurance company’s actuaries. But the exact total of the payments is unknown, since the annuitant’s actual lifespan is unknown. Annuitants who live longer than expected are paid from the extra funds available to the insurance company from annuitants who die earlier than expected. Since the total amount of the payments is unknown, the principal and interest components of each payment are not obvious – hence the judicial rule to characterise all the payments as income. The rule is applied to fixed-term annuities as well, even though the interest and principal can be easily calculated in these cases. To assess all of a purchased annuity payment is obviously unfair, since there would be no recognition of the amount paid by the annuitant to acquire the annuity payments. Not surprisingly, legislation has long since overturned the judicial rule in part by allowing a taxpayer to reduce the amount of income by allowing for the cost of the annuity (it is not, however, a deduction in the sense of Div 8 of the ITAA 1997). The reduction formula, in s 27H of the ITAA 1936, is not based on the actual proportions or estimated proportions of interest in each payment. Instead, the taxpayer is allowed to pro-rate the capital (called the “undeducted purchase price”) over each payment and reduce each annuity payment by an equal amount. In the case of a life annuity, the deductible amount is calculated as if the taxpayer were going to live the exact period estimated by the Commonwealth actuary. In terms of elderly persons investing in annuities to be paid for the rest of their lives, this treatment makes sense. They wish to secure money for the rest of their lives and to have an even profile of income for tax purposes over that period. As s 27H originally applied to all purchased annuities, however, it gave rise to opportunities for tax planning because the taxation of the income in an annuity differs from the taxation of the interest component in a principal and interest loan. Hence taxpayers with different tax positions could exploit the timing differences. The legislative response to such schemes is found in s 159GP(10) which defines annuities other than ineligible annuities to be qualifying securities. Ineligible annuities are defined in s 159GP(1) as annuities issued by insurance companies to individuals. Annuities that are treated as qualifying securities are specifically taken out of the s 27H pro-rata recognition formula by s 27H(4). The effect of these provisions is to treat purchased annuities (issued by someone other than an insurance company) as principal and interest loans and to recognise the “interest” component on a compounding basis over the life of the annuity. The sections have no effect on annuities issued by insurance companies and have done nothing to inhibit the marketing of investment annuities by that sector. This treatment will effectively continue under the TOFA regime, see s 230-460(1), (5). The taxation of annuities and other periodic payments is further considered in Chapter 6. [3.485]

3.73

126

Question

A purchases an annuity of $30,000 per year for a cost of $250,000. The term of the annuity is for the life of A and on her death, for the life of B with the annuity payable after A’s death to B. How are A and B taxed, if at all, on the annuity payments? Assume that for the purposes of s 27H, A’s life expectancy is five years and B’s 12.5 years. [3.485]

Income from Property

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Implicit interest or purchase price [3.490] One effect of the exemption from taxation of long-term capital gains prior to 1985

was the encouragement of vendor-provided finance by way of instalment sales. If the purchaser of property did not have the cash to pay for the asset at the time of purchase, the vendor could lend the purchase price to the purchaser and, in addition to the non-assessable capital gain realised on the sale of the asset, derive interest income over the loan period. An alternative arrangement was for the vendor to allow the purchaser to pay for the property on an instalment basis, over time. From an economic perspective, an instalment sale was similar to a vendor-provided principal and interest loan. Quite clearly, no vendor in a normal commercial transaction would allow a purchaser to pay over an extended period of time without explicitly charging interest on the unpaid balance or implicitly imposing an interest charge by adjusting the “sale” price upwards to reflect the delayed payments. The legislature adopted s 262 of the ITAA 1936 to ensure the implicit interest component of instalment sale payments was assessable. This section forestalls arguments against apportionment of the kind discussed in Chapter 2. To successfully assess the implicit interest component of instalment sale payments, the ATO had to show that the payments contained an “income” component in the face of the taxpayer’s assertion that the entire amount was merely a delayed payment of part of the purchase price. One of the leading examples of judicial characterisation of instalment payments is the House of Lords’ decision in Scoble. The case contains an interesting twist in that it was the taxpayer who sought dissection of the instalment payments into interest and principal components, not the UK revenue authorities. The tax dispute arose out of a transfer of land by the East India Company to a railway company. The agreement provided that the East India Company could purchase the railway after 50 years and in that event, instead of paying the purchase price in one sum, could elect to “pay an annuity” over 49 years. The agreement stated that “the rate of interest which shall be used in calculating such annuity” was to be tied to the Bank of England interest rate. The powers of the East India Company were vested in the Secretary of State for India who exercised the option to purchase the railway and elected to pay for it by the annuity. The issue raised was whether the “annuity” was taxable in full or only as to the interest element. The House of Lords held that only the interest element was taxable.

Scoble v Secretary of State for India [3.500] Scoble v Secretary of State for India [1903] AC 299 The loose use of the word “annuity” undoubtedly renders a great many of the observations that have been made by the Attorney-General and Solicitor-General very relevant to the question under debate. Still, looking at the whole nature and substance of the transaction (and it is agreed on all sides that we must look at the nature of the transaction and not be bound by the mere use of words), this is not the case of a purchase of an annuity; it is a case in which, under powers reserved by a contract, one of the parties agrees to buy from the other party what is their property

and what is called an “annuity” in the contract and in the statute is a mode of making the payment for that which had become a debt to be paid by the government. If it was to be a debt paid by the government, it introduces this consideration: was it the intention of the Income Tax Act ever to tax capital as if it was income? I think it cannot be doubted, both upon the language of the Act itself and the whole purport and meaning of the Income Tax Acts, that it never was intended to tax capital, as income at all events. [3.500]

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The Tax Base – Income and Exemptions

Scoble v Secretary of State for India cont. Under the circumstances, I think I am at liberty so far to analyze the nature of the transaction as to see whether this annual sum which is being paid is partly capital, or is to be treated simply as income; and I cannot disagree with what all the three learned judges of the Court of Appeal pointed out, that you start upon the inquiry into this matter with the fact of an antecedent debt which has got to be paid; and if these sums, which it cannot be denied are partly in liquidation of that debt which is due, are to be taxed as if they were income in each year in which it is being exacted, the result is that you are taxing part of the capital. As I have said, I do not think it was the intention of the Legislature to tax capital, and therefore the claim as against a part of those sums fails.

My Lords, as I have already said, I do not think it is a matter on which one can dogmatize very clearly. Where you are dealing with income tax upon a rent derived from coal, you are in truth taxing that which is capital in this sense, that it is a purchase of the coal and not a mere rent. The income tax is not and cannot be, I suppose from the nature of things, cast upon absolutely logical lines and to justify the exaction of the tax the things taxed must have been specifically made the subject of taxation, and looking at the circumstances here and the word “annuity” used in the Acts, I do not think that this case comes within the meaning which (using the Income Tax Acts themselves as the expositors of the meaning of the word) is intended by the word “annuity” and that is the only word that can be relied upon here as justifying what would be to my mind a taxation of capital.

[3.510] In Vestey v IRC, the taxpayer sold shares valued at £2 m for the sum of £5.5 m

expressed to be payable without interest by 125 annual instalments of £44,000. In default of payment of an instalment, interest on the unpaid instalments became payable at 4%. There was evidence in correspondence that the £5.5 m had been derived using a net interest figure of 2% on £2 m but there was no evidence that the taxpayer was aware of this correspondence or had assented to it. The Revenue sought to tax the whole amount of each instalment as an annuity while the taxpayer claimed that none of it was taxable, and as a fall-back position argued for apportionment of the instalments into principal and interest elements. Cross J chose to apportion each payment into principal and interest components.

Vestey v IRC [3.520] Vestey v IRC [1962] Ch 861 But the agreement takes the form of a sale for a purchase price equal to the aggregate of all the instalments and that, says counsel for the appellant, differentiates this case from the Scoble case. He says that the provision for payment of the whole balance of the purchase price on default of payment of an instalment … shows – if the point be material – that the figure of £5,500, 000 is a real figure. He says further, and says truly, that no case can be found in which the courts have dissected sums which were expressed to be instalments of a purchase price into capital and

128

[3.510]

interest elements. Finally, he relies strongly on a statement of the law by Romer LJ in CIR v Ramsay (1935) 20 TC 79 at 98. Romer LJ, in the Ramsay case said: If a man has some property which he wishes to sell on terms which will result in his receiving for the next 20 years an annual sum of £500, he can do it in either of two methods. He can either sell his property in consideration of a payment by the purchaser to him of an annuity of £500 for the next 20 years, or he can sell his property to the purchaser for £10,000, the £10,000 to be paid by

Income from Property

Vestey v IRC cont. equal instalments of £500 over the next 20 years. If he adopts the former of the two methods, then the sums of £500 received by him each year are exigible to income tax. If he adopts the second method, then the sums of £500 received by him in each year are not liable to income tax, and they do not become liable to income tax by it being said that in substance the transaction is the same as though he had sold for an annuity. The vendor has the power of choosing which of the two methods he will adopt, and he can adopt the second method if he thinks fit, for the purpose of avoiding having to pay income tax on the £500 a year. The question which method has been adopted must be a question of the proper construction to be placed upon the documents by which the transaction is carried out. In this case counsel submitted that the parties have clearly chosen the second of the two methods to which Romer LJ referred. Counsel for the Crown first submitted that this was a sale in consideration of an annuity, and not a sale for a purchase price payable by instalments at all. The sum of £5,500,000, they said, is simply the aggregate of the instalments, and cannot properly be described as the purchase price. If there was any purchase price it was £2,000,000. Further, even if periodic payments of sums without interest, the aggregate of which exceeds the present value of the property sold, can be properly described as instalments of purchase price if the period is relatively short, they cannot be so described if the period is as long as this. Finally, on this branch of the argument they submitted that the wording of the agreement was more consistent with a sale for an annuity than a sale for a purchase price payable by instalments. In my judgment, this last point has no substance in it. The agreement follows closely the wording of familiar precedents for a sale in consideration of a purchase price payable by instalments … with, of course, the difference that the precedents envisage that the purchase price will be the value of the property at the date of

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sale and provide for payment of interest from time to time on the outstanding balance whereas here no interest is payable but the purchase price is far more than the value of the property sold at the date of sale. Again, if Romer LJ is right, it seems to me to follow that the £5,500,000 can properly be regarded as the purchase price of these shares. The £10,000 in his example must clearly have been more than the value of the property at the date of the supposed sale. If it had been worth £10,000 the annuity would have been more than £500 a year. He is, I think, saying, quite clearly and unmistakably, that a man who wishes to exchange a capital asset for a right to receive annual sums over a period of years can avoid paying any tax on the annual sums by selling the asset for a sum in excess of its then value, to be paid by instalments over a period without interest. That is precisely what the appellant has done here. It is, of course, true that the period chosen is longer than the 20 years given by Romer LJ, but, as I have already said, I cannot see how the length of the period can make a difference. I asked counsel where he would draw the line. He suggested that a proper limit to take might be the expectation of life of the vendor; but this would mean that a transaction which would have one result for tax purposes if the vendor was 25 would have another if he was 75. The question cannot be one of degree. It is a point of principle, and if Romer LJ was right I think that the appellant is entitled to succeed. Then was Romer LJ right? I am conscious that it must appear presumptuous in me to question the correctness of a clear and positive statement of the law made by Romer LJ, but, try as I will, I cannot see how the second branch of the proposition can be reconciled with the decision of the House of Lords in Scoble’s case … It is, of course, true that in Scoble’s case the value of the property sold and the rate of interest taken for the purpose of fixing the amount of the annuity appeared on the face of the documents whereas in this case these facts have been established by outside evidence. But I think that later cases … make it clear that this makes no difference. Then, if it is not the law that by selling property for an annuity for a fixed period you subject the whole annuity to tax, why should it be the law that by [3.520]

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Vestey v IRC cont. selling property for a purchase price greater than its present value payable by annual instalments you free the whole of each instalment from tax? If

the Crown cannot say that there is any magic in the use of the word “annuity”, why should the taxpayer be able to say that there is any magic in the use of the words “purchase price”?

[3.525]

Questions

3.74

Where property is sold in return for a series of payments, on what basis, in view of these cases and Peter Dixon, may all the payments be taxable? When are none of them taxable? When will the courts dissect such payments into taxable and non-taxable elements?

3.75

What is the effect of s 262 of the ITAA 1936 in cases of this kind? How does that section relate to the attitude to apportionment revealed in McLaurin v FCT: see Chapter 2.

3.76

To what extent were the courts influenced by the notion of income as a gain in deciding these cases?

[3.530] Another legislative response to the difficulties in dissecting the interest and principal

components of instalment sale payments appears in ss 103-10 and 103-15 which operate through ss 116-20(1) and 110-25(2). These include in the capital proceeds or cost base all amounts paid or payable in the future to the vendor (and correspondingly for the purchaser). The effect of the provisions is to bring forward to the time of sale all future payments, including implicit interest components. They are dealt with further in Chapter 12. It will be apparent that the current law in relation to the taxing of financial assets and liabilities consists like much else of a patchwork of provisions added to ordinary concepts of income over the years. Seventeen years after the original announcement in 1992, the TOFA regime came into effect in 2009 and 2010 to deal with financial instruments more consistently (see Chapter 12) but it will be apparent from the brief comments on TOFA above that the rules will still to some extent be a patchwork.

(b) Rent, Premiums, Repairs and Leasehold Improvements (i) Rent and premiums [3.540] The term rent is traditionally applied to the receipt by an owner of property of payments for the use of the property by another. In the case of real estate, rent is the periodic payment by the tenant/lessee (user of the property) under a lease to the landlord/lessor (owner). Property law regards the grant of a lease as a conferring on the tenant/lessee of an interest in the land, and so the transaction may be characterised as the disposal of property by the owner to the lessee, on the one hand, or as the use of the lessor’s property by the lessee, on the other. Rental payments, received in respect of the use of property, have always been considered income according to ordinary concepts. On the other hand, premiums or payments given in respect of the grant of a lease have often been characterised as non-assessable capital gains, unless they could clearly be identified as amounts paid in lieu of ordinary rent or were received 130

[3.525]

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in the ordinary course of a property business. The distinction between rent and premiums is thus similar to that between capital premiums or discounts and interest payments drawn by Lord Greene in Lomax v Peter Dixon. The artificiality of this distinction led to a number of different approaches to lease premiums in the income tax legislation over the years. In the ITAA 1997 the matter is primarily left to the CGT in cases where a premium is not ordinary income. Event F1 on premiums is designed to tax lease premiums without a cost base and without the benefit of the transitional rule for pre-CGT assets. Otherwise it was argued that it may have become common to replace rent with lease premiums for any pre-20 September 1985 land. Other F events deal with various transactions in leases and there are also special rules on leases in the capital proceeds rules in ss 116-20, 116-25 and 116-75, and in Div 132. [3.545]

3.77

3.78 3.79

3.80 3.81

Questions

Do you agree with the argument referred to above that treating leases as disposals of part of an asset would have led to the conversion of rent of assets acquired prior to 20 September 1985 to premiums? In answering this question consider the position of the lessee. Do you think that the rules on lease premiums as regards the lessor and lessee are correct in principle? Are the special CGT lease rules confined to land or do they encompass “leases” of other assets? What happens if a lease is prematurely determined in return for a payment from the lessee to the lessor, or from the lessor to the lessee? What happens if a lease is extended in return for a payment from the lessee to the lessor, or from the lessor to the lessee? (See also the discussion of FCT v Cooling and following cases in Chapter 5.) What happens if the lessee acquires the interest of the lessor in the leased property? Why are there special rules for long-term leases and Crown leases in the CGT? (See also Subdiv 124-J.)

(ii) Repairs [3.550] Almost all lease agreements provide for one or both of the parties to the lease to

assume some responsibility for repairing the leased property. A common arrangement is for the lessee to assume responsibility for repairs caused by day-to-day wear and tear, and for the lessor to assume responsibility for structural repairs. Does the assumption by the tenant of this obligation to repair defects represent additional (non-cash) income to the landlord? The division of responsibility for repairs will usually be reflected in the rate of rent charged. In theory, so long as the lessee is using the rented premises to derive assessable income, he or she should be indifferent between higher rent and less responsibility for repairs, and lower rent and more responsibility for repairs – rent will be deductible as an ordinary business expense and the cost of repairs will be deductible under s 25-10. The lessor, in theory, should also be indifferent between these two options. If the first alternative is incorporated into the lease agreement, higher rental income will be offset by larger repair deductions. If the lessee fails to comply with a lease covenant to repair the premises, the lessor will have grounds for recovering compensation. In the absence of statutory measures, payments of this type usually would neither be deductible to the lessee nor assessable to the lessor as ordinary income. Section 25-15 allows the lessor a deduction for such expenses, provided the rented property is used to derive assessable income. That section is complemented by s 15-25 which [3.550]

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includes the compensation or damages in the lessor’s assessable income where the lessee would be allowed a deduction for the payment under s 25-15. [3.555]

3.82

Question

The taxpayer rented a house to a tenant for a weekly rental. The parties signed a standard form rental agreement purchased at a local stationery store. The agreement provided for a bond of six weeks’ rent to be held in trust until the end of the lease period, at which time it would be returned to the tenant provided the property had been kept in good repair. In the event of non-compliance with the repair covenant, the lessor would be entitled to keep the bond. Shortly before the lease was due to expire, the tenant abandoned the premises, leaving them in a poor state of repair. The landlord withdrew the bond payment and used it to help pay the repair costs she incurred. Is the bond money assessable to the landlord under CGT? Does the CGT render s 25-15 unnecessary?

(iii) Leasehold improvements [3.560] We noted earlier that basing the CGT on assets may enable some gains that would be

encompassed by a comprehensive income concept to continue to escape taxation. One type of gain that may fall into this camp is leasehold improvement gains. Leasehold improvement gains are realised by lessors when their tenants improve leased property and leave the improvements on the property when they vacate at the end of the lease. Leasehold improvement gains generally will not be assessable as ordinary income. [3.565]

Questions

3.83

In 1986, an English company with operations in Australia leased a rental property for an employee it was transferring to Sydney from the head office in London for a six-year period. When negotiating the lease arrangements, the lessee requested permission to pave the driveway on the property and construct a garage. The understanding of the parties was that under relevant State property law both the driveway and garage would revert to the lessor at the end of the lease. The lessee put in a paved driveway that cost $3,000 and a garage that cost $15,000. At the end of the lease period, both the driveway and garage remained in good condition. Because building costs had climbed substantially over the intervening six years, the estimated value of the paved driveway and garage was $26,000 at that time (ie valuers said the property was worth $26,000 more with the improvements than it would have otherwise been). Does a CGT event occur for the lessor as a result of these events? (See Determinations TD 46 – TD 48.)

3.84

What happens under the CGT if a lessor pays a lessee on termination of a lease for fixtures that the lessee has attached to the leased property?

(c) Royalties [3.570] Many payments called royalties will constitute ordinary income from property and be

assessable under s 6-5. Amounts which are “royalties” but do not fall within s 6-5, are assessable under a specific inclusion provision, s 15-20. Notice that s 15-20 goes to some pains to say that it only applies to royalties “disregarding the definition of royalty” that exists in the Act. The point being emphasised is to ignore the definition of royalty because that definition was enacted only for the flat-rate gross withholding on payments made to non-residents. So, the scope of s 15-20 is limited by two 132

[3.555]

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exclusions: it does not apply to amounts which are already ordinary income, and it only applies to amounts that are royalties in common parlance. It is not clear what payments, if any, will nowadays fall within s 15-20. The term “royalties” has a broad range of meanings, not all of which carry over to its usage in the tax law. In general speech it is used to describe a range of gains that, apart from bearing a common label, have little resemblance to each other in a legal or economic sense. The royalties with which most laypersons are familiar are royalties paid for the use of intellectual property such as patents, copyrights or registered designs. Royalties for the use of intellectual property are commonly paid on a per-unit basis – a set amount for every book, tape or CD sold, so much for every watch produced with a particular brand name, so much for every product made using a protected process, and so on. With changing commercial practice, royalty entitlements have been extended to intellectual knowledge that falls short of “property” but nevertheless may receive legal protection under the law relating to confidential information. Examples of such knowledge include secret processes and “know-how”: compare Ruling TR 98/3 which has been extracted above. The term “royalties” may also be used to describe the periodic payments made for the assignment of intellectual property rights. The authors of this book, for example, will receive payments called royalties in the contract based on its sales, even though they have retained no legal interest in the copyright. That has been transferred lock, stock and barrel to the publisher in return for periodic payments calculated on a “per book sold” basis. “Royalties” has another quite different usage to describe the payments made to a real property owner for the exploitation of natural resources such as minerals or timber located on the property owner’s land. These payments are usually calculated on a “per unit of measurement” basis – so much per tonne of gravel, per linear metre of timber, and so forth. The distinction between a payment for use and a payment for assignment is very tenuous in the case of intellectual property, which may be broken up by time and geography, and in the case of land where part of the land is being removed (which may in turn be renewable like timber or non-renewable like minerals). Further, it is quite common in both these areas for transactions to contain both lump sum and periodic per-use payments. This is particularly common where the purchaser has some doubts about the value of property and the vendor some confidence about its value. For example, the vendor of mining rights might “sell” the rights for $1 m plus $10 per tonne of mineral extracted. Similarly, the Parisian owner of a clothing design might “license” all Australian rights to her “designer label” to an Australian manufacturer for a lump sum and a payment per item of clothing produced. Even where property is transferred outright, as was the case with the copyright to this book, subsequent payments will be considered ordinary income provided they are based on use or exploitation of the property. On the other hand, if payments are for the transfer of the property, without reference to subsequent use or exploitation, they will be capital amounts even if paid on a periodic basis (as in an instalment sale situation). The correct characterisation of payments remains important – though much less so than previously – even following the enactment of CGT for a number of reasons. Leaving aside the obvious case of a “sale” of a pre-20 September 1985 asset, the most important consequence of characterisation is timing. If future payments are assessable as ordinary income or under s 15-20, they are in effect excluded from the calculation of an assessable capital gain from the sale by s 118-20 and enter assessable income only as received. As s 15-20 has only a residual operation, if any, we consider the case law on it very briefly. [3.570]

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(i) Payments for natural resources [3.580] The gains realised by a land owner for the sale of resources found under, or on, or

growing on her or his land may be assessable as income from business – a mining, quarrying or farming business, as the case may be. If the land owner instead allows another person to extract a resource from the property, payment for the resource may be a capital or income payment, depending on how the land owner structures the transaction. Prima facie, a sale of resources on a per-unit basis will generate ordinary income (and royalties within s 15-20 apart from the exclusion of ordinary income from that provision), while the sale of a “right to remove” minerals or timber for a lump sum calculated without direct reference to the amount of resources extracted will be a capital receipt, consideration for the sale of a property interest and not within s 15-20. These propositions flow from two cases concerning removal of timber from land. In McCauley v FCT (1944) 69 CLR 235; 3 AITR 67, the taxpayer was a dairy farmer who had trees growing on his land. He made a written agreement with one Thomas Laver, in which he was described as the vendor and Laver as the purchaser. The vendor agreed to sell and the purchaser agreed to purchase the right to cut and remove the standing milling timber then growing on specified land “at or for a price or royalty of three shillings (3s) for each and every one hundred (100) superficial feet of such milling timber so cut”. The purchaser agreed to cut and remove all the milling timber from the property within a period of 12 months and to pay the price or royalty under the contract monthly. The agreement contained provisions for monthly statements of timber removed and for what may be described as a minimum of interference with the use of the property, as a grazing property. The High Court held that the payments received were assessable under s 15-20. In the next case, Stanton v FCT (1955) 92 CLR 630; 6 AITR 216, the taxpayer went out of his way to draft the agreement for the taking of timber so as to avoid the result in McCauley’s case. The taxpayer, who was a grazier, was entitled as tenant in common with another grazier to a piece of land upon which stood a quantity of pine timber and of hardwood timber. On 12 September 1951 they entered into an agreement with a sawmiller in which they sold 500,000 super feet of millable pine timber and 2,500,000 super feet of millable hardwood timber with the right to cut and remove the timber from the land. If trees were less in girth than certain measurements they were excluded. The price was £17,500, of which £7,500 was apportioned to the pine timber and £10,000 to the hardwood timber. Of the price, £500 was to be paid as a deposit and £17,000 by equal quarterly payments of £1,416 13s 4d without interest. For s 15-20 to apply the Court considered that, “it is inherent in the conception expressed by the word royalty that the payments should be made in respect of the particular exercise of the right to take the substance and therefore should be calculated either in respect of the quantity or value taken or the occasions upon which the right is exercised”. This element was lacking in the agreement in this case, unlike McCauley’s case, and the payment was therefore outside s 15-20. Ordinary income did not receive specific consideration in the judgments in either case. It was apparently assumed that the two questions (ordinary income and royalty) were identical. A number of cases from other common law jurisdictions quoted in the judgments concerned income tax statutes where this identity is clear and perhaps this is why the High Court did not deal separately with the two issues. 134

[3.580]

Income from Property

[3.585]

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Questions

3.85

Can you see any convincing distinction between McCauley and Stanton? In Stanton, although not explicitly mentioned in the judgment, the payments were to be made over a three-year period, and the timber was to be removed over the same period in a steady progression. Is this relevant to any distinction between the cases?

3.86

A taxpayer who owns land, but not the minerals on the land (a common position in Australia where minerals are reserved to the Crown), grants a miner the right to cross his land to remove minerals to which the miner is entitled under mining legislation. The agreement provides for a payment per tonne of minerals removed and expresses the payment to be for damage to the land from the transport of the minerals and for putting the land back into its original condition. Are the payments pursuant to the agreement taxable under s 15-20 or otherwise? (See Barrett v FCT (1968) 118 CLR 666.) A taxpayer who owns a company, the business of which is the sale of timber sleepers to the railways, purchases a farm for a hobby and then enters into a series of Stanton agreements for the sale of timber on the land to the company. Are the payments under the agreements taxable under s 15-20 or otherwise? (See White v FCT (1969) 120 CLR 191.) How do the results in the cases accord with the concept of income as gain? Can any distinction be drawn between the taxation of timber and minerals because the former is a renewable resource whereas the latter is not? How would the CGT apply to the agreements in McCauley’s and Stanton’s cases? Would it make any difference if the land on which the trees were growing was acquired before 20 September 1985, and in that event if the relevant trees were planted after 1985? Do these cases reflect an income concept based on gains or flows? What do you think is the most appropriate way to tax these kinds of transactions?

3.87

3.88

3.89

3.90

(ii) Intellectual property and know-how [3.590] Unlike tangible property, which has a physical basis, intellectual property and

know-how exist only as intangible legal rights and information. The inherent value of intellectual property and know-how is minimal; its value derives from exclusivity: a patent is of value only because it entitles the holder to produce something that no one else is legally able to produce without the permission of the owner of the patent. Similarly, know-how can be marketed only so long as the knowledge is not freely available elsewhere. The importance of exclusivity to the value of intellectual property and know-how add an important dimension to the problem of characterising payments received in respect of these rights and information. Payments may be made not only for the transfer of property or right to use property or information, but also for the vendor’s or owner’s agreement to refrain from continuing to use the rights or communicating the information to others. Depending on exactly what the taxpayer has provided for the payment received, the consideration may be characterised as a royalty payment, as an income amount but not a royalty, or as an assessable capital gain. The difficulties inherent in the process of distinguishing the purpose of payments and their consequent income or capital characterisation is well illustrated in the judgment of Lord Denning MR in Murray v Imperial Chemical Industries Ltd [1967] Ch 1038. [3.590]

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Murray v Imperial Chemical Industries Ltd [3.600] Murray v Imperial Chemical Industries Ltd [1967] Ch 1038 In the 1950s, the taxpayer company, Imperial Chemical Industries Ltd were exploiting a new fibrous material which they called Terylene. They manufactured it on a large scale at Wilton, but they could not make enough to meet the world demand. So they granted exclusive licences to foreign companies in various countries. In each licence they covenanted that they would not themselves enter the market for that country. They covenanted to “keep out” of that country. In return for these “keep out” covenants, they received considerable sums of money from the overseas companies. The question is whether these sums are part of the profits of the taxpayer company which should be brought into tax. The amount of tax involved is over £1 million … The master patents for Terylene were owned by the Calico Printers’ Association (CPA), who granted the taxpayer company an exclusive licence to exploit them and to grant sub-licences to others. The ancillary patents were owned by the taxpayer company themselves but they were unable themselves to exploit the world market for Terylene. So they granted sub-licences … A typical sub-licence was that granted by the taxpayer company to a Dutch company covering the Netherlands and Belgium. (i) The taxpayer company granted to the company an exclusive licence to use the major patents (owned by CPA) in return for a royalty based on the net invoice value of the Terylene products sold or utilised. (ii) The taxpayer company granted an exclusive licence to use the ancillary patents (which they owned) in return for a royalty of £10,000 a year for ten years. (iii) The taxpayer company agreed to provide “know-how”. No separate consideration was stated for “know-how”, because they expected to get their return by way of the royalties coming in sooner. (iv) The taxpayer company agreed to “keep-out” of the Netherlands, Belgium, and, in addition, Luxembourg, and not to operate there in the patented article Terylene or in products similar to Terylene for the period of the patent and a little longer. In return for this “keep-out” covenant, the licensee agreed to pay the sum, described as 136

[3.600]

a capital sum, of £400,000 payable by six equal annual instalments, but the licensee had the option of discharging the annual instalments by one payment … The question for decision is as to the £400,000 payable for the “keep-out” covenant by annual instalments. Was it a trading receipt and taxable as part of the income of the taxpayer company or was it a capital receipt which is not taxable? In considering this question, I would point out that this “keep-out” covenant is not a covenant “in gross”. It does not stand by itself. It is ancillary to the grant of a licence. Its effect can best be understood by remembering the different kinds of licence with which we are familiar. An ordinary “licence” is a permission to the licensee to do something which would otherwise be unlawful. It leaves the licensor at liberty to do it himself and to grant licences to other persons also. A “sole licence” is a permission to the licensee to do it, and no one else, save that it leaves the licensor himself at liberty to do it. An “exclusive licence” is a permission which is exclusive to the licensee, so that even the licensor himself is excluded as well as anyone else. A “keep-out” covenant is a covenant which bolsters up an exclusive licence. It makes express that which would otherwise be implied. The licensor covenants expressly with the licensee that he will not enter on the domain which he has granted to the licensee. In the present case the “keep-out” covenants are somewhat wider than the exclusive licence in area, time and products; but this makes no difference to the tax position. The receipts by the taxpayer company bear the same character – capital or income – no matter whether the “keepout” covenant is co-extensive with the licence or somewhat wider than it. In these circumstances I do not think that it would be correct to consider a “keep-out” covenant as a thing by itself. The essence of the transaction in each case is that the taxpayer company granted to the foreign company an exclusive licence to use the patents in the country concerned for the term of the patents and in return received remuneration in the shape of: (a) a royalty

Income from Property

Murray v Imperial Chemical Industries Ltd cont. payable on the net invoice value of products sold or utilised. (This was for use of the master patents of CPA.) (b) A royalty of a fixed sum payable each year. (This was for use of the ancillary patents of the taxpayer company.) (c) A lump sum payable by instalments over six years. (This was said to be for the “keep-out” covenant.) Now the taxpayer company is not a dealer in patent rights or patent licences. When they granted this exclusive licence, they were to my mind disposing of a capital asset. If this had been an assignment of patent rights, there could be no doubt that the taxpayer company would be disposing of a capital asset. I see no difference in this regard between an assignment of patent rights and grant of an exclusive licence for the period of the patent. It is the disposal of a capital asset. But this does not determine the quality of the money received. A man may dispose of a capital asset outright for a lump sum, which is then a capital receipt. Or he may dispose of it in return for an annuity, in which case the annual payments are revenue receipts. Or he may dispose of it in part for one and in part for the other. Each case must depend on its own circumstances; but it seems to me fairly clear that if and in so far as a man disposes of patent rights out-right (viz., by an assignment of his patent, or by the grant of an exclusive licence) and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If and in so far as he disposes of them for annual payments over the period, which can fairly be regarded as compensation for the user during the period,

then those also are revenue receipts (such as the royalties of £10,000 a year in the present case). If and in so far as he disposes of the patent rights outright for a lump sum, which is arrived at by reference to some anticipated quantum of user, it will normally be income in the hands of the recipient … If and in so far as he disposes of them outright for a lump sum which has no reference to anticipated user, it will normally be capital … It is different when a man does not dispose of his patent rights, but retains them and grants a nonexclusive licence. He does not then dispose of a capital asset. He retains the asset and he uses it to bring in money for him … Similarly a lump sum for “know-how” may be a revenue receipt. The capital asset remains with the owner. All he does is to put it to use. Applying these criteria, in the present case it is quite clear that the royalties for the master CPA patents and the royalties for the ancillary patents of the taxpayer company were revenue receipts. That is admitted. So far as the lump sum is concerned, I regard it as a capital receipt, even though it is payable by instalments. I am influenced by the facts: (i) that it is part payment for an exclusive licence, which is a capital asset; (ii) that it is payable in any event irrespective of whether there is any user under the licence. Even if the licensees were not to use the patents at all, this sum would still be payable; (iii) that it is agreed to be a capital sum payable by instalments and not as an annuity or a series of annual payments. In these circumstances I am quite satisfied that the lump sum was a capital receipt and the taxpayer company is not taxable upon it.

[3.605]

3.91

CHAPTER 3

Questions

How are the following payments with respect to patents and similar rights treated under ordinary income principles in the cases of disposal, and non-exclusive and exclusive licences: 1.

payment for each use of the patent;

2.

annual payments related to usage;

3. lump sum payments related to usage; and 4. lump sum payments not related to usage? (See also Rolls-Royce Ltd v Jeffrey, Kwikspan Purlin Systems Pty Ltd v FCT in Chapter 5.) [3.605]

137

The Tax Base – Income and Exemptions

3.92

3.93

Did Lord Denning draw any distinction between the tax treatment of intellectual property and know-how in Murray v Imperial Chemical Industries Ltd? Is it necessary that payments of the kinds in these cases be characterised as royalties for them to be taxable as ordinary income? What do you consider is the most appropriate way to tax transactions of these kinds?

[3.610] The operation of s 15-20 in the case of intellectual property has also been the subject

of two decisions. Because of international tax issues, the question of whether the payments were ordinary income did not arise. In each case, applying the words of the High Court in Stanton’s case in characterising royalties, it was held that the payments were not within s 15-20. In FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 7 ATR 726; 77 ATC 4365 the taxpayer was a Canadian company which entered into an agreement with Western Mining Corporation Ltd under which it agreed to provide technical assistance and know-how (none of which had been patented) to Western in respect of the Sherritt system for treating nickel ores that Western was mining in Australia. In return, Western agreed to pay the taxpayer an amount calculated as a percentage of the sale value of the nickel treated by the process. Mason J in the majority said, “Here the substantial, if not the sole, consideration for the payments was not the grant of a right but for the provision of technical assistance and information which Western was entitled to use once it was supplied, without the grant of any additional right so to do”. In the second case, Aktiebolaget Volvo v FCT (1978) 8 ATR 747; 78 ATC 4316, the taxpayer was a Swedish car company which entered into an agreement with its Australian assembler and distributor, Volvo Australia Pty Ltd, not to sell its products to any other company in Australia; to use its best endeavours to prevent companies in other countries to which it sold its products from exporting those products to companies in Australia; and not to allow any other company in Australia to use the word “Volvo”. Under the agreement Volvo Australia was obliged to pay to the taxpayer an amount equal to 4% of its sales. Jenkinson J held that the payments were not a royalty within s 15-20 again on the basis that the payments were not in respect of the grant of a right of the relevant kind as described in Stanton’s case. It was made clear in both these cases that the term “royalties” in s 15-20, putting aside the legislative definition, does not mean the same thing as it may do in everyday speech. Amendments to the definition of “royalties” in s 6(1) of the ITAA 1936 ensure that the definition catches both types of payments (see paras (c) and (f)) but the definition is mainly relevant to international situations, not domestic cases. Domestically nowadays transactions in patents and copyrights are largely dealt with both on the income and deductions side through Div 40 of the ITAA 1997 which is discussed in Chapter 10, ordinary income under s 6-5 and deductions under s 8-1. The operation of CGT is normally excluded by s 118-24. [3.615]

3.94

138

Would the payments in these two cases be ordinary income?

[3.610]

Question

CHAPTER 4 Income from the Provision of Services [4.10]

1. INTRODUCTION........................................ ................................................. 142

[4.10]

(a) The General Principle ........................................................................................... 142

[4.20]

(b) Taxation and Work Effort ..................................................................................... 144

[4.30]

2. DETERMINING INCOME QUALITY – GIFTS AND OTHER BENEFITS.... ....... 146

[4.40] [4.60] [4.80] [4.110] [4.140] [4.170] [4.190]

Hayes v FCT ............................................................................................................... Scott v FCT ................................................................................................................ FCT v Dixon ............................................................................................................... FCT v Harris ............................................................................................................... Smith v FCT ............................................................................................................... FCT v Holmes ............................................................................................................. Payne v FCT ...............................................................................................................

[4.220]

3. FRINGE BENEFITS ....................................... ................................................ 165

[4.230] [4.240] [4.260] [4.280]

(a) Background to the FBT ........................................................................................ David Collins, Taxation of Fringe Benefits – An Economist’s Perspective ........................... (i) Reasons for the non-taxation of fringe benefits ..................................................... (ii) Possible solutions .................................................................................................

165 166 168 169

[4.320] [4.330] [4.340] [4.360] [4.380] [4.390] [4.400] [4.410] [4.430] [4.510] [4.530]

(b) Operation of the FBT ........................................................................................... (i) Concept of fringe benefits provided ..................................................................... Westpac Banking Corporation v FCT ............................................................................ Roads and Traffic Authority of NSW v FCT .................................................................... (ii) Provided to employees/associates by employer/associate/arranger ...................... (iii) In respect of employment ................................................................................... Ruling MT 2016 ......................................................................................................... Ruling MT 2019 ......................................................................................................... (iv) Taxable value of benefits ..................................................................................... (v) Otherwise deductible rule .................................................................................... (vi) Integrating FBT and the ITAA ..............................................................................

170 172 172 174 176 178 179 179 181 190 193

[4.540] [4.550] [4.570] [4.580] [4.590] [4.600] [4.610] [4.620] [4.630] [4.640]

(c) Problems of FBT ................................................................................................... 194 (i) Over- and under-inclusiveness of the FBT base ...................................................... 195 (ii) Taxable value ....................................................................................................... 196 (iii) Tax rate ............................................................................................................... 196 (iv) FBT-inclusive tax base ......................................................................................... 197 (v) GST-inclusive tax base .......................................................................................... 198 (vi) Tax-exempt employers ........................................................................................ 199 (vii) Interaction with surcharges – reportable fringe benefits ..................................... 200 (viii) Problems of FBT for international placements .................................................... 200 (ix) Unallocable benefits ............................................................................................ 201

[4.650]

4. SPECIAL CATEGORIES OF EMPLOYEE REMUNERATION ............ ................. 203

[4.660]

(a) Employee Share Schemes .................................................................................... 203

147 150 153 154 155 159 161

139

The Tax Base – Income and Exemptions

[4.680] [4.690]

(b) Deemed Dividends – s 109 .................................................................................. 208 Ferris v FCT ................................................................................................................ 209

[4.710]

5. PAYMENTS FOR RESTRICTIVE COVENANTS AND VARYING SERVICE CONTRACTS ............................................ ...................................................... 211

[4.720] [4.730]

(a) Income from Services or the Sale of an Asset ........................................................ 211 Brent v FCT ................................................................................................................ 212

[4.740] [4.750] [4.770] [4.790] [4.810]

(b) Payments for Varying Contract Rights .................................................................. Scott v Commissioner of Taxation (NSW) ..................................................................... Commissioner of Taxes (Vic) v Phillips .......................................................................... Reuter v FCT .............................................................................................................. Bennett v FCT ............................................................................................................

[4.820] [4.830] [4.850]

(c) Payments for Restrictive Covenants ...................................................................... 219 Higgs v Olivier ............................................................................................................ 219 FCT v Woite ............................................................................................................... 220

[4.870]

6. TERMINATION PAYMENTS AND RETIREMENT INCOME............ ................. 223

[4.880]

(a) Retirement Incomes Policy ................................................................................... 223

[4.900] [4.910] [4.970] [4.1000] [4.1010] [4.1020]

(b) Superannuation ................................................................................................... (i) Contributions to a superannuation fund ............................................................... (ii) Tax position of the fund ....................................................................................... (iii) Regulation of superannuation funds .................................................................... (iv) Moving amounts between funds ........................................................................ (v) Taxing payments out of superannuation funds .....................................................

[4.1070] [4.1080] [4.1130] [4.1140]

(c) Other Termination and Retirement Payments – Golden Handshakes etc ............... 240 (i) Employment termination payments ...................................................................... 240 (ii) Assessment of employment termination payments ............................................... 244 (iii) Death benefit termination payments ................................................................... 245

[4.1150] [4.1160] [4.1170] [4.1180] [4.1190]

(d) ................................................................................................................................. Early Retirement, Redundancy and Invalidity Payments, and Unused Leave (i) Early retirement schemes ...................................................................................... (ii) Redundancy ........................................................................................................ (iii) Invalidity payments ............................................................................................. (iv) Unused leave payments ......................................................................................

213 214 215 216 218

225 226 233 235 237 237

246 246 246 247 247

[4.1200] 7. SALARY PACKAGING AND INCOME SPLITTING.................. ....................... 247 [4.1210]

(a) Salary Packaging .................................................................................................. 247

[4.1220]

(b) Alienation of Personal Services Income ................................................................ 251

Principal Sections ITAA 1936 s 6(1)

ITAA 1997 –

s 23L

–

140

Effect This section contains various definitions for the Act including a definition of “income from personal exertion”. This definition does not appear in ITAA 1997. This section attempts to integrate the FBT and income tax by deeming fringe benefits to be exempt income.

Income from the Provision of Services

s 25(1)

CHAPTER 4

s 6-5

This section includes a taxpayer’s gross income in her or his assessable income. ss 26(d), 27C Divs 82, 301 These rules include termination payments in the assessable income of employees if the payment is made by the employer or a superannuation fund. s 26(e) s 15-2 This section includes in assessable income the value to the taxpayer of certain benefits provided in respect of the taxpayer’s services. ss 26AC, 26AD Divs 83-B, 83-C These provisions deal with accrued long service and annual leave payments paid in a lump sum. ss 27E, 27F, 27G Div 83-C This Division deals with early retirement scheme payments, bona fide redundancy payments or invalidity payments. s 109 – This section deems excessive payments for services and retirement allowances paid to associates of a private company to be dividends. Div 13A Div 83A This Division taxes employees on the value of shares provided under an employee share acquisition scheme. Divs 84 – 87 – These Divisions enact rules trying to eliminate the tax advantages associated with being self-employed, rather than being an employee. s 290-60 – This section allows an employer to deduct (without limit) contributions to superannuation funds made for the benefit of employees. s 290-150 – This section allows self-employed taxpayers to deduct (without limit) contributions to superannuation funds made for their own benefit. Div 290-D – This Division provides a tax offset to a taxpayer who makes a contribution to a superannuation fund for the benefit the person’s spouse. Pt IX Div 295 This Division defines the amount of taxable income of a superannuation fund. Div 301 – This Division imposes tax on benefits paid by a superannuation fund to a (living) member, aged under 60. Div 302 – This Division imposes tax on benefits paid by a superannuation fund to the estate or dependents of a deceased member. Fringe Benefits Tax Assessment Act 1986 ss 9, 10 These sections provide the taxable value of a car benefit. s 18 This section provides the taxable value of a loan benefit. s 19 This section provides the “otherwise deductible” rule for loan benefits. s 20 This section defines an expense payment benefit. s 40 This section defines a property benefit. 141

The Tax Base – Income and Exemptions

s 42 s 44 s 45 ss 48, 49 s 66

s 136(1)

s 148(1)

s 148(3)

This section provides the taxable value of a property benefit. This section provides the “otherwise deductible” rule for property benefits. This section defines a residual benefit. These sections provide the taxable value of residual benefits. This section imposes FBT on the sum of all fringe benefits paid by an employer in respect of employees. This section contains the definitions necessary for FBT including the definitions of “fringe benefit”, “employer” and “employee”, and “in respect of employment”. This section broadens the definition of “in respect of” the employment of the employee given in s 136(1). This section deems a benefit to be provided where the employer does not enforce a prohibition preventing employees enjoying the benefit.

1. INTRODUCTION (a) The General Principle [4.10] In this chapter we examine the principle that an amount which is a reward for

providing services has an income character. Care needs to be taken when reading any of the extracted cases because most of the leading cases on this topic were decided according to the law pre-1985, and so without regard to the effects of CGT, FBT, etc. The cases should be approached through the sort of analysis we have already tried to outline in Chapter 2: • Is the payment in question included in assessable income because it is within the judicial concept of income? In this area, that is s 6-5 of the ITAA 1997. • Whether or not it would be within the judicial concept, is the payment included in assessable income by virtue of some specific statutory regime (for example, the payment would give rise to a capital gain)? • Does it create a fringe benefit taxable to the employer? • If the payment is included in assessable income by more than one regime, or gives rise to both assessable income and a fringe benefit, how are the tax overlaps reconciled? Nevertheless, the analysis – particularly of taxing income from services, even after 1985 – should still commence with an examination of whether the amount is income according to ordinary concepts (for which the cases are the only source). To look only at specific sections of the Act (as the High Court did in Smith v FCT (1987) 164 CLR 513) is apt to lead to the error of ignoring the lacunae, overlaps and inconsistencies of treatment with which the Act abounds. Unfortunately this method of analysis means that you will have to know something about

142

[4.10]

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almost every part of the income tax before you can begin to study any part of it. So it may be worthwhile to take a moment now to revise the material in Chapter 2 before proceeding further. The principle that a reward for providing services has an income nature, has a broad application. A payment can be income as a reward for providing services regardless of the form of the receipt, the time of remuneration or the character of the services performed. So, assessable receipts can include: an employee’s wages or the managing director’s salary; contemporaneous weekly payments, a deferred lump sum, or even anticipated payments; payments for the provision of an isolated service or for regular ongoing employment; payments which are contractually required or an unexpected bonus; payments directly from the employer or from third parties such as tips. Notice that the principle refers to a payment for providing services, and this term could refer just as easily to the activities of an independent contractor as it obviously does to those of an employee. For independent contractors, it applies to their fees, commissions, bonuses and so on. Although the principle that a reward for the performance of services is income is simple to state, it is often difficult to apply. Where difficult questions of interpretation arise, the Act, as is common with fundamental issues, gives little assistance except at the periphery. Section 6(1) of the ITAA 1936 contains a definition of “income from personal exertion” but it derives from the days when different rates of tax applied to income from personal exertion and income from property, and adds nothing to our definition of income from services except perhaps a few examples. There is a comment to this effect in Scott v FCT (1966) 117 CLR 514. The definition was not rewritten for the ITAA 1997 because the “distinction between income from personal exertion and income from property … no longer has any practical effect” according to the Explanatory Memorandum to the Tax Law Improvement Act 1996. It is interesting, therefore, that it was not for that very reason removed from the Act by the Tax Laws Amendment (Repeal of Inoperative Provisions) Act 2006. In addition to the general inclusion provision in s 6-5 of the ITAA 1997, s 15-2 of the ITAA 1997 (the rewritten version of s 26(e) of the ITAA 1936 which is mentioned often in the extracts below) contains quite a comprehensive statement that the taxpayer’s assessable income will include “the value … of all allowances, gratuities, compensation, benefits, bonuses and premiums provided to you in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by you”. It includes amounts in income whether received “in money or in any other form”. Section 15-2 is obviously quite broad, but there is a question whether it does more than state the ordinary concepts notion of income. There are suggestions in many of the early cases that its predecessor, s 26(e) of the ITAA 1936, was probably otiose (Hayes v FCT (1956) 96 CLR 47). Section 15-2(3)(d) makes it clear that the section operates only as a fallback after s 6-5 of the ITAA 1997 has been exhausted, so there will not be overlap between s 6-5 and s 15-2, but whether s 6-5 leaves any room for s 15-2 to operate is an important issue discussed later. Notice, however, that s 15-2 contains its own valuation rule – it includes in income “the value to you of …” certain benefits. This is a different formulation from the ordinary income rule which would include in income the amount into which a benefit is convertible. Hence s 15-2 may have some room for operation if it generates a different value. This chapter will examine the major issues that arise in the taxation of income from services in the following order. [4.10]

143

The Tax Base – Income and Exemptions

1.

2. 3.

First we will explore how the courts have formulated a test to state the requisite connection between the services and the payment such that the payment should be called a product of those services. The issue is essentially one of finding a sufficient connection between the taxpayer’s services and the payment in question, and it arises most often in connection with gifts and other windfalls. We will then break from the examination to explore the effect upon the ordinary usage notion and the income tax generally of the FBT introduced from 1986. Later we will look at some of the specific regimes in the ITAA to tax special types of employee remuneration: Div 83A and s 109.

4.

We will also explore the boundaries of the concept of income from services, looking for example at payments which capitalise existing employment contract rights or which are the price for employees accepting restrictions on their ability to work.

5.

The taxation of retirement income and, in particular, the taxation of superannuation funds and payments from them to fund members will be examined. Finally, we will explain the important practice of salary packaging seen in the modern workplace.

6.

(b) Taxation and Work Effort [4.20] It is one of the ironies of studying taxation to realise that Western societies decided

almost without exception to impose taxes upon the very things that the societies claim to value highly: working hard and saving for the future. The reasons that led them to this view will not be explored here. Rather, we will examine very briefly some of the potential consequences for modern societies of policies which collect large proportions of the government’s revenue by taxes on wages: the product of work. It should be borne in mind, however, that the effect of the tax on wages on the working patterns of individuals is an extremely complicated issue and we will necessarily be simplifying the issue greatly. Impose a tax on something and the government must expect various things to happen in response. For example, some individuals will stop doing whatever is taxed if there is an untaxed alternative, some individuals will continue what they were doing but try to find a lawful way around the tax, some will cheat, while others will just battle on and suffer the tax cost. In this context, generations of economists have grappled with the question: which of these consequences follow from the tax on wages? Ignoring for the moment the cheating solution, in general terms, it is argued that two different effects can be expected from taxing the returns from working. The first and deleterious consequence is a substitution effect: some individuals will decide that it is not worthwhile working longer or harder and will substitute (untaxed) leisure for (taxed) labour. They might decide not to work overtime, or not to apply for a promotion or to take early retirement. Alternatively, some individuals will decide that it is necessary to work even harder in order to regain the level of income and lifestyle that they enjoyed before the imposition (or increase in the rate) of the tax on the product of their work. Much recent tax debate and tax reform has centred on the first proposition – the reduction in tax rates that occurred throughout the Western world in the late 1980s was justified in part by arguments that high rates of income tax on wages discouraged people from working. You will have noticed that these two effects work in opposite directions and there is no reason to suppose a priori that one effect is stronger. Hence, economists spend a large amount of time and effort in empirical research trying to estimate the size of these effects. This research 144

[4.20]

Income from the Provision of Services

CHAPTER 4

is made even more complicated because other social and cultural factors influence the work decision. For example, rigid working hours set in industrial agreements limit the ability of employees to vary their labour supply slightly – in many industries, working is still largely an “all or nothing” decision. Because for many people hours of work cannot readily be changed, the pattern which seems to emerge is that for the primary income earner in a household, the level of taxation has little effect on work effort. In contrast, the effect of taxes on the working patterns of the secondary income earner in the household is estimated to be much larger. In more concrete terms, the effect of the tax on work may have a differential impact, discouraging women in particular from entering or remaining in the paid workforce. Further, some effect of the tax on work might be seen in decisions such as taking early retirement, working less overtime, working less strenuously, emigrating to work overseas or moving into employment where the taxed pecuniary reward is not such an important motivation (for example, moving out of the more highly paid production line and into the more congenial but less well-paid cleaning staff). It is important to remember that the substitution effect of a tax is a function of the marginal tax rate of the employee – the tax rate that would be payable on the next dollar of income. At first glance this might be understood to mean that the disincentive to work becomes more pronounced as income (and marginal tax rates) increase – that is, that the tax on working is most discouraging to those who already earn a great deal. But it is unfortunately the case that our entire tax and transfer system – that is, including the social security system – also has high marginal tax rates at the bottom of the income range. (How the high rates on low-income earners come about is described in Chapter 6.) This means that there may also be a pronounced substitution effect for low-income earners, discouraging them from entering the paid workforce and contributing to their continued poverty. Attributing a decision not to pursue paid work to laziness simply ignores financial disincentives. For this reason also, much of the debate about flattening the tax rate scale stems from the fact that substitution effects increase with increases in marginal rates and this is what a progressive tax scale promises. But reducing high marginal rates due to the progressive income tax rates at high-income levels does not solve the problem of high implicit rates for low-income earners. If we assume for the moment that the substitution effect of the tax on wages is strong, is there some way to solve the problem without abandoning vertical equity? Economists from the optimal tax school suggest that taxes should be designed to minimise the “excess burden” of a tax. That is, an important criterion in imposing a tax should be whether it imposes a cost on the economy over and above the amount of the tax which the government collects. In the case of the tax on wages, the excess burden is seen in the lower amount of work that individuals do (and the higher amount of leisure that they consume) than would be the case if the tax was not there. An excess burden benefits no one because it is a loss to the taxpayer which is not reflected in revenue to the government – the individuals would prefer to work more and take less leisure, but the effect of the tax both discourages them from doing what they would prefer, and means that the government receives less revenue in the process. One solution to the disincentive effect of the tax on wages is, some economists have suggested, to tax income earning potential rather than its product. Under such a system the measure of a taxpayer’s labour income (I) would be something like:

[4.20]

145

The Tax Base – Income and Exemptions

I = wh where: “w” represents the wage rate per hour

“h” represents the number of hours in the week Defining income in such a way would have the effect of eliminating any substitution effect – the employee pays tax on leisure as well as labour. Such a solution also has the important effect of making a vertical equity comparison more comprehensive. At the moment, the income tax only measures the observable product of labour rather than the less obvious endowment of the ability to work. Hence we treat as equal someone who works one day per week for $1,000 (and cruises the Whitsunday Islands for the other six) and someone who works six days per week plus overtime and also earns $1,000 per week. Some would argue that the person who relaxes six days of every week has a higher capacity to pay tax than the other and so should pay more tax but implementing such a system, is, of course, no easy matter.

2. DETERMINING INCOME QUALITY – GIFTS AND OTHER BENEFITS [4.30] This chapter examines one aspect of the ordinary usage notion of income – that an

amount which is a reward for performing a service is considered to be income. However not every payment received by an employee will be taxable as income. Indeed, not even every payment received by an employee from her or his employer will be taxable as income. Some payments are excluded from the tax base because it is said in the particular circumstances of the case that the amount is insufficiently connected to the employment for it to be called the product of the employment. The cases arise in two different situations: benefits provided to employees by their employers which are said to be a gift; and benefits received by employees from third parties which are tenuously connected to the employment. Gifts, prizes and other windfalls show a glaring shortcoming of our income tax base when compared with the comprehensive tax base ideal, as they present a situation where the taxpayer admits that there is gain but asserts that there is no assessable income for taxation purposes. The problem is essentially a clash between two conflicting principles: the principle that a mere gift is not income; and the principle that a reward for services is income. So these cases usually turn on questions of fact and degree, and are consequently never easily reconciled. The test of adequate connection is whether the receipt is a product of the employment but, as Parsons tellingly observes, “the notion of product may be illustrated; it cannot be defined” (R W Parsons, Income Taxation in Australia, Law Book Co, Sydney, 1985, para 2.135). Given this prospect, perhaps the best that can be hoped for is to know the tests that are applied in the cases and how they are formulated and reformulated in each case, to recognise which facts have significance and what their significance is, and to be able to muster the competing arguments from each side. In other words, one should not expect that answers will be predictable from some sort of mechanical application of a formula. In all of these cases care should be taken to identify what is sufficient to connect the payment to the income concept of a reward for services, and then how an income characterisation is imparted to a payment through that connection. It may help to understand the problem of defining whether there is an adequate connection to an income-producing category, if we represent it diagrammatically: 146

[4.30]

Income from the Provision of Services

CHAPTER 4

where: “A” represents a situation in which the employment is the sole and motivating cause of the payment “B” represents a situation in which the employment is an important cause of the payment although there are other less important causes “C” represents a situation in which the employment is one of many causes of the payment with no particular importance “D” represents a situation in which the payment is motivated by one or more causes, and the fact that the recipient is also an employee is almost fortuitous. The problem for the courts is twofold: to define and then accurately communicate to others the point to the left of which there is (and to the right of which there is not) a sufficient connection between the employment or services for the payment to be called a product of the employment or services, and then to locate the facts of the particular case to be decided in relation to that point. In this chapter we will look only at cases where the connection (if any) will be to services provided by the recipient, but it needs to be stressed that gifts and other windfalls can also be income because they are related to some other income-producing activity. An example arose in FCT v Cooke and Sherden (1980) 10 ATR 696 where the alleged gifts were considered by the Federal Court to be adequately connected to the taxpayers’ businesses for the gifts to be taxable (although they were not in fact taxed for other reasons). Another example of the same issue arose in FCT v Squatting Investment Co Ltd (1954) 88 CLR 413, which is often referred to in the extracts below, where an unexpected bonus distribution to the taxpayer from the proceeds of a wool transaction was held to be sufficiently connected to the taxpayer’s business to have an income character. Both cases are discussed in Chapter 5. We will begin by looking at the first group of cases – cases of benefits provided to employees by their employers or former employers. An example of a gift paid to an employee which was held not to have an income character arose in Hayes v FCT. Hayes was an accountant and had once been employed by Richardson as a general financial adviser. Richardson’s business expanded and was incorporated on Hayes’ advice, with Hayes subscribing for some shares. Richardson was apparently satisfied with what he had achieved and retired. The company soon began to flounder without his active participation and so he was prevailed upon to return. He agreed to do so only upon the condition that he had full control of the company and so all shares (including Hayes’) were sold to Richardson, subject to an understanding that they would probably be returned later. The company flourished under Richardson’s renewed control and a public company was formed to raise capital and expand the business. “In a spirit of generosity” Richardson made several large gifts, including parcels of shares in the public company, which he directed the company to allot to Hayes. The ATO included the par value of the shares in Hayes’ assessable income as deferred income from services (rendered either to Richardson or to the company) relying upon both ordinary concepts expressed in s 25(1) and upon s 26(e) of the ITAA 1936 (now s 6-5 and s 15-2 of the ITAA 1997 respectively). Fullagar J in the High Court held that the payment did not have an income character.

Hayes v FCT [4.40] Hayes v FCT (1956) 96 CLR 47 The Commissioner contended that the receipt was an income receipt because it fell within the

general conception of income, or alternatively that it fell within the terms of s. 26(e) of the Act [4.40]

147

The Tax Base – Income and Exemptions

Hayes v FCT cont. … I doubt very much whether s. 26(e) has the effect of bringing into charge any receipt which would not be brought into charge in any case either by virtue of the general conception of what constitutes income or by virtue of the definition of income from personal exertion in s. 6. The words “directly or indirectly” are doubtless intended to cast the net very wide, but it is clear that there must be a real relation between the receipt and an “employment” or “services” … If the receipt in the present case does not fall within the general conception of “income”, it is not, in my opinion, caught by s. 26(e) … A voluntary payment of money or transfer of property by A to B is prima facie not income in B’s hands. If nothing more appears than that A gave to B some money or a motor car or some shares, what B receives is capital and not income. But further facts may appear which show that, although the payment or transfer was a “gift” in the sense that it was made without legal obligation, it was nevertheless so related to an employment of B by A, or to services rendered by B to A, or to a business carried on by B, that it is, in substance and in reality, not a mere gift but the product of an income earning activity on the part of B, and therefore to be regarded as income from B’s personal exertion. A very simple case is the case where A employs B at a salary of £1,000 per annum, and at the end of a profitable year “gives” him a “bonus” of £100. Obviously the bonus is income. It is paid without obligation, but it is clearly in truth part of what B has earned during the year … A clear example on the other side of the line would be provided if the staff of a company were to collect voluntary subscriptions and make a presentation to a retiring manager … While I would not say that the motive of the donor in making the payment or transfer is, in cases of this type, irrelevant, motive as such will seldom, if ever, in my opinion, be a decisive consideration. In many cases, perhaps in most, a mixture of motives will be discernible. On the one hand, personal goodwill may play a dominant part in motivating a voluntary payment, and yet the payment may be so related to an employment or a business that it is income in the hands of the 148

[4.40]

recipient. On the other hand, the element of personal goodwill may be absent – the dominant “motive” may have been of the most purely selfish and “commercial” character – and yet it may be impossible to find any connection with anything that can make it income. The question in each particular case is as to the character of the receipt in the hands of the recipient … The test to be applied is an objective, not a subjective, test. This, I think is the whole point of a passage in the judgment of Kitto J in the Squatting Investment Co Ltd v FCT (1953) 86 CLR 570 at 633 case … [where] His Honour speaks of “gifts” as being “taxable” if they are “made in relation to some activity or occupation of the donee of an income producing character”. The point is illustrated by reference to expressions used in some of the English cases, and his Honour then contrasts “mere gifts” – “gifts” which are not related in any such activity or occupation and have no significant character except as expressions of a desire to benefit the donee … The view that what the appellant received in this case was income seems to rest on the view that the gift of the shares was motivated, at least to a substantial extent, by gratitude for services rendered, and advice and assistance given, by the donee to the donor in the past. But this is clearly not enough to make what he received income in his hands. It may be conceded that this motive of gratitude played a part in the donor’s decision to make the gift … But gratitude for services rendered was by no means the sole or exclusive motive. It is clear that the donor was moved very largely by a general feeling of goodwill arising from a close relationship which had both a business aspect and a personal aspect. It is clear also that he was moved to no small extent by the fact that Hayes had, some three years before, parted very much against his will with his shares in the proprietary company. He had told Hayes that he “would make it up to him”, and he was now “making it up to him”. So much for the donor’s motives. But as I have said, motive as such cannot be a decisive factor in cases of this kind. What is decisive in my opinion, is the fact that it is impossible to relate the receipt of the shares by Hayes to any income producing activity on his part. It is impossible to point to any employment or “personal exertion”, of which the

Income from the Provision of Services

Hayes v FCT cont. receipt of the shares was in any real sense an incident, or which can fairly be said to have produced that receipt. Hayes was only employed by Richardson from 1939 to 1944, and it seems absurd to say that the shares represented additional remuneration for work done in that employment. From 1944 to 1950 he was employed by the proprietary company, but it seems equally out of the question to say that the shares represented additional remuneration for work done for the company during that period. I accept of course, what was said by Dixon CJ and Williams J in Dixon’s case … I agree that, “if payments are really incidental to an employment, it is unimportant whether they come from the employer or from somebody else”. It is perfectly consistent with this to say that, in determining whether a payment is “really incidental to an employment”, the fact that it is not made by the employer but by some third party may be a very relevant consideration. Its relevance in the present case, however, need not be considered, for the position simply is that there is nothing whatever to suggest that the gift can properly be regarded as money earned by Hayes as director or secretary of the proprietary company. It was not paid to him in any such capacity. It was in no true sense a product or an incident of any employment in which Hayes had engaged or any business which he had carried on.

[4.45]

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The only other way, so far as I can see, in which the case can be put for the Commissioner is to say that the gift of the shares represented a reward or recompense for the general advice and guidance given informally on a number of occasions to Richardson personally, and proving of benefit in the long run to Richardson himself or to the company in which he had a controlling interest. I think that the gift was intended in part, though only in part, as such reward or recompense. But surely it is utterly unreal to say that, whenever Hayes expressed a particular opinion or recommended a particular course, he was engaging in an activity capable of producing income for him. Such an idea is foreign to the whole idea of what constitutes income from personal exertion. If Hayes had been employed to give such advice or guidance, or if he had carried on a business of giving such advice or guidance, the position might well have been different. But he was doing neither of those things. If A tells his friend B in a casual conversation that he thinks that the shares of the Z company will rise greatly in a short time, and B buys shares in the Z company and makes a large profit, it will be impossible to contend that a gift of £1,000 by a grateful B to his friend A is income earned by A. A has earned the money only in the loose sense that he has done something for which B is grateful. He has not earned it in the sense – the only relevant sense – that it is the product of a revenue-earning activity on his part.

Questions

4.1

Richardson gave some more shares to his sons. Would the value of these shares have been assessable as income to his sons? Richardson also gave some shares to Hayes and another employee to hold “on behalf of” the employees of the company. Would the value of those shares have been included in their assessable income? (Recall the discussion in Chapter 3.)

4.2

What test does Fullagar J suggest should be used to ascertain whether the connection between the payment and the employment is sufficient for the gift to have an income character?

4.3

How is the relationship between the general inclusion rule s 25(1) and s 26(e) explained? Is the relationship between s 6-5 and s 15-2 the same?

4.4

Could the gift of the shares now be taxed to Hayes as part of an employee share scheme under Div 83A? You may wish to come back to this question after reading further. [4.45]

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The Tax Base – Income and Exemptions

4.5

4.6

How would Hayes be decided after FBT? (See the definition of fringe benefit in s 136(1) of the FBTAA 1986 and consider whether the shares were given “in respect of the employment of the employee”. See also the definition of “in respect of” also in s 136(1) and read s 148(1).) Would it make any difference to your answer to the previous question if you had concluded that the shares would be covered by Div 83A? (See para (ha) of the definition of fringe benefit in s 136(1) of the FBTAA 1986.)

[4.50] The same problem of gift payments arose in the later case of Scott v FCT. The taxpayer was a solicitor and received a gift of £10,000 from Mrs Freestone, the widow of a former client and friend of Scott. Mrs Freestone was herself currently a client of Scott in respect of the administration of her late husband’s estate. During the course of the administration of the estate, Scott assisted in developing and realising one of the assets of the estate (a block of land near Parramatta) at greatly enhanced values, and he also helped her create a monument to her late husband and his comrades in submarines in World War II. (It is the K13 monument on Pennant Hills Road, Carlingford, Sydney.) The circumstances of the gift are detailed in the extract from the judgment of Windeyer J in the High Court.

Scott v FCT [4.60] Scott v FCT (1966) 117 CLR 514 On 19 August 1960 … Mrs Freestone went with the taxpayer in his car on … [a] mission relating to her property outside Parramatta … As they were returning to Parramatta she told the taxpayer that she intended to distribute some of her money as gifts and that she proposed to give him £10,000. He was, he says, astounded by this. It was entirely unexpected. She confirmed this. He was “speechless” … The story is a remarkable one. But I am satisfied that, except in one or two matters as to which their recollection was faulty, the events occurred as Mrs Freestone and the taxpayer said they did … Mrs Freestone having told the taxpayer in the car that she wanted to give him £10,000 – having, she said, “thought about it well beforehand”, went on to tell him of other gifts she proposed to make … She produced her cheque book; and on her instructions the taxpayer wrote out four cheques … [including one drawn]: “LG Scott & Co, £10,000” … The taxpayer paid his into his private bank account at Epping. The taxpayer stated that he applied the whole of the sum of £10,000 given to him to his personal advantage. In answer to questions that I asked he said that there was not any understanding that he should disburse any of the 150

[4.50]

money in any way on Mrs Freestone’s behalf and that he did not do so. He said, and I accept his evidence, that the sum of £10,000 went in part in reduction of his overdraft with the bank and in part for various purposes of his own including the construction of a swimming pool. I am satisfied that Mrs Freestone expected the taxpayer to charge his ordinary professional costs for all work that he did for her. Whatever the extent of his services to his client had been, £10,000 must have greatly exceeded any charges that could properly be made for them. … The case for the Commissioner is that the £10,000 formed part of the taxpayer’s assessable income, either as within the general concept of income upon which the tax is levied, or because it was brought into charge by s. 26(e) of the Act. It was also argued that, independently of the rest of the Act, it could be regarded as brought into charge by the definition of income from personal exertion in s. 6. I am unable to follow the last proposition. It seemed to be based upon a misunderstanding of an observation by Dixon CJ and Williams J in FCT v Dixon (1952) 86 CLR 540 at 555. Their Honours there said that expressions used in the definition of income from personal exertion could, in an appropriate case, be used as an indication that a given receipt is income. The

Income from the Provision of Services

Scott v FCT cont. definition enumerates certain forms of income which, for the purpose of the Act, are income from personal exertion … The definition does not I think bring anything into charge as income. It refers to what is already by its nature income. By describing what income from personal exertion is, the definition is indirectly indicative of what income is. That is all: but otherwise it is irrelevant. I reject the contention that of its own force it makes the receipt of £10,000 income of the recipient. The answer to the question in this case depends therefore on a general conception of the nature of income, bearing in mind s. 26(e) … Counsel for the Commissioner pointed to the wide words “in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him” and said that they must be given their full meaning and effect. This of course is so. But what is their full meaning and effect? That is the question. It is no doubt an orthological question. But it is not to be answered by reading the words in the abstract with the aid of a dictionary. Their meaning and the limits of their denotation must be sought in the nature of the topic concerning which they are used. They are in an income tax statute. Dixon CJ and Williams J said [in Dixon’s case]: “We are not prepared to give s. 26(e) a construction which makes it unnecessary that the allowance, gratuity, compensation, benefit, bonus or premium shall in any sense be a recompense or consequence of the continued or contemporaneous existence of the relation of employer and employee or a reward for services rendered given either during the employment or at or in consequence of its termination.” … It was said that if a testator left by will a legacy to a servant in his employment whose wages had been fully paid, and by his will expressed the legacy as given because of long and faithful service, it would be within the words of s. 26(e) and thus be income of the legatee. I do not think that the words of s. 26(e) compel that conclusion. And I do not think that a legacy given by a grateful testator to, say, his physician would ordinarily be income in his hands. And the position would, it seems to me, be no different if the same gifts were made, not by will but by the

CHAPTER 4

donor in his lifetime. That is not because the words of s. 26(e) could not describe such gifts but because it stands in an Act the purpose of which is to impose a tax on income. To take another illustration: suppose members of a society made a gift to a man because he had rendered some special services to the society. In terms such a testimonial gift, whatever form it took, money or plate or a picture, although the product solely of the donors’ appreciation of the donee’s services would be within the words of s. 26(e). But would it therefore necessarily be income of the recipient liable to tax? I think not. And would a person who on restoring lost property to its owner was given a reward for his services be taxable on the basis that the reward was part of his income? Again I think not, but again the words of s. 26(e) would cover the case. As I read s. 26(e) its meaning and purpose is to ensure that certain receipts and advantages which are in truth rewards of a taxpayer’s employment or calling are recognised as part of his income. In other words the enactment makes it clear that the income of a taxpayer who is engaged in any employment or in the rendering of any services for remuneration includes the value to him of everything that he in fact gets, whether in money or in kind and however it be described, which is a product or incident of his employment or a reward for his services. If, instead of being paid fully in money, he is remunerated, in whole or in part, by allowances or advantages having a money value for him they must be taken into account. The enactment does not bring within the tax-gatherer’s net moneys or moneys’ worth that are not income according to general concepts. Rather it prevents receipts of moneys or moneys’ worth that are in reality part of a taxpayer’s income from escaping the net … I return to the general concept of income. Whether or not a particular receipt is income depends upon its quality in the hands of the recipient. It does not depend upon whether it was a payment or provision that the payer or provider was lawfully obliged to make. The ordinary illustrations of this are gratuities regularly received as an incident of a particular employment. On the other hand, gifts of an exceptional kind, not such as are a common incident of a man’s calling or occupation, do not [4.60]

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The Tax Base – Income and Exemptions

Scott v FCT cont. ordinarily form part of his income. Whether or not a gratuitous payment is income in the hands of the recipient is thus a question of mixed law and fact. The motives of the donor do not determine the answer. They are, however, a relevant circumstance … An unsolicited gift does not, in my opinion, become part of the income of the recipient merely because generosity was inspired by goodwill and the goodwill can be traced to gratitude engendered by some service rendered. It was said for the Commissioner that if a service was such as the recipient was ordinarily employed to give in the way of his calling, and the gift was a consequence, however indirect, of the donor’s gratitude and appreciation of that service, then it must necessarily be part of the donee’s income derived from the practice of his calling, and caught by s. 26(e). But as thus expressed, this proposition is, I think, a mistaken simplification. It was based upon the fact that in Hayes v FCT (1956) 96 CLR 47 at 56 Fullagar J regards as decisive that it was impossible to relate the receipt of the shares there given to any income-producing activity on the part of the recipient. In the present case the taxpayer was

[4.65]

engaged in an income-producing activity, his practice as a solicitor, to which it was said the gift could be related. But because the absence of a particular element was decisive in favour of the taxpayer in one case it does not follow that the presence of that element is decisive in favour of the Commissioner in another case. The relation between the gift and the taxpayer’s activities must be such that the receipt is in a relevant sense a product of them … To analyse motives and seek the ultimate causes of conduct can seldom yield any single or simple result. Mrs Freestone, I assume, would not have made her gift to the taxpayer if she had not appreciated his help to her and his friendship. If he had not acted for her as he did in relation to her husband’s estate, if he had not been a friend of her husband, it probably would not have occurred to her to make him a beneficiary in her distribution of part of the moneys that she got from the estate. He no doubt was aware of this. Nevertheless I do not think that her gift to him was in a relevant sense given or received as a remuneration or recompense for services rendered so as to form part of his assessable income.

Questions

4.7

What test does Windeyer J suggest should be used to ascertain whether the connection between the payment and the employment is sufficient to characterise the payment as having an income quality? Is it different from the test in Hayes v FCT?

4.8

How would Scott be decided after FBT? Would Scott be an employee and would the gift be “in respect of any employment” to satisfy the definition of fringe benefit in s 136(1) of the FBTAA 1986?

[4.70] You will already have noticed several references in the extracts to the decision of the

High Court in FCT v Dixon. The case contains many strands of reasoning, and as Bowen CJ later observed in FCT v Harris (1980) 10 ATR 869 at 873: “it is difficult to derive a simple ratio decidendi from the reasons for judgment.” Here we are primarily concerned with the question whether the payments made to the taxpayer were assessable as a product of services. The taxpayer in Dixon volunteered for service in World War II and his former employer made voluntary supplementary payments to him to make up the difference between the military pay and his former salary. The High Court held that the supplement was income but not because it was a product of services rendered. In their joint judgment, Dixon CJ and Williams J observed as follows. 152

[4.65]

Income from the Provision of Services

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FCT v Dixon [4.80] FCT v Dixon (1952) 86 CLR 540; 5 AITR 443 The Commissioner’s case has been supported on the ground that according to ordinary conceptions of what is income the derivation by the taxpayer of £104 from Macdonald, Hamilton & Co, as well as the derivation of his military pay, formed his income, and therefore became part of his assessable income … The Commissioner further relies, but this time as an independent ground only, on the provisions of para (e) of s. 26 … Before turning to the other grounds upon which the Commissioner rested his case, we shall state our reasons for declining to apply s. 26(e) to the supplementary payments provided by Macdonald, Hamilton & Co as allowances, etc given, etc in relation, directly or indirectly, to the taxpayer’s employment by that firm or services rendered by him to them. There can, of course, be no doubt that the sum of £104 represented an allowance, gratuity or benefit allowed or given to the taxpayer by Macdonald, Hamilton & Co. Our difficulty is in agreeing with the view that it was

allowed or given to him in respect of, or in relation, directly or indirectly, to any employment of or, services rendered by him. It is hardly necessary to say that the words “directly or indirectly” extend the operation of the words “in relation to”. In spite of their adverbial form they mean that a direct relation or an indirect relation to the employment or services shall suffice. A direct relation may be regarded as one where the employment is the proximate cause of the payment, and an indirect relation as one where the employment is a cause less proximate, or indeed, only one contributory cause … We are not prepared to give s. 26(e) a construction which makes it unnecessary that the allowance, gratuity, compensation, benefit, bonus or premium shall in any sense be a recompense or consequence of the continued or contemporaneous existence of the relation of employer and employee or a reward for services rendered given either during the employment or at or in consequence of its termination.

[4.90] All the judges held that the payments were assessable and also agreed that they were

not the product of his services, although they disagreed on the reasons for finding that the payments had an income nature. The other reasons are discussed in Chapter 6. [4.95]

4.9

4.10

Questions

How would Dixon be decided after FBT? Is he an employee? (See the definitions of “employee” and “former employee” in s 136(1) of the FBTAA 1986.) Is the payment “in respect of the employment” for the definition of “fringe benefit” in s 136(1)? Might the payment not be a fringe benefit because it is “salary or wages” for para (f) of the definition of “fringe benefit”? What test of connection is stated in the first three cases between the receipt and the provision of services to establish an income nature? What factors are taken into account?

[4.100] The judgments in Dixon’s case were carefully analysed in FCT v Harris. A retired

bank employee received an ex gratia payment of $450 from his former employer to supplement the superannuation payments which he already received in the form of a pension. The bank’s apparent concern was to boost the pensions of retired employees as the value of their pensions had been seriously eroded by inflation. The Full Federal Court held by a majority that the supplementary payment was not income despite the apparent similarity to Dixon. One interesting feature of the case is the attempt, at least by Deane J, to expound a methodology for solving these gift cases. [4.100]

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The Tax Base – Income and Exemptions

FCT v Harris [4.110] FCT v Harris (1980) 10 ATR 869; 80 ATC 4238 In the present case, there are circumstances pointing in different directions and the decision whether the receipt was income according to ordinary concepts turns on questions of emphasis and degree. Bowen CJ and Fisher J have pointed to a number of factors which militate against regarding the receipt as such income and I am conscious of the force of the matters to which they have referred. Ultimately, however, I am persuaded by the combination of a number of considerations that the preferable conclusion is that the receipt constituted income according to ordinary concepts and was properly included by the Commissioner in the taxpayer’s assessable income of the tax year … The first is the relationship of the receipt and the taxpayer’s former employment … Notwithstanding the fact that the receipt could not properly be regarded as the product of that employment, the relationship between the receipt and the taxpayer’s former employment with the bank points, in my view, towards the receipt being income. The receipt could not properly be seen as being a mere gift or present made to the donee on personal grounds … It was

received by the taxpayer because he was one of a class of ex-employees of the bank whose wellbeing the bank was, for proper commercial reasons, concerned to protect. Secondly, the payment was related to an annual period and was part of one group of a series of annual groups of payments. Regularity and periodicity are factors of some importance in determining whether particular receipts possess the character of income in the hands of the recipient … Thirdly, the payment was made to supplement income because of the erosion of the value of such income as a result of inflation and was made by the entity which was entitled to direct an increase in that income and which would, in the event of resulting deficiency of pension funds, be liable to make up the deficiency. A payment of capital can, of course, be made to supplement an inadequate income. The fact that a payment, which is a periodic payment, is made to supplement income is however, in my view, a factor pointing to the receipt of the amount paid being a receipt of income …

[4.120] The result, although not the reasoning, of Harris has since been changed by statute

with the introduction of s 27H of the ITAA 1936. [4.125]

Questions

4.11

Identify the issues common to Dixon and Harris. What facts distinguish them – apart from the result?

4.12

What factors are taken into account in determining the income quality and how do they differ from those previously analysed?

4.13

Does the method of analysis, particularly of Deane J, differ from the analysis of previous cases and is it satisfactory?

4.14

Would it make any difference if the payments in Harris had been frequent and he had relied upon them to meet recurrent expenses? (See FCT v Blake (1984) 15 ATR 1006; 84 ATC 4661.)

4.15

How would the payment in Harris be taxed today? (See s 27H(1)(b) of the ITAA 1936.) Might the payment also give rise to a fringe benefit? (See para (k)(i) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986 and para (a)(ii) of the definition of

154

[4.110]

Income from the Provision of Services

4.16 4.17

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“eligible termination payment” in s 27A of the ITAA 1936.) What difference would it make to your conclusion if the payments had been made by the trustees of the superannuation fund? What if Harris had taken a lump sum and then received a supplementary payment? Try this quick revision. Answer and cite the relevant authority which discusses the following problems. (a) Can there be income from services where there is only an isolated service? (b) Does it matter that at the time of receiving the payment, the employment has come to an end?

[4.130] The position reached by the cases extracted so far seemed tolerably clear – at least as

clear as one can ever hope to be when dealing with cases that depend very much on their own facts. They also appeared to settle the issue of the relationship between ordinary usage under s 6-5 of the ITAA 1997 and the effect of s 26(e) of the ITAA 1936. Yet these issues nevertheless continue to engender debate and controversy as illustrated by the High Court decision in Smith v FCT. The issue in Smith was whether $570 paid by Westpac to Smith under its “Encouragement to Study Scheme” was assessable as income of the taxpayer. Under the scheme, the bank made payments to employees who successfully completed approved subjects and courses of study (approval being given to courses related to banking). The bank made it clear that the scheme was intended to assist in staff development and it encouraged employees to participate. What is surprising about the case is not simply that it reached the High Court (why did the Court grant leave to appeal on such a case post-FBT?), but more importantly, that judges in both lower courts and the High Court could have concluded that the payment was not assessable income and, in doing so, could have developed some of the reasoning to be found in the extract below. The authors of the Butterworths Weekly Tax Bulletin put the matter very succinctly: “Not the least interesting aspect of this case is that, in the course of three appeals, no less than nine eminent justices have considered the case and have held, by a bare majority of five justices to four, that the payments fell within s 26(e); this in a case the facts of which in the editors’ respectful opinion, would appear to admit of very little doubt” ([1987] Butterworth’s Weekly Tax Bulletin, para [639]). A majority of the Court (Toohey, Wilson and Brennan JJ) held the amount assessable. Justices Deane and Gaudron dissented.

Smith v FCT [4.140] Smith v FCT (1987) 164 CLR 513 Wilson J: The problem presented by the present case is whether the facts establish the requisite relationship between the benefit received by the appellant and his employment. It is not sufficient to find that the appellant received the benefit at a time when there was an employment relationship existing between himself and the Bank. The mere temporal connection would not enable the payment to be characterised as a benefit given to him in relation directly or indirectly to his employment. It is tempting to strive to identify criteria which will assist in the process of characterisation. But however helpful such criteria

may be, it is unwise to expect any paraphrase to provide a final or overriding test. Ultimately, it is the words of the statute that must prevail … On the facts of the present case, I conclude that the benefit received by the appellant was a product or incident or a consequence of his employment. The gift, if it be so described, in no sense carried the overtones of a personal gift from the donor to the donee personally. Nor is it sufficiently described merely as a gift from an employer to an employee. When all the circumstances are taken into account, the benefit [4.140]

155

The Tax Base – Income and Exemptions

Smith v FCT cont. is the product of a scheme embodied in the rules of the Bank, and administered within that organisation, designed to encourage not only the efficiency of employees within it but to provide them with the incentive to advance their prospects of promotion within the Bank. In my view, the requirement of a relationship between the benefit and the employment necessary to attract the provisions of s. 26(e) is satisfied. Brennan J: Liability to tax under s. 26(e) does not arise merely because the taxpayer is an employee of or has rendered services to the person from whom the allowance is received: for example, a father’s employment of a child does not necessarily make the value of a gift from the father to the child part of the child’s assessable income. It is necessary that there be some connection between the payment of an allowance to the taxpayer and either his employment or services he has rendered … It is not necessary that an allowance be paid as remuneration for the work which an employee is employed to perform; it is sufficient to attract s. 26(e) that the allowance be paid to an employee in consequence of his employment. When is an allowance paid in consequence of employment? … There is no doubt that voluntary payments may fall within s. 26(e) … If an allowance is paid under a contract between the payer and the taxpayer, the consideration for the payment is usually decisive of the matter “in respect of, or for or in relation … to” which the allowance is paid, but if the allowance is paid voluntarily, it is necessary to inquire “how and why it came about that the gift was made” … When an allowance is paid voluntarily by an employer to an employee, the ascertainment of any relationship between the payment and the employment raises some evidentiary problems. The motives of the employer might be thought to be the most direct evidence of how and why the employer made the gift, but an unexpressed motive, uncommunicated to the employee, can hardly be determinative of the character of the receipt in the hands of the employee … 156

[4.140]

If the motive of the employer is communicated to the employee or is known by him, the common understanding of the motive for the payment may be cogent evidence of “how and why it came about that the gift was made” … [T]he character of the allowance paid by the Bank to the appellant is not in doubt. Its character is established by the scheme promulgated by the Bank and acted on by the appellant. The allowance was paid because the Bank had a scheme for paying allowances to its employees and the appellant fulfilled the two requirements on which the payment of allowances under the scheme depended: the appellant was employed by the Bank and he completed a prescribed course. The question of law that arises on those facts is whether such a payment was made in consequence of the appellant’s employment … Of course, it will frequently be a difficult question of fact to decide whether a particular allowance which is paid voluntarily is paid for a reason which brings the allowance into or for a reason which carries it out of the tax net. But if the employment (or some aspect of the employment) is the reason or one of the reasons why the allowance is paid, the allowance falls within s. 26(e) … In this case, an allowance was payable only to those in the Bank’s employment, and the scheme provided for payment of the allowance to any employee who qualified by completing a prescribed course. Although no course of study was mandatory for any employee, the approved courses were calculated to improve the skills of the Bank’s employees. The scheme was an aspect of their employment. The allowance was not paid as a mere mark of an employer’s personal esteem for particular employees. I am quite unable to say that the allowance was paid for considerations extraneous to the employment. On the contrary, the allowance was paid because it was an incentive to an employee to improve his skills to his own advantage and to the anticipated advantage of the Bank. The relationship between the employment of the appellant and the payment of the allowance was substantial. In my opinion, the employment was a direct cause of the payment. It follows that the allowance was paid “in consequence of” the employment, and thus was paid “in respect of … or in relation …

Income from the Provision of Services

Smith v FCT cont. to” the employment. The relationship prescribed by s. 26(e) was established. Toohey J: Although not formally stated, there was an assumption underlying the argument of counsel for the respondent that if the sum of $570 was not assessable by reason of s. 26(e), it was not assessable under s. 25(1). The precise relationship between ss 25(1) and 26(e) was therefore not fully argued. As Gibbs J pointed out in Reseck v FCT (1975) 133 CLR 45 at 47; 5 ATR 538 at 539: “Speaking generally, s. 26 does not limit s. 25 but includes as assessable income some receipts that might not ordinarily have been regarded as income.” Whether receipts falling within s. 26(e) are within that description is a question that has not yet been determined. Gibbs J left the matter open in Reseck for that case was concerned with the operation of s. 26(d). In Hayes v FCT (1956) 96 CLR 47 at 54; 6 AITR 248 at 253 [11 ATD 68] Fullagar J said: “I doubt very much whether s. 26(e) has the effect of bringing into charge any receipt which would not be brought into charge in any case either by virtue of the general conception on what constitutes income or by virtue of the definition of income from personal exertion in s. 6.” Because of the way in which this

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appeal has been argued, it is unnecessary to try to resolve the doubt raised by Fullagar J. The matter must remain open though, having regard to the breadth of language used in s. 26(e), there are strong arguments for the conclusion that receipts that might not ordinarily be regarded as income are included … The amount received by the present appellant was an amount allowed, given or granted to him in respect of his employment. It was paid by the bank in accordance with a policy designed to encourage its employees to increase their knowledge in subjects relevant to the banking industry and therefore to increase their proficiency as employees. It is not to the point that the courses might stand employees in good stead if they later changed their employment. The sum paid to the appellant was one of many such sums paid by the bank to its employees under its “Encouragement to Study” scheme. There was an evident connection between the appellant’s employment and the sum he received. And in a very real sense the payment was a consequence of the existing relation of employer and employee. It was only as an employee that the appellant qualified for the benefits payable under the scheme … [T]here is no element of gift or personal bounty or of considerations extraneous to the appellant’s employment.

The minority opinion was delivered by Gaudron J, dissenting, with whom Deane J agreed. The subject payment of $570 to the taxpayer was neither recompense for the relationship of employer and employee nor reward for services rendered. It was recompense or reward for completing an approved course of study which, although approved by the Bank, was required neither as a condition of the relation of employer and employee, nor as a qualification necessary for the rendering of services in that relationship. The consequential relationship between payment of the benefit and the relation of employer and employee is not constituted simply by a definitional requirement of a continuing employer and employee relation as a condition of eligibility to receive payment, for the paragraph is

concerned with the allowing, giving or granting of the relevant benefit, and not with eligibility to receive the benefit. In the present case the Commissioner of Taxation relies on a number of matters, additional to the eligibility requirement, to establish that the amount paid was paid in consequence of the employment relationship. Those matters are the highly organised nature of the bank’s “Encouragement to Study” policy, the large number of employees who have participated therein, the publication of the policy within the bank’s staff rules, the bank’s requirement that the courses undertaken have some relevance to banking, the advantages to the bank of having suitably qualified staff, and the bank’s practice of [4.140]

157

The Tax Base – Income and Exemptions

Smith v FCT cont. making payments pursuant to the policy in the same manner and at the same time as ordinary salary. It seems to me that, apart from the two matters relating to the nature of approved courses and the advantages to the bank of having suitably qualified staff, these are matters of administration, rather than matters indicative of a relationship between employment and the payment in question. On the other hand, the advantages to the bank of the policy and the bank’s requirement that courses have relevance to banking indicate that the bank’s motives in the establishment, maintenance and administration of the policy are employment related. But the motivation of the bank in establishing and maintaining the policy does not provide any relevant causal link between the employment of the taxpayer and the making of any particular payment. The proximate case of

that payment is the successful completion of a subject or a course of study. Less proximate causes of the payment include the employee’s undertaking the requisite course work, and enrolling in the course of study. Still less proximate is the existence of the bank’s policy under which payments are made. The fact that the policy exists because of the advantages to the bank in having suitably qualified employees does not serve, in my view, to make the payment a payment made in consequence of the relation of employer and employee, or in the words of the paragraph “in respect of, or for or in relation directly or indirectly to, [the] employment of” the taxpayer, for the paragraph looks not to a relationship between payment and employmentrelated benefits to an employer but to a relationship between a particular benefit allowed, given or granted to a taxpayer and his employment. I would allow the appeal …

[4.150] Consider these facts about Smith v FCT: the payment was made by an employer to an

employee during current employment; it was payable only to employees; no personal or other altruistic motive was raised; the activity of which the payment was the direct product was one which the employer had encouraged and sought; to put it more bluntly, this may not really have been a “gift” case at all, but rather one where the payment had become virtually a contractual obligation of the employer. In other words, the bank rewarded those of its employees who performed another service which the bank asked of them – upgrading their qualifications. Further, the possibility that these payments might be income according to ordinary concepts seems never seriously to have been considered by the Court, as all the discussion centres on s 26(e). These features are disturbing not because a majority of the High Court reached the wrong result, but because it took such angst and tortuous efforts to reach the right result and, in doing so, the Court both questioned matters which were not raised and ignored simple approaches which could have resolved the case. [4.155]

Questions

4.18

What does the majority in Smith identify as the requisite connection between the payment and the employment or services?

4.19

What is the relationship between s 6-5 of the ITAA 1997 and s 26(e) post-Smith?

4.20

How would Smith be dealt with after FBT? In particular consider what sort of fringe benefit this might be. (See ss 20, 40 and 45 of the FBTAA 1986.) An employer offers a prize of $5,000 for the best suggestion by an employee for improving productivity in the company. Is this prize assessable? Would it make any difference if the winner had resigned by the time the prize was awarded? A parent company is proposing to sell a subsidiary as a going concern. In order to maximise the price obtained on the sale, the company makes a payment to several

4.21

4.22

158

[4.150]

Income from the Provision of Services

4.23

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senior managers who are employed by the subsidiary, to ensure they remain with the subsidiary after it is sold. Is the amount assessable to the recipients? (See Dean and McLean v FCT (1997) 37 ATR 52; 97 ATC 4762.) A taxpayer is threatened with dismissal as a result of complaints lodged with his employer. He institutes proceedings to restrain his dismissal and is eventually successful. His employer decides that, in addition to reinstating him, it will make a voluntary contribution to his legal expenses. Is this amount assessable as income from his employment? (See FCT v Rowe (1997) 187 CLR 266; 35 ATR 423; 97 ATC 4317 – extracted in Chapter 6.)

[4.160] At the beginning of this section we mentioned that a second group of cases also arises

in this area – cases where the benefit is provided to the employee but by someone other than the employer. In the UK there are many such cases usually involving professional athletes who win prizes donated by third parties (such as TV stations) or receive amounts raised at testimonials, matches and dinners. Australia has similar cases: Kelly v FCT (1985) 16 ATR 478; 85 ATC 4283 (the Sandover Medal awarded by Channel 7). This issue was considered by the High Court in the case of FCT v Stone (2005) 222 CLR 289; [2005] HCA 21 which concerned appearance money, endorsements and government grants given to a part-time athlete. The problem, albeit in a different context, was considered by the Full Federal Court in FCT v Holmes. The taxpayer in Holmes was employed on a tug owned by P & O Maritime Services. The owners of a stricken oil tanker, the Kirki, contracted with United Salvage to salvage the ship. United Salvage in turn subcontracted with P & O, whose ship Lady Kathleen had been first on the scene and initially rescued the ship. The Lady Kathleen was later assisted by two other ships. The head salvage agreement provided for a “salvage reward” if the Kirki was saved and no compensation if it was lost. The subcontract between United Salvage and P & O repeated these terms. This contract was signed by P & O on behalf of itself and its employees on the Lady Kathleen, though they were not direct parties to the contract. An arbitrator determined first the share of the reward to be paid to each of the ships, the share of the amount going to the Lady Kathleen to be paid to P & O and the share to be paid to the crew members and, finally, of the amount going to the crew members of the Lady Kathleen, the amount to be paid to each member. Four members were awarded larger amounts for their bravery in the rescue and the remaining amount was divided among crew members on a pro rata basis by reference to their salary entitlements. The ATO assessed the taxpayer on the amount he received, relying on s 25 or, in the alternative, s 26(e). In a joint judgment, Hill, Cooper and Kiefel JJ said the following.

FCT v Holmes [4.170] FCT v Holmes (1995) 58 FCR 151; 31 ATR 71; 95 ATC 4476 In summary therefore, it can be said that Mr Holmes, a seaman who participated in a successful salvage operation, became entitled under the common law of Admiralty to a reward. The question is whether the receipt of that reward constitutes assessable income to him.

concepts emphasised that Mr Holmes was in receipt of his normal salary or wages in accordance with the relevant award and that the right he had to payment arose not from his employment with the Lady Kathleen but out of the success of the salvage operation …

The tribunal in concluding that the payment to Mr Holmes was not income in ordinary

Likewise the tribunal rejected a submission on behalf of the Commissioner that the payment [4.170]

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The Tax Base – Income and Exemptions

FCT v Holmes cont. received by Mr Holmes was made assessable income under s. 26(e). In so doing, the tribunal placed emphasis upon the fact that in no sense could the amount paid to Mr Holmes be said to have any relationship with his employment with P & O, albeit that if he had not been an employee of that company he would not have been on board when the salvage operation took place. Accordingly the tribunal concluded that the payment received by Mr Holmes fell outside s. 26(e). The conclusion of the tribunal that the salvage payment to Mr Holmes was unrelated in any relevant sense to his employment with P & O was clearly correct. The law of Admiralty imposes on the owner of properties salved an obligation to pay those who save them. The obligation does not rest in contract … The right to a salvage award is personal to the salvor who renders the salvage service. It is not, in the case of a crew member, a derivative right through the ship owner or employer … We find it unnecessary to determine whether the payment made to Mr Holmes constituted income in ordinary concepts. If the payment falls within s. 26(e) of the Act it will constitute assessable income and it would no longer seem to matter whether it might also form part of assessable income by virtue of being income in ordinary concepts within s. 25… In Smith v FCT (1988) 164 CLR 513 Brennan J pointed to the width of the language of s. 26(e) reflected in part by the words “in respect of” and in part by the words “directly or indirectly” … His Honour pointed to the difficulty which arises where the allowance was paid voluntarily rather than pursuant to a legal obligation. That difficulty divided the court in Smith.

There is no question in the present case, however, of the payment to Mr Holmes being voluntary. He had a legal right to it, even if it can be said that his participation in the salvage operation which gave rise to that obligation was voluntary. Toohey J, in Smith (in a judgment with which Wilson J agreed), cited with approval, as illustrating the width of the language of s. 26(e), what was said by Dickson J of the Supreme Court of Canada in Nowegijick v R (1983) 144 DLR (3d) 193 at 200: The words “in respect of” are, in my opinion, words of the widest possible scope. They import such meanings as “in relation to”, “with reference to” or “in connection with”. The phrase “in respect of” is probably the widest of any expression intended to convey some connection between two related subject-matters. The question thus becomes whether there was a real connection between the payment received by Mr Holmes and the services rendered by him in the course of the salvage operation. Once the question is posed it is difficult to see how it can be answered other than in favour of the Commissioner. The fact that the obligation to make a payment to Mr Holmes arose only in the event that the salvage operation was successful can hardly operate to break the connection between the payment and the rendering of services. To the contrary, it renders clear that which the law of Admiralty itself makes clear, that the payment to a person participating in a successful salvage operation is a payment in recognition of the services which the participant in the salvage has performed. The payment to Mr Holmes was a reward for the services rendered by him and, as such, falls squarely within the language of s. 26(e).

[4.180] A more common, and potentially more important, example of the same problem

arose in relation to benefits under frequent flyer and similar customer loyalty schemes. In essence, these schemes involve a volume discount – “buy 10 flights and get the eleventh free”. The problem for the ATO was that it was usually the employer who purchased the 10 flights (and deducted their cost as a business expense), while it was the employee who took the 11th free flight and used it to fly off on vacation. In January 1993, the ATO released Taxation 160

[4.180]

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Ruling TR 93/2 on the tax consequences of frequent flyer schemes. It took the view that the value of the free flight was assessable as income of the employees (where the benefit was in cash, could be redeemed for cash, or could be transferred to a third person) to the extent to which the points used to accumulate the free ticket had accrued as a result of work-related travel. If the free flight was partly attributable to business travel and partly from other personal travel, the value of the free flight would have to be apportioned. The same rule applied to self-employed people. In general terms, the ATO might have tried to impose tax on the value of benefits under frequent flyer schemes in three ways. It might have tried to attack the employer’s tax deductions for the 10 flights. As we shall see in later chapters, the provisions which permit the ATO to deny deductions where private benefits arise as an incident of business expenditures would be hard to trigger in these circumstances for various reasons. So, because the ATO was generally precluded from attacking the deduction, it had to rely on his powers to impose tax on the employee for the value of the 11th flight and/or to impose FBT on the employer. Qantas was unhappy with the Ruling and decided to try to attack it on two fronts. First, it changed the Terms of Membership of its frequent flyer scheme so members could elect that their points would not be available to acquire tickets in the name of someone other than the member – points had never been redeemable for cash, but by ensuring that they could not be transferred to or for the benefit of a third person, it was hoped that the Ruling could be rendered irrelevant. Second, Qantas decided to initiate a court challenge to test the ATO’s position. An employee of KPMG, the firm of accountants advising Qantas, was chosen and she sought a Private Ruling from the ATO that she would not be taxable if she either used her points to bring her parents from the UK to visit her, or if she went to visit her parents. She indicated that the points to be redeemed for the tickets would arise solely from work-related travel and hotel accommodation. The Private Ruling was refused, consistent with Ruling TR 93/2, and she appealed to the Federal Court against the denial. The action, Payne v FCT (1994) 28 ATR 58; 94 ATC 4191, did not reach a resolution because Hill J in the Federal Court found he lacked adequate information to determine whether there was a sufficient connection between Payne’s employment and the benefit. This line of attack was abandoned. Instead, Payne decided to bring her parents to Australia on free tickets in late 1993, disclosed this in her return, was assessed by the ATO to tax on the value of the tickets as the Ruling indicted, and in Payne v FCT (1996) 32 ATR 516, challenged that assessment in the Federal Court. The ATO argued that the value of the tickets was assessable under either s 25(1) or s 26(e) of the ITAA 1936. Foster J in the Federal Court rejected both arguments. He relied in part on the rules of valuation and derivation drawn from cases we have examined already in Chapter 2: Cooke and Sherden and Constable.

Payne v FCT [4.190] Payne v FCT (1996) 66 FCR 299; 32 ATR 516; 96 ATC 4407 Was there liability to tax under s. 25(1)? [I]n this appeal, the Commissioner has submitted that the provision, at Payne’s request, by Qantas of the relevant flight tickets to her parents constituted a derivation of “income” by her pursuant to that section.

The concept of “income” was fully considered by a Full Court of this court in FCT v Cooke & Sherden (1980) 10 ATR 696; 29 ALR 202, where a comprehensive review of earlier decisions was undertaken … The analogy with the present case is obvious. The reward tickets available because of the accrual [4.190]

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The Tax Base – Income and Exemptions

granted to him” during the year of income under assessment.

Payne v FCT cont. of the required number of points could be used only by the program member or his or her permitted nominee. They were not transferable and, if sold, were subject to cancellation. They were not money and, in my view, could not be turned to pecuniary account. They could not therefore be regarded as “income” within the meaning of s. 25(1). I should note that a submission was but faintly made on the part of the Commissioner that it was conceivable that the recipient of a ticket under the scheme could transfer it to a permitted family nominee in consideration of an undisclosed payment. Such a transaction would be in flagrant breach of the terms of the contract, would render the ticket liable to cancellation and would, undoubtedly, smack of fraud. I cannot entertain the submission as having been seriously put. I reject it … Is the benefit taxable under s. 26(e)? Considerable argument has been addressed as to the meaning and application of this section …

It appears to us that the taxpayer became entitled to a payment out of the fund by reason of a contingency (viz: an alteration of the regulations curtailing the rights of members) which occurred in that year enabling him to call for the amount shown by his account. It was a contingent right that became absolute. The happening of the event which made it absolute did not, and could not, amount to an allowing giving or granting to him of any allowance, gratuity, compensation, benefit, bonus or premium … All that occurred in the year of income with respect to the sum in question was that the future and contingent or conditional right became a right to present payment and payment was made accordingly. This, in our opinion, cannot bring the amount or any part of it within s. 26(e). The amount received by the taxpayer from the fund is a capital sum, and, unless it or some part of it falls under s. 26(e) (there being no other applicable imposition of liability), it is not part of the assessable income.

[T]here are relevantly three requirements under s. 26(e), all of which must be met before the flight reward tickets can be treated as assessable income. First, there must be a “… benefit …”. Secondly, that benefit must be “allowed, given or granted” to Payne. Finally, the benefit must be allowed, etc, “in respect of … any employment … or services rendered” by Payne. I turn first to the second of these requirements.

This reasoning was relied upon by counsel for Payne. In the same way as the payment to Constable occurred by virtue of a contingent contractual right becoming absolute and was not, therefore, the “allowing, giving or granting to him of any … benefit”, the provision of the free airline ticket in the present case, which occurred by reason of the crystallising of a contractual entitlement, did not fall within the wording of the section …

Is the benefit granted”?

I am satisfied that the submission made on behalf of Payne is correct. The provision of the free travel by Qantas to her parents at her request, consequent upon the accrual to her of the requisite number of “points”, resulted from a personal contractual entitlement on her part and could not be properly characterised as a “benefit … given” within the meaning of the section …

“allowed,

given

or

The majority in Constable decided that case on the basis that the second requirement was not fulfilled. They considered the regulations governing the administration of the fund and the basis upon which the taxpayer had withdrawn the relevant moneys. They then said (at CLR 417-8): [W]e are of the opinion that, whether or not the payment or any part of it may be described as an allowance, in respect of the taxpayer’s employment, it cannot correctly be said that it was such an allowance, etc “allowed given or 162

[4.190]

Are the flight reward tickets a “benefit” within s. 26(e)? As I consider that this case can be disposed of on other grounds, I think it both unnecessary and undesirable that I further consider this submission …

Income from the Provision of Services

Payne v FCT cont. Are the flight reward tickets sufficiently connected to Payne’s employment? The remaining question in the case was one to which considerable argument was directed. That is whether the provision of free travel to Payne was “in respect of, or for or in relation directly or

CHAPTER 4

indirectly,” to her “employment” with KPMG. It was the Commissioner’s contention that this requirement was clearly satisfied insofar as the relevant points would not have been earned by Payne under the program had she not undertaken the necessary flights in the course of her employment, it being emphasised that the flights (and also qualifying accommodation expenses) had been paid for by her employer.

His Honour then considered the decisions in Dixon, Scott, Hayes and Smith. He continued: The effect of Smith’s case in the present context The Commissioner puts a simple argument. He says that whatever might have been the previous effect of the judgments in Dixon, Hayes and Scott, the situation since Smith is transparently simple. If the payment or benefit sought to be brought to tax under s. 26(e) is a “consequence” in a completely objective sense of the employment relationship, then it is caught by the section. It is sufficient if the employment relationship is a mere causa sine qua non, even though there be another cause of the payment or benefit which could be described as the causa causans or the predominant or effective cause. Payne’s free ticket was a “consequence” of her employment in that the flights which earned the necessary points were undertaken in the course of her employment and paid for by her employer. By parity of reasoning her employment was a “contributory cause” of the receipt of a free ticket. There can be no doubt that if the section requires only a “but for” or “causa sine qua non” connection between employment and receipt, then Payne’s free ticket can be attributed to her employment, and the section brought into play. Does Smith’s case require this result? In my view, it does not. In order for Smith’s case to be properly analogous to the present case, its facts would require alteration. It would be necessary for the employer to have required the employee to undertake the courses at the expense of the employer and as part of his employment. If, in those circumstances, the employee, through

zealous application to his studies, had been so successful as to receive a money prize awarded independently by the institution providing the courses then a more clearly analogous question would have arisen. Would that independently awarded prize have been taxable in his hands as a benefit caught by s. 26(e)? In my view, if those had been the facts in Smith’s case, the decision would have been against taxation of the benefit … In my view, s. 26(e) clearly requires that the relevant benefit be given or granted by the donor or granter in view of the taxpayer’s employment by himself or some other employer. Although questions of motive may not require any close examination, in my opinion, the section, nevertheless, requires a recognition on the part of the donor or granter of the relationship between the benefit granted, and the employment of the donee or grantee taxpayer. In other words the employment must be either wholly or partly the reason for the donor or granter making the gift or the grant … [I]n the present case, Qantas provided the free ticket not because of Payne’s employment with KPMG, but because she had become entitled to it under Qantas’ own scheme. I consider that this analysis of the situation is consistent with the approach to the section adopted in the lengthy passage that I have cited above from the judgment of Windeyer J in Scott. I am also satisfied that it is in accord with the passages I have cited from the judgment of Wilson, Brennan and Toohey JJ in Smith’s case. It must be remembered that there were significant differences between the facts in Smith’s case and those in the instant case, and statements in the judgments in Smith must be read against the [4.190]

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The Tax Base – Income and Exemptions

Payne v FCT cont. background of those differences. In Smith, the payment was made by the employer. It was made pursuant to a scheme instituted by the employer. It was a scheme from which the employer derived benefit, namely enhancement of its employees’ skills in the performance of their work. The payment was intended to be an encouragement to employees to undertake the extra training involved in the scheme. It was accepted as such by the employees who undertook the training. In the present case, these features are totally lacking. The benefit was received under a scheme instituted by Qantas for its benefit. The employer had no part in the scheme as such. The employer did not arrange for the employee to participate in the scheme. It did not pay for the employee’s participation in the scheme. It did not even, so far

as the facts show, encourage its employees to participate in the scheme. It did nothing to provide the benefit alleged to be taxable in the employee’s hand. In my opinion, it is the factors present in Smith’s case but absent in the present case which must be kept squarely in mind when reading and considering the passages which have been cited above … In my view, the judgments in Smith illustrate rather than depart from the view of the section established in Dixon, Hayes and Scott insofar as those cases established, in my opinion, that, for a benefit, etc, to be caught by the section, there needed to be a role played by the employer in the giving, etc, of the benefit. In Smith’s case there was a clear and positive role played by the employer, which is totally lacking in the present case.

[4.200] In the light of this decision, Ruling TR 93/2 and a number of other consequent

Rulings were withdrawn and replaced. Taxation Ruling TR 1999/6 states unequivocally, “8. Flight rewards received by employees from employer-paid expenditure are not assessable income”. The Ruling also says that free flights do not (usually) give rise to a fringe benefit and do not (usually) give rise to business income to an independent contractor. At the same time, a separate Taxation Determination TD 1999/34 was issued. It reaches the unremarkable conclusions that a benefit derived under a “consumer loyalty program” as a result of making private expenditure is not assessable income. [4.205]

Questions

4.24

Would the ATO have succeeded in FCT v Holmes if it had based the assessment on s 6-5 of the ITAA 1997 alone?

4.25

Would the ATO have succeeded in FCT v Holmes if it had based the assessment on the CGT regime?

4.26

The frequent flyer Ruling TR 1999/6 takes the view that FBT would not usually be payable on benefits provided to employees. This is a trifle odd at first glance because it is a non-cash amount, typically the kind of thing thought of as a fringe benefit. Why might this be – consider who the parties are to this transaction?

4.27

Consider again the position taken by Foster J in Payne in relation to the words “allowed, given or granted”. He held that all that had happened in the year of income was that a contingent right became absolute and that this was not a “benefit given”. Is this conclusion supported by the passage quoted from Constable? The passage from Constable concludes that the amount in question was not income because it had been derived in a prior year. Is this timing aspect what Foster J is focusing on? Or is he saying something else?

164

[4.200]

Income from the Provision of Services

4.28

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The taxpayer introduced a prospective foreign buyer to a property developer and assisted with the Foreign Investment Review Board application when the foreign buyer decided to buy the property. The property developer gave the taxpayer a Gold Coast unit worth $1 m, which it described as “commission payable to you pursuant to the sale …”. Is the taxpayer assessable on the value of the home unit? (See Brown v FCT [2002] FCAFC 318.)

[4.210] The emphasis of this part of the chapter has been on income according to ordinary

concepts – whether or not s 6-5 has been triggered. There are a number of other specific statutory regimes that we will examine later in the chapter such as the FBT regime, s 109 of ITAA 1936, the termination payments regime in Divs 80 – 83 of the ITAA 1997 and the rules governing superannuation and CGT which always have to be borne in mind for amounts that are not ordinary income or added into statutory income. But with these exceptions, there are few other provisions which include amounts arising from employment as statutory income: • s 15-3 of the ITAA 1997 includes in income an amount received for agreeing to return to work; • s 15-70 of the ITAA 1997 includes in income an amount received as reimbursement of the expenses incurred in using your car for work purposes where the reimbursement is calculated on a cents-per-kilometre basis; and • s 15-80 of the ITAA 1997 includes in income an amount which an employer contributes to a first home saver account on behalf of an employee.

3. FRINGE BENEFITS [4.220] We have deliberately left until now the detailed discussion of the regime that is

probably the most important mechanism (apart from ss 6-5 and 15-2 of the ITAA 1997) for taxing benefits received during employment – the FBT. Although it is levied under separate legislation and forms a discrete tax, FBT – like CGT – has to be considered first as an independent source of tax liability and then be correlated with the income tax. In fact, the FBT regime applies to every benefit provided by an employer to an employee – it is only because of specific exceptions that salaries, for example, end up being taxed only under the ITAA. In other words, if one looks at the drafting of the laws, everything provided to an employee in respect of the employment is a fringe benefit unless there is an exception which removes it. Much of what follows will by now be relatively familiar to you from the discussion in Chapter 2, and because we have already asked you to examine the FBT consequences of payments to answer accurately the questions asked earlier in this chapter. In this part of the chapter we will give some background to the introduction of FBT and we will approach, in a systematic way, the formalities of its operation.

(a) Background to the FBT [4.230] A working definition of a fringe benefit is: it is a reward for service, in a form other

than contemporaneous payments in cash. In other words, they are benefits provided to employees which form an integral part of the employee’s total package. The Asprey Committee (Taxation Review Committee, Full Report, AGPS, Canberra, 1975, para 9.2) defined fringe benefits to be “any benefit, other than salary and wages, derived from an [4.230]

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employment”. So fringe benefits include benefits in kind (which may or may not be convertible into money) that increase the employee’s purchasing power or relieve her or him of an obligation. The possible range of fringe benefits is enormous but common examples of non-cash benefits are providing free (or at a subsidised rate): the use of a car; car parking; low-interest personal and housing loans; subsidised goods and services; subsidised holidays and travel; an entertainment allowance and unverified expense account; paying some of the employee’s bills such as telephone and electricity accounts, educational costs for employees’ children, and health insurance premiums; payment of subscriptions to clubs, professional associations and unions; and establishing employee share acquisition schemes. Fringe benefits also encompass deferred payments and could easily include payments such as superannuation, termination and special leave payments, golden handshakes and so on. Items such as these often comprise major elements in the employee’s remuneration. The 1985 Draft White Paper (Reform of the Australian Tax System; Draft White Paper, AGPS, Canberra, 1985, p 96) suggested that benefits other than salary often comprised almost 20% of the total remuneration of senior white-collar employees. Although fringe benefits form part of the employee’s reward for service, prior to FBT they often escaped tax completely or were taxed at less than their full value. It is necessary to tax fringe benefits in order to preserve the underlying idea that a gain should be treated as income, and also to maintain the idea of horizontal equity (preventing taxpayers receiving income in one form from being treated more favourably than taxpayers receiving the same amount in another). And if it is true that fringe benefits are more common for high-income earners than for wage and salary earners, then there is also implicit vertical inequity if fringe benefits are allowed to go untaxed. While this may be true as a starting position, the recognition that fringe benefits were difficult to tax led to increasingly sophisticated negotiations for salary packages, even by trade unions, as well as employees in professions. But it would be a mistake to think that the push to substitute fringe benefits for cash salary came exclusively from employees. Employers also benefited where a fringe benefit could be provided cheaply, reducing the employer’s total labour costs. The employer would benefit if it could give rewards such as access to an employee share scheme or a superannuation scheme for employees costing (say) $15,000 in lieu of cash, where the employee would have to spend (say) $20,000 to acquire these same benefits. It is clear that the non-taxation of fringe benefits seriously distorted choices about the form of remuneration. David Collins, in “Taxation of Fringe Benefits – An Economist’s Perspective” (1987) 4 Australian Tax Forum 95, provides an explanation why economic distortion is a significant problem.

David Collins, “Taxation of Fringe Benefits – An Economist’s Perspective” [4.240] David Collins, “Taxation of Fringe Benefits – An Economist’s Perspective” (1987) 4 Australian Tax Forum 95 The preferential tax treatment of some types of income will, inevitably, involve reallocation of productive resources in such a way that income receipts are biased towards the favoured form. The allowance for tax purposes of entertainment expenses would imply much higher levels of such 166

[4.240]

expenditure, since the effective (net of tax) cost of entertainment would be below its true resource cost, the difference being borne by the taxpayer. The non-taxation of the private use of employers’ cars has almost certainly led to the purchase of more expensive vehicles since the private car use

Income from the Provision of Services

David Collins, “Taxation of Fringe Benefits – An Economist’s Perspective” cont. has been subsidised by the taxpayer, with the employer being able to determine the extent of subsidy from the public purse through the ability to determine the outlay on the vehicle. A narrow income base distorts relative rates of return since the tax concessions produce artificially low after-tax rates of return in some areas. Thus the allocation of productive resources is distorted, and productivity will decline since resources will shift from areas of high gross rates of return to areas of relatively low gross but relatively high net rates of return. At the same time, a deadweight loss is being experienced because the value of the subsidised fringe benefit to the recipient will usually be less than the resource costs to the community of producing that benefit. We have all heard stories of people who dined out regularly on untaxed expense allowances because it was cheaper than eating at home. All other things being equal, the recipient should prefer a benefit in cash to a benefit in kind provided at the same cost because the recipient has the discretion to spend the cash in accordance with her or his own preference patterns.

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In relation to taxes on business generally, the argument is often put that the level of taxation is too high and that the absence of taxes such as those on fringe benefits or capital gains is desirable on allocative grounds because of the resulting lower level of business taxation. If the desirability of lower levels of business taxation is, for the purposes of argument, accepted it can still be shown that partial and discriminatory tax concessions are inferior to the application of lower rates to a more comprehensive income base. This is an argument about the inefficiency of “taxation expenditures”. Although FBT clearly has the potential to be an important revenue-raiser, the case for FBT does not rest solely on revenue-raising considerations. Advocacy of the taxation of fringe benefits is not inconsistent with support for lower levels of business taxation and support for lower levels of business taxation provides a weak case for the non-taxation of fringe benefits. Similarly, the suggestion that a broad-based consumption tax could be used as an alternative source for the revenue yield of the FBT misses the point that the FBT’s rationale is not simply revenue-raising.

[4.250] Until 1 July 1986 fringe benefits were taxable under the general provisions of ss 25(1)

and 26(e) of the ITAA 1936. But the general impression seemed to be that fringe benefits were simply not being taxed. Taxing fringe benefits under s 25(1) was obviously difficult given the Tennant v Smith [1892] AC 150 requirement that the benefit be cash or convertible into cash. But observe the neglected words in s 26(e) “whether … granted in money, goods, land, meals, sustenance, the use of premises or quarters or otherwise” – this formula obviously rendered taxable non-cash benefits and benefits in kind. In addition to these sections, there were, and still are, some more specific regimes for a range of identified fringe benefits. For example, the former s 26AAC (now Div 83A of the ITAA 1997), taxes the income from employee share acquisition schemes and has survived both the introduction of the FBTAA 1986 and a concerted attempt to impose FBT on them in the mid-1990s. Sections 26AAAA and 26AAAB, applicable from 1 July 1977, taxed the value of employee housing but have now been replaced by FBT provisions. Section 26AAB attempted to tax the value of cars, but fared even more poorly than s 26AAAA – it was enacted in 1974 and repealed in 1975 without ever becoming operative. But ss 25 and 26(e) were alleged to be unable to catch fringe benefits and that problem, according to the Draft White Paper, cost the government about $700 m in lost tax revenue. It is important to spend some time considering why, despite the breadth of s 26(e) and the precision of other regimes, and despite the fact that they were clearly taxable, fringe [4.250]

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benefits nevertheless often escaped tax. We will then consider how and to what extent the regime implemented to overcome this problem – FBT – has changed this. (i) Reasons for the non-taxation of fringe benefits

Administrative difficulties [4.260] One obvious difficulty for the revenue is detection. In most cases, the ATO only

knows what taxpayers voluntarily disclose in their annual tax returns. If no amount appears on an employee’s payment summary (a document produced by the employer, one copy of which is given to the employee and another filed with the ATO) stating how much income has been paid to the employee and how much tax has been withheld, it is almost impossible for the ATO to know of the existence of a fringe benefit except by correlating the employer’s return with that of each employee. But even that cross-checking might not be sufficient for accurate taxation of fringe benefits unless the amount of the benefit is separately identified in the employer’s return and some allocation to individual employees is made. A second difficulty is valuation. Most tax returns (even before the system of self-assessment) are accepted by the ATO at face value so that even when a taxpayer disclosed the receipt of a fringe benefit, the ATO would rely on the taxpayer’s assessment of its value. This allowed employees, who were minded to do so, to under-disclose the value of a benefit. But even for those who wanted to “do the right thing”, it was often difficult to provide any accurate value of some fringe benefits. [4.265]

4.29

4.30

4.31

Questions

Consider a low-interest housing loan, say of $100,000 at 5% per annum interest rate when savings bank rates were 7.5% – how much income was received by the employee? What amount was income if the employee would not have been eligible for a loan from a savings bank, but might have been able to get a loan at a higher rate from a non-bank lender? What if the employee would not have been able to secure a loan at all from usual sources? What amount of income was derived by an employee who could drive to and from work in the company car? What if the car could be used on weekends? What if the employee was prohibited from using the car on weekends but did so anyway? On what basis could the ATO have disagreed with the value chosen?

Legal problems [4.270] Even assuming that a fringe benefit has the character of income as a reward for

service, there is a problem of determining that an employee has derived a benefit, especially if the fringe benefit is paid to an associate rather than the employee. The problem arises because employees are usually on a cash basis of tax accounting which means that income only arises when it is received by the employee. Even a doctrine of constructive receipt (see ss 6-5(4) and 6-10(3) of the ITAA 1997) which renders assessable amounts paid on behalf of an employee, did not cope well with amounts paid to third parties if the payment was not made at the direction of the employee. This lacuna was compounded by the fact that there is no necessary correspondence between assessability to the employee and deductibility to the employer – so that the employer might be assured of the deduction for making the payment whether or not the employee was assessed. More importantly, it was possible to manipulate the nature of the fringe benefit so that it no longer possessed the characteristics of income that courts had identified as essential. For 168

[4.260]

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example the most common manipulation was to invoke the Tennant v Smith requirement that the benefit be in cash or convertible into cash. Even though this common law rule was supplemented by s 26(e) taxing the “value to the taxpayer” of some benefits which were neither cash nor convertible, this valuation rule was not always applied. The rules for the valuation of fringe benefits were never successfully resolved. Courts could choose, and often fluctuated between, a variety of rules: the cost to the employer – but what is the cost to an employer of employee share schemes; the market value of the benefit provided – but there were problems where there was no real market equivalent; the replacement value – but this was always met by the counterfactual argument that the employee would not have driven a Rolls Royce or lived in Toorak if he or she had to pay for it herself; and subjective value, the Donaldson test (Donaldson v FCT [1974] 1 NSWLR 627; (1974) 4 ATR 530; 74 ATC 4192) discussed below. The availability of alternative valuation methods made it difficult to administer the tax rules well. These legal difficulties could often be manipulated to facilitate a low-tax outcome – by working with the interplay between the timing and valuation rules. An employer would provide something which, when derived, had a market value of almost nil because of the conditions attaching to it. In such a case, the benefit would be taxed only at the time it was provided because there is only one tax accounting event when the income was derived. When the conditions lapsed, the benefit would later become very valuable, but by then it had already been taxed. But was it correct to say that the law was totally inadequate as the Draft White Paper suggests? Some very specific regimes appeared to cope well such as s 26AAC (which is discussed below). It has been suggested that the real problem was that the rules were difficult to administer and people realised that escaping detection was easy. Richard Vann has argued: “s 26(e) is not a limited or defective provision as some have suggested … The failure to tax fringe benefits in full up until the present has resulted as much from the faint-hearted practice of the revenue as defects in the law.” (R J Vann, “General Principles of the Taxation of Fringe Benefits” (1983) 10 Sydney Law Review 90). Under a comprehensive income tax, there is no doubt that fringe benefits should be taxed, but in essence they raise problems primarily of administration rather than principle. Being taxable counts for little if the tax cannot be enforced. (ii) Possible solutions [4.280] In theory at least, there are three possible ways to tax fringe benefits. One is simply to

enact a series of valuation rules, include the value of fringe benefits together with the cash component, and then withhold tax at the source out of the cash component on the sum of the cash plus benefits. This would tax fringe benefits under the personal income tax system at the employee’s marginal rate. A second alternative would be to deny an allowable deduction to the employer for the cost of providing fringe benefits. This would tax fringe benefits under the corporate income tax system at the employer’s marginal rate – usually 30% as most employers are companies, but less if the employer was tax exempt or in tax loss that year. The third alternative would be to impose a special excise tax on employers on the value of fringe benefits they provide. Governments that have grappled with the problem of taxing fringe benefits have contemplated all three systems. [4.280]

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Asprey Committee [4.290] The Asprey Committee considered the real problem was the failure by employees to

disclose the existence of benefits and so it suggested that an adequate solution would be for all amounts given as fringe benefits to be included in the PAYG system and be shown on payment summaries. The effect of their solution would be to make the ATO aware of the existence of the fringe benefit. The Committee recognised that this solution would not solve valuation problems but they said that a comprehensive system requiring employers to calculate cash values would not be practical because the valuation problem for employers was too great. Their compromise solution was to increase the disclosure obligations of employers to require the disclosure of all fringe benefits of which the employer knows, to take tax instalment deductions from regular benefits (examples were given of motor vehicles, low-interest loans and expense accounts), and ensure that the calculation of a value for benefits be made by the employer but with the ability of the employee to assign a different value and then for the ATO to revalue.

New Zealand Task Force on Tax Reform (McCaw Committee 1982) [4.300] This Committee suggested two different solutions for different types of fringe

benefits: for easily calculable items (for example, education expenses for executives’ children) tax would still be imposed on the employee. The fringe benefit would be included as wages for PAYG purposes and the tax would be calculated upon the basis of cost to the employer. For other specified items (motor vehicles, low-interest loans, subsidised goods and services provided by employer) they recommended as an interim measure (although it was ultimately enacted by the government) that a tax be imposed upon the employer at the top personal marginal rate which was non-deductible to the employer, and that the value of the benefit taxed should be determined by a formula regardless of the subjective benefit to the employee.

Draft White Paper [4.310] The authors of the Draft White Paper considered that there were two options open to

curb the abuse of fringe benefits. The first would be to enforce existing laws more vigorously and to include a defined value for fringe benefits in the employee’s assessable income. This would be “the best approach” because it would tax the employee’s total remuneration in whatever form at the employee’s marginal rate. But this would require “clear but necessarily arbitrary rules” for valuing benefits given to the employee or related person and strengthening the reporting requirements on employers to disclose all non-cash benefits not presently appearing on payment summaries. The second approach would be to tax benefits in the hands of the employer and exempt the receipt from income tax in the hands of the employee. This was the preferred solution because it was thought to be administratively simpler, “less disruptive” and “would go a long way to creating more equitable arrangements”. That system was eventually introduced in the FBT. In the years since its introduction, the FBT has become the focus of much criticism. We will look at “the problems with the solution” after we have a more complete grasp of the operation of the FBT system.

(b) Operation of the FBT [4.320] The FBT regime introduced from 1986 adopts the second position taken in the Draft White Paper: taxing the employer rather than the employee, at a rate which is the highest 170

[4.290]

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marginal rate for individuals, using often arbitrary values for fringe benefits, and exempting the employee from income tax on fringe benefits. Unlike CGT, the FBT is enacted in separate legislation not within the body of the ITAA, although it clearly has to be integrated with the income tax. The tax imposed in s 66 of the FBTAA 1986 and the Fringe Benefits Tax Act is currently set at a rate of 49% – the same rate as the top personal marginal rate (45%) plus the Medicare levy 2% and the temporary budget repair levy of 2%). From 1 April 2017, it is scheduled to return to 47%. Under s 66(1) of the FBTAA 1986 tax is “imposed in respect of the fringe benefits taxable amount of an employer [and] is payable by the employer”. The “fringe benefits taxable amount” is defined in s 5B to mean the sum of the taxable value of all benefits provided by the employer during the year (“the aggregate fringe benefits amount”), adjusted to deal with the GST and grossed-up by the FBT payable on those benefits. In other words, FBT is payable on a tax-inclusive base – the total of the value of the benefit plus the FBT payable on the benefit. This is just the same as the taxation of salary – employees are taxed on their total wages (which includes the amount that will be deducted as income tax). There are five essential steps to be considered in determining the liability of an employer to FBT. 1.

First, there is a scope and classification issue. Tax is payable where an employer provides a “fringe benefit” but not all the items we have identified as fringe benefits in common parlance are caught by the FBT regime. The first issue is to identify whether a transaction involves a “fringe benefit” that is within the scope of the FBTAA 1986 and, if so, what category of fringe benefit the transaction falls into. 2. There is then a timing dimension. The employer must have provided the fringe benefit in the FBT year. For some reason, the FBT year runs from 1 April to 31 March in each year. 3. Thirdly, the transaction must involve the right parties. The fringe benefit must be provided to an employee or associate by an employer, associate or arranger. All of these terms are defined and, as is usual, extended in a variety of ways to encompass extraneous relationships which, at first sight, would not appear to be current employment relationships. 4. Next there is a connection test. The fringe benefit must be provided “in respect of” the employment. This is the same issue that was discussed above in relation to gifts: determining whether there is a sufficient connection between the employment and the benefit. 5. Finally, there is valuation. The employer is taxed on the grossed-up sum of the taxable values of all the fringe benefits provided. The valuation rules are the core of any system of taxing fringe benefits and are a function of the category of fringe benefit. The assigned value can be a realistic measure of the cash equivalent, but can also be an arbitrary number or the vehicle for providing some degree of concessional treatment. It is important to examine each element separately because, as with much of the recent tax legislation, inclusions and exemptions are introduced at each stage. For example, some items are not fringe benefits, such as employee share acquisition schemes and superannuation; some people whom one would not normally consider employers are included; the connection between the employment and the provision of the benefit may be wider than under common law tests; and some items are given preference by concessional taxable values or exemptions such as in-house child care, staff dining rooms or some staff discounts. Notice, however, that some of these steps are elided in the way the legislation is put together – while conceptually [4.320]

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there are five discrete issues, the legislation deals with some of them together. The discussion below sets out the issues in the order that the legislation presents them. (i) Concept of “fringe benefits provided” [4.330] We will examine first the scope and classification issues. In order to understand the

ambit of the FBTAA 1986, we can start with the general definition of “benefit” contained in s 136(1). Divisions 2 to 11 of Pt III of the Act feed into this definition by defining the specific goods, services and payments with which they deal to be benefits. Divisions 2 to 11 expressly define as benefits: • providing cars and car parking facilities to employees (Divs 2 and 10A); • making low-interest loans to employees, and waivers of loans (Divs 3 and 4); • paying an employee’s expenses (Div 5); • providing housing and meals, and payment of living-away-from-home allowances (Divs 6, 7 and 9); • subsidised airline fares offered to employees (Div 8); • entertainment, particularly in the form of meals (Divs 9A and 10); and • other forms of property provided by an employer to an employee (Div 11). In addition to these specific definitions, there is an important group of residual benefits in Div 12 which is a category of fringe benefits comprised of all “benefits” not dealt with under more specific provisions. Section 6 says that the specific inclusions do not limit the generality of the term “benefit”. This residual category can be important as Westpac bank discovered. It realised that the low-interest loans it offered to bank employees were fringe benefits and paid FBT on them. It failed, however, to pay FBT on the establishment fees on those loans (amounting to almost $2 m) that it would usually charge to customers but did not charge for employees. Westpac argued that the checking it undertook prior to granting a loan was something it did for its own purposes to protect its investment, and that process conferred no benefit on its employees. So doing this activity for nothing was not a benefit for its employees, but rather for itself. The most that could be said was that it was one less cost of borrowing money, but Div 4 of the Act set out exhaustively the taxable value of making a loan of money. In Westpac Banking Corporation v FCT, the Full Federal Court held that Div 4 is not an exhaustive statement of the FBT consequences of making a low-interest loan and a residual fringe benefit did arise where the bank accepted and assessed the loan application, and did other things in order to process the loan. Lindgren J in the Full Federal Court was able to discern a benefit in addition to charging at a low interest rate.

Westpac Banking Corporation v FCT [4.340] Westpac Banking Corporation v FCT (1996) 70 FCR 52; 34 ATR 143; 96 ATC 5021 In the case of both ordinary and employee applicants for financial accommodation, the bank assesses the application in all its relevant respects, takes a decision, and, if the decision is a favourable one, writes advising the applicant of the approval and of the terms and conditions on which the 172

[4.330]

financial accommodation will be made available and inviting the applicant to sign and return an “acknowledgment” agreeing to those terms and conditions. When the applicant does this, an

Income from the Provision of Services

Westpac Banking Corporation v FCT cont. establishment fee is payable by an ordinary customer, but not, at least ordinarily, by an employee. In my view, the steps taken by the bank to which I have referred involve the provision of a benefit or service by it to the applicant, whether the applicant is an ordinary customer or an employee. It is true that, in the case of both outsiders and employees, the bank acts in what it perceives to be its own commercial interests. But this is not inconsistent with the proposition that its conduct as described also constitutes or includes the provision of a benefit or service to the applicant. Where the benefit or service begins and ends may be arguable. According to the narrower view, it comprises only the writing of the letter of offer or commitment and the receipt, by way of return, of the applicant’s written acknowledgment. On the other hand, and more

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broadly, it may be that it extends back to include the antecedent steps of investigation, assessment and decision. What is important is that at least that for which outsiders pay an establishment fee includes the writing of the letter of offer or commitment and receipt of the applicant’s signed acknowledgment. Although the evidence did not include the form of letter written to outsiders, the writing of the letter of offer or commitment, whether to them or to employees, at least once the signed acknowledgment is returned, gives rise to a legal or moral obligation on the part of the bank to make the financial accommodation available. I have no difficulty in regarding this as a benefit or service provided by the bank. It is beside the point that it may not be proper to view each isolated act of the bank, such as the inspection of any security offered, as the provision of a benefit or service by it to the applicant. Again, the acts with which we are concerned in the present case are those for which ordinary customers pay an establishment fee.

[4.350] The next step in the legislative trail is to move from “benefit” to “fringe benefit.” Not

all “benefits” will be “fringe benefits”. Fringe benefits are defined in s 136(1) of the FBTAA 1986 to include certain benefits and to expressly exclude other benefits from being subject to FBT. Most of the excluded benefits are excluded from FBT because they are dealt with in the ITAA under special schemes. Examples of exclusions from the concept of fringe benefit are: salary and wages; employee share acquisition schemes; payments to superannuation funds; eligible termination payments on cessation of employment; payments of a capital nature for restrictive covenant; personal injury settlements; and deemed dividends under Div 7A and s 109. All of these are dealt with in the ITAA. There is also an exclusion for exempt benefits. Examples of exempt benefits can be found scattered throughout the FBTAA 1986. Many are contained in Div 13 of Pt III and others are in earlier Divisions dealing with particular types of fringe benefits, for example: s 22 exempts the reimbursement of some costs paid to an employee who uses a car for work; and s 47(2) exempts in-house child care facilities. For exempt benefits and other benefits which are excluded from being fringe benefits, the employer is not taxed on the benefit under FBT and any tax consequence must be found in the ITAA. Finally, there is a group of benefits which enjoy reduced taxable values in Div 14. Finding, and then properly classifying, a benefit is an important task for the parties to any remuneration arrangement. Wrongly classifying a sum will lead to difficulties – for the employee who has failed to report it believing it to be a fringe benefit and therefore the employer’s responsibility, and for the employer who has treated it, say, as a pension and therefore the employee’s responsibility. An example of this problem arose in Tubemakers of Australia Ltd v FCT (1993) 25 ATR 183. The taxpayer had been in the habit of paying premiums to its associated medical benefits fund to provide hospital, medical, pharmaceutical [4.350]

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and similar benefits for its current and former employees with 25 years’ service. In order to reduce its FBT cost (and presumably also the cost to its employees) the company decided to stop paying premiums and, instead, to pay cash to former employees which they could use to pay fund premiums or as they wished. The ATO nevertheless assessed Tubemakers to FBT on the cash payments. The taxpayer argued that the amounts paid to ex-employees were excluded from the definition of fringe benefit in s 136(1) either as a payment of “salary or wages” or as a “pension or retiring allowance”. The Federal Court held that the amount was no longer a retiring allowance, but was in the nature of a pension and so not a fringe benefit. Another example arose in Roads and Traffic Authority of NSW v FCT. The ATO assessed the taxpayer to FBT on three types of benefits that it provided to its employees – travel allowances, camping site allowances and camping accommodation. The employees in question were road workers who were entitled under relevant State awards to receive variously designated cash amounts and accommodation on-site in remote areas. The ATO argued that these were expense payment fringe benefits, living-away-from-home allowances and residual benefits, respectively. The ATO failed on all counts. The Court held that the travel allowances were simply additional salary. The camping allowance and the provision of camping accommodation were potentially taxable as fringe benefits, but were protected by the operation of the otherwise deductible rules discussed below. The extract below considers the position of the cash travel allowance. Hill J observed as follows.

Roads and Traffic Authority of NSW v FCT [4.360] Roads and Traffic Authority of NSW v FCT (1993) 43 FCR 223; 26 ATR 76; 93 ATC 4508 The Authority paid amounts in respect of travel to its employees in the relevant years of $938,209 and $1,298,232, respectively. Travelling allowances were required to be paid pursuant to the various Awards under which employees worked. Section 25(2)(a) of the General Construction and Maintenance, Civil and Mechanical Engineering &c (State) Award (agreed by the parties to be typical of provisions found in all relevant awards) provided as follows: Employees of NSW Government Departments and instrumentalities … shall be paid as follows: (a) Fares … (1) An employee who travels to and from his place of work by a public conveyance shall be paid all fares actually and necessarily incurred in excess of $1.00 per week or 20 cents per day … (3) Where an employee elects to travel by his own conveyance, or does so because the use of available public transport is impracticable, fares shall be 174

[4.360]

calculated and paid for as if travel were made in the ordinary way by public transport … Sample forms in evidence show that the employee was asked to fill in the actual transport used by him, the public transport route appropriate and the fare charged for that public transport. In some cases the employee was required to certify the information to be correct and that either the fare in question was actually and necessarily incurred by the employee, or an entitlement existed to an equivalent fare under the Award. In other cases there was no requirement for certification. Where certification was required it was not always completed. A perusal of forms in evidence indicate that some employees travelled by car, others by private bus and others by public transport. In some cases the actual mode of travel was not filled out. It seems that a substantially large number of employees travelled by car, presumably their own car. When the form was completed by the employee, it was handed to the timekeeper at the works office and checked to ensure that the

Income from the Provision of Services

Roads and Traffic Authority of NSW v FCT cont. public transport route claimed for was the shortest route and that the fares claimed accorded with those published by the relevant transport authority … At the end of each fortnight the time sheets were certified as correct by the foreman at the job site and forwarded to the works office for processing when the relevant fare allowance was calculated and paid to the employee in accordance with the terms of the award. As a matter of procedure, the Authority did not check whether the employee did in fact use public transport or indeed whether the employee incurred any expenditure at all. New forms were only completed where an employee changed job sites. The Commissioner claims that these payments fell to be taxed as expense payment benefits defined by s. 20 of the [FBTA] Act … It was submitted for the Commissioner that each of the payments made to employees by the Authority “reimbursed” the employees in whole or in part in respect of expenditure incurred by the employee … For the Authority it was submitted that none of the payments in question operated to reimburse the employees in respect of expenditure incurred by them, but that even if a payment did so operate, the amounts in question would fall within the definition of salary or wages within s. 221A of the ITA Act. The word “reimburse” is defined in the Macquarie Dictionary as meaning “to make repayment to for expense or loss incurred; to pay back; refund; repay”. Thus an employee who travelled by government bus and who had the whole, or perhaps substantially the whole, of the amount he had paid refunded to him would, in ordinary parlance, be said to have been reimbursed that amount. On the other hand, an employee who travelled in his own car but who was paid an amount dependent upon the cost of public transport less a small sum, would not, in ordinary parlance, be said to have been reimbursed anything.

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The ordinary meaning of the word reimburse, however, is expanded by the definition in s. 136(1) so that if the result of a payment is indirectly a reimbursement, the payment in question will be taken to be a reimbursement and the payment thus fall within s. 20. Notwithstanding the width of the definition of reimburse contained in s. 136(1), I doubt if it could properly be said that a payment of an amount of money having no relationship at all to the actual cost (for example, of private car transport) operated so as to have the effect or result, directly or indirectly, of reimbursing the whole or part of the expenditure of operating the vehicle. It seems to me that the concept of re-imbursement requires that the payment in question be made by reference to actual cost, that is to say that there would need to be some correspondence between the payment and the expenditure incurred, even if the reimbursement were to be but partial reimbursement. Under the Award, an employee could, it would seem, elect to travel by bicycle at no, or minimum, cost, but nevertheless be paid what it would have cost had he travelled by public transport less $1 per week or 20 cents per day. A payment to such a person could by no stretch of the imagination be said to involve a reimbursement … However, in my view it is ultimately unnecessary to determine the issue because the payments in question fall within the definition of salary or wages within s. 221A of the ITA Act and, accordingly, do not fall within the definition of fringe benefit … [T]he payments in question have little relation, except in the case of an employee who actually uses public transport, to the actual cost incurred by the employee. The amount is payable whether or not the employee travels by public transport, provided he travels by some form of conveyance. The payment is made to persons who are employees and made to them pursuant to their Award. No question arises of the payment being a mere gift. There is no question of employees being required to account for the moneys they receive.

[4.360]

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[4.370] You may care to contrast this view of the difference between an allowance and a

reimbursement with that expressed by the Commissioner in Taxation Ruling TR 92/15. The second issue on our list was timing. Assuming there is a benefit, it must be provided or deemed to be provided – this is the term which allocates benefits to various years. Section 136(1) of the FBTAA 1986 gives a definition of “provided” which probably adds nothing to the natural meaning of the word. Section 148(3) of the FBTAA 1986 defines “deemed to be provided” as arising where: a thing which would be a benefit is done; the thing is prohibited; but the prohibition is not consistently enforced, that is, the employer “turns a blind eye”. Similar provisions exist for some of the specific benefits dealt with under other Divisions, for example, s 7(4) says a prohibition on using a car that is not consistently enforced means that the employee is entitled to use the car. The meaning of “provided” was considered by Hill J at first instance in Westpac Banking Corporation v FCT (1996) 32 ATR 479; 96 ATC 4366. In that case, the bank decided not to collect almost $2 m in establishment fees on low-interest loans made to employees. It argued that in order to “provide” a benefit it had to undertake some affirmative action: “the word ‘provide’ is defined in relation to a benefit to include, to ‘allow, confer, give, grant or perform’. It is said that each of these expressions require some positive act and that to fail to charge an amount cannot be the provision of any benefit.” Hill J disagreed and found that the benefit had been relevantly provided. [4.375]

Questions

4.32

Are these items benefits and, if so, what kind of benefit are they: a payment of $100 to the taxpayer in Smith prior to enrolment to assist him to (a) meet all the costs of the course (such as books and fees): consider ss 20, 40, 45; (b) meals provided to an employee in the staff canteen: consider ss 40, 41; (c) meals provided to an employee at a restaurant for which the employee is reimbursed: see s 20; (d) meals provided to an employee at a restaurant where the employee charges the bill to the employer’s credit card: see ss 20, 40, 45, 150.

4.33

Was a benefit provided, and if so of what kind, in the case of: (a) Smith v FCT? (b) FCT v Dixon? (c)

4.34

FCT v Harris?

Consider the taxpayer in Payne and assume that the employer was involved in the scheme in such a way that a fringe benefit arises – that is, assume the airline is an arranger for the employer. In what year would the benefit have been provided – in the year she joined, as she accrues points, or in the year that tickets are issued? Would there be more than one benefit?

(ii) Provided to employees/associates by employer/associate/arranger [4.380] The third issue in our list involves identifying the proper parties to the transaction. In

order to be a fringe benefit, something must be provided to an employee or its associates, by 176

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the employer or its associate or an arranger. “Employee” and “employer” are defined in s 136(1) to include current, future and former employees and employers. Current and former employees and employers are also defined in s 136(1) and that definition takes you to the definition of “salary or wages” also in s 136. The definition of “salary or wages” takes you to the withholding rules in Div 12 of the Taxation Administration Act 1953. If a person receives one of these payments, he or she is receiving salary or wages with the result that he or she is an employee and the person making the payment is an employer. A future employee is defined in s 136(1) of the FBTAA 1986 to mean someone who “will become a current employee”. This definition is apparently intended to catch signing-on bonuses but there has been some speculation that it could catch a multitude of other payments. Who can say that any given person may not become an employee at some future time? The better view is probably that “will” means that you can say at the time the gift is made that the person will (not may) become an employee. (See Rulings MT 2016 and MT 2019 extracted below.) An associate of an employee or employer is defined in s 136(1) of the FBTAA 1986 to have the same meaning as it does in s 26AAB of the ITAA 1936. The definitions in s 26AAB(14) and (15) include as an associate: certain relatives, a partner and the spouse or child of a partner, trustees of trusts of which the taxpayer could become a beneficiary, companies informally controlled by the taxpayer either because the directors usually act in accordance with the taxpayer’s directions or because the taxpayer can (alone or with others) control 50% of the voting power. Note also that s 159 of the FBTAA 1986 needs to be considered even though the s 136(1) definition of “associate” does not refer to the existence of the section. Section 159 includes as associates individuals such as de facto spouses, related companies (defined in s 158 to include parent, subsidiary and sister companies), and former partners. An employer can also act by an arranger. The idea is that, while the benefit is provided by another person, it does so at the behest of the employer. A common example would be where the employer, say a university, places its account with a particular bank on the understanding that all of the university’s employees will be offered home loans on slightly advantageous terms. This is captured in para (e) of the definition of “fringe benefit” in s 136 – a benefit provided under “… an arrangement … between the employer … and the arranger …” In such a case, the employer pays tax on the value of the benefit provided to the employee by the third party arranger. At the other extreme there are the kinds of situations seen in the frequent flyer schemes examined in Payne. Here, there was no explicit arrangement between KPMG and Qantas that Qantas would provide flights to Ms Payne. Indeed, Qantas probably had no idea who employed Ms Payne, and KPMG probably had no idea just how many frequent flyer schemes Ms Payne belonged to (although they undoubtedly knew that she was in the Qantas scheme in order to set up the test case). The ATO took the view, however, that unless the employer was a party, no arrangement existed between the airline and the employer to provide benefits to the employees, and he has maintained this position in Taxation Ruling TR 99/6. But employers and third parties will not always be unaware of the other’s situation and it can be a difficult matter to determine when an implicit understanding might amount to an arrangement. For example, the bank might take a unilateral action based on a business judgment that it is in the bank’s best interests to offer low-interest loans to university employees – it will make the university happy and less likely to shift its account to another bank. (Of course, the university might quickly become very unhappy if that generous act on the bank’s part unwittingly [4.380]

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triggered an FBT liability for the university.) The legislation now tries to address these situations in para (ea). There will only be a fringe benefit provided if “the employer … participates in or facilitates the provision or receipt of the benefit or … a scheme or plan involving the provision of the benefit and the employer or associate knows, or ought reasonably to know, that the employer or associate is doing so …” So, if the university advertises that its employees qualify for low-interest loans with this bank, there may well an arrangement, but if the bank advertises it, there may not. At present, FBT does not apply to income in kind derived outside the employment context. For example, in Taxation Ruling TR 93/38 the ATO expresses the view that FBT has no application to low-interest loans provided by insurance companies to insurance agents, as they are independent contractors and not employees of the insurance company. Consequently, the interest saving is a non-cash business benefit and assessable as income under s 21A of the ITAA 1936. [4.385]

4.35

Question

Would the payments have been made between an employer and an employee in: (a) Hayes v FCT? (b)

FCT v Dixon?

(c)

FCT v Harris?

(iii) In respect of employment [4.390] The fourth element in defining the scope of FBT is the connection test – the

requirement that a benefit be provided in respect of employment. It is this requirement that identifies those benefits which are the real target of the tax. Every benefit, even those provided to associates of employees, must be “in respect of” the employment of some employee. Section 136(1) of the FBTAA 1986 defines “in respect of” to include “for or in relation directly or indirectly” to an employment. This is the same wording as is used in s 15-2 of the ITAA 1997 so that the connection between the employment and the benefit is not initially different under s 136(1). But s 148(1) of the FBTAA 1986 substantially extends the s 136 definition of “benefits provided in respect of an employment”, by stating that there may nevertheless be a benefit provided in respect of employment, even though the employer provides the benefit in respect of some other matter; the employer provides it in respect of past or future employment; the employer provides a benefit that is partially detrimental; the employer provides a benefit that is surplus to the employee’s needs; the employer provides a benefit that is not “in the nature of income” (for example, one not convertible into money); and whether or not the employer provides the benefit as “a reward for services rendered”. When the legislation was released, the extension of the requisite connection in s 148 caused an outcry because it was thought the definition extended to catch payments not even remotely connected with employment. The ATO issued Rulings MT 2016 and MT 2019 which retreated from some possible interpretations of the section perhaps almost to the point of re-establishing the common law test. The first ruling states:

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Ruling MT 2016 [4.400] 2. An essential element of the definition of fringe benefit is that the benefit must be one provided in respect of the employment of the employee. Unless a benefit is provided in the context of an employer-employee relationship the tax has no application … 5. Sub-section 148(1) does not remove in any circumstances the fundamental requirement that, before there can be a tax liability, the benefit under consideration has to be provided in respect of the employment of the employee … 7. It has been suggested that subsection 148(1), particularly when read in the context of the definition of “employee” in section 136 which takes in current, future and former employees, extends the meaning of “in respect of the employment of an employee” and, consequently, gives excessive width to the coverage of the Fringe Benefits Tax Assessment Act. Some examples of benefits said to be thus brought within the scope of the Iclude: (a)

the value of accommodation and meals provided in the family home where children of a primary producer work on the famiIfarm …

(c)

birthday presents given to children who work in small businesses run by their parents;

(d)

a wedding gift given by parents to an adult child who had some years earlier worked after school in the family business;

(e)

an interest-free or concessional loan given to such a child for the purpose of buying a matrimonial home;

(f)

the rental value of a farm homestead occupied by a family whose private company conducts the farmingIiness in which they work and holds the title to the homestead. 9. The reference in the law to future or former employees does not curtail the requirement that the benefit also be provided in respect of the employment of the employee. In the context of “future” or “former” employees the reference to employment is, by virtue of the definitions of those terms and the definition of “current employee”, a reference to the employment activities ultimately undertaken in the case of a future employee or formerly undertaken in the case of a former employee. 10. Seen in context, therefore, the reference to future and former employees ensures only that a benefit provided in respect of employment activities does not escape fringe benefits tax merely by virtue of the fact that it is given in advance of the employment commencing or after the employment ceases. For example, the inclusion of former employees ensures that a benefit (for example, a low interest loan) that continues to be provided to a former employee by virtue of his or her former employment remains subject to fringe benefits tax … 11. In each of the examples … above, the facts as presented lead strongly to the conclusion that the benefits and gifts were given in an ordinary family setting and would have been a normal incidence of family relationships. It would not be concluded that they were to any extent provided in respect of either past or current employment of the recipient members.

Ruling MT 2019 [4.410] This ruling deals with the application of the FBT to benefits provided by a family private company to a shareholder of the company who is also a past or current employee of the company or an associate of such an employee …

3. [T]he first point to note is that for the benefit to be liable to FBT, it must be provided to the shareholder at a time when that person is an “employee” or an associate of an employee. The term “employee” is defined in the legislation to mean a current employee, a future employee or a [4.410]

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Ruling MT 2019 cont. former employee. The term “current employee” is, in turn, defined to mean, in effect, a person who is an employee for the purposes of the PAYE provisions of the income tax law. A shareholder will meet this definition if at the time when the benefit is provided he or she is in receipt of salary or wages from the company or is a director who receives directors’ fees … 6. By virtue of para 148(1)(a) of the Fringe Benefits Tax Assessment Act, a benefit provided to a person by reason of both his or her employment activity and shareholding will be taken to be provided in respect of the person’s employment. If, however, it can be established that a benefit is provided to a shareholder/ employee solely by reason of that person’s position as a shareholder of the company and not to any extent by reason of that person’s employment by the company, the benefit will not be subject to FBT … 8. Where a benefit is provided to a shareholder/employee of a family company in connection with the performance of his or her

duties as an employee, it is considered that the benefit is provided in respect of the person’s employment. For example, where a car owned by a family company is used by a shareholder/ employee in the course of his or her employment by the company, it is considered that any use, or availability for use, of the car by the employee (or an associate) for private purposes is a benefit provided in respect of his or her employment … 9. In relation to benefits that are not expressly linked to the carrying out of the employee’s duties, it is necessary to examine all the facts and circumstances of the case to establish whether the benefit is fairly to be regarded as having been granted to the shareholder/employee in his or her capacity as an employee or as a shareholder. Factors such as the nature of the benefit, any cash remuneration paid, the nature and extent of any trading activities of the company, the extent of any services rendered by the shareholder/ employee and the extent of his or her shareholding may be relevant in concluding whether a non-cash benefit was provided as remuneration for services or in the capacity of shareholder.

[4.420] The connection test, that a benefit must be provided “in respect of employment”, has

become a matter of some dispute. In two recent cases, J & G Knowles v FCT (2000) 44 ATR 22 and Starrim Pty Ltd v FCT (2000) 44 ATR 487, courts examined whether the payment was made to a company director (who is an employee for FBT purposes) because of their position as director, or for some other reason – say, because they were shareholders of the company or in some other capacity. In Knowles, the company was a trustee of a unit trust. The units were held by the family trusts of the four directors. So effectively, the income and assets of the head trust belonged to the four directors and their families. This was at the heart of the dilemma. Were the benefits provided to the directors because they were directors of the company (in which case FBT would apply) or because they were beneficiaries of the trust? The issue arose because the company allowed each director to write cheques for personal expenses on the company’s cheque account. When the cheques were met, the amount paid out was treated by the company as a loan to the director’s trust. As the Court noted, “there was no relationship between the amount of money each director requested be paid and the personal effort involved in working as a director. Nor was there any relationship between the amount paid at the request of one director and the amount paid at the request of the others.” The ATO argued that amounts were loan fringe benefits because loans had been made to the directors in respect of their duties. The Full Federal Court, however, considered the facts ambivalent: “the material before the AAT pointed in 2 directions. The first was that the directors drew upon the assets of the unit trust because ultimately the trust was established, and its assets were to be 180

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held and applied, for their benefit and that of their families. The second is that it was agreed between the directors that, as an incident of their directorship, each of them were entitled to draw upon the appellant’s funds by way of loans for their personal benefit. In the first case it is unlikely that there would be a sufficient connection with the employment, while in the second the loans are likely to be an incident or product of it.” The Court remitted the matter to the AAT to re-examine the facts, but with the benefit of a re-expression of the connection that must be found. They said: The words “in respect of” have no fixed meaning. They are capable of having a very wide meaning denoting a relationship or connection between 2 things or subject matters. However the words must, as with any other statutory expression, be given a meaning that depends on the context in which the words are found … The AAT was correct in stating that the phrase requires a “nexus, some discernible and rational link, between the benefit and employment”. That, however, does not take the matter far enough. For what is required is a sufficient link for the purposes of the particular legislation. It cannot be said that any causal relationship between the benefit and the employment is a sufficient link so as to result in a taxable transaction. For example, a discretionary trust with a corporate trustee might be established to purchase a family home for the benefit of its directors and their family. It does not follow that the rent free occupation of that home on the authority of the directors is a benefit provided “in respect of” their employment for the purposes of the FBTAA. While there is a causal relationship between the provision of the benefit and the employment it is not a sufficient or material relationship. The rent free occupancy arises because the trust was established for that purpose; a reason extraneous to the employment of the directors.

When the case was reconsidered by the AAT, it concluded that the loans had not been made to them as directors, but rather because they were “ultimate owners of the business and its assets” – that is, as trust beneficiaries: Re J & G Knowles (2000) 45 ATR 1101. In Starrim, the company lent money to the directors who were also shareholders of the company in order that the shareholders could finance the purchase of a block of land. The land in question was actually the site of a business that the company had just purchased, so it was clearly in the company’s interest to have the purchase completed. Again, the ATO argued that the funds had been advanced to the shareholders as directors of the company. The Court upheld the AAT’s view that the funds had been advanced to them as purchasers of the property. [4.425]

4.36

Question

Would there have been an adequate connection between the payment and the services for FBT to apply to the payment (assuming it was otherwise applicable) in Hayes, Dixon, Harris, Smith, Scott, Kelly and Payne?

(iv) Taxable value of benefits [4.430] Once it is concluded that there is a fringe benefit, its taxable value must be determined

– the final issue in our list. By s 66(1) of the FBTAA 1986, FBT is payable by the employer on the fringe benefits taxable amount which is defined to be the sum of the taxable values of all fringe benefits provided during the year grossed-up for the tax and adjusted for GST. Individual taxable values must be calculated under the rules provided by each Division for each benefit, because the FBTAA 1986 gives separate valuation rules for each type of benefit. We will deal with five examples of the valuation rules: cars and car parking; loans; entertainment; property fringe benefits; and residual benefits. [4.430]

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Cars [4.440] In general terms, s 7(1) of the FBTAA 1986 says a car benefit arises where a car that is

owned or leased by an employer is either made available for private use or is actually used by an employee for private purposes at any time on any day during a year. Note that almost every word in this summary is given extended definitions by the FBTAA 1986. Section 7(2) says that a car is made available for the employee’s private use if it is garaged at the employee’s residence (although there is an exception in subs (2A) if the employee drives home an ambulance or police car). In AAT Case 9824 (1994) 29 ATR 1246; Case 58/94 (1994) 94 ATC 498 the Tribunal applied this rule to a car that was used exclusively in a business which was run from the home of a director just because it was garaged at that home. In Ruling MT 2021, the ATO takes the view that s 7(2) would apply if the car is garaged at the employee’s home even if the employee was overseas at the time. Section 7(3) says that a car is made available for an employee’s private use if the employee has custody or control of the car and is not performing employment duties at the time. Notice in subs (4) that even if private use is prohibited by the employer, that prohibition will be disregarded if it is not consistently enforced. Section 8(2) exempts a car benefit if the private use is “minor, infrequent and irregular”. Notice also that not every vehicle is a “car” – the definition in s 136 of the FBTAA takes one to the definition in s 995-1 of ITAA 1997 which excludes vehicles designed to carry more than 1 tonne or more than eight passengers – and not every “car” gives rise to a taxable car fringe benefit – s 8(3) exempts the benefit if the car was unregistered. To determine the taxable value of a car fringe benefit, the employer can elect to use either a statutory formula or the operating cost method. The statutory method is somewhat arbitrary but involves less paperwork. As the operating cost method attempts to follow the actual costs of running the vehicle, it generally requires more documentation in the form of log books to be kept. An employer can use different systems for different cars and for different years. Statutory formula: The statutory formula is given in s 9(1) of the FBTAA 1986. At its simplest, the statutory value is (the car’s value × stipulated fraction based on annual kilometres driven × the number of days of private use per year/number of days on which the car was used or made available for private use) minus the employee’s contribution to running costs. The car’s value is initially its cost, but declines to two-thirds of its cost after the fourth year: see s 9(2)(a). The stipulated fraction which is given in s 9(2)(c)(ii) used to vary with the numbers of kilometres driven per year, but was changed to a fixed rate of 20% in 2011. The amount of the benefit is then reduced by any amount which is the recipient’s contribution. Operating cost method: The operating cost method of valuation is provided in s 10 of the FBTAA. The operating costs are defined in s 10(3) to include fuel, maintenance and repairs, registration, insurance, and either depreciation and imputed interest or lease costs. These costs are then pro-rated to exclude business use, leaving the proportion of costs attributable to private use as the amount of the taxable value. Employers must establish the percentage of business use by keeping log books. If log books are not kept for 12 typical weeks per year or are defective, the whole use is assumed to be private. The log book rules are contained in ss 10A to 10B.

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Questions

4.37

Alpha Pty Ltd purchases a car on 1 April for $30,000 and makes it available to B who drives it primarily on business. B garages the car at home. During the next year the car travels 45,000 kilometres. Alpha pays the following expenses: insurance $500; registration $500; fuel, oil and maintenance $2,000. What is the taxable value of the car using the statutory method?

4.38

Assuming that the log books record 30,000 kilometres travel for business trips, what is the taxable value of the car using the operating cost method, if the depreciation rate is 22.5% and the imputed interest rate 14%.

4.39

Ignoring FBT, how much should a conscientious taxpayer have disclosed as assessable income if all these facts had occurred in 1984?

4.40

Why do you think the government changed to the fixed rate of business use in s 9(2)(c)(ii)? For example, if a car is driven less than 15,000 kilometres in a year, what would be your guess about the proportion of the travel that would be business-related?

4.41

Consider the FBT consequences of this transaction. On 1 April 2001, an employer enters a lease of a new car for five years. The employer will provide the use of the car to the employee as a car fringe benefit for the next five years. According to the terms of the lease, the car will have a residual value at the end of the lease of $15,000 and the understanding in the industry is that the employer will be able to buy the car for this amount from the lessor at the expiry of the lease. On the same day, the employer enters a contract to sell the car to the employee in five years’ time for $15,000. It is expected that the car will have a market value in 2006 of $25,000. What are the FBT ramifications in 2001? What are the FBT ramifications in 2006?

4.42

What difference would it make if, rather than execute a separate agreement, the employer simply assigned to the employee its rights under the lease agreement (with the consent of the lessor) in 2006?

[4.450] Car parking is rather oddly one of the more complex FBT areas and is in many ways

emblematic of the problems of the FBT. Initially, car parking facilities provided by an employer were treated by the ATO either as an expense payment benefit or as a residual benefit: see Ruling MT 2021. But in 1987, s 58G was inserted into the FBTAA 1986 to provide that car parking was exempt from FBT. This exemption was removed in 1993 – the government’s target was clearly the free provision of valuable parking spots in the CBD to high-income executives. Implementing the proposal has proved something of an administrative nightmare, as we shall see. Division 10A enacts the FBT on car parking – it is one of the longest regimes in the Act. A parking benefit can arise independent of any associated car fringe benefit. Section 39A provides that a car parking benefit arises on any day where: • the vehicle being parked falls within the definition of a “car” in s 136(1) of the Act; • the car is parked for a period or periods that total more than four hours during a day; • it is parked between 7 am and 7 pm (“daylight period”); • it is parked either at the employer’s business premises or at the business premises of someone else (the car park operator) that is in the vicinity of the employer’s premises; • the car is parked at a place that is within 1 kilometre of a “commercial parking station”;

[4.450]

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• that parking station charged at least $5 (indexed from 1995; $7.07 for the 2008–2009 FBT year) to members of the public for all-day parking on the first of April of that year (“car parking threshold”), provided that the price on that day was “representative” (see ss 39AA and 39AB); • the car is either the employer’s vehicle but is provided as a fringe benefit, or it is the employee’s car; • the employee has a primary place of employment and the car is parked close to that primary place of employment; and • the car was used by the employee that day to travel between home and work. These rules have proved to be an administrative quagmire. Many important details are left to be dealt with by Taxation Ruling TR 96/26. It may give you some idea of the complexity involved if you realise that Ruling TR 96/26 consolidated and replaced eight prior Rulings trying to make these rules more workable. Consider the following questions. • How is the 1 km measured – by road, by foot, as the crow flies? Where is it measured from and to? Section 39B assists a little by saying that the 1 km is measured to the car entrance of the commercial car park. According to TR 96/26 the entrance is within the 1 km radius if it can be reached “by the shortest practicable route … travelled by foot, car, train, boat, etc., whichever produces the shortest practicable route. Where the shortest route can be travelled on foot, we expect that public thoroughfares such as arcades through shopping centres will be utilised in determining the distance. However, illegal or impractical shortcuts through, eg private property, will not be considered to be part of a practicable route.” • How many benefits arise if there are only five spots but someone inconsiderately parks across two lanes? What happens if one shift finishes at 2 pm and another starts immediately? What happens if the same employee works from 7 am till noon and from 2 pm till 7 pm? According to TR 96/26, “one car parking space can give rise to more than one benefit on a day if more than one car is parked in a space for more than four hours in total. This may occur because vehicles are coming and going from the car park during a day, where cars are made available to employees for use on a pool basis or where employees work in shifts.” As a result, there is an alternative method of valuing just the individual car spaces in s 39FA. • What is a “commercial” car park? Does it include vacant sites and parking meters? What about a shopping centre car park where there is no charge, provided the driver produces a receipt for a purchase of at least $10 from a shop in the centre? What about a council car park where there is no charge for the first two hours but a fine of $20 for vehicles parked beyond that time? According to TR 96/26 none of the following are commercial car parks: parking provided for short-term shoppers or hotel guests; all-day parking where the fee is nominal; car parking for a short period to cater for a special function; parking facilities provided by a sporting venue to persons associated with the venue; parking provided by a business for its own employees and those of a nearby business, but to no other person, if there is no commercial car park within 1 km; and a kerbside parking meter. And TD 94/54 says that the showroom of a car dealer is not a “parking facility”. • Does the commercial car park charge a fee above the threshold? For example, what if it charges $10 per day on weekdays and $5 per day on weekends; it charges $10 per day for casual parking but $150 per calendar month; does it make any difference if the month has only 20 weekdays or if it has 22? Section 39E says to pro-rate the fee (weekly, monthly, yearly) by the number of business days in the period, which would suggest that a car benefit can arise in the first month but not the second. 184

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• What happens if the employee usually works at one place but visits another work site during a day? The policy seems to be to catch employees who regularly park in the CBD but TR 96/26 states “employer-provided parking for vehicles used for work-related purposes, which are parked next to temporary places of work (eg electricity substations)”. Consider an employee who goes to service a ski lift in the Snowy Mountains. • There is a threshold figure of $5 (indexed annually from 1995) to try to eliminate small benefits. What happens if a local commercial car park has an early bird special for all-day parking? What if it has lower effective rates for taking a space on a monthly basis? What if your factory happens to be alongside an airport with a very expensive short-term parking facility? According to TR 96/26 “the lowest all-day fee may include a fee which a commercial parking station charges for bona fide early bird parking where a reasonable number of parking spaces are set aside for those purposes”. Sections 39AA and 39AB were introduced to require that the comparison rate must be “representative”. History has confirmed that this is a difficult area, even for sophisticated taxpayers. In Virgin Blue v FCT [2010] FCAFC 137, the issue was whether the parking lot which Virgin provided for its Melbourne staff to park their cars were “at or in the vicinity of” their workplace at Tullamarine airport as required by s 39A(1)(f). The lot was almost 2 km from Terminal 3 where Virgin operates, and was a 15 minutes bus ride or 20 minutes on foot. The Full Court held that the car park was not “in the vicinity” of Terminal 3 (the portion of Melbourne airport where the employees worked), and so no fringe benefit arose. The Court said, “that the bus trip, taken twice a day, between the car park provided and the primary place of employment takes 15 to 20 minutes, excluding waiting time, serves only to strengthen this conclusion.” In FCT v QANTAS [2014] FCAFC 168, the employer allowed staff to park free on Qantas’ bases at various airports while they were working at the airport. The ATO argued that QANTAS had to pay FBT on the value of the parking provided to its employees because the parking stations at airports constituted a “commercial parking station” within a kilometre of the QANTAS base. The definition of a “commercial parking station” in s 136 refers to, “… a permanent commercial car parking facility where any or all of the car parking spaces are available in the ordinary course of business to members of the public for all-day parking on that day on payment of a fee …” QANTAS had two imaginative (but unsuccessful) arguments why these car parks were not “commercial parking stations.” First, it argued when the definition referred to parking spaces being made available to “members of the public”, the section was referring just to people who were commuters, and the people who parked at airports were not commuters. Secondly, the airport is only in the business of offering parking to a small subset of “the public” – just to passengers and their relatives dropping them off or collecting them. (This restriction was actually stipulated on the ticket for the car park at Canberra airport.) These matters all go to the question whether or not a taxable car parking fringe benefit has been provided. When it comes to finding the taxable value of a car parking fringe benefit, matters become more complicated. For the 1993 and 1994 FBT years, there were only two methods for calculating the taxable value of car parking fringe benefits: the commercial parking station method (s 39C); and the market value method (s 39D). For the FBT years beginning 1 April 1995 and later years, a further three methods for calculating the taxable value were added: the average cost method (s 39E); the car spaces method (s 39FA); and the 12-week register method (s 39GA). An employer may elect to use any of the methods, but where no election is made, the employer must keep records of actual benefits provided. [4.450]

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• Where the commercial parking station method is used, the value of the benefit is the lowest all-day parking fee charged in the ordinary course of business at any permanent commercial parking station available to the public within 1 km of the parking facilities provided by the employer: s 39C of the FBTAA 1986. • Where the market value method is used, the value of the benefit is the amount that the recipient could be expected to pay for the benefit if the provider and the recipient were dealing with each other at arm’s length: s 39D. The employer must obtain a valuation report from an independent valuer to substantiate the amount used. TR 96/26 sets out a number of requirements about the qualifications that will be accepted as suitable and the form of the valuation report. • Where the average cost method is used, the value of the benefit is the average of the lowest fees charged by an operator of a commercial parking station within a 1 km radius of the employer’s parking premises on the first and last day the benefit is provided during the FBT year: s 39DA. • Where the spaces formula method is used, the value of the benefit is based on the number of car parking spaces available for employees, rather than the number of individual car parking benefits provided during the year: s 39FA. The amount is still derived from the commercial parking station method, the market value method or the average cost method, but the method assumes that a parking space will be used on 228 days during a year. Importantly, it caps the benefit by reference to the number of employees who work for the employer. • Finally, the 12-week register method allows an employer to calculate the taxable value of car parking benefits provided during an FBT year on the basis of the taxable value of benefits provided during a representative 12-week period: s 39GB. Like the statutory formula method, this is primarily a record-keeping system that avoids the need for the employer to keep detailed records of the number of car parking fringe benefits for a full 12-month period. If all of this sounds ludicrously complex, the government probably secretly agrees with you. In 1999, the government decided to enact a number of exceptions as a result of the report of the Small Business Deregulation Task Force. Section 58GA now contains an exemption if the employer provides car parking on its premises (or at least not in a commercial car park), provided the employer is not a government body or a listed public company and has an annual turnover of less than $10 m.

Loans and waivers [4.460] A loan benefit arises where an employer lends money (though not goods) or extends

an existing loan to an employee at a reduced interest rate (s 16). If the employer is a bank, loans at current market interest rates to employees are exempt under s 17 of the FBTAA 1986 (even though this could just as easily have been dealt with by recognising that a loan on these terms has a nil taxable value). In essence, the taxable value of a loan benefit is defined in s 18 as the difference between the interest actually charged to the employee and a notional amount referred to as the benchmark interest rate which, when you follow all the re-definitions, means the “large bank housing lenders variable interest rate for loans on housing for owner occupation last published by the Reserve Bank of Australia before the commencement of the year of tax”. Loans and extensions to existing loans are also subject to the “otherwise deductible” rule which will reduce the FBT value where the employee uses the benefit to produce assessable income. This rule is discussed in more detail later. 186

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A loan waiver benefit arises where an employer decides to forgive an existing debt (s 14). It is not clear what happens if the employer does not formally waive the debt, but the debt just becomes irrecoverable because of the effect of the statute of limitations.

Entertainment [4.470] The treatment of expenditure on entertainment is one of the perennial difficulties of

an income tax. Images of business conferences held in exotic locations, corporate hospitality boxes at major sporting events and long business lunches lubricated by expensive wines, all subsidised by a tax deduction, are understandably not ones that appeal to the taxpaying public or their elected representatives. Consequently, governments have tried various measures to curb the extent to which these kinds of activities are subsidised by the tax system. The technical problem is to differentiate the business component of these expenditures from the personal consumption element of business entertainment – how to dissect the part that is just like promotional expenses incurred in representing the firm to its clients from the part that is a form of personal consumption for the employees. The approach adopted in the Draft White Paper in 1985 was simply to deny deductions to employers for the cost of all forms of entertainment provided by a business – in other words, to tax entertainment under the employer’s tax and at the employer’s tax rate by refusing to reduce the employer’s profits by the amount expended on entertaining both employees and clients. This was enacted as s 51AE of the ITAA 1936, now Div 32 of the ITAA 1997. The consequence of this position was to impose (usually) 30% tax on these benefits, rather than 46.5%. It was recognised from the beginning that this policy would not work where the employer was exempt from tax – simply denying a tax deduction to a person who did not pay tax to begin with was not going to result in imposing tax on these kinds of benefits. Consequently, Div 10 of the FBTAA 1986 stipulated that a taxable fringe benefit would arise where entertainment was provided by an employer who was wholly or partly exempt from income tax. The expenditure incurred by the employer in providing the entertainment or reimbursing the employee for its cost would be the taxable value of the fringe benefit. But where the entertainment expenses remained deductible under the income tax (such as provision of meals to employees in staff cafeterias, the cost of meals at certain business seminars, meals on business travel away from home) no fringe benefit would arise. In 1994, the government decided that this approach was no longer suitable. Instead, it decided to impose FBT on entertainment given by taxable (as well as tax-exempt) employers and to reinstate the tax deductibility of entertainment expenditure for employers where the expenditure gave rise to a fringe benefit. This would have the effect of taxing the business-related component of the entertainment at the employer’s rate (eg the cost of the client’s lunch) while taxing the part that was a taxable fringe benefit (eg the cost of the employee’s lunch) at the FBT rate. But businesses complained again about the compliance difficulties associated with this system for entertainment – some was not deductible; some was subject to FBT. (Who ordered the chicken? Was it the employee or was it the client?) So, in 1995 the government introduced another system – an option for a 50/50 split (half would be non-deductible and the other half deductible but subject to FBT) for entertainment in the form of meals provided to employees, and also for the “entertainment facility leasing expenses” of corporate boxes and similar hospitality facilities. A new s 51AEA of the ITAA 1936 (now Div 32 of the ITAA 1997) was introduced to allow a deduction to an employer of [4.470]

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50% of its expenses for meal entertainment, and Div 9A was introduced into the FBTAA 1986 to impose FBT on the same 50%. Under the 50/50 split method, the taxable value of meal entertainment fringe benefits is 50% of the employer’s meal entertainment expenditure during the FBT year. Again this can be determined by using a 12-week register of the employer’s meal entertainment expenditure. The idea that food is itself “entertainment” is a trifle odd – contrast a long lubricated business lunch at the latest Michelin 2-star restaurant with the instant coffee, dubious milk and packet of stale biscuits provided in the tea room – and the ATO takes the view in IT 2675 and Taxation Ruling TR 97/17 that only the provision of food or drink that has an element of entertainment satisfies the definition, ie the provision of food or drink must confer entertainment on the recipient. So the Ruling considers that “the provision of morning and afternoon tea to employees … on a working day, either on the employer’s premises or at a worksite of the employer, is not entertainment. The provision of light meals (finger food, etc), for example in the context of providing a working lunch, is not considered to be entertainment. The provision of food or drink in these circumstances does not confer entertainment on the recipient” (TR 97/17, para 19). But at “business lunches and drinks, dinners, cocktail parties and staff social functions … the provision of the food or drink confers entertainment on the recipient [and this is so] whether or not business discussions or business transactions occur at the same time” (para 20). On the other hand, “food or drink provided where an employee is travelling in the course of performing their employment duties … is not provided by the employer in order to confer entertainment on that employee [and] the meal does not have the character of entertainment” (para 21). Ruling TR 97/17 contains a long table setting out various permutations and combinations that will and will not amount to meal entertainment for the purposes of Div 32 of the ITAA 1997 and Divs 9A and 10 of the FBTAA 1986. Some examples will give you a flavour of the complexity of this area. In the ATO’s view: • if the employer provides food and drink at a social function at its premises, the employer is providing entertainment; • if the employer provides food and drink at a morning or afternoon tea or light lunch at its premises, the employer is not providing entertainment; • if the employer provides food and drink at a restaurant, the employer is providing entertainment; • if the employer provides food and drink, including alcohol, at a restaurant but the employee is travelling on business, the employer is not providing entertainment; • if the employer pays for an employee to attend a seminar at which coffee and pastries are served, the employer is not providing entertainment; • if the employer pays for an employee to attend a convention at which there is a gala dinner including alcohol, the employer is providing entertainment.

Property fringe benefits [4.480] A property fringe benefit arises when an employee gives an item of property to an

employee for nothing, or the employee pays less than the required amount. (Notice that if the employer just lets an employee use an item of property, this is not a property benefit; it is a residual benefit or maybe a car benefit.) The taxable value of a property benefit depends on whether or not the goods are an “in-house benefit”, in which case concessions apply. An “in-house property benefit” is defined in s 136 to mean something like trading stock – tangible 188

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property that the employer sells in its business principally to outsiders. A different taxable value is calculated for external property benefits – generally ones the employer does not ordinarily deal in and so has probably had to buy in especially from an external supplier. Section 42 sets out the taxable value of in-house property benefits. The taxable value of the benefit value will be the difference between the amount charged to the employee and some other amount – an amount that differs depending on whether the employer is a manufacturer or a trader, and whether it operates in the wholesale or retail market: • if the employer is a manufacturer of this kind of property which it sells principally to other businesses, the amount is the lowest price charged to commercial buyers (s 42(1)(a)(i)); • if the employer is a manufacturer and it sells directly to the public, the amount is 75% of the retail sales price (s 42(1)(a)(ii)); • if the employer is not a manufacturer of this kind of property, but instead purchased the property, the amount is the lower of the employer’s cost and the “notional value” of the property (s 42(1)(b)). Notional value probably means “retail price” in ordinary parlance – it is defined in s 136 to mean the amount that the employee could expect to have to pay if it wanted to buy the item; and • if none of these apply, the amount is 75% of the “notional value” of the property (s 42(1)(a)(iii), (1)(c)). So there is still a substantial tax concession available for fringe benefits in this form. It means, for example, staff discounts provided by a retailer are only taxed if the goods are sold to employees below cost. For manufactured goods, the employer can still deliver a benefit FBT free if the employee pays wholesale prices. For external property benefits, the taxable value is usually the difference between the cost to the employer and the price charged by the employer to the employee (s 43). Just as the “otherwise deductible rule” allows an employer to reduce the taxable value of loan fringe benefit because of the use to which the employee puts the loan, so too s 44 reduces the taxable value to the employer of property fringe benefits because the employee would be entitled to an income tax deduction for the cost of the benefit, if he or she had paid for it. We will return to this idea later.

Residual benefits [4.490] A residual benefit is, as its name suggests, any fringe benefit not specifically dealt with

under the other Divisions of Pt III of the FBTAA 1986. For residual benefits, the taxable value again varies according to whether the benefit is an “in-house benefit” or an “external benefit” and also whether it is a “period” or “non-period” benefit – whether a benefit is provided on a single occasion or whether it is provided over a period. For in-house period and non-period residual benefits, ss 48 and 49 provide that if the goods are also provided to the public, the taxable value will be the difference between the price to employee and 75% of the price charged to the public. For external residual fringe benefits, the taxable value will be the difference between the price to employee and the cost to employer. Again an “otherwise deductible” rule is provided in s 52.

Exemptions and concessions [4.500] We need finally to refer to the various exemptions and concessions offered for some

types of fringe benefits through their taxable value. Exemptions and concessions exist in many places, and work generally in one of four ways: [4.500]

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• in the conditions, found in Divs 2 – 12, which determine whether or not a fringe benefit exists; • in determining the taxable value of those fringe benefits; • in the various exempt benefits provided in Div 13; and • in the reductions to taxable value found in Div 14. The main examples of exempt benefits are grouped in Div 13. They include reimbursing expenses for job interviews (s 58A), various job relocation expenses (ss 58B, 58C, 58D, 58F), newspapers (s 58H), after-hours taxi travel to or from home (s 58Z). There is also a $1,000 general threshold for certain kinds of in-house benefits provided by employers contained in s 62. There is also a general exemption for certain kinds of minor and infrequent benefits where the notional taxable value of the benefits provided during the year would be under $300 (s 58P). Division 14 contains reductions to taxable value of various benefits. Examples include the housing, fuel and holiday benefits provided to employees working in remote areas. [4.505]

4.43

4.44

4.45

Questions

How are the following cases treated (if at all) under the FBT? You will need to consider whether the item is a fringe benefit and, if so, of what type; whether it is provided by an employer in respect of an employee; and then determine its taxable value. (a) a car is provided by an employer to an employee which is used exclusively for the private purposes of the employee. No log book is kept. All the running and garage costs at a city parking station are paid by the employer; (b) the car is kept on the employer’s premises and is available only for business use by employees. No log book is kept. The employer pays all the costs of the car. Consider how these potential fringe benefits are dealt with: (a) a loan is made by the Australian branch of a Japanese bank to an employee stationed in Sydney, the loan being in yen with an interest rate of 6% which is a commercial rate for yen; (b) interest-free loans made by a family company to its employee directors are cancelled, the loans being repayable at call. Consider these potential fringe benefits: (a) conveyancing services are provided to an employee of a solicitor free of charge; (b) the solicitor permits the employee to do her or his own conveyance using the firm’s facilities free of charge; (c) (d) (e) (f)

4.46

a private school provides places free of charge to the children of the teachers; a brewery provides free beer to all employees at lunch; a company provides a free lunch to senior executives in the board room; a company provides free use of a house that it owns to a husband and wife who are directors of the company. The company was formed in the 1970s as a death duty avoidance device. The husband and wife draw directors’ fees. What kind of benefit arises where an employer reimburses the parking station expenses of an employee?

(v) “Otherwise deductible” rule [4.510] Many fringe benefits – loan and property benefits, for example – are subject to a

special valuation rule known as the “otherwise deductible rule”. Its operation is complicated 190

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to explain and may be more easily demonstrated by an illustration. In essence, these rules are needed to deal with situations created by the way FBT operates – that is, FBT is collected directly from the employer rather than at the level of the employee, and it is collected on the gross value of the benefit provided, not on a net value. The two examples below show one situation where the employee will already be adequately taxed on a fringe benefit under the income tax regime (and so her employer should not be liable to FBT as well), and another where no tax, either FBT or income tax, should actually be paid. Consider first what happens if the employee uses the fringe benefit represented by a low-interest loan to generate assessable income? What would happen if, for example, she lends the money borrowed from her employer at a low interest rate to some other institution at a higher interest rate? For example, assume that she earned $40,000 salary and borrowed $50,000 at 10% from the employer under an employer-subsidised loan scheme which she on-lent at 15%, which we will assume is the current benchmark rate. Her income tax position would have been: Salary Interest received Interest paid Taxable income

$40,000 $7,500 (5,000) $42,500

The employee is effectively taxed on both the salary and the low interest portion of the loan under the income tax and is taxed on the right amount – the net $42,500. But the low interest element is also a loan fringe benefit and is taxed to the employer as a fringe benefit. Unless something is done, the employee will pay on the $2,500 under the income tax and the employer will also pay tax (FBT) on the same $2,500 – remember the amount of the fringe benefit is the difference between the benchmark rate (15%) and the rate actually charged (10%) which equals 2.5% of $10,000, that is $2,500. The double tax problem is addressed in the FBT by the otherwise deductible rule. Under the otherwise deductible rule in s 19 of the FBTAA 1986, the taxable value to the employer of the loan made to the employee will be reduced to the extent the loan is used by the employee to generate assessable income. Similar otherwise deductible rules are a common feature of the valuation rules in other Divisions of Pt III and so we will look at s 19 in some greater detail to see how they work in this relatively straightforward circumstance. We will use the example just given: The employee on-lends at 15% the loan of $50,000 originally made by the employer at 10% and assume that all the events occurred after 1 April 1988. Now begin reading s 19(1). You will see after para (d) that “the taxable value … of the loan fringe benefit” is calculated using the formula given there rather than the s 18 calculation where the earlier paras (a) to (d) are satisfied. [4.515]

4.47 4.48 4.49

Questions

Is para (a) of s 19(1) satisfied; is she an employee? Is para (b) of s 19(1) satisfied; would she have been entitled to a once-only allowable deduction under the ITAA if she had paid interest as postulated? Is para (ba) of s 19(1) satisfied; is the gross deduction (see para (b)(i)) larger than the amount of interest that would have been allowable as a deduction to her? [4.515]

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4.50

Is para (c) of s 19(1) satisfied; is this an “employee credit loan benefit”? If not, assume that the declaration has been given.

4.51 4.52

Are either of para (ca) or (d) of s 19(1) applicable? Assuming that paras (a) to (d) of s 19(1) have been satisfied, now calculate the taxable value using the formula TV–ND. (See para (ba) for the definition of the notional deduction.) Assume for s 18 that the notional amount of interest is 14%.

[4.520] Section 19 is clearly a complex provision to apply and it can be made even more

difficult where the taxpayer’s position is slightly out of the ordinary. What happens, for example, if the employer lends not to the employee alone, but to the employee and their spouse jointly? The total low-interest amount is clearly still a fringe benefit – it is provided to an employee and an associate of the employee – but can s 19 still apply where the loan is then applied by them together to generate other income? In National Australia Bank v FCT (1993) 46 FCR 252; 26 ATR 503; 93 ATC 4914 the ATO argued that s 19 could not apply because the once-only income tax deduction required for s 19 was actually attributed to a different taxpayer under the income tax – the partnership of the taxpayer and spouse. The argument was unsuccessful. Another variation also arose in that case from sequential loans – where the employee borrowed at the low interest rate (say 10%), lent to the spouse at a slightly higher rate (say 11%), and the spouse then used the loan to produce a greater amount of assessable income (say 15%). This is a common income splitting technique designed to use the income-earner’s creditworthiness to secure the loan but to channel most of the income to the spouse who faces the lower marginal tax rate. A line of cases discussed in Chapter 7 has held that in certain circumstances, the first borrower is not entitled to deduct the full amount of interest incurred. Ryan J applied these cases to s 19 to hold that in the application of s 19, the “once only deduction” allowable would not be the amount of interest actually charged to the employee but only a fraction of that amount. The second instance where an “otherwise deductible” rule is needed arises where an employee would not be subject to tax if he or she had taken the cash instead and then spent to buy the fringe benefit at a store. This will commonly arise where an employer provides a benefit in kind that would, if purchased by the employee, have given rise to an offsetting allowable deduction. In other words, the employee would have had no income tax liability if they had received cash and then spent it to buy the fringe benefit. But because FBT is levied at the employer level, there is the possibility of FBT where there would not have been income tax on the cash equivalent. Consider the position of an employer, say an accounting firm, that decides to purchase a book costing $100 and give a copy to each employee involved in providing tax advice. This would be a property fringe benefit. However, if the employees had been paid $100 salary and purchased the book themselves, they could have deducted its cost and no income tax liability would be imposed on the $100 of salary. Section 44 attempts to recreate this result by again reducing the taxable value of the fringe benefit where the employee would be entitled to a once-only deduction. The operation of the otherwise deductible rules can be seen in Roads and Traffic Authority of NSW v FCT. The case involves the explicit otherwise deductible rule in s 52 of the FBTAA 1986 for property benefits, and a hidden one in s 30(1)(b) for living-away-from-home allowances. The ATO tried to impose FBT on the employer for the cash camping allowances and accommodation in camp sites that it provided to its employees who worked in remote areas. Hill J found that although the camping allowance was a living-away-from-home allowance, it was paid to meet expenses that would be deductible to the employee and so was 192

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not taxable. Similarly, in relation to the accommodation provided to employees in camp sites, the employees would be entitled to a “once-only deduction” where they were required to reside at the work site for periods of time and to bear the cost of the accommodation as part of their employment. Consequently, the otherwise deductible rule applied and the benefit had no taxable value. One important term in the otherwise deductible rules is the requirement of a “once-only deduction”. This creates serious problems where the benefit provided would not be immediately deductible if purchased, but would be fully deductible over time through the depreciation provisions in Division 40 of the ITAA 1997 or similar provision. So, for example, assume that the employer provides the employee with a low-interest loan to buy an investment property and pays the employee’s legal expenses of $500 in seeking advice about whether to take up the loan. The low interest component would be dealt with under s 19 of the FBTAA 1986 because the loan will be used to produce further income. But the $500 legal expenses will create a problem. They are deductible in part only, and over a period of five years under s 25-25 of the ITAA 1997; the employee is not entitled to a “once-only deduction”. Consequently, the full value of the payment of the legal expenses is taxable in full where the employer pays the amount as a fringe benefit, even though the employee would have been entitled to exclude the $500 from his income, albeit over five years. [4.525]

4.53

Question

What would happen if an employer provided its employees each with a notebook computer for use at home, in the expectation that it would be used at least in part for work purposes, but in all likelihood mostly for private purposes? Consider whether s 58X would apply. Until 13 May 2008, s 58X(2) used to refer specifically to mobile phones, pocket calculators, PDAs, notebook computers and laptops. Do you think the new wording includes notebook computers? What happens if it does not?

(vi) Integrating FBT and the ITAA [4.530] FBT can be viewed as if it were a discrete tax, distinct and isolated from the income

tax. It is imposed: • under a different Assessment Act (compare the integration of CGT into the ITAA); • upon another class of taxpayers, that is, employers, so that it is not at least formally on those who gain but those who pay; • upon a different tax base than the income tax – that is, the gross value of benefits provided; and • using a different assessment period (April to March). But there has to be a means of integrating the FBT with the ITAA because they both deal with a common matter – rewards provided to employees – and are interrelated by express terms. There are exemptions within each relating to the other, definitions needed for one can be found in the other and, of course, the subject matter of each tax could often be dealt with under either – or both. The goal of FBT is to ensure that all remuneration to employees is taxed but that it is taxed only once either in the hands of the employer or the employee. There are many ways in which the FBT and the ITAA are integrated to achieve this result: 1.

Some benefits are excluded from the operation of FBT by the definition of “fringe benefit”. For example, s 136(1) of the FBTAA 1986 excludes from FBT wages and [4.530]

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salaries, share schemes, and eligible termination payments. These of course are all taxed under ITAA 1997, hence the exclusion from FBT. 2.

For benefits which are covered by FBT, s 23L of the ITAA 1936 makes non-assessable non-exempt income any “income” derived by a taxpayer by way of the provision of a fringe benefit. This prevents double tax and allows the FBT to have primacy.

3.

Not only are taxable fringe benefits removed from the income tax, so too are exempt fringe benefits – that is, no income tax is payable on income that is a fringe benefit, whether the benefit is taxed under the FBT or not. Section 23L(1A) of the ITAA 1936 makes exempt income a fringe benefit that is made an exempt benefit because of para (g) of the definition in s 136(1) of the FBTAA 1986. Here the issue is not one of double tax, but rather of preserving the exemption offered in the FBT from being negated by the imposition of income tax.

4.

Some benefits are included as fringe benefits taxable to the employer where the employee is already adequately taxed and where the employee would not ultimately have paid tax if he or she had been paid in cash instead. This would arise where the employee was entitled to a deduction against the cash salary if it had simply bought the fringe benefit. The otherwise deductible provisions attempt to alleviate this situation. They effectively pass back the employee’s deduction to the employer in ways discussed above.

5.

Since 1999, employees have been required to report certain kinds of fringe benefits in their income tax returns. These benefits are not reported so that they can be taxed; they are reported in order to judge whether the employee is a high-income or low-income person. For example, the amount of fringe benefits received during a year affects whether the person is entitled to enjoy the tax rebate for low-income earners, is required to pay the Medicare levy surcharge imposed on high income earners or is required to start repaying a HECS-HELP debt. Amounts which are non-deductible to employers under the ITAA have to be adjusted with the FBTAA 1986. Special rules deny deductions to employers for some entertainment expenses, fines and so on. Without some adjustment, the employer (rather than the employee) would pay income tax on these benefits (by having its taxable income increased by the amount which it was not allowed to deduct from its assessable income) and again under FBT. Where these two regimes overlap, the FBT regime is given priority, so that the benefit is made deductible but only where it will be subject to FBT. (See, for example, ss 26-30(3), 26-45(3) and 32-20 of the ITAA 1997.)

6.

7. 8.

Employers are entitled to a deduction for the payment of FBT under s 8-1. Also, an employer is assessable on a payment made by an employee in reimbursement of the FBT liability (due to the repeal of s 23M of the ITAA 1936).

(c) Problems of FBT [4.540] The discussion above suggests that there are reasons of horizontal and vertical equity

for taxing fringe benefits as if ordinary income. It also suggests that economic efficiency would be enhanced if the tax system did not influence choices about the manner in which remuneration is taken and offered. FBT was designed to accomplish these goals, but how successful is it? If one were to judge by the ongoing condemnation of the tax by industry since its inception, and the level of tinkering undertaken by government enacting carve-outs, concessions and qualifications, it has serious shortcomings. 194

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In this section we will look again at what FBT was intended to achieve and will explore some of the problems that it has created in the process. All stem from the design of the tax – it is a flat rate, excise tax on gross benefits provided. The simplest way to tax fringe benefits would have been to enact a series of valuation rules and then to require employer withholding – it is the valuation part that is crucial; the rest is relatively simple. Chapter 9 of the Asprey Committee report suggested just this. The Committee suggested that an adequate solution would be for all amounts given as fringe benefits to be included for PAYG withholding and be shown on group certificates. The FBT solution came from the New Zealand Task Force on tax reform (the McCaw Committee), but it recommended the FBT only for certain difficult-to-tax items and only as an interim measure. The Draft White Paper picked up this approach because it was said to be administratively simpler and “less disruptive”. But the criticism levelled against FBT has been lasting. The report of the Review of Business Taxation in 1999 recommended that “all employee fringe benefits (with the exception of entertainment and on-premises car parking) provided to an individual employee be taxed to that employee, with that tax being collected under the PAYG system” (recommendation 5.1). This recommendation was immediately rejected by the Treasurer, Mr Costello, on the fallacious ground that, “there are about 70,000 employers that are subject to [FBT] at the moment, about 1,000,000 employees [and this would imply] taking [tax] off a smaller group and putting it onto a larger group …” (Treasurer’s press conference, 24 February 1999). The fallacy is that the 1,000,000 employees would actually have much of a role in the payment of tax. If the tax on fringe benefits were collected by PAYG withholding, the main work would still be done by the 70,000 employers. Certainly, employees would have to report their fringe benefits in their tax return as income; at the moment, they report fringe benefits in their tax return as a reportable fringe benefit. (i) Over- and under-inclusiveness of the FBT base [4.550] The evil which FBT was introduced to remedy is obvious enough, but the FBT scheme is not a completely consistent and exhaustive solution to it. As D J Collins observed in “Taxation of Fringe Benefits – An Economist’s Perspective” (1987) 4 Australian Tax Forum 95: “not all … employment benefits have been defined to be fringe benefits for the purposes of the current FBT legislation and some benefits which have been included in the tax base are, it could be argued, not genuine benefits.” In simpler terms, the FBT base is both over- and under-inclusive. [4.555]

4.54

Question

How does FBT deal with payments such as the following? the reimbursement to employees of employment expenses; (a) (b) the reimbursement of petrol costs for undertaking an isolated errand: see s 22 of the FBTAA 1986 and s 15-70 of the ITAA 1997; (c) a payment of the type made in Hochstrasser v Mayes: see s 58C of the FBTAA and compare it to the result in that case – see also Ruling IT 2614; (d) study leave; (e) long service or annual leave beyond award requirements; (f) employer-funded superannuation; and (g) food and drink provided on the taxpayer’s premises: see s 41.

[4.560] But the problem of the tax base being under-inclusive is not the matter that has so

focused the complaints from industry, as one might expect. The matter that has concerned [4.560]

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them is the over-inclusive nature of the base where it picks up items that are not gains from employment. Consider as an example s 47(3) and (4) which states that using the office toilet is not a fringe benefit. It is odd to think that such a provision is necessary. If it is, there is clearly an over-reaching definition of benefit somewhere if it includes items that are better seen as “working conditions” than “fringe benefits”. And while this provision has addressed some working conditions, the issue will not be a simple one as the exception is qualified. What is the status, for example, of the toilet in the shopping centre for a person who works in one of the shops? This is not just an idle question. In long-running litigation Esso has been arguing with the ATO over the term “business premises”. This term is used in s 47(2), which creates an exemption from FBT for a fringe benefit being the provision of a child care facility on the business premises of the employer. The ATO had taken the sensible view that the exemption was triggered if the premises in question was “off-site” – that is, if main offices were in the CBD, a dedicated child-care facility located in a leafier suburban site would be “business premises” of the employer; the child care facility did not have to be in the basement or on the roof of the head office (TR 96/27, para 41). But in the Ruling, the ATO had expressed the view that this exemption did not apply where two or more employers shared control of the child care facility, or the site was owned as tenants in common because a shared facility was not the exclusive business premises of the employer. This view was upheld in AAT Case 12,826; Re Esso Australia Ltd v FCT (1998) 38 ATR 1160; 98 ATC 2085 but overturned by Merkel J on appeal in Esso Australia Ltd v FCT (1998) 40 ATR 76. The ATO accepted the decision and issued an extensively revised ruling, TR 2000/4, outlining what he believes the words “business premises” mean. (ii) Taxable value [4.570] The problems of defining the base are compounded by difficulties in calculating the

taxable value of many benefits. It is not sufficient to guarantee neutrality for the FBT to have a base which covers most fringe benefits. Incentives to substitute fringe benefits for cash will still persist if the FBT regime gives a more favourable tax result than the income tax in other ways – for example, by subjecting a smaller amount to the tax, or by having the amount included taxed at a preferential rate. There are examples in FBT where less than the full value of a fringe benefit included in the FBT base is subject to the tax. For example, where an item of property is provided by an employer from its own stock it is an “in-house benefit” and is usually taxable at either a wholesale market price or 75% of retail. Where the item was purchased, the taxable value is the employer’s cost which again might be a wholesale price. Perhaps the most concessionary valuation rules apply to car fringe benefits. The nature of the concessions and their impact on their environment is analysed in Celeste Black, “Fringe Benefits Tax and the Company Car: Aligning the Tax with Environmental Policy” (2008) 25 Environmental and Planning Law Journal 182. (iii) Tax rate [4.580] Once the choice is made to tax the employer rather than the employee on the value of

fringe benefits, a decision must be made on an appropriate tax rate to apply to the fringe benefit. Some of the problems of setting a rate are obvious: • if the employee had paid the tax, he or she would have paid tax at progressive rates so ought the employer pay at progressive marginal rates; 196

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• if the employer does not pay tax at a rate related to the employee, does it pay at a rate applicable to an individual or pay at the company rate? Revenue neutrality will be encouraged if the FBT rate produces the same resulting revenue as that payable if the tax is paid by the employee, but the tax will only be comparatively efficient if it creates no greater substitution incentives. FBT is often regressive because the rate of tax has been set at the top personal marginal rate plus Medicare levy without regard to the employee’s actual marginal rate. This would not be a serious problem if all fringe benefits could in practice be “cashed out” by employees – that is, the employee could revert to their marginal tax rate by electing to take cash instead of fringe benefits. The taxpayer in Tubemakers (above) was trying to reduce the total tax cost of providing benefits to retired workers, few of whom would have been facing a lower marginal tax rate. But that will not be possible for all benefits. You may wish to consider what cash alternative is available to a taxpayer in the position of the taxpayer in Roads and Traffic Authority where its employees are working on a stretch of road 200 km from the nearest town – there is likely to be little practical alternative to providing accommodation in kind. The first Discussion Paper of the Ralph Committee, A Strong Foundation (AGPS, Canberra, 1998, p 20) notes that even where both the employee and employer are willing and it is possible as a practical matter, the ability to cash out benefits can sometimes be constrained by industrial awards and enterprise agreements. Again, Roads and Traffic Authority displays the kind of benefits that still commonly exist under awards. (iv) FBT-inclusive tax base [4.590] Another dimension to this problem arises from the decision in 1994 to include the

FBT in the tax base – that is, the decision that the tax base should be a tax-inclusive base, like the income tax base. Prior to 1994, FBT was levied on a tax-exclusive base – the value of the fringe benefit did not include the FBT that had to be paid on it. This was the first step. There was another step, which was the treatment of the payments of FBT itself. It was made non-deductible to employers for income tax purposes becoming an additional cost to the employer (s 51(4A) of the ITAA 1936). Under that system, once the highest marginal tax rate for employees (49% today) significantly exceeded the company tax rate (then 36%), there was still an incentive for remuneration to be provided by way of fringe benefit rather than salary. The employer could provide (or the employee could receive) larger benefits to employees at the same cost to it as providing the remuneration in the form of salary. The reason was that the provision of a fringe benefit under the FBT system really consists of two benefits – the actual fringe benefit and the employer (not the employee) paying tax on it. But these two benefits were taxed at different rates: the benefit was taxed at the FBT rate, but the second benefit was taxed only at the corporate rate. Now, s 66 imposes on employers a liability to pay FBT on their “fringe benefits taxable amount”. Part IIA sets out how the “fringe benefits taxable amount” is calculated. It basically takes the after-tax value of a fringe benefit and adds back the amount of FBT. The FBT rate is then applied to the grossed-up amount of taxable values to determine an employer’s FBT liability. The reason why this was done, and how it works, probably deserves some clearer exposition. The table below compares paying cash salary to paying a fringe benefit under both [4.590]

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systems. (Note that, to avoid complicating things too much, the table uses current tax rates, not the actual tax rates in 1994.) Cash salary Cost to employer Employer’s tax deduction at 30% FBT at 49% Employer’s tax deduction for FBT at 30% After tax cost to employer

196 (58) – – 138

Fringe benefit pre-1994 100 (30) 49 – 119

Employee’s benefit Employee’s income tax at 49% After-tax benefit to employee

196 96 100

100 – 100

Fringe benefit post-1994 100 (30) 96* (28) 138 100 – 100

*

96 is the tax rate of 49% applied to $196. The $196 is derived from the taxable value of the fringe benefit: $100 multiplied by (49% / (1 – 49%)) = $196. The example assumes that the employee is getting $100 worth of reward for her efforts, either as after-tax cash or tax-free fringe benefit; the employer used to pocket the $19 tax saving. And remember that these figures will change from 1 April 2017 if the temporary budget repair levy is repealed and the FBT rate declines to 47%. (v) GST-inclusive tax base [4.600] The FBT gross-up procedure was made even more complicated with the introduction

of the GST in 2000. Now it is necessary not only to gross-up the value of a benefit for the FBT on it, it is also necessary to gross-up for the GST that has not been paid (and the tax on the GST). Indeed, the interaction of FBT and GST which the rules in Part IIA try to solve is so fiendishly difficult that most of the permutations are ignored here. The complication arises in part because GST is meant to be a cost to consumers, but not to businesses (like employers). In other words, if the employee had to buy a fringe benefit that is subject to GST such as a book, he or she would have to earn $110 (after payment of income tax), but his or her employer can buy the same item for $100 (after the refund of the GST of $10 charged to it). However, not all employers (banks and insurance companies, for example) are entitled to recover all the GST embedded in their costs. This kind of employer has to pay $110 because it will not get a full refund of the GST of $10. A third part of the puzzle arises because not all commodities are subject to GST, even when purchased by consumers. So, for a fringe benefit which is not subject to GST to begin with, such as a prescription medication, the employee would only have to earn $100 (after payment of income tax) in order to buy the fringe benefit. For the easiest cases, the gross-up formulas are now contained in s 5B(1B) and (1C) of the FBTAA. Subsection 5B(1B) provides the gross-up rate for “Type 1 fringe benefits”. Type 1 benefits are those which are subject to GST and for which the employer can recover a GST input credit (s 5C(3)). Section 5B(1C) provides the gross-up rates for “Type 2 fringe benefits” (defined in s 5C(4) as those benefits that are not subject to GST, and so no input tax credit 198

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arises for the employer). The formula in s 5B(1B) converts to a gross-up rate of 2.14. The formula in s 5B(1C) converts to a gross-up rate of 1.96. To see how these gross-up formulas work, consider an employee who is offered either a GST-taxable fringe benefit by an employer or is offered the cash to buy the same benefit. Cash salary Cash salary Employee’s tax (at 49%) Value of salary

$214 (114) $110

Fringe benefit Value of benefit Employee’s tax Value of benefit

$110 Nil $110

Now consider the position of the employer who offers either a GST-taxable fringe benefit to the employer or else the cash to buy the same benefit. Cash salary Cash salary

$214

Tax deduction (at 30%) Cost of salary

(64) $150

Fringe benefit Cost of benefit (after input credit) FBT ($110 × 2.14 x 49%) Tax deduction (at 30%) Cost of benefit

$100 $114 (64) $150

For GST-free benefits, the gross-up formulas do not need to take into account the GST and so work as did the old gross-up rules – that is, $100 of GST-free fringe benefit becomes a benefit with a taxable value of $196. The relationship between GST and FBT is discussed more fully in two Rulings: TR 2001/2 and GSTR 2001/3. (vi) Tax-exempt employers [4.610] For taxable employers the change from a tax-exclusive to a tax-inclusive calculation

in 1994 worked as designed, but these changes had important consequences for employers in tax loss and tax-exempt bodies, particularly charities and hospitals. The value to them of a tax deduction for FBT was reduced (to zero in the case of a tax-exempt employer) so that their cost of providing fringe benefits increased substantially. In other words, a tax-exempt employer was required to calculate its FBT liability by the gross-up method but was unable to utilise the tax deduction for FBT. Therefore, from 1 April 1994, the government amended s 65J(1) of the FBTAA to allow many tax-exempt employers to claim a rebate against their FBT liability. The rebate is available, for example, to religious institutions, research bodies, charities and many not-forprofit organisations. The rebate is calculated under s 65J(2A). It results in most cases in the organisation being able to pay benefits with a value of up to $30,000 per employee per annum before FBT will be triggered. If the benefits exceed $30,000 it must pay FBT on the excess. [4.615]

4.55

4.56

Questions

What incentives will operate where an employer, prior to the introduction of FBT, paid the car insurance premiums of its employees where most of them earned less than $30,000 per annum? What if most earned over $130,000? Will FBT have the somewhat perverse effect of encouraging more staff discounts and executive dining rooms? [4.615]

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(vii) Interaction with surcharges – reportable fringe benefits [4.620] We made the point above that FBT is designed to leave employees out of the system so

far as possible: to collect the tax from the employer; to make the benefit exempt from tax at the employee level; and to have no final reconciliation at the employee level, which means passing the benefit of employee deductions back to the employer through the “otherwise deductible” rules. But in 1999, the government decided to require all employers to report the value of fringe benefits on their PAYG Payment Summaries and for employees to transfer this amount onto their tax returns: see s 135M of the FBTAA 1986. Why bother? The intention of this measure was to ensure that access to social security benefits and other regimes, which depend upon a person’s income, would be calculated based on a person’s cash salary and fringe benefits, not just on the person’s cash salary. So we now have requirements to report “reportable fringe benefits”. The measure affects the computation of the low income tax offset, Medicare Levy surcharge and HECS-HELP debts. What seems like a simple idea has again been implemented with an enormous degree of complexity. An employer is required to report on an employee’s Payment Summary any fringe benefit where the taxable value of the benefit exceeds $1,000. For some reason, however, not all benefits are counted. Section 135P(2) and s 5E(3) combine to exclude car parking fringe benefits and meal entertainment fringe benefits from the reporting requirement, and these exemptions from reporting have gradually expanded over time with special exemptions for military personnel, police and so on: s 5E(3) of the FBTAA. Further, even some benefits which were exempt from FBT so far as the employer was concerned, now have to be identified and valued by the employer so that they can be reported on the group certificate. Notice, finally, that the amount which has to be reported is the “grossed-up” taxable value of the benefit – that is, the value of the fringe benefit is grossed-up for FBT, but not for GST. (viii) Problems of FBT for international placements [4.630] One of the most significant issues with the entire FBT edifice – and there are many – is

the way that the FBT works internationally. The international norm is that employees are taxable on their salaries and benefits, they pay that tax to the country where they work, and if they also owe tax to their home country, they are entitled to a credit for the paid abroad to reduce the tax payable in their home country – a position which is reflected in the international tax treaties that Australia executes with other countries. Employers may have withholding obligations, but it is the employee who bears the formal and effective burden of the tax. Fringe benefits tax departs from this model. The formal incidence of FBT is on the employer, not the employee. So consider a foreign employer who brings staff to work in its Australian branch. It will face FBT in Australia if it, say, provides them with short-term rented accommodation for a year or so. If the employees remain residents of their own country, they may be liable to tax in their home country on these fringe benefits, and would be entitled to a credit against the tax in their home country for any Australian tax they paid. Unfortunately, they have not paid any Australian tax, notwithstanding that their employer may well have debited their salary package for an amount of Australian FBT. This means that an employee is potentially subject to double tax on things which we choose to call fringe benefits and tax in that manner. No unilateral mechanism in a foreign country is likely to solve the problem, nor will most of our tax treaties accomplish this task unless, and until, we renegotiate all our treaties to include appropriate provisions. 200

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In reality, what is likely to happen is that the employer will simply bear the cost of the Australian FBT and probably also the employee’s home country income tax, but it unnecessarily adds to the cost of having Australian operations. And while Australia may argue that it has the prime right to tax fringe benefits in these circumstances, and it is for the home country to work out some way to recognise this, we have made it a problem by adopting a practice which departs from the international norm. (ix) Unallocable benefits [4.640] There is one very plausible reason for using FBT in substitution for withholding from

wages. That reason arises from the problem of non-individualised benefits. Taxpayers often enjoy global benefits like a subsidised canteen or health clinic, which are provided indiscriminately to all employees and probably in different amounts. With these benefits, there is real difficulty in isolating a benefit that is attached to only one employee and valuing it accurately. Where benefits cannot easily be allocated to individual employees, there is good reason to use an undifferentiated employer-based tax like FBT as the mechanism for taxing the benefit. (Indeed this is probably the best argument in favour of the FBT way of doing things – there is no need to work out who had the chicken for lunch; who used the medical clinic last year; who parked in Bay 12 last Thursday.) The alternative is to deny the employer any income tax deduction. Unfortunately, the Australian FBT failed for a long time to grasp this point. So, when the first car parking rules were introduced all the requirements of the section looked to the employee and not the car space. Eventually, it was considered that if the parking spot was the valuable item, one quite acceptable way to tax it was simply to tax the spot – see the spaces method in s 39FA. But this is the only example in the law, and the basic pattern of insisting on trying to allocate benefits to individual employees has been followed elsewhere. This lesson was forgotten when the government announced the reportable fringe benefits scheme in 1999 – it requires benefits to be attributed to individual employees, although not all benefits are reportable benefits, in recognition of the difficulty of doing this. This issue of being able to (or having to) allocate benefits to individual taxpayers has cropped up in another way in the FBT regime. During the 1990s, a number of mass-marketed tax schemes were promoted to employers as tax-effective ways of reducing their income tax, while not triggering FBT. These schemes were investigated by the Senate Economics Committee and described in its 2002 report, Inquiry into Mass Marketed Tax Effective Schemes and Investor Protection. Some of these schemes involved superannuation and are described below; others involved setting up “employee benefit trusts” or “employee incentive schemes”. They operated in this fashion: the employer would set up a trust, with itself or a related entity as trustee, and then contribute cash to the trust. The beneficiaries of the trust were described in discretionary terms: the employees, directors or others, to be designated by the employer at some later time, because of meritorious service. (In another variant, the beneficiaries of the trust were denominated by holding units, but those units were only issued – to employees, directors or others – by the trustee at some later time in response to a request from the employer to issue units because of meritorious service.) The trustee would then invest the contributions in various ways, sometimes lending the contributions back to the employer. The taxpayers were told that this resulted in a tax saving – the contribution to the trust was deductible to the employer as a cost of employing its employees; the trustee did not pay on the amount it received because it represented the corpus of the trust, not income of the trust, and [4.640]

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no fringe benefit arose to the employer because no particular employee had been designated as entitled to the amount contributed to the trust, and in any event, the benefit had not yet been provided to an employee or an associate of the employee. The ATO disagreed. The ATO took the view in TR 1999/5 – Employee benefit trusts and non-complying superannuation funds – that the trustee was an associate of the employee and the inability to allocate the benefits to a particular employee did not matter for FBT purposes: 5. A trustee of a trust … that is constituted to provide benefits to employees can be an associate of an employee … notwithstanding that no employee (or associate of the employee) is a beneficiary or member when the benefit is provided to the trustee. It is sufficient if, at the time the benefit is provided to the trustee, there is an arrangement to benefit the employees and an employee will subsequently be made a beneficiary.

This view was subsequently tested in the courts in a number of cases starting with Essenbourne v FCT (2002) 51 ATR 629; [2002] FCA 1577. This company had contributed $252,000 to an employee benefit trust which the ATO assessed to FBT as either a property benefit or a residual benefit. Kiefel J disagreed with the ATO’s view: 54 In my view, Essenbourne is correct in its contention that the definition of “fringe benefit” requires reference to a particular employee in connexion with the benefit said to have been provided. This is reflected in the references to a benefit being “provided to the employee or to an associate of the employee” and to the benefit being provided “in respect of the employment of the employee”. The latter reference, in particular, can only be to a particular person’s employment.

The ATO decided not to appeal against this decision and continued administering the law on the basis of the views in TR 1999/5. The ATO lost this point in a series of cases: Kajewski v FCT (2003) 52 ATR 455; [2003] FCA 258; Pridecraft and Spotlight Stores v FCT (2004) 55 ATR 745; [2004] FCA 650 and on appeal (2004) 58 ATR 210; [2004] FCAFC 339; Indooroopilly Children Services Qld v FCT (2006) 63 ATR 106; [2006] FCA 734 and on appeal (2007) 158 FCR 325; [2007] FCAFC 16. Eventually the Federal Court lost its patience with the ATO’s refusal to accept defeat. In February 2007, Allsop J in the Full Court said in Indooroopilly: 3. … [the] taxpayers appeared to be in the position of seeing a superior court of record in the exercise of federal jurisdiction declaring the meaning and proper content of a law of the Parliament, but the executive branch of the government, in the form of the Australian Taxation Office, administering the statute in a manner contrary to the meaning and content as declared by the Court; that is, seeing the executive branch of government ignoring the views of the judicial branch of government in the administration of a law of the Parliament by the former. This should not have occurred. If the appellant has the view that the courts have misunderstood the meaning of a statute, steps can be taken to vindicate the perceived correct interpretation on appeal or by prompt institution of other proceedings; or the executive can seek to move the legislative branch of government to change the statute.

The ATO withdrew TR 1999/5 in June 2007 and appears to accept the position expressed in Essenbourne. When TR 1999/5 was withdrawn, the notice of withdrawal says: 3. The decision of the Full Federal Court in Indooroopilly … found that, for the purposes of determining whether there was a fringe benefit, it was necessary to identify, at the time a benefit was provided, a particular employee in respect of whose employment the benefit was provided. 5. TR 1999/5 is withdrawn as the Commissioner accepts the finding of the Full Court in Indooroopilly, as set out in paragraph 3 of this Notice.

Before we leave this point it is worth noting that while the ATO might have lost the battle in these cases, it by no means lost the wars. The taxpayers in Kajewski, Pridecraft and Spotlight 202

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Stores and Indooroopilly all failed, but for other reasons. They were denied the benefit of the deductions claimed for the contribution to these funds either under s 8-1 or because Pt IVA was applied, and so the ATO collected some tax – 30% from the companies under income tax, rather than 49% from the companies as FBT.

4. SPECIAL CATEGORIES OF EMPLOYEE REMUNERATION [4.650] In this part of the chapter we return to focus on the operation of the ITAA and will

consider two of the statutory regimes which are found there to tax certain forms of employment income. Unlike FBT, these regimes complement and modify ordinary usage income and s 15-2 of the ITAA 1997, supplementing rather than attempting to completely supplant them with some other tax. But because they are so specialised, there are suggestions, at least in one of the cases, that there will often be little residual room for ordinary usage and s 15-2 to operate if, through some oversight, the specific regimes do not apply.

(a) Employee Share Schemes [4.660] One important regime in the Act to include a particular kind of employment income is

the set of rules dealing with employee share schemes. These rules were previously found in s 26AAC of the ITAA 1936 and then Div 13A of the ITAA 1936. The new rules are now in Div 83A of the ITAA 1997, enacted in 2009, and these rules were subject to significant tinkering in 2015. The history is important because the old rules continue to apply to the older schemes and shares or options issued under them. The regime provides a series of rules for taxing the value of shares and options to purchase shares given to employees as part of their salary package. It was introduced to overcome what were seen as the practical and administrative difficulties arising from the decision of the House of Lords in Abbott v Philbin [1961] AC 352 (extracted in Chapter 2) and the later Australian decision in Donaldson. It is worthwhile having dedicated rules to deal with one of the most significant forms of high-income executive remuneration. A simple example may help to see just why this can be a complex area: • Day 1: assume the company allots to an executive for free an option to acquire a share in the company on the following terms: the employee must pay $20 if she wishes to exercise the option and acquire the share, the option cannot be exercised for 2 years, any shares acquired cannot be sold for a further 2 years, and the option expires after 4 years. On Day 1, the shares in the company are trading at $18 (ie the exercise price is more than the current value of the shares); • 2 years later: the employee exercises the option, pays $20 and is issued 1 share. On this date, the company’s shares are trading at $23; • 2 years later: the restriction on selling the shares lapses. On this date, the shares are trading at $24; • 3 years later: the employee sells the share on market for $25. Clearly, the employee has made $5 (sale price of $25 less exercise price of $20) but when was it made, and how much of it is employment income and how much is (potentially discount) capital gain? Employee share acquisition schemes raise these fundamental questions of derivation, timing and valuation: what was the item of income (the grant of the option, the issue of the share, the sale proceeds); when was it realised (Day 1, Year 3, Year 5, Year 8); and what was its value at the time it was derived (nil, $3, $4 or $5); if the employment income is [4.660]

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less than $5, is there a further amount of capital gain involved? And to make matters worse, what happens if the shares were bought for $23 but sold for $19? In Abbott v Philbin the revenue authorities had taken the view that the employment income in question was the sale proceeds but the Court disagreed. Similar issues arose in the subsequent Australian case Donaldson v FCT in the Supreme Court of New South Wales. In this case the taxpayer participated in an employee share scheme designed to reward key employees for satisfactory performance. The terms of the scheme (in essence) provided for the trustee of the scheme to be granted notes, which were convertible into shares in the company with a par value of 50 cents upon the exercise of an option. The notes were held upon trust for the employees and Donaldson had rights as a beneficiary of the trust to 1350 notes. In addition to the right to require conversion of the note into a share, the note also bore interest payable by the company at 6.5% per annum. The employee, Donaldson, paid 0.1 cents per share on the grant of the notes and had to pay the remaining 49.9 cents plus a premium of 41 cents per share on the exercise of the option – that is, at the time the notes were issued, the company’s shares were probably trading at around 91 cents, even though they only had a face value of 50 cents. As in Abbott v Philbin, the employee’s interest in the shares (through the trust mechanism) could not be readily assigned, and in addition, because this scheme was intended to encourage and reward future performance, the options to convert the notes into shares could not be exercised unless, and until, the employee had successfully completed each of three succeeding periods of satisfactory performance. The ATO, having no doubt observed the result in Abbott v Philbin, claimed that the value of the employee’s interest in the notes was taxable under s 26(e) of the ITAA 1936 in the year in which he received that interest and decided, by a more or less arbitrary calculation, that the value of the options exercisable in three years was 10 cents per share, those exercisable in seven years were valued at 5 cents per share and those exercisable after 10 years were valued at 2 cents per share. Bowen CJ found in favour of the ATO because of the onus of proof rule in s 190(b) of the ITAA 1936 (now ss 14ZZK and 14ZZO of the TAA 1953), but did, in the course of the judgment, point out some major differences between s 26(e) and the position under the judicial concept of income. Again the main problems concerned the time of derivation, the valuation of the notes and the expected shares into which they could be converted. [4.670] It is against this background of cases, Tennant v Smith, Abbott v Philbin and

Donaldson, that statutory rules – first s 26AAC, then Div 13A and now Div 83A – were introduced. They are intended to declare both the time of derivation of the income that employee shares and options represent, and the amount of income that is derived. The correct tax policy position is easy to understand in the abstract – employees should be taxable on the market value of benefit they receive, less any amount which the taxpayer has to pay for it – but there have been many disagreements about how to implement this position. Some issues revolved around the time at which the income is derived – in particular, whether income was derived when options were granted or only when they were exercised and turned into shares. Secondly, how should the rules deal with shares which were allotted but were subject to restrictions on transfer (having managers dump their shares is a bad look!) or risk of forfeiture (benefits could be cancelled for misbehaviour) – should these matters defer derivation or affect the value, or be ignored unless and until they materialise? In addition, there has been a competing policy stemming from corporate law theory that share-based remuneration gives the proper incentives to management, and that in order to encourage 204

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employers to offer such schemes, some concessions should be attached to income derived from approved employee share schemes. (This can be seen in s 83A-5(b).) And a new concern emerged – cash-poor start-up companies in the IT industry often pay their staff in shares but our rules were less generous than the US rules, creating an incentive, so it was argued, for fledgling IT firms to leave Australia. (This can be seen in s 83A-5(c).) In this space, decisions about what to tax and when to tax are hotly contested and the answers on those issues can have vastly different consequences on how much. Division 83A, the current regime governing the taxation of shares provided to employees under employee share acquisition schemes was introduced in 2009 and substantially amended in 2015. It applies where the taxpayer acquires an “ESS interest”, defined to mean a share, a stapled security (typically a share in a company and a unit in a trust which are traded as a single investment) or an option to acquire a share (s 83A-10(1), s 83A-335). An ESS interest also includes an interest in a trust which owns shares or options (s 83A-10(1)). The inclusion of interests in trusts is important because many of the largest companies will operate their share schemes through trusts – they will either allocate shares directly to a trustee to hold the shares for the benefit of the employees, or they will pay cash to the trustee and it will then use the money to subscribe for shares in the employer or acquire shares on market. At the big end of town, employees of multinationals will typically have an interest in a trust which owns shares rather than being given shares directly, and the shares will typically be shares of the listed parent rather than any particular subsidiary for which the executive works. Secondly, the taxpayer must acquire their ESS interest under an “employee share scheme”, defined to mean a scheme under which ESS interest are issued to employees of the company or to employees of one of its subsidiaries “in respect of their employment” (s 83A-10(2)). We will start our analysis of Div 83A with a simple example: the employer company issues for free a share worth $20 directly to the employee. Division 83A requires the employee to include the amount of the discount on the issue of the share in assessable income – ie difference between the market value of the share ($20) and any consideration paid or given by the employee to acquire the share (nil): s 83A-25(1). The amount is included in the year in which the ESS interest (the share) is acquired. The amount is included in the assessable income of the employee even if the share is actually allocated to an associate (eg the spouse or family company) of the employee: s 83A-305. Because these rules can apply to shares in unlisted companies, regulations set out a framework for valuing those shares. A number of concessions can then apply to reduce the amount included in the employee’s income or to defer the income (and thus, the tax) to a later year: 1.

One concession exists for start-up companies: s 83A-33. The amount of the employee’s income is reduced to nil if a long list of conditions about the employer, the shares and the terms of the share plan is met: the employer must be a resident, not listed on a stock exchange, incorporated for less than 10 years, the corporate group has a turnover under $50m, the discount is no more than 15% of the market value of the shares, the value of the employee shares represents less than 10% of the value of the shares on issue, there is at least a 3-year time limit on being able to dispose of the shares and the scheme is open to at least 75% of employees who have served longer than 3 years with the company. Where all these conditions are met, no amount is included in assessable income, but that doesn’t mean the employee’s shares are entirely tax-free. Rather, the implication of the exemption is that the employee will pay CGT instead. CGT will be applied to the [4.670]

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gross proceeds (the employee has no cost base in the shares because of s 83A30(2)) at the time the employee eventually sells the shares. The capital gain will likely be eligible for the 50% discount. 2.

A second, much less generous, concession is available for minor discounts: s 83A-35. Employees with (adjusted) taxable income under $180,000 can exclude up to $1,000 of discount from their assessable income under s 83A-35(1) provided the shares are ordinary shares, there is at least a 3-year time limit on being able to dispose of the shares, the value of the employee shares represents less than 10% of the value of the shares on issue and the scheme is open to at least 75% of employees who have served longer than 3 years with the company. Where all these conditions are met, the taxpayer can save up to $490. Where these conditions are met, the amount included in assessable income is reduced by up to $1,000 and to ensure that this concession is not reversed by the CGT rules, the employee is treated as having a cost base in the shares of the full market value at the time of issue: s 83A-30(1).

3.

A third concession exists where the shares are issued subject to conditions which mean there is a “real risk” that the shares might be subsequently forfeited or cancelled: s. 83A-105(3). It is not obvious what circumstances are within this concept of a “real risk” of forfeiture. It probably applies if there are performance hurdles or a requirement to serve a minimum term of employment. It is less obvious whether cancellation on dismissal for bad conduct is included. Where the shares are issued but with a “real risk” of forfeiture, the employee need not include the discount in its income until the year in which the “ESS deferred taxing point” occurs: s 83A-110. The “ESS deferred taxing point” is the earliest of a number of possibilities: the shares are sold, the risk of forfeiture evaporates, any restrictions on disposal lapse, the employee leaves employment or 15 years has expired: s 83A-115. In addition to the real risk of forfeiture, a multitude of other conditions must be met: the shares must be ordinary shares, there is at least a 3-year time limit on being able to dispose of the shares, the value of the employee shares represents less than 10% of the value of the shares on issue and the scheme is open to at least 75% of employees who have served longer than 3 years with the company: s 83A-45, s 83A-105. If it turns out that an employee has already been taxed on the value of a share and the share or option is then forfeited, the entire Division is deemed never to have applied to the taxpayer: s 83A-310. The implication of this is that (subject to the tax statute of limitations), the taxpayer can then file an amended return for the relevant year excluding the amount from that year’s income. With regard to the CGT consequences, the employee is treated as having acquired the share at its market value at the time of the ESS deferred taxing point: s 83A-125. 4. A fourth concession exists where the shares are acquired under a scheme where employees can sacrifice up to $5,000 of their cash income for free shares: s 83A-105(4). Again, for these kinds of schemes, the employee need not include the discount in his or her income until the year in which the “ESS deferred taxing point” occurs: s 83A-110. A list of further conditions must be met for these kinds of schemes and, again for CGT purposes, the employee is treated as having acquired the share at its market value at the time of the ESS deferred taxing point: s 83A-125. With regard to options, the rules are even more complex and so we give here a highly simplified outline of their effects. The enactment of Div 83A in 2009 enacted a rule insisting taxpayers would derive assessable income at the time an option was allotted to them (or a 206

[4.670]

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trustee for them) if it was allotted at a discount. This rule is still in s 83A-25(1). Prior to this date, options were typically taxed only at the time they were exercised or sold, so the 2009 amendments had the important effect of advancing the time at which income was derived from the issue of options. But taxing at the time an option is granted involves reduced accuracy in determining the amount of income. As you can imagine, accurately valuing an option that may last for several years (in an unlisted company!) is a very difficult matter. Consequently, the regulations contained detailed provisions to determine the market value of an option. While any discount on the issue of options is in theory still taxable at the time of issue, it will almost always be the case that s 83A-25 will not apply because the options will be issued subject to a real risk of forfeiture or with conditions on sale or exercise: s 83A-105. This means the discount will be dealt with under Div 83A-C instead and the taxing point deferred under s 83A-120. The “ESS deferred taxing point” for options will be the earliest of a number of possibilities: • the option is sold, • the risk of forfeiting the unexercised option and any restrictions on disposal of the unexercised option have lapsed, • the employee leaves their employment, • 15 years has expired since the grant of the option, • if the option has been exercised and the employee receives shares, that date when those shares can be sold without restriction and can no longer be forfeited. Notice that the date of exercise per se is not in this list. So if the option is exercised and the employee acquires shares which cannot be sold for a further period, the taxing point has not yet been reached. And notice also that the share acquired as a result of exercising an option is not within these rules – they have done their work once they have dealt with the option: s 83A-20(2). Because employee share schemes involve benefits that are archetypal fringe benefits and will also likely be capital assets of individuals, correlation is needed with both FBT and CGT. Correlation is also needed with ordinary usage income and s 15-2 of the ITAA 1997. • Section 15-2(3) excludes amounts under employee share schemes from being included in income under s 15-2. • Shares or options acquired under employee share schemes covered by Div 83A are excluded from FBT by s 136(1)(ha) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986. • Some of the interaction with CGT has been noted above. Rules in Div 83A and Div 130-D of the ITAA 1997 dictate the CGT consequences for an employee who acquires shares or options under an employee share scheme. First, the employee’s cost base in a share will begin with the market value of the share at the time that it was acquired: s 83A-30(1). (Other rules in the CGT which might apply are switched off: s 130-80.) This means the embedded discount (taxed at the time the share was issued) is not taxed again when the share is sold. If the share was issued subject to a real risk of forfeiture, and the taxing point deferred, s 83A-125 deems the share to have been acquired at the ESS deferred taxing point for its market value on that date. For shares and options where the employee has enjoyed the $1,000 income exclusion, the same rule applies so that the benefit of the $1,000 is not recaptured on a subsequent sale of the shares. And if the share is acquired by exercising an option, the transaction with the option does not generate a separate capital gain: s 130-80. [4.670]

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Finally, it is worth remembering that the rules in Div 83A only apply to an “ESS interest” issued under “an employee share scheme”. Many companies operate so-called “phantom” schemes where the employees actually receive cash, albeit an amount of cash based on the share price. An “ESS interest” is defined mean a beneficial interest in “a share in [a] company or a right to acquire a beneficial interest in a share in the company” so if the employee receives cash equivalent to the value of a share, but not an actual share, the arrangement is not within Div 83A. The Full Federal Court decision in Blank v FCT [2015] FCAFC 154 is an example of such an arrangement. Blank worked for various companies in Glencore mining group in Switzerland, Hong Kong and Australia from 1993 to 2006 and, as an employee, was entitled receive amounts under the terms of several generations of the profit participation plans it established for employees. Under the plan, amounts were only payable on termination of employment, and another term required participants to use some of the money they received to purchase shares in the company (and to deposit the shares in a blocked safe keeping account so that they could not be sold for a period after they left employment). On his retirement in 2007 he signed a Deed relinquishing his rights under the schemes and over the next 3 years received amounts exceeding USD 160 m. Blank’s main argument was that the conferring of the rights under the schemes was the amount that was income – ie an argument basically invoking Abbott v Philbin. The implication of this argument was that, at the time the rights were conferred, he was not a resident of Australia and was working overseas so the amounts were not taxable in Australia. However, he conceded that in 2007, he derived a capital gain but argued he had a significant cost base in the rights he abandoned and this reduced the amount of tax payable. The Court held (by majority) that the amounts received by Blank were ordinary income as a reward for services. They disagreed with his argument because, they held, the various provisions of the plan documents, “were not the benefit (or even part of the benefit) conferred on the appellant under the relevant profit sharing arrangements but only mechanisms for calculating his profit share to be paid on termination exposes the fact that it was the payment of this profit share that was the actual benefit conferred on the appellant.” Pagone J dissented based on his view of the plan documents. He held, “Mr Blank had a chose in action upon the grant of the GS and phantom units under the participation agreements similar to that considered in Abbott v Philbin.” Instead, he held the amount Blank received represented a capital gain from the cancellation of these rights. Neither the ATO nor the taxpayer argued that the arrangement was within the rules for employee share schemes. At the time of writing, the High Court is set to hear the appeal in this case so we may yet learn more about the treatment of these plans.

(b) Deemed Dividends – s 109 [4.680] Section 109 of the ITAA 1936 deems certain payments made to associates of private

companies to be dividends with the intention that they will be included in the assessable income of the recipient. Initially, the intention of this section (and s 108 which has since been replaced by Division 7A) was to catch “disguised dividends” paid by private companies to their shareholders in order to avoid the double tax on dividends in a classical system of company taxation: the system which taxed the company on its profits and the shareholder on dividends paid from those taxed profits. The effect of these sections is that deemed dividends become assessable income of the taxpayer through s 44(1) of the ITAA 1936 which includes in 208

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the assessable income of a shareholder dividends paid to the shareholder by a company out of its profits. Section 109 is relevant to the current discussion of income from services because it operates to deem excessive amounts paid as remuneration for services rendered, or retiring allowances to be dividends. The main effects of deeming the services payment or retiring allowance to be a dividend will be on the private company that pays it – the company could claim a deduction for a payment of salary but it is denied any deduction for the payment of a dividend so that it will have an extra amount included in its taxable income. For the recipient, however, there are also deleterious consequences even though both remuneration for services rendered and retiring allowances would ordinarily be included in assessable income quite apart from s 109 of the ITAA 1936. Even though s 109 makes assessable a payment that would be assessable anyway, s 109 remains because government policy has always ensured that retirement allowances are taxed at lower rates than ordinary income, so that it can make a substantial difference to the total tax paid by the employee if the payment is taxed as ordinary income as a deemed dividend, rather than as a retirement allowance. We have reviewed this policy because, although the drafting appears to give the ATO an unfettered discretion to deny a deduction and deem an excessive amount to be a dividend, it is not quite this simple. Rather, courts have indicated that it is necessary for the ATO to look at the purpose of s 109 in the framework of the Act to see if the mischief that it was designed to cure is evident before he invokes it. For example, it seems that mere size is insufficient to support the ATO’s decision to trigger the provision. In Ferris v FCT, the ATO attacked a $270,000 retiring allowance paid to the departing managing director. The ATO took the view that only $78,000 was reasonable and deemed the balance to be a dividend. He formed this judgment based on one of his Rulings, IT 2026, a Ruling which has now been archived, but which dealt implicitly with the size of reasonable benefits that the ATO would allow a taxpayer to save for in a superannuation fund. Davies J in the Federal Court analysed the policy of s 109 and the position of Ferris. He noted that Ferris did not hold many shares in the company, with the implication that it was hard to see how such a large payment could represent a dividend paid on so few shares, or give to Ferris the kind of control of the company that he would need if he was trying to take money out of the company as salary or a retiring allowance rather than a dividend.

Ferris v FCT [4.690] Ferris v FCT (1988) 20 FCR 202; 19 ATR 1705; 88 ATC 4755 Section 109 is concerned with the payment of sums which are so high as to amount to a diversion to remuneration or retiring allowance of profits that ought to have been retained by a company and taxed as such or distributed and taxed on their distribution as dividends. Necessarily, the mischief which the section is designed to prevent is most clearly seen in those instances where the recipient of the payment is a shareholder or is related to a shareholder, particularly in those cases where the recipient of the payment has sufficient influence by virtue of

his shareholding or of the shareholding of a related person to influence or direct the destination to which profits of the company will be put. Section 109 requires for its operation a decision by the Commissioner that a sum paid or a part of a sum paid was unreasonable in amount. In a simple case where a sum is paid by a company to directors who are also the shareholders in the company or are closely associated to shareholders in the company, the Commissioner may readily form his own view as [4.690]

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Ferris v FCT cont. to whether the sum paid was a fair payment by way of remuneration or retiring allowance, for if the sum were not paid as remuneration or retiring allowance it would nevertheless enure to the benefit of the directors or their associated shareholders by virtue of being retained or distributed as profits of the company. However, when remuneration is paid to a director who has no, or no significant, shareholding in the company and the payment is made in good faith by directors who are independent of the recipient, on what basis is the Commissioner to decide that the sum paid is unreasonable? Clearly, if the sum is paid, it must be paid by way of remuneration or retiring allowance for the director has no shareholding interest which would justify it …

into account the standard he has enunciated in Ruling IT 2026. Particularly that will be the case where the payment would have enured to the benefit of or would have gone to the recipients in any event and the sole question is whether it ought to have gone by way of remuneration or retiring allowance on the one hand or by way of profits on the other. But Ruling IT 2026 will not necessarily be relevant to or, if relevant, will not necessarily carry weight in a s 109 determination. The question in s 109 is not whether a payment or the amount thereof was excessive having regard to standards laid down by the Commissioner for the administration of s 23F superannuation funds but whether in the particular circumstances of the case, the payment by the company to the recipient or its amount was unreasonable.

In making a decision under s 109, the Commissioner may in an appropriate case take

[4.700] It is also necessary to take some care to see how the regimes in ss 6-5, 15-2, Div 82 of

the ITAA 1997, and ss 44(1) and 109 of the ITAA 1936 all fit (or do not fit) together. The non-meshing of these provisions is illustrated by the decision of the Federal Court of Australia in FCT v Comber (1986) 10 FCR 88; 17 ATR 413; 86 ATC 4171. The taxpayer set up and was managing director of a private company, but he was not a shareholder. He was employed for 11 years at a lower salary than he deserved and on his retirement the company paid him a large golden handshake of $100,000. The company sought to deduct this payment under s 78(1)(c) of the ITAA 1936 (now s 25-50 of the ITAA 1997) and the taxpayer included 5% of the sum in his assessable income as a retirement allowance under s 26(d), the predecessor of the rules in Div 82 of the ITAA 1997. The ATO concluded that only $41,500 was reasonable and included 5% of this amount in his income, arguing that the remaining $58,500 was deemed to be a dividend under s 109 and thus included in the taxpayer’s assessable income under s 44(1) as a dividend. Section 44(1) taxes dividends which are paid to shareholders but the problem in this case was that Comber was not a shareholder. The Federal Court held that s 26(d) imposed tax on 5% of the $41,500 but that s 109 did not apply to the balance, nor did any other section of the Act. In the light of this and other unfortunate experiences, s 109 was amended so that it now meshes fully with s 44(1) by deeming the following elements necessary for s 44(1) to operate: • any excess over the appropriate amount being distinguished as a separate sum; • the excess will be deemed to be a dividend; • the recipient will be deemed to receive the sum as a shareholder; • the sum will be deemed to be paid out of profits; • the sum will be deemed to be paid on a particular day. The following questions examine how s 109 meshes with the other sections of the Act. 210

[4.700]

Income from the Provision of Services

[4.705]

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Questions

4.57

What happens when the excess is deemed to be a dividend? Will it remain an employment termination payment and be taxed again under Div 82 as an employment termination payment? (See s 82-135(h) of the ITAA 1997.)

4.58

Will the payment be a fringe benefit to the employee? (See para (n) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986.)

4.59

Can a s 109 deemed dividend be franked so that the shareholder/employee obtains a franking credit and might effectively receive the deemed dividend tax-free? (See the list of unfrankable distributions in s 202-45(g)(iii) of the ITAA 1997.)

5. PAYMENTS FOR RESTRICTIVE COVENANTS AND VARYING SERVICE CONTRACTS [4.710] This part of the chapter looks at a number of characterisation issues and allows us to combine the three regimes examined – ordinary usage income and statutory income, FBT and CGT. The cases fall into three categories.

1.

Is a payment for the provision of knowledge a reward for service or the sale of an asset? 2. Is a payment for varying agreed rights under an existing service contract a capital sum, as if on the disposal of a capital asset, or should it be treated as equivalent to the income that would have been earned under the contract? 3. Is a payment for the grant of a restrictive covenant a capital sum or received in substitution for income and so to be treated as if income? As will be seen, these payments may raise many possible tax consequences. Not only might the payments have an income nature according to ordinary concepts or statutory income, give rise to fringe benefits, or generate capital gains, they might also be employment termination payments and subject to the special rules for these payments.

(a) Income from Services or the Sale of an Asset [4.720] Even after CGT, important consequences still attach to distinguishing between a

reward for service and the sale of an asset. In Brent v FCT the taxpayer was the wife of Ronald Biggs, one of the Great Train Robbers. Biggs was later to gain even more fame by singing with the soi-disant musical group – the Sex Pistols. Brent executed an agreement purporting to sell for $65,250 “the exclusive right to publish and/or reproduce throughout the world … the life story of the vendor and especially the story of the vendor’s life with her husband, Ronald Arthur Biggs” and was paid $10,000 on signing the agreement. Two journalists questioned her for most of five days and took notes of her answers to their questions. She was shown typescript prepared by journalists and could comment upon it but did not often do so and was generally ignored when she did. She eventually signed the manuscript but was paid nothing further for reasons which do not appear in the report. The ATO included the whole of the $65,250 in her assessable income as a reward for services. She contended that the payment was a capital receipt on the sale of her pre-CGT asset. Gibbs J in the High Court disagreed with her.

[4.720]

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Brent v FCT [4.730] Brent v FCT (1971) 125 CLR 418 The question whether the amount payable under the agreement was income in my opinion depends on whether it should properly be regarded as a sum earned by the appellant in relation to services rendered by her for the company. If so, it would not only be income within ordinary usages and concepts, but would also be within the scope of s. 26(e) of the Act. If the moneys were, in truth, earnings from the performance of services by the appellant, it would not matter that she carried on no business or vocation, or that the moneys became payable as the result of an unexpected stroke of fortune or that there was no element of regularity or periodicity about their receipt. The question, therefore, is whether the moneys she received answer that description or whether they were rather, as the appellant contended, the consideration for the sale of proprietary rights or of rights analogous to rights of property. That question must be answered by examining the agreement and the manner in which the parties to it carried it out. By cl 1 of the agreement the appellant purported to sell to the company the exclusive right to publish and reproduce her life story and especially the story of her life with Biggs. This provision was of doubtful value. At the time the agreement was signed no story had been written. As a matter of construction “the life story” referred to in cl 1 would appear to mean the life story embodied in the manuscript which was in due course to be signed by the appellant … If cl 1 purported to confer on the company an exclusive right to publish any account of the life of the appellant, it would be quite illusory, for anyone who could obtain enough information to enable him to do so would be entitled, subject to such restrictions as the law of copyright and defamation might impose, to write a biography of the appellant. By cl 4 the appellant purported to assign to the company her copyright in the manuscript which she intended to sign. It is clear, however, that, in the events which happened, the appellant had no copyright to assign. The stories were about her life but she did not write them 212

[4.730]

and they were not told in her words; the journalists who made the notes were not mere amanuenses who took down and transcribed word for word what she said, but they gave to the stories the form in which they finally appeared. In those circumstances the appellant, who had provided the ideas but not the form in which they were expressed, had no copyright. Clauses 5 and 7 of the agreement required the appellant to perform certain services for the company – to assist its agents, to make herself available for interview and to give information and to sign the manuscript. She, in fact, did these things. Clause 6 also required the appellant to make available (but not to sell or give away) all photographs and tokens in her possession relating to the subject matter of the agreement. It may be inferred from the fact that the articles when published did contain photographs that the appellant made some available; whether she made available any tokens (whatever they might be) does not appear. Clause 8 contained an undertaking by the appellant not to communicate with or make statements to others relative to the subject matter of the agreement and, in particular, not to give press, radio or television interviews on any subject within sixty days from the signing of the manuscript. This negative covenant was no doubt of real value to the company, but it was ancillary to the main purposes of the agreement. In substance, the appellant earned the money payable under the agreement by devoting her time to the interviews at which she was questioned, by disclosing all the facts about her life with her husband that were thought worth printing and by lending her name to the stories which the journalists produced. The agreement to make available, apparently on loan, the photographs and tokens may rightly be regarded as a subsidiary matter and the negative covenant in cl 8 was ancillary to the main purpose of the agreement. The purported grant of the exclusive right to her life story and the purported

Income from the Provision of Services

Brent v FCT cont. assignment of the copyright were, in truth, inefficacious to convey any rights to the company … It is not possible speaking strictly to say that in communicating the information to the agents of the company the appellant was parting with property. Neither know-ledge nor information is property in a strictly legal sense, although they can be said to be property in a loose metaphorical sense … As a matter of law the agreement entitled the appellant to payment for services rendered to the company in making herself available for interview, in communicating information and in signing the manuscript which the journalists produced and which was not her property … There is no special reason as a matter of fact to treat the information which she possessed as equivalent to a right of property; it was not acquired in the conduct of a business, and could

not be described as property in a business sense, it did not relate to anything in which copyright existed, and there was no other justification for regarding it as having in fact a character which the law denied it. The fact that the appellant had secret information made her services more valuable but moneys paid as the consideration for services rendered are income notwithstanding that the person rendering the services is employed only because of the special knowledge or information that she possesses. It is impossible to hold that the appellant sold any property to the company. As I have said, the purported sale of the right to publish her life story and the purported assignment of copyright were illusory and the agreement to make available photographs and tokens and the negative covenant contained in cl. 8 of the agreement were subsidiary to the main objects of the agreement. In my opinion the consideration provided by the agreement was for services rendered by the appellant to the company and was properly treated as income.

[4.735]

4.60

4.61

4.62

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Questions

What would have been the result in Brent if the taxpayer had written the story herself and simply assigned the copyright to the newspaper? What if Mrs Brent died leaving a diary of her experiences and the diary was sold to a newspaper? If the sale of property characterisation is adopted, on what grounds may there nevertheless be an amount included in assessable income? What is the effect of s 15-15 of the ITAA 1997 – could this have been a profit-making undertaking? Even if Brent’s argument had been successful, what result would follow post-CGT if she had entered into the contract after 19 September 1985? Would it make a difference if the events in her story pre-dated CGT? Would it make any difference if the facts pre-dated CGT but she only learned of them post-CGT?

(b) Payments for Varying Contract Rights [4.740] When the parties to an employment contract agree to bring it to an end, the

employee’s right to wages for the balance of the term is bought out and the employee’s rights are “capitalised” in the sense that future periodic wages are usually commuted into a present lump sum. Is this sum liable to be included in assessable income? In Scott v Commissioner of Taxation the taxpayer had been appointed chairman of a board established under the Metropolitan Meat Industry Act for 10 years at a salary of £2,500 per annum from 1 August 1931. The board was dissolved by a later Act and his position abolished but the later Act provided that he was entitled to compensation calculated on the same basis as if he had been wrongfully dismissed. He recovered £7,000 compensation in an action for wrongful dismissal which the Commissioner then included in the taxpayer’s assessable income on any one of three [4.740]

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different grounds: the amount was income according to ordinary concepts; it was included in income as a retiring allowance under s 11(i) of the Income Tax (Management) Act 1928 (NSW), the equivalent of the current Div 82 of the ITAA 1997; or it was included in his assessable income under s 11(j) of the New South Wales Act, the equivalent of s 15-2 of the ITAA 1997. Jordan CJ in the Supreme Court of New South Wales held that the payment was not included in assessable income under any of these provisions.

Scott v Commissioner of Taxation (NSW) [4.750] Scott v Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215 Now, according to the ordinary meaning of “income”, as an English word, there can be no doubt that such a receipt as that now in question is not income. If a business consists in the making of numbers of commercial contracts in the hope of making profits by their performance, any damages that may be recovered as compensation for the breach of one of those contracts is a receipt that must be taken into account for the purpose of arriving at the total profits, and ultimately at the net income, of the business. So, too, must any receipt in the nature of compensation for a partial restriction of general trading opportunities. But a price received as a consideration for going out of business or compensation received for being prevented from carrying on business any further, or for being

prevented from continuing in employment, is not income, according to the natural meaning of the word. The sum in question in the present case was compensation made payable because the appellant’s office had been abolished before the period for which he had been appointed to hold it had expired, and was measured by the amount of damages which he would have been entitled to recover if he had been wrongfully dismissed. The mere fact that this particular measure was adopted is not, of course, conclusive; but it is, I think, manifest that such a sum is not liable to be taxed as income unless an intention is to be found in the Act that the word is to be read with an extended meaning large enough to cover such a receipt.

[4.760] Stephen J agreed that the payment was not income according to ordinary concepts

nor caught by the equivalent of s 15-2, but dissented from the view that it was not a retiring allowance. The reasoning of Jordan CJ in relation to the statutory provisions turned on the interpretation of words “allowances or gratuities” in the section given the legal obligation to make the payment. This aspect of the holding was later overcome, at least in relation to retiring allowances, by adding the words “made (whether voluntarily, by agreement or by compulsion of law)” to s 27A of the ITAA 1936. Interestingly, those words were not retained when s 27A was moved and rewritten as Divs 80 – 83. You should contrast the attitude of Jordan CJ to the relevance of the measurement chosen, with the reasoning expressed and the result reached in Commissioner of Taxes (Vic) v Phillips. The taxpayer in Phillips had an agreement to serve as managing director of Central Theatre Company for 10 years. The terms of the agreement provided that he would receive the normal director’s fee, and in addition an amount equal to 12.5% of Central’s net annual profits from one of its theatres, payable monthly. Central sold the theatre but the purchaser did not want to retain Phillips as manager and so Central cancelled Phillips’ contract agreeing to pay him compensation. The compensation agreed upon was £20,301 calculated at £5,252 for each remaining year in Phillips’ contract. The figure of £5,252 was calculated at £101 per week which was estimated by the parties from past experience to be the amount Phillips would have 214

[4.750]

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been likely to receive if the agreement had run its course. During the year of income Phillips received £4,444 by instalments of £404 every four weeks. Dixon and Evatt JJ in the High Court found that the amounts had the character of income.

Commissioner of Taxes (Vic) v Phillips [4.770] Commissioner of Taxes (Vic) v Phillips (1936) 55 CLR 144 The substance of what the taxpayer obtained under the agreement he made was a right to receive a monthly payment of £404 during the unexpired residue of his agreement of service with the company. The agreement of cancellation or rescission substituted this payment for the monthly payments which he would have earned by directing the theatre, payments of uncertain amount representing 12.5% of the profits. An estimate of these future payments of uncertain amount produced the regular monthly sum of £404. He gave up the right to the future payments calculated upon the profits and was relieved of the duties of management. While, if his agreement had gone on, the performance of that agreement would have been the proximate source of the income and its amount would have fluctuated, under the new arrangement the receipts were derived from the mere subsistence of the contract, which needed no performance on the part of the taxpayer, and the amount of the monthly payment was fixed. It appears to us that, for future income which he had a right to earn by performing the agreement, he exchanged a right to receive, through the same duration of time and at the same intervals of time, amounts estimated as equivalent to the income otherwise payable to him. It is true that to treat a sum of money as income because it is computed or measured by reference to loss of future income is an erroneous method of reasoning. It is erroneous because, for example, the right to future income may be an asset of a capital nature and the sum measured by reference to the loss of the future income may be a capital payment made to

replace that right. Or, again, the computation may be done for the purpose of ascertaining what capitalised equivalent should be paid for the future income. But, where one right to future periodical payments during a term of years is exchanged for another right to payments of the same periodicity over the same term of years, the fact that the new payments are an estimated equivalent of the old cannot but have weight in considering whether they have the character of income which the old would have possessed. Even in the case of a sale of land, the parties may, if they choose, adopt a consideration consisting of annual payments which are income and not merely deferred payments of capital. A contract of service is valuable only because of the income it will bring during the residue of its term. It is not a piece of marketable property. Unless it is rescinded or broken, it is not usually possible to obtain a lump sum or any other consideration representing its value. When such an occasion arises its value is likely to be expressed in terms of income and is by no means certain to be translated into capital. No prima facie reason exists for regarding as instalments of capital annual payments which are taken in place of the contractual rights such a contract gave. In the present case, the contract expressed the total of the monthly payments as a lump sum. But the period being fixed, the rate of payment being estimated and the intervals being already established, the statement is no more than an arithmetical equivalent. Indeed, it is not the present value of the future payments but merely their sum.

[4.780] In Phillips the taxpayer gave up one income stream from his employer in return for

another. The principle that the case displays is that where an amount substitutes for another amount that would be income if it were received, the first amount is also income. It is another aspect of ordinary usage income and we will explore it more fully in Chapter 6. But does it [4.780]

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make any difference if the replacement comes not from the employer, but from a third party? This issue was explored by the Full Federal Court in Reuter v FCT, a case which emerges from the turmoil of the 1980s and involves some of its most infamous characters and events – Laurie Connell and his merchant bank Rothwells, Alan Bond and his company Bond Media Limited, Warwick Fairfax and his company Tryart, the 1987 stock market collapse, and the battle for the Fairfax media empire. Warwick Fairfax engaged Rothwells to advise and assist Tryart in connection with the proposed acquisition of John Fairfax Limited in return for a success fee of $100 m. Rothwells then engaged Reuter as a consultant on the deal, with Laurie Connell promising Reuter a share of the success fee, likely to total about $45 m. When the stock market collapsed in November 1987, Rothwells ran into financial difficulty and sought to sell the anticipated success fee to Bond Media Limited (BML) in return for an immediate cash payment. Reuter feared that Rothwells might go into liquidation and that he would have to battle with the bank’s creditors for a share of the success fee, and so to protect his position, he threatened to seek an injunction blocking the sale of the success fee to BML. To prevent this, Rothwells and BML entered into a multi-stepped transaction. First, Rothwells agreed to pay BML a procurement fee as consideration for BML agreeing to purchase the anticipated success fee. BML, in turn, agreed that it would pay $8 m of the proceeds of the procurement fee to Reuter. In return for the payments, Reuter entered a Deed of Covenant under which he promised not to undertake any action that would hinder the assignment by Rothwells of its anticipated success fee to BML. The Commissioner assessed Reuter on the basis that s 25 of the ITAA 1936 applied. In a joint judgment, Jenkinson, Lee and O’Loughlin JJ upheld the following assessment.

Reuter v FCT [4.790] Reuter v FCT (1993) 27 ATR 256; 93 ATC 5030 Counsel for Reuter contends in this appeal that whilst it is appropriate to look at all the circumstances which bear upon the character of the payment made, a clear statement in the Deed of Covenant that the payment had been made in return for Reuter’s acceptance of a restriction of his right to claim, or commence proceedings in relation to, the Tryart fee demonstrated the character of the payment, namely a receipt in the nature of capital and not one received as income according to ordinary concepts … The consideration for the payment described in the Deed of Covenant is only part of a matrix of relevant events providing the context in which the Deed was executed and in which the character of the payment must be found. The record in the Deed that the payment made to Reuter had connection with the covenants to be provided by Reuter in the Deed, did not exclude connection with other events and was not conclusive of the nature of the payment received by Reuter. The issue to be decided was whether, 216

[4.790]

in fact, the payment was a “product” of the taxpayer’s services having regard to all relevant material. The following facts found by his Honour were relevant to the character of the payment. Reuter was aware that the threat of administration in insolvency was overhanging Rothwells and that any payment to him by Rothwells may have to be disgorged to a liquidator subsequently appointed. Reuter was also aware that if Rothwells succeeded in assigning or charging its right to be paid a fee by Tryart, Rothwells would not be able to pay any fee to Reuter. On 10 November 1987 Reuter and Dougherty had indicated to Rothwells that they would agree, or had agreed, to accept $10m in payment for the services they had provided to Rothwells. On 19 November 1987, as part of the Facility Agreement made between Reuter and BML, Rothwells required BML to contract with Rothwells that BML would apply $10m of a $17m “procurement advisory fee” payable to BML by Rothwells upon delivery of the loan, to discharge

Income from the Provision of Services

Reuter v FCT cont. the sum of $10m to be paid by BML to Reuter and Dougherty to obtain their execution of a Deed of Covenant of even date for the purpose of facilitating the loan transaction between Rothwells and BML and the delivery of the loan to Rothwells. It is clear from the foregoing that events outside the Deed bore upon the character of the payment received by Reuter from BML. Such events relevant to characterisation of the payment were the willingness of Reuter and Dougherty respectively to accept a fee of $8m and $2m from Rothwells and the agreement between BML and Rothwells that BML would use a fee payable by Rothwells to BML to pay $8m and $2m to Reuter and Dougherty respectively to obtain covenants from them sufficient to encourage BML to perform the Facility Agreement and put Rothwells in funds by the delivery of the loan from BML. If the anticipated covenants in the Deed provided the sole foundation for the payment of $8m to Reuter by BML, Rothwells had no interest in securing from BML a contractual obligation to make that payment from a fee to be paid to BML by Rothwells. The tripartite nature of the arrangements provided a nexus between the services rendered by Reuter to Rothwells which had earned a fee of $8m, the obligation of Rothwells to pay $8m for those services and the sum of $8m received by Reuter from BML. It may be noted that the Deed of Covenant between BML and Reuter did not effect an assignment or

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relinquishment by Reuter of any rights or of any property. BML paid $8m for Reuter’s agreement not to claim any part of the Tryart fee without the prior approval of BML and for Reuter’s agreement to indemnify BML to the extent of $8m if Reuter did claim, presumably against BML as assignee of the Tryart fee, any part of that fee. The connection between Reuter’s entitlement to a fee for the provision of his services to Rothwells and the sum paid by BML is patent. As long as Reuter continued to acquiesce in the Rothwells proposal that he be paid a fee of $8m for his services, the sum of $8m paid by BML replaced the need for Reuter to make any claim on the Tryart fee. Whether the sum received by Reuter effected a compromise of Reuter’s claim against Rothwells for the payment of the agreed percentage of the Tryart fee is unnecessary to decide and is irrelevant to a conclusion that the sum received by Reuter from BML was so connected with the services provided by Reuter to Rothwells as to be a product of those services. It is in that context that the question of the character attached to the sum received by Reuter had to be determined. Part of the relevant evidence was within the Deed but significant evidence outside the Deed made it obvious that the nexus between the sum of $8m received by Reuter from BML and the services provided by Reuter to Rothwells was such that it could be said that the sum received, however described, was a product of those services and properly characterised as income according to ordinary concepts.

[4.800] The transaction contrasts nicely with the course of action chosen by the taxpayer in

Bennett v FCT. The taxpayer in Bennett was employed as the managing director of radio station 2GB under a seven-year contract entitling him to a salary of £1,040 plus 5% of gross revenue plus 10% of the proceeds of the sale of transcripts. During negotiations for the sale of the company which owned the radio station, he agreed to the cancellation of his contract and entered a new one reappointing him as managing director but for a shorter term (although there was an option to extend the term), and with fewer powers. In consideration, he was promised three payments totalling £12,255 which the Commissioner assessed as income. Williams J in the High Court held that the amounts were of a capital nature and therefore not assessable as income.

[4.800]

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The Tax Base – Income and Exemptions

Bennett v FCT [4.810] Bennett v FCT (1947) 75 CLR 480; 4 AITR 12 It was contended for the respondent that the sums of £3,000, £4,000 and £5,255 were part of the remuneration of the appellant for his services as managing director under his new appointment commencing on 12 November 1936, and as such part of his assessable income. But the payment of these sums had no relation to any services which he had rendered to 2GB in the past or was bound to render to 2GB in the future. The whole of the £12,255 was payable whether he rendered any services as managing director between 12 November 1936 and 1 January 1940 or not. The payments were not made to him as compensation for the remuneration which he would have received if he had remained managing director for the original term ending on 24 August 1942 instead of his term being shortened to 1 January 1940 because he had the option to extend the term to 24 August 1942. If the company exercised the option to extend the term the payments would not increase his remuneration, because he was entitled to them whether he served the company as managing director during the further term or not. If the appellant exercised the option, they would not increase his remuneration because he had then to refund them wholly or pro tanto. The effect of the

[4.815]

cancellation of the indenture of 24 August 1935 and the re-appointment of the appellant as managing director of 2GB under the indenture of 12 November 1936 was that the appellant, instead of having unfettered control of the business of 2GB, was relegated to a position of subordination to the directors. The fluctuating portion of his remuneration as managing director depended upon the success of the company’s business … But the substance of the matter is that the sum of £12,255 was a lump sum payable by instalments as compensation for the cancellation of the indenture of 24 August 1935, and such payments are of a capital nature unless the compensation is some form of equivalent for the loss of the income which the taxpayer would have earned under the agreement but for its cancellation, as in the case of the payments in C of T (Vic) v Phillips (1936) 55 CLR 144. The payments in the present case are simply payments made as part of the consideration for the appellant agreeing to cancel one agreement under which he had certain rights and entering into a fresh agreement under which he had different rights.

Questions

4.63

What is the distinction between Bennett and Phillips? Why was the payment in one case characterised as income and in the other as capital?

4.64

When an employment relationship continues between the parties, in what circumstances will a payment be treated as one made in exchange for giving up contractual rights? If it is so treated, on what grounds may the payment still be classified as income?

4.65

These cases exhibit some of the possible tax treatments but the particular result in each case may no longer follow – we may now reach another combination of three different results. What ought to be the result if Scott, Phillips and Bennett were litigated today? You will need to consider the effect of s 15-2, the definition of “employment termination payment” in s 82-130, FBT and CGT.

4.66

Under the terms of the award, the employer can require the employee to work during a rostered meal break but must pay a meal penalty – an additional $7.50. Is this amount assessable to the employee?

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[4.810]

Income from the Provision of Services

4.67

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The taxpayers had been entitled to one rostered day off (RDO) per fortnight, but in February 1988, the employer, Shell, unilaterally varied the terms of employment, increasing formal working hours from a nine-day fortnight to a five-day week. The taxpayer received a lump sum equal to three months’ salary, payable in three instalments, as compensation for the loss of the RDOs. Are these sums income or capital? (See AAT Case 8145 (1992) 23 ATR 1243; Case Z9 92 ATC 267.)

(c) Payments for Restrictive Covenants [4.820] Employees sometimes receive payments from their former employers in return for

agreeing to submit to restrictions on their future behaviour. The payments are designed to reduce the employee’s value to another potential employer who is in competition with the former employer. In most cases, the payment is made on retirement and is designed to neutralise the value of the information in the employee’s head, and to allow the former employer to capitalise on its investment. This is a different fact pattern from Bennett where the employee agreed to accept restrictions on his powers while continuing in his employment, but it raises similar tax issues to those we have just examined with a few additional complications. This area is very fertile territory for legal analysis because of the multitude of taxing possibilities, for example: • the payment might be taxable as ordinary usage income as a reward for a service, or included as statutory income under s 15-2 or some other provision; • the payment for the restrictive covenant might be subject to CGT; • the payment might be a fringe benefit; • because it is paid at about the time that the employment has ceased, it might be taxable as an employment termination payment; and finally • it might be taxable as ordinary usage income under the compensation receipts principle just discussed. The analysis of the ordinary usage position usually begins with Higgs v Olivier. The taxpayer, Lord Olivier, made an agreement following the completion of a film version of Henry V not to act in any film made by other movie producers for 18 months so that the producer could market the film without competition from other films featuring the taxpayer. The revenue authorities argued that the payment of £15,000 he received was a reward for service but Harman J denied that it had an income character.

Higgs v Olivier [4.830] Higgs v Olivier [1951] 1 Ch 899 If there were any evidence that the agreement of 1945 was a device of some sort whereby the taxpayer obtained, as his reward for playing in and producing Henry V, a further remuneration, it would be easy to see that that would be a taxable sum. There appears to have been some suggestion before the Commissioners to that effect, but the Commissioners found that there was no evidence to support it … The Crown had to face the fact that the agreement of 1945 was an agreement not to act, and their answer was

that money might be made by refraining just as by ceasing to refrain, and that this was an incident in the career of a popular actor by which he exploited his personality, just as he might have exploited it in the opposite way, by acting. On the other hand, the taxpayer’s argument was that, so far from being an incident of his vocation, the payment was a payment for not exercising his vocation – for refraining from exercising it, from putting his art and his [4.830]

219

The Tax Base – Income and Exemptions

Higgs v Olivier cont. personality to a profitable use. With that submission, in substance, the Commissioners have agreed. They held that the agreement and the Deed of Covenant could not be read together. The taxpayer had performed all his services under the former, before the latter came into existence. They found it impossible to say that the sum of £15,000 under the deed of 1945 came to the taxpayer as part of the income from his vocation. On the contrary, it came to him for refraining from carrying on his vocation, and in their opinion was a capital receipt. Had there been evidence that it was a regular practice with actors to accept sums as a condition of not exercising their art, it would not be right to come to the conclusion that it was not an incident of the vocation of such persons …

Numerous cases were cited, but I do not think that a review of them would be of value. Possibly Glenboig Union Fireclay Co Ltd v IRC – on which both sides rely – is nearer to the present case than any other … That seems to be analogous to the present case. The respondent had, as he testified, ample opportunities in the year in question of making a profit by the exploitation of his art as a film actor. Those he agreed to forgo, and for that forbearance he received a sum of money … Consequently, if I were at liberty to regard the matter, as the Attorney-General invited me to do, as res integra, I should come to the same conclusion as that at which the Commissioners have arrived. All I need say is that there is evidence on which they could come to the conclusion which they reached, and that conclusion, being one of fact, it is not for me to dispute it.

[4.840] The proposition that a payment to an individual for entering into a restrictive

covenant is a capital amount is usually based on the judgment in Higgs v Olivier but it was never expressly held that the same result would be reached in Australia. In Dickenson v FCT (1958) 98 CLR 460; 7 AITR 257 at 280 Kitto J suggested that the result in Higgs v Olivier might have been different in Australia had the case been decided on the basis of the ITAA 1936 rather than UK legislation. Be that as it may, a similar, if more unusual, payment was made in FCT v Woite with a similar result. The taxpayer was a football player who lived in South Australia and received a payment of $10,000 for agreeing (in a form of contract referred to as Form 4) not to play football in Victoria unless it was for North Melbourne. He retired from play without leaving South Australia but was not required to refund the payment to the Victorian club. The Commissioner argued that the amount was income according to ordinary concepts but Mitchell J, in the Supreme Court of South Australia, disagreed. The Commissioner’s argument picks up the argument, rejected in the last two paragraphs of Olivier, that the payment was for the surrender of rights so insubstantial that it could not be for the surrender of a capital asset.

FCT v Woite [4.850] FCT v Woite (1982) 31 SASR 223; 13 ATR 579; 82 ATC 4578 [Counsel for the Commissioner] submitted that the respondent had not established that the $10,000 paid to him was not a reward received by him as a professional footballer and that such an award was subject to taxation. The Board of Review had rejected this argument and said that

220

[4.840]

it treated the sum of $10,000 as “a non-assessable receipt of a capital nature”, and as “a payment for giving up a permanent asset and no more” … Of course, if the advantage which was given up was shown to be merely illusory, there might be reason for saying that the payment was not in

Income from the Provision of Services

FCT v Woite cont. fact for the surrender of this advantage but for some other purpose and the taxpayer might not then discharge the onus of establishing that the payment was not income. In the present case, however, the effect of the signing by the taxpayer was that he deprived himself of the opportunity, which otherwise would have been open to him, of accepting any offer, which might be made at any time by any Victorian football club other than North Melbourne to play professional football in Victoria. In the events which happened he remained in South Australia until his retirement from playing football but the bar to his acceptance of a contract with any football club other than the North Melbourne Football Club

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remained and still remains. The payment of the $10,000 did not in any way affect the income from football which the respondent received in South Australia. Had the signing of Form 4 by the respondent been followed by a contract with the North Melbourne Club to play football for that club it may well have been difficult, if not impossible, for the respondent to discharge the onus of establishing that the $10,000 was not income … In the case at bar the restriction was not an obligation undertaken incidentally to the playing of football for reward by the taxpayer. It did not affect his playing in South Australia for which he received income. It simply restricted him from seeking or accepting a contract with all but one of the football clubs in Victoria.

[4.860] It was thought in 1985 that the inclusion of payments (such as those listed above) in

assessable income would be more likely after the introduction of CGT. The Explanatory Memorandum to the Income Tax Assessment Amendment (Capital Gains) Act 1986 (Cth) states quite unequivocally that s 160M(7) of the ITAA 1936 would apply to payments such as these even though it would be difficult (without such an open-ended and ambiguous section) to argue that there was a transaction involving an “asset”. Yet the Explanatory Memorandum states: [S]ubsection 160M(7) [now s 104-135 of ITAA 1997] also applies, subject to the other provisions of Pt IIIA, in situations where there is a disposal of an asset created by the disposal. Examples of the acts, transactions or events affected by this provision include that of an amateur sportsman who receives a payment on becoming a professional, the receipt of consideration for entering into exclusive trade tie agreements or restrictive covenants, or in connection with the variation, cancellation or breach of business contracts or agency agreements.

But despite the optimism of the drafter of the legislation, the ability of the CGT to collect tax on payments for restrictive covenants was rejected (albeit unconvincingly) by the High Court in Hepples v FCT (No 2) (1992) 173 CLR 492; 22 ATR 852. The taxpayer, who had been employed as a manager of Hunter Douglas, signed a restraint of trade agreement limiting his ability to use the knowledge and information he had acquired while an employee for two years after he left employment. In return, he received payment of $40,000. The ATO sought to tax the payment only under the CGT, and did not argue that it was income under ordinary concepts, apparently accepting Higgs v Olivier as authoritative in Australia. The High Court held by majority that neither s 160M(6) [now s 104-35] nor s 160M(7) of the ITAA 1936 applied to the case, although different majorities decided each issue – Mason CJ, Deane, Toohey and McHugh JJ (Brennan, Dawson and Gaudron JJ dissenting) holding that s 160M(6) did not apply; Mason CJ, Brennan, Deane and McHugh JJ (Dawson, Toohey and Gaudron JJ dissenting) that s 160M(7) did not apply. Because of the confusion caused by the High Court’s divided judgment and its contradiction of Parliament’s expressed objective (expressed at least in the Explanatory Memorandum if not [4.860]

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The Tax Base – Income and Exemptions

in the text of the legislation) of trying to tax such payments, Parliament intervened to overturn the Hepples decision. Several major amendments were made to Pt IIIA by the Taxation Laws Amendment Act (No 4) 1992 (Cth), expanding the definition of an asset to include “incorporeal property” and deeming more of the requisite elements for s 160M(6) of the ITAA 1936. According to the Explanatory Memorandum to the second Bill, the new s 160M(6) was still intended to tax payments made to a taxpayer for “agreeing not to compete with another person”, “agreeing to only play sport with a particular club”, and “agreeing with a film company not to appear in a film made by another company”. These amendments appear to have overcome the shortcomings that prevented the section from applying to the payment for a restrictive covenant received by the taxpayer in Hepples. These amended provisions are now to be found in ss 104-35 and 104-155 of the ITAA 1997. The focus of the legislative flurry which succeeded Hepples was s 160M(6). However, in Paykel v FCT (1994) 49 FCR 41; 28 ATR 92; 94 ATC 4176 the ATO decided to test s 160M(7) (s 104-155 of the ITAA 1997) to see if it would support an assessment of tax on a restrictive covenant payment. It is the provision in CGT that most clearly taxes capital receipts which do not involve actual disposals of assets. The taxpayer was the principal shareholder and managing director of Paykel Bros, an oil and chemical company. In 1989, the company was sold to a US buyer, Efhco. At the same time, the taxpayer entered into an agreement with Efhco by which he agreed to retire as a director and employee of Paykel Bros and covenanted not to divulge any of the company’s confidential information nor to carry on any business in Australia or South East Asia in competition with the company for the following five years. The taxpayer received a payment of $400,000 for the agreement, which the ATO assessed under s 160M(7). Heerey J upheld the taxpayer’s appeal and adopted the view that “Hepples stands for the proposition that a payment by an employer to an employee in consideration of the employee’s covenant not to compete after the termination of his or her employment is not within s. 160M(7)”. Even apart from the ordinary usage income idea of a reward for service and the CGT provisions, the ATO had another potential provision to apply in his efforts to impose tax on restrictive covenant payments. Division 82 includes an employment termination payment in a taxpayer’s assessable income. Section 83-130 defines an employment termination payment to mean “a payment … received … in consequence of the termination of your employment”. Paragraph (j) of s 82-135, however, specifically excludes from the definition “a capital payment for, or in respect of, a legally enforceable contract in restraint of trade by you so far as the payment is reasonable having regard to the nature and extent of the restraint”. There is one final possibility for taxing income from restrictive covenants to be explored. This is the principle: where an amount substitutes for another amount that would be income if it were received, the first amount is also income. This is another aspect of ordinary usage income and we will explore it more fully in Chapter 7. If it was clear that a payment under a restrictive covenant by a person merely substituted for an amount that would be income, the covenant payable under the covenant is also income, taking on the character of the amount for which it substituted. [4.865]

4.68 4.69

222

Questions

Can a payment for an agreement not to do a particular thing, or if it is ever done, not to do it in a particular way, be a reward for service? In some jurisdictions, payments such as those in Paykel would be considered ordinary income on the basis that the taxpayer’s right to retain the payment only continues so [4.865]

Income from the Provision of Services

4.70

4.71

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long as the taxpayer does exactly what he has been contracted to do, namely not divulge secrets and not work in competition with the former employer. In other words, the “negative” covenant is viewed as a positive act because it requires continuously renewed restraint on the part of the taxpayer. Had the ATO assessed the taxpayer in Paykel on the basis of s 6-5 of the ITAA 1997, might this argument have succeeded? Might the payment in Olivier have been an employment termination payment? What is the effect of para (j) of s 82-135? Would the contract in Woite have been within para (j)? Could the payments in either of these cases have been a fringe benefit taxable to the employer under FBT? (See para (m) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986.)

6. TERMINATION PAYMENTS AND RETIREMENT INCOME [4.870] We now turn to consider the tax treatment of payments which are made at or about

the end of a taxpayer’s (current) employment. You will soon see that there is a myriad of payments encompassed within this description, many with their own idiosyncratic tax treatment. We need to consider how tax is imposed on the many different sorts of payments made, either once or over a period of time, after a taxpayer leaves their current employment and eventually leaves the paid workforce. There are many complicated provisions because the rules need to deal with the diversity in: • the variety of types of payments: for example, a “golden handshake” made voluntarily by a former employer, payments from a superannuation fund, agreed termination payments, statutory redundancy payments, payments to induce early retirement, lump sums for unused holidays, long service or sick leave, ex gratia payments to dependants of deceased employees, lump sums paid on retirement or total disability, pensions and annuities on retirement and insurance payouts to the relatives or estate of a deceased worker; • the variety of payers: for example, the payments might come from an employer, the government or third parties such as superannuation funds or insurance companies; • the variety of times involved: payments might be made upon a change of job, upon retirement, and after retirement; • the variety of recipients: for example, the employee, her or his spouse and dependants, her or his estate. If we try to organise all these permutations into the groups that raise similar issues, three main distinctions appear: 1. payments made from private sources when the taxpayer leaves the paid workforce; 2. payments made from public sources when the taxpayer leaves the paid workforce; 3. payments made as part of a career change. Obviously these different groupings raise different policy issues, suggesting that different rules are needed for each group, but rules to treat them differently have only recently emerged in Australia. We will begin by looking at payments that occur when a taxpayer leaves the paid workforce completely and collects – whether from their savings or direct from their employer – the money which will have to support them (at least in part) for the rest of their lives.

(a) Retirement Incomes Policy [4.880] Australia has two systems intended to provide income for citizens to live on after they

retire from the paid workforce. One is the private system (superannuation) and the other is a [4.880]

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The Tax Base – Income and Exemptions

public system (the aged pension). While it has always been governmental policy to encourage citizens to save during their working life for their retirement – a policy which has been reflected in provisions offering generous tax treatment to these savings – for many low-income taxpayers, retirement income meant relying exclusively upon the aged pension. It may seem strange to some to view these systems as complements, but the similarities are striking. For example, both involve the taxpayer saving some of their income while they work – those in the private system save by making contributions into a private fund; for those in the public system, their saving is by paying higher taxes. Both systems involve a large element of government expenditure – for those in the private system, the subsidy is given in the form of tax concessions at the point when the taxpayer makes contributions to a fund and the fund earns income on those contributions; in the public system, the subsidy occurs when the taxpayer draws against the pension. In other words, it would be a mistake to view the superannuation system as not involving a cost to society or to suggest that only the aged pension is a “government hand-out”. For most of the rest of this section we will concentrate on the private superannuation system but the existence of the parallel public system should not be forgotten. We will look more closely at some of the aspects of the aged pension system in Chapter 6. The level of government support for the private superannuation system has raised claims by civil society groups that retirement savings have been too favourably treated and that the tax concessions are unfairly distributed predominantly to high-income taxpayers. These criticisms have been taken seriously and the great complexity in the Act that you will all too soon encounter has been caused by the efforts of governments, on the one hand, trying to encourage taxpayers to save for their retirement through granting tax concessions, but at the same time, trying to control the size of the cost to government of the tax concessions and to change their distribution. As a consequence, Australia’s tax rules in this area have been changed more or less continuously since 1983 and we are now up to the fifth major revision of the rules. More changes will undoubtedly follow from current parliamentary inquiries and the research work of other bodies. In addition, because taxpayers must plan for their retirement over their entire working life, major changes must, if they are not to operate retrospectively, deal with difficult transitional issues for income saved at one time but withdrawn from saving at another time and under a different tax system. [4.890] Before we get too far into the analysis, it is important also to remember that the

Australian tax system only recently began to distinguish between payments that were made on a change of employment (ie resignation or retrenchment) from payments made on the permanent cessation of paid employment (ie retirement). The reason was that until the 1980s, most workers stayed with their employers for much of their working life, few workers enjoyed superannuation benefits and so the main tax issue was how to deal with the gold watch – a token present (and hopefully a big cheque), given at the retirement party. This changed with compulsory superannuation and increased employee mobility, and so we now have two discrete sets of rules – one dealing principally with payments from employers on resignation, and the other dealing with payments from superannuation funds on retirement. It is also worth drawing to your attention early in the discussion the fact that since 1983, Australia has been gradually heading in a different direction from most of the rest of world by taxing contributions to superannuation funds and the earnings of the funds, in order to reduce the size of the tax subsidy for retirement saving. That is, we have been heading toward income tax treatment rather than a consumption tax treatment of savings for retirement – the difference is that amounts are taxed when they are earned under an income tax, but are taxed 224

[4.890]

Income from the Provision of Services

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when they are consumed under a consumption tax. This process took another step in 2006 when the Treasurer announced that, after 1 July 2007, superannuation payments received by people over 60 would be tax-free. The following table shows how the government’s strategy for taxing superannuation has shifted forward the point at which the tax is collected:

Contributions Fund earnings Benefits

Pre-1983 Exempt Exempt Exempt

1983–88 Exempt Exempt Taxed

Post-1988 Partly taxed Partly taxed Exempt/partly taxed

Post-2007 Partly taxed Partly taxed Typically exempt

Lump sum payments made on termination or retirement might be capital or income according to ordinary concepts. If the payment is characterised as representing deferred compensation for services rendered, it will be income as in Blank’s case (discussed above). The payment might be deferred compensation where it is stipulated in the contract of employment – an employee cannot convert contemporaneous income into capital (one would hope) simply by having the employer agree that the employee would be paid $1 per week during the employment and another $500 for every week worked, the latter sum to be paid if the employee resigns or the employer terminates the employment. Further, some payments made on retirement might be income by the periodicity principle (as in Commissioner of Taxes (Vic) v Phillips). But payments made on retirement can be capital if they are paid for the loss of the opportunity to serve (as in Scott v Commissioner of Taxation (NSW), extracted above) even if paid in the form of several instalments (as in Bennett v FCT). The common law was, however, superseded in most cases by the statutory rule, s 26(d) of the ITAA 1936, which largely avoided the need to make these capital-or-income distinctions. The section provided for the inclusion in assessable income of only 5% of an amount paid in a lump sum “in consequence of retirement from or the termination of any office”. This very favourable treatment of lump sums was not extended to pensions or annuities. If an employer paid a pension to an ex-employee, the whole of the pension was treated as income according to ordinary concepts and taxed. If the employer or the employee used their savings to purchase an annuity from an insurance company (an annuity is a series of recurrent payments purchased by the taxpayer from some third party, usually an insurance company), again the whole of each payment would be income according to ordinary concepts. However, because each payment contained a repayment of the purchase price paid by the taxpayer, the former s 26AA of the ITAA 1936 (now s 27H of the ITAA 1936) allowed the taxpayer to exclude from each recurrent payment an amount representing the “undeducted purchase price” of the annuity, that is, the taxpayer’s personal after-tax contributions to her or his superannuation fund. Compared to the treatment of lump sums, however, pensions and annuities were heavily taxed and effectively discouraged.

(b) Superannuation [4.900] Most private saving for retirement occurs through the superannuation system and we will spend most of our time looking at this system. The private system is now pervasive because of the policy of successive governments expressed in the Superannuation Guarantee Scheme, which commenced in 1992. The Superannuation Guarantee Scheme was designed to [4.900]

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ensure that all employees had a percentage of their wages diverted into a private superannuation fund during their working life so that future demands on the age pension could be commensurately reduced. While the almost universal coverage of superannuation has been applauded, the design and operation of the system and the amount of money not being collected because of the tax concessions for superannuation, has become a major source of angst for governments. The 2016 election was fought around competing options for curbing the cost of the tax concessions embedded in the rules. At the time of writing it is not clear just how the system will be changed to deliver more government revenue but further tinkering is inevitable. While we will pay most attention to the rules in the tax legislation, there are extremely important regulatory rules in the Superannuation Industry (Supervision) Act 1993 (the “SIS Act”) and accompanying regulations. One important concept found in those rules is the distinction between a complying and non-complying superannuation fund. A complying superannuation fund is defined in s 45 of the SIS Act to mean a superannuation fund that has elected to be regulated under the SIS Act and meets the requirements of the Act. As we will see, one consequence of making the election is that the fund becomes subject to tax at the rate of 15%. The superannuation system involves three main players (the employer, the employee and the fund) and three time periods (when contributions are made usually by employers and sometimes by members, when the invested contributions earn income, when the accumulated contributions and earnings are withdrawn by the employee on retirement or sometimes change of job). These elements are described in Div 280 of the ITAA 1997, which is a guide to the taxation of superannuation. At its simplest, we need to consider the following three things: 1.

What is the tax treatment of contributors (the employer, the employee or sometimes the government) who pay amounts to superannuation funds? The rules about this are principally in Div 290 of the ITAA 1997.

2.

How is the fund treated on the contributions received and the earnings made from investing those contributions? The rules about this are in Div 295 of the ITAA 1997.

3.

How is the employee taxed on payments out of the fund? The rules about this are principally in Div 301 of the ITAA 1997.

(i) Contributions to a superannuation fund [4.910] The treatment of contributions to superannuation funds is stipulated in Div 290 of

the ITAA 1997. For reasons which are now lost in history, you will see that different rules are provided which depend upon whether the contribution is made by the employer (Subdiv 290-B) or the employee (Subdiv 290-C). The rules about employees are less generous. This is a strange distinction to draw as, simply by manipulating the source of the payment, the same transaction will generate substantially different tax consequences. That is, an employee will suffer less tax overall if they arrange to take less cash salary and have the employer pay a higher amount to a superannuation fund, compared to taking the full cash salary and then putting some of it into a superannuation fund themselves. Indeed, the ATO has even issued a Ruling, TR 2001/10 – Salary Sacrifice Arrangements – which describes when the ATO will accept that the taxpayer has effectively substituted a higher employer superannuation contribution for lower cash salary. 226

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Contributions by employers [4.920] Employer contributions to superannuation funds raise a number of important issues –

is the amount deductible to the employer, does it involve a fringe benefit and does it give rise to any income tax or FBT consequences to the employee? Employer deductions. It has usually been the case in Australia that payments to funds by employers for their employees have been treated as tax deductions for the employer. This is provided in s 290-60 of the ITAA 1997 which allows employers a deduction for contributions paid to a “superannuation fund” to provide “superannuation benefits” for an “employee”. Section 290-10 makes it clear that this Division is the exclusive source of the deduction for contributions to superannuation funds for the purpose of providing superannuation benefits – s 8-1 of the ITAA 1997 is not available to employers. Until 2001, the ITAA 1936 allowed an employer to claim an unlimited deduction for amounts contributed to both a complying and a non-complying superannuation fund. While this may seem oddly generous, the ATO expected that contributions to non-complying funds would be fringe benefits for the purposes of the FBTAA 1986 and so attract FBT at 49% removing any tax advantage (while contributions to complying funds would not be fringe benefits). But various tax scheme promoters in the 1990s saw opportunities here and “non-complying super fund schemes” were created in two flavours – controlling interest superannuation schemes and off-shore superannuation schemes. These schemes tried to ensure a deduction for the employer, no income to the employee and no FBT for the employer (even though the recipient of the contribution was a non-complying fund). Eventually the government decided it needed to act more decisively and the rules were changed in 2001 to make contributions to such schemes even more unattractive: they were made non-deductible to the employer and could be a fringe benefit. Many of these schemes then came to court. It no doubt came as something of a surprise to the investors (and an embarrassment to those who devised and sold them) that many of the schemes were held by the courts to be ineffective. The history of these schemes can be seen in Harris v FCT (2002) 125 FCR 46; [2002] FCAFC 226, Prebble v FCT (2003) 131 FCR 130; [2003] FCAFC 165, Walstern v FCT (2003) 138 FCR 1; [2003] FCA 1428 and Cameron Brae v FCT (2006) 63 ATR 488; [2006] FCA 918, as well as in the 2002 report of the Senate Economics Committee, Inquiry into Mass Marketed Tax Effective Schemes and Investor Protection. The ATO won them all, with the Federal Court denying the employer a deduction for the contribution made to the non-complying fund. As Hill J put it in Walstern: The ability of a private company employer to obtain unlimited deductions for contributions made to a superannuation fund benefiting employees who are directors and shareholders without either the trustee of the fund being liable to pay tax on the amounts contributed or the employer being liable to pay fringe benefits tax must be the holy grail for tax planners. This is what was offered to the applicant in the present proceedings … by a well-known firm of chartered accountants [the now defunct Arthur Andersen].

The rule about deductibility now in s 290-60 does not differentiate whether the employer is contributing to a complying or non-complying fund. However, s 290-75 requires that the recipient fund must either be a complying fund or, if it is not, the employer must have grounds for believing that it is. This might seem to disadvantage complying funds, but as we will see, a non-complying fund will be subject to a high rate of tax on this contribution so that the benefit of the employer’s deduction is reversed. [4.920]

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The timing rules in relation to employer contributions have also been clarified. The former rules used to allow an employer a deduction for superannuation contributions at the time that amounts were “set aside”. This rule meant that an employer who “self-insured” their employees’ superannuation benefits, usually under a defined benefit fund – that is, the employer personally guaranteed the employees’ benefits – could claim a deduction each year as expected benefits grew in size, rather than when they were eventually met. This was typically done by an appropriation in the accounts of the employer to recognise their growing liability. Now, s 290-60(3) allows the deduction in the year that the contribution is “made” which presumably means more than just set aside by the taxpayer as a fund for the purpose of making provision for superannuation benefits. Retrieving amounts from defined benefit funds. For those who followed the takeover battles of the 1980s, or who remember the film Wall Street, it will come as no surprise that superannuation is sometimes an important feature in a corporate takeover. Many takeovers were financed by short-term debt repaid when the buyer of the company raided the target company, or in a more sophisticated play, stripped out the surplus in the superannuation fund of the company they had just bought. The idea of a surplus in a superannuation fund might seem odd, but a surplus can arise in a defined benefit fund where the amount in the fund determined by an actuary to be more than adequate to meet the current and expected claims on the fund. Where an employer receives a refund of an amount previously deducted for contributions to a superannuation fund, it is included in the employer’s assessable income: s 290-100. FBT. Deductibility is not the only issue for the employer; there is also the issue of FBT. Paragraph (j)(i) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986 makes it clear that the payment by the employer of an amount to a “superannuation fund” that the employer believed to be a complying fund will not be a fringe benefit. Issues for employees from employer contributions. The last issue is one for the employee – is there a derivation of income or some other tax consequence for the employee at that time? The entire superannuation system is based upon the assumption that no income is derived by an employee when an employer contributes an amount to a superannuation fund for the employee, but it is difficult to find a robust authority for this proposition. The authority that is usually cited is Constable, which was examined in Chapter 2. But a careful reading of the case shows that the view that the employee does not derive income when an amount is paid to a superannuation fund depended upon the fact that the employee had merely a contingent interest in the fund into which the money was put. The move to regulate superannuation more closely, and to give employees something closer to a vested interest in their benefits, may have the unfortunate outcome of calling into question the result in Constable. Because the superannuation system is regarded as a very big drain on tax revenue, the government has tried various mechanisms to limit its tax loss. Early approaches tried to attack the amount of deductible contributions that an employer could make. • One system worked by trying to work backward from a maximum benefit that could be accumulated inside the superannuation system: the amount of the contribution that an employer should be allowed to make would be based on assumptions about the size of the ultimate permitted benefit, the time until the benefit could be taken, the rate of return until then, the amount of contributions from the employee, the number of other funds of which the employee was a member, etc. In practice, such a system proved too difficult to administer. 228

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• Consequently, the government tried to limit the amount employers could contribute by a more blunt calculation – the age of the member. From 1997 to 2007, the government operated a system which limited contributions based on the age of the employee for whom the contributions are. But all rules of thumb have some inaccuracies: these rules were administered by each employer in isolation, so if the employee worked for two employers, the employee could receive two maximum contributions; if the employee worked half of the year for one employer and half for another, the employee could again receive two contributions. So in 2007, the government changed its approach, changing the way the cap was decided and making the member responsible for the consequences if the cap was breached. The new cap was a fixed amount of $50,000 per employee (indexed annually); in the 2009–2010 Budget, the figure was reduced to $25,000 per employee and despite some movements in policy in the interim is expected to return to $25,000 per person per year under measures currently before Parliament. But this limit is not enforced by rules denying the employer’s deductions; in fact, the implication of s 290-60 is that an employer can deduct a contribution of any size. Instead, the limit is enforced indirectly. Until July 2013, the cap was enforced through the excess contributions tax system, then found in Subdiv 292-B. This regime used to apply a special tax to excess “concessional contributions” (ie amounts which the employer had deducted in excess of the relevant cap). The tax was imposed under the Superannuation (Excess Concessional Contributions Tax) Act 2007 at a dedicated flat rate and payable by the member. After July 2013, the separate tax approach was (partly) scrapped. Instead, the cap is now enforced through Div 291 which includes the amount of any excess concessional contributions back into the member’s assessable income: s 291-15(a). This means the excess will be taxed at the member’s marginal tax rate, although, as the trustee of the superannuation fund will already have paid 15% tax on all concessional amounts that entered the fund, the member is then given a tax offset of 15%: s 291-15(b). Notice that the tax must be paid by the member even though the cash has gone into the superannuation fund. Consequently procedures in Div 96 of sch 1 of the Taxation Administration Act 1953 allow the member either to retrieve money from the superannuation fund and pay the tax assessment, or direct the trustee of the fund to use money in the member’s account to pay the tax to the ATO on the member’s behalf. And because it will take the ATO some time (often a year or more) to determine whether excess non-concessional contributions have been made and then work out the new amount of taxable income and tax payable, rules in Div 95 of sch 1 of the Taxation Administration Act 1953 impose on the member a further “charge” calculated at the shortfall interest rate on the tax deficiency from the first day of the income year until the day on which the amount of extra tax is due to be paid. This charge is imposed by the Superannuation (Excess Concessional Contributions Charge) Act 2013. From July 2012, a second change was introduced again in an attempt to curb the cost of the superannuation system. Div 293 of the ITAA 1997 imposes another tax (called rather unimaginatively, “Division 293 tax”) on contributions made for members with taxable income exceeding $300,000: s 293-15. This figure is expected to drop to $250,000 under measures currently before Parliament. So, while concessional contributions for most superannuation fund members are subject to tax at a flat rate of 15%, if the member has taxable income in excess of $300,000 (or $250,000), their concessional contributions are taxed at 30%: [4.920]

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• the standard tax on concessional contributions is levied at 15% and imposed on the trustee of the fund, and • Division 293 tax on concessional contributions is levied at 15% and imposed on the member. Division 293 tax is imposed by the Superannuation (Sustaining the Superannuation Contribution Concession) Imposition Act 2013. Again, because the tax must be paid by the member even though the cash has gone into the superannuation fund, the procedure in Div 135 of sch 1 of the Taxation Administration Act 1953 sets up another regime to allow the member to use money in the superannuation fund to pay the Division 293 tax assessment.

Contributions by employees [4.930] The basic position in Australia was that all contributions to superannuation funds

made by people who are full-time employees were non-deductible to the employee – although s 290-150 might lead you to think otherwise. The rule in s 290-160 would prevent members (ie the employee) claiming a tax deduction for their own contributions unless, less than 10% of their income is from employment. Until recently, employees received no subsidy to provide directly for their own retirement, but in a surprise announcement in 2016, the government decided to give a tax concession to anyone between 18 and 75 who contributes to a superannuation fund: s 290-150. The extent of superannuation coverage began to increase after 1986 when, as part of the centralised wage agreement reached between employer and union representatives, the Conciliation and Arbitration Commission set up a framework for trade unions to create superannuation funds (referred to as productivity funds) for the benefit of members. Under the system, employers agreed to pay 3% of an employee’s salary to the fund. This system was expanded by the government through the Superannuation Guarantee Scheme which began in July 1992. It required all employers to contribute to superannuation funds up to 9% of the employee’s salary by 2002. While these two measures extended the coverage of superannuation, under both systems contributions were still only made by employers. The first change to the position of employee contributions was announced in the 1997 Budget. The government proposed a tax offset for personal superannuation contributions made by employees with little or no employer superannuation support. As most employees had some superannuation because of the Superannuation Guarantee Scheme, few people qualified for the tax offset – principally part-time low income workers and such people rarely had spare cash to put into a superannuation fund. The system of tax offsets for employee contributions lasted until 1 July 2003 when it was replaced by the current government co-contribution system discussed below. The 2016 announcement allowing deductions for contrbutions by any member (effectively capped at $25,000) expands the concession beyond just employees. Undeducted contributions. Even though member contributions will become deductible, total contributions are capped and so an issue arises about the treatment of additional non-deductible (“non-concessional”) contributions members might decide to make. Fund members can make additional contributions each year to their superannuation out of their after-tax savings. They can contribute an amount up to the non-concessional contributions cap, but there are consequences if the member exceeds this amount. The government regulates non-concessional contributions for the same reason as it regulates concessional contributions – to prevent the accumulation of excessive amounts of money (in this case, the earnings on the 230

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non-concessional contributions rather than the contributions themselves) inside the taxconcessional superannuation environment. Again the system works by expressing an arbitrary cap, and then visiting the consequences of breaching it on the member in the form of a special-purpose tax. The treatment of excess non-concessional contributions is regulated in Subdivs 292-B and 292-C. A non-concessional contribution is, in general terms, a contribution made to a complying superannuation fund that was not included in the taxable income of the fund: s 292-90(2). (A fund will not include an amount it receives from a member in the fund’s income unless it receives a notice from the member pursuant to s 290-170 saying that they intend to claim a tax deduction for this contribution: s 295-190, item 1.) Members can either withdraw the excess under Subdiv 292-B or s 292-80 imposes tax on a person who has an “excess non-concessional contribution” for a year. The excess contributions tax is imposed under the Superannuation (Excess Non-concessional Contributions Tax) Act 2007, at a dedicated flat rate of 49%. At the time of writing, the excess is the amount by which the non-concessional contribution exceeds the non-concessional contributions cap (s 292-85) and the cap for non-concessional contributions is set at 6 times the amount of the concessional contribution cap for the year. Thus, for most employees, the current cap for “non-concessional contributions” will be $150,000 (ie 6 x $25,000 which is the current concessional contribution cap. In fact, the rules in s 292-85(3) and (4) allow an employee to bring forward 2 more years of non-concessional contributions and contribute up to $450,000 in year (in which case no further non-concessional contributions can be contributed in years 2 and 3). Proposals currently before Parliament will, if enacted, change this system to permit members to make undeducted contributions of only $100,000 per year (though still with the possibility of bringing forward up to 3 years’ worth of contributions into a single year until the member turns 65). A second proposal would will deny the ability to make undeducted contrbutions of any size after 1 July 2017 if the member already has an account balance of $1.6m.

Contributions by the self-employed [4.940] Self-employed taxpayers have gradually become entitled to increased deductions for

contributions to superannuation funds. For many years, the deduction was limited to a dollar value which fell far short of the amount to which the taxpayer could fund retirement benefits if the contribution had been made by an employer. Accordingly, self-employed taxpayers, most notably doctors and lawyers, adopted many and various devices to convert themselves into employees either of their practice company, when doctors were allowed to incorporate, or of an associated service company – the typical mechanism by which Australian lawyers divert income to their families. An example of this can be seen in FCT v Gulland, Watson, Pincus (1985) 160 CLR 55. Not surprisingly these devices were challenged by the ATO, often successfully. The position changed markedly after the 1989 Budget. Self-employed taxpayers became entitled to a deduction of $5,000 per annum and 75% of any amount contributed over $5,000, subject again to the operation of the age-based contribution limits that were then in operation. As a result of the 2007 changes, the position of self-employed taxpayers changed again. They are now entitled to deduct amounts paid to a superannuation fund without any express limit as to the size of the contribution (s 290-150). Contributions by the self-employed are subject to the same kinds of conditions we saw above for contributions made by employers [4.940]

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and a few additional ones, principally that the fund must be a complying fund (s 290-155) and the taxpayer must be aged between 18 and 75 (s 290-165). The taxpayer must give notice to the trustee of the fund that it is proposing to deduct the contributions so that the trustee knows to include the amount as taxable income of the fund (s 290-170). Notice that while there is no cap on the size of contributions in the deductibility rules – the taxpayer can deduct the entire amount of the contribution – the excess concessional contribution system will apply to contributions by the self-employed, so making a contribution in excess of $25,000 will simply trigger an amount of additional assessable income under s 291-15. We have focused so far on those who are exclusively self-employed. The situation was a little more complicated where a person was employed part-time and was also self-employed – for example, a farmer who was employed off-farm in order to have a regular income. So far as any employer contributions were concerned, the situation was governed by the rules discussed above for employer contributions, but what if the person wanted to make additional personal contributions from their business profits? Section 290-160 allowed the person to deduct additional personal contributions only if the income from their employment was less than 10% of their total assessable income and reportable fringe benefits for the year. In other words, if they earn too much off-farm, they were allowed to deduct any personal superannuation contributions. This changed with the 2016 announcement extending concessions to any member contrbutions.

Contributions by the government [4.950] We noted above the government co-contribution system which began on 1 July 2003

as a replacement to the former tax offsets for personal contributions by low-income employees. Under this system, the government tries to encourage low-income individuals to make personal contributions to superannuation funds by matching their contributions with a cash payment direct to the fund. In 2007, the system was extended from only employees to include the low income self-employed. The legislative framework is set out in the Superannuation (Government Co-contribution for Low Income Earners) Act 2003. In order to be eligible, the person making the contribution must have at least 10% of their income from employment or self-employment – in other words, they are not living off the income from a sizeable pool of investments – and be less than 71 years old. When the system began, for every dollar contributed (out of after-tax income) up to a maximum of $1,000, the government would make a contribution of the same amount directly to the fund. In the May 2004 Budget, the government’s contribution was increased to $1.50 for every dollar contributed. So a maximum contribution of $1,000 made by a person on the lowest income level would attract a government contribution of $1,500. The size of the matching government co-contribution also depends on the person’s income level. Government co-contributions do not form part of the income of the fund (s 295-170(1)), so they are worth even more than an equivalent amount of employer contribution. An employer would have to make a taxable contribution of $1,765 to achieve the same result as a $1,500 government co-contribution.

Contributions by a spouse [4.960] Another development has been the introduction of a mechanism for making

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in the paid the workforce. In 1997 the government introduced an income-tested tax offset for a taxpayer who made a superannuation contribution on behalf of his or her (low income) spouse. The rules are now found in Subdiv 290-D. In order to qualify for any tax offset, the person must make a contribution for a spouse (as defined) to a complying superannuation fund, and both parties must be residents (s 290-130). The spouse must have a total assessable income and reportable fringe benefits less than $13,800 for the year. The maximum contribution that will qualify for a tax offset is, in effect, set at $3,000. Spouse contributions do not form part of the income of the fund (s 295-165). (ii) Tax position of the fund

Tax liabilities of funds [4.970] Until July 1988, superannuation funds were generally exempt from income tax, both

on contributions made to them and on the earnings from investments made with those contributions. Some superannuation funds had been subject to tax on their income but only where the fund was not complying with other requirements, such as the prudential rules against investments in employer-related bodies or by funding to pay excessive benefits. The exempt status of complying superannuation funds changed with the Economic Statement of May 1988 when a 15% tax on superannuation funds was announced, commencing on 1 July 1988. The provisions giving effect to the tax on funds are now contained in Div 295 of the ITAA 1997 and under the new system tax is payable on the income of funds whether or not they comply with all the regulatory requirements in the Superannuation Industry (Supervision) Act 1993 (Cth). The tax is imposed on the “superannuation provider” (s 295-5(2)) which is defined in s 995-1 to mean the trustee of the superannuation fund. The principal reason for introducing the tax, according to some commentators, was not just the policy desire to move the treatment of retirement savings from a consumption to income tax treatment, but also the need to find a revenue source to fund the reduction in the corporate tax rate from 46% to 39% which occurred at the same time. One curious feature of the decision to impose tax on superannuation funds is that at the time that the tax was being introduced, the imputation system for shareholders in corporations was amended to permit superannuation funds access to tax credits for payments of corporate tax. The effect of giving superannuation funds access to imputation credits is to give the fund a tax credit for tax paid at the company rate (currently 30%) to offset against the fund’s own tax liability (at 15%). In effect, the Treasurer imposed tax on the funds and then gave funds the means to eliminate it. (Some have suggested that the decision to bring funds into the imputation system was tacit recognition of the government’s inability to control the sale of unusable imputation credits by superannuation funds to others for whom they were valuable.) Access to imputation credits permits funds not only to derive dividend income effectively tax-free, but also to shelter other income behind the excess credits. For every $70 of fully franked dividends received, a superannuation fund can earn another $100 income from other sources: $70 dividend + $30 imputation credit + $100 (say) interest = $200 income and a tax liability of $30, fully paid by the $30 imputation credit.

Fund tax rate [4.980] The basic tax rate of 15% applies to complying superannuation fund income – that is,

a fund that elects to be regulated and satisfies the requirements of the Superannuation Industry [4.980]

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(Supervision) Act 1993. If the fund fails to meet those standards either deliberately or unintentionally, it may lose this preferential treatment and have to pay higher rates of tax on its earnings. The income of (resident) non-complying funds is taxed at the top personal marginal rate – currently 47% – effectively precluding them being a tax-effective vehicle for retirement saving. Note in addition, some items of income of complying funds can also be taxed at that rate – most commonly related party income and contributions for members who have not informed the trustee of their tax file number. This is discussed below.

Tax base [4.990] Superannuation funds pay tax (at either 15% or 47%) on their income which, at least

initially, is calculated as for other taxpayers. So, for example, if the fund earns rent, interest, dividends or capital gains, and incurs expenses in earning these amounts such as depreciation or accountant’s fees, the net amounts are taxed as they would be if an individual earned them: s 295-10 of the ITAA 1997. Division 295 consists largely of adjustments to the amounts that would otherwise be the fund’s taxable income under the ordinary rules, and of rules intended to split the income into various components so that different rates can be applied. Remember that a complying fund must be a resident, so it is taxed on worldwide income. We will discuss the position of complying funds. 1. Contributions. The basic position is that all contributions to a qualifying fund that are deductible to the contributor are included in the fund’s income: ss 295-165 and 295-190 of the ITAA 1997. This rule is needed because these contributions presumably represent the corpus, not the income, of a superannuation fund. This means that tax at 15% is imposed on all contributions by employers (s 295-165 Item 1) and the self-employed (s 295-190 Item 1). But most contributions by employees out of their own funds, government co-contributions (s 295-170) and contributions by one spouse for another (s 295-165) do not form part of the income of the fund. 2. Investment income. The fund’s management will take the contributions and invest them on behalf of the members. These investments will return the usual kinds of income – dividends, interest, rent, and so on. These amounts are included in the assessable income of the fund under s 295-10, Step 2. However, once a fund starts paying a pension to a member, the investment income derived from any assets specifically set aside to meet that pension (or a proportion of all the investment income of the fund’s assets) is exempt from tax: ss 295-385, 295-380. This rule (and the rule that superannuation benefits received after 60 are tax-free) creates an interesting incentive – anyone aged 60 or over should arrange for their entire salary to be put into a fund (taxed at 15% at the time of contribution, instead of the member’s marginal rate) and then live off a superannuation pension instead (no tax on the income used to fund the pension in the hands of the fund, and no tax on the pension in the hands of the recipient). 3. Gains and losses. Capital gains on investments by funds are included in its assessable income but without the general grandfathering of assets acquired prior to September 1985 which is a feature of Australia’s CGT. All gains accruing after 1 July 1988 are taxed by giving the fund a deemed cost for all assets of their real cost or their value at 30 June 1988, whichever is higher: s 295-90. In fact, special provisions exist for complying funds which guarantees CGT treatment on all gains and losses arising from CGT events happening to their assets: s 295-85(2). The purpose of this rule is to avoid disputes about whether gains or losses on fund assets are income or capital. 234

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4. Related party income. If a fund derives non arm’s-length income (such as dividends or interest from the employer) this income is split from the other income of the fund so that even a complying fund will pay tax at 47% on this income: s 295-550 of the ITAA 1997. Section 26(1) of the Income Tax Rates Act 1986 imposes tax at the 47% rate on this component of the fund’s income. 5. Eliminated income and special deductions. Many other adjustments are made in Div 295 to exclude amounts from the income of the fund and to allow them to deduct additional expenses. The position of non-complying funds is slightly different. Section 26(2) of the Income Tax Rates Act 1986 imposes tax at the rate of 47% on all the income of non-complying funds. Finally, there is a question about how all of these rules fit with the rules about taxing trusts – which is what superannuation funds are. The former s 278(2) of the ITAA 1936 said that the superannuation provisions (then found in Pt IX of the ITAA 1936) stated exhaustively the tax liability on the income of a superannuation fund – the income of a trust that was a superannuation fund income would not be taxed in the hands of the trustees or beneficiaries under Div 6 of the ITAA 1936, for example. This section has not been rewritten in that form, although it appears that the drafter believes s 295-5(2) is sufficient to exclude the operation of other trust rules for both complying and non-complying funds. (iii) Regulation of superannuation funds [4.1000] The discussion has so far referred to complying and non-complying funds and

indicated some of the differing tax consequences associated with each but only hinted at the meaning of these terms. Complying means complying with the Superannuation Industry (Supervision) Act 1993 (SIS Act), but it is important to note that the SIS Act governs both complying and non-complying funds – it sets higher standards for complying funds. In order to be a complying superannuation fund, the fund must satisfy (at least) two tests under s 42 of the SIS Act. 1. First, the fund must be a “resident regulated superannuation fund” at all times during the year of income when it was in existence. In general terms, a “resident regulated superannuation fund” is a fund that meets the following requirements: it is a resident; the fund has a trustee; the trustee is a corporation or the fund was formed with the purpose of providing old-age pensions; and the trustee has given the ISC an irrevocable election to become a regulated superannuation fund: s 19 of the SIS Act. 2. The second requirement is that, either the fund has not contravened the SIS Act and Regulations or, if it has, it does not fail the culpability test in relation to those contraventions. The “culpability test” is failed where members of the fund are knowingly involved in a contravention of the Act, and the regulator (either APRA for larger funds or the ATO for self-managed superannuation funds) is of the view that a notice of non-compliance should be issued to the fund in relation to that year of income: s 42(1A) of the SIS Act. Similar requirements are set out separately for complying self-managed superannuation funds in s 42A of the SIS Act. These are the two threshold requirements to be a complying fund, but the more important requirement in practice is the second. The requirement that a “complying superannuation fund” not contravene the Act or Regulations means it must comply with (at least) the following provisions. [4.1000]

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1. The fund must be an indefinitely continuing fund formed and operated solely to provide benefits to members on retirement or disability and to a member’s dependents and spouse on death: s 62 of the SIS Act. 2. It must meet the prescribed operating standards set out pursuant to Pt 3 of the SIS Act in the Regulations: s 34(4) of the SIS Act. The Regulations prescribe exacting standards in relation to various matters such as the provision of information to prospective and ongoing members, record-keeping, making and managing fund investments and the manner in which accounts are to be prepared. 3. The trustees of the fund must undertake to act in accordance with various standards, including acting honestly, exercising appropriate care and skill, acting in the interests of members, and formulating a sound investment strategy: s 52(2) of the SIS Act. And various matters must not appear in the rules of the fund – for example, the trustees must not be subject to direction by any other person: s 58 of the SIS Act. 4. Benefits are to be protected: Pt 5 of the Superannuation Industry (Supervision) Regulations (SIS Regulations). The taxpayer’s interest in the fund is protected against being reduced by various charges and forfeitures. This has been a major problem for small accounts where the administration charges of fund managers have been more than the fund earnings, so that low-income earners, already paying a 15% tax on entry, have seen negative returns on their involuntary savings. For this reason, the government created a parallel regime – the retirement savings account (RSA) system – which is offered by banks and operated for the most part as if bank accounts. They have the advantage that they are capital guaranteed – the taxpayer cannot lose if the bank invests the money unwisely – and if the balance of the account is under $1,000, the provider can only take its fees from the account income. Needless to say, the return on such accounts is rather modest. 5. Benefits must be “preserved” until retirement: Pt 6 of the SIS Regulations. This means that benefits can only be paid to an employee on retirement from the workforce after 55, death or permanent invalidity. These rules are intended to prevent employees from drawing against their benefits prior to retirement. They also prevent employers claiming deductions for contributions and then “retrieving” from the fund, both processes usually occurring without the employee ever becoming aware – that is, the employer operates the fund as its own savings account. 6. Indirect methods which might permit members to access their benefits early are prohibited. Benefits cannot be lent to members prior to retirement and funds cannot (usually) buy assets from members: ss 65 and 66 of the SIS Act. 7. Funds can borrow only to meet short-term liquidity problems: s 67 of the SIS Act. However, recent history has seen a proliferation of schemes by which self-managed superannuation funds attempted to “borrow” money from financiers in forms which did not amount to borrowing. The most significant is borrowing on limited-recourse terms which was regularised in s 67(4A) and has become the safe-harbour method of financing investments by small superannuation funds into negatively-geared residential real estate. 8. Funds are limited in their capacity to make investments in entities related to the employer. This rule was inserted because of abuses where employers, who for the most part controlled the investment of the fund’s assets, would use the fund as a source of cheap capital: Pt 8 of the SIS Act. 9. Members of funds, as well as employers, must be given a role in the management of the fund: Pt 9 of the SIS Act. 236

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10. Trustees must also create various administrative mechanisms to deal with providing information, handling inquiries, keeping records, resolving complaints, preparing and filing reports with the Insurance and Superannuation Commissioner, and having the accounts audited: Pts 12 – 14 of the SIS Act. The notion of the “culpability test” was mentioned above as one of the two main threshold requirements to be a complying fund. This test can only be failed where the regulator issues a notice. This system is one of the major changes that the SIS Act has brought about. Prior to the SIS Act, breaches of the regulatory system had only one consequence – additional tax liabilities arose for the fund. This was not a satisfactory position because it was the members who would suffer the consequences of infractions of which they were often unaware, and were usually committed by trustees, managers or employers over whom they had little control. Now various civil and criminal penalties are created and imposed directly on those responsible. (iv) Moving amounts between funds [4.1010] It is worth mentioning briefly here the system for dealing with movements of money

between funds operating within the superannuation environment. Because superannuation is still often organised around the workplace, many private sector funds are set up by individual employers and limit membership to people who are their current employees. (Industry funds and funds offered by financial institutions will not have these kinds of limitations.) This creates a problem if the employee is a member of such a fund but leaves to work for another employer. The member will have to withdraw their benefits and this would, were it not for the system of rollovers, trigger tax on the benefit. The system of rollovers is set out in Div 306. Section 306-5 provides that a rollover benefit paid to a member is non-assessable non-exempt income if it meets the conditions in s 306-10, most importantly that the benefit is taken from one complying fund and deposited into another complying fund. If the employee cannot find another employer quickly, or the new employer’s fund will not accept contributions, the money can also be parked in an “approved deposit fund” offered by a financial institution until another fund is found, or it is withdrawn from the superannuation environment altogether. The next question to consider is the position of the two funds. Is the amount involved deductible to the first fund and assessed to the second, or does the cashflow occur tax-free for both parties? Apparently, the rule in s 307-15 is meant to apply here so that, even if the payment goes straight from one fund to another, it is viewed for tax purposes as having been paid to the member and then contributed by her to the next fund. The first fund is not entitled to deduct the amount in computing its tax liability: s 395-495 Items 1, 2. So far as the receiving fund is concerned, s 295-190 Item 2 says that it will have to include the amount in its assessable income only if the payment was not taxed in the first fund and is not excessive (in which case another tax would have been triggered). The implication is that money can move between taxed funds free of further tax. (v) Taxing payments out of superannuation funds [4.1020] The tax systems of many countries collect no tax on retirement savings until they are

withdrawn to be consumed and then they are taxed in full. Australia had no real tax on withdrawals until 1983, and since then has gradually imposed tax earlier in the savings cycle as the prior discussion outlines. In the period after 1983, tax was collected on benefits paid; [4.1020]

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between 1988 and 2007, less tax was imposed on benefits paid (because tax had already been collected from the fund when contributions were made); and the 2007 reforms took this process to the next step, eliminating all tax on benefits paid to members aged 60 or older, or so it is said. Notice, however, that each elaboration of the rules has to have complex transitional provisions to deal with entitlements under the former regime – it does not engender confidence in planning for retirement if individuals see their former position damaged by each round of legislative reform. Our politicians cannot, it seems, be prevented from constantly tinkering; but at least they tinker only for the future and try to leave the past alone. We will examine separately the tax position for benefits paid in a lump sum and those paid as a pension – the rules sometimes differentiate between two types of superannuation benefit: a superannuation income stream benefit (a pension), and superannuation lump sum. The discussion below examines the tax liability of the recipient of a payment from a fund. It is worth noting that the fund itself is not entitled to deduct the amount of the payment in computing its tax liability: s 395-495 Items 1 and 2.

Lump sums [4.1030] The entry point to these extremely complex provisions is s 301-10 of the ITAA 1997.

It says with disarming simplicity that a superannuation benefit received by a taxpayer aged 60 years or above is non-assessable, non-exempt income. The heading to the section reinforces the impression – it proclaims, “all superannuation benefits are tax free”. This was a key element to the 2007 reforms introduced by the Coalition parties, but it was regarded as so important by the ALP that the latest review of the Australian system announced, Australia’s Future Tax System (the Henry Review), was specifically forbidden from reconsidering this position. Yet the simplicity of s 301-10 must be more than a little misleading because the rules about the tax treatment of superannuation payouts continue for another 50 pages. Those 50 pages deal with all of the situations not covered by that simple rule and there are many: • amounts received by people aged under 60. (For this group, the treatment depends on (i) just how much below 60 they are and (ii) the form in which the benefit is paid. If the recipient is too young (below preservation age), a lump sum is taxed at a maximum rate of 20% and a pension is taxed at marginal rates but with a 15% tax offset. If the recipient is between preservation age and 60, a lump sum is tax-free up to the low-rate cap which is currently $185,000 and the balance is taxed at a maximum rate of 15%, while a pension is taxed in full at marginal rates but with a 15% tax offset); • amounts received by the member’s dependants or estate, rather than the member; • amounts paid from a non-complying fund – notice that the rule in s 301-10 only applies to payments that are “superannuation benefits”, a term which s 301-5 defines so as to exclude amounts paid from a non-complying fund. And there are other complications: • the tax-free treatment of benefits assumes that an appropriate amount of tax will have been collected from contributions and earnings. But what if that assumption is not correct? So, there are rules to deal with the payment of amounts that represent amounts not taxed in the hands of the fund. This will usually apply only to public sector superannuation funds such as some schemes for judges, police and parliamentarians; • and the reverse needs to be dealt with. There will be amounts that were not taxed in the fund but that happened because they were contributed out of after-tax dollars – personal non-concessional contributions by members being the obvious example. Rules are needed 238

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to ensure that these amounts can be returned tax-free to members, even though they represent amounts not taxed in the hands of the fund. So, while the comprehensibility of the rules in Divs 301 – 307 may be an enormous improvement on their predecessor, they are still by no means easy. Much of the complexity stems from having to split a lump sum or pension into various components. That process remains difficult. The new rules at least structurally separate the treatment of benefits paid to (living) members (Div 301), benefits paid on the death of a member (Div 302), benefits paid because a member has been permanently disabled and benefits paid from non-complying funds (Div 305). Express rules about apportioning superannuation benefits are now set out in Subdiv 307-C.

Pensions [4.1040] A pension is an archetypal example of ordinary income and so, prima facie, is

taxable in full at the marginal rate of the recipient. That position has been qualified in two important respects. First, where a pension has been “purchased” the taxpayer is entitled to the benefit of special provisions in s 27H. The second qualification is that pensions paid from superannuation funds are entitled to special tax treatment. The provisions formally refer to the payment of a “superannuation income stream benefit”; we will refer to it as a pension. The rules in relation to pensions paid from superannuation funds resemble the rules we just outlined pensions paid from a complying superannuation fund to members aged 60 and over are tax-free – but have to differ slightly from those for benefits paid as a lump sum because of the different form of the payment. And the system will become more compex if proposals to insert Div 294 to limit the size of a pension that can be paid tax free are enacted. The terminology of superannuation refers to a member’s account “moving into pension phase” when the member retires and starts drawing a pension from the fund. At this point, any income which the fund makes from holding or selling the assets used to fund that pension (referred to as “segregated pension assets”) is exempted from tax under s 295-385. The proposal before Parliament will limit the value of the assets that will enjoy this tax-free treatment to $1.6m. If the member has more than $1.6m in their superannuation account when they retire, the earnings on the surplus will be taxed at 15%. However, the member will still not be the tapayer; the tax will be collected from the fund, and the entire pension will remain tax-free in the member’s hands. A simple example will show how this is meant to work. Assume the member has $2.4m in their account at retirement invested in shares and bonds and the assets currently earn 5% – ie $120,000 per annum. Under current law, a pension of $120,000 would be entirely tax-free, whereas if the member had taken the $2.4m out of the superannuation system as a lump sum on retirement, the entire $120,000 would have been subject to income tax in the mmber’s hands. Under the new system, the member will receive a smaller pension of $114,000 – $80,000 can still be taken tax-free ($1.6m x 5%) but the earnings on the other $800,000 ($800,000 x 5% = $40,000) will be taxed at 15% ($40,000 x 15% = $6,000).

Non-complying funds [4.1050] The rules just described deal with payments of lump sums and pensions to current

and former members of a complying taxed fund, their estates and their dependants, made in accordance with the fund’s rules. There are also further special rules to deal with similar transactions involving funds that have always been non-complying funds, and funds that changed their status. [4.1050]

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The discussion above noted that the taxable income of a non-complying fund (both contributions and earnings) is taxed at the highest personal marginal rate (45%) rather than at 15%. So, because the fund has already paid tax in full on the contribution and accumulating income, the payment out of the fund is not taxed: s 305-5. This exemption can be lost if the fund has changed its status.

(c) Other Termination and Retirement Payments – “Golden Handshakes” etc [4.1070] The previous section described the current tax treatment of payments out of

superannuation funds made when taxpayers leave their current employer (rollovers) or the paid workforce altogether (lump sum and pension benefits). This is clearly now the most important set of rules for most taxpayers. This section examines the tax treatment of another set of payments made at the end of a current employment – voluntary payments made directly by employers to employees, their dependants and estates which do not go through the superannuation system. The kinds of payments that arise at around the time that an employee leaves would include golden handshakes to retiring employees, payments under bona fide redundancy schemes to retrenched employees, payments to induce employees to take early retirement, unused leave entitlements paid in cash to retiring employees, invalidity payments made to injured workers and death benefits paid to the estates of workers who die. These rules are discussed here because all the payments occur at about the same time – around the time at which the employee stops working for the employer. Until 2007, they were also governed by the same set of rules – that is, the rules which governed superannuation also governed termination bonuses, death benefits, unused leave payment and so on. This had happened because the superannuation rules were grafted onto a concessionary regime that had already existed to encourage employers to make voluntary payments to retiring workers in the pre-compulsory superannuation world. In 2007, the rules governing the two situations were separated. The rules we are examining are in Divs 80 – 83 of the ITAA 1936. They deal with payments labelled “employment termination payments” (ETP), death benefit termination payments, unused leave payments, invalidity payments, and so on. In most cases, payments made at the end of a person’s current employment which have not come from a superannuation fund will raise the following three questions: 1.

2.

3.

Is the payment assessable under these rules? If not, no further consideration of these rules is necessary. Instead, the payment may be taxable if it is otherwise of an income nature. If not, there may be a capital gain. What portion is includable in assessable income? We have already seen in relation to superannuation that it is necessary to dissect and to apportion amounts to determine the tax treatment and the same kind of dissection can apply for these payments as well. What rate applies? Again, as we saw in the previous section, different marginal rates can apply under the superannuation system, and rate concessions can apply for these payments as well.

(i) Employment termination payments [4.1080] The first step in understanding these rules is the notion of an “employment

termination payment,” which is defined in ss 82-130 and 82-135. The two sections express a series of inclusions and exclusions but the most important inclusion for this discussion is in 240

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para (1)(a)(i), which is the general provision including payments “in consequence of the termination of your employment”. Employment includes holding an office such as being a company director: s 80-5. This is the same test that was previously used in s 26(d) of the ITAA 1936, and then in s 27A of the ITAA 1936, so the cases which interpreted that phrase in the repealed sections are still relevant, even though the new context may prove to give different meanings. One intended sphere of operation of para (1)(a)(i) is for employer-initiated voluntary payments such as golden handshakes made to resigning or retiring employees. This is referred to as a “life benefit termination payment”: s. 82-130(2). The definition cures some of the defects that had been found to exist in the earlier rules: it is not restricted to a “capital amount” which is “paid in a lump sum” so that it will catch multiple payments; it will also catch the transfer of property as a payment (ss 80-15 and 80-20). A second area this definition is meant to cover is a payment made to a deceased worker’s spouse or dependents, again typically by the employer: “a payment – received by you after another person’s death, in consequence of the termination of the other person’s employment”: s 82-130(1)(a)(ii). “Termination” of employment is defined to include both the retirement and the death of the taxpayer: s 80-10. This is referred to as a “death benefit termination payment”: s. 82-130(3). Excluded from the definition of an ETP are: • amounts paid from a superannuation fund, as they will be dealt with under Div 301: s 82-135(a); • pensions and annuities, as they will be assessed under s 6-5 and s 27H: s 82-135(b); • accumulated annual and long service leave payments dealt with by rules in Div 83: s 82-135(c) and (d); • some of a redundancy or early retirement payments also dealt with under Div 83: s 82-135(e); • deemed dividends dealt with under s 109: s 82-135(h); • capital payments made for personal injuries suffered: s 82-135(i); and • payments made for a restraint of trade agreement: s 82-135(j). We have already noted that the use of the phrase “in consequence of the termination of … employment” in the definition of ETP imports the cases on the same phrase in the former s 26(d). They help to identify the required connection between the termination and the payment for it to be an eligible termination payment and show that it can be difficult to determine that a payment is made “in consequence of retirement”. You will recall that in Constable the assessment was based upon s 26(e), as the ATO assumed that s 26(d) was inapplicable to the payment made: Constable had not yet retired and the payment was made to him instead because the fund was being wound up. In Reseck v FCT at least two different views are expressed on the correct construction of the phrase “in consequence of retirement”. Reseck was an employee who was retrenched because of insufficient work. He received a payment on termination which was stipulated in his award and calculated by reference to the number of shifts he had worked. He was re-employed by the same employer in another district on the following Monday for a further six months. The taxpayer wanted the payment taxed under s 26(d) but the ATO sought to tax it as ordinary income arguing that s 26(d) only caught capital payments. [4.1080]

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Apart from its interpretation of the phrase, the case is also important because in it the judges have to deal with the correlation of sections of the Act where amounts might be included in assessable income because of two sections which overlap only in part – in this case, ss 25(1) and 26(d). This is the principal case on the single-meaning analysis discussed in Chapter 2, and which ss 6-5 and 6-10 of the ITAA 1997 now attempt to solve. With regard to the meaning of the phrase “in consequence of retirement”, Gibbs J observed: The question in the present case is whether the amounts received by the taxpayer were allowances of the kind described in s. 26(d). In most cases in which a workman ceased his employment on a Friday and commenced employment again with the same employer on the following Monday it would be impossible to say that his employment had ever been terminated … [But, assuming there was a termination of employment] the question that then arises is whether the allowance was paid in consequence of the termination of the employment of the taxpayer. Within the ordinary meaning of the words a sum is paid in consequence of the termination of employment when the payment follows as an effect or result of the termination. In the present case the payment did follow as a result of the termination of the taxpayer’s services. It is not in my opinion necessary that the termination of the services should be the dominant cause of the payment… For example, a retiring allowance is plainly intended to be within s. 26(d) but such an allowance is made in consequence of the employee’s past service as well as in consequence of his retirement and in many cases it could not be said that the retirement rather than the service was the substantial cause of the payment or that the former cause predominated over the latter. Moreover, in many cases allowances, gratuities or compensation are paid in consequence of the provisions of an industrial agreement or of the industrial law but the words appearing immediately before the proviso to para (d) of s. 26 show that the paragraph will nevertheless be applicable. In the present case the allowance was paid in consequence of a number of circumstances, including the fact that the taxpayer’s service had been satisfactory and that the industrial agreements provided for the payment, but it was nonetheless paid in consequence of the termination of the taxpayer’s employment. It follows that the receipts in the present case … came within the provisions of s. 26(d), with the result that 5% of the amount only should have been included in the assessable income.

Jacobs J expressed a different view from Gibbs J on the required connection between the payment and the termination for the payment to be “in consequence” of the termination: I have no doubt that the amounts were allowances to the appellant, that they were paid in lump sums and that they were paid in consequence of the termination of his employment. It was submitted that the words “in consequence of” import a concept that the termination of the employment was the dominant cause of the payment. This cannot be so. A consequence in this context is not the same as a result. It does not import causation but rather a “following on”. [4.1100] This divergence of views on the meaning of “in consequence of termination” caused

some difficulties to other courts until Brennan J redefined the connection test in the Federal Court in McIntosh v FCT (1979) 10 ATR 13; 79 ATC 4325. He said the test was whether the retirement was “the occasion of and a condition of entitlement” to the payment. [4.1120] The phrase “the occasion of and a condition of entitlement” has both time and

causation dimensions. The problem with a time test is that it can be very elastic and so when the ETP rules were rewritten in 2007, it became a requirement of the test that to be an ETP, the payment must be received no later than 12 months after the termination of employment: s 83-130(1)(b). This was done no doubt in response to cases such as Seabright v FCT (1998) 40 ATR 1160; [1998] AATA 985, Gillespie v FCT (2001) 49 ATR 1012; [2001] AATA 1009 and FCT v Pitcher (2005) 146 FCR 344; [2005] FCA 1154 where the taxpayers ceased employment with a pension, and then decided to commute the pension to a lump sum after 242

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several years – in Seabright’s case 12 years after leaving employment, or in Gillespie’s case 13 years later. The ATO argued, understandably, that the lump sum was no longer received in consequence of termination; it was now received in consequence of the existence of a right to convert the pension and a decision to exercise that right. The ATO lost all of these cases. The addition of s 82-130(1)(b) should help eliminate this type of dispute. Because these rules have always involved tax concessions (the current nature of which is set out below), there have always been ongoing attempts by taxpayers to expand the scope of these rules. Cases such as Freeman v FCT (1983) 14 ATR 457 show attempts to expand the application of an ETP from a retirement payment to a change-of-job payment, like the change of job necessitated by selling the company. Seabright, Gillespie and Pitcher show the attempt to expand it to pension commutation payments. Another attempted expansion was to try to include involuntary payments. Two Federal Court decisions show this development. • The first case was Le Grand v FCT (2002) 124 FCR 53; [2002] FCA 1258. The case concerned an employee who commenced proceedings against his employer for wrongful dismissal and engaging in misleading and deceptive conduct, claiming over $2 m in damages for the balance of his salary and profit share due under his employment contract, as well as compensation for distress, humiliation and loss of reputation. The taxpayer settled the case for just over $500,000. He reported the payment as an ETP, and paid tax at 47% on the amount in excess of his RBL. The ATO then issued a further assessment seeking a further $85,000 in termination payments surcharge (discussed below) – that is, a further 15% of the entire amount. The taxpayer was understandably surprised – having paid tax at 47% on most of the payment, he was now being asked to pay a further 15% on much of it. The taxpayer replied that the entire payment was not really “in consequence of the termination of” his employment. It was instead a payment made in settlement of his actions. Goldberg J reviewed Reseck, McIntosh, Freeman and the subsequent cases and held that the entire payment was an ETP. The outcome was an effective tax rate far in excess of the top personal marginal rate. The irony is that rules which began life as an apparent concession now became a substantial penalty (due to the imposition of termination payments surcharge). • The second case is Dibb v FCT (2004) 136 FCR 388; [2004] FCAFC 126. Again, the taxpayer launched an action for wrongful dismissal, malicious conspiracy and sundry other harms which had caused him economic loss and various personal injuries. He was offered $118,000 by his employer which he rejected. He also rejected an order made in the Industrial Relations Commission and decided to sue in the Federal Court. Eventually the action was settled for just under $800,000 less tax calculated on the basis that the payment was an ETP. The taxpayer signed the Deed, took the money and then sought a Private Ruling from the ATO on the tax treatment. He argued to the ATO that the sum was not entirely an ETP because some of it was a bona fide redundancy payment, some of it related to his personal and psychological injuries and only the balance was an ETP. The ATO took the view that the entire amount was an ETP and ruled accordingly. The Full Federal Court agreed that, notwithstanding the period of time that had elapsed between the dismissal and the settlement, the payment was still made “in consequence of” the termination of the employment. The Court did, however, think the ATO had erred in not examining whether any part of the payment represented a redundancy payment. The extension of ETP treatment to more or less involuntary payments should not have been seen as entirely unexpected. It was mentioned above that there are various exclusions for some kinds of involuntary payments – for example unused statutory entitlements that have to be paid out in cash – which implies that such payments could be included but for the exclusion. [4.1120]

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The ATO has issued a Taxation Ruling TR 2003/13 in which it tries to set out the metes and bounds of the phrase “in consequence of …” for the definition of ETP and consolidates the text of a number of earlier rulings on various aspects of the same issue. The Ruling is quite brief (although the discussion and examples are extensive), and says: 5.The phrase “in consequence of” is not defined in the ITAA 1936. However, the words have been interpreted by the courts in several cases. Whilst there are divergent views as to the correct interpretation of the phrase, the Commissioner considers that a payment is made in respect of a taxpayer in consequence of the termination of the employment of the taxpayer if the payment “follows as an effect or result of” the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer. 6.The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and circumstances of each case.

And it is worth noting just how the ATO regards the outcome of cases such as Seabright noted above. It draws a distinction between situations where the taxpayer is exercising a right to commute a pension that was available when the pension was established, and the exercise of a right that arose subsequently: 7.The greater the length of time between the termination of employment and the payment, the more likely that the causal connection between the termination and the payment will be too remote for a conclusion that a payment was made in consequence of the termination of employment. However, length of time will not be determinative when there is a presently existing right to payment of the amount at the time of termination. Accordingly, if at the time of termination of employment the taxpayer has the right to commute a pension to a lump sum amount at a later date, the subsequent exercise of that right will be considered to be in consequence of the termination of employment. 8.Where, after the date of termination, a taxpayer obtains the right to commute a pension to a lump sum, the payment resulting from exercising that right would not be one that is made in consequence of the termination of employment. The payment does not “follow on as an effect or result of” the termination. The obtaining of the right to commute is an intervening event which makes the causal link between the termination and payment too remote. [4.1125]

Questions

4.72

An employee on a fixed-term contract accepts an offer to become a permanent employee of the company. Under the contract the employee was entitled to a sum called a “termination payment” calculated at the rate of $20 for every week worked. Is this amount an ETP?

4.73

Would an issue of shares or the grant of an option be an eligible termination payment under para (1)(a)? What is the value of an eligible termination payment that is a transfer of property? See s 80-15.

4.74 4.75 4.76

Would s 82-135(b) affect the decisions reached in Constable? What payments would be excluded from being an ETP by s 82-135(i)? Would s 82-135(j) have any operation in a situation such as Higgs v Olivier [1951] 1 Ch 899 extracted above? Would the payments under a restraint of trade agreement be taxable twice if they are found to be of an income nature?

(ii) Assessment of employment termination payments [4.1130] There are several distinctions which must be drawn before the prevailing tax rate for

an ETP can be applied and the amount of tax calculated. The first is to determine whether the 244

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payment is a life benefit termination payment (Div 82-A) or a death benefit termination payment (Div 82-B). In both cases it is then necessary to dissect the payment into a tax-free component and a taxable component. The tax-free component consists of: • the portion of the payment that is an invalidity segment: s 82-140(a) and s 82-145; and • any portion that relates to service prior to 1983: s 82-140(b) and s 82-155. All of the balance of the payment (the taxable component) is included in assessable income of the recipient under s 82-10(2) for a life benefit termination payment, a portion of the balance is included in assessable income of the recipient for a death benefit termination payment: s 82-65(2) and (3). When an employee receives a life benefit ETP and the appropriate dissections have been made, the various rates of tax can then be applied to the taxable component. The rate applied will differ according to two variables: the age of the recipient and the size of the payment. Age and amount If the employee is under preservation age at end of year – up to the ETP cap amount – over ETP cap amount If the employee has reached or exceeds preservation age at end of year – up to the ETP cap amount – over ETP cap amount

Tax rate (%) 30 marginal rate

15 marginal rate

Notice a few things about this computation: • the rates up to the ETP cap are effected by granting a tax offset to ensure that the maximum tax on the payment, which is assumed to be the top slice of the taxpayer’s income, does not exceed the relevant rate: s 82-10(3). The payment may, however, not be liable to tax at the rate indicated if the taxpayer’s personal marginal rate is less than the rate stipulated; • on the other hand, amounts in excess of the ETP cap amount are taxed at 49%, regardless of the taxpayer’s actual marginal rate – they are an “employment termination remainder” included under a “maximum tax rate provision” so far as the Income Tax Rates Act 1986 is concerned, which triggers tax at 49% • the ETP cap amount was set at $140,000 in 2007–2008 and is indexed annually: s 82-160. For 2014-15, it is $185,000; • the ETP cap is more correctly described as being the lower of two caps, a process that was introduced to take into account any other life benefit ETP (from any employment) received in the same year, and any other life benefit ETP received in earlier years arising from the termination of the same employment: s 82-10(4); • the Medicare levy applies and has to be added to the rates stated in Div 82. (iii) Death benefit termination payments [4.1140] The focus so far has been on employment termination payments made to the

employee on resignation or retirement. Slightly different rules are applied if the payment is made to someone other than the employee because it is made after the death of an employee in consequence of the termination of the employee’s employment: s 82-130(1)(a)(ii). After the tax-free component has been excised, the treatment of the remaining taxable component turns on two variables: whether the amount is being paid to a dependant of the deceased (or to the [4.1140]

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trustee of the deceased employee’s estate for the benefit of a dependant) and the size of the payment. Dependency and amount If the payment is made to (or for) a dependant – up to the ETP cap amount – over ETP cap amount If the payment is made to (or for) a non-dependant – up to the ETP cap amount – over ETP cap amount

Tax rate (%) nil 45 30 marginal rates

(d) Early Retirement, Redundancy and Invalidity Payments, and Unused Leave [4.1150] We have mentioned on several occasions that special rules apply to the treatment of

payments made on the invalidity of an employee, or under a bona fide redundancy scheme or approved early retirement scheme. These rules provided various concessions. (i) Early retirement schemes [4.1160] Payments made to induce the early retirement of employees are dealt with under Subdiv 83-C. In order to be an “early retirement scheme”, it must be approved by the ATO, applicable to classes of employees rather than a few selected individuals and be “implemented to rationalise or reorganise the employer’s operations” by replacing skills, replacing employees who have attained a particular age, rationalising or relocating part of the business operations of the employer, or the introduction of new technology: see s 83-180. The ATO is now routinely approached for a Class Ruling prior to implementing an early retirement scheme. Payments pursuant to an approved scheme which are under a statutory limit are non-assessable, non-exempt income: s 83-170(2). The limit is calculated as a base amount, plus a variable amount per year of service: s 83-170(3). Both the fixed and the variable amounts are indexed in accordance with movements in average weekly ordinary time earnings. Any excess over the statutory tax-free limit remains within the definition of ETP, and will be taxed as an ordinary ETP – s 82-135(e) only excludes from being an ETP the part that is made non-assessable, non-exempt income by s 83-170. (ii) Redundancy [4.1170] Payments made because an employee has been made redundant are also dealt with in Subdiv 83-C. The payment must be made for a redundancy rather than simply dismissal. Redundancy would typically mean that a particular position no longer exists, so that if another person is subsequently employed to perform the same services, this may mean there was no redundancy. Taxation Ruling TR 2009/2 sets out the matters the ATO considers indicate a redundancy. There are additional requirements that, in order for the payment to be bona fide, the payments must be made to employees who are less than 65, at arm’s length, and there is no plan to re-employ them: s 83-180(2). The taxation of a bona fide redundancy payment is the same as that for an early retirement scheme payment – a payment under the statutory limit is excluded from the definition of ETP and is non-assessable, non-exempt income: s 83-170(2). Any excess remains an ETP, and is taxable as an ordinary ETP. 246

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(iii) Invalidity payments [4.1180] Invalidity payments are dealt with in s 82-150 and form part of the tax-free

component of an ETP – in other words, the tax exempt from tax. An invalidity payment can only arise where “two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, training or experience” (see s 82-150(1)(d)). The amount that qualifies as an invalidity payment is defined by the formula in s 82-150(2). It takes the employee’s entire ETP and apportions it by time between the employee’s prior working life and the time remaining until retirement, set either at 65 or when the employee “would have” retired. The “invalidity” portion is the amount attributable to the future service that the employee is now unable to perform. The balance remains an ETP and is taxed accordingly. (iv) Unused leave payments [4.1190] At one time, some employees practised a mild form of tax planning by taking

accrued long service leave and annual leave entitlements in a lump sum on the termination of their employment. The practice was intended to ensure that the payment would be assessed under s 26(d), rather than as salary, so that only 5% of the sum was assessable. These rules were tightened up in 1978 and then further tightened in 1993. The complexity of the current rules, now contained in Subdivs 83-A and 83-B, is largely due to handling these transitions. If, to keep things simple, we assume the taxpayer joined the workforce in 1994 or later, and the taxpayer was not made redundant, injured at work or induced into early retirement, then a payment for unused annual leave or unused long service leave is included in assessable income and taxed at marginal rates: ss 83-10(2) and 83-80(1). If, however, the taxpayer was made redundant, injured at work or induced into early retirement, the rates are more generous – a payment for unused annual leave or long service leave is included in assessable income but taxed at no more than 31.5% (ss 83-15(a) and 83-85). [4.1195]

4.77

Question

An employed solicitor is offered the opportunity to become a principal in the partnership. She has accumulated long service and annual leave which she surrenders as part of her payment to acquire a share of the capital of the firm. What tax consequences follow?

7. SALARY PACKAGING AND INCOME SPLITTING [4.1200] The final part of the chapter considers two of the most common forms of tax

planning affecting wage and salary income put in place by employees: • salary packaging strategies by which employees try to secure the highest level of benefit from their wage by taking it in different components; and • income splitting strategies by which employees and others who sell their labour try to divert their income to taxpayers facing lower marginal tax rates.

(a) Salary Packaging [4.1210] Earlier in this chapter we described the substantial tax savings that employees

sought by taking some of their salary as fringe benefits in the days prior to FBT. Another [4.1210]

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section described the tax concessions associated with superannuation, now substantially wound back with the increased taxes on funds. It might be thought that FBT and the changes to superannuation have put a stop to the practice of taking non-cash salary by eliminating most of the potential tax savings. That would be a misleading impression – even today there is a thriving industry based around the practice of salary packaging, especially for high-income earners. If FBT and the superannuation changes were meant to return equity to the taxation of labour income, they have not been entirely successful. Salary packaging relies on two features of the income tax system: the different tax rates applied to income taken in different forms; and the different tax treatment of expenses when paid by the employer rather than the employee. We have not yet examined the treatment of expenses in much detail, but we have seen some examples of the different treatment of expenses in the case of superannuation contributions and non-deductible expenses for entertainment. We have seen more examples of different tax rates applied to different income streams. Salary packaging combines both the tax positions of the employer and employee to reduce the effective marginal tax rate (EMTR) on the elements in the total package. This section draws together several of the streams we have already examined in this chapter to create a more unified picture. Understanding the benefits of packaging for employers and employees may be easier if you consider the following examples. 1.

Salary. This is a tax deduction to employers, meaning that employers can reduce their tax by a proportion of the salary expense. No FBT is payable by the employer on cash salary, but salary is taxable as income to employees. The total tax payable on cash salary is determined by the employee’s marginal tax rate (which is affected by the progressive rate scale, tax offsets and so on). In short, salary is taxed once at up to 46.5% in the hands of the employee.

2.

“Pure” fringe benefits. These are generally deductible from the income tax liability of the employers, but subject to FBT. They are not taxed to the employee as income. Thus, fringe benefits are effectively taxed once at a flat rate of 49% collected before the benefit leaves the hands of the employer.

3.

“Concessional” and exempt fringe benefits. The effective tax rate on the fringe benefit may be reduced on some occasions if the benefit is given a concessionary value (cars have a built-in concession) or if is treated as exempt (child care). The employer will usually still be entitled to a tax deduction and the employee is still not taxed on these benefits. In this case, the EMTR may be as low as 0%.

4.

Superannuation. Contributions to superannuation funds may be made by the employer, the employee or the government. If the employer contributes, the employer claims a tax deduction for the contribution but the fund pays 15% tax on the contribution. (Employees will taxable income over $300,000 will face a further 15% tax on the contribution.) If an employee contributes, the employee will typically not be able to deduct the payment, but the fund may receive a government co-contribution depending upon the income level of the employee. The fund will not have to pay tax on either the employee’s own after-tax contribution or the co-contribution. The effective tax rate on this income going into the fund will be the contributor’s marginal rate (on the undeducted personal contribution) and 0 on the government’s share. The tax rate on the fund’s income made from this investment is 15%, and the tax rate on the same

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income (plus earnings) on its way out of the fund may range from 0 (for benefits paid to employees over 60) to 34% (for payments to people under aged 60 – ie 49% less a 15% tax rebate). 5.

Tax exempt sector. One group that has special privileges in the FBT regime is the tax exempt sector, particularly charities. They enjoy two types of privileges. First, some public benevolent institutions are exempt from FBT. For others, there is a special rebate of FBT on the benefits they provide designed to compensate them when the FBT gross-up system was introduced. Consequently they have a strong incentive to provide fringe benefits rather than salary.

6.

Fringe benefits taxed to the employer under the income tax. At present, where the employer uses the 50/50 split for meal and other entertainment expenses, one half is non-deductible to the employer, meaning that the employer pays tax on these benefits under the income tax rather than FBT. The other half is a fringe benefit, subject to FBT and not income of the employee. In this case, the EMTR of the non-deductible half depends upon the current tax position of the employer. For a profitable employer which is a company, the EMTR is 30% – the value of the tax deduction which the company has given up in order to pay the benefit. But for a company that has no tax liability (for example, it has made a loss on the year) the tax rate may be as low as 0 per cent (the EMTR will eventually depend upon the length of time until the employer turns tax positive and interest rates in the meantime). Another way to look at salary packaging is to compare the EMTRs of the various components that might be put together to form a package: EMTR (%) 0

15

19 30

32.5 37 Uncertain 45

Type of benefit Exempt benefits (child care, in-house dining); salary used to purchase deductible expenses; fringe benefits that would be deductible if employee had bought them; government co-contribution to superannuation fund; tax free component of an ETP; fringe benefits provided by rebatable employer; death benefit termination payment up to ETP cap paid to a dependant Deductible contributions to superannuation funds for employees; earnings accumulating in superannuation funds; taxable component of life benefit ETP up to cap for employee at or above preservation age Salary and wages from $18,200 to $37,000 Non-deductible employer entertainment benefits; life benefit ETP paid to employee below preservation age up to cap; death benefit ETP paid to non-dependent up to cap; deductible contributions to superannuation funds for employees with income over $300,000 Cash salary between $37,000 and $80,000; Cash salary between $80,000 and $180,000 Fringe benefits with concessionary values – cars, in-house fringe benefits, etc; spouse contributions to a superannuation fund Cash salary over $180,000; fringe benefit with no concession attached; some ETPs (below preservation age, exceeds applicable cap, paid to non-dependent); non-concessional contributions to superannuation fund [4.1210]

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EMTR (%)

Type of benefit

Note Notice that: • the income tax rates on salary are the rates that apply for 2015–16, • the rates are increased by up to 2% for the Medicare levy, • the Medicare levy can be increased by a further 1.5% if the person has sufficient income and does not have private health insurance. • for the 3 income years ending 2015–17, the rates are increased by a further 2% for the temporary budget repair levy From the employer’s point of view this means that the cost of labour can be substantially reduced by moving to packaging of salaries – that is, the employer can deliver the same disposable income to the employee by combining fewer salary elements but offering them in a way that bears the lowest tax rate. Similarly, from the employee’s point of view, the employee can try to convince the employer that for the same total cost to the employer, the employee can receive a pay rise. For the employer and employee there is a potential win–win situation; the loser, of course, is the government, collecting less revenue from the same amount of “packaged” income. Just how much better off the employer and the employee become as a result of packaging cannot be predicted a priori. There is a “stake” (the amount of tax not being paid) available for division between the employer and employee, and the share of the stake that each party ends up with depends how persuasively each can bargain. It may well be that the employer converts to packaging in order to reduce total labour costs taking all the tax saving for itself, or maybe the employee convinces the employer to pass on all the benefits of the tax saving to the employee. In either case, the party who benefits does so at the government’s expense, but the amount of the government’s loss will depend upon the particular bargain struck and the form of benefits agreed upon. Finally, salary packaging can generate synergy, with additional savings arising elsewhere in the tax system by the strategy of reducing the cash component in total salary. For example, every employer is liable for other taxes and charges such as payroll tax and Workcover insurance as a cost of employing labour. In some cases these on-costs are calculated on a base which recognises salary payments; occasionally “pure” fringe benefits are included; exempt benefits rarely; and non-deductible benefits almost never. The employer can, therefore, reduce not only the amount which it pays to employees and the ATO, but also the indirect costs of labour that it pays to other authorities. Similarly from the employee’s point of view, there may be synergy with other taxes and benefits. For example, if salary can be reduced, the employee might be able to avoid or reduce the Medicare levy or perhaps claim some rebate or offset which is subject to withdrawal. Again, the issue will be what employee benefits are counted for the purpose of the penalty or benefit? We saw above that reportable fringe benefits are taken into account when determining whether the taxpayer can enjoy the low-income tax offset, suffer the Medicare Levy surcharge, or have to start repaying a HECS-HELP debt. But, notice that not all fringe benefits are reportable, and this is not the sum of the penalties and benefits that are measured by reference to income. Other government benefits may also be delivered subject to an income test which will usually not include fringe benefits because they are not to be currently separately 250

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identified on an employee’s group certificate. Note finally that the rate of tax saving falls under the progressive income tax rates as the salary income decreases – that is, shifting $1 from salary to exempt fringe benefit saves a high-income taxpayer $0.46 while it can save a low-income taxpayer much less. In other words, the greatest benefits from packaging still flow to higher income earners. You can also see from the table above how packaging reinforces vertical inequity: for low-income taxpayers there are few benefits that offer much scope for packaging. Having described the goals sought by taxpayers and their advisers, there is a real possibility that some of the current forms of salary packaging “don’t work”. Why, for example, doesn’t s 6-5(4) of the ITAA 1997 operate? What would occur if the employee just directed the employer to pay an amount to a third party rather than direct to the employee? It is arguable that in many instances, the employee has just directed the employer to apply part of its cash salary every week to meet certain expenses. If this is correct, the salary will have been derived by the employee and will remain taxable as cash salary, notwithstanding that the employee will now not receive the salary in cash. In Taxation Ruling TR 2001/10 – Salary Sacrifice Arrangements, the ATO adopts the view that, provided the employees have agreed to receive part of their total amount of remuneration as non-salary benefits before the employee has earned the entitlement to receive that amount as salary or wages, the arrangement is effective to prevent the employee from deriving the cash applied under the arrangements as salary. We will return to this issue when we examine tax accounting issues. [4.1215]

4.78 4.79

Questions

Does the practice of salary packaging defeat the goal of vertical equity? Why do you think the government permits salary packaging to survive? Indeed, why do many government departments offer salary packaging to their staff? Do you think different reasons apply to different kinds of benefits? For example, do you think different reasons apply to employer-sponsored child care and superannuation than apply to entertainment fringe benefits? In which group would you place cars?

(b) Alienation of Personal Services Income [4.1220] The previous discussion has considered whether an amount is income or not. This

section looks at a slightly different question – if it is income, whose income is it? That is, the issue we are considering here concerns the proper taxpaying unit. We will look at the rules in this chapter because they arise only for income arising from performing personal services. One of the ongoing concerns of the government in the late 1980s and 1990s was the ongoing trend away from traditional full-time employment relationships and toward temporary, more or less independent, contracting arrangements. In part, this “trend” was simply the outworking of non-tax factors: the market and government policy. “Downsizing” and retrenchments were occurring in the economy as a result of the recession of the late 1980s, and there was increased de-formalisation of labour relations occurring as a result of government policies to promote individualised contracts, workplace agreements and industry restructuring. Those who had been dismissed and more flexible workers re-entered the labour market wherever they could, often as small entrepreneurs rather than employees. The ATO and Treasury apparently viewed the trend as indicating possible tax avoidance as well as the outcome of market forces and government policies – that employees were choosing to reconstruct their working conditions in order to avoid the tax obligations imposed on employees. This may have been true in some cases, but it was also true that many employers [4.1220]

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were keen for this rearrangement to occur so that they could escape the obligations imposed on them by workplace laws (such as workers compensation), State revenue laws (such as payroll tax), as well as income tax laws. The concern of Treasury and the ATO lies in the many and important differences in tax treatment between employees and contractors. These differences are systemic and can be very significant. Some of the main differences are summarised in very general terms in the following table. Issue

If the person is an employee … Withholding of tax at source Tax is withheld from payments of salary and wages at source

Time at which tax is effectively paid

Tax rate applicable Number of taxpayers

Allowable deductions

Substantiation of expenses

Superannuation contributions

If the person is a contractor … Tax is not withheld from the contract price at source (unless one of the industrybased or ABN withholding regimes is triggered) An instalment is paid in the An instalment is paid (through withholding) during quarter that the income is earned under the PAYG the current year, with a balancing adjustment at the system with a balancing adjustment at the end of the end of the year year Personal marginal rates on Corporate rate if the income employment income is retained within a company All income taxed to the Some income might be shifted to spouses and/or employee children using interposed entities Arguably more deductions Arguably fewer deductions were allowable to employees were allowable than contractors Contractor’s expenses are Employee deductions are not subject to the substantiasubject to the detailed tion rules substantiation rules Would be deductible if paid Would be deductible if paid by a company or if paid by by the employer, but not if the contractor directly up to paid by an employee the contribution limits

Needless to say, there were many attacks on these practices by the ATO using various weapons, most notably the general anti-avoidance rule in Pt IVA of the ITAA 1936, to counter some or all of the benefits that might arise. These efforts were sometimes successful and sometimes not, but they could not address the more fundamental problem – insisting in the teeth of the evidence that every arrangement for the performance of work falls neatly into either employment on the one hand, or independent contracting on the other. This is the old distinction drawn for tax and labour law purposes between a “contract of service” (employment) and a “contract for services” (independent contracting). Unfortunately for the ATO, the real world admits too many shades of grey whether by design or circumstance, for all relationships to fit easily into either of these Procrustean beds. 252

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When the Review of Business Taxation released its Report in September 1999, it made a series of recommendations designed to ensure that earnings from personal services provided “in an employee-like manner” would be treated the same way for all taxpayers. The goal was to achieve the same tax outcome for personal services income – whether the income was earned through a company, using some other entity such as a trust, or was earned directly by the individual worker. The recommendations were intended to achieve three outcomes: to counter splitting income between several family members (or entities) using interposed entities; to prevent personal services income being taxed at the reduced corporate rate rather than progressive personal income tax rates; and to prevent contractors “over-claiming” deductions for their expenses compared to the deductions allowed to employees. The government accepted these recommendations, and measures to implement them commenced in July 2000. Their history and operation is well described by Allsop J in IRG Technical Services Pty Ltd v FCT (2007) 165 FCR 57; [2007] FCA 1867. The measures are contained in Divs 84 – 87 of the ITAA 1997. The most important point to note about these measures is that they affect: (a) the independent contractor; and (b) any interposed entity used by the independent contractor. They have no direct impact on firms dealing with either the independent contractor or any interposed entity. The measures apply not to a class of taxpayers but to a class of income – defined as “personal services income”. Section 84-5 defines “personal services income” as “income [which] is mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income)”. Taxation Ruling TR 2001/7 sets out the ATO’s understanding of this phrase. The argument that an amount is not personal services income, and certainly not the income of the employee when it is derived by an interposed company, was rejected by the Federal Court in Fowler v FCT (2008) 167 FCR 425; [2008] FCA 528. The obvious distinction is with income from investment, or income arising from the sale of goods or real property. But there are likely to be many circumstances where it is not easy to differentiate between income from the performance of services and income from sales or investment activity. Examples of this kind of demarcation problem abound in the application of Sale of Goods legislation, and will no doubt provide a fertile source of case law. An existing tax law example of the services v sale distinction is Brent v FCT (1971) 125 CLR 418, discussed above and quoted below. The issue in that case was whether the taxpayer derived income from the performance of services or a capital gain. The taxpayer recounted her colourful life with one of the Great Train Robbers, Ronald Biggs, to journalists who transcribed and embellished it, in return for $65,250. The terms of the contract between Brent and the newspaper constructed the arrangement as a sale of her copyright and other artefacts, but the High Court viewed the income as from the performance of services. Gibbs J said, As a matter of law the agreement entitled the appellant to payment for services rendered to the company in making herself available for interview, in communicating information and in signing the manuscript which the journalists produced and which was not her property. There is no special reason as a matter of fact to treat the information which she possessed as equivalent to a right of property; it was not acquired in the conduct of a business, and could not be described as property in a business sense, it did not relate to anything in which copyright existed, and there was no other justification for regarding it as having in fact a character which the law denied it. The fact that the appellant had secret information made her services more valuable but moneys paid as the consideration for services rendered are income notwithstanding that the person rendering the services is employed only because of the special knowledge or information that he possesses. It is impossible to hold that the appellant sold any property to the company. As I have said, the purported sale of the right to publish her life story and the [4.1220]

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purported assignment of copyright were illusory and the agreement to make available photographs and tokens and the negative covenant contained in cl. 8 of the agreement were subsidiary to the main objects of the agreement. In my opinion the consideration provided by the agreement was for services rendered by the appellant to the company and was properly treated as income.

According to the Explanatory Memorandum to the Bill which enacted these measures, “by reason of this definition, income which is ancillary to an entity supplying goods or granting a right to use property; or principally generated by assets an entity holds is not personal services income as it is not paid mainly as a reward for an individual’s personal effort. Rather, it is paid mainly as consideration for the provision of the goods or due to the use of an asset.” In other words, investment income is not personal services income, nor is, say, the portion of the price of selling a photocopier which relates to the 12-month service warranty. Paragraph 1.27 of the Explanatory Memorandum to the Bill which enacted these measures gave as “examples of income that will clearly be from personal services”: • salary or wages; • income of a professional person practising on his or her own account without professional assistance – for example, a medical practitioner in a sole practice; • income payable under a contract which is wholly or principally for the labour or services of a person; • income derived by a professional sports person or entertainer from the exercise of his or her professional skills. This does not include income from endorsement by the person of a sponsor’s products; and • income derived by consultants, for example, computer consultants or engineers from the exercise of personal expertise. It is stated that only individuals can have “personal services income” (s 84-5(2)), but the regime treats amounts received by interposed entities as still the “personal services income” of (some) individual. That is, s 84-5(1) states that the amount is “your” personal services income even if it is “ordinary or statutory income of any other entity”. [4.1225]

4.80

Question

Would the following transactions give rise to “personal services income”? the income of a portrait painter who contracts to prepare a portrait of the subject for a price;

(a)

(b)

income from writing a software program for another;

(c)

the income of a builder from a contract to construct a house on another’s land;

(d)

the income of a retailer of goods who agrees to deliver the goods and to install them in situ;

(e) (f)

the income of a farmer who sells (or forward sells) crops grown by the farmer; income from leasing equipment where the contract includes a service warranty that ensures prompt repair of the leased equipment in the case of breakdown;

(g)

income from the sale of a car with a warranty;

(h)

dividends derived from shares issued to an employee under an employee share scheme.

[4.1230] Where personal services income is derived, two main consequences are made to

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• The deductions which can be claimed against that income are limited by Div 85. The limitation is not triggered, however, where the individual carries on a personal services business: s 85-30. • Where income representing personal services income is derived by an interposed entity, the personal services income (and related allowable deductions) may be attributed and taxed to an individual, and excluded from the income of the entity that actually derived it by Div 86. Again, the attribution will not occur where the entity carries on a personal services business: s 86-15(3). The assumption behind the first consequence – that there is a substantive difference between the deductions that an employee can claim (ie a loss or outgoing “incurred in gaining or producing … assessable income”) and those allowed to an independent contractor (ie a loss or outgoing “necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income”) – is probably not correct. It is certainly difficult to identify any individual item that becomes allowable under s 8-1(1)(b) that is not allowable under s 8-1(1)(a) as a matter of principle. The evil that these rules are intended to solve is probably simply the “hiding” of non-allowable expenses inside a business – ie evasion (rather than avoidance) based on mischaracterisation or non-disclosure. The second set of outcomes can be avoided if the interposed entity pays out the income it is receiving as salary to someone sufficiently promptly: s 86-15(4). Such a payment will, of course, simply trigger tax for the recipient to be collected by withholding in the usual way. Central to both sets of rules is the concept of a “personal services business”. The term is defined in Div 87. It is the statutory phrase which identifies when it is considered an independent business is being carried on, so that the operative rules in Divs 85 and 86 are not triggered. Notice that both an individual and an interposed entity may need to consider the personal services business test. Section 87-15 which defines a “personal services business” is a complex provision to grasp because of the way it is constructed. If we start with subs (2), it sets out four tests that might be met during the relevant year of income. These four tests are potentially available to indicate that the taxpayer is carrying on a business: 1.

Unrelated clients. The individual or personal services entity must have two or more unrelated clients and the services are provided as a direct result of the individual or entity offering its services to the public: s 87-20(1).

2.

Employees. The individual engages other persons to perform work for it worth at least 20% (by market value) of his or her principal work for that year: s 87-25(1).

3.

Business premises. The individual or personal services entity must, at all times during the income year, have the exclusive use of business premises which are used mainly to produce personal services income and are physically separate from any premises used for private purposes of the individual entity or associate: s 87-30. 4. Results test: An individual meets the results test in an income year if, in relation to at least 75% of the individual’s personal services income, the income is for producing a result, the individual is required to supply the equipment needed to perform the work and liability for the cost of rectifying any defect in the work performed is born by the individual: s 87-18. The decision in Taneja v FCT [2009] AATA 87 makes it clear that there are three discrete limbs, all of which have to be satisfied. The ATO has set out the understanding of the meaning of these tests in Taxation Ruling TR 2001/8. [4.1230]

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Reading subs (1) would suggest that the individual will be carrying on a personal services business either if the ATO has given its blessing by issuing a determination (paras (a) and (b)) or one of those four tests is met (para (c)). But the flowchart in s 87-5 certainly contradicts this impression. It starts with just the results test and then another test about 80% of the income. The diagram is correct and the best place to start trying to understand how the text of Subdiv 87-A accomplishes what the flowchart explains is s 87-15(3). It starts by asking (a) whether 80% or more of the income came from a single customer and (b) whether the results test is met. Where the answer is yes, then it will apply rather than subs (1) and the taxpayer must secure the ATO’s blessing no matter what. So it would seem that the first place to start is either the 80% question or the results test – in fact, it turns out to be the results test. That is because subs (3) works on the premise that one of the other three tests has been met and not the results test. When that has happened, then if 80% or more … etc. So the place to start is with the results test. If it is met, then a personal services business will exist because subs (1)(c) will be met and subs (3) will not be invoked because neither (a) nor (b) can be satisfied. If the results test is not met, then both of two other requirements must be met in order to carry on a “personal services business” – less than 80% of “an individual’s personal services income” during the income year must be derived from the same entity and the entity must satisfy one of the other three tests: s 87-15(3). If either the 80% test is not met, or the entity does not satisfy any of three tests, the only hope is to secure a determination from the ATO that there is a personal services business under Subdiv 87-B. Assuming we have “personal services income” and no “personal services business”, the operative provisions for these measures in Divs 85 and 86 are then triggered. • Division 85 operates on the individuals (and only individuals) who are performing the work and denies them deductions for various outgoings. • Division 86 operates in respect of the interposed personal service entity and reconstructs the tax outcome to the entity and individuals who stand behind it. Division 85 operates on the individuals performing the work. Note that it operates both where the person works directly as an independent contractor, and where the person is attributed with income through a personal services entity. In both cases, it denies deductions to the individuals for various outgoings. It does not operate, however, where the individual derives its income as an employee (s 85-35) or where the individual passes the personal services business test (s 85-30). Section 85-5 says that Div 85 is intended to prevent an individual who is an independent contractor from deducting an expense that would not be deductible if the individual were an employee. This intention is given effect in s 85-10. It provides that an individual: cannot deduct under this Act an amount to the extent that it relates to gaining or producing that part of your ordinary or statutory income that is your personal services income if (a) the income is not payable to you as an employee; and (b) you would not be able to deduct the amount under this Act if the income were payable to you as an employee.

Section 85-10(2) then gives exceptions to this basic rule. It states that deductions will not be denied for expenditure directed to gaining work, insuring against loss of income, liability insurance, engaging another entity to perform work, making contributions for superannuation, or meeting workers compensation or GST obligations. 256

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It was argued above that the assumption behind the basic rule in s 85-10(1) – that there is a substantive difference between the deductions that an employee can claim (ie a loss or outgoing “incurred in gaining or producing … assessable income”) and those allowed to an independent contractor (ie a loss or outgoing “necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income”) – is probably not correct. It may be, therefore, that this general rule has no consequences; it is instead the specific denials that follow in Div 85 which are significant and operative. These rules are discussed in Taxation Ruling TR 2003/10. Those specific denials are listed in ss 85-15 to 85-25. These sections amplify s 85-10(1) by specifically denying deductions for expenses which relate to gaining or producing the personal services income and are: • payments of rent, mortgage interest, rates and land tax for the individual’s residence: s 85-15; • payments to associates (unless they perform the principal work of the individual contractor): s 85-20; and • superannuation contributions made for the benefit of associates (unless they perform the principal work of the contractor, and the amount of the contribution is no more than required under the Superannuation Guarantee system): s 85-25. Section 86-10 says that Div 86 is intended to prevent alienation of personal services income through companies, partnerships or trusts. It does this by including in the assessable income of the individual who performed the work the personal services income paid to an interposed “personal services entity”. Taxation Ruling TR 2003/6 explains how this attribution occurs. Section 86-15(1) says: Your assessable income includes the amount of ordinary income or statutory income of a personal services entity that is your personal services income.

A “personal services entity” is defined as “a company, partnership or trust whose … income includes the personal services income of one or more individuals”: s 86-15(2). This is an interesting definition because there is no notion of control or ownership of the entity in either of these provisions. There are two exemptions from attribution under these rules: • There is no attribution of income where the personal services entity conducts a personal service business: s 86-15(3). • There is no attribution where the personal services entity promptly pays an amount of salary or wages to the worker as an employee: s 86-15(4). The amount must be paid to the individual within 14 days after the end of the PAYG period in which the entity derived the amount. Of course, doing so simply triggers taxation on the individual rather than the entity (which is exactly what the attribution would produce), but payment will advance the time of derivation of the worker’s income from the end of the year of income to the time of payment. Where attribution of personal services income occurs, the individual is then entitled to reduce the amount attributed by certain of the deductions to which the interposed entity is entitled: s 86-20(1). Subdivision 86-B however, prevents the entity from deducting certain expenses. This denial is important because of the flow-on effect it has for the individual – the amount by which the attributed amount can be reduced will be smaller. Consequently, although it might [4.1230]

257

The Tax Base – Income and Exemptions

seem more appropriate to look at these rules under the treatment of entities, we will look at them here because their real impact is in their effect of the reduction in the amount attributed to the worker. Notice finally that losses remain locked in the personal services entity – even a partnership. This occurs under s 86-20(1). Where an amount is attributed to the worker and later distributed to the individual by the interposed entity (after the 14-day period), it is not again assessable to the recipient: s 86-35. This rule applies whether the amount is paid to the worker (presumably as salary) or is included in the net income of a personal services entity – that is, if the entity is a partnership or a trust. It is not clear whether this immunity from further taxation also applies if the amount forms the basis for a dividend paid by the entity. Because the income and deductions relating to the derivation of the personal services income will have been attributed through to the worker by ss 86-15 and 86-20, it is then necessary to exclude them from the income of the personal services entity. This occurs under s 86-30. It provides that the personal services income included in the income of a personal services entity and attributed to an individual is neither its income nor exempt income. For the amounts promptly paid out to the individual as salary or wages, which are not subject to attribution, the entity can still claim a deduction for the payment made against its (remaining) income.

258

[4.1230]

CHAPTER 5 Business Income [5.10]

1. INTRODUCTION........................................ ................................................. 261

[5.20]

2. IDENTIFYING A CONTINUING BUSINESS ...................... ............................ 262

[5.30] [5.40] [5.50] [5.70] [5.100] [5.120]

(a) The Characteristics of a Business .......................................................................... 263 (i) Business or enthusiastic pastime? .......................................................................... 263 Martin v FCT .............................................................................................................. 264 Ferguson v FCT ........................................................................................................... 266 Ruling TR 97/11 ......................................................................................................... 268 (ii) Businessperson or passive investor? ...................................................................... 269

[5.130] [5.140]

(b) Profit Motive ....................................................................................................... 272 FCT v Stone ............................................................................................................... 273

[5.160] [5.170]

(c) Start-Up Operations ............................................................................................. 276 Fairway Estates Pty Ltd v FCT ...................................................................................... 276

[5.190]

(d) Losses from Quasi-Hobby Activities ...................................................................... 278

[5.200]

3. ISOLATED TRANSACTIONS ................................ ........................................ 282

[5.210] [5.220]

(a) Isolated Ventures .................................................................................................. 284 FCT v Whitfords Beach Pty Ltd ..................................................................................... 285

[5.240]

(b) Statutory Profit-Making Schemes ......................................................................... 290

[5.250]

4. DEFINING THE SCOPE AND ORDINARY COURSE OF THE BUSINESS... ...... 291

[5.260] [5.270] [5.290]

(a) Gifts, Prizes and Windfalls .................................................................................... 292 Federal Coke Co Pty Ltd v FCT ..................................................................................... 293 FCT v Squatting Investment Co Ltd .............................................................................. 294

[5.310] [5.320] [5.340]

(b) Government Subsidies ......................................................................................... 296 GP International Pipecoaters Pty Ltd v FCT ................................................................... 296 First Provincial Building Society Ltd v FCT ..................................................................... 298

[5.350]

(c) Illegal Activities .................................................................................................... 300

[5.360] [5.370] [5.400]

(d) Unusual Transactions and the Ordinary Course of the Taxpayer’s Business ........... 302 FCT v Myer Emporium Ltd ........................................................................................... 302 Ruling TR 92/3 .......................................................................................................... 306

[5.420] [5.430] [5.450]

(e) Ending or Restricting the Operation of a Business ................................................ 308 Dickenson v FCT ......................................................................................................... 309 MIM Holdings Ltd v FCT ............................................................................................. 310

[5.470]

5. CLASSIFYING BUSINESS ASSETS AND LIABILITIES: REVENUE AND STRUCTURAL TRANSACTIONS................................ ........................................ 312

[5.480]

(a) Transactions with Trading Stock ........................................................................... 314

[5.490]

(b) Gains on Disposal of Machinery and Equipment .................................................. 315

[5.500] [5.510]

(c) Transactions with Contract Rights ........................................................................ 317 (i) Contract rights as revenue assets .......................................................................... 317 259

The Tax Base – Income and Exemptions

[5.520] [5.540] [5.550] [5.560] [5.580]

Californian Oil Products v FCT ..................................................................................... Heavy Minerals v FCT ................................................................................................. (ii) Compensation for income ................................................................................... Glenboig Union Fireclay Co v IRC ................................................................................ Allied Mills v FCT ........................................................................................................

318 319 320 320 321

[5.600] [5.610] [5.630]

(d) Know-how and Related Assets ............................................................................. 322 Rolls-Royce Ltd v Jeffrey ............................................................................................... 323 Kwikspan Purlin Systems Pty Ltd v FCT ......................................................................... 325

[5.640] [5.650] [5.670]

(e) Transactions with a Taxpayer’s Business Premises ................................................. 325 Ruling IT 2631 ........................................................................................................... 326 Montgomery v FCT ..................................................................................................... 328

[5.690] [5.700] [5.710] [5.730] [5.740] [5.760]

(f) Realising Financial Investments ............................................................................. (i) Banks and insurance companies ........................................................................... Australasian Catholic Assurance Co v FCT .................................................................... (ii) Investment trusts and companies ......................................................................... London Australia Investment Co Ltd v FCT ................................................................... AGC (Investments) Pty Ltd v FCT .................................................................................

[5.770] [5.780]

(g) Gains on Liabilities ............................................................................................... 340 FCT v Orica Ltd .......................................................................................................... 343

331 331 332 334 335 339

Principal Sections ITAA 1936 s 6(1) s 21A

ITAA 1997 s 995-1 –

s 25(1)

s 6-5

s 25A

s 15-15

s 26(g)

s 15-10

s 51(1)

s 8-1

–

Div 35

–

s 40-285

–

Div 70

260

Effect This section contains a definition of “business”. This section includes the value of any “non-cash business benefit” in the assessable income of the person carrying on the business. This section includes in a resident taxpayer’s assessable income, gross income derived from all sources. This has been interpreted to include the profit derived from carrying on a continuing business or carrying out an isolated business venture. This section, formerly s 26(a), includes in a taxpayer’s assessable income, the profit emerging from carrying out a profit-making undertaking or scheme that does not involve the sale of property acquired after 20 September 1985. This section includes the amount of any bounty or subsidy in the proceeds of a business. This section allows as a deduction from assessable income for expenditure incurred in carrying on a business to derive assessable income. This regime requires a taxpayer to defer the recognition of losses from certain businesses until they generate profits. This section includes gains from the sale of depreciable plant as assessable income. This Division enacts part of the tax regime for assets which are the trading stock of a business.

Business Income

ITAA 1936 s 160ZA(4)

ITAA 1997 s 118-20

s 160L

s 118-25

s 160ZB

s 118-37

Sch 2C

Div 245

CHAPTER 5

Effect This section attempts to integrate gains from carrying on a business with capital gains tax by reducing the amount of any capital gain by the amount of gain that will be taxed under the ordinary and statutory income provisions. This section attempts to integrate gains from carrying on a business with capital gains tax by excluding disposals of assets which are trading stock from being disposals for the purposes of capital gains tax. This section excludes gains and losses from gambling from the calculation of capital gains or losses. This Schedule contains the debt forgiveness rules which reduce a taxpayer’s tax attributes (such as carry forward losses) where its debts are forgiven.

1. INTRODUCTION [5.10] In the previous chapter we looked at one of the categories of “income according to

ordinary concepts and usages” – in that case, payments which are a product of services – and the various statutory modifications and extensions to that idea. Another category of “income according to ordinary concepts and usages” is the gain generated by carrying on a business. The gain derived from carrying on a business is income assessable under s 6-5 of the ITAA 1997. In an extension to this idea, some taxpayers who do not carry on a continuing business can find they too make ordinary usage income even though they are carrying out an isolated transaction. These simple propositions – that a gain from carrying on a continuing business or from an isolated transaction in some cases has an income character – are just the first step. There is a second step to consider because not all amounts earned by a taxpayer who is carrying on a business will be ordinary income – only those amounts which are within the scope and ordinary course of the taxpayer’s business. In broad terms, this chapter discusses four issues in relation to the taxing of receipts alleged to be the product of a business: • The first issue is to identify the range and the method of application of the tests which will suggest whether the taxpayer is carrying on a continuing business. There are also special rules to deal with losses that arise from activities that are a business but which generate losses. These issues are dealt with in Section 2. • The second issue takes us down the path of taxpayers who do not have a business – that is, their activities do not amount to a continuing business based on the tests discussed in Section 1. However, the proceeds of an isolated transaction carried out by a taxpayer without a business can be taxed as the profits of an isolated business-like transaction, or under other provisions of the Act. This issue is dealt with in Section 3.

[5.10]

261

The Tax Base – Income and Exemptions

• In the third section we return to taxpayers who have an ongoing business. We then attempt to identify “the scope and ordinary course” of the taxpayer’s business to decide whether this transaction forms part of the business or is, in some sense that is relevant for tax, so alien to the business that it should not be considered part of carrying on the taxpayer’s business. This is dealt with in Section 4. • The final issue (which is often and easily confused with the third) is to characterise the gain admitted to be within the scope of the business. If the gain arises on the sale of an asset of the business, is the asset a capital asset, trading stock or a revenue asset of the business and is the gain of a revenue or capital nature? If the gain arises on a business liability, is the gain of a revenue or capital nature? If there is neither asset nor liability, is the mere receipt taxable? This issue is dealt with in Section 5.

2. IDENTIFYING A CONTINUING BUSINESS [5.20] You will have noticed in the previous paragraphs that we differentiated a continuing

business from an isolated business-like transaction. The logical place to commence this chapter is by asking: what facts indicate that the taxpayer is carrying on a business? For most companies and many partnerships this is rarely an issue – they are usually formed expressly to operate mines, factories, shops, or sell services, and as we will see, they are organised and operated in such a way that they meet the tests for deciding what amounts to a business. But where the taxpayer is an individual and sometimes also a trust, it is not always so clear. And, even for companies, partnerships and trusts, there is a critical distinction between carrying on a business and being an investor which affects the operation of our tax. So our discussion here examines two ideas that are the antitheses of business: • activities that are a hobby, pastime, recreation, amusement or similar essentially noncommercial activity; and • activities that are merely making or realising a passive investment. We start this chapter by looking at the first issue: is this activity a business or is it simply a form of non-commercial pastime? No one would seriously doubt that Coca Cola, BHP Billiton, the National Australia Bank, Woolworths or Microsoft are all carrying on businesses. So too is your local service station, coffee shop or hairdresser, albeit in a much smaller way. But the kinds of activities we are looking at here are much less obvious: they involve part-time farmers, race horse owners, fanatical stamp collectors, participants in organised but obscure sports, part-time musicians and “professional” gamblers. These kinds of taxpayers are not as obviously “in business” as Microsoft or National Australia Bank, especially since many of them will only be making losses and will have full-time jobs elsewhere. Determining whether or not a taxpayer doing one of these things is carrying on a business, is vital in the income tax system because, subject to some specific provisions in the Act: • receipts from activities that do not meet the tests for being a “business” will not give rise to ordinary income; and • more commonly, the losses that these activities invariably generate will not be allowable deductions. So determining whether or not a business exists is an important place to start, but remember that falling into, or outside, the “business” rubric is not the only test of whether amounts generated by trading or working activities will be within the tax system. Conceptually, carrying on a business can be thought of as combining services and property in a systematic way with the expectation of gain and so, even for activities which are not within this business 262

[5.20]

Business Income

CHAPTER 5

rubric, gains generated may yet be ordinary income under these other principles – as the product of providing services or as gains derived from property. Some gains which fall outside the ordinary income notion altogether can yet be taxable under statutory provisions. The capital gains tax obviously increases the scope for taxing gains from non-business activities.

(a) The Characteristics of a Business [5.30] In ordinary parlance, the idea of a business involves multiple transactions, which are

organised in a systematic manner, to be repeated indefinitely, and are motivated by the goal of making a profit. The Act has a definition of sorts – it gives some indication of the range of activities that may constitute a business in the definition of “business” in s 995-1 of the ITAA 1997. Elsewhere, the Act relies upon finding the existence of a business as a precondition for other results: see, for example, the definition of “income from personal exertion” in ss 6(1) and 262A of the ITAA 1936 and ss 8-1, 15-10, 26-47, Div 35 and Div 70 of the ITAA 1997, all of which rely upon a prior finding that a “business” exists. Unfortunately the definition of “business” in s 995-1 of the ITAA 1997, like its predecessor in s 6(1) of the ITAA 1936, is of little practical use in these kinds of matters – it is just too vague. It does not really assist in defining when a series of activities becomes a business, nor does it assist in determining whether an individual gain made by a taxpayer who is carrying on a business is income of the business according to ordinary concepts. Consequently, the meaning of business has been formulated by judges and in the typical common law way: by the accumulation of hundreds of decisions, each reaching a result but on the precise set of facts which the court was called on to analyse. The determination that a business exists is, like all questions of fact, a matter of judgment, impression and degree. Guidance can be gleaned from indications in the cases but they offer nothing that approaches a rule – at best they are a collection of indicia. One of the sources habitually cited (at least by authors) for tests on the meaning of a business is the Final Report of the Royal Commission on the Taxation of Profits and Income (UK 1955, Cmnd 9474). The Royal Commission listed six “badges of trade”: the subject matter of the trade; the length of the period of ownership; the number and frequency of similar transactions; the extent of any supplementary work on the property sold; the circumstances surrounding the sale; and the taxpayer’s motive. This list is helpful but subject to some obvious limitations: the list relates only to “trade” and trading is only one form of business activity; and the transportability of the list is also open to some doubt. It was prepared for the context of the United Kingdom income tax which depends upon gains falling into appropriate schedules. One of those schedules taxes the profits of a concern “in the nature of trade”, that is, the profit which arises from an isolated transaction. The aggregation of isolated and continuing activities is unhelpful for an Australian audience unless kept clearly in mind. (i) Business or enthusiastic pastime? [5.40] As the existence of a business is a question of fact largely untrammelled by statutory

intervention, the only way to answer the question, “is the taxpayer carrying on a business?” is by developing an informed judgment steeped in the cases. We will extract three cases on the general issue, “is there a business?”, and then proceed to some more specific issues. In Martin v FCT (1953) 90 CLR 470 the Commissioner attempted unsuccessfully to maintain that the taxpayer was carrying on a business of gambling on horse racing over a number of years. During that time he had also been a hotelier and then a farmer. Using his own [5.40]

263

The Tax Base – Income and Exemptions

punting system, he placed 602 bets (totalling £10,000 in one year), kept records of every bet placed and the results of the 275 winning bets. Webb J in the High Court had found that the taxpayer was carrying on a business of gambling but the Full High Court overturned the holding:

Martin v FCT [5.50] Martin v FCT (1953) 90 CLR 470 The taxpayer is not by occupation a bookmaker or trainer or jockey. During the whole of the year ending 30 June 1944 he was carrying on the business of a small hotel-keeper in the Metropole Hotel, Ipswich, Queensland. He continued to carry on this business till the end of March 1945 when he sold the business and bought a farm. In the last two years the taxpayer also indulged in the luxury of racing and breeding racehorses and owned blood stock and his capital account in these years showed entries of prize moneys and racing and stud expenses. Over the two years the taxpayer was also successful in his racing, his expenses for the year ending 30 June 1945 being £186 9s. 0d. and the prize money £91 2s. 0d. and for the year ending 30 June 1946 his racing and stud expenses being £652 1s. 2d. and the prize money £950 14s. 8d. The definition of income from personal exertion includes the proceeds of a business carried on by the taxpayer, but the pursuit of a pastime, however vigorous the pursuit may be, does not usually amount to carrying on a business and gains or losses made in such a pursuit are not usually considered to be assessable income or allowable deductions in computing the taxable income of a taxpayer. The onus, if the case is one in which onus assumes any importance, is on the appellant to satisfy the court that the extent to which he indulged in betting and racing and breeding racehorses was not so considerable and systematic and organised that it could be said to exceed the activities of a keen follower of the turf and amount to the carrying on of a business. But no question of onus appears to us really to arise. It is simply a question of the right conclusion to draw from the whole of the evidence. Although the issue is one of fact, there is no conflict of evidence and the case is one of those cases where the court of appeal is in as good a position to reach a conclusion as the judge below. Webb J.

264

[5.50]

held that the taxpayer was carrying on a business of racing and betting because of (1) the considerable amount of time spent by him in racing and betting operations; (2) the very large proportion of his assets and income applied by him for that purpose; and (3) the systematic methods employed by him which were, his Honour thought, really directed more to making profit than pursuing pleasure. With all respect to his Honour the evidence does not appear to us to justify these conclusions. In fact, the taxpayer frequented one racecourse and then only on ordinary racing days. If the number of bets he made appears at first sight to have been large, they do not seem to add up to more than about one bet on each race and therefore not to point to more than a normal propensity of racegoers who bet as a pastime. The taxpayer could afford this indulgence since he was, on the evidence, so successful. He said that he never ventured much over £100 on any race and that the biggest bet he ever won was £500 to £40 on one of his own horses. He said that he stayed away from the races for the first nine months after he purchased the hotel, for he was then in a new job and had to concentrate on that until he had control of it. It appears that the taxpayer, like many other persons who find pleasure in betting and even more pleasure in winning, used a system which he believed would bring him out on the credit side in the long run, that he sometimes got a friend who accompanied him to the races to lay his bets for him when he was himself occupied in the saddling paddock, and that he engaged trainers from time to time to train his racehorses. But we do not consider this evidence to be symptomatic of a business of betting or racing. It illustrates the normal and usual activities and nothing more of persons who derive pleasure from betting on the racecourse and racing under their own colours.

Business Income

CHAPTER 5

[5.60] It is interesting to speculate why the ATO litigated Martin – why it wanted these

activities to be classified as a business. Undoubtedly there was a short-term gain to the revenue. Maybe the ATO even felt that this taxpayer’s system was so good his luck was unlikely to run out. But it is invariably the case that, in the long run, gamblers lose. But the ATO did not abandon its attempts to tax punters. The issue whether gambling on horse races could be a business was raised again in a series of cases in the late 1980s. In each case, the ATO lost and the betting activities of the punters were not classified as amounting to a business: • In Evans v FCT (1989) 20 ATR 922 the taxpayer had credited his successful gambling as the explanation for his sudden increase in wealth during an ATO audit of his affairs. Unfortunately for the taxpayer, the ATO apparently accepted this evidence, but then claimed that the proceeds of his gambling were assessable because Evans was carrying on a business. Hill J held that the taxpayer’s activities did not amount to a business because he did not try to maximise his return: Evans bet with the TAB rather than on-course bookmakers who would offer better odds and he bet in “exotic” ways such as quinellas or trifectas. Instead, the judge concluded the evidence showed a taxpayer who simply gambled for personal pleasure. • In Babka v FCT (1989) 20 ATR 1251 the ATO attempted to assess a successful punter on his winnings, almost $1.5 m over 10 years. Hill J found that, despite the taxpayer’s betting system, considerable devotion of time, extensive records and detailed accounts, the evidence showed no more than that he was a keen follower of the turf. The element of chance in horse racing, the judge suggested, would almost invariably lead to the conclusion that the activity would not be a business. • In Brajkovich v FCT (1989) 89 ATC 5227 the taxpayer alleged that his betting amounted to a business in order to claim allowable deductions for his losses. The claim failed despite evidence that he gave up his business to concentrate on his gambling on horse races, cards, football and two-up (losing over $950,000 in the process). According to the Full Federal Court these activities displayed no more than a simple passion for gambling, albeit on a large scale. After these cases, the ATO issued Taxation Ruling IT 2655. It says: “The Commissioner … considers that it will be rare for a taxpayer with no connection with racing other than betting to be carrying on a business of betting or gambling.” The Ruling is probably best understood as a direction from senior sources within the ATO to zealous tax auditors to stop trying to tax a punters’ gambling winnings. But there is one important reason why exasperated tax auditors might pursue gambling activities – it is often a remedy of last resort where an audit of a taxpayer discloses unreported income which the taxpayer attributes to the largely unverifiable source of gambling winnings. The auditor may well not believe the taxpayer, but may try to render the matter moot by asserting that even if the amount is from gambling it is taxable in the circumstances of the particular taxpayer. If we leave gambling as perhaps an idiosyncratic context, it is much more common to see instances of taxpayers claiming to be carrying on a business where they are operating a hobby farm or vineyard and they are hoping, like the so-called Pitt Street or Collins Street farmers, to take advantage of the losses they make (and perhaps even the tax concessions given to primary [5.60]

265

The Tax Base – Income and Exemptions

producers) to reduce their tax liability on their other employment or business income. The issue whether the taxpayer was carrying on a business of primary production arose in Ferguson v FCT (1979) 9 ATR 873. The taxpayer, who was a naval officer, argued that his small activities, carried on by a manager on Ferguson’s behalf, amounted to a business of primary production. The taxpayer entered an agreement to lease five Charolais cattle and then a second agreement to agist them on property owned by the manager. The ATO’s position – that the taxpayer was not carrying on a business – was advanced on several fronts. The ATO argued that the activities did not amount to a business; it also argued that the activities were preliminary – they were not yet a business; and it argued that the taxpayer had such a peripheral connection with the activities, that it could not be said to be his business – he was merely funding the business of another. Bowen CJ and Franki J in the Full Federal Court began their judgment with some general observations about the tests which are used by courts to decide whether the taxpayer is carrying on a business:

Ferguson v FCT [5.70] Ferguson v FCT (1979) 9 ATR 873 Section 6 of the Income Tax Assessment Act 1936 defines “business” stating that it includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee. This does not afford much assistance in the present case. It is necessary to turn to the cases. There are many elements to be considered. The nature of the activities, particularly whether they have the purpose of profit making, may be important. However, an immediate purpose of profit making in a particular income year does not appear to be essential. Certainly it may be held a person is carrying on business notwithstanding his profit is small or even where he is making a loss. Repetition and regularity of the activities is also important. However, every business has to begin and even isolated activities

may in the circumstances be held to be the commencement of carrying on business. Again, organisation of activities in a business-like manner, the keeping of books, records and the use of system may all serve to indicate that a business is being carried on. The fact that, concurrently with the activities in question, the taxpayer carries on the practice of a profession or another business, does not preclude a finding that his additional activities constitute the carrying on of a business. The volume of his operations and the amount of capital employed by him may be significant. However, if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business even though his operations are fairly substantial.

They then turned to the facts of the case before them and attempted to apply these indecisive criteria: Turning to the facts of the present case, there is evidence of considerable system and organisation in relation to the breeding scheme itself. It is true that most of this was done by the manager. On the other hand, the appellant paid for the manager’s services. In return for the fees he paid these things were done for him.

266

[5.70]

The application and results of the system and organisation maintained by the manager were communicated to the appellant in the form of a monthly report covering the breeding program, a timely livestock report and calving report and general reports as to market conditions. The appellant read these reports and also subscribed to and read periodicals relating to primary

Business Income

Ferguson v FCT cont. production. Since July or August 1973 he had maintained a card index system in which he recorded particulars as to date of birth, type, sire and dam, date of artificial insemination in relation to each beast or natural mating, and calving. He also maintained a “ledger” as a record of his receipts and payments. The appellant spent a fair amount of his spare time on maintaining familiarity with the progress of the cattle through received reports and through reading periodicals. He was overseas for a period of two years and two months from January 1974 to March 1976 and continued his activities while abroad, although there is some evidence of the taxpayer having remained ignorant for 16 months as to whether one of the heifers had fallen pregnant or not. Receipts were obtained from the sale of bull calves, although due to a number of factors these receipts were insufficient in the relevant years to cover his outgoings. On the face of it, he was conducting his activities on a commercial basis and was, it would seem, carrying on a business. However, it was argued on behalf of the ATO, that the object of the appellant was to start a business of commercial cattle production with a herd of 200 breeding cows on his own land; that he could have done this by simply buying a herd of 200 cows and a property; and, that if he had done that the herd would have been trading stock because it would have constituted livestock used in the business. Up to this point we do not

CHAPTER 5

think we would necessarily disagree with the argument. Counsel for the ATO then proceeded to argue that instead of purchasing the herd the appellant adopted this alternative mode of acquisition by means of the lease agreement and the management agreement; that in doing this he was not carrying on his intended business; that what he was doing was not part of that intended business because he had not yet commenced that business; that until he commenced that intended business he was simply acquiring cattle for it in a particular way and his expenditure until the herd was used in that intended business was of a capital nature, being concerned with circulating capital and, therefore, did not fall within s. 51(2); and that when he did commence the intended business and the herd that accumulated was used in that business it would properly be brought in as trading stock and he would then be entitled to a full deduction for expenses incurred in the acquisition. It is true to say that the appellant’s long-term object was as counsel for the ATO stated. However, it does not follow that because one tax result would follow if he carried out his object by purchasing 200 cows, the same result must follow if he adopts a different method. It may do so. It depends upon the method adopted. The question is, what is the proper conclusion, having regard to what he did? In our opinion, the proper conclusion is that his activities in advance of carrying out his ultimate intention were such as to constitute a business. We believe the learned trial judge was wrong in his conclusion. We would answer question (i) in the affirmative.

Fisher J agreed with this result: It seems to me necessary to give more detailed consideration to the activities of the taxpayer at the first stage. The fact that he ultimately intended to carry on the business of cattle raising or primary production on his own property with the stock acquired during the first stage does not necessarily preclude the finding that the taxpayer was also carrying on business during the first stage. A person may conduct a business, albeit of a limited nature, the activities of which business are preparatory to or in preparation for the

conduct of another business on a larger scale. The question is whether the more limited activities at the earlier stage, standing alone, constitute a business. It is my opinion that in the present case the taxpayer had embarked upon a commercial activity which activity was primarily designed to build up a herd of cattle as cheaply as possible. He proposed ultimately to use this herd for the purpose of producing assessable income by selling the members thereof and their natural [5.70]

267

The Tax Base – Income and Exemptions

Ferguson v FCT cont. increase. Until, however, he had acquired the desired numbers he proposed to sell off only the unwanted male calves. These sales were sales of the by-products of the venture and an inevitable feature of his activities. The evidence is that he sold more of the calves than he retained. Moreover the venture as a whole had a

commercial flavour, was conducted systematically and, as counsel for the ATO conceded, in a businesslike manner. It could not be said that there was anything haphazard or disorganised in the way in which he carried out the activity. In my opinion it amounted to the carrying on of a business and thus the outgoings claimed are allowable as a deduction under the second limb of s. 51(1).

[5.80] The effect of this decision was, of course, that Ferguson could shelter some of his

income from the Navy behind the loss generated by the cattle production. He might also have had access to income averaging and other benefits offered to primary producers, which have the effect of reducing the total tax payable. [5.90] The ATO has issued a series of Taxation Rulings which try to clarify the law on when a

taxpayer is carrying on a business. Among the more important are TR 93/26 in relation to horse racing, TR 95/6 on farming and primary production, and TR 97/11 on the general question of whether a taxpayer is carrying on a business of primary production.

Ruling TR 97/11 Some indicators of carrying on a business of primary production [5.100] 12. Whilst each case might turn on its own particular facts, the determination of the question is generally the result of a process of weighing all the relevant indicators. Therefore, although it is not possible to lay down any conclusive test of whether a business of primary production is or is not being carried on, the indicators outlined below provide general guidance. 13. The courts have held that the following indicators are relevant: • whether the activity has a significant commercial purpose or character; this indicator comprises many aspects of the other indicators; • whether the taxpayer has more than just an intention to engage in business; • whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity; • whether there is repetition and regularity of the activity;

268

[5.80]

• whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business; • whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit; • the size, scale and permanency of the activity; and • whether the activity is better described as a hobby, a form of recreation or a sporting activity. 14. A taxpayer does not need to derive all his/her income from the primary production activity. The taxpayer may also be employed in some other occupation or profession. What is important is that the taxpayer’s primary production activity amounts to the carrying on of a business. This activity is considered separately from any other employment or business carried on by the taxpayer. The fact that another business is carried on does not necessarily mean that the primary production activity is also a business. 15. We stress that no one indicator is decisive, and there is often a significant overlap of these indicators. For example, an intention to make a

Business Income

Ruling TR 97/11 cont. profit will often motivate a person to carry out the activity in a systematic and organised way, so that the costs are kept down and the production and the price obtained for the produce are increased. 16. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the “large or general impression gained” (Martin v. FC of T (1953) 90 CLR 470 at 474) from looking at all the indicators, and whether these factors provide the operations with a “commercial flavour” (Ferguson

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v. FC of T (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case. 17. Subject to all the circumstances of a case, where an overall profit motive appears absent and the activity does not look like it will ever produce a profit, it is unlikely that the activity will amount to a business. 18. The following table provides a summary of the main indicators of carrying on a business. The last three items shown are factors which support the main indicators.

Indicators which suggest a business Indicators which suggest a business is not is being carried on being carried on a significant commercial activity purpose and intention of the taxpayer in engaging in the activity an intention to make a profit from the activity the activity is or will be profitable repetition and regularity of activity activity is carried on in a similar manner to that of the ordinary trade activity organised and carried on in a businesslike manner and systematically – records are kept size and scale of the activity not a hobby, recreation or sporting activity a business plan exists commercial sales of product taxpayer has knowledge or skill

not a significant commercial activity no purpose or intention of the taxpayer to carry on a business activity no intention to make a profit from the activity the activity is inherently unprofitable little repetition or regularity of activity activity carried on in an ad hoc manner activity not organised or carried on in the same manner as the normal ordinary business activity – records are not kept small size and scale a hobby, recreation or sporting activity there is no business plan sale of products to relatives and friends taxpayer lacks knowledge or skill

[5.110] There are many other Rulings on this territory, trying to distinguish business from

pastimes – TR 1999/17 deals with whether athletes and sportspeople are carrying on a business (para 29 ff), TR 2005/1 deals with whether various kinds of authors, artists, composers or performers are carrying on a business, TR 2003/4 deals with whether boat owners who charter their boats to others are carrying on a business and TR 2008/2 deals with the position of various players in the horse racing industry. The principles invoked in these Rulings all allude to TR 97/11. (ii) Businessperson or passive investor? [5.120] Some of these same issues arise in the exotic tax-driven schemes marketed through the financial press every year, particularly in late June, primarily to high-income taxpayers. Many of these products have similar elements: [5.120]

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• taxpayers are sought by advertisements in the financial press often directed to a broad non-specialist audience, or through direct marketing to tax agents and financial planners; • the taxpayer’s role is limited to making a small initial cash contribution (which is said to generate large and immediate tax deductions exceeding the amount of cash contributed); • the balance of the investment often comes from substantial borrowing usually from parties related to the vendor; • the funds raised from individual taxpayers are combined to acquire large sites and other pooled inputs; • the funds raised from all the taxpayers are used in producing exotic agricultural, pastoral or fishery products such as pine or tea tree plantations, almonds, avocadoes, macadamias, chestnuts or guavas; • the individual taxpayers have little or no direct involvement. Management of these activities is provided by associates of the current owner/vendor. Indeed, they are usually regulated under the Corporations Act 2001 under the regime for “managed investment schemes.” These situations raise slightly different issues from the business-or-hobby dichotomy that we have focused on so far. No one is a participant because they enjoy the activity; indeed, their involvement in the activity is minimal. These taxpayers are engaged in an activity because they hope to make money from it, not because they enjoy it – it is not like sailing or horse racing or wine-tasting or sitting on the verandah of the farmhouse in the twilight. So the issue is principally whether the taxpayer is carrying on its own business or simply investing in a business being undertaken by someone else. These kinds of investments are attractive and marketed on the basis of a quick tax-driven profit because the early-year deductions will exceed the immediate income, and the amount of deductions available is enhanced by the debt component. The deductions claimed – for the management fees charged, interest incurred, rent, planting, cultivating, harvesting, marketing and other costs – rely upon a view that the taxpayer is carrying on a business. But to the naked eye it would seem that the taxpayers involved more closely resemble investors in a business conducted by others and are principally trying to buy more tax deductions than their current outlay on the cost of the product. These kinds of transactions were at the heart of the so-called “mass-marketed tax-effective schemes” which abounded in the mid-to late-1990s. As we will see, the government responded to the significant threat that these schemes posed to revenue by enacting special rules: see [5.190]. In addition, the ATO successfully challenged a number of taxpayers who had invested in these arrangements. Interestingly, for many years, it did not argue that the taxpayers were not carrying on a business. Rather, it attacked some cases by arguing that the taxpayer incurred the relevant expenses at a time when the taxpayer’s business had not yet commenced: see Howland-Rose v FCT (2002) 118 FCR 61; [2002] FCA 246; Vincent v FCT (2002) 124 FCR 350; [2002] FCAFC 291. However, the argument was not always successful: see Puzey v FCT (2003) 131 FCR 244; [2003] FCAFC 197; FCT v Sleight (2004) 136 FCR 211; [2004] FCAFC 94. The ATO was more often successful in arguing that the general anti-avoidance rules defeated the taxpayer’s ambitions. This doctrine is discussed later. Eventually, the ATO decided to tackle the issue head-on. The ATO had traditionally accepted that taxpayers such as these who invested in managed agricultural investment schemes were carrying on a business and in the ruling on these kinds of schemes, TR 2000/8, had sought primarily to control their potential damage to the revenue in other ways. However, in 2007 the ATO withdrew TR 2000/8 and issued TR 2007/8 which took a rather different 270

[5.120]

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view – that amounts paid by the taxpayers to the promoters of these schemes were not payments of management fees, rent, interest and so on. Rather, the cheque which the taxpayer wrote was “the capital cost of the investor’s interest in the scheme, and hence not deductible amounts under s 8-1 …; the better view is considered to be that the investors’ contributions obtain for them an income producing asset, in the shape of their interest in the scheme, the cost of which is on capital account” (para 7). Hance v FCT [2008] FCAFC 196 was a test case organised to validate this new view. The case put to the Court was restricted to the explicit argument that the taxpayers who were proposing to participate in a managed investment scheme for growing almonds would not be carrying on a business – they were just buying an interest in a managed investment scheme which was an income-producing asset like a share in a company or a unit in a trust. The Full Federal Court disagreed: In the present case the continuation of the operation over an extended period of time, the repetitive nature of the work involved in farming each Almondlot (to be paid for on a regular basis) and the return in the form of almond crops (to be received from year to year) all suggest an ongoing business. The applicants may not have control over the way in which their Almondlots are farmed, but that is an incident of their grouping for the purposes of management. Each applicant may terminate the management agreement for breach or, in company with other Growers, resolve to dismiss [the manager] as manager. Each applicant has an ongoing commitment to paying [the manager] to do what is necessary in order to facilitate commercial production of almonds over a lengthy period of time. In light of [the manager’s] authorization to pool almonds for sale, each applicant is likely to obtain a return for his product in a proportion differing in some degree from the actual contribution to the pool of almonds made by him. This scheme, allowing both for pooling and for the easy ascertainment of a grower’s entitlement on sale, seems to us to reflect no more than a commercially sensible mechanism which, it is probably envisaged, will be fair and economical to all growers in the circumstances. In our view each applicant will be carrying on an individual business on his or her Almondlots with the purpose of producing almonds for sale at a profit (para 90).

As a result of the case, the ATO withdrew TR 2007/8. This story still has some way to go. Questions

[5.125]

5.1

Assume that a taxpayer wanted to carry on a business through an agent – in what ways would it look different from the arrangement in Ferguson?

5.2

Assume that a taxpayer wanted to invest in another’s business – in what ways would it look different from the arrangement in Ferguson? What different tax consequences follow from each characterisation?

5.3

What are the factors identified in the cases which determine whether there is a business? Can any identifiable weight be attached to particular factors? How important, for example, is: • • • •

the scale of the operation; the frequency of transactions; the nature of the assets involved; that the activities are carried on by a corporation, partnership or trustee rather than an individual;

• • • •

that the taxpayer has a full-time job, or another business; that the taxpayer sets up an organisation to assist in selling; that the taxpayer improves or develops the asset; how the taxpayer financed the operation? [5.125]

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5.4 5.5 5.6 5.7 5.8

5.9

How are the factors, once found in a set of facts, to be applied? If the expenses incurred by Ferguson had not been allowed as deductions, would they have been available to form part of the cost base of some asset for capital gains tax? How would the gains and losses made by Martin, Evans and Babka be dealt with after capital gains tax? (See s 118-37 of the ITAA 1997.) What are the differences between Martin on the one hand and Ferguson on the other? That is, why is Martin not in business, while Ferguson is? It has been suggested that while Australia lacked a capital gains tax, the lack of a determinate rule and the business gains principle in general performed a policy function of equating income derived from property with that derived from services. What evidence of this is apparent in the cases and how did it come about? The taxpayer owns an expensive boat which she uses on the weekend. She has been told that every other boat owner in the marina claims depreciation for the cost of their boats (and so pays less tax). Section 26-47 prohibits a taxpayer from deducting the cost of a boat unless the taxpayer uses the boat “mainly for letting on hire in the ordinary course of a business” that the taxpayer carries on. She decides she has to start a “business” of chartering the boat to the public. Unfortunately, she works full-time and cannot be available to run such an operation. Further, she doesn’t want to charter the boat on weekends as this is when she uses it. The marina owner regularly charters boats in the marina to the public. She decides to lease the boat to the marina owner for two years under terms that allow the marina operator to charter the boat to the public except on weekends. She is entitled to 50% of gross rentals received by the marina operator. Is she carrying on a business? (See Taxation Ruling TR 2003/4.)

(b) Profit Motive [5.130] The definition of a continuing business which was used as the starting point to this

chapter was that a business involves multiple transactions which are repeated and ongoing indefinitely, organised in a systematic manner and are motivated by the goal of deriving a profit. We now explore some of these ideas in more detail, starting with the idea that a business is an activity conducted for profit. How significant to the existence of a business is the subjective purpose of the taxpayer to acquire a profit? Would it matter if the taxpayer expected to make losses, at least in early years? Would it matter if the taxpayer never really expected the activity to recover its costs, but was willing to undertake the activity anyway? Would it matter if the taxpayer hoped to make a profit, but, viewed objectively, was unlikely ever to succeed? Some of these issues were addressed by the High Court in Stone v FCT (2005) 222 CLR 289; [2005] HCA 21. That case concerns an elite athlete (who was also a serving Queensland police officer) who received a variety of payments from her chosen sport of javelin. Over a series of years as she progressed in the sport, she started generating money from her sport and during the 1999 income year received four kinds of payments totalling over $135,000: prize money ($93,429), appearance fees ($2,700), some commercial sponsorships in cash and equipment ($12,419), and grants from various government and government-affiliated agencies ($27,900) such as the Australian Olympic Committee and the Queensland Academy of Sport. The ATO took the view that her activities were sufficient to amount to a business and so she was assessed to tax on all of these receipts. Stone conceded that the appearance fees and sponsorships were assessable as income from services, but claimed the grants and prizes money were not assessable as she was not carrying on a business. At first instance, in Stone v 272

[5.130]

Business Income

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FCT (2002) 51 ATR 297; [2002] FCA 1492, Hill J found for the ATO – that she had become a “professional athlete” in part. The Full Federal Court disagreed in Stone v FCT (2003) 130 FCR 299; [2003] FCAFC 145 largely because of their view that she was insufficiently driven by the desire for profit – she was, “a career police woman” and not engaged in business as a professional athlete. The Full Federal Court said she was insufficiently driven by the pursuit of profit for her activities to amount to a business: Sportsmen and sportswomen who can fairly be said to be carrying on a business would be expected to choose the competitions and contests in which they compete, with a mind directed towards the reward that is likely either for having participated, or for having performed well, in the particular contest or competition. A sportsman or sportswoman engaged in a business activity would choose a competition or contest where the prize money is likely to be maximised. That would not necessarily involve choice of the competition or contest where the prize money is greatest, unless the sportsman or sportswoman had a prospect of real success in the contest. However, Ms Stone did not select the competitions in which she competed on the basis of likely receipt of money but rather on the basis of the need to participate in competitions in order to gain competitive experience. Thus, it could not be said that Ms Stone’s criteria for choosing contests and competitions in which she competed was indicative of a business activity.

The result was overturned on appeal to the High Court which took a different view of the significance of the pursuit of profit:

FCT v Stone [5.140] FCT v Stone (2005) 222 CLR 289; [2005] HCA 21 The Commissioner submitted that because the taxpayer had turned her talent as an athlete to account for money, the sums she had described in her return were business income. The Commissioner contended that an athlete was to be identified as having turned his or her talent or skills to account for money when others recognised the athlete as a celebrity or personality having marketable value. Thus, so the submission proceeded, the taxpayer was shown to have turned her talent to account for money by either or both of two events: first, when she was paid to endorse a product and, secondly, when she was paid more than the reimbursement of expenses to appear at a function. The absence of any subjective purpose of the taxpayer to profit from her athletic endeavours was said to be irrelevant. The taxpayer submitted that the receipts in issue were to be treated as income only if the relevant receipts arose from an act done in carrying on a business. It was necessary, so the taxpayer submitted, to find not only that a business was being carried out but also that the activity producing the receipt was an activity in the course of carrying on that business. The taxpayer submitted that she was not conducting

a business. It was said that the evidence showed that the taxpayer’s motivation was her desire to excel, to represent her country and win medals, not to make money. Competing contentions were made about the significance, if any, to be attached to the magnitude of the sums in question when compared with the taxpayer’s income as a police officer, and to whether the payments under consideration were periodic or not. The taxpayer’s submissions sought, at times, to distinguish between “sport” and “business”, and to distinguish between “prizes” or “gifts” on the one hand and “income” on the other. Emphasis was given to the fact that the taxpayer had chosen the events she entered by reference to the quality of the competition she would encounter, not any consideration of the financial consequences of participation or success. What she received as prizes and [government grants] were characterised as either gifts or as a means of helping to defray the large expenses she incurred in pursuing her goal of representing her country. What was said to set sponsorship receipts apart from the other receipts in question was that the [5.140]

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The Tax Base – Income and Exemptions

FCT v Stone cont. sponsorship receipts were rewards for services rendered, whereas the other payments were not. Once it is accepted, as the taxpayer did, that the sums paid by sponsors to her, in cash or kind, formed part of her assessable income, the conclusion that she had turned her sporting ability to account for money is inevitable. The sponsorship agreements cannot be put into a separate category marked “business”, with other receipts being put into a category marked “sport”. Nor can some receipts be distinguished from others on the basis that the activity producing a receipt was not an activity in the course of carrying on what otherwise was to be identified as a business. Agreeing to provide services to or for a sponsor in return for payment was to make a commercial agreement. What the taxpayer received from her sponsors were fees for the services she provided. But when these arrangements are set in the context of her other activities during the year, it is evident that the sponsorship arrangements she made were but one way in which she sought to advance the pursuit of her athletic activities. No doubt, as the taxpayer pointed out, pursuit of her athletic activities was expensive. And it must be accepted that her principal motivations were the pursuit of excellence and the pursuit of honour for herself and her country. But the sponsorship arrangements show not only that the taxpayer made those arrangements to assist her pursuit of athletic activities but also that she was able to make them because of her pursuit of those activities. Having this dual aspect, the sponsorship agreements cannot be segregated from other aspects of her athletic activities. All of the receipts now in question were related to the taxpayer’s athletic activities. Some of those amounts (in particular, the sponsorship amounts) were paid in return for the taxpayer’s agreement to provide services; some (like the government grants) were not. Perhaps the appearance fees may fall into that former class rather than the latter. Apart from appearance fees, and apart from the amount paid to the taxpayer by [government] for being selected in the Australian Commonwealth Games Team, the 274

[5.140]

other payments made to her appear in each case to have been paid in accordance with, or subject to, her undertaking contractual obligations or inhibitions. The prizes she won, it may be assumed, were paid pursuant to a contractual obligation of the event organisers. What is clear, however, is that at least some of the amounts which the taxpayer received during the 1998–1999 year in connection with her athletic activities were payments made and received in accordance with a contract which stipulated obligations undertaken by the taxpayer. Even if it is right to see [government grants] as unsolicited by her, they were made available only upon her undertaking certain inhibitions not only on her future sporting conduct but also on her future commercial exploitation of success in competition. Taken as a whole, the athletic activities of the taxpayer during the 1998–1999 year constituted the conduct of a business. She wanted to compete at the highest level. To do that cost money – for equipment, training, travel, accommodation. She sought sponsorship to help defray those costs. She agreed to accept grants that were made to her and agreed to the commercial inhibitions that came with those grants so that she might meet the costs that she incurred in pursuing her goals. Although she did not seek to maximise her receipts from prize money, preferring to seek out the best rather than the most lucrative competitions, her pursuit of excellence, if successful, necessarily entailed the receipt of prizes, increased grants, and the opportunity to obtain more generous sponsorship arrangements. That other sports and other athletes may have attracted larger rewards is irrelevant. No doubt it is necessary to take account of the taxpayer’s statement that she did not throw javelins for money. [But] the state of mind or intention with which a taxpayer undertakes activities giving rise to receipts is relevant, but it is only one fact to take into account, in deciding whether the receipts are properly to be classed as income. If a taxpayer has a view to profit, the conclusion that the taxpayer is engaged in business may easily be reached. If a taxpayer’s motives are idealistic rather than mercenary, the conclusion that the taxpayer is engaged in a business may still be reached. The “wide survey

Business Income

FCT v Stone cont. and exact scrutiny” of a taxpayer’s activities that

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must be undertaken may reveal, as it does in this case, that the taxpayer’s activities constituted the carrying on of a business.

[5.150] A moment’s reflection about Stone suggests it was an odd case for the ATO to pursue.

No doubt the tax on $130,000 was attractive, but will the case lead to other problems – the kinds of problems that led to the decision to cease pursuing gamblers? Ms Stone began throwing javelins in 1987 when she was 14 years old; she began soliciting sponsors in the early 1990s; she began competing successfully nationally in 1994; she won her first cash prize ($250) in 1995; she received her first government grant in 1995; she was on the 1996 Australian Olympic team but did not win a medal and she enjoyed some success overseas in other competitions. Her history from 1987–1998 shows the life of an elite athlete in an obscure sport: always searching for money to fund equipment, travel and living expenses which comes in haphazardly and in tiny amounts – $600 from the Queensland Police Sporting Association, $1,600 from the Caboolture Shire Council, $300 for coaching at a Toowoomba clinic, 31 personal appearances for a total of $2,700 – recurring injuries, declining involvement and eventual retirement in 2000. The year 1998–1999 was clearly a bumper year for her, winning almost $100,000 in prize money, and this is the year for which tax was assessed. The obvious question is, so what about all those earlier years when her receipts did not cover her expenses? Was she carrying on a business in those years as well? Would she have had carry-forward losses available to reduce the tax in 1999? And what about all those less successful athletes (not to mention buskers, garage bands, painters, performance artists, aspiring poets and budding novelists) who will never have a $130,000 year, and have to rely on their “day jobs” to pay the bills? Can they now deduct the losses from their activities from their wage income? In short, is this a case that was worth winning or has the decision just opened the door to the losses from a multitude of loss-making ventures being deducted from other kinds of income? As we will see below, the revenue is afforded some protection from this outcome by Div 35 of the ITAA 1997, but it is a limited protection. And one might also wonder if the Government was really happy with the ATO win – is this just going require that it makes larger cash grants to sponsored athletes because they will now lose part of their sponsorship funding in tax? [5.155]

Questions

5.10

How significant is a deliberate intention (or perhaps resignation) not to make a profit? Consider whether the activities of a religious order would be a business if they deliberately sold tracts at a loss on the street corner to spread their message. Would it make any difference if the occasion of a sale was also used to solicit “donations”?

5.11

A retailer deliberately sells some of his stock at a loss as a “loss leader”. Are these sales part of a business?

5.12

The taxpayer was an evangelist who supported himself and his family entirely out of voluntary and unsolicited donations. While the taxpayer knew the contributions would probably result from his evangelistic work, he claimed that his purpose was not to solicit funds but to carry the word of God. Is he carrying on a business? (See G v CIR (NZ) [1961] NZLR 994.) [5.155]

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The Tax Base – Income and Exemptions

5.13

The High Court says that Ms Stone, “turned her sporting ability to account for money” and this fact led to the conclusion that she was carrying on a business. Does this mean the notion of “profit” is now irrelevant, and what matters is just the receipts side of the equation? In other words, would it (or should it) matter if, over her sporting life, Ms Stone would never have recouped all of the expenses from her sporting activity?

(c) Start-Up Operations [5.160] The previous section considered one specific aspect of “carrying on a business” – can

a taxpayer be carrying on a business if it expects to make commercial losses or is, from an objective perspective, unlikely ever to make a profit? This section examines another aspect – the timing problem. In order to be assessable or to claim deductions, the taxpayer must establish that it is currently carrying on a business, not merely preparing for one. Every business must start somewhere, and the cases discussed in this section are examples of taxpayers trying to portray new ventures or pilot projects as ongoing businesses. In these cases, the taxpayers have to use only one of the factors identified earlier in the chapter to indicate the existence of a continuing business – the use of a system – because at this stage there is no evidence of repetition. The ATO was unsuccessful with the argument that the activities were merely preparatory in Ferguson and the same issue arose in Fairway Estates Pty Ltd v FCT (1970) 123 CLR 153. The company was incorporated in 1958 with the object of carrying on a business as a moneylender. In order to raise capital, it speculated in land development using funds borrowed from a related company. It also derived some income by providing vendor finance to buyers. These transactions occupied most of the activities of the company until 1964. In 1959 it had lent £59,500 to Jubilee Tin Pty Ltd to develop a tin mining venture but by 1963 it had received only £5,950 interest and was still owed £53,880. The company sought a deduction under s 63 of the ITAA 1936 (now s 25-35 of the ITAA 1997) claiming that the amount represented a bad debt incurred in carrying on a business of moneylending. Barwick CJ in the High Court accepted the taxpayer’s characterisation of its activities:

Fairway Estates Pty Ltd v FCT [5.170] Fairway Estates Pty Ltd v FCT (1970) 123 CLR 153 The first question is whether the taxpayer, to satisfy the terms of s. 63, must be carrying on the business of lending money at the time of making the advance in respect of which the deduction is claimed. It seems to me that this must be so, that the advance must be made as part of a business of moneylending then carried on by the taxpayer. In applying this construction of the section to the facts of this case the critical question is whether or not the appellant was carrying on the business of lending money at all at the time of the advance to Jubilee. The appellant was incorporated to carry on the business of the lending of money along with other activities. This, I am satisfied, was an actual 276

[5.160]

intention of its subscribers and not merely a precautionary inclusion of an object in its memorandum along with a large number of other possible courses of action. The appellant’s association with United, having regard to the activities and financial resources of that company, confirms the view that the appellant intended throughout to carry on the business of the lending of money as opportunity offered. However, up to the date of the advance to Jubilee it had not commenced to carry on any such business. As I have said, its sole activity up to that time was the purchase of land and its sale in subdivision. But, because of its association with United I believe it would have lent money to

Business Income

Fairway Estates Pty Ltd v FCT cont. sundry members of the public who had applied prior to that time at the address in common use by the appellant and United had Mr Wolfe or Mr Witheriff decided that it should do so. Yet in fact it did not do so. Here, if the transaction is a loan of money, it was made as a matter of business. It was not made in connection with the land-selling business of the appellant. In my opinion, it was not intended to be a single and isolated transaction; that there were to be no further advances of money. I accept the expressions in the minutes of the appellant as to the intention of the appellant as genuine. It is of course true as the respondent’s counsel has emphasised that there were no loans made between the date of the advance to Jubilee and August 1960, or as he preferred to state the fact, only one loan in the first 21 months of the appellant’s existence. The force of this fact would be greater in my mind if the question was whether the appellant intended to carry on the business of moneylending. But given that

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intention, which as I have said, I regard as fully established by other evidence, I do not regard the fact that there was no immediate repetition of the lending of money or that there was a considerable break before there was any continuity in the making of loans as definitive of the question whether the business of lending money was being carried on at the time of the advance to Jubilee. I am of the opinion that the proper conclusion in this case is that the appellant was carrying on the business of lending money at the time it made the advance to Jubilee and that that loan was the first transaction in a business of the lending of money then commenced and intended to be carried on. … I have therefore come to the conclusion that the amount written off by the appellant in the year under review constituted a bad debt in respect of the loan of money to Jubilee made by the taxpayer at a time when it was carrying on the business of the lending of money and that the advance was made in the ordinary course of that business. Accordingly, in my opinion, the appeal should succeed.

[5.180] The result in this case should be contrasted with that in Southern Estates Pty Ltd v

FCT (1967) 117 CLR 481. In that case the taxpayer claimed deductions on the basis that it was carrying on a business of primary production. In 1960 it purchased a one-half interest in a large tract of undeveloped land and during the next two years expended large sums of money reclaiming and improving the land with the eventual intention of grazing sheep on it and, once its value as grazing land had been established, to sell it at a profit. The taxpayer claimed that it was entitled to a deduction for the clearing costs under s 75 of the ITAA 1936. The High Court found that the taxpayer was not engaged in a business of primary production, although that may have been its intention when the land was fit for that purpose. The activities were merely preparatory. Barwick CJ observed: I am unable to read “a taxpayer engaged in” as satisfied by one of whom no more can be said than that he intends to engage in. To prepare land for primary production, even for primary production thereon by the person making the improvement is not of itself, in my opinion, to engage in primary production.

The same issue arose in the later decision in AAT Case 5593 (1989) 20 ATR 3140. In that case the taxpayer decided to embark upon growing chestnut trees. He took advice from agronomists, prepared detailed estimates and revenue projections, ploughed his land, planted lupins in order to raise nitrogen levels in the soil and then, after devoting two days each week to the project for two years, abandoned it. He did so because unforeseen expenditure on constructing additional dams would render the project unprofitable. The ATO claimed that the [5.180]

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taxpayer was merely preparing for the eventual chestnut business but the Administrative Appeals Tribunal distinguished the decision in Southern Estates saying that it had no universal application to the preparation of land for agricultural purposes. We mentioned above that, more recently, the ATO has had some success using this weapon as the means of defeating some of the mass-marketed scheme transactions of the 1990s. He succeeded in a few cases by arguing that the taxpayer incurred the relevant expenses at a time when the taxpayer’s business had not yet commenced: Howland-Rose v FCT (2002) 118 FCR 61; [2002] FCA 246; Vincent v FCT (2002) 124 FCR 350; [2002] FCAFC 291. However, the argument was not always successful: Puzey v FCT (2003) 131 FCR 244; [2003] FCAFC 197; FCT v Sleight (2004) 136 FCR 211; [2004] FCAFC 94. What tax treatment is provided for so-called “pilot projects”? They might be classified as preparatory activities and not amounting to a business, or, alternatively, as a separate business albeit on a small scale and preparatory to another later business. The result reached by the Supreme Court of Victoria in Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101 suggests that they must be capable of some independent existence if they are to amount to their own business. In this case the taxpayer was the vehicle used by the publishing firm, Macmillan, and an Australian consortium to explore the possibility of establishing a paper mill complex at Mount Gambier. Macmillan sent consultants and a survey team from Canada to continue the assessment of the project, particularly suppliers of raw materials, engineering and economic feasibility. Once the project was considered feasible, the taxpayer was incorporated in 1961 with a share capital of £1 m subscribed for by Macmillan and the Australian promoters equally. The company was to be used to carry out the pilot project and the eventual construction of the mill at an expected cost of £15 m if that occurred. In 1962 Macmillan decided to withdraw from the project and it collapsed. The shareholders in the company then funnelled investment moneys into the company to shelter some of the subsequent investment income from tax by using the accumulated debts of the company to reduce the income. The Court held that the activities amounted to a pilot project and were not deductible. Menhennitt J said: Everything that was done in this case, up till the time when the project ceased, was in my view entirely preliminary and directed to deciding whether or not an undertaking would be established to produce assessable income. … The critical point is that the company had not reached a stage remotely near the carrying on of a business. … All that had happened had been that certain investigations had been made to decide whether or not the business was feasible, and whether or not it was economically viable on a competitive basis, but nothing had been done which could be said to be carrying on a business or anything associated with or incidental to the carrying on of a business.

Just as every continuing business must start with one transaction, so every business carried on by a mortal must end. But it is apparently necessary to distinguish between cessation of a business and its mere suspension. A business was found to be merely suspended in AGC (Advances) which is discussed later. Apparently the repetitive activity had continued in that case, although the careful observer would have been hard pressed to find any evidence of it.

(d) Losses from Quasi-Hobby Activities [5.190] If one reads the cases to elicit which facts indicate that a taxpayer is carrying on a business, it seems that it is relatively easy for a taxpayer to generate activities that will amount to a “business”. This is one part of the ongoing difficulty that the tax authorities have had with agricultural, forestry and other tax deferral schemes of the kind seen in Ferguson the 278

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“mass-marketed tax effective schemes” of the late 1990s, and in the treatment of quasi-hobby activities such as Stone. We noted above that every year exotic quasi-investment products are marketed through the financial press to high-income earners. These arrangements typically rely for their “return” to buyers on the tax deferral arising from prepayments and large start-up costs, combined with a long delay before any income is generated. Similarly, high net worth individuals can afford to lose money on their expensive pastimes, but they would prefer it if the tax authorities assisted them by allowing deductions for their expenses. Where the “business” generates losses – be they losses arising in the early years from timing mismatches, or permanent losses from expensive hobbies – these losses are then used to offset the tax payable on the taxpayer’s other income, such as income from employment or some other business. In the case of agricultural schemes, the ATO has tried to limit the tax-driven aspects of these schemes in Rulings such as IT 360 (deductibility of prepayments to afforestation companies), IT 2195 (deductions for afforestation schemes after Lau’s case), TR 95/6 (deductions for primary production and forestry) and TR 2000/8 (investment schemes). Recommendation 7.5 in the final report of the Review of Business Tax (the Ralph Report) took the further step of recommending a series of legislative measures to quarantine and defer the ability of a taxpayer to use these losses from various activities that passed the first hurdle of being a “business” but which displayed other features suggesting that this was either just an expensive hobby or pastime, or was a mass-marketed investment scheme with tax avoidance features. The obvious targets were the agricultural and forestry schemes, hobby farms and the like (though as we shall see, like much tax law once the rules are written down as law, the actual impact becomes much broader than the intended target). The Ralph Report recommended that “a loss arising in a year of income from an activity conducted or carried out by an individual taxpayer not be offset against other income of that taxpayer in that year unless the particular activity satisfies …” a series of tests. The recommendation was thus to quarantine and defer the use of business losses in some situations. The measures were introduced as Div 35 of the ITAA 1997 which began for the 2000–2001 income year. The ATO has issued Rulings on how it understands the measures to work – TR 2001/14, TR 2003/3 and TR 2007/6 – and it is regularly noted in other Rulings that touch on hobbies such as TR 2005/1 on “professional artists”. Division 35 applies to business activities but only if they are undertaken by an “individual alone or in partnership”: s 35-10(1) of the ITAA 1997. The consequences of the Division applying are triggered where the allowable deductions for the business activity in any year exceed the assessable income it generates, unless the activity meets one of several relieving tests. Where the relieving tests are not met, the loss from the activity is first deducted from the taxpayer’s exempt income (if any) (s 35-15(2) of the ITAA 1997), and any remaining loss must be carried forward to a subsequent year until there is a profit from that activity, and is then deducted from the profit. If the relieving tests are met, the loss can be applied in the usual way against current year income from other sources. Notice a few things about the way these measures operate: • First, as we noted above, they only apply to individuals or partnerships with a partner who is an individual: s 35-10(1) of the ITAA 1997. They do not apply to companies or trusts. This decision no doubt rests on the fact that losses are locked within companies and trusts, and are not directly available to any high net worth individuals who might happen to be shareholders or beneficiaries. In other words, there should be no problem with losses from the target activities turning up in the hands of shareholders or beneficiaries. But one might [5.190]

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ponder why a high net worth taxpayer who already carries on a business in corporate form might not decide to buy one of the target investments in the company to offset its income, rather than his or her own income. • Next, the activity in question must already be a “business” as understood at law. If the taxpayer is simply engaging in an expensive hobby, the rules don’t apply and they don’t need to. But what about a taxpayer who is simply an investor in the business of another? This situation is omitted from the regime and this appears to be intentional. But it is not obvious why a taxpayer cannot claim all the same deductions under the first limb of s 8-1 (which does not require the taxpayer to be carrying on a business) that he or she would be entitled to if they were carrying on a business. If that is so, there seems to be a fundamental flaw in the regime. Indeed, in the cases which have examined these kind of schemes, the taxpayers claimed their deductions relying principally on the first limb of s 8-1 without asserting that they were carrying on a business: see for example, FCT v Lau (1984) 16 ATR 55; FCT v Emmakell Pty Ltd (1990) 21 ATR 346; and FCT v Brand (1995) 31 ATR 326. • In theory, the measures apply “to each business activity” of a taxpayer, on an activity-byactivity basis. This appears to be intended to be a different notion from all the taxpayer’s business activities considered together. Hence, a taxpayer who carries on an unincorporated business in two locations and has losses on a bookshop but profits on a café, would be caught by these rules unless one of the relieving tests is available. It is more difficult to know how the regime applies if the café and bookshop are in a single building – does the regime still apply? Section 35-10(3) allows a taxpayer to “group together business activities of a similar kind” but this probably doesn’t help the café-cum-bookshop owner. • Finally, the regime requires a year-by-year analysis. A taxpayer who happens to have a bad year in the café but a good year in the bookshop can find him or herself within these rules, paying tax on the bookshop profits and not being able to use the losses from the café to reduce the tax in that year. The impact of the application of the regime arises where the allowable deductions “attributable to the business activity for that income year” exceed “your assessable income … from the business activity for that year”, that is, where there is a revenue loss from a business activity: s 35-10(2) of the ITAA 1997. Where this is the case, the taxpayer must first subtract the loss from its exempt income of the current year: s 35-15(2) of the ITAA 1997. Next, s 35-10(2) says the Act then applies “as if the excess were not incurred in that income year” – in other words, there is just no longer any loss to be used in that year. Instead, the Act applies as if the excess “were an amount attributable to the activity that you can deduct from assessable income from the activity for the next year in which the activity is carried on”. That is, the loss becomes another deduction which can be used in a later year but only against the income from that business activity. These effects will not occur if the taxpayer meets any one of four objective tests in the loss year or if the ATO exercises its discretion. There are also special modifications made for primary producers and artists. For primary producers and artists, the rule will not apply unless they have income from other sources exceeding $40,000. This is presumably designed to allow some farmers and struggling artists to work part-time (“off-farm income”) and still have their farming and arts losses available to reduce their overall tax. The four relieving tests are:

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1.

If the business activity generates assessable income exceeding $20,000 during the loss year: s 35-30 of the ITAA 1997. This is likely to be an easy test to manipulate in some industries. For example, a hobby farmer with cattle will presumably sell $20,000 worth of cattle on the last day of the year and then buy $20,000 worth of cattle at the same sale. 2. If the business activity has generated profits in three of the last five years: s 35-35 of the ITAA 1997. In fact, the section says the five years counted includes the current year (which by definition is a loss year) and the four prior years, so this rule becomes: the taxpayer must have triggered profits in three of the four prior years. 3. If the business activity uses real estate “on a continuous basis in carrying on the activity in that year” which cost (or is now worth) $500,000 or more: s 35-40 of the ITAA 1997. In counting up the $500,000, the section says to exclude a dwelling and the adjacent land if it is used mainly for private purposes (s 35-40(4)), so a taxpayer who operates his or her business from home is rarely going to be able to use this test. This test may lead to some curious incentives. For example, a partner in a law firm about to buy land for a winery will presumably now want to buy a larger winery – land costing $400,000 just won’t do. An apportionment rule exists in s 35-55 to apportion the values of land for this section where a single parcel of land is used only partly for the business activity. 4. The total value of listed assets “used on a continuing basis in carrying on the activity” is $100,000 or more: s 35-45. The only assets which can be counted are depreciables, trading stock, leased assets, trademarks, patents, copyrights and similar rights. But for this test the taxpayer cannot count real property or cars. Importantly, the taxpayer cannot count shares in a company which owns the business real estate – a not uncommon structure designed for asset protection purposes. Assets are valued at the end of the year and their value is derived from the taxpayer’s accounts, not the market value: depreciables are valued at written-down value; inventory is valued at closing cost; leased assets are valued at the sum of future rentals owed, reduced by the interest component; and trademarks etc are valued at reduced cost base. The same apportionment rule in s 35-55 applies to apportion the value of assets for this section where a single asset is used only partly for the business activity. Notice, however, that the relieving tests are not available to individuals whose adjusted taxable income exceeds $250,000 in a year: s 35-10(1)(a) and (2E). If none of these tests is met, s 35-55(1) provides the ATO with a discretionary power to ignore the failure. The discretion can be exercised for one or more income years but is limited to a consideration of the impact of “special circumstances outside the control of the operators of the business activity”, or there is an objective expectation that the business will meet one of the four objective tests “within a period that is commercially viable for the industry concerned”. The ATO has indicated it understands this to mean that the business is in a start-up phase. The operation of the discretion is described in TR 2007/6. [5.195]

Questions

5.14

These rules may seem reasonably straightforward, but consider a few issues regarding the difficulties they present. Do these rules apply to the losses from a negatively-geared investment in real estate? Why not?

5.15

How is the taxpayer’s loss computed, and can the method of calculation trigger or conceal a loss? For example, assume the taxpayer operates a café and bookshop from the same premises, but that they have to be treated as different business activities. She has gross revenue of $6,000 from the café and $15,000 from the bookshop. She pays [5.195]

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5.16

5.17

5.18

5.19

$13,000 as wages to a part-time employee who works for both activities. The taxpayer has an overall profit, but we have to allocate the wages bill. How is this to be done? If it is simply split evenly between the two activities, the café will have a loss. If the cost is apportioned using revenue as indicative, there is no loss. How is extraneous income dealt with? For example, assume the taxpayer has a business bank account and it generates some interest income during the year. Does this income get counted toward the amount of the loss? Is it “assessable income from the business activity”? Now assume the taxpayer has a net loss of $25,000 from its business activity in Year 1, and in the next year the taxpayer has a further loss of $10,000 but now satisfies the $20,000 assessable income test. In Year 2, the taxpayer also has $100,000 income from employment. Clearly the current year $10,000 loss is not affected, and can be deducted from the wages, but what about the $25,000 loss from last year? Does that loss remain restricted or is it now unrestricted and able to reduce the taxpayer’s employment income? You might wish to compare your answer with the view in paragraphs 1.22, 1.23 and 1.27 in the Explanatory Memorandum to the New Business Tax System (Integrity Measures) Bill 2000. What would happen if the taxpayer only had $15,000 of other income in Year 2 – would the taxpayer carry forward an unrestricted loss into Year 3 (to offset against the Year 3 wages) or a restricted loss? There are rules that state what happens if the taxpayer becomes bankrupt (in s 35-20), but what happens if the taxpayer dies before the activity generates a profit? What happens if the partnership is terminated before it generates a profit? What happens if the taxpayer abandons this business activity before it generates a profit? So much for death. What about resurrection? Could a taxpayer restart a business activity that it had abandoned and then restart claiming the former losses? What if the taxpayer shut down its business activity, but purchased a profitable business activity of the same kind from another taxpayer – would the former losses be available?

3. ISOLATED TRANSACTIONS [5.200] The issue so far has been whether the observable characteristics of the taxpayer’s

activities display enough of the relevant characteristics to amount to an ongoing business. One attribute of the archetypal business is that it operates with some continuity over an extended, perhaps indefinite, period – this is the element of repetition. The issue to be considered now is whether activities which are quite “commercial” can amount to a business, or some other notion that attracts the label “ordinary usage income,” when they are isolated transactions without a larger context and with no prospect of longevity or repetition. In other words, if the taxpayer plans a one-shot project, can any profit be taxable as ordinary income, or is it instead governed only by the capital gains tax provisions? One common instance of the issue now under discussion can be seen in the standard dilemma of “empty nesters.” The taxpayer owns a substantial home on the quarter-acre block in the leafy suburbs but the children have now grown up and left home, and the dog has died. If the taxpayer decides to sell the home for $1m, any gain or loss would not be ordinary income – the home was not bought with the conscious intention of selling it and the taxpayer is not carrying on a business because there is no system, repetition and so on – and the family home is exempt from CGT. What would happen if the taxpayer decided to try something more adventurous to raise the sale price – approach the Council for permission to subdivide the land, get a building permit approved, and then sell the back half undeveloped for $1.1m? The 282

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taxpayer might get even more ambitious – demolish the existing house, subdivide the land, erect in its place two smaller townhouses at a cost of $400,000, and then sell them for $2m? In each case, this is a single transaction, probably not to be repeated, but done intentionally to make money. The home was not originally bought with the intention of selling it, but either project involves a deal more effort than a simple sale. Is that money taxable as ordinary income? In both these cases, the activity is clearly a one-shot operation; neither has much in the way of system; and both are on quite a small scale. In short, each one lacks the characteristic elements of an ongoing business. But is that the end of the (tax) story? In Australia prior to capital gains tax, the taxing of an isolated instance of purchase-andsale, or an isolated instance of purchase-development-and-sale, might have been dealt with in any one of five ways: • The most common method was under the “first limb” of s 25A(1) of the ITAA 1936, formerly s 26(a). It taxed the “profit arising from the sale by the taxpayer of property acquired by [the taxpayer] for the purpose of profit-making by sale”. This option was virtually eliminated with the introduction of capital gains tax in 1985. • A profit could also be taxed under s 26AAA if it arose from the sale of an asset within 12 months of its purchase. This option was abolished by s 26AAA(1A) as part of the Economic Statement of 25 May 1988, once the comprehensive CGT had started. • The transaction could be characterised as a “profit-making scheme or undertaking” so that any profit generated could be included in assessable income under the “second limb” of s 25A(1) of the ITAA 1936, now rewritten as s 15-15 of the ITAA 1997. • The transaction could be characterised as an isolated income-generating venture and any profits made would be in the nature of income as the product of that venture and assessable under s 6-5 of the ITAA 1997. • Finally, in a pre-CGT world, no income tax consequences would arise if the transaction amounted to the “mere realisation of a capital asset” even if it were done “in an enterprising way”. Of course, after the introduction of capital gains tax in 1985, this option can give rises to tax consequences, but only under CGT. This section will explore the two ideas of an isolated income-generating venture (s 6-5) and a profit-making scheme (s 15-15) as they are, apart from capital gains tax, the current possibilities for taxing the profit made from an isolated instance of purchase-and-sale or purchase-development-and-sale. We will then consider the means of reconciling these two ideas with capital gains tax. In reading what follows, it is important to bear in mind the different situations being considered and how they fall along the spectrum: • A taxpayer who did not buy an asset with the clear expectation of selling it at a profit, but on discovering that it is now quite valuable, changes her mind and decides to sell it unimproved; • A taxpayer who did not buy an asset with the clear expectation of selling it at a profit, but on discovering that it is now quite valuable, decides to sell it, and undertakes some modest improvements to the asset in order to enhance the profit on reselling it; • A taxpayer who did not buy an asset with the clear expectation of selling it at a profit, but on discovering that it is now quite valuable, decides to sell it, and undertakes significant improvements to the asset in order to maximise the profit on reselling it; • A taxpayer who bought an asset with the clear expectation of selling it at a profit. [5.200]

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(a) Isolated Ventures [5.210] The discussion so far may have given the false impression that income will only be

derived where there is a “business”, and that a business must be characterised by repetition. Clearly, recurrent activity either of buying and selling or of performing services will be important evidence of the existence of a business, but there is ample authority that an isolated or casual transaction may give rise to assessable income – in fact, quite a special type of income-generating activity with its own idiosyncratic tax consequences. The cases discussed below turn on two discrete criteria: • whether the asset was originally bought with the clear expectation of selling it at a profit; and • if the asset was not originally bought with the expectation of selling it at a profit, the extent of the improvements made to the asset in order to enhance the profit on reselling it. There is UK authority that even a single speculative purchase and resale can trigger ordinary usage income. For example, in Rutledge v IRC (1929) 14 TC 490, the taxpayer purchased 1,000,000 rolls of toilet paper in Germany for £1,000 and resold it as one consignment in England, making a profit of over £10,000. The profit was held to be taxable as trading income. Similarly, in Martin v Lowry [1927] AC 312 the taxpayer purchased 44,000, 000 yards of government surplus cloth which he hoped to resell at a profit. When he could not dispose of the cloth in one consignment, he set up premises, employed staff and undertook extensive advertising eventually selling the cloth and making a profit of £1,900,000. The profit was again held to be taxable as trading income. In both cases the taxpayer had purchased just one asset and done little more than resell it, and yet in both cases the profit made was treated as ordinary income because the taxpayer purchased the asset with the clear expectation of reselling it at a profit. The English cases in this area such as Rutledge or Martin v Lowry might be of limited use in Australia because of the specific inclusion in the UK legislation of an “adventure in the nature of trade” as generating income. Nevertheless, it seems clear that in Australia, a single instance of purchase-for-resale will generate ordinary income. As the High Court says in Myer Emporium (extracted below): It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.

Where the taxpayer did not buy with the clear intention – held at the time of buying the asset – of reselling it at a profit, there are difficulties in distinguishing an isolated purchase and sale which generates assessable income from one which does not. Prior to 1985, there was a multitude of cases involving these kinds of one-off deals done by taxpayers without an ongoing business. They were invariably argued by the ATO on the basis that the taxpayer made income under s 25(1) of the ITAA 1936, under the first limb of s 26(a) of the ITAA 1936, or under the second limb of s 26(a) of the ITAA 1936 and it did not really matter which section applied. Sometimes the courts applied s 25(1), sometimes s 26(a) and sometimes they found for the taxpayer. But the case which reminded advisers of the potential application of the 284

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notion of an isolated income-generating venture triggered from changing one’s mind about whether to keep or sell an asset, was the decision of the High Court in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355. In Whitfords Beach the company had purchased a large tract of land (over 1,500 acres) outside Perth in 1954 so that the members of the company could continue to enjoy access to their fishing shacks on the beach. Not surprisingly, as time passed the land appreciated substantially in value (and probably also the attractions of fishing lessened) and the shareholders of Whitfords Beach Pty Ltd changed their minds about keeping the asset and decided to sell the land. They did so by arranging to sell for $1.6 m their shares in Whitfords Beach Pty Ltd to a syndicate of three companies, all of which were property developers. Notice that there was no dispute about the treatment of the profit made by the shareholders on the sale of their shares in Whitfords Beach Pty Ltd – the profit was a capital gain because they had not bought with the intention of resale at a profit, and they had done no more than decide to realise the profit inherent in the increased value of the land by selling the shares. The transfer of the shares was completed on 20 December 1967 and Whitfords Beach Pty Ltd, now under the control of its new shareholders and directors, then proceeded to develop the land for resale. The articles of the company were changed so that development could proceed, and Whitfords Beach appointed two of the purchasers as managers of its land for 15 years with powers to do all that was necessary to subdivide, develop and sell the land. Under the direction of the managers the company then procured the rezoning of the land to permit subdivision and development, and arranged for water to be supplied to the sites, roads to be built, and electricity, sewerage and other services to be provided. The first subdivided lots were sold in 1971. The managers anticipated that the whole project would generate a profit of $7 m by the time it was completed. The ATO assessed the company Whitfords Beach Pty Ltd to tax on the profits from the sale of the land that arose from sales during the years 1972–75. The High Court unanimously upheld the assessment. Notice that the company had not purchased the land with the expectation of reselling it at a profit, but the extent of the development made to the land by the company under the direction of its new owners affected the treatment of the land in the hands of the company. Gibbs CJ held that the profits made by the company from the venture were assessable as income from carrying on a business-like transaction designed to realise a profit, that transaction being the development and sale of the company’s only substantial asset. He began his judgment with a discussion of the history and background to the introduction of s 26(a):

FCT v Whitfords Beach Pty Ltd [5.220] FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355 A profit made on the sale of an asset may be treated as assessable income within the Act for one of a number of reasons. In the first place, if the profit should be regarded as income in accordance with the ordinary usages and concepts of mankind, it will be assessable income within s. 25(1) of the Act. When the owner of an investment chooses to realise it, and obtains a greater price for it than he paid to acquire it, the enhanced price will not be income within ordinary

usages and concepts, unless, to use the words of the Lord Justice Clerk in Californian Copper Syndicate v. Harris (1904) 5 T.C. 159, that have so frequently been quoted: “what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.” In Jones v. Leeming [1930] A.C. 415 it was held by the House of Lords that, assuming that there was no adventure or concern in the nature of [5.220]

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FCT v Whitfords Beach Pty Ltd cont. trade within s. 237 of the Income Tax Act 1918 (U.K.), the profit made on an isolated transaction of purchase and re-sale did not become income merely because the property was bought with the intention of re-selling it at a profit. The case did not decide that the fact that the purchase and re-sale was an isolated transaction necessarily meant that it was not a trading adventure – many cases, before and since, including Californian Copper Syndicate v. Harris and Edwards v. Bairstow [1956] A.C. 14, are opposed to that proposition; what was held was that if, as a matter of fact, the transaction was not a trading transaction, the profit did not become income merely because the asset had been bought with the intention of making a profit on its re-sale. Soon after Jones v. Leeming was decided, the Income Tax Assessment Act 1922 (Cth), which was then in force, was amended by the Income Tax Assessment Act 1930 (Cth) by inserting in the definition of “income” words which were repeated in s. 26(a) of the Act. The profit on the sale of an asset may be assessable income within this provision, even though it would not ordinarily be regarded as income and would not fall within s. 25(1) of the Act. It is sometimes said that the purpose of enacting s. 26(a) appears to have been overcome by the decision in Jones v. Leeming. That statement seems correct so far as the first limb of s. 26(a) is concerned. Having regard to the existing state of the law to which I have referred, the first limb can in my opinion only have been intended to treat as income profits arising from the acquisition and sale of property which was acquired by the taxpayer for the purpose of profit making by sale, notwithstanding that the profits did not arise in the carrying on or carrying out of a business – notwithstanding, in other words, that the profits would ordinarily be regarded as a capital gain. The words of the first limb, when given their ordinary and natural meaning, support this conclusion, for they contain nothing to suggest that capital gains are to be excluded, and if they did apply only to profits that constituted income

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in accordance with ordinary concepts they would effect no alteration to the law as already established. The purpose of the second limb of s. 26(a) is, however, less clear. The enactment of the second limb was not necessary to undo the effect of Jones v. Leeming; the first limb would have been sufficient for that purpose. The words used in the second limb of s. 26(a) do not refer to an operation of business. It may be perhaps that the draftsman of s. 26(a) thought that he should, out of an abundance of caution, enact into legislation the principles already established by the courts. In Premier Automatic Ticket Issuers Ltd v. F.C.T. (1933) 50 C.L.R. 268, Dixon J. said that the adoption of the provision which later became s. 26(a) “probably has no more effect than to give legislative authority to the tests propounded and applied in decisions of this court”. If the words of the second limb are literally construed they are wide enough to include profits which are income according to ordinary concepts as well as profits of a capital nature. In so far as they include profits which are income in character they appear to overlap to some extent the provisions of s. 25(1). In practice in some (if not most) cases it has been found unnecessary to determine whether the profits in question were assessable under s. 25(1) or s. 26(a); it was enough to decide whether or not they were taxable. Although in many cases the assessment will be the same whether the case is regarded as falling within s. 25(1) or s. 26(a), there may be cases in which a different result will be arrived at depending on which provision is held to be applicable. I am not persuaded that a difference will result from the fact that s. 25(1) refers to “gross income” and s. 26(a) to “profit”, for I agree with Mason J. in Commercial & General Acceptance Ltd v. F.C.T. (1977) 137 C.L.R. 373, that “gross income” includes “a net amount which is income according to the ordinary concepts and usages of mankind, when the net amount alone has that character, not being derived from gross receipts that are revenue receipts”. There can I think be no doubt that when particular transactions (for example, the buying

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FCT v Whitfords Beach Pty Ltd cont.

beyond this and engaged in a [business of profit making] in land albeit on one occasion only”.

and selling of stock-in-trade) which might otherwise fall within the words of s. 26(a) form part of the conduct of a wider business, it is not permissible to treat each such transaction as separately taxable under s. 26(a).

The words “merely” and “mere” in these statements seem to me to be an important part of the definition of the line between profits that are taxable and those that are not. If the taxpayer does no more than realise an asset, the profits are not taxable. It does not matter that the taxpayer goes about the realisation in an enterprising way, so to secure the best price. Further, the mere magnitude of the realisation does not convert it into a business. But if the taxpayer does engage in an operation of business, the proceeds are income and taxable.

The present case is not one in which the alleged profit making undertaking or scheme forms part of a larger operation. The alleged scheme forms the whole of the taxpayer’s operations. The question that arises is whether profits arising from the carrying on or carrying out of a profit-making scheme that itself constitutes the whole of the taxpayer’s business are taxable under s. 26(a), notwithstanding that in the absence of the provisions of that paragraph the profits would fall within s. 25(1). It is implicit in what I have said that I consider that the second limb of s. 26(a) includes profits which would not otherwise have fallen within s. 25, because they could not be described as income in the ordinary sense. However, I should make it clear that I regard it as established that profit yielded by the mere realisation of a capital asset not acquired for the purpose of profit making by sale would not be either assessable income within s. 25(1) or the profit arising from the carrying on or carrying out of a profit making undertaking or scheme within s. 26(a). If the second limb of s. 26(a) had the effect of including such profits in assessable income, the first limb would be entirely nugatory. It is clear that the first limb of s. 26(a) has no application to the present case. In the present case the property sold, the land, was not acquired by the taxpayer for the purpose of profit making by sale, although the shares in the taxpayer were acquired by the present shareholders for the purpose of making a profit by the sale of the land. The question whether the profits were income within ordinary concepts depends on the application of the tests laid down in Californian Copper Syndicate v. Harris and in the cases that have followed that decision. The question is “whether the facts reveal a mere realisation of capital, albeit in an enterprising way, or whether they justify a finding that the [taxpayer] went

Since the question to be decided is one of fact, it will be unprofitable to examine the particular circumstances of the various cases in which the question has been discussed. In the present case I gravely doubt whether the profits resulting from the development, subdivision and sale of the land would have been taxable if it had not been for the events that occurred on 20 December 1967. Had those events not occurred, the situation of the taxpayer would have been analogous to that of the company in Scottish Australian Mining Co. Ltd v. F.C.T. (1950) 81 C.L.R. 188. However, on 20 December 1967, the taxpayer was transformed from a company which held land for the domestic purposes of its shareholders to a company whose purpose was to engage in a commercial venture with a view to profit. Counsel for the taxpayer submitted that it was not permissible to blur the distinction between the company and its shareholders. That of course is true, but in deciding whether what was done was an operation of business, it is relevant to consider the purpose with which the taxpayer acted and, since the taxpayer is a company, the purposes of those who control it are its purposes. The three companies which became the shareholders, or the two which became the managers (it matters not which), represented the directing mind and will of the taxpayer and controlled what it did, and their state of mind was the state of mind of the taxpayer. The purpose of those controlling the taxpayer was to engage in a business venture with a view to profit. Moreover, although the taxpayer was not formed for the purpose of selling land, after December 1967 it became a company which [5.220]

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FCT v Whitfords Beach Pty Ltd cont.

that the profits were income within ordinary concepts and taxable accordingly.

existed solely for the purpose of carrying out the business operation on which the new shareholders had decided to embark when they acquired their shares. It is in the light of these circumstances that the extensive work of development and subdivision is seen to be more than the mere realisation of an existing asset and to be work done in the course of what was truly a business venture. For these reasons, although the case is not without its difficulties, I have concluded

Wickham J., at first instance, answered the first question raised for the determination of the court as follows: Question: Does any part of the proceeds of sale of the subject land constitute assessable income of the taxpayer, and if so on what ground? Answer: Yes, all of the proceeds were assessable under the provisions of s. 25. For the reasons I have given I consider that the answer was correct, assuming as I do that “proceeds” was intended to mean “profit”.

[5.230] The decision in Whitfords Beach has been relied upon in a variety of contexts, including in the decision in Myer Emporium (extracted below). In Myer the taxpayer sold to a financier the rights to future interest receipts it was entitled to under a loan it had made to a related company. The transaction was conceived so that the company could make the loan to the subsidiary and, instead of receiving periodic payments of interest which would have been assessable as income, it would sell the stream of anticipated payments for a sum representing their present value, effectively capitalising the expected interest. The High Court held that the profit made on the sale by the taxpayer of the right to receive the payments of interest was of an income nature. The decision does not make clear, however, whether the transaction amounted to its own income-generating activity as the scattered references in the judgment to Whitfords Beach might suggest, or whether it amounted to an unorthodox departure from existing operations but one which was nevertheless sufficiently connected to the existing business operations. This dilemma is explored more fully in Section 4. Courts continue to have to address the notion of an isolated income-generating transaction, even in a post-CGT world. One example is McCurry v FCT (1998) 39 ATR 121. In this case the taxpayers purchased land and constructed three townhouses on it. They attempted to sell the townhouses but were not succcessful and decided instead to move into two of them (the third remained vacant, as the taxpayers never attempted to find tenants for any of the properties). Two years later, the market had improved, and they sold all three townhouses and made a profit of over $70,000. The taxpayers argued that the transaction involved the construction and unplanned sale of an investment property, and that such a series of transactions would generate only a capital receipt, not ordinary usage income. Davies J acknowledged the distinction: Property may be acquired as an investment to provide either potential income returns which are foreseen or as a hedge against inflation in the value of the currency… [But] if a property is acquired in the course of a business or commercial dealing with a view to obtaining a profit from its development and sale, that venture is not regarded as an investment and the profit derived therefrom will be income for the purposes of s 25(1) of the ITAA 1936.

His Honour then continued: In a case such as the present where the taxpayers were not carrying on a business, the profit to be assessable must have been derived from a transaction that can be described as a commercial dealing. A profit making undertaking or scheme is such a dealing. 288

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He found that the taxpayers were carrying out a “commercial dealing” even though it may not have been fully formed in their minds when they purchased the land. Hence their profit was assessable under s 6-5, and not only under CGT: In my opinion, the taxpayers entered into a profit-making undertaking or scheme which was a business or commercial dealing in the sense I have described when they acquired the property … Their venture was a trading venture and from this venture they made the profit which had been anticipated.

The decision in CMI Services Pty Ltd (1990) 21 ATR 445 is another example. The issue in this case was, just how committed does the taxpayer have to be at the time of acquisition to reselling the asset? The possibility of eventually reselling the asset “if I can get a good price” is probably lurking in the back of the minds of most buyers of investment-type assets, such as real estate, shares, collectibles or artworks. It is raised a bit more starkly for the owners of negatively-geared real investments. These taxpayers buy a property aware that the monthly rent will not cover their regular expenses – interest, rates, repairs, insurance and so on. Given that they are making an annual loss, the investment only makes sense if the value of the property is increasing by at least the difference, but this increase in value can only be realised by selling the property. So does this mean that every negatively-geared property investor will make ordinary income when they sell the property – that is, they must have bought with the purpose of selling the property? Justice Lockhart examined this difficulty and hints that the answer is to determine which purpose was primary – earning the inadequate current income, or making a profit by sale: In one sense most investors in property, real or personal, who primarily seek a satisfactory return of income on their investment, make their investment decisions with an eye to the possibility of resale if the income does not come up to expectation. Speaking generally, they do not carry on the business of buying and selling those assets. But if their activities are in real estate, in substantial sums and not inconsiderable in volume and are undertaken with the intention of reselling the properties if the income yield is not satisfactory the question becomes more complex. The answer depends on the facts of the particular case.

Before we leave this discussion it is worth pointing out again that this issue is relevant only for taxpayers who do not already operate a business – for them the issue is, did the taxpayer purchase the asset with the clear expectation of reselling it at a profit? But for taxpayers who carry on a business, the analysis is different because the existence of the business creates the presumption that they are acting for the purpose and with the expectation of making a profit. In Westfield (discussed below) Hill J put it this way: In a case where the transaction which gives rise to the profit is itself a part of the ordinary business (for example, a profit on the sale of shares made by a share trader), the identification of the business activity itself will stamp the transaction as one having a profit making purpose. Similarly, where the transaction is an ordinary incident of the business activity of the taxpayer, albeit not directly its main business activity, the same can be said. The profit making purpose can be inferred from the association of the transaction of purchase and sale with that business activity.

Once it is clear that the activity of buying and selling, which generated the profit, was not an activity in the ordinary course of business, or, for that matter, an ordinary incident of some other business activity, the profit in question will only form part of the assessable income of the appellant, by virtue of its being income in accordance with the ordinary concepts of mankind, if the appellant had a purpose of profit making at the time of acquisition. [5.230]

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The Tax Base – Income and Exemptions

[5.235]

Questions

5.20

What circumstances in the Whitfords Beach case led the Court to conclude that this activity was carrying on an income-generating activity, and not the mere realisation of a capital asset that had not been bought for the purpose of resale at a profit?

5.21

Does it make any difference to the tax consequences if the taxpayer is assessed under s 15-15 or as an isolated income-generating activity? What if the venture produces a loss? (See s 25-40.)

5.22

The reach of the ordinary usage notion into the realisation of land that was a capital asset when it was purchased causes some problems of overlap with s 15-15. How does Whitfords Beach deal with the potential overlap between the isolated venture and s 15-15?

(b) Statutory Profit-Making Schemes [5.240] Running in tandem with the common law concept of an isolated income-producing venture is the statutory extension – the “profit-making undertaking or scheme”. This idea used to be referred to as the “second limb” of s 25A, and before that the second limb of s 26(a) of the ITAA 1936. It is now expressed in s 15-15 of the ITAA 1997. Section 15-15 includes in assessable income the “profit arising from the carrying on or carrying out of any profitmaking undertaking or plan”. But, following the introduction of capital gains tax, the section is qualified by s 15-15(2)(b) so that it “does not apply to a profit that arises in respect of the sale of property acquired on or after 20 September 1985”. Thus it seems at first glance to be a mere historical curiosity confined to transactions with property owned prior to 1985. It was always a matter of much conjecture to speculate exactly how far s 26(a) and then s 25A went towards establishing an implicit capital gains tax in Australia. When capital gains tax was introduced in 1985, this debate was thought to be rendered moot because of the enactment of s 25A(1A) (now s 15-15(2)(b)). Many understood the effect of this provision to be to limit the section exclusively to transactions with property which was owned by the taxpayer on 19 September 1985. The ATO appears not to share this view. The present attitude of the ATO, so far as it can be gleaned, is that s 15-15 will also apply to profits arising from carrying out a profit-making scheme where a taxable profit is realised without a “sale”. This view can be seen in the comments of the ATO in Taxation Ruling IT 2495 on so-called debt defeasance arrangements (which has now been withdrawn). The effect of this interpretation is that s 15-15 still has some potential scope for operation in respect of property acquired post-September 1985 where the taxpayer carries out a scheme which does not involve a sale of property. Cases such as XCO Pty Ltd (1971) 124 CLR 343 and Bidencope (1978) 140 CLR 533 – which deal with buying debts at a discount and then collecting more than their cost – show that profit can arise without the occurrence of a “sale”. Where the property sold by a taxpayer was acquired prior to September 1985, or the profit arises from a transaction that is not a “sale”, the second limb of s 25A can operate to impose tax upon the profits generated from a single speculative transaction. Being a statutory rule, the limits of the provision are at least formally fixed by the terms of the Act and close attention has to be given to the judicial interpolation that occurred in relation to the predecessors of s 15-15. The earlier versions were subject to many arcane judicial limitations imposed through the multitude of cases. This common law remains important today in the interpretation of s 15-15 290

[5.235]

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of the ITAA 1997. Earlier editions of this book consider some of these cases – Steinberg v FCT (1975) 134 CLR 640, McClelland (1970) 120 CLR 487 and so on. Notice one important structural issue. There is likely to be an overlap problem where an isolated transaction might give rise to assessable income under s 6-5, as well as a profit under s 15-15, and a capital gain under the capital gains tax provisions. The two contradictory possibilities suggested for correlating ss 6-5 and 15-15 are complete conjunction and complete disjunction: • It was suggested by the Privy Council in McClelland (1970) 120 CLR 487 that s 15-15 was applicable only to gains from schemes which would have been assessable income already. This follows from the remarks that a s 15-15 scheme must exhibit the characteristics of a business deal and also the suggestion that the argument that the taxpayer was carrying on a business “introduced no new element in the problem”. • Some members of the High Court suggested in Steinberg and in Whitfords Beach that the second limb only operated to tax amounts which would have been a capital gain. For example, Gibbs CJ in Whitfords Beach said: “although the provisions of s. 26(a), if given full effect, would overlap those of s. 25, the second limb applies only to profits not attributable to gross income that has already been captured by s. 25.” There is also authority in Investment & Merchant Finance that s 15-15 cannot apply to a transaction which forms part of a continuing business. This debate about the priority between s 6-5 and s 15-15 is rendered largely redundant by s 15-15(2)(a). It now provides that the section does not apply to a profit that is assessable as ordinary income under s 6-5. The debate about the priority between CGT and s 15-15 is not principally a matter of judicial interpretation. Because s 15-15 will usually deal with assets, the potential for overlap is real, but s 118-20 of the ITAA 1997 is intended to operate to reduce the amount of any capital gain by the amount that will be taxed under s 15-15. That is, preference is given to taxing the profits under s 15-15. [5.245]

5.23 5.24

5.25 5.26

5.27

Questions

How far does s 15-15(2)(b) restrict any residual operation for the section after capital gains tax? Is it possible for the “profit arising” from a profit-making scheme to be realised without a sale occurring? For example, do the debt-factoring transactions in XCO and Bidencope involve the “sale” of property? How would XCO and Bidencope be decided after capital gains tax? Does the transaction involve a CGT event with an asset? (See s 104-25(1) of the ITAA 1997.) Assume that under s 15-15 the profit would be $45,000 but under capital gains tax (apart from s 118-20) the capital gain would be $50,000. This could arise if the assets ventured in the scheme are valued at a time later than their acquisition. How will s 118-20 operate? Assume the reverse: that the net capital gain is $25,000 and the profit under s 15-15 would be $50,000 because of the 50% reduction for capital gains derived by individuals. How will this overlap be dealt with?

4. DEFINING THE SCOPE AND ORDINARY COURSE OF THE BUSINESS [5.250] Once the existence of a business has been divined, the taxation of the receipts and

outgoings of the business operates on the assumption that gains made on transactions “within [5.250]

291

The Tax Base – Income and Exemptions

the scope and ordinary course of the business” are income. This proposition suggests the corollary that a gain needs to be within the ordinary course of the business to fall within the business gains principle, and so it is necessary to define the “metes and bounds” of each business. The cases usually quote the judgment of Dixon and Evatt JJ in Western Gold Mines NL v C of T (WA) (1938) 59 CLR 729 at 740 that, “in considering whether a profit arising from a transaction is of an income or capital nature, it is necessary to make both a wide survey and an exact scrutiny of the taxpayer’s activities”. One way to see this issue is to ask the question: Why is it that the proceeds of sale of a real estate developer’s own home are not income? The answer is because selling your own home does not fall within the ordinary course of the taxpayer’s business activity – it is inadequately connected with carrying on the real estate development business. So we need a test to define, or at least describe, where a taxpayer’s business starts and stops. It is in essence a connection test and it is the same question that was asked in Chapter 4 when dealing with income from personal services. In that context the question was framed: Is the payment the product of the services? In this section the question is framed: Is the payment the product of the business? The cases will often phrase the question as: Is the transaction “within the scope and ordinary course” of the taxpayer’s business? The evidence that the question is the same will be apparent when reading the next extracts – they deal with the same types of problems: gifts, prizes and so on – and there is even a reference in Federal Coke to the judgments in Hayes and Scott. But there is a second aspect to this phrase, “the scope and ordinary course of the business”. Not only do we need to define where the business starts and stops – that is, its scope – it is also apparently necessary to distinguish various kinds of receipts which admittedly are sufficiently connected to the business, but nevertheless are not among the receipts that it is within “the ordinary course” of the business to receive. This may be another way of asking the scope question, but it is not treated in this manner in the cases. It may also be another way of asking the question with which section 5 of this chapter is concerned (the character of assets), but again it is not treated in this manner. But we will assume that there are two questions to ask: • A connection question: What transactions are sufficiently connected to the business to be within the scope of the business? In other words, does this transaction derive from the business operations, or to put it another way, is there a “perceived connection” between the taxpayer’s business and this transaction?; and • A character question: Are those transactions within the ordinary course of the business? That is, are the transactions what an accountant might call abnormal or extraordinary?

(a) Gifts, Prizes and Windfalls [5.260] In order for a receipt to be income of the business, it must be a product of the business

– that is the meaning of the connection or scope of the business test. One of the clearest situations where some disjunction between the business and gain might arise would be likely to be gifts and other unexpected and unsolicited payments. An example of a gift-type payment which was held not to produce assessable income arose in Federal Coke Co Pty Ltd v FCT (1977) 7 ATR 519. Bellambi had negotiated a fixed-price long-term contract to supply Le Nickel with rutile. The contract had been negotiated at a time when the price was high, but the bottom dropped out of the rutile market and Le Nickel found it could buy its requirements much cheaper on the spot market. It asked to be released from the contract and Bellambi agreed, provided Le Nickel paid compensation. The compensation payment was made, but it was paid to Federal Coke, a company related to Bellambi. In the 292

[5.260]

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Federal Court, Bowen CJ held that the payments made to Federal Coke did not have an income character because they were insufficiently connected to any recognised incomeproducing activity conducted by Federal Coke – either the provision of services or carrying on its business:

Federal Coke Co Pty Ltd v FCT [5.270] Federal Coke Co Pty Ltd v FCT (1977) 77 ATC 4255 Each receipt in the hands of Federal is broadly in the nature of a gift, being a sum received without consideration. Certainly Federal, although it suffers economic detriment as one of the consequences of the compromise arrived at between Bellambi and Le Nickel, was not a party to the amending deed and gave no consideration either to Bellambi or to Le Nickel, by reason of the amending deed entered into with Bellambi, was no doubt obliged to make the payment and Bellambi could have enforced it. But so far as Federal was concerned, each payment was received by that company on a voluntary basis. In my view, for purposes of income tax, the same principles apply in determining whether an amount received without consideration is income as apply in determining that question in relation to a gift proper. A mere gift or receipt without consideration, if nothing more appears, is prima facie not income in the hands of the recipient (Hayes v. F.C.T.). Further facts may appear which show that it was so related to income-earning activities of the recipient as to be, in truth, a product of those activities. Thus gifts by employers to employees related to their services have been held to be assessable income. Gifts to persons who are not employees but which are related to services which they have rendered such as tips to a waiter, a railway porter or a taxi cab driver, or a jockey, have been held to be income. The same principle applies in the case of persons or corporations engaged in some profession or business. Thus an additional payment made by the government to a wool grower, who had previously submitted wool for appraisal and been paid for it, the additional payment by the government being discretionary

but related to the amount of wool supplied, was held to be in a real sense a product of the business of wool growing carried on by the recipient and to be income in its hands (Squatting Investment Co. Ltd v. F.C.T. (1953) 86 C.L.R. 570). On the other hand, a payment made to a solicitor by a woman client for whom he had acted, which was held on the evidence to be not a product of his professional activities but a payment made by way of bounty, was held not to be income in his hands (Scott v. F.C.T. (1966) 117 C.L.R. 514). In the present case, and regarding the matter from Federal’s point of view, it is seen that the two receipts were part of one large and unprecedented sum; that they were received without any consideration passing from that company; and that they were in no sense the product of any business or income producing activities which it carried on. Federal’s business was the production of coke and even this had ceased by the time the payments were received. Federal did not carry on any business of receiving payments or acting as banker or financial repository on behalf of Bellambi or the Bellambi group. Furthermore, the receipts did not constitute a compensatory equivalent for any loss suffered by Federal in its business. They were treated in its accounts as a capital receipts. Even if it should be held that in their origin in the arrangements made between Bellambi and Le Nickel the receipts should be regarded as somehow impressed with the character of income, it does not appear to me, having regard to the circumstances of Federal. On the contrary, having regard to all the circumstances, it appears to me that in the hands of Federal they bore the character, not of income, but of capital.

[5.270]

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The Tax Base – Income and Exemptions

[5.280] FCT v Cooke and Sherden (1980) 10 ATR 696 (extracted in Chapter 2 at [2.230]) is

often taken to be another example of the same issue as Federal Coke. In Cooke and Sherden, the taxpayers were not assessed on the value of a holiday awarded to them by their principal supplier. But Cooke and Sherden is probably not a case about a receipt that was insufficiently connected to the taxpayer’s business. Rather, it was primarily decided on the convertibility issue – either there was no income as the holiday was not convertible into cash, or the amount of income was of nil value because that was the amount of cash into which the prize could be converted. But the prize was undoubtedly the product of their business. The existence of a valuation rule (similar to that found in s 26(e)) applicable for this kind of business benefit would have led to some amount being included in their income. That rule, which is now supplied by s 21A of the ITAA 1936, is discussed below. Notwithstanding the impression that might be conveyed by Federal Coke and Cooke and Sherden, prizes, gifts, windfalls and other unsolicited payments can be the product of a business. The leading example of a windfall payment which was held to be income as the product of a business arose in the decision of the Privy Council in FCT v Squatting Investment Co Ltd (1954) 88 CLR 413. At the outbreak of World War II, the UK government agreed to purchase all of Australia’s surplus wool production for the duration of the war at an established price. If the wool was subsequently to be resold outside the UK, it was agreed that any profits would be divided equally between the governments of Australia and the United Kingdom. The Australian government passed regulations acquiring the whole of the wool clip in every year and paid graziers compensation for their wool. The taxpayer in this case sold its wool and was compensated. After the end of hostilities the wool reserves were sold and payments were made to the Australian government which decided to distribute these additional amounts to the people who had supplied the wool. The taxpayer in this case received £22,851 paid by the Australian Wool Realization Commission. The Privy Council held the amounts to be income:

FCT v Squatting Investment Co Ltd [5.290] FCT v Squatting Investment Co Ltd (1954) 88 CLR 413 What, then, is the nature of the payment now in question, and in what capacity did the respondents receive it? Having regard to the whole history of the matter, beginning with the Wool Purchase Arrangement and the regulations of 1939, continuing with the submission of wool for appraisement by the respondents and the classification of that wool as participating wool, and ending with the payment of the sum in question pursuant to s. 7 of the Act of 1948, their Lordships come to the conclusion that the payment must be regarded as an additional payment voluntarily made to the respondents for 294

[5.280]

wool supplied for appraisement or, if the compulsory acquisition can properly be described as a sale, a voluntary addition made by the Commonwealth to the purchase price of the wool. Their Lordships are in agreement with the reasoning and the decision in Ritchie’s case (1951) 84 C.L.R. 553, and the following passages are particularly germane to the present problem: “they (the payments) constitute receipts resulting from the operations of wool-growing. As possible or contingent receipts they were in contemplation when the appraisements were made. The title to receive them when in the end it is placed on a

Business Income

FCT v Squatting Investment Co Ltd cont. legal basis consists in the submission of shorn wool for appraisement for the purposes of the Wool Purchase Arrangement. … They are receipts resulting from the operations of growing wool.” The respondents were in business as wool suppliers at all material times, and the payment was made to them, not because of any personal qualities, but because they, among others, supplied participating wool. They supplied the wool in the course of their trade and this further payment was made to them because they

CHAPTER 5

supplied it. In the present case the respondents were still trading when the payment was made. It was in their hands a trade receipt of an income nature. Their Lordships express no opinion as to the proper description of the payment in the hands of a payee who was not trading at the date of the payment, as this case is not before the Board. … For these reasons, which are in substance the same as the reasons given by Fullagar and Kitto JJ. in the High Court, their Lordships are of opinion that the sum in question forms part of the assessable income of the respondents under s. 25 of the Income Tax Assessment Act.

[5.300] There are also various statutory provisions which confirm that unsolicited payments

can be income as the product of a business. Section 15-10 of the ITAA 1997 (discussed below) provides, if it were in doubt after Squatting Investments, that bounties and subsidies paid to a person who carries on a business will be included in its assessable income. Another issue can arise concerning gifts in-kind, a matter we have examined in Chapter 2. Amendments to overturn the decision in Cooke and Sherden now exist in s 21A of the ITAA 1936. Section 21A(1) deems a “non-cash business benefit” to be convertible into cash. The term “non-cash business benefit” is defined in s 21A(3) to mean property or services provided “in respect of” or “for or in relation directly or indirectly” to a business relationship. You will already have observed that these terms are the same as the connection test provided for services income in s 15-2 of the ITAA 1997 and in the definition of fringe benefit in s 136(1) of the Fringe Benefits Tax Assessment Act 1986. Section 21A seems intended to operate simply as a valuation regime. It does not, apparently, make into income an amount which does not already have an income character, or at least, would have an income character if it were convertible into cash. This follows from s 21A(2) which ascribes a value “if a non-cash business benefit … is income derived by a taxpayer”. It is also the view expressed in the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 4) 1988 which introduced the section. [5.305]

5.28 5.29

5.30

5.31 5.32

Questions

Would the amount involved in Federal Coke have been income to Bellambi if it had received the amount instead of Federal Coke? The members of a sport team make a gift to the owner of the field where they practise each week, hoping that it will help the owner of the field to stay in business. Is the gift income? (See IRC v Falkirk Ice Rink (1975) 51 TC 42.) A taxpayer won a competition run by a daily newspaper which rewarded the newsagency which sold the highest number of newspapers beyond a set target. The prize was a motor vehicle which the taxpayer then sold. Is the prize income? (See Case V6 (1987) 87 ATC 140.) How much income would have been derived by the taxpayers in Cooke and Sherden if s 21A had been enacted at that time? How would s 21A affect these transactions: [5.305]

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The Tax Base – Income and Exemptions

(a) (b)

5.33

a supplier makes an interest-free loan to a dealer; a supplier makes a loan at market interest rates but forgives the loan prior to repayment; (c) a supplier grants credit to a dealer who could not obtain credit from another source; (d) the owner of the premises grants a “rent-holiday” to the tenant for two months? How would the decisions in Federal Coke, Cooke and Sherden, and Squatting Investment be affected by capital gains tax?

(b) Government Subsidies [5.310] In the interventionist world of modern government and commerce, it is common for

taxpayers to solicit and receive direct or indirect subsidies to assist them with their businesses. Section 15-10 of the ITAA 1997 includes subsidies in the assessable income of a taxpayer where the payments are received in relation to carrying on a business. A “subsidy” is not defined in either Act and not surprisingly, there have been some disputes as to what constitutes a subsidy. In the context of the ITAA 1936, a key question confronting the courts was whether s 26(g) (the provision as written in the 1936 Act) applied only to amounts that would constitute ordinary income in any case or whether it extended to amounts that would be considered capital receipts under ordinary concepts. The ITAA 1997 resolves this issue by stipulating that s 15-10 applies only to subsidies that are not ordinary income. But that provision implies that there is some scope for s 6-5 to include a subsidy in assessable income as an aspect of ordinary usage income. The High Court decision in GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124, displays a subsidy (of a kind) that was assessable under the ordinary concepts notion. The High Court did not even bother to consider s 15-10. The taxpayer was a joint venture company incorporated for the sole purpose of performing a contract with the State Energy Commission of Western Australia (SECWA) to coat the pipes to be used in a natural gas pipelines. GP had proposed to use a plant in The Netherlands to coat the pipes, but SECWA insisted it be done locally at a plant which would have to be built for the purpose. It was estimated by GP that the cost of constructing a local plant would be about $4,252,600 and that the residual value of the plant, after the contract had been performed, would be about $1,115,300. To enable the construction of a local plant, SECWA agreed to pay an “establishment fee” to GP of $4,675,000. The ATO claimed that this amount was income to the company. In the High Court, Brennan, Dawson, Toohey, Gaudron and McHugh JJ observed:

GP International Pipecoaters Pty Ltd v FCT [5.320] GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124 The question in this appeal is the character of the establishment costs as receipts in the hands of the taxpayer. “Whether or not a particular receipt is income depends upon its quality in the hands of the recipient” (Scott v. F.C.T.). The relevant question is not the character of the expenditure 296

[5.310]

by SECWA. A receipt may be income in the hands of a payee whether or not it is expenditure of a capital nature by the payer. Nor is the relevant question the nature of the expenditure made by the taxpayer in the construction of the plant. A taxpayer may apply income in the acquisition of a

Business Income

GP International Pipecoaters Pty Ltd v FCT cont. capital asset or, conversely, apply a capital receipt to discharge a liability of a non-capital nature. The Commissioner and the taxpayer both treated the cost of constructing the plant as capital expenditure, but the question is not whether that was an expenditure of capital nor whether the plant was used for the purpose of producing assessable income so that depreciation of the plant was deductible under s. 54 of the Act. The relevant question is whether the receipt of the establishment costs was income in the taxpayer’s hands. It is necessary to keep that question steadily in mind and not to confuse the character of the receipt with the nature of the asset acquired by application of the moneys received. Although the amount received as establishment costs was expended by, and was intended by SECWA to be expended by, the taxpayer to meet the costs of constructing the plant so far as that amount would extend, and although the amount expended on the construction of the plan was a capital expenditure, it does not follow that the taxpayer’s receipt of the establishment costs was a receipt of capital. To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by the recipient’s purpose in engaging in the transaction, venture or business. The factors relevant to the ascertainment of the character of a receipt of money are not necessarily the same as the factors relevant to the ascertainment of the character of its payment. What was the scope of the business in which the establishment costs were received and what was the taxpayer’s purpose in engaging in it? The taxpayer submits that its business consists in the coating pipes, not in the construction of the

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plant. Therefore it is that contract which is critical to the ascertainment of the true scope of the taxpayer’s business. The activity of the taxpayer corresponds with what the contract required. The contract defines both what the taxpayer was bound to do and the consideration for doing it. It bound the taxpayer to construct the plant and to coat the pipe required by SECWA, and conferred on the taxpayer a right to receive the moneys payable thereunder including the establishment costs. The terms of cll. 3 and 4 of the contract show that the entirety of the obligations on one side were to be performed in consideration of the agreement to perform the entirety of the obligations on the other. The establishment costs were received by the taxpayer under the contract as part of the monetary consideration payable for the taxpayer’s agreement to perform, or its performance of, the entire contract. It is impossible to treat the business of the taxpayer as limited to the coating of the pipe when the construction of the pipe-coating plant was an integral part of the work which the taxpayer was bound to perform. The establishment costs were not received under a severable part of the contract relating to the construction of the plant. By constructing the plant and coating the pipe the taxpayer performed the obligations in consideration for which it was entitled to be paid the establishment costs and other moneys payable under the contract. It earned the money by doing the work it had contracted to do. Looking at the contract as it was to be performed, it is clear that the cost of constructing the plant was the taxpayer’s debt, not SECWA’s; and the plant was the taxpayer’s asset, not SECWA’s. If the establishment costs had been received as the price on sale of the plant which the taxpayer had constructed for its own purposes, the receipt may well have borne the character of capital. The establishment costs were not received on either of those bases. The establishment costs were received under the contract which provided that the taxpayer should construct the plant for its own use and retain ownership of it. The taxpayer received the establishment costs and owned the plant it constructed. To say that the taxpayer made no profit in constructing the plant is to overlook the [5.320]

297

The Tax Base – Income and Exemptions

GP International Pipecoaters Pty Ltd v FCT cont. fact that the taxpayer’s receipt of the establishment costs allowed it to construct the plant it needed to perform its contractual obligation of pipe-coating at a net cost to itself which was $4,675,930 less than the actual cost of construction. This sum was a gain by the taxpayer, made in and by reason of the ordinary course of the business which it carried on. Applying “a business conception to the facts” the receipt of the establishment costs must be classified as a receipt of income. There was no disposition of a capital asset throughout the entire venture, yet the work which was done – construction and coating – yielded receipts consisting in the establishment

costs plus the amounts paid for coating the length of pipe required. If that aggregated sum be treated as the revenue derived from the carrying on of the business, the profit is arrived at by deducting expenditure on revenue account incurred in pipe-coating and the depreciation of the plant. That result accords with business conceptions, but it would distort those conceptions to omit the receipt of $4,675,930 from the calculation of a revenue profit arrived at after deducting depreciation on the plant. To omit the receipt of $4,675,930 from the calculation of the revenue profit would require the receipt to be treated as a capital profit, though it was not received as a gift intended to replenish capital nor in exchange for a capital asset.

[5.330] Where a subsidy would not be income according to ordinary concepts, s 15-10 must

also be considered. In the context of both the ITAA 1936 and 1997, the possible application of the provision raises two questions: first, is the amount received a “subsidy”; and second, if so, is it received “in relation to carrying on a business”? Both these issues arose in First Provincial Building Society Ltd v FCT (1995) 30 ATR 207. The taxpayer was a building society required under State legislation to contribute to an industry-wide “Contingency Fund” established to protect depositors’ funds in case of failure by a building society. When a national scheme was established for the supervision and regulation of building societies, the State scheme was no longer required. The State government passed legislation providing for the assets of the fund to be transferred to the State’s consolidated revenue, and further provided for payments from consolidated revenue to each building society – the amount calculated by reference to each society’s contributions to the fund. The taxpayer appealed a private ruling that said the entire payment would be assessable in its hands. Somewhat surprisingly, on the appeal the taxpayer conceded the payment was a “subsidy” and this issue was not considered in great detail by the Full Federal Court, which heard the taxpayer’s appeal. Nevertheless in his judgment, Hill J discussed the meaning of subsidy before looking at whether the payment was received in relation to carrying on a business:

First Provincial Building Society Ltd v FCT [5.340] First Provincial Building Society Ltd v FCT (1995) 30 ATR 207 It was conceded, on behalf of the applicant, that the present payment could correctly be described as a “subsidy” within the meaning of that word in s 26(g), albeit not a subsidy made assessable income within the words of the paragraph. In my view, that concession was correctly made.

298

[5.330]

The word “subsidy” appears originally to have applied to taxes or tributes granted by Parliament to the King for the urgent need of the kingdom. … However in modern usage, as Jowitt’s Dictionary of English Law observes, the word: “generally means financial assistance granted by

Business Income

First Provincial Building Society Ltd v FCT cont. the Crown”. This is the meaning which the word truly has in the present context. The word, in the context of an agreement which provided that the Commonwealth would pay a “subsidy” to a company was said, by Windeyer J in Placer Development Ltd v Commonwealth, to derive from the Latin subsidium meaning “an aid or help”. His Honour said: The word is no longer used in its early legal sense of a grant to the Crown. It ordinarily means today not aid given to the Crown but aid provided by the Crown to foster or further some undertaking or industry. … There are two limbs to the first part of para (g). The first includes in assessable income a bounty or subsidy received by the taxpayer in the carrying on of a business. In that context the word “in” means “in the course of” and requires a direct relationship to exist between the bounty, on the one hand, and the carrying on of the taxpayer’s business, on the other. The second limb comprehends a bounty or subsidy received “in relation to” the carrying on of the taxpayer’s business. These words no doubt are sufficiently wide to cover the first limb, but were obviously intended to extend it. Thus the relationship between the receipt of the bounty, on the one hand, and the carrying on of the business, on the other, may be less direct where the second limb is sought to be applied than where the first limb is applied. Under either limb, the relationship must be to the “carrying on” of the business. These words may perhaps be understood in opposition to a relationship with the actual business itself. They would make it clear, for example, that a bounty received, merely in relation to the commencement of a business or the cessation of the business, would not be caught. The expression “carrying on of the business” looks, in

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my opinion, to the activities of that business which are directed towards the gaining or producing of assessable income, rather than merely to the business itself. The applicant in the present case is a building society. Metaphorically it can be said that it trades in money, even if it is not strictly correct to call money its stock in trade … There are, on the facts of the present case, no restrictions on the way in which the money received by the applicant may be used, any more than there are restrictions upon the way in which its share capital may be used. The payment, when made, would form part of the ordinary circulating assets of the applicant to be used in its day to day activities. It is true also that the amount received from the Queensland Government would assist the applicant to meet its capital adequacy requirements without the need for capital restructure (at least to that extent). In a real sense, however, the payment assists the applicant to continue to carry on its building society activities and can thus be said to have been made in relation to the carrying on of its business. The words “in relation to” are words of wide import. They are capable of referring to any relationship between two subject matters, in the present case the receipt of the bounty or subsidy, on the one hand, and the carrying on of the business, on the other. … If the relationship were a merely remote one, para (g) would have no operation. What is necessary, at the least, in the present context is that there be a real connection. But the existence of the alternative first limb of the paragraph makes it clear that the relationship need not be direct, it may also be indirect. In my opinion, the present is a case where there is a real relationship between the amount paid by the Queensland Government, on the one hand, and the carrying on by the applicant of its business as a building society on the other, so that the amount forms part of the applicant’s assessable income under s 26(g).

[5.340]

299

The Tax Base – Income and Exemptions

[5.345]

5.34

Question

A taxpayer invested heavily in new plant and equipment in reliance upon the continuation of a current government tax exemption for products made using recycled inputs. Shortly afterwards, the government repealed the tax exemption and the taxpayer’s products became liable to sales tax. The taxpayer sought some recompense from the government and the Treasurer agreed to make ex gratia payments to a range of people including the taxpayer. The amount of the payment was based on the amount of future sales tax to which the taxpayer’s customers would now suffer. Is the amount a subsidy? (See Re Softex Industries [2002] AATA 1232.)

(c) Illegal Activities [5.350] The fact that a business is illegal or does lawful things in an illegal way is irrelevant to

whether its proceeds will be taxed. Illegal receipts can be adequately connected to a business to be taxable. In the United States, where illegality is apparently more common (some tax investigators even carry guns), there has been greater attention to taxing ill-gotten gains. In US tax jurisprudence the Supreme Court noted in James v United States (1961) 366 US 213 that, it had been a well established principle … that unlawful, as well as lawful gains the term “gross income”. Section 11B of the Income Tax Act of 1913 provided that “the net income of a taxable person shall include gains, profits, and income … from … the transaction of any lawful business carried on for gain or profit, or gains or profits and income derived from both legal and illegal sources,” to remove the incongruity of having the gains of the honest laborer taxed and the gains of the dishonest immune.

In the US, this principle has been applied to gains from illicit traffic in alcohol, protection payments made to racketeers, ransom payments made to kidnappers, bribes paid to public officials, money derived from the sale of unlawful insurance policies, graft, black market gains, funds obtained from the operation of lotteries, gains on the illegal sale of narcotics, income from race track bookmaking and illegal prize fight fixtures. It also led to the conviction and imprisonment of Al Capone in 1931 for evasion of income tax laws, rather than a conviction of murder, robbery or extortion. In Australia, the position is not always so easy because, in order to be taxable, the illegal activities must display the elements that make it a continuing business or an isolated business venture for the profits to be taxable. For example, in Case W27 (1989) 89 ATC 4946; AAT Case 4946; 20 ATR 3340, the taxpayer embezzled funds from his company, but, as the Tribunal noted, “it [was] unreal to view his pattern of activity during 1982 as constituting the carriage of a systematic business of defrauding his own company. Such a finding would be necessary to support the respondent’s argument [that the money was assessable].” With the exception of Zobory v FCT (1995) 30 ATR 412 (which dealt with the assessability of interest earned on stolen money) and FCT v La Rosa (2003) 129 FCR 494; [2003] FCAFC 125 (which dealt with the deductions available to a drug dealer who was robbed of his cash), the closest that most of the reported Australian cases approach allegations of illegality is in trying to determine the tax consequences of gambling. We have already seen an example in Martin but it is rather trifling compared to reported US decisions. That is not to say, however, that crime is not evident in tax law in Australia – many skirmishes between the well-known Sydney identity, 300

[5.345]

Business Income

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Abe Saffron, and the ATO in relation to undisclosed income can be seen reported in the tax decisions: see, for example, Saffron v FCT (1991) 22 ATR 131 and Saffron v FCT (No 2) (1991) 22 ATR 307. The ATO has issued Taxation Ruling TR 93/25 on the taxation of income from illegal activities. It expresses the view that illegal activity can be sufficiently organised, repetitive and profit-oriented that it will amount to a business activity and be taxable: 1.

What is normally accepted as income is determined according to the ordinary usages and concepts of humankind. Receipts from a systematic activity, where the elements of a business are present, are income irrespective of whether the activities are legal or illegal.

2.

In the case of an isolated transaction, the assessability of the proceeds must depend on the circumstances of each case.

3.

Where an amount included as income is recovered or repaid, this amount may be excluded from the assessable income of the year in which the proceeds were derived, subject to the objection and amendment provisions of the ITAA and the TAA 1953. This Ruling does not sit easily with Zobory which held that a thief was not assessable on the interest earned on stolen money because he held the interest (and presumably also the principal) on trust for his victim. If that is so as a matter of trust law, then presumably it must be the case that the perpetrator is a mere trustee whether he acts once or often. Another potential area where the consideration of illegality might have been raised is the doctrine of ultra vires. But the abolition of the former requirement that a company have defined objects in its memorandum of association has reduced the scope even for this possibility. [5.355]

Questions

5.35

The reports are littered with cases in most of which the taxpayers are held not to be carrying on a business of gambling, although the ATO has been successful on a number of occasions. Section 118-37 of the ITAA 1997 also excludes gains from gambling from the operation of capital gains tax. Should gambling profits be excluded from the income tax base? What consequences would you expect to follow from the exclusion?

5.36

While gambling profits may be outside the income tax system in most cases, gambling is not excluded from other tax bases in Australia. The States rely upon gambling taxes for a significant proportion of their revenue. What do you think would be the likely incidence of these taxes? Would it be preferable if this revenue were collected through the income tax? Would the American system be preferable where the bookmaker withholds tax from winnings?

5.37

Assume the taxpayer is involved in armed robbery activities. What would be the tax treatment of the costs of undertaking this activity – cars, firearms, bribes and so on? FCT v La Rosa (2003) 129 FCR 494; [2003] FCAFC 125 confirms such deductions would be available in Australia. The government announced after the La Rosa decision in the Full Federal Court that it would consider amending the law so as to deny deductions for expenses incurred in illegal activities. This rule was enacted in s 26-54 of the ITAA 1997, but notice that it is limited to amounts incurred furthering illegal activities that amount to indictable offences and under Australian law. So now ask, what happens if the taxpayer incurred expenses in Australia undertaking armed robberies in New Zealand? [5.355]

301

The Tax Base – Income and Exemptions

(d) Unusual Transactions and the Ordinary Course of the Taxpayer’s Business [5.360] The cases suggest that one reason why a gain may raise a tax dilemma is because it is

entirely novel or it represents a major departure from the business’ existing practices. Financial accounting procedures used to require a reporting entity to prepare its accounts to disclose separately its ordinary operating profit and the result of transactions that were “abnormal” or “extraordinary”. This is the kind of tax territory we are in. For tax purposes, novelty may indicate that this transaction was not an aspect of the conduct of the taxpayer’s business but rather it was an extraordinary (and non-income) transaction. In the language of the cases, the transaction would not be “within the scope and ordinary course” of the taxpayer’s business. The cases suggest that a novel transaction may generate a profit which is a capital gain to the business. On the other hand, they also suggest that a novel transaction might generate ordinary income if it represents a new departure for an existing business, a modification of the existing business or if it constitutes its own new business. The most important development in the case law concerning the problem of defining the scope and ordinary course of the business was the decision of the High Court in 1987 in FCT v Myer Emporium Ltd (1987) 163 CLR 199. The taxpayer in Myer entered a “tax effective financing” scheme. Myer lent $80 m to one of its subsidiaries, Myer Finance, at 12.5% interest, the loan not being repayable for seven years. Three days later Myer assigned to Citicorp Canberra the right to receive the interest stream on the loan for $45,370,000. It retained the right to be repaid the principal sum at the end of the loan. (Citicorp was willing to pay for the interest because it had accumulated tax losses which could shelter some of the interest it would receive from tax in its hands.) The taxpayer argued essentially that the transaction was not taxable because the proceeds of the sale of the income stream represented the proceeds of the disposal of a capital asset, and it was a capital asset because selling financial instruments such as this was outside the scope and ordinary course of its business, which was a retailer and property developer. In a joint judgment the High Court held that the amount received on the sale of the interest stream was income according to ordinary concepts because the taxpayer had set up the entire transaction with the explicit purpose of making a profit, notwithstanding that the transaction was not within the scope and ordinary course of its business:

FCT v Myer Emporium Ltd [5.370] FCT v Myer Emporium Ltd (1987) 163 CLR 199 The Commissioner submits that a gain made by a taxpayer as the result of a business deal or a venture in the nature of trade is income of the taxpayer, even if the transaction that yields the gain is outside the ordinary course of business. According to the argument, the amount falls within either s. 25(1) or the second limb of s. 26(a). The taxpayer makes two responses to this argument: (1) that a gain made as the result of a business deal or a venture in the nature of trade is not income unless it is made in the ordinary course of carrying on a business; and (2) 302

[5.360]

that the realisation of a capital asset is capital, not income, the amount received by Myer representing the receipt of a capital asset. Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer’s business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course

Business Income

FCT v Myer Emporium Ltd cont. of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer’s intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction was extraordinary judged by reference to the ordinary course of the taxpayer’s business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a “one-off” transaction preclude it from being properly characterised as income (F.C.T. v. Whitfords Beach Pty Ltd). The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit making by the means giving rise to the profit. The celebrated decision in Californian Copper Syndicate v. Harris (1904) 5 T.C. 159 makes the point. The important proposition to be derived from Californian Copper is that a receipt may constitute income, if it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer’s business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction. Several different strands of thought have combined to deter courts so far from accepting the simple proposition that the existence of an intention or purpose of making a profit or gain is enough in itself to stamp the receipt with the character of income. The first was the notion that the realisation of an asset was a matter of capital, not income. The second was the apprehension that windfall gains and gains from games of

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chance would constitute income unless the concept of income, apart from income from personal exertion and investments, was confined to profits and gains arising from business transactions. And the third notion was that a gain generated by recurrent transactions is income, whereas a gain generated by an isolated transaction is capital. The proposition that a mere realisation or change of investment is not income requires some elaboration. First, the emphasis is on the adjective “mere”. Secondly, profits made on a realisation or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realised subsequently in order to capture the profit arising from their expected increase in value. It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realisation. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction. If Myer’s decision to assign to Citicorp the moneys due or to become due under the loan agreement had been unrelated to and independent of its decision to enter into the loan agreement, the argument that the assignment amounted to no more than the realisation of a capital asset would perhaps have had more force, though, as will appear later, we do not consider that the respondent’s argument would have prevailed even in such a situation. However, in the actual circumstances, as we have stated them, the consideration received for the assignment is necessarily income. Myer also relied strongly on the statement made by Dixon and Evatt JJ. in C. of T. (Vic.) v. Phillips: “it is true that to treat a sum of money as income because it is computed or measured by reference to loss of future income is an erroneous method of reasoning.” [5.370]

303

The Tax Base – Income and Exemptions

FCT v Myer Emporium Ltd cont. Neither the decision nor the discussion in Phillips is decisive of the present case. The point is that the consideration for an assignment of the right to future income may constitute income in a variety of circumstances. Many instances may be given of the sale of a capital asset for a consideration which is income in the hands of the seller. For the most part these are instances of the sale of a capital asset for periodic, regular or recurrent receipts, periodicity, regularity or recurrence being characteristics of an income receipt. See, for example, Egerton-Warburton v. D.F.C.T. [extracted in Chapter 6] where a property was sold in return for an annuity. But there is no reason for thinking that the conversion of a capital asset into an income receipt is confined to such cases. The periodicity, regularity and recurrence of a receipt has been considered to be a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind. Valuable though these considerations may be in categorising receipts as income or capital in conventional situations, their significance is diminished when the receipt in question is generated in the course of carrying on a business, especially if it should transpire that the receipt is generated as a profit component of a profitmaking scheme. If the profit be made in the course of carrying on a business that in itself is a fact of telling significance. It does not detract from its significance that the particular transaction is unusual or extraordinary, judged by reference to the transactions in which the taxpayer usually engaged, if it be entered into in the course of carrying on the taxpayer’s business. And, if it appears that there is a specific profit-making scheme, it is pointless to say that it is unusual or extraordinary in the sense discussed. Of course it may be that a transaction is extraordinary, judged by reference to the course of carrying on the profit-making business, in which event the extraordinary character of the transaction may reveal that any gain resulting from it is capital, not income. Myer’s business at all relevant times was that of retailer and property developer. Before 304

[5.370]

acquiring Myer Finance, Myer carried on business as a financier, though its business as a financier seems to have been confined to transactions relating to the Myer group. The transactions in question here were entered into by Myer in the course of its business. The transactions, more particularly the assignment, were novel in the sense that it was the first time that Myer had entered into such an arrangement. But this fact does not take them out of the course of the carrying on of Myer’s profit-making business. If the two transactions, namely the loan agreement and the assignment, are considered as separate and independent transactions, Myer’s argument that no relevant profit arose from the assignment has compelling force. But once the two transactions are seen as integral elements in one profit-making scheme, it is apparent that Myer made a relevant profit, that profit being the amount payable on the assignment. The accounting basis which has been employed in calculating profits and losses for the purposes of the Act is historical cost not economic equivalence. And so a taxpayer who lends money for a stipulated period at interest is treated as exchanging the money lent for a debt of the same amount, unless the loan is made at a discount or premium, in which case there may be a gain or loss on capital account. In the ordinary case, the debt is brought to account in the same amount as the money lent. The amount of the debt is not reduced because the lender is kept out of the use and enjoyment of the money lent for the period of the loan. If economic equivalence were the appropriate accounting basis, the debt would be brought to account at the beginning of the period in an amount less than the amount of the money lent and would increase day by day until it equalled the amount of the money lent when the period expired. The aggregate of the two amounts – the debt and the right to interest – would equal, throughout the period, the amount of the money lent, assuming that the rate at which the principal debt was discounted and the rate of interest payable on the principal debt were the same. On that basis, both the debt and the right to interest might be treated as capital assets. But when a debt is brought to account in the same amount as the amount of the money lent,

Business Income

FCT v Myer Emporium Ltd cont. the right to interest on the money lent is not treated as an asset at all. It does not appear in either the balance sheet or the profit and loss account of the lender. The right to interest is not distinguished for accounting purposes from the interest to which it relates. So long as the amount of the principal debt is treated as equivalent to the amount of the money lent, the right to interest cannot be treated as an additional capital asset. If the lender sells his mere right to interest for a lump sum, the lump sum is received in exchange for, and ordinarily as the present value of, the future interest which he would have received. This is a revenue not a capital item – the taxpayer simply converts future income into present income: see Commissioner of Internal Revenue v. P.G. Lake, Inc. 356 U.S. 260 at 266–267 (1958). By a transaction consisting in the making of a loan and a sale of the right to interest on the money lent, the lender acquires at once a debt and the price which the sale of the right has fetched. The price of the right is the lender’s compensation for being kept out of the use and enjoyment of the principal sum during the period

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of the loan and, like the interest for which it is exchanged, it is a profit. It is immaterial that the lender receives the profit not from the borrower but from the other party to the transaction, and it is immaterial that the profit is received immediately and not over the period of the loan. In this case, the sale of Myer’s right to interest produced an immediate cash receipt. For an outlay of $80,000,000 in the transaction Myer acquired a debt of $80,000,000 owed by Finance and $45,370,000 in cash from Citicorp. It has made a profit of $45,370,000. True it is that Myer will not now receive the interest which would have become payable to it during the period of the loan but that will be reflected only by an absence of the income by way of interest which would otherwise have been received in future years. Myer received the profit of $45,370,000 during the 1981 income year and that receipt forms part of its assessable income for that year. What we have said leads to the conclusion that the amount in question formed part of the income of Myer under s. 25(1) of the Act. A similar chain of reasoning would have led to the conclusion that the amount constituted assessable income under the second limb of s. 26(a).

[5.380] Many learned minds have attempted to plumb the depths of the Myer judgment. You

also may care to try to comprehend exactly what was being said. It was accepted that the receipt was novel so why was it taxable? Was the High Court saying that the sale of the interest stream was an isolated one-shot business venture (like a Whitfords Beach business) carried on by Myer as an entirely separate operation from its principal business? Might the Court have been saying that even a novel transaction generates business income for a taxpayer with a business if it is deliberate? Does it make any difference which (if only one) was intended? There are other possible interpretations of the judgment. One would be to suggest that the High Court was simply abolishing the “ordinary course of business” idea. While this is possible, some later decisions of the Federal Court imply that the members of that Court do not believe this is what the High Court meant. For example, in FCT v Spedley Securities Ltd (1988) 19 ATR 938, Fox, Fisher and Sheppard JJ in the Federal Court said: If the proposition were correct it would mean that any receipt by a business would necessarily be of an income nature, and this would be contrary to authority, to the Act itself and to basic concepts concerning the distinction between capital and income.

A more considered discussion of the meaning of the Myer decision was offered in Westfield v FCT (1991) 21 ATR 1398. In that case, the company carried on a business developing shopping centres, usually on land owned by it. This involved the design, construction, letting [5.380]

305

The Tax Base – Income and Exemptions

and management of the shopping centres. The evidence, accepted by the Court, was that at no time did the company buy and sell land for profit but rather it bought land for future shopping centre development. In the early 1970s, the company projected that Mount Gravatt near Brisbane was a potential area for developing a shopping centre and in 1978 it decided to buy options over several adjoining parcels of land. Meanwhile, it embarked upon planning for the development of the centre in conjunction with an existing centre owned and operated by part of the David Jones group. Eventually, negotiations between Westfield, the council, other property owners, and David Jones broke down and Westfield notified the council and the owners of the land over which it held options that it would not be proceeding with the development. Three months later, Westfield learned that a competitor had become interested in carrying out the same project that Westfield had just abandoned and so Westfield renegotiated another option over the land in an effort to keep the competitor out and maintain the status quo. While this was occurring, the adjoining shopping centre was sold by David Jones to the AMP Society and negotiations began again, this time with AMP. At about the same time, Westfield exercised the option to buy the land. Westfield then negotiated with AMP on the basis that it would be prepared to sell the land to AMP, provided that AMP then engaged Westfield to design, build and operate a shopping centre on the site. Eventually this was agreed to and Westfield sold the land to AMP, making a profit of about $267,000 on the sale. The ATO assessed the taxpayer on these profits as assessable income from Westfield’s business. The Court allowed the appeal, holding that the profit was not income. Hill J noted: where a transaction falls outside the ordinary scope of the business, so as not to be a part of that business, there must exist, in my opinion, a purpose of profit making by the very means by which the profit was in fact made [although] there may be a case, the present case is not one, where the evidence establishes that the taxpayer has the purpose or intention of making a profit by turning an asset to account, although the means to be adopted to generate that profit have not been determined. While a profit making scheme may lack specificity of detail, the mode of achieving that profit must be one contemplated by the taxpayer as at least one of the alternatives by which the profit could be realised. [5.390] Following these (and other decisions discussed below) the ATO issued a Ruling

stating his view of the law on when the profits from a transaction will be deemed to be assessable. That Ruling, Taxation Ruling TR 92/3 states:

Ruling TR 92/3 [5.400] 6. Whether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present: (a)

306

the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

[5.390]

(b)

the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

7. The relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer’s intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

Business Income

Ruling TR 92/3 cont. 8. It is not necessary that the intention or purpose of profit making be the sole or dominant intention or purpose for entering into the transaction. 9. The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit making at the time of acquiring the property. …

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14. It is not necessary that the profit be obtained by a means specifically contemplated (either on its own or as one of several possible means) when the taxpayer enters into the transaction. It is sufficient that the taxpayer enters into the transaction with the purpose of making a profit in the most advantageous way and that a profit is later obtained by any means which implements the initial profit making purpose. It is also sufficient if a taxpayer enters into the transaction with the purpose of making a profit by one particular means but actually obtains the profit by a different means.

[5.410] The related ruling, Taxation Ruling TR 92/4, says that losses will be allowed as

deductions to taxpayers where, if a profit had arisen instead, the profit would have been assessable income under TR 92/3. Many commentators have suggested that the Ruling overstates the position, at least in so far as it purports to express current rules, because it fails to take seriously the limitations expressed in Westfield and other cases subsequent to Myer. Some of the ATO’s subsequent attempts to invoke the Myer principle have also failed to find favour with the courts. For example, in FCT v CSR Ltd (2000) 45 ATR 559, the ATO attempted to argue that a $100 m settlement received by the company in settlement of a protracted legal claim with its presumed insurers was assessable as ordinary income under this concept. CSR had alleged that various insurance companies were responsible to meet CSR’s liabilities arising from its asbestos mining operations at Wittenoom, an assertion which the companies stoutly resisted. The Full Federal Court disagreed with the ATO’s claim that the $100 m was assessable as ordinary income for reasons largely associated with the problems of apportionment (discussed in Chapter 2). But the Court also rejected the ATO’s other arguments. The ATO had claimed that “one must take a broad view of a taxpayer’s situation in determining whether an amount received was in the nature of income according to ordinary concepts …” and that taking out insurance and recovering settlements, were a “regular and recurrent feature of the business of CSR”. The Court replied that: It is true that in Myer Emporium the High Court had regard to the nature of Myer’s business at all relevant times as a financier in determining that the consideration received by it for the assignment of future interest due or to become due under a separate loan agreement was income within s. 25(1). However, their Honours stated as follows: It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization… In the present case, the arising of the right to indemnity was not planned by CSR at all and was certainly not part of a plan of which the payment of the Settlement Sum was part.

[5.410]

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The Tax Base – Income and Exemptions

[5.415]

Questions

5.38

Might the High Court in Myer have been saying that the test “within the ordinary course of the taxpayer’s business” is no longer relevant?

5.39

Might the High Court have been saying that the activity was its own isolated business venture and it was therefore within the scope of that business? Might the Court have been saying that the scope of the business and the ordinary course of the business should be drawn widely so that every activity will almost inevitably fall within the scope of the business? Do you agree with the reconstruction of the judgment in Myer offered in Spedley Securities? Do you have any other interpretation of it?

5.40

5.41 5.42

What limitations on the meaning of Myer are suggested in Westfield?

5.43 5.44

How does Taxation Ruling TR 92/3 take these limitations into account? A taxpayer held valuable patents and trademarks over intellectual property developed in its business. It decided to abandon the business because it was insufficiently profitable, and sold the rights to the purchaser who insisted that it pay the price as a royalty for the use of the rights – it wanted to claim the payments as an allowable deduction. The taxpayer then sold its rights to the payments promised under the royalty agreement to Citicorp for the present value of the promised future payments. Is the payment received on the sale of the income stream income of the taxpayer according to the Myer principle? Is that the only basis on which the payment might be assessable? (See Henry Jones (IXL) Ltd v FCT (1991) 91 ATC 4663.)

(e) Ending or Restricting the Operation of a Business [5.420] It would be a most unusual way of carrying on a business if the taxpayer were to sell

the business. The taxpayer who sells obviously eliminates any possibility of continuing the business. The proceeds of sale of the business are clearly capital receipts. Beyond this, there is even authority that amounts collected after the cessation of a business which represent the proceeds of sales made while the business was operating are no longer proceeds of the business and may be capital receipts: Lawford v C of T (NSW) (1937) 1 AITR 89. Consequently, there are statutory rules that try to overcome this outcome by impressing assets and amounts with an income character because their source was once a business: see s 70-90 of the ITAA 1997 and s 101A of the ITAA 1936. But what consequence follows if the taxpayer does not sell out entirely but substantially constrains the business operation, for example, by accepting a restriction on the ability to carry on the business in the same manner or in the same area as before? Is this equivalent to selling a part of the business, or selling the business for a term? Or can it be an act done in the ordinary course of carrying on the business? An example of this problem occurred in Dickenson v FCT (1958) 98 CLR 460. The taxpayer was the owner of a petrol station in Kingsgrove, a suburb of Sydney, and was approached by Shell in 1952 when it commenced to set up the system of tied distribution sites. Dickenson and Shell entered an agreement in June 1952 under which he promised to sell Shell products exclusively at the site (unless Shell could not deliver sufficient quantities) for the next 10 years. He promised to purchase at least 6,000 gallons of petrol every month. Two further agreements were executed on 30 June and 1 July. Under these agreements, Dickenson received two payments of £2,000 for entering a restrictive covenant not to trade at any non-Shell site within five miles for the next five years. He also executed two further documents on 30 June. Under the first document he leased his 308

[5.415]

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site to Shell for 10 years at an annual rent of £1,040 and under the second, Shell sub-let the site back to him for 10 years at an annual rent of £1,040. The High Court held by a majority that the two sums of £2,000 did not have an income character. Dixon CJ observed:

Dickenson v FCT [5.430] Dickenson v FCT (1958) 98 CLR 460 In my opinion each of the two sums of £2,000, combining to form substantially one receipt of £4,000, had the character of capital and not income. I shall therefore do no more than state the essential reason which leads me to treat the transaction as one of capital. It appears to me that the sum or sums were paid as the quid pro quo for an effective tie of the appellant’s business to one wholesale vendor of petrol. The appellant’s business constituted a profit yielding organisation of a definite structure under his control and he received the money as part of an inducement to change a feature in it. The feature to be changed was the use of a plurality of petrols and oils, and this was replaced by a restriction to the purchase and sale of the products of one company. The same inducement caused him to limit himself in what he might do elsewhere than at his then present business site. At the same time, of course, the business obtained some assurance of a supply from the single source. It may be that in a sense the sum of £4,000 was compensatory for the loss

of future profits which the restriction might involve. It may be that it was meant as present payment by way of incentive to promote sales of the product derived from the single source. But if either or both of these elements formed part of the rationale of the payment, it amounted to a capitalisation of these elements. It is true that the restrictions were to operate only over limited periods but, once he had bound himself, a modification or re-adjustment of his business was effected. It could exist at the end of the term only in the altered form, although of course after five years he might consistently with the covenants start another business in the neighbourhood. But only by active steps could his present business be restored to its former character. There is nothing recurrent in the nature of the payment. It is not a formal or natural incident of carrying on such a business and it does not represent a purpose of which such a business is carried on. I think therefore that the sum ought not to be treated as a profit of the existing business.

Kitto J agreed with the decision of the Chief Justice and more clearly relied upon the reasoning that a disposal of part of the business is not in the ordinary course of carrying on the business: But a lump sum payment for a restriction of a garage and its proprietor to one brand of petroleum products for a period of ten years, effectuated by means of a lease and sub-lease of the premises as well as by personal covenants, seems in the nature of a sale price for a substantial and enduring detraction from pre-existing rights. The restriction does not strike my mind as an obligation undertaken incidentally to the carrying on of the business. Rather does it take a substantial piece out of the ordinary scope of the business activities to which otherwise the appellant might apply himself and for which he might use his

premises. The consideration for it was paid to the appellant in two sums but was otherwise nonrecurring. Although the two deeds of covenant related to an aggregate period of only five years, there is nothing in the case to suggest any likelihood that at the end of that period further payments would be made in consideration of further similar covenants. All things considered, the two payments savour much more of capital than of income. I should add that it does not seem possible to regard them as amounting to a rebate in advance against the price of petroleum products to be purchased by the appellant from [5.430]

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Dickenson v FCT cont. the Shell Company, for there is nothing to suggest that the parties attempted to make any

calculation by reference to probable sales, or that they ever regarded the £4,000 as related in any way to such sales.

[5.440] The tied distribution site system which began in the petrol industry after World War II

generated a number of fascinating tax cases. Other possible methods of achieving the tie, and with different tax consequences, are reported in BP and in Strick v Regent Oil which are discussed in later chapters. These cases discuss the deductibility of the payments made by the petrol company to lock up the various sites. (There is also an interesting characterisation dilemma that any deal like the one in Dickenson involves: when is the transaction a restriction, and so potentially outside the course of the business, like selling part of the business would be; and when is the transaction an opportunity, bringing with it a secured source of supply, income and profits?) Put another way, was Dickenson’s transaction a hindrance or an opportunity?) There are other possible steps along this slope. What consequence follows if the taxpayer does not sell out entirely, nor accept a constraint on the operation of the entire business, but rather accepts a restriction on its ability to use a key asset of the business for its own benefit? Is this equivalent to selling a part of the business? In MIM Holdings Ltd v FCT (1997) 36 ATR 108 the Full Federal Court considered such a dilemma. The taxpayer was the holding company of Mount Isa Mines Ltd, which had established a power station at its mine site that supplied power to the mine, smelter and associated installations. The power station also supplied power to the local area. In 1982, the taxpayer was approached to try to secure the continuation and expansion of this supply arrangement. At that time, however, the increasing demands for power from both the mine and town were proving a difficulty. Long negotiations were eventually concluded and an agreement was prepared called the “Reservation Agreement” under which the State Electricity Commission agreed to pay MIM Holdings amounts totalling $15 m over three years in return for ensuring that Mount Isa Mines Ltd would keep a defined part of its generating capacity available to supply the town with electricity. The amount was described in the Agreement as a “non-refundable capital contribution” and was paid to the taxpayer rather than the subsidiary. The ATO initially took the view that the amounts were a taxable capital gain but later that they were income. The taxpayer appealed, arguing that the payments were of a capital nature received for restrictions on the use of a significant asset, namely the generation plant of a subsidiary. Northrop, Hill and Cooper JJ upheld the assessment:

MIM Holdings Ltd v FCT [5.450] MIM Holdings Ltd v FCT (1997) 36 ATR 108 The difference between the parties lies not in any question of principle under the Income Tax Assessment Act 1936 (Cth) (the Act) in its application to the facts of the present case, but rather in a difference between the parties in characterising the payments. 310

[5.440]

For Holdings it is submitted that the true construction of the Reservation Agreement viewed against the background of the circumstances to which reference has been made, was that the payments in the relevant years of income were made by the Queensland

Business Income

MIM Holdings Ltd v FCT cont. Government for the restriction on the use by Isa of a significant group asset, namely its generation plant. The payments, it is said, were payments calculated by reference to the cost of that asset and were, as a consequence of both these matters, of a capital nature. It is accepted by the Commissioner that if the proper characterisation of the payments is that they were payments for a restriction as submitted by senior counsel for Holdings, then they should properly be treated as on capital account. However, the Commissioner submits that the payments should be seen as payments in return for Holdings promising that its subsidiary, which was bound to do its bidding, would make available a stipulated level of power (between 22 and 27 megawatts) to the Queensland Government when required. In our view, the characterisation of the payment received by Holdings was not that of a payment for the imposition of some restriction, fetter or tie on the part of Isa. The present was not a case where a fee was paid to secure that Isa not utilise the whole or some part of the electricity which it generated. So to describe the arrangements between the parties would involve a misleading half-truth. The clear contractual arrangement between the Government of Queensland and Holdings was that there was to be constructed by Isa a generating plant having a capacity greater than the needs of Isa and that Holdings would ensure that up to the 27 megawatts of power being power referred to in the reservation agreement, would be made available for reticulation by the Government as and when required and pursuant to a distribution agreement that was ultimately to be entered into as the bulk supply agreement. No doubt it was a consequence of Holdings ensuring that Isa made available the 27 megawatts that, if demand required it, capacity to that amount would not be available to Isa for its use. But the payment was not made for this restriction but rather, as the agreement itself made explicit, for Holdings ensuring that its subsidiary, Isa, would supply the demands of the Queensland

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Government up to the requisite 27 megawatts as required in accordance with the reservation agreement. Once the question of characterisation is determined, the conclusion is inexorably reached that the payments are of an income character. The relevant principles can be shortly stated. 1. In determining whether a payment has the character of income or capital, regard must be had to the character of the receipt in the hands of the recipient: Scott v FCT; Hayes v FCT; Federal Coke Co Pty Ltd v FCT. So here regard is to be had to the quality of the payment in the hands of Holdings. 2. The court is obliged to have regard to all of the facts and can not disregard the separateness of different corporate entities or decide liability to tax upon the basis of the substantial economical business character of what was done: Federal Coke. 3. Where the recipient of a payment provides consideration for a payment, that consideration will ordinarily supply the touchstone for ascertaining whether that payment was received on revenue account or not: Federal Coke. Here the consideration was the undertaking of Holdings that Isa would supply the demands of the Queensland Government for electricity up to the stated 27 megawatt limit. 4. The answer to the question whether a receipt is income or capital will not be determined by the character of expenditure which the recipient is required to make: GP International Pipecoaters Pty Ltd v FCT. Thus the fact that expenditure was required to be made to build the additional generating capacity was not determinative of the character of the payments received by Holdings. 5. While periodicity, regularity or recurrence may stamp a particular receipt as income, the fact that a receipt is in a lump sum will not require the conclusion that the payment was of a capital nature. 6. The test to be applied in determining whether an item is income or capital will be objective rather than subjective: Hayes. 7. Amounts paid in consideration of the performance of services will almost always be income: Hayes. Thus if the agreement is properly [5.450]

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The Tax Base – Income and Exemptions

MIM Holdings Ltd v FCT cont. characterised as one whereby Holdings is to procure its subsidiary to make capacity available, it will most likely have the character of income. 8. However, a payment made to a person to fetter that person’s capacity to perform services or to carry on business may be a capital payment: Higgs (Inspector of Taxes) v Olivier. Thus if the agreement is properly to be seen as a restriction or fetter, that might lead to the conclusion that it was received as capital.

Senior counsel for Holdings relied heavily upon Dickenson’s case with which it was suggested the present facts had analogy. The present case bears, with respect, little resemblance at all to the facts in Dickenson. The fact that a consequence of the agreement with the Queensland Government was a practical restriction on the ability of Isa to use the totality of electricity generated at all times is but incidental to the arrangement and a consequence of it. It is not what the payment received by Holdings was for.

[5.460] Particular reliance was placed upon the decision of the High Court in GP

International Pipecoaters. In that case the Full High Court emphasised the fact that the taxpayer’s business corresponded with what the contract required, namely it extended beyond merely coating pipes to the construction of the plant. Thus the payment of the monetary consideration to the taxpayer took the character of income. Their Honours said, “the establishment costs were not received under a severable part of the contract relating to the construction of the plant.” This comment was no doubt made in answer to the argument which appears on the preceding page of the report that the scope of the taxpayer’s business was coating pipes but not constructing plant. It follows from the principles set out above, that once the payment in question is characterised as a payment for ensuring that Isa would make available capacity up to the requisite amount upon demand, and as required by the Queensland Government, it is clear that the payment had the character of income. [5.465]

Questions

5.45

Would the result in Dickenson have been any different if Dickenson owned 10 garages and entered into a restrictive covenant for each one with different oil companies?

5.46 5.47

What would be the effect of capital gains tax on the result in Dickenson? A similar problem arises in relation to the commencement of a taxpayer’s business – is a payment received by the taxpayer to assist it to start its business a receipt of that business? Consider GP International Pipecoaters.

5. CLASSIFYING BUSINESS ASSETS AND LIABILITIES: REVENUE AND STRUCTURAL TRANSACTIONS [5.470] The final issue to explore in relation to taxing the gains of a business is one of

characterisation – assuming the taxpayer is carrying on a continuing business, and assuming the transaction in question is connected to the business activities of the taxpayer, and assuming the transaction occurs in carrying on that business, is any profit being made a capital or revenue profit? It was suggested above that the sale of the property developer’s home was not taxable because it was not connected with the business. Also, it was suggested in Section 4 that the sale by the property developer of the entire business would not be within the ordinary course of 312

[5.460]

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carrying on the business. Neither transaction would generate a receipt having an income nature according to ordinary concepts (although s 70-90 of the ITAA 1997 might apply to dissect and tax the proceeds of any trading stock sold when the whole of the business was sold). The current question is slightly different. An example of the current characterisation issue to be explored is: what are the consequences of selling the property developer’s head office? The head office is undoubtedly connected to the business – it is an integral, not extraneous, asset of the business so that it meets the test in Section 3. But it might be so large an element of the business or so unusual a transaction that its sale would be outside the ordinary course of carrying on the business. Does this mean that any gain made on the sale of the head office would be a capital gain only? The answer depends upon the characterisation issue: determining the status of the asset in the context of the business. Properly classifying assets is not simple. The problem can be seen in the tendency to divide all the assets of a business into two mutually exclusive groups: trading stock of the business – those assets which are constantly churned and generate profit by resale for a price in excess of cost; and capital assets – which form the fixed capital of the business and do not generate ordinary income when sold. The unfortunate tendency is to see all the assets of a business in these two exclusive groups. Yet the majority of the remainder of this chapter will deal with the “undefined middle” – assets which are not trading stock of the business, and yet which, when sold, generate assessable ordinary income. Trading stock is simply one of the classes of assets which form the revenue assets of a business. The problem which this characterisation issue raises is the need for the courts to prescribe a test which will accurately depict each class of assets and which can be communicated to others for them to apply. The test which is usually cited for almost all issues on taxing business income is given in Californian Copper Syndicate v Harris (1904) 5 TC 159. As Hill J puts it in FCT v Hyteco Hiring (1992) 24 ATR 218: “no case concerned with the characterisation of profits as income or capital is complete without reference to the well known comments of Lord Justice Clerk in Californian Copper Syndicate.” The case involved a company incorporated to mine sites in California. The company purchased one very substantial site which consumed most of its capital. The company then sold the site to another company and the revenue authorities claimed that the resulting profit was income. The test of the Lord Justice Clerk in the Scottish Court of Exchequer is quoted with totemic solemnity in almost every subsequent case: It is quite a well settled principle in dealing with questions of assessment of income tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit in the sense of Schedule D of the Income Tax Act of 1842 assessable to income tax. But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business. The simplest case is that of a person or association of persons buying and selling lands or securities speculatively, in order to make gain, dealing in such investments as a business, and thereby seeking to make profits. There are many companies which in their inception are formed for such a purpose, and in these cases it is not doubtful that, where they make a gain by a realisation, the gain they make is liable to be assessed for income tax. What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being – is the sum [5.470]

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The Tax Base – Income and Exemptions

of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit making?

The case proposes a test but it may be thought to be an indecisive test. The assets owned by a business are not simply and easily divisible into trading stock which generates income when sold, and all the remaining assets which are capital assets and would usually generate capital gains (or losses) when sold. There is the middle group of assets of which the mine in Californian Copper Syndicate was probably one, and the cases make it clear that the proceeds of sale of these other assets, which are admitted not to be trading stock, can generate income. These assets we will call “revenue assets” – a term originally coined by Professor Ross Parsons to describe this group (and not to be confused with the defined term “revenue asset” in s 977-50 which is used principally in the rules about value shifting). But it is important to keep firmly in mind the division of assets of a business: • capital assets, which will (usually) include depreciable assets; • trading stock (being one class of revenue assets); • revenue assets in general (assets which are not trading stock but which generate ordinary income when sold). One consequence of the width of our capital gains tax is that, as we have noted many times before, it has the potential to apply to virtually every transaction which involves the sale of an asset, or possibly even a mere receipt of money. Hence the need for reconciliation between the capital gains tax and the ordinary income provisions to avoid double taxation. In the case of continuing businesses with trading stock, capital gains tax is prevented from applying by s 118-25 of the ITAA 1997 which instructs us to disregard any capital gain or loss realised on the disposal of an asset which at the time of its disposal constituted trading stock. Section 118-24 provides a similar rule for depreciable assets. For revenue assets, the reconciliation must come about through s 118-20, reducing the capital gain by the amount included in assessable income or exempt income. There may also be consequences under various statutory income provisions which will have to be reconciled with the capital gains provisions through s 118-20. The remainder of this chapter will look at examples of the characterisation problem in a series of contexts: transactions with a taxpayer’s machinery and equipment, contract rights used in the business, know-how and related assets, the taxpayer’s business premises, its investments and liabilities.

(a) Transactions with Trading Stock [5.480] The proceeds of the sale of trading stock are the quintessential income of receipts of a

continuing business. Trading stock is defined in s 70-10 of the ITAA 1997 as “anything produced, manufactured or acquired that is held for the purpose of manufacture, sale or exchange in the ordinary course of a business.” The standard example of trading stock is the inventory displayed on the shelves of a retail store – the groceries on the shelves of Woolworths or Coles. But notice that the definition also includes raw materials that are inputs to the things that will eventually be sold – the car alarm purchased by Holden from the manufacturer for installation into a Commodore. Holden is not going to resell the car alarm, but because it will be selling a Commodore with an alarm, the alarm is also trading stock of Holden. Notice that the amount which is ordinary income is the gross proceeds of sale. This is spelt out in the (non-operative) s 70-5(1) – “you bring your gross … earnings to account, not your 314

[5.480]

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net profits and losses on the disposal of trading stock.” There is no dedicated provision which includes the proceeds of sale as ordinary income; the amount is included under s 6-5. This definition of trading stock incorporates the idea that we have already noted – that income arises from transactions within the ordinary course of the taxpayer’s business. Indeed it is a critical condition for something to be trading stock that is held to be used in that way, but this is not the end of the story. Section 70-90 of the ITAA 1997 includes in assessable income the value of an asset which once was trading stock of the business if it is then sold outside the ordinary course of the business. The standard example would be the sale of a business “as a going concern” – that is, the sale of all of the assets of a business, including the trading stock. Another example would be a bulk sale of the entire inventory to a single buyer. Neither sale would be within the ordinary course of the taxpayer’s business, and so s 70-90 comes into play. Similarly, s 70-115 includes in assessable income any insurance payment received by a taxpayer for the loss or destruction of trading stock. Again, such a transaction (the entire stock was destroyed in a fire) would not be within the ordinary course of the taxpayer’s business. We examine more issues about the definition of trading stock and the operation of these provisions in Chapter 12.

(b) Gains on Disposal of Machinery and Equipment [5.490] The profit made on the sale of trading stock is assessable as income, but what about

the profit made on the sale of the various machines and equipment that were used to make or display the trading stock – for example, the shelving and the cash registers in Woolworths or Coles? The answer typically would be no – under Australian jurisprudence, a taxpayer’s plant and equipment form part of the profit-yielding structure, and so the profit (or loss) made on the sale of an item of plant would typically be a capital matter. But the statutory depreciation rules have always contained special statutory adjustments to deal with settling up the difference between the depreciation already allowed for an item of plant, and the actual cost when the asset is sold. So if, for example, a taxpayer bought a machine for $100,000, claimed $20,000 as deductible depreciation while the machine was being used, and then sold it for $85,000, $5,000 would be included in the taxpayer’s statutory income – adding back the $5,000 as income gets to the real cost to the taxpayer of using the machine, not the $20,000 which the depreciation rules initially guessed, but the $15,000 which has occurred. These rules are found in s 40-285 of the ITAA 97. However, the application of Div 40 is not the only way in which gains made on the sale of plant may be liable to tax. There have been some cases arguing that the profit made on the sale of machines is ordinary income, assessable under s 6-5. The flurry of cases began in the early 1990s when the ATO decided to assess as ordinary income (rather than as capital gain) the profit made by taxpayers who sold depreciated plant at a price which exceeded its cost. (The ATO could not claim the excess over cost was assessable under Div 40, as at that time, the rule only clawed back the excess amount of depreciation allowed up to cost. That is, the taxpayer bought the machine for $100,000, claimed $20,000 as deductible depreciation, and then sold it for $110,000. Under the former version, $20,000 would be included in the taxpayer’s statutory income, but the other $5,000 was not.) The ATO claimed that the profit on the sale of plant owned by taxpayers was assessable to the taxpayer in four cases: • FCT v Cyclone Scaffolding Pty Ltd (1987) 87 ATC 5083. In this case the taxpayer owned scaffolding equipment which it hired to the public, although it occasionally sold scaffolding equipment to governmental and semi-governmental authorities. The taxpayer usually made [5.490]

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special purchases of equipment for the purposes of these sales but, on occasion, it also sold some of its hiring equipment. In addition, the taxpayer also “sold” plant where hirers lost or destroyed the equipment, because under the terms of its hiring contracts, the hirer was required to pay the taxpayer’s current list price for any equipment lost or destroyed. The ATO unsuccessfully attempted to assess the company on the basis that the amounts received from sales of equipment and from payments by hirers for replacement equipment were assessable income. • Memorex Pty Ltd v FCT (1987) 87 ATC 5034. In this case the taxpayer carried on business as a supplier of computer equipment. It bought the equipment from its American parent company and then either sold it or leased it out to customers. Some goods which were on lease were sold to the customers, and some leased equipment was also “sold” to its finance company to secure borrowings by the company. The taxpayer treated equipment which it leased to customers as depreciable plant and, if it sold the leased equipment for a consideration greater than the depreciated value, the depreciation recouped was brought to account as assessable income under s 59 of the ITAA 1936 (the predecessor of s 42-190 of the ITAA 1997). The ATO took the view that where the leased goods were sold for a price higher than their cost, the excess was an assessable profit under ss 25(1) or 26(a) (now ss 6-5 and 15-15), and succeeded in his assessment. • FCT v GKN Kwikform Services Pty Ltd (1991) 91 ATC 4336. In this case the taxpayer was in the business of hiring out scaffolding to the building industry. The scaffolding hired out was treated by the taxpayer as plant and depreciated in its returns. As in Cyclone Scaffolding where hirers failed to return all the equipment, they were liable to pay to the taxpayer compensation for the items not returned at a price above their cost to the taxpayer. The ATO treated these profits as assessable. The taxpayer objected, but the Full Federal Court held that the profit resulting from the compensation payments was assessable income under s 6-5(1). • FCT v Hyteco Hiring Pty Ltd (1992) 92 ATC 4694. Again the question was the character of profits made on the disposal of plant by a leasing company. In this case, the plant was forklift trucks, and disposal occurred to a related sales company within the corporate group when the trucks had outlived their life for leasing, although they might still have some resale value as secondhand plant. The ATO argued that the disposal of the trucks when they became unsuitable was an ordinary incident of the taxpayer’s business and thus the profits made on disposal should be included in income. The Federal Court held that the profit was a capital receipt. As is common in the treatment of business income, no clear rationale emerged from these cases – the ATO was successful in two of the cases and the taxpayer successful in the other two. Indeed, the reasoning in the cases is sometimes impenetrable, sometimes less than compelling and always obscure. Despite the ambiguity, the ATO issued a Ruling, Taxation Ruling IT 2550, stating his view of the circumstances in which these profits would be assessable, even though the Ruling concedes that the “decisions are not readily reconcilable”. The story becomes even more complicated when CGT is added. After September 1985, gains or losses on the disposal of all assets (including depreciating machines and equipment) have been subject to CGT. This duplication led to complex rules to remove the unnecessary overlap between the depreciation recapture in Div 40 and CGT. However, with the release of the RBT’s final report in September 1999, Recommendation 8.11 of the RBT’s report proposed that all gains or losses on disposals of depreciable plant be treated as assessable income or allowable deductions, and that depreciable plant be excluded from the CGT regime altogether – in other words, replacing the CGT with statutory income as the backup to the 316

[5.490]

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depreciation rules. Legislation to give effect to this change was first introduced in 1999 but it is now contained largely in the amendments made for depreciable plant by the New Business Tax System (Capital Allowances) Act 2001. The current rules for the treatment of plant are found in three places: • First, s 40-285(1) says that a taxpayer must include in their assessable income any amount received in excess of the plant’s adjustable value at the time of sale. So if, for example, a taxpayer bought a machine after 1985 for $100,000, claimed $20,000 as deductible depreciation while the machine was being used, and then sold it for $110,000, the entire $30,000 would be included in the taxpayer’s statutory income under these rules. • The second rule is s 118-24. It provides that any gain or loss on the disposal of an item of plant depreciated under Div 40 is disregarded. In other words, there should be no CGT consequences to the sale of plant, only the income consequences stipulated under s 40-285. • The final rule is s 104-235 – CGT event K7. It does generate CGT consequences on the sale of depreciable plant, but only if the asset was not used exclusively to produce assessable income. In other words, if a depreciable asset was used partly for business and partly for private purposes (or partly for earning assessable income and partly to earn exempt income), some of the gain will be recaptured under Div 40 and some will be taxed as a capital gain.

(c) Transactions with Contract Rights [5.500] This section and the next examine the treatment of transactions with intangible

assets. Characterising intangibles appears to cause the tax Australian system a lot of difficulty. Apparently a taxpayer can have lots of plant and equipment, factories or warehouses and all will remain properly classified as capital assets, but our courts seem more ready to classify intangibles as revenue assets. The difficulty increases if the intangible is not one created by a dedicated legal regime such as a copyright or patent. In Rolls-Royce Ltd v Jeffrey (extracted below) the House of Lords described the taxpayer’s various intangibles as “sui generis” and “not easily compared with factory or office buildings, warehouses, plant and machinery or such independent legal rights as patents, copyright or trade marks, or even with goodwill …”. When the nature of the asset is regarded as odd, it should probably not be surprising if its tax treatment turns out to be something of a problem. (i) Contract rights as revenue assets [5.510] Examples of capital and revenue assets can be found in many cases involving

transactions with rights under contracts. A taxpayer whose business consists of providing services – such as an agent distributing a manufacturer’s products, or servicing a manufacturer’s clients – may have valuable rights against the manufacturers under the various contracts which establish the business. If the taxpayer sells these contract rights or surrenders them to the manufacturer for consideration, are the receipts income? This problem arose in Californian Oil Products v FCT (1934) 52 CLR 28. The taxpayer had an exclusive agency for five years in NSW to import and resell petrol and lubricants manufactured by Union Oil. After two years, the supplier decided that it wanted to terminate the exclusive agency and California Oil agreed to surrender its rights upon payment of £70,000. In the High Court, Gavan Duffy CJ, and Dixon J determined that the receipt did not have an income character: [5.510]

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Californian Oil Products v FCT [5.520] Californian Oil Products v FCT (1934) 52 CLR 28 The question for decision is whether instalments of the sum of £70,000 form part of the assessable income of the taxpayer in the year in which they are received.

consisted exclusively in marketing in parts of Australia the products of the Union Oil Co. The cancelled contract of agency constituted its authority for five years to carry on that business.

In our opinion they do not form part of its assessable income because they are not of an income nature and they do not fall within any of the special provisions of the Income Tax Assessment Act 1922-1932 making liable to taxation receipts, which, otherwise, would not be considered income. This conclusion is based upon the substantial nature of the transaction which produced the sum of £70,000. It was, in our opinion, not an incident in the carrying on of the taxpayer company’s trade, but the relinquishment and abandonment of the only business which the company conducted.

It may be assumed that, in estimating the sum to be paid to the taxpayer company for the cancellation of the contract, both it and the Union Oil Co. were guided by their opinion of what the future profits would be. But it is fallacious to treat a sum as income because it is measured by reference to a loss or deprivation of future income or earnings.

The powers taken by the taxpayer company in its memorandum of association were ample to enable it to undertake other activities besides the selling of petrol and petroleum products, but, admittedly, it did not do so. The actual business which it established and carried on was confined to dealing, under the successive arrangements we have described, with the goods produced by the Union Oil Co. of California. The contract of agency conferred for a term of years upon the taxpayer company rights by the exercise of which it might or would have been able to earn profits. But the profits would have arisen from the exertions of the taxpayer company in disposing of the Union Oil Co.’s merchandise. They would have consisted in the net amount of the percentage commission paid as remuneration for the services that it actually performed as agent. The contract operated to secure to the taxpayer company definite advantages. It gave an opportunity of performing those services for a period of time which was both certain and lengthy at a fixed remuneration likely to be profitable. But the company did not, as consistently with its objects it might have done, carry on a business of making contracts with customers and performing them. Its business

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[5.520]

Lord Buckmaster said in the Glenboig Union Fireclay Co.’s case (1922) 12 T.C. 427: “there is no relation between the measure that is used for the purpose of calculating a particular result and the quality of the figure that is arrived at by means of the application of that test.” Sums of money paid by way of damages, compensation or indemnity for a loss of profit incurred in the course of carrying on an enterprise or undertaking may, no doubt, be considered income, because they are part of the profits derived from carrying on the business, although they are occasioned by unusual or exceptional circumstances or events. In the present case the sum in question was paid as the consideration for the termination of the agency which constituted the only business carried on by the taxpayer company. It was “truly compensation for not carrying on their business”. It comes within the principles expressed by Rowlatt J. in Chibbett v. Joseph Robinson & Sons (1924) 9 T.C. 48, when he said: “a payment to make up for the cessation for the future of annual taxable profits is not itself an annual profit at all.” It is not within the qualification of that statement made by Lord Macmillan in Dewhurst’s Case (1932) 16 T.C. 605, which, in effect, was that, if the payment represents deferred or contingent remuneration for services performed, the payment “does not necessarily cease to be remuneration for services because it is payable when the services come to an end”.

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[5.530] The result in Californian Oil and that in Dickenson (discussed above), which takes a

similar approach, should be contrasted with that in Heavy Minerals v FCT (1966) 115 CLR 512. The question in this case was the assessability of £221,000 received as compensation for agreeing to cancel a long-term supply contract. The company negotiated long-term contracts to sell stipulated quantities of rutile to various companies including Union Carbide, two other United States companies and a German company at prices ranging from £48 to £100 per ton. When the price of rutile fell to £30 per ton, it ceased mining and merely purchased rutile on the market for resale to the purchasers. It was not long before the purchasers sought to be released from the contracts and Heavy Minerals extracted a cancellation fee. Windeyer J observed:

Heavy Minerals v FCT [5.540] Heavy Minerals v FCT (1966) 115 CLR 512 The taxpayer’s case was expressed in more than one way. But each really amounted to an assertion that the agreements it had with the American buyers and the German buyer were in themselves a capital asset. The several contracts the taxpayer had made with the buyers abroad were each described in phrases culled by counsel from judgments in other cases as “not an ordinary commercial contract for the sale of goods”; as a “framework” within which “the parties were to work in the future”; as part of a “capital structure”. It was said that certain terms of the contracts were unusual, as they created a relationship that does not ordinarily, it was said, exist between buyer and seller. In one case, the German contract, the buyer contracted to buy rutile from the taxpayer only: in another, the contract with the American wholesaler, the taxpayer contracted not to sell to other persons in America except to certain persons described. Whether such restrictions were or were not unusual in forward selling contracts in the rutile trade I do not know. But assuming they were, I cannot see that they were other than a part of the terms on which the taxpayer company agreed to sell, and the buyers agreed to buy, quantities of rutile to be delivered over a period. The contracts that were cancelled were not in the same terms. The only common

feature seems to be that goods were to be supplied from time to time in the future. Even if these contracts were such that they seemed to ensure that the taxpayer would have a secure market and some regular customers, that would not of itself make them part of the capital of its business. As to words and phrases like “framework”, “capital structure” and others which were used to beg the question, the remarks of Lord Radcliffe in Commissioner of Taxes v. Nchanga Consolidated Copper Mines Ltd [1964] A.C. 948, are much in point. The appellant sought to liken the moneys which the buyers paid to be released from their contracts to a price received as a consideration for going out of business as in Californian Oil Products Ltd v. F.C.T. (1934) 52 C.L.R. 28. But there is no analogy. The taxpayer’s business was mining rutile and dealing in rutile. Its capital assets were the mining lease and the plant. After the contracts were cancelled it still had these. It was free to mine its rutile and to sell it if it could find buyers: and it tried to do so. The taxpayer was not put out of business by the cancellation of its overseas contracts. It did not go out of business when they were cancelled. What happened is that because the price of rutile had drastically fallen it could not carry on its business at a profit.

[5.540]

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(ii) Compensation for income [5.550] One other possibility for taxing the proceeds of disposals of contract rights has been

implicitly referred to in some of the extracts above. In C of T (Vic) v Phillips, (see Chapter 6), Dixon and Evatt JJ held that the amounts received for agreeing to surrender the contract were assessable because they were an exact substitute for the payments which would have been made had the contract continued. In effect, Phillips was receiving the stipulated income despite the termination. This same potential characterisation has been raised with the surrender of other contract rights apart from service contracts. For example, in Van den Berghs v Clark (extracted in Chapter 6) the Court considered an argument that payments received on the surrender of rights under a market sharing agreement were income.

In Glenboig Union Fireclay Co v IRC (1922) 12 TC 427, which has been referred to in the extracts above, the taxpayer had mining rights to work clay deposits in areas including under the tracks of a railway. The railway company exercised its statutory powers to restrain the mining of the deposit and was then obliged to pay compensation to the company. The amount of compensation was fixed by arbitration at £15,300 and the issue before the House of Lords was whether this receipt was trading income of the company. Lord Buckmaster observed:

Glenboig Union Fireclay Co v IRC [5.560] Glenboig Union Fireclay Co v IRC (1922) 12 TC 427 I am quite unable to see that the sum represents [income]. It is said, and it is not disputed, that the amount in fact was [calculated] by considering that the fireclay to which it related could only be worked for some two and one half years before it would be exhausted, and it is consequently urged that the amount therefore represents nothing but the actual profit of two and one half years received in one lump sum. I regard that argument as fallacious. In truth the sum of money is the sum paid to prevent the Fireclay Company obtaining the full benefit of the capital value of that part of the mines which they are prevented from working by the Railway Company. It appears to me to make no difference whether it be regarded as the sale of an asset out and out, or whether it be treated merely as a means of preventing the acquisition of profit that would otherwise be gained. In either cases the capital of

320

[5.550]

the company has to that extent been sterilised and destroyed. … It is unsound to consider the fact that the measure, adopted for the purpose of seeing what the total amount should be, was based on considering what are the profits that would have been earned. That, no doubt, is a perfectly exact and accurate way of determining the compensation, for it is now well established that the compensation payable in such circumstances is the full value of the minerals that are to be left unworked, less the cost of working, and that is, of course, the profit that would be obtained were they in fact worked. But there is no relation between the measure that is used for the purpose of calculating a particular result and the quality of the figure that is arrived at by means of the application of that test. I am unable to regard this sum of money as anything but capital money.

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[5.570] Finally, a case which brings together these two ideas is Allied Mills v FCT (1989) 20

ATR 457. The taxpayer had a diversified business in the food industry. Its nine divisions were engaged in the production, manufacture and distribution of food ingredients, food products and by-products. In 1973 it became the sole distributor of Peek Frean biscuits in Australia, PNG and Fiji and also had a licence to manufacture and sell one Peek Frean product, “Vita Weat” biscuits. When Arnotts bought Peek Frean in 1975, the existing arrangements were continued with some variations but in late 1976 or 1977, Arnotts informed the taxpayer that the arrangements were not satisfactory. After some negotiation, the sole agency was terminated and the taxpayer received $372,700 as “compensation for termination of agreement”. The ATO assessed the amount as income under s 25. The Full Federal Court upheld the assessment:

Allied Mills v FCT [5.580] Allied Mills v FCT (1989) 20 ATR 457 The activities and structures of the appellant as a whole must be considered in determining whether the rights of the appellant which were terminated by the 1977 agreement constituted a structural asset. Normally in order for a contract to be regarded as a capital asset it must be a contract which is of substantial importance to the structure of the business itself. This is a factual matter and inevitably a matter of degree. Here the appellant was not parting with a substantial part of its business or ceasing to carry on business as was the case in Californian Oil Products. Furthermore the appellant was not disposing of part of the fixed framework of its business in the sense required by Van den Berghs v Clark. The contracts here in themselves yielded profit; they did not simply provide the means of making profit. Also, the arrangements between the appellant, Peek Frean Australia and its parent, and later Arnotts, fluctuated considerably over the years of their existence in the sense that there was no element of permanence in them; they were varied not infrequently during a period of a few years and primarily with reference to matters concerning the distribution arrangements for the sale of Peek Frean products and Vita Weat biscuits.

In no real sense, therefore, could the payment be considered as a payment for the giving up of a capital asset. In return for payment of the $372,700 the appellant gave up the right to exploit its sole distributorship of Peek Frean products and Vita Weat and rights ancillary thereto and thus earn profits. Contracts are made to be performed, not terminated, so in one sense the termination of contracts will be outside the ordinary course of business. Yet it is clear that payments made upon the termination of contracts may be of an income nature. What is important in characterising the payment is not the fact that it is made as compensation for the termination of the contract, which will often be outside the ordinary course of business, but rather the nature of the contract which generated the payment, and the way in which that contract related to the structure and business of the taxpayer. Here the contract in question was one whereby the appellant undertook, for a fee, to provide distribution services for the owners of the Peek Frean biscuit range. We have taken into account that the appellant did not enter into a large number of distribution arrangements and that of the two arrangements which it entered into with some elements of similarity to the present arrangements, both

[5.580]

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Allied Mills v FCT cont. differed from those last-mentioned arrangements in material respects. Nevertheless, it seems to us that it was part of the appellant’s business to provide such distribution services. The contract in question was therefore one made in the ordinary course of the business of the appellant. The

payment made upon its termination was essentially designed to compensate the appellant for the loss of the anticipated profits flowing from the contract. They should be regarded on the same footing as the profits themselves would have been. In our opinion the receipt by the appellant of $372,700 was of an income nature.

[5.590] The principle that a receipt may be income if it is in substitution for an amount that

would have been income had it been received (or perhaps if it is compensation for an asset that is a revenue asset of a business), is discussed more fully in Chapter 6. [5.595]

Questions

5.48 5.49

How would California Oil be dealt with after capital gains tax? How would Heavy Minerals be dealt with after capital gains tax?

5.50

A taxpayer had a contract to perform management services for eight years. After four years the other party to the contract was taken over and unilaterally terminated the management contract. The taxpayer decided to accept $165,000 in return for promising not to pursue legal action. Is this amount assessable to the taxpayer? (See Case Z21 (1992) 92 ATC 218.)

(d) Know-how and Related Assets [5.600] Similar characterisation issues arise in relation to other intangible assets such as

know-how and secret information. In Rolls-Royce Ltd v Jeffrey [1962] 1 WLR 425 the House of Lords held that the proceeds of licensing agreements were assessable as income. The company had developed technical expertise in the design and manufacture of aircraft engines. Its ordinary method of exploiting this expertise was by manufacturing and selling engines, but some countries refused to purchase manufactured engines, preferring to manufacture domestically. Rolls-Royce entered agreements with the governments of several of these countries (including France, the US and Australia) under which it agreed to provide certain drawings and technical information, to train technicians from these countries and to send its own staff to supervise manufacturing operations. In return, Rolls-Royce received payments in the form of lump sums and royalties. It argued that the lump sums were not assessable as they were for sale of part of the capital structure of the business. The House of Lords disagreed. The capital structure of the business was, the company argued, embodied in the drawings, documents and information generically termed “know-how” and by these licences it was parting with some of that structure. The reasoning of the members of the House of Lords varies substantially. Lord Reid suggested that there was no sale of an asset but the payments were instead received for performing services, or that if the payments were for the sale of an asset, the transaction was not the sale of the structure of their business but was within the widened business (that is, concentrating on the scope and ordinary course issue):

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Rolls-Royce Ltd v Jeffrey [5.610] Rolls-Royce Ltd v Jeffrey [1962] 1 WLR 425 I cannot accept the contention that by each of these agreements the appellants sold a part of that capital asset and received a price for it. There is nothing in the case to indicate that that capital asset was in any way diminished by carrying out these agreements. The whole of their knowledge and experience remained available to the appellants for manufacturing and further research and development, and there is nothing to show that its value was in any way diminished. They had not even given up a market which had been open to them. They could not sell their engines in these countries whether they made these agreements or not. If they had not made these agreements they would have got nothing from these countries; by making them they were able to exploit their capital asset by receiving large sums for its use there. In essence what they did

was to teach the “licensees” how to make use of the “licences” which they granted. But the appellants say that, nevertheless, these receipts did not come to them as receipts of their trade of manufacturing and selling aircraft engines and motor cars, and for that reason should not enter the computation of the profits of that trade. I cannot agree. It is for each trader to determine the scope of his own trade. No doubt a trader can carry on two separate trades simultaneously. But the facts of this case clearly indicate that this course of granting “licences” was merely an extension of their existing trade devised to meet the difficulty that they could not sell their engines in the countries of the “licensees”. It was merely another method of deriving profit from the use of their technical knowledge, experience and ability.

Lord Radcliffe, on the other hand, concentrated on the place of the asset in the business of the taxpayer and concluded (in effect) that the “know-how” was treated as a revenue asset of this business: It is fundamental to the appellants’ case that we should categorise this asset as being part of their fixed capital. Indeed, their argument proceeds from the premise that it is fixed capital. That, I think, is to start from too assured a base. An asset of this kind is, I am afraid that I must use the phrase, sui generis. It is not easily compared with factory or office buildings, warehouses, plant and machinery or such independent legal rights as patents, copyright or trade marks, or even with goodwill. “Know-how” is an ambience that pervades a highly specialised production organisation and, although I think it correct to describe it as fixed capital so long as the manufacturer retains it for his own productive purposes and expresses its value in his products, one must realise that in so describing it one is proceeding by an analogy which can easily break down owing to the inherent differences that separate “know-how” from the more straightforward elements of fixed capital. For instance, it would be wrong to confuse the

physical records with the “know-how” itself, which is the valuable asset: for, if you put them on a duplicator and produce one hundred copies, you have certainly not multiplied your asset in proportion. Again, as the facts of the present appeal show, “know-how” has the peculiar quality that it can be communicated to or shared with others outside the manufacturer’s own business, without in any sense destroying its value to him. It becomes, if you like, diluted, and its value to him may be affected, though, in my view, it begs the question to say that that value is necessarily reduced because the asset is used for outside instruction. These considerations lead me to say that, although “know-how” is properly described as fixed capital by way of analogy, it is the kind of intangible entity that can very easily change its category according to the use to which its owner himself decides to put it. I am not sure that it is too much to say that it is his use of it that determines the category. It is not like a single [5.610]

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Rolls-Royce Ltd v Jeffrey cont. physical entity which must be employed for production or else broken up: it is more like a fluid in store which can be pumped down several channels. I do not therefore think that this appeal can be decided by the simple set of propositions: “‘know-how’ is an item of fixed capital.” A lump sum received by a trade on a “sale of such an item should not go to his income account”. It makes no difference that the item is disposed of, by several separate transactions divided from each other by time “intervals”. Now as to the licence agreements. Putting aside the actual patents which are found by the case stated to have been such as to have “very little store” set by them in this context, there is really no licensing done at all. Whatever else the lump or capital sums payable under the agreement are paid for, it is not for a licence in the ordinary sense: it is for the making available, the imparting, of the “know-how”, both as recorded in the drawings and other data and as conveyed by direct instruction, advice and information. No doubt the things to be supplied are tangible objects, but then so are textbooks, formulae or recipes. They are teaching at long range. I have not been able to see why these “capital” receipts should not be brought into account in the assessment of the appellants’ trading profits. It seems to me that, so long as they kept their “know-how” to themselves, they used it for the manufacture of their own engines, and its value was expressed in the successful sales which they achieved of those products. I daresay that they

would have preferred, ideally, to reserve their “know-how” solely for the purposes of their own manufacture. I am not sure of that, when I read some of the chairman’s speeches at the annual meetings. However that may be, it is clear that they saw that, having the “know-how” they could derive profit from the manufacture of their engines, even by others, in parts of the world where they either could not or would not sell or manufacture them themselves, provided only that they equipped those others with the requisite expertise. So they turned the “know-how” to account by undertaking for reward to impart it to the others in order to bring about this alternative form of manufacture. My Lords, in my opinion, moneys so obtained arise from the appellants’ trade as “manufacturers of motor-cars and aero engines”. I appreciate their point that such moneys are not derived from their own operations of manufacture and therefore, if assessable at all, must be attributable to a new and separate trade consisting of the exploitation of “know-how” for reward. But this, with all respect, is a verbalism, and I think that the respondents were right in saying that the appellants’ new way of exploiting “know- how” was no more than a development of their direct manufacturing trade and do not rank or need to rank as a separate business. In my view, that expresses the reality of the matter, since, as manufacturers, the appellants were interested to promote the production of their engines for reward to themselves, and it was a question of trading policy by which method they secured this result by manufacturing and selling on their own or by selling to others the essential secrets of manufacture.

[5.620] There are at least three possible explanations of Rolls-Royce. One explanation is

similar to the reasoning of Lord Denning in the decision Murray v Imperial Chemical Industries Ltd (discussed in Chapter 3). That explanation is that the company had made the selling of its know-how an activity of its business so that the know-how which would ordinarily have been a structural asset had, in the circumstances, become a revenue asset. This of course implies that any characterisation of an asset is not final but has to be made in the context of each realisation. Another explanation of Rolls-Royce is that the know-how of the taxpayer remained a structural asset but that the transactions under which the know-how was sold were equivalent to non-exclusive licences to use the asset. The receipts were thus income derived from property. Another explanation is that no asset was sold or made available to the 324

[5.620]

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buyer, but rather the company simply performed a service for the buyer – instructing the buyer in methods of manufacture – and the receipts were income as rewards for services. A different result from Rolls-Royce was reached by Campbell J in Kwikspan Purlin Systems Pty Ltd v FCT (1984) 84 ATC 4282. In that case the Court held that a single lump sum received for an exclusive licence to use a patent and the provision of know-how was not income from carrying on a business. The taxpayer held a patent for an invention known as the Kwikspan Purlin system. It granted four exclusive licences during a two-year period in discrete geographical areas of Australia in return for lump sum payments and a royalty. As well as permitting the manufacture of the products, the taxpayer also agreed to supply technical information. The taxpayer argued that the grant of an exclusive licence, or even four exclusive licences, amounted to the sale of its patent, by analogy with Murray v ICI: see above, Chapter 3. The ATO assessed the taxpayer on the basis that the lump sums were in the nature of income as the product of a business. Campbell J in the Supreme Court of Queensland disagreed. He said:

Kwikspan Purlin Systems Pty Ltd v FCT [5.630] Kwikspan Purlin Systems Pty Ltd v FCT (1984) 84 ATC 4282 The main contention of the Commissioner is that the challenged receipts are the proceeds of a business and not proceeds from the realisation of an asset. But the taxpayer was not in the business of dealing in patents. It was the owner of an invention that was sold under a trade name and the fact that several licences were granted for different places in Australia is the same as if one licence had been granted for the whole of Australia. Of course, if a company puts its assets to gainful use … as distinct from realising them, that will generally amount to carrying on a business. There were some other submissions in support of the assessments which should be looked at

briefly. The point was made that the taxpayer had no business premises of its own or staff of its own. But I do not think that advanced the argument that it was carrying on a business. It was stressed that the objects clause of the memorandum of association of the company was widely drawn. But that fact is not decisive and a widely drawn objects clause is typical of most companies. It has often been remarked before that these cases can stand on a knife edge. This case is not as finely balanced as that, as I see it. In my opinion the payments in question were wrongly included in the taxpayer’s assessable income under s. 25(1).

[5.635]

Questions

5.51

Can an asset change its character? How is the result in Rolls-Royce to be explained?

5.52

What is the effect of capital gains tax on Rolls-Royce and Kwikspan?

(e) Transactions with a Taxpayer’s Business Premises [5.640] We asked the question above, what are the consequences for a property developer of

selling its head office? The head office is undoubtedly within the scope of, and sufficiently connected to, the business but is any profit made of an income or capital nature? One would ordinarily assume capital. According to Hill J in Westfield (discussed above), profits arising on moving a taxpayer’s headquarters would not be of an income nature. He said:

[5.640]

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A taxpayer carrying on a business might sell its headquarters in order to move to larger premises and make a profit over historical cost. The transaction of sale may be one which arises in the ordinary course of the taxpayer’s business, but that profit will not ordinarily be income, particularly where, at the time of the acquisition of the site, there was no intention or purpose of profit making by sale when the premises became too small.

This observation should have taken no one by surprise – it seems obvious in the case of an owner-occupied building. But what about transactions with leased premises? Would a profit arising from a change of leased headquarters be similarly capital? In his decision in FCT v Cooling (1990) 90 ATC 4472, Hill J had examined the assessability of an amount paid to a taxpayer by a prospective landlord. The amount was paid as an inducement to the taxpayer to move its headquarters and have his service company take a lease in the landlord’s building. His Honour held that the amount was assessable income because of the decision in Myer. Hill J said: If the transaction can properly be said to have been entered into by the [taxpayer’s] firm in the course of carrying on its business and if it can be said that the arrangement is a profit-making scheme in the sense that those words are used by the High Court in Myer then it will follow that the amount received by the parties will be income, and it will not matter that vis-a-vis the firm, the transaction was extraordinary… Where a taxpayer operates from leased premises, the move from one premises to another and the leasing of the premises occupied are acts of the taxpayer in the course of its business activity just as much as the trading activities that give rise more directly to the taxpayer’s assessable income. Once this is accepted, the evidence established that in Queensland in 1985 it was an ordinary incident of leasing premises in a new city building, at least where the premises occupied were of substantial size, to receive incentive payments of the kind in question. Why then should a profit received in the course of business where the making of such a profit was an ordinary incident of part of the business activity of the firm not be seen to be income in ordinary concepts?

Because of the prevalence of lease incentive payments, and the variety of forms in which they were provided both before and more especially after Cooling, the ATO issued Taxation Ruling IT 2631 in which it stated its views of the circumstances in which a lease incentive in various forms would be assessable:

Ruling IT 2631 [5.650] 8. In view of the decision in Myer and Cooling, where a business taxpayer is given a cash incentive to enter into a lease of business premises, the incentive is income of the taxpayer. This position will also apply to amounts paid in consideration of the variation of a lease to take up extra space or to relocate within the same building. An incentive paid to encourage a tenant to remain within the same leased premises would also be income. 9. If a non-cash incentive is received in similar circumstances, that is, a business taxpayer receives a non-cash incentive to enter into or vary

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a lease of business premises, it will have an income character provided that it is convertible to cash, either as a matter of fact or through the operation of s 21A. 10. The question arises as to whether an incentive paid to a taxpayer entering into a business is income. On balance, it is considered that the decisions in Myer and Cooling could not be interpreted to treat a one-off payment of this kind to a new business taxpayer as income. Such a payment, however, would constitute an assessable capital gain by the operation of s. 160M(7).

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[5.660] The Ruling then goes on to identify and distinguish a series of circumstances:

• incentives that will be treated as being convertible into cash and give rise to income in their convertible value (for example, transfers of cars, boats, paintings used by the tenant for private purposes); • incentives that will be treated as being convertible into cash and give rise to income, but for which depreciation will be allowed to reduce their value (for example, cars, boats and paintings used by the tenant to produce assessable income, free fit-out provided by the lessor owned by the lessee); • incentives that are conceded not to be convertible into cash and give rise to no income (for example, rent-free periods); • incentives that will be treated as income but reduced to a zero value because of the “otherwise deductible” rule in s 21A (for example, interest-free loans, paying the cost of moving stock, free use of the lessor’s fittings); and • incentives that will be treated as income but reduced to a zero value because of the “non-deductible” expenditure rule in s 21A (for example, free holiday packages provided by the lessor). Lease incentives were very common during the glut of CBD office space as developers sought occupants for their vacant towers and many incentives were paid during the 1980s long before Cooling had been decided, so it was to be expected that the lawyers and accountants who had received these incentives might decide to challenge the outcome of Cooling. There was also some litigation overseas in Canada (Ikea Ltd v Canada (1998) 1 SCR 196) and New Zealand (IRC v Wattie [1999] 1 WLR 873) where the issue had been ventilated. In Australia, further litigation inevitably followed. The decision in a subsequent case Rotherwood v FCT (1996) 32 ATR 276 appeared to confirm the Cooling decision, but three subsequent cases, Lees & Leach v FCT (1997) 36 ATR 137, Selleck v FCT (1997) 36 ATR 558 and in the Federal Court in Montgomery v FCT (1998) 38 ATR 186, cast doubt both on Cooling and IT 2631. These decisions showed the divergent tax treatment that can arise from commercially identical transactions – where the landlord offers an incentive in the form of reduced rent over the term of the lease, a rent-free period at the start of the lease, the free fit-out of the premises to the tenant’s specifications, or a lease incentive payment (with higher stipulated rental in the case of the latter two options). All of these options ultimately result in a lower cost of premises for the tenant over the term of the lease, though only the first two are reflected in a reduction in the deduction claimed for “rent” in the accounts of the occupant. If the free fit-out and the lease incentive were assessable as income and the higher rent was deductible as business expense, the income and deductions would “wash”, leaving the taxpayer in the same overall tax position (though the timing would be different). But if the lease incentive payment or the fit-out were not assessable and the higher rent fully deductible, there would be a mismatch. The assessability of cash lease incentives was considered by the High Court in the latest of these cases, FCT v Montgomery (1999) 198 CLR 639. The taxpayer failed in its attempts to overturn the ATO’s assessment that the lease incentive was ordinary income. In this case, Freehill, Hollingdale & Page in Melbourne had just completed a major renovation of its existing premises in BHP House when its landlord decided it had to remove the occupants of [5.660]

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the building and gut it in order to remove the asbestos that the building contained, a process which was expected to take up to four years. Consequently, the firm moved into new premises in 101 Collins Street and received inducement payments totalling $29 m over three years from their new landlord. At first instance, the taxpayers lost but the Full Federal Court found that the amount was not income because it was not received in the course of the taxpayer’s business nor from a profit-making transaction. On appeal, the High Court disagreed and held by a 4:3 majority that the amount was assessable under s 25. The majority judgment (Gaudron, Gummow, Kirby and Hayne JJ) is a difficult judgment – it contains no clear statement of why the receipt was taxable, but does contain a lot of statements about why some of the ATO’s arguments were wrong. For example, all the judges disagreed with the ATO’s argument that the incentive was paid in compensation for undertaking the obligation to pay higher rent – they found no relationship between the amount of the incentive and the amount of the rent. The closest we can come to a ratio emerging from the majority judgment is that the taxpayer’s receipt was the product of a new way in which it exploited its existing capital, which makes the case similar to Rolls-Royce. They said:

Montgomery v FCT [5.670] Montgomery v FCT (1999) 198 CLR 639 The Commissioner’s contention that the sums received under the inducement agreement were income in the hands of the taxpayer was put in several ways. It was said that because the sums received were an incident of a transaction that occurred in the course of the business activity of the taxpayer (even though it was not in the ordinary course of that business) and because the receipts were an ordinary incident of a transaction of that kind, the receipts were income. Next, it was said that the receipts were a gain from a profit-making undertaking or scheme and that a significant purpose of the taxpayer in entering the transaction was the derivation of a gain. Finally, it was said that it was an amount, received in business, as an incentive to pay greater rental payments than the taxpayer would otherwise have been prepared to pay and in circumstances, first, where the rental payments are a deductible expense and, secondly, where the incentive was bargained and negotiated for in the natural course of carrying on the taxpayer’s business. Before examining these contentions, or the taxpayer’s arguments in answer, it is as well to say something about the fundamental issues that are raised by a debate about whether a particular receipt by a taxpayer is capital or income. The core of the meaning of “income” in a context such as the present can be identified 328

[5.670]

from what was said by Pitney J in the opinion of the Supreme Court of the United States in Eisner v Macomber (1919) 252 US 189 at 206-207: The fundamental relation of “capital” to “income” has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time. For the present purpose we require only a clear definition of the term “income,” as used in common speech, in order to determine its meaning in the Amendment; and, having formed also a correct judgment as to the nature of a stock dividend, we shall find it easy to decide the matter at issue. After examining dictionaries in common use, we find little to add to the succinct definition adopted in two cases – “Income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through a sale or conversion of capital assets … Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy. The

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Montgomery v FCT cont. Government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word “gain,” which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. “Derived-from-capital”; – “the gainderived-from-capital”, etc. Here we have the essential matter: not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being “derived”, that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal; – that is income derived from property. Nothing else answers the description. As was noted in Myer Emporium Ltd both the “ordinary usage meaning” of income and the “flow” concept of income derived from trust law have been criticised. But both the ordinary usage meaning and the flow concept of income are deeply entrenched in Australian taxation law and it was not suggested by either party that there should be any reconsideration of them. Nor was it suggested that they should be replaced by concepts of gain or realised gain concepts that some economists consider preferable. What can be seen from the passage from Eisner v Macomber is that income is often the product of exploitation of capital. But, of course, that is not always so. The worker’s wages are not (except figuratively) the product of exploitation of the worker’s capital. Further, as has so often been stated, income will frequently be recurrent or periodical. But again, the fact that a person only ever works for wages for one week, and receives but a single pay packet (or more likely written advice of electronic funds transfer) does not make the wages thus earned any the less income in the hands of the worker. Most receipts from carrying on a business are income. But some receipts, such as amounts paid on disposing of capital assets of the business, are properly classified as receipts on capital account.

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Each of the general propositions we have mentioned is qualified: income is often (but not always) a product of exploitation of capital; income is often (but not always) recurrent or periodical; receipts from carrying on a business are mostly (but not always) income. Further, in a case where it is said that the receipt is from carrying on business, often there will be a real and lively question whether what has been done amounts to carrying on business or is, in truth, no more than a singular transaction of purchase and resale of property … The character of these receipts The inducement amounts received by the firm did not augment the profit-yielding structure of the firm. The lease was acquired as part of that structure; the inducement amounts were not. There was, in the words of Pitney J in Eisner v Macomber “not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being ‘derived’, that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal”. To put the matter another way, the firm used or exploited its capital (whether its capital is treated for this purpose as being the agreement to take premises or its goodwill) to obtain the inducement amounts. As the papers presented to the firm in August 1989 said, the firm was then “of a size which makes it a particularly attractive tenancy target”. And it was because it was a particularly attractive tenancy target that it was suggested in those papers that the firm should receive a good inducement offer to take premises. The firm used or exploited its capital in the course of carrying on its business, albeit in a transaction properly regarded as singular or extraordinary. And the sums it received from the transaction were not as some growth or increment of value in its profit-yielding structure – the receipts came in or were derived for the separate use, benefit and disposal of the firm and its members as they saw fit. (That the firm decided to retain the sums received rather than distribute them to partners – other than to the extent necessary to meet the amounts of taxation payable by partners on account of their receipt – is of no consequence. [5.670]

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Montgomery v FCT cont. The very fact that the firm chose to dispose of the sums in this way demonstrates that they were receipts at the disposal of the firm.)

The primary judge was right to hold that the amounts paid under the inducement agreement were (to the extent of the taxpayer’s interest in the partnership) assessable income of the taxpayer.

The minority judgment (Gleeson CJ, McHugh and Callinan JJ) is a more conventional analysis of the issue (and one which appears to have been written with the majority’s position in mind): We are unable to accept that the inducement payment is properly characterised as proceeding from the use or exploitation by the firm of its capital, whether the relevant capital is taken to be the agreement to lease the Collins Street premises or the goodwill of the firm. We say that for the following reasons. First, such characterisation involves disregarding the entire transaction and directing attention to only part of it. This, as was noted earlier, is the opposite of the approach taken in Myer. Secondly, the agreement to take the lease, for which the inducement payment was part of the consideration, was not, at the time of the agreement for the inducement payment, an asset of the firm capable of exploitation. The owner of the premises agreed to grant, and the firm agreed to take, the lease. The rights to be granted under the lease were to form part of the capital structure of the firm. The receipt of the inducement payment accompanied, and was occasioned by, the lease agreement, but it did not constitute an exploitation of the agreement. Thirdly, the asset of the firm which was its goodwill must be identified accurately. It is something different from the firm’s size. The firm’s size was not part of its capital. The goodwill

of a firm has been described as “the attractive force which brings in custom”. Depending upon the nature of the firm’s trade or business, it may be related to a variety of factors including the premises from, or the locality in, which it operates. What made the firm in the present case an “attractive tenancy target” was primarily its size but also, no doubt, its reputation. Those matters would have increased its bargaining power in negotiations about the size of the inducement payment, but it does not follow that it is correct to regard any part of the payment, let alone the whole of it, as the fruit of exploitation of the firm’s goodwill. Fourthly, there is a measure of inconsistency between the appellant’s reliance on the circumstance that, in the prevailing market conditions, receipt of an inducement payment was an ordinary incident of taking up a lease of a substantial portion of a new building in Melbourne, and a contention that the payment in the present case resulted from the exploitation of the firm’s goodwill. Putting all other objections to the proposition to one side, the most that could be said is that the firm’s size and reputation meant that it could expect to be offered a larger payment than some other prospective tenants.

[5.680] It might be thought that this case resolved any lingering doubts about the assessability

of incentive payments, but the taxpayer in O’Connell v FCT (2002) 121 FCR 562; [2002] FCA 904, a partner in Peat Marwick, persisted in trying to argue that the incentive he received was not assessable. He claimed that the decision in Montgomery was distinguishable – he chose his new building in order to have more appropriate accommodation, not in order to receive the inducement. The Court disagreed based on the evidence. Goldberg J said: 330

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I do not accept that the T & G site was chosen by PMH solely for its physical requirements. I am satisfied that the financial incentive offered played a significant role in the decision-making process of PMH, particularly having regard to the firm’s proposal, carried into effect, to use its reputation and exploit its tenancy requirements to maximise the value of its tenancy and minimise its long-term rental costs. [5.685]

5.53

Question

Some of these cases occurred before the full impact of CGT came into effect (for example, the lease incentive payments in Selleck were received from 1985–86) or else CGT was not argued before the Court (as in Montgomery where the incentives were received from 1990–92). What would be the impact of CGT on these payments? Consider s 104-155 of the ITAA 1997.

(f) Realising Financial Investments [5.690] For tax purposes, the concepts of business and investing are mutually exclusive – in fact, they are diametrically opposed. Business typically involves activity, repetition, system and gains to be derived from trading, while investing is typically passive, infrequent, not very numerous, and gains are expected to arise from mere holding. This is why it is axiomatic that the trustees of superannuation funds, for example, are not regarded as deriving business income – in the paradigm case, they simply hold investments from which income is derived and, if they happen to sell an investment, any profit is treated as a capital gain (and to avoid any argument about it, s 295-85 of the ITAA 1997 provides that CGT treatment is the exclusive tax regime for gains and losses made on the sale of the assets of a complying superannuation fund). One consequence of the dichotomy between business and investing is that any gain on realising an investment asset held by a business would usually be characterised as capital gain and not income, even though the gain was realised on investments made by a taxpayer who carries on a business. So, for example, when a holding company sells the shares in its subsidiary in a takeover, the profit made is not income of the business of the parent. But as the definition of a continuing business suggested above merely requires repetition, system and overall profit-making purpose, there seems to be no reason in logic (let alone in experience) why those characteristics are confined to trading in beans but not in bonds, or in shoes but not in shares. If Lord Radcliffe is correct in Rolls-Royce, whether an asset (which might somewhat unhelpfully be termed “an investment”) is a revenue or a capital asset of the business, really depends upon the use to which the asset is put in the particular business, rather than on the nature of the asset per se.

(i) Banks and insurance companies [5.700] The so-called “banking and insurance cases”, some of which are extracted in this

section, illustrate one group of cases in which the courts have routinely concluded that activities connected with making and realising financial investments do generate ordinary usage income. In the activities of such institutions, assets which to other taxpayers might be considered to be investments and hence capital, are apparently revenue assets of the business. One of the leading cases establishing this principle in Australian tax law is Australasian Catholic Assurance Co v FCT (1959) 100 CLR 502. During the year of income, the company sold 14 blocks of flats at a large profit. The flats had been bought as a long-term investment expected to generate a 10% annual return through rent over about 30 years. Because of rent [5.700]

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control imposed during World War II and rising maintenance costs, the company decided to sell the flats. Menzies J in the High Court held that the profit made on the sale was assessable as ordinary usage income:

Australasian Catholic Assurance Co v FCT [5.710] Australasian Catholic Assurance Co v FCT (1959) 100 CLR 502 There is one other important finding of fact that I make; namely that the flats sold in 1951 were not acquired by the taxpayer for the purpose of profit making by sale so as to bring the profit that was ultimately made into the taxpayer’s assessable income by virtue of the first part of s. 26(a) of the Act. The main argument for treating the profits in question as assessable income is that they were profits from the carrying on of the taxpayer’s life assurance business and were accordingly income according to ordinary concepts, and properly taxable as such. That they were profits from the carrying on of that business is, I think, an inescapable conclusion. The flats were bought as good investments and were sold to avoid their becoming bad investments, which was what was intended from the very first, although it was hoped and, indeed, expected, they would not have to be sold until a long time after 1951. So much was indeed conceded. It was said, however, with the support of weighty authority, that not all proceeds of a business are income for the purposes of the Act. It is said that these profits were the proceeds of the business in a very special sense, since they arose out of transactions outside the ordinary course of the taxpayer’s business and the sales were forced upon the taxpayer by unexpected developments. I am ready enough to accept this contention to the extent that it was unexpected developments that dictated the sales in 1951, but I cannot agree that the sale of the flats purchased as investments was outside the ordinary course of the taxpayer’s business and I do not think that to say that there were but few transactions establishes any such thing. If a block of flats was sold in 1952, it would be difficult, having regard to what occurred between 1947 and 1951, to say that such a sale was outside the ordinary course of the taxpayer’s business and yet I cannot think that the sale in 1952 would stand on a different 332

[5.710]

footing from an earlier sale. If however, the sales were in the ordinary course of the taxpayer’s business, as I think they were, the particular reason for deciding to sell cannot be decisive of the question whether the profit made is income or not. It is not necessary to undertake an elaborate discussion of the many authorities that bear upon the problem that faces me here, but there are four cases to which I think I should refer. [His Honour then referred to Northern Assurances Co v Russell (1889) 2 TC 571; Punjab Co-op Bank Ltd, Amritsar v Income Tax Commissioner, Lahore [1940] AC 1055; Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604; and Producers’ and Citizens’ Co-op Assurance Co Ltd v FCT (1956) 95 CLR 26.] It was … suggested here that freeholds are in a special category and that cases dealing with the sale of investments such as shares or securities are not to be applied to a case where the investments realised are freehold properties. I am disposed to think that it may be easier to treat the profit made upon the sale of securities other than freehold as assessable income than to treat as such a profit made upon the sale of land. It seems to me, however, that the difference is one of degree rather than character. It was said here that if the profit which the taxpayer made is taxable, so is every other profit made by a taxpayer when it sells part of its real estate; but my decision falls far short of the acceptance of such a conclusion and rests upon the narrower ground that this taxpayer, as part of its ordinary investment business, bought real estate to obtain a high return and sold it profitably when it was found to be producing a low return, and so made a profit upon its buying and selling which I regard as income according to ordinary concepts, because in the ordinary course of carrying on business, the taxpayer must from time to time change its investments to use its funds to the best

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Australasian Catholic Assurance Co v FCT cont. advantage. What it makes or loses in doing so is, I think, properly to be regarded as something to be taken into account, together with intermediate income, in deciding whether, overall, the investment produced a profit or a loss. Any profit realised on sale is of the same character as the annual income, and both go to make up the return.

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In reaching this conclusion, I am not disposed to rely upon s. 26(a) at all because I doubt whether it applies to the taxpayer’s life assurance business as a whole and, if it does not, I doubt, further, whether it would be proper to extract from such business a series of transactions such as the purchase and sale of the flats and to label them “the carrying on or carrying out of” a “profit making undertaking or scheme”.

[5.720] What is the basis for the proposition that a bank derives income from realising

investments where other taxpayers would derive only capital gain? The judgments of Barwick CJ and Jacobs J in London Australia Investments below, explain these cases as arising from the peculiar nature of banking and life assurance business. A bank generates its profit by obtaining a greater flow of income from its investments than the cost of servicing the money it borrowed to buy them. Because it must be ready to meet a call for a return of the money by those who have lent to it, it also must be able to surrender and change its investments. The realisation of a profit on changing an investment made by the bank or insurer is incidental to the making of the ordinary profit by the excess of income flows over the servicing costs. It is clear that not every asset owned by a bank or insurance company is a revenue asset of the business. Not every asset will be used by the bank nor realised for meeting the recurrent demands of investors. Indeed Menzies J acknowledged this when he rejected the company’s argument that if the profit made in Australasian Catholic Assurance were taxable, so also would be every other profit made by any taxpayer, including presumably insurance companies, when it sold part of its real estate. Even assets held by a bank or insurance company can be treated in the context of the business as structural assets. In National Bank of Australasia v FCT (1968) 118 CLR 529 the taxpayer took over Queensland National Bank and with it a parcel of shares in a pastoral company owned by that bank. Queensland National Bank had foreclosed mortgages on some rural properties, forming the company to operate the properties, and had treated the distributions as reducing the bad debts recorded on the books for unrecouped loans. The taxpayer held the shares because it wanted to continue trading with the pastoral company and because it wanted to retain the image that the Queensland National Bank had developed of being concerned for primary producers. It also wanted to derive the dividends on the shares. Kitto J held that the profit derived on the sale of the shares was not assessable as income. Until 1984 it was thought that the potential application of the principle was probably restricted to banks and life insurance companies. In Chamber Of Manufacturers Insurance Ltd v FCT (1984) 84 ATC 4315 the Full Federal Court extended the application of the principle to the activities of a general insurer. Because general insurers operate in a manner different from banks and life insurers, it was thought that the banking and insurance cases had no application to them. A bank or life insurer can be thought of as holding money on behalf of the customer – the funds are invested by the customer with the institution and will inevitably be returned at some stage with accumulation – in the case of a life insurer either at death or even during the currency of the policy as bonuses. A general insurer holds a fund to meet [5.720]

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claims but does not receive those funds as if an investment, nor does it give a return on an investment in the same way. The discussion in Chamber of Manufacturers revolves around the issue whether assets earmarked in a “reserve fund” held available to meet claims by policy holders are revenue assets of the business. The result of the case suggests that if an asset might be made available to meet claims against the company, it will be a revenue asset. (ii) Investment trusts and companies [5.730] The “banking and insurance cases” have often been regarded as “the-exception-that-

proves-the-rule” – that is, the rule that the making and realising of investments will not, except for those idiosyncratic taxpayers, generate ordinary usage income. But the High Court has not limited the principle to just banks and insurance companies. In the London Australia Investments case (extracted below) the High Court held that gains on realising “investments” held by a non-bank investment company were ordinary usage income. As a result of that case, it is now much more open to speculation how far gains made on realising investments by taxpayers, other than banks or insurance companies, are susceptible to being characterised as income being gains from a business which involves the making and turning over of investments. Obvious candidates for this kind of treatment would include the modern managed investment fund industry – the kinds of funds offered to the public by fund managers such as Colonial First State, BT, MLC, Macquarie or ING. These companies manage portfolios of shares, corporate bonds or property on behalf of retail investors. The fund managers often actively “manage” the portfolio of assets on behalf of their investors, switching from share to share as values rise and fall, and may turn over 20% or more of the fund’s assets in a single year. The recognition that investing is not carrying on a business is the rationale for the old s 26(a) of the ITAA 1936 cases and explains the need for CGT. The possibility that so-called investors might be carrying on a business or might be receiving the profits of a profit-making scheme was first canvassed in Charles v FCT (1954) 90 CLR 598. In this case, the taxpayer invested in a unit trust, the precursor of the modern managed fund. The trustee received the invested funds and “managed” them so as to generate the maximum return for unit-holders which was paid half-yearly. During the year, Charles received £830 as a distribution from the trustee. Of this, £440 represented dividends and interest on the investments received by the trustee and was treated as income to Charles. The other £390 represented profits made when the trustee realised some of the assets of the unit trust. The Commissioner argued that this latter amount was included in the taxpayer’s assessable income either as the profits of a business or under the second limb of s 26(a), as it retained its character as trading profits when distributed to the beneficiaries of the trust such as Charles. The High Court was prepared to agree that the distributions made to the beneficiaries retained whatever character they had in the hands of the trustee, but they found that the trustee was not carrying on a business even though the Court recognised that “the dealings were considerable, they occurred frequently and produced substantial profits”. Because the profits on sale were not the proceeds of a business, they remained capital when distributed to the beneficiaries. The case which first suggested that an “investor” might nevertheless be carrying on a business, of which the investments formed the revenue assets, was the decision of the High Court in London Australia Investment Co Ltd v FCT (1977) 138 CLR 106. Barwick CJ, who dissented from the majority, described the investment strategy of the company in this way: 334

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London Australia Investment Co Ltd v FCT [5.740] London Australia Investment Co Ltd v FCT (1977) 138 CLR 106 The appellant is an investment company incorporated in New South Wales with a shareholding predominantly held by residents of the United Kingdom. It did not carry on any business in Australia other than investment in Australian companies with a view to the production of an income from dividends. … It suffices for my present purpose to say that the appellant, with the advice and recommendations of an Australian management company which managed its affairs in Australia, pursued a policy of endeavouring to maintain a consistent yield on its capital invested in shareholding in Australian companies. It did not purchase or otherwise acquire shares in order to make a profit by their re-sale. But, in order to maintain the desired yield, it was advisable if not indeed necessary from time to time to realise shares which, by reason of changes in market value or dividend paid, ceased to provide that yield. It must appear, certainly at first sight, extremely odd that an accretion to capital derived from the sale of an asset, not forming part of circulating capital and not purchased or held as a trading asset, should be accounted income. But the question is whether, none the less, the decisions and settled doctrine in the law of income tax required such a conclusion. Discussion of the subject usually begins with a citation of the remarks of the Lord Justice Clerk in Californian Copper Syndicate (Limited and Reduced) v. Harris. The oft citation of the truism there expressed has given it a delphic significance. But, in truth, what was there said furnishes no criterion for determining such a question as is now before this court in this case. Of course, what is produced by a business will in general be income. But whether it is or not must depend on the nature of the business, precisely defined, and the relationship of the source of the profit or gain to that business. Everything received by a taxpayer who conducts a business will not necessary be income. As I have said, it must depend on the essential nature of his business and the relationship of the gain to that business and its conduct.

In holding that gains upon the realisation of securities by banking and insurance companies constitute income by the banking or insurance business, the court relied upon the particular nature of those businesses and the relationship which investment realisation bore to that nature. In contrast, the High Court in Charles v. F.C.T. held that such realisation did not form part of the income of the unit trust business conducted by the taxpayer. The court accepted that the switching or realisation of investments was not part of the particular investment business conducted by the unit trust company. No doubt the switching or realisation was incidental to that business and occurred because of the exigencies of that business. But as trafficking in shares did not form part of that business, the gains or losses were not income gains or losses. That the appellant carried on investment in Australian shares as a business or business activity cannot be doubted. The essence of that business was the receipt of dividends in order to service the dividend to be paid by the appellant to its United Kingdom shareholders. Quite clearly, it was no part of that business to traffic in shares. Accordingly, no shares were acquired with the purpose of making profit by their re-sale. But, as the maintenance of the subscribed capital and of a consistent yield upon it was also of the essence of the company’s business, realisation of shares from time to time became necessary or advisable. Market conditions and the fortunes of companies in which shares were held determined whether or not realisation should occur. Those realisations could be said, in my opinion, to be a result of the nature of the company’s business but not part of that nature. Here, quite clearly, the realised shares did not form part of the appellant’s stock in trade or of any circulating capital. The money invested in them formed part of the capital of the appellant, capital derived from the subscription of shareholders except to the extent that possibly some part of the equalisation account had at some stage been carried to capital reserve. But, in that event, the augmentation was contingent [5.740]

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London Australia Investment Co Ltd v FCT cont. and problematical. Subsequent losses on realisation may reduce that accretion: indeed may fully absorb it. In my opinion, nothing in the banking and insurance cases included in the references I have made requires the conclusion that the gains or losses on realisation of shares by this company formed part of, or in the case of a loss, a reduction of, its assessable income. For present purposes I am prepared to treat that decision as explicable on the footing that the investment in the real estate by the taxpayer was part of the nature of its particular business of insurance.

There may be good reasons, in my opinion, for doubting that conclusion but it is unnecessary for me in the decision of this case to pursue that matter. On the other hand, the reasoning of the court in Charles v. F.C.T. supports the view that such a conclusion should not be drawn in this case. If analogy is of any assistance to decision in this kind of case, the investment policy outlined in the reasons for judgment in Charles v. F.C.T. bears a striking similarity to the investment policy evidenced and accepted in this case. In my opinion, the gains or losses in realisation of shares by the company accumulated by pursuit of its investment policy cannot properly be brought to account in determining the assessable income of the company.

Gibbs J, who was one of the majority, disagreed, finding that the profits were assessable as income: In the present case the taxpayer naturally placed considerable reliance on the finding that the shares were not bought for the purpose of selling them at a profit. That is indeed an important circumstance. It was then submitted that the shares were acquired on the capital account of the company, for the purpose of adding to its profit-making structure, as the means of producing dividend income, rather than as part of the profit-earning activities within that structure. If that submission were correct, the fact that the shares were realised in a methodical and enterprising way, so as to secure the best results for the taxpayer, would not convert the proceeds of realisation into income. But the question whether the shares were acquired on the capital account of the taxpayer can only be answered by applying the tests indicated by Californian Copper Syndicate v. Harris. Helsham J. found that during the three years in question it was an integral part of the taxpayer’s business to deal in shares, in the sense that switching of investments was desirable to produce the best dividend returns and was indeed necessary if the taxpayer’s policy of investing in shares with growth potential was to be adhered to. In my opinion it is impossible to controvert that finding; it was clearly right. Although the company’s business was to invest in shares with 336

[5.740]

the primary purpose of obtaining income by way of dividends, the conduct of the investment business required that the shares should frequently be sold when the dividend yield dropped, which for practical purposes usually meant when the shares went up in value. The taxpayer systematically sold its shares at a profit for the purpose of increasing the dividend yield of its investments. The sale of the shares was a normal operation in the course of carrying on the business of investing for profit. It was not a mere realisation or change of investment. The present case is in my opinion indistinguishable from the decision in Colonial Mutual Life Assurance Society Ltd v. F.C.T. On behalf of the taxpayer it was submitted that the decision in Colonial Mutual Life Assurance Society Ltd v. F.C.T., and in other cases such as Punjab Co-op. Bank Ltd, Amritsar v. Income Tax Commissioner, Lahore; Australasian Catholic Assurance Co. Ltd v. F.C.T. and C. of T. (N.S.W.) v. Commercial Banking Co. of Sydney depended on the special nature of the business of banking or insurance which the taxpayer carried on. With all respect I cannot agree. In all those decisions the test suggested in Californian Copper Syndicate v. Harris was applied. That test is applicable to any business, and if the sale of the shares is an act

Business Income

London Australia Investment Co Ltd v FCT cont. done in what is truly the carrying on of an

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investment business the profits will be taxable just as they would have been if the business had been that of banking or insurance.

Jacobs J joined in forming the majority but his approach to the problem was quite different from that of Gibbs J. He provides an interesting explanation of the rationale supporting the banking and insurance cases: Though the findings of Helsham J. certainly preclude a conclusion that shares were acquired and disposed of for a primary or dominant purpose of profit making, he did not conclude that there was no purpose at all in a relevant sense, when the shares were respectively acquired, of re-sale at a profit. I am not sure that he found it necessary to direct his mind to this question. Rather, he was satisfied to rely upon the scale of the activity as itself constituting the business. I do not think that a conclusion on scale by itself provides the answer; but it is very important evidence tending to show a business of acquiring and disposing of shares and it was some evidence from which a purpose of thereby making a profit might be inferred. It was for the appellant to rebut the latter inference. In my opinion it has not done so. It has in its favour the very important circumstance that the source of the funds was the subscribed capital of the company. But this is only part of the evidence. The evidence taken as a whole strongly supports a conclusion that a purpose or intention or expectation implicit in the carrying into effect of its investment policy was that shares acquired would be re-sold if and when an occasion arose which would make it desirable so to do and an element of desirability was that there would be greater financial benefit in disposing of the shares at an enhanced value than in retaining them. The fact that enlargement of dividend income was the dominant purpose does not gainsay the existence of a concurrent purpose of re-sale if and when the re-sale would throw up a profit which could be used to enlarge the dividend income. The massive scale of the activities in the years in question practically compels the inference that the investment policy was one which in its inception and throughout the course of carrying

it into effect would in the expected state of the rising market require frequent and regular realisations of shares whenever they rose in market price before dividends from them were increased. But it is the expected increase in dividend which causes shares to rise in price. The investment policy of the company was such that on a purchase of any particular parcel of shares the company had a then present purpose, intention or expectation of not awaiting an increase in dividends if the market price rose in expectation of such an increase but of anticipating the rise in dividend by realisation of the shares at an enhanced price. It is true that the purpose or intention or expectation was contingent in the sense that sale would only take place if dividends had not been raised before the share price also rose. The contingency of this purpose enabled a finding to be made that higher dividend yield was the primary purpose of the operations and that therefore s. 26(a) was not applicable. But when with such an investment policy, which envisages regular and frequent sales of the shares acquired, operations are conducted on such a very large scale, the proper conclusion is that the acquisitions and disposals of shares were part of a business of acquisition and disposal. It is no answer to say that if the share prices did not fall proportionately to a lowered dividend, so that a lowered return on market price would be currently received, the investment policy would require sale, even at a loss. The dealings took place on a market which was regarded by the company as having growth potential. A rising, not a falling, market was expected and it was on that expectation that the investment policy was based.

[5.740]

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[5.750] The ATO has focused a great deal of attention on pursuing profits made by banks,

insurance companies and investment companies from realising investments. A few of the recent cases are summarised below. None of the cases raise profound new directions but they do suggest that the distinctions suggested above between banks, life insurance companies, general insurance companies and investment companies may be breaking down. No obvious distinction is maintained in the cases and no different principles are applied: • CMI Services Pty Ltd v FCT (1990) 90 ATC 4428. In this case the taxpayer was a subsidiary of an insurance company established to invest surplus funds of the parent company. It purchased a series of properties with the stated intention of holding them for as long as they provided adequate rental income and did not demand excessive management effort. Two were disposed of when structural faults were discovered but the Full Federal Court held that the profit made on the sale simply arose according to its investment plan and so the profit made was assessable. • FCT v Equitable Life & General Insurance Co Ltd (1990) 90 ATC 4438. In this case the taxpayer had carried on a life insurance business but decided to abandon it. The company retained its share portfolio from which it derived income. Shares were periodically sold over seven years until the entire portfolio was liquidated. The Full Federal Court held by majority that the taxpayer’s profits did not arise from any business activity as it lacked a management or investment strategy, and held that the profits were not income. • FCT v Radnor Pty Ltd (1991) 91 ATC 4689. In this case the taxpayer was a special-purpose company set up to hold the investments of three trusts established for the benefit of people with physical and mental disabilities. The investment decisions had been made by members of the families but it was decided to appoint a professional manager to manage the portfolio. The manager followed an investment policy which primarily sought dividend income, with low capital risk and capital growth for protection against inflation. Under the direction of the manager, the taxpayer made some profits when investments were changed. The Full Federal Court refused to overturn the decision of Davies J that no business income arose from these activities. He was influenced by the fact that the company was obliged to invest to generate income through dividends but also to act to protect capital. The frequency of transactions and the appointment of a professional manager were not sufficient to change this result. • RAC Insurance Pty Ltd v FCT (1990) 90 ATC 4737. In this case the insurance subsidiary of the Royal Automobile Club of Western Australia was held to be assessable on profits from sales of securities, even though the securities had been purchased as long-term investments to ensure the long-term stability of the company and were held to maturity. • Employers Mutual Indemnity Association Ltd v FCT (1991) 91 ATC 4850. In this case the taxpayer tried to take the argument in RAC Insurance even further. It argued that profits it made on one portfolio were not assessable because it held this portfolio as its “third line of defence” rather than as a reserve available to meet primary claims. The argument failed. Finally, in AGC (Investments) Pty Ltd v FCT (1992) 92 ATC 4239 the taxpayer, which was a wholly-owned subsidiary of an insurance company, was used as the vehicle for investing excess funds of the parent. The taxpayer claimed (and the Full Federal Court agreed that the evidence demonstrated) that it acquired securities with a view to their long-term capital growth. In September 1987, in the belief that the share market was overvalued, the taxpayer 338

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instructed the manager of its portfolio to commence selling shares in listed public companies and to reinvest the proceeds in fixed-interest securities. The taxpayer made a profit of over $45 m over cost which the ATO included in its assessable income. The ATO succeeded before Hill J but the Full Federal Court held that even though the taxpayer was the investment vehicle for its parent company, it did not necessarily follow that the investments were not made on a long-term basis. Accordingly, the surplus realised in 1987 was on capital account. Beaumont, Gummow and French JJ observed:

AGC (Investments) Pty Ltd v FCT [5.760] AGC (Investments) Pty Ltd v FCT (1992) 92 ATC 4239 The central issue was the true characterisation of the appellant’s purpose in acquiring its share portfolio. This is a question of fact, albeit of secondary fact. There is no real dispute about the primary facts, and little appears to turn on the credit of the individual witnesses called on behalf of the appellant. But the proper inferences to be drawn from the primary facts are contentious. On behalf of the appellant, it is said that the oral evidence of those concerned with the management of the portfolio demonstrates that the investments were acquired on a long-term footing and were realised, as a general rule, only in exceptional circumstances. The appellant says that this version of the events is fully supported by the contemporary documentation. On the other hand, the Commissioner contends, in accordance with the conclusion of Hill J., that in the particular circumstances of this case, especially when regard is had of the relationship between the appellant and A.G.C. (Insurances) and in the light of the correspondence in 1978 concerning the possible impact on the appellant of the decision of the High Court in the London Australia case, the appellant failed to discharge the onus of establishing the absence of a profitmaking purpose in acquiring the portfolio.

now in question in order to maintain the liquidity of [the parent company].

The facts of the present case may be distinguished from the usual circumstances of an insurance company or a bank, where the need to buy and sell securities on a regular basis, in order to maintain liquidity, justifies the conclusion that this is a normal step in carrying on a banking or insurance business, with the consequence that the profits so earned are regarded as income. The evidence here indicates that there was no necessity for the appellant to buy the securities

In our opinion, when regard is had to the whole of the material in evidence, it should be concluded that the appellant has discharged the statutory onus of demonstrating, as a matter of proper inference from the facts, that at the time of acquisition, the shares in its portfolio were not acquired with an intention that they be realised subsequently at a profit. It must follow, in our view, that the surpluses realised in 1987 were on capital account.

It must follow, we think, that it was not part of the corporate scheme that the appellant buy equities in order to maintain liquidity for the insurance operations of the A.G.C. Group. The memorandum and the other evidence, documentary and oral, to which we have earlier referred, demonstrate that it was at all times intended that the appellant invest long-term. Its subsequent conduct was consistent with this intention. As we have noted, 26 of the equities acquired were held for a period exceeding 15 years, 20 for between ten and 15 years and a further 14 for between five and ten years. This pattern of activity is inconsistent with an objective or purpose of acquiring the shares in order to provide liquid funds for the Insurance Division. It may be accepted, as Hill J. found, that the appellant was the investment vehicle for the Insurances Division. But it does not necessarily follow that the investments made by the appellant were not made on a long-term basis. The evidence demonstrates that, in fact, the securities now in question were acquired with a view to their long-term capital growth.

[5.760]

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[5.765]

Questions

5.54

What was the reason for the decision in Charles? Have the attitudes of the courts and investors to trusts and the operations of unit trusts changed since Charles in such a way to produce different results?

5.55

Consider the tax implications of the following situations: (a) an insurance company sells its head office at a profit; (b) a bank acquires a majority shareholding in a finance company, operates it as a subsidiary and some years later sells the shares in the finance company at a profit; (c) an insurance company acquires a majority shareholding in a hotel chain and a year later sells the shares at a profit in response to a takeover offer; (d) an insurance company segregates its investments into two accounts, and investments in only one of these accounts are ever sold to meet claims on the insurance company; (e) a bank invests a large amount in a subsidiary’s share capital, the subsidiary invests in a wide range of shares, and whenever the bank is in need of funds it borrows from the subsidiary which sells some of its investments to obtain the necessary funds; (f)

a unit trust funds its operations by accepting cash subscriptions and sells investments when funds are required to redeem the units of its investors.

(g) Gains on Liabilities [5.770] So far, this chapter has considered whether the gains made on realising certain kinds

of business assets and investments are income. A similar question is raised by gains realised on transactions with liabilities. It is, of course, more than possible for liabilities to be discharged on advantageous terms, generating a gain for the taxpayer. The questions is, what tax consequences follow? This problem arises in a number of different contexts. We will look at three: 1.

A taxpayer borrows an amount of money from another person. The time for payment comes around and the taxpayer manages to repay less than the face value of the debt. If the taxpayer secures the release of a $1 m debt for $850,000, is the $150,000 saved taxable as income to the taxpayer?

2.

A taxpayer owes money to another person but, in contrast to the situation described above, the amount of the debt is deductible and has been deducted by the debtor. (The debt, for example, might be for the purchase of inventory.) When the time for payment arrives, the taxpayer is permitted to pay only $850,000. Again, if the taxpayer is able to buy $1 m worth of inventory (and is allowed to deduct $1 m as its cost) but eventually pays only $850,000, is the $150,000 saved taxable as income to the taxpayer?

3.

Finally, consider the position of a taxpayer who wants to sell her business. At the time of sale, the business will have a number of assets and liabilities to third parties – for example, amounts accruing to staff for annual leave and long service leave that could be taken by staff soon after the business is sold. In settling on the price, the buyer will

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probably pay less cash to the seller because of these liabilities, but agree to assume responsibility for the full liability to the employees. Again, does the vendor make ordinary income if she is relieved from having to pay the full amount of the liability to her staff? Let us start with example 2 – release from liabilities for amounts already deducted. In British Mexican Petroleum Co Ltd v Jackson (1931) 16 TC 530, the taxpayer owed substantial debts to Hustacea. Because of the financial difficulties of British Mexican Petroleum, Hustacea agreed to release the taxpayer from various debts owed from the purchase of inventory – that is, amounts which British Mexican Petroleum had already deducted from its income. The House of Lords held that the accounts of the prior years could not be reopened to amend the figures for that year to reflect this new development. At the same time the Law Lords rejected another solution, that the cancellation of the previously deducted debt represented a gain which was income. Lord Thankerton said, “I am unable to see how the release from a liability, which liability has been finally dealt with in the preceding account, can form a trading receipt in the account for the year in which it is granted”. And Lord Macmillan said: if the accounts for the year to 30 June 1921, cannot now be gone back upon, still less in my opinion can the appellant company be required to enter as a credit item in its accounts for the 18 months to 31 December 1922, the sum of £945,232, being the extent to which the Hustacea company agreed to release the appellant company’s debt to it. I say so for the short and simple reason that the appellant company did not, in those 18 months, either receive payment of that sum or acquire any right to receive payment of it. I cannot see how the extent to which a debt is forgiven can become a credit item in the trading account for the period within which the concession is made.

This problem commonly arises in an international context where a liability to pay an amount of money is recorded in the taxpayer’s accounts denominated in $A, but when the time comes to settle the liability, it requires more (or less) than the $A amount recorded to discharge the liability because of movements in the foreign currency relative to the $A. Depending on the direction of the currency fluctuations, the taxpayer may make gains or losses. A series of decisions attempted to state when these gains and losses will be of an income or capital nature: see Texas Co (Australasia) Ltd (1940) 63 CLR 382; Armco (Australia) Ltd (1948) 76 CLR 584; Caltex Ltd (1960) 106 CLR 205; Commercial and General Acceptance Ltd v FCT (1977) 137 CLR 373; International Nickel Australia Ltd v FCT (1977) 137 CLR 347; Avco Financial Services v FCT (1982) 150 CLR 510; Hunter Douglas Ltd v FCT (1983) 14 ATR 629. For most non-bank taxpayers, these cases are now significantly supplemented (if not supplanted entirely) by the foreign exchange rules in Div 775 of the ITAA 1997. For banks, the proposed rules on the Taxation of Financial Arrangements rules also provide a statutory regime for dealing with gains and losses. We will revisit this type of transaction in Chapter 6, but it is clear in our jurisprudence that the mere fact that a taxpayer receives a refund of an allowed deduction does not make the refund income. Similarly, it seems, the fact that a taxpayer is relieved of having to pay the full amount of an allowed deduction is not of itself enough to make the difference income. Now let us look at the first example. The US courts have long had a doctrine that a taxpayer can make ordinary income from a discharge of indebtedness. This follows from the decision reached by the Supreme Court of the United States in United States v Kirby Lumber Co (1931) 284 US 1. Regulation 62, article 545(1)(c) of the US Treasury Regulations provided, “if the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or [5.770]

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income for the taxable year”. Holmes J said he could “see no reason why the regulations should not be accepted as a correct statement of the law”. The same issue arose in Australia in Mutual Acceptance Ltd v FCT (1984) 84 ATC 4831. The taxpayer was a finance company lending mainly to retail customers to finance the purchase of consumer goods. In order to make these loans, it borrowed by issuing debentures to individuals and other institutional lenders. The taxpayer was approached by several institutional debenture holders who wanted to redeem their debentures because the fixed interest rate payable by the taxpayer on the debentures was well below current market rates. The appellant agreed to repay the debentures early and paid the debenture holders about $22,030 less than the face value of the debentures. The ATO treated the $22,030 as “profit … included as assessable income”. Enderby J in the Supreme Court of New South Wales upheld the assessment, saying: in my opinion, notwithstanding [counsel’s] valiant efforts the “gain” resulting from the redemptions was a “gain” in the nature of income. The decision whether to redeem or not was an exercise in judgment exercised by the appellant’s officers. It was part of the ongoing business of producing revenue from the lending of money. It was in the nature of that business that application for redemption would from time to time be received. They were contemplated in the prospectuses. It was part of the trade of the appellant and was sufficiently recurrent. From a practical and a business point of view, the gain had the character of income which could be expected to arise from time to time from the difference between the price of its borrowed money and the price of the money it loaned out. The gains were incidental to that main object. In my opinion they are properly classified as revenue or income. They are similar in that respect to exchange rate gains that are regarded as incidental to the main purpose for which money has been borrowed when that purpose is the production of income.

In the light of this decision, the ATO released Taxation Ruling IT 2495 (now withdrawn) dealing with debt defeasance transactions. He took the view in that Ruling that gains made on these transactions are assessable as income either under ordinary usage notion or under s 15-15. The Ruling, which was released on 15 September 1988, is an example of the ATO’s belief that s 25A had survived its apparent repeal by s 25A(1A), a view which presumably remains applicable to the rewritten provision in s 15-15. Taxation Ruling IT 2495 was withdrawn by the ATO in 1998 in light of the developments arising out of the Orica litigation (extracted below). This area quickly became important in tax as more companies began to engage in innovative financial transactions of this kind. In the mid-1990s two cases ran in tandem through the Federal Court and Full Federal Court on the treatment of the gain made on redemption of liabilities. They were Unilever Australia Securities Ltd v FCT (1994) 28 ATR 422 (Spender J); (1995) 30 ATR 134 (Full Federal Court) and ICI Australia v FCT (1994) 29 ATR 233 (Ryan J); (1996) 33 ATR 174 (Full Federal Court). These cases had reached different results on similar transactions and were something of a cause célèbre. Eventually, the ICI litigation was taken to the High Court in FCT v Orica Ltd (1998) 39 ATR 66, a case that we have examined already in relation to its impact on CGT. ICI (which later changed its name to Orica) had borrowed $98 m at various times between 1966 and 1970 through a series of debenture issues with various redemption dates. The mechanism for issuing debentures involved the appointment of a trustee for the debenture holders who advanced the funds to ICI and to whom ICI owed its obligations under the Trust Deed to pay the interest and repay the principal. Each Trust Deed imposed on ICI an obligation limiting the ratio of liabilities to assets in the group. This obligation placed a serious 342

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restriction on ICI’s operations and it decided to rearrange its liabilities. In 1986, ICI entered an agreement – the Principal Assumption Agreement – with the trustee and the Melbourne and Metropolitan Board of Works (MMBW). (It also entered another agreement – the Interest Assumption Agreement – with the trustee and the State Bank of New South Wales, but the case concerned only the Principal Assumption Agreement.) The key provisions of the Principal Assumption Agreement stated: • ICI would pay to MMBW an amount equal to the aggregate of the sum of the present values of the principal amounts owed on all the outstanding debentures (about $62 m). The present value was calculated using the Commonwealth Bond rate. • In return, MMBW would “assume in the manner provided in this Agreement the obligations of [ICI] to make due and punctual payment of the principal amount of all [debentures] in accordance with Clause 3 of each of the Trust Deeds … and [MMBW] shall indemnify [ICI] and the Guarantors, and keep them indemnified, in respect of such obligations”. (This kind of arrangement was known in the industry as an “in-substance defeasance” because ICI continued to be liable for all its obligations under the Deeds – it simply acquired rights against MMBW by virtue of the payment.) As a consequence of this Agreement, the provisions in the Trust Deeds relating to the financial ratios were deleted and guarantees of the debts given by another company in the group were released. The ATO originally assessed ICI on the basis that $36 m (the difference between the $98 m owed and the $62 m received) was income in 1986, the year in which the Agreement was made. The ATO then assessed ICI on the basis that $8 m (the difference between the value of debentures which fell due for payment during that year and a part of the amount received) was income in 1987, the year in which some payments were made. At first instance, in the Federal Court, Ryan J had held that the difference between the amount payable under the Agreement and the face value of the debentures was assessable as income under either s 25 or s 25A, and had then applied Div 16E to the transaction. The taxpayer appealed to the Full Court which allowed the appeal by majority. The majority of the Court (Lockhart and Sheppard JJ) held that the difference was not income according to ordinary concepts and did not arise from a profit-making scheme. They also rejected an argument that the difference was assessable as a capital gain, because ICI’s rights under the Agreement were not an “asset” of ICI and there was no disposal by MMBW performing its obligations under the Agreement. All of the judges held that Div 16E did not apply. The majority in the High Court (Gaudron, McHugh, Kirby and Hayne JJ) agreed that the difference was not income, although they disagreed with the Federal Court on the application of CGT. In a joint judgment, Gaudron, McHugh, Kirby and Hayne JJ stated:

FCT v Orica Ltd [5.780] FCT v Orica Ltd (1998) 39 ATR 66 It is convenient to deal first with whether the taxpayer derived income (as income is ordinarily to be understood) or made a profit from a profit-making scheme. Income or profit? Consideration of these matters must begin from an understanding of the effect of the Principal Assumption Agreement. In particular, it

must begin from the recognition that following the making of the Principal Assumption Agreement, the taxpayer remained liable on its debentures. MMBW agreed that it would “assume … the obligations of the [taxpayer] to make due and punctual payment of the principal amount of all Stock and agreed that it would indemnify the taxpayer and its guarantors, and keep them [5.780]

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FCT v Orica Ltd cont. indemnified, in respect of those obligations”. But this stops well short of discharging the taxpayer from the obligations which it owed under each of the trust deeds. Some other aspects of the Principal Assumption Agreement should be noted. The taxpayer made a single payment under the Principal Assumption Agreement – $62,309,546. That agreement required payment of “an amount equal to the aggregate” of the respective present values of the debenture stock then on issue. MMBW’s obligation under that agreement was to make a series of payments – a payment as each debenture issue fell due for repayment. On no view, then, did the taxpayer receive, at the time of the making of the Principal Assumption Agreement, a benefit which was to be calculated as the difference between the amount which it outlaid under that agreement and the total amount which MMBW bound itself to pay in the future. At the time of the making of the agreement, the taxpayer received nothing except MMBW’s promise to perform in the future. That promise is not income. Next, little or no guidance is offered by considering what other transactions the taxpayer might have made to achieve a commercial result substantially the same as the commercial result said to flow from the making of the Principal Assumption Agreement. Examination of other transactions does not reveal whether or when the taxpayer derived income as a result of the making of the Principal Assumption Agreement. Income according to ordinary concepts? The Commissioner did not contend that the whole of each payment made by MMBW was income of the taxpayer. Central to the Commissioner’s contentions was the proposition that the “benefit” or the “gain” which the taxpayer obtained was the difference between the amount which it outlaid and the amounts which MMBW paid under the agreement. This difference would be measured, so the argument proceeded, without regard to what is often called the “true value” of money and was properly to be considered as income emerging as each payment was made by MMBW. 344

[5.780]

For present purposes, two aspects of this argument may be accepted: that the taxpayer received a benefit each time MMBW made a payment and that, “the accounting basis which has been employed in calculating profits and losses for the purposes of the Act is historical cost not economic equivalence.” It follows that the fact that the amount outlaid by the taxpayer at the time of making the Principal Assumption Agreement may be seen as the then present value of the rights which it acquired is nothing to the point. It follows also that nothing turns on the parties’ choice of the Commonwealth Bond rate as the basis of the calculation of the net present value of the obligations undertaken rather than some other discount rate such as the rate of return that the taxpayer might have generated from the use of the funds within its own business. The nature of the “benefit” or “gain” Plainly, then, the difference between the taxpayer’s payment and MMBW’s payments can be found reflected in the taxpayer’s accounts. Is that difference a benefit or gain to the taxpayer and, if it is, what is its nature? There are several features of the difference between the amounts of the payments which are important. First and foremost, the difference is a difference between an amount that was expended and an amount that would have had to be expended. Secondly, the obligation of the taxpayer that was satisfied by the payment made by MMBW was an obligation of the taxpayer that was on capital account. Thirdly, the transaction was a singular transaction concerning liabilities separately created by the taxpayer in raising capital for its business. We deal with each of these in turn. A reduction in expenditure When MMBW made each payment and that payment was applied in satisfaction of the principal due on debentures, the taxpayer received the benefit of its liability being discharged to the extent of the payment made. But what is said to be the benefit to the taxpayer is not that receipt but the difference between outlays – one it actually made and one that it would have otherwise had to make. Thus the question of characterisation is very different from the question which arose in cases such as Hartland

Business Income

FCT v Orica Ltd cont. v Diggines upon which the Commissioner relied in this respect. There, voluntary payments made by an employer in discharge of an employee’s obligations to income tax were held to be “profits and emoluments” of the taxpayer within the meaning of Sched E of the Income Tax Act 1842 (UK). Leaving aside the radical differences in statutory regime under consideration, the question in that case was to characterise the benefit constituted by the payments, not to characterise the difference between actual and hypothetical outlays. That difference is a reduction in expenditure not any inflow or gain to the taxpayer. If, however, the relevant enquiry is an enquiry about the character of the difference between an outlay (the sum paid by the taxpayer under the Principal Assumption Agreement) and a receipt (the value of the benefit received in money’s worth when MMBW paid an amount applied in satisfaction of the taxpayer’s liability to debenture holders) other considerations arise. Again we note, but do not stay to consider, that there may well be difficulties presented by the facts that the taxpayer’s outlay was made in one year of income (1986) and that MMBW’s payments (and thus the benefits to the taxpayer) would occur over several later years (between 1987 and 2000). What is significant in this context is that the benefit received was satisfaction of an obligation on capital account. Capital account? That the taxpayer’s liability to its debenture holders was a liability on capital account was not (and could not be) disputed. No doubt, as is established by GP International Pipecoaters Pty Ltd v FCT: … it cannot be accepted that an intention on the part of a payer and a payee or either of them that a receipt be applied to recoup capital expenditure by the payee determines the character of a receipt when the circumstances show that the payment is received in consideration of the performance of a contract, the performance of which is

CHAPTER 5

the business of the recipient or which is performed in the ordinary course of the business of the recipient. But that is not this case. The benefit obtained by the taxpayer was not the receipt of money into its hands which at its choice was then applied in satisfaction of a capital obligation. It was a benefit constituted by the discharging of that capital obligation. A singular transaction Nor is this a case in which a finance company engages in various transactions on capital account yielding a difference properly regarded as a gain or loss on revenue account from the use of the company’s working or circulating capital. The present transaction was a singular transaction, not part of the regular means whereby the taxpayer obtained returns. It must be acknowledged, of course, that the fact that it was a singular transaction is important but, standing alone, is not determinative of the characterisation of a “profit” or “gain” under consideration. In FCT v Myer Emporium Ltd the court said: Although it is well settled that a profit or gain made in the ordinary course of carrying on a business constitutes income, it does not follow that a profit or gain made in a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer’s business is not income. Because a business is carried on with a view to profit, a gain made in the ordinary course of carrying on the business is invested with the profit-making purpose, thereby stamping the profit with the character of income. But a gain made otherwise than in the ordinary course of carrying on the business which nevertheless arises from a transaction entered into by the taxpayer with the intention or purpose of making a profit or gain may well constitute income. Whether it does depends very much on the circumstances of the case. Generally speaking, however, it may be said that if the circumstances are such as to give rise to the inference that the taxpayer’s intention or purpose in entering into the transaction was to make a profit or gain, the profit or gain will be income, notwithstanding that the transaction [5.780]

345

The Tax Base – Income and Exemptions

FCT v Orica Ltd cont. was extraordinary judged by reference to the ordinary course of the taxpayer’s business. Nor does the fact that a profit or gain is made as the result of an isolated venture or a “one-off” transaction preclude it from being properly characterised as income. The authorities establish that a profit or gain so made will constitute income if the property generating the profit or gain was acquired in a business operation or commercial transaction for the purpose of profit-making by the means giving rise to the profit. But here the taxpayer acquired no asset which it put to use in a way that realised a profit. Rather, it acquired rights in relation to the satisfaction of liabilities it had incurred to provide it with capital in its business. While the difference between outlay and liability must find its reflection in the taxpayer’s accounts, the accounting difference between the amount outlaid in a singular transaction to acquire the rights to have another pay sufficient to meet existing capital liabilities of the taxpayer in the future is not a profit or gain to the taxpayer and is not income according to ordinary concepts. Profit-making scheme The Commissioner contended that the transaction by which the taxpayer outlaid money to procure future payment of moneys to be applied in payment of the debentures was a profit-making scheme for the purposes of s 25A of the ITAA 1936. The Principal Assumption Agreement created obligations closely related to the debentures that the taxpayer had issued and it cannot be understood without reference to the arrangements governing those debentures. But that is not to say that there was a scheme whereby the taxpayer incurred certain future obligations and acquired the right (for a smaller

price) to have someone make payments which would discharge those obligations. If that had been the course of events, the two transactions might be seen as “integral elements in one profit-making scheme”. If the two transactions are to be considered as separate and independent transactions, the taxpayer’s argument that no relevant profit arose would have “compelling force”. The Commissioner did not seek to mount a case that the two transactions were to be seen as integral elements in the one profit-making scheme. The issue of the debentures being unrelated to the later arrangements made with MMBW, the two transactions (or sets of transactions) are properly seen as separate and independent and the Commissioner contended that the “scheme” was constituted by or reflected in the Principal Assumption Agreement. Not income or profit from profitmaking scheme Standing alone, the Principal Assumption Agreement reveals no profit for the taxpayer, only an accounting difference between the face value of the debentures and the amount paid by the taxpayer to have MMBW pay amounts satisfying the principal sums due. For the same reasons that this difference does not constitute income according to ordinary concepts, it is not profit arising from a profit-making scheme. The taxpayer outlaid a smaller sum than the total it would have had to outlay over the next 14 years but it thereby reduced the expenditure it would otherwise have made on capital account and did so by the singular transaction embodied in the Principal Assumption Agreement (and associated agreements). For these reasons we reject the Commissioner’s contentions that the taxpayer derived income according to ordinary concepts or made a profit arising from a profit-making undertaking or scheme.

[5.790] Gummow J agreed with the majority. Brennan CJ dissented, upholding that the

second of the assessments – which included in ordinary income so much of the difference – as related to debentures redeemed during the 1987 year.

346

[5.790]

Business Income

CHAPTER 5

It is far from clear what the impact of the Orica decision is on Unilever. Remember that in Unilever, a majority in the Full Federal Court had taken the view that the gain made on the same kind of a debt defeasance arrangement was assessable as ordinary usage income. Unilever chose not to fight on. But the High Court held in Orica that the taxpayer made only a capital gain, not ordinary income; and made the capital gain from the performance of the contractual rights it had secured, not from making the contract. However, Unilever was a finance company whose only activities included borrowing and lending; Orica was not. In so far as debt defeasance was concerned, the resolution of this decision was, for some business taxpayers, likely to be moot by the time the decision was handed down. In the 1995 Budget, the Treasurer had announced that the government would enact statutory provisions dealing with the forgiveness of commercial debt. These rules were enacted in 1996 and are now in Div 245 of the ITAA 1997. They provide a complicated statutory regime for dealing with debts that are released or forgiven. The new regime applies to “commercial debts” that are “forgiven.” When they are triggered, rather than require the taxpayer to recognise the value of the debt as income when their obligations are cancelled, the provisions achieve an indirect recognition of the benefit by providing for the “net forgiven amount” of a commercial debt to be applied to reduce, in order, the debtor’s carry-forward revenue losses, net capital losses, undeducted balances of deductible expenditure and the cost base of assets at the beginning of the year. If there are insufficient amounts to absorb the total debt forgiven, the balance is ignored: s 245-195(1) of the ITAA 1997. The commercial debt forgiveness provisions only apply to “commercial debts”. In general terms, a debt is a commercial debt for the purposes of the legislation if the whole or any part of the interest payable on the debt is, was, or would be an allowable deduction to the debtor: s 245-10. The event which triggers these provisions is the “forgiveness” of the debt: s 245-35. This occurs when a debt is released or waived or when it can no longer be recovered because of the expiry of the statute of limitations. Forgiveness of debts effected under a bankruptcy law, by will, or for reasons of natural love and affection are excluded from the commercial debt forgiveness provisions: s 245-40. It is interesting to consider whether these provisions would actually apply to a taxpayer in the position of Orica. Remember, the High Court went to great pains to point out that under the Principal Assumption Agreement “the taxpayer remained liable on its debentures”. In other words, Orica remained liable for the debt, it had just secured some additional security for its performance, which then enticed the lenders to change the gearing ratios in the Deeds. This is a different transaction from one where the borrower is released from ever having to pay the amount of the debt in full because it is insolvent. According to the Explanatory Memorandum to Taxation Laws Amendment Bill (No 2) 1996, these provisions are designed to apply to something called an “in substance forgiveness”: 6.21 Debts will be taken to be forgiven where a debtor is effectively released from the obligation to pay the debt notwithstanding the existence of arrangements which imply that the debt remains on foot.

[5.790]

347

The Tax Base – Income and Exemptions

6.22 Under some arrangements, the debtor’s obligation to pay the debt may not cease immediately but at some future time. Nevertheless, the debt will be treated as forgiven immediately if the debtor and creditor are not acting at arm’s length and they agree either that the debtor will not have to pay any consideration for the concession granted by the creditor or merely a token amount. 6.23 A debt which is treated as forgiven because of such an arrangement would not be subject to the debt forgiveness provisions again when the debt is actually forgiven. To have the provisions apply upon actual forgiveness would result in double taxing of the debtor on the same debt. Example: 6.24 G owes H $100,000, but cannot pay the full amount of the debt. H agrees to release G from this debt in return for an immediate payment of $1,000 and an additional payment of $1 in 5 years time. Arguably, G’s debt to H will exist until G pays this additional $1, as until then G has a further obligation to meet before H becomes obliged to release the debt. However, this further obligation would generally be regarded as of a nominal kind having regard to: • the amount of the debt; • the amount of the payment; and • the likelihood of the obligation being met.

Finally let us look at the third example of a “debt relief” situation – where a taxpayer’s liability is taken over by some other person, but this time in exchange for less cash, rather than an explicit cash payment like Unilever or Orica. The example used above was when a buyer assumes responsibility to pay amounts accruing to staff for sick leave, annual leave and long service leave. This problem – how to handle the employee liabilities – could be managed in a couple of different ways. The interesting dilemma is when approaching the same problem one way offers a different tax outcome from doing it another way. So assume our vendor owns a business with gross assets valued at $1 m. There is only one employee; she has worked in the business for 12 months and is now entitled to four weeks’ annual leave. If she were to take the leave tomorrow, she would be entitled to her annual leave and the payment of $20,000 in wages. What should the parties do? Should the vendor sell the assets for $980,000; or should the vendor sell the assets for $1 m and then write a separate cheque for $20,000 and give it back to the buyer? What would be the position of the vendor and the purchaser under each option? Ideally, the tax result of both transactions should be the same, but are there discrepancies in the tax outcome if the deal is done one way rather than the other? The parties in FCT v Foxwood (Tolga) Pty Ltd (1981) 147 CLR 278 decided to cash-out the position – that is, the vendor sold the assets at full price and then wrote another cheque back to the purchaser for the amount of the leave liabilities – in this case, a liability for annual leave and the liability for long service leave. The ATO argued that the taxpayer should be treated as if it had paid the amount “for the purpose of discharging a contractual obligation under taken in the course of and for the purpose of disposing of a capital asset”. The High Court disagreed that the payment represented a payment to help in the disposal of a capital asset. Gibbs J said: From a practical, although not from a legal, point of view the payment discharged the obligation of the taxpayer to the employees. It would be too narrow a view to hold that the object of the payment was to enable the purchaser to pay the employees; the object … of the 348

[5.790]

Business Income

CHAPTER 5

contract, was to discharge the obligation of the taxpayer to the employees by paying the requisite amount to the purchaser and obliging him to pay the employees. The payment therefore had the same character as a payment made directly to the employees would have had.

However, the Court then held that the amount paid for the long service leave liability was not deductible. The reason for the difference stemmed from the High Court’s construction of the position of buyers and sellers under industrial law. The High Court found that the relevant Act made the buyer exclusively liable for the long service leave. The effect of the contract for the sale of the business, and the transfer of the services of the employees to the purchaser, was that the taxpayer was not liable, and never could become liable, to pay anything to his former employees in respect of long service leave. It is impossible to say that the object of the payment … was to discharge a liability which did not and never could exist. By this part of the payment the taxpayer made a contribution to assist the purchaser of the business to discharge obligations which would be expected to bind the purchaser in the future. It was not an unreasonable provision to make in a contract for the sale of the business. A payment of that kind was not incidental or relevant to the gaining or producing of the taxpayer’s income or clearly appropriate to or adapted for that purpose; it was incidental and relevant to the sale of the business. The amount … paid in respect of long service leave is therefore not deductible within s 51(1).

The taxpayer in TNT Skypak International (Aust) Pty Ltd v FCT (1988) 19 ATR 1067 adopted the other option – the contract for the sale of the assets set the purchase price lower by the amount of the liabilities. The ATO argued that the amount represented an amount which the buyer had received from the vendor and that this amount was of an income nature. When it became apparent that no payment had actually passed from the vendor to the buyer, the ATO argued that the “payment” had come about by a set-off. Gummow J had little difficulty in finding that there was no actual payment. Nor, he held, could there be a set-off – the vendor owed nothing to the buyer and set-off only happened when each party owed amounts to the other. The Act now contains specific provisions to deal with the treatment of what it calls “accrued leave transfer payments”. Section 26-10 denies the paying company (Foxwood Tolga) a deduction, while s 15-5 treats the amount paid as assessable income of the recipient. This may seem odd but the buying company will be entitled to a deduction when it pays the amount to the employee. The provision says nothing about what happens if the parties do it the TNT Skypak way. [5.795]

5.56 5.57

5.58

Questions

Do you think the debt forgiveness provisions would apply to a taxpayer in the position of Orica? Look at the definition of “forgiveness” in s 245-35 of the ITAA 1997. There are already provisions in the Act which impose tax in various ways on debts which are forgiven. For example, if an employer forgives a debt that an employee owes, this is a debt waiver fringe benefit and taxable to the employer. How is this dealt with under the commercial debt forgiveness rules? Further, s 109F of the ITAA 1936 will include in a shareholder’s assessable income, the amount forgiven by a private company to whom the shareholder owes money. How will this be dealt with under commercial debt forgiveness rules? (See s 245-40.) Why do you think Div 245 reduces valuable tax-reducing attributes, rather than simply including in income the amount forgiven? You may wish to consider the US case of Zarin v Commissioner (1990) 916 F.2d 110 (3d Cir). Zarin became a problem casino gambler and eventually owed Resorts International Hotel $3.4 m for chips “purchased” [5.795]

349

The Tax Base – Income and Exemptions

on credit and subsequently lost gambling at the casino. The casino sued and Zarin eventually settled the debt by paying $500,000. The IRS claimed that in the year of settlement, Zarin derived $2.9 m of income from the discharge of indebtedness for less than its face amount. Do you agree that Zarin made $2.9 m in income from this transaction?

350

[5.795]

CHAPTER 6 Compensation Receipts and Periodic Receipts [6.10]

1. COMPENSATION RECEIPTS ................................ ........................................ 352

[6.20] [6.40]

C of T (Vic) v Phillips ................................................................................................... 353 FCT v Sydney Refractive Surgery Centre Pty Ltd ............................................................ 354

[6.60] [6.70] [6.90] [6.110]

(a) Compensation Under Statute, as Insurance or Damages ...................................... FCT v Slaven .............................................................................................................. Carapark Holdings Ltd v FCT ....................................................................................... FCT v Smith ...............................................................................................................

[6.130] [6.140] [6.150] [6.160] [6.180] [6.190] [6.200]

(b) Compensation for Assets that are Damaged, Destroyed or Confiscated ............... 364 (i) Loss of trading stock ............................................................................................. 364 (ii) Revenue assets ..................................................................................................... 364 Van den Berghs Ltd v Clark ......................................................................................... 365 (iii) Depreciable assets ............................................................................................... 366 (iv) Structural assets .................................................................................................. 366 Ruling TR 95/35 ........................................................................................................ 368

[6.210] [6.220] [6.240] [6.260]

(c) Compensation for Allowable Deductions ............................................................. HR Sinclair & Son Pty Ltd v FCT ................................................................................... Allsop v FCT ............................................................................................................... FCT v Rowe ................................................................................................................

[6.320]

2. PERIODIC PAYMENTS .................................... ............................................. 379

[6.330] [6.340]

(a) Periodic Payments on Which to Live .................................................................... 379 FCT v Dixon ............................................................................................................... 380

[6.380] [6.390]

(b) The Interaction of the Income Tax and Social Security Systems ............................ 381 Keily v FCT ................................................................................................................. 383

[6.410] [6.420] [6.440] [6.460]

(c) Periodic Payments and Instalments of Purchase Price ........................................... Egerton-Warburton v Deputy FCT ................................................................................ Just v FCT .................................................................................................................. Moneymen Pty Ltd v FCT ............................................................................................

356 356 359 360

370 371 372 374

385 386 387 389

Principal Sections ITAA 1936 s 25(1)

ITAA 1997 s 6-5

s 26(j)

s 70-115, s 15-30, Div 20

Effect The principal section which includes in assessable income amounts which are income according to ordinary concepts and usages. These provisions include in assessable income amounts received as insurance or indemnity for trading stock, assessable income or allowable deductions.

351

The Tax Base – Income and Exemptions

ITAA 1936 s 27H

ITAA 1997 –

s 72(2)

Div 20

–

Div 52

s 160M, s 160N

s 104-20, s 104-25

s 160ZB

s 118-37

s 160ZZK, Div 124B s 160ZZL

Effect This provision includes in assessable income the amount of any annuity derived by the taxpayer and allows the taxpayer to exclude some of the annuity where it was purchased. This provision includes in assessable income a refund of any rates previously allowed as a deduction. This Division makes some social security benefits exempt income. These provisions include the destruction or surrender of tangible and intangible assets as disposals for capital gains tax. This provision excludes amounts received as compensation for personal injuries and from injuries in the taxpayer’s vocation from capital gains tax. These provisions allow a rollover for the gain made on the involuntary disposal of a CGT asset.

1. COMPENSATION RECEIPTS [6.10] One aspect of the ordinary usage notion of income referred to in s 6-5 of the ITAA

1997 is that a payment which is compensation or in substitution for an item that would have been assessable as income is itself assessable as income. A statutory elaboration to this ordinary usage idea is expressed in s 15-30 of the ITAA 1997 which includes in a taxpayer’s assessable income an amount received “by way of insurance or indemnity for the loss of an amount [that] would have been included in your assessable income” where the amount is not assessable under s 6-5. We will refer to this idea as the “compensation receipts” principle. As a matter of logic there is a related idea – that a receipt which recoups to a taxpayer an amount that has previously been allowed as a deduction should also be assessable as income. While the logic is appealing, this second idea is curiously not recognised in the cases as a general principle. Instead, this idea is limited to business taxpayers, supplemented by Div 20 of the ITAA 1997. According to s 20-10 – a non-operative provision – “your assessable income may include an amount that you receive by way of insurance indemnity or other recoupment if it is for a deductible expense and it is not otherwise your assessable income”. We have seen the compensation principle in operation already. Although the make-up pay in FCT v Dixon (1952) 86 CLR 540 (Chapter 4) was not itself wages, it was nevertheless assessable as compensation for the lost wages; again in FCT v Myer Emporium Ltd (1987) 163 CLR 199 (Chapter 5) the proceeds of selling the right to the interest was assessable as income as compensation for the interest itself. In Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 (Chapter 2), however, the compensation was stipulated to be for the loss of the office – that is, the loss of the opportunity to earn further income – and therefore was not assessable income. These cases illustrate how crucial the characterisation of payments is for their treatment: payments which are received as a substitute for some other amount will be given the same character as the payments for which they substitute, and if that character is of an income nature, the substitute is also assessable as ordinary income. But payments which compensate for the loss of an asset will be given the character of the asset they replace, and if 352

[6.10]

Compensation Receipts and Periodic Receipts

CHAPTER 6

that character is capital, the substitute is not ordinary income (although it might be included as statutory income or give rise to a taxable capital gain). The distinction made in the cases, between compensation for the asset which produces the income and compensation for the loss of the income itself, is one which after some reflection might appear unconvincing. In most cases, the value of an asset is simply the present value of the future income flows which it is expected to generate. If that measure was adopted to calculate what the taxpayer was being compensated for, it might seem that there is no distinction to draw. We have, on one reading of the case, already seen an example of this in Myer Emporium where the High Court found a payment of the present value of the right to the future interest income stream to have an income nature. Nevertheless, in so far as there is a consistent underlying rule to be found in these cases, it is that the character of the asset for which compensation is received is crucial. Consider, in this respect, the application of the principle in the decision of the High Court in C of T (Vic) v Phillips (1936) 55 CLR 144. You will recall that we have already looked at Phillips in the context of termination payments (Chapter 4). The taxpayer in Phillips had a contract to serve as managing director of Central Theatre Company for 10 years. The terms of the agreement provided that he would receive the normal director’s fee and in addition, an amount equal to 12.5% of Central’s net annual profits from one of its theatres, payable monthly. Central sold the theatre but the purchaser did not want Phillips as manager and so Central cancelled Phillips’ contract and agreed to pay him compensation. The compensation agreed upon was £20,301 calculated at £5,252 for each remaining year in Phillips’ contract. The annual figure of £5,252 was agreed upon “having regard to the amounts he had received in the past [and] the annual amount the taxpayer was likely to receive in the future, if his agreement were to go on” and amounted to £101 per week. During the year of income Phillips received £4,444 by instalments of £404 every four weeks. The Court found that the payments were of an income nature but the judges disagreed about the reasons. We will begin with the judgment of Dixon and Evatt JJ:

C of T (Vic) v Phillips [6.20] C of T (Vic) v Phillips (1936) 55 CLR 144 The substance of what the taxpayer obtained under the agreement he made was a right to receive a monthly payment of £404 during the unexpired residue of his agreement of service with the company. The agreement of cancellation or rescission substituted this payment for the monthly payments which he would have earned by directing the theatre, payments of uncertain amount representing 12.5% of the profits. An estimate of these future payments of uncertain amount produced the regular monthly sum of £404. He gave up the right to the future payments calculated upon the profits and was relieved of the duties of management. While, if his agreement had gone on, the performance of that agreement would have been the proximate

source of the income and its amount would have fluctuated, under the new arrangement the receipts were derived from the mere subsistence of the contract, which needed no performance on the part of the taxpayer, and the amount of the monthly payment was fixed. It appears to us that, for future income which he had a right to earn by performing the agreement, he exchanged a right to receive, through the same duration of time and at the same intervals of time, amounts estimated as equivalent to the income otherwise payable to him. It is true that to treat a sum of money as income because it is computed or measured by reference to loss of future income is an erroneous method of reasoning. It is erroneous because, for example, the right to future income [6.20]

353

The Tax Base – Income and Exemptions

C of T (Vic) v Phillips cont. may be an asset of a capital nature and the sum measured by reference to the loss of the future income may be a capital payment made to replace that right. Or, again, the computation may be done for the purpose of ascertaining what capitalised equivalent should be paid for the future income. But, where one right to future periodical payments during a term of years is exchanged for another right to payments of the same periodicity over the same term of years, the fact that the new payments are an estimated equivalent of the old cannot but have weight in considering whether they have the character of income which the old would have possessed … A contract of service is valuable only because of the income it will bring during the residue of its term.

It is not a piece of marketable property. Unless it is rescinded or broken, it is not usually possible to obtain a lump sum or any other consideration representing its value. When such an occasion arises its value is likely to be expressed in terms of income and is by no means certain to be translated into capital. No prima facie reason exists for regarding as instalments of capital annual payments which are taken in place of the contractual rights such a contract gave. In the present case, the contract expressed the total of the monthly payments as a lump sum. But the period being fixed, the rate of payment being estimated and the intervals being already established, the statement is no more than an arithmetical equivalent. Indeed, it is not the present value of the future payments but merely their sum.

[6.30] You should compare Phillips with the Full Federal Court decision in Sydney Refractive

Surgery Centre. This case is a robust application of the distinction between compensation for damage to the asset which produces the income and for the loss of the income itself. It is a striking decision because the amount of the compensation was calculated using precisely the future income flows which the taxpayer had expected to collect. The taxpayer had been defamed in a series of broadcasts on Channel 7’s Today Tonight program and was awarded damages. The judge in the defamation action calculated the amount of the damages in the following steps: first, the judge estimated the number of surgical procedures that the taxpayer had lost because of the defamatory publications; that number was multiplied by the average revenue per procedure; the likely total costs were subtracted, giving the lost net revenue; 36% of that amount was then subtracted to reflect the tax that the taxpayer would have had to pay on that net revenue. (The corporate tax rate at the relevant time was 36%.) The last step is intended to prevent the unjust enrichment of the plaintiff. If the taxpayer had actually performed the lost operations, it would only have retained 64% of its net profit, losing 36% in tax. So if the defendant is to put the plaintiff in the position it would have been if the defamation had not happened, it needs to pay only 64% of the lost profit, not 100%. Notice, however, that this treatment assumes the damages payment is not itself assessable. The ATO threw the system out of alignment by assessing the damages, already reduced by an amount of notional tax, to the payment to real tax. This would have left the taxpayer with only 41% of its lost profit. Justices Ryan, Edmonds and Gordon found for the taxpayer:

FCT v Sydney Refractive Surgery Centre Pty Ltd [6.40] FCT v Sydney Refractive Surgery Centre Pty Ltd (2008) 172 FCR 557; [2008] FCAFC 190 Both before the primary judge and on appeal, SRSC contended that whether a payment 354

[6.30]

constitutes income in the hands of a taxpayer must be determined by its character (ie what the

Compensation Receipts and Periodic Receipts

FCT v Sydney Refractive Surgery Centre Pty Ltd cont. payment was for) rather than the manner in which the amount was calculated. The Commissioner accepted that the character of the payment is the issue but submitted that the manner of calculation in some cases will shed light on the character of the payment and that this was one of those cases. To put it in more concrete terms, the Commissioner acknowledged that, had damages in this case been awarded, for example, on an at large or lost goodwill basis, then those damages would not have been income. On the other hand, where, as here, damages are awarded solely by reference to lost profits, the Commissioner’s view was that the character of the payment will be different. The proper test was and remains to look at the character of the payment in the hands of the taxpayer. For an award of damages, that in turn requires an examination of the nature of the claim or cause of action in respect of which the payment was made. It is settled that an award of damages for personal injuries is not taxable. The question therefore is whether defamation constitutes a claim for personal injury. We agree with the learned trial judge that an award of damages in a defamation claim “is, in point of principle, for impairment of the plaintiff’s earning capacity and not for loss of income as such”. A corporation’s reputation is part of what enables it to earn money; an injury to that reputation diminishes its capacity to earn because it reduces the corporation’s ability to induce others to do business with it. An award of damages for that injury is therefore no different from an award for the loss of an arm or any other injury impairing earning capacity. In contrast, an injury that does not impair the plaintiff corporation’s ability to earn, but instead simply frustrates its receipt of certain moneys (ie reduces its revenue) will be assessable. For example, suppose B trespasses on A’s factory grounds, erecting a roadblock so that raw

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materials cannot be delivered, and A claims damages in respect of the diminished output (ie for the loss of use of the factory during the period of the roadblock). Or suppose that A has a contract for the supply of widgets by B, but C tortiously interferes and prevents the delivery, and A then claims damages based on the resale price of the widgets. In those cases, a damages award is not only measured by lost profits but is for lost profits (ie a substitute for revenue not received), and will therefore be assessable as income. However, as the learned primary judge correctly noted, that principle does not apply here because a claim for defamation damages based on an injury to business reputation is a claim, regardless of how measured, for compensation for lost earning capacity resulting from damage to a capital asset. It is true that the most appropriate method of measuring loss of earning capacity due to injury to a capital asset will of course depend on the circumstances. For example, in some cases there will be evidence of the corporation’s value as a going concern before the injury (eg valuation, fair market sale, market capitalisation as reflected in share price) and after the injury (eg subsequent arm’s length sale of the business as a going concern, later share price or valuation). In those cases, it might be best to assess damages based on the difference in value (assuming that there are no other confounding or contributing factors that could account for the difference). In other cases, however, such evidence may not exist (eg where the company ceases to trade), and thus a lost profits method may be the best or only approach that can be taken. However, as this analysis makes clear, the nature of the injury itself (and thus the character of the payment received by the taxpayer in compensation for it) does not and cannot change according to the way in which the resultant loss is measured or the evidence which is adduced based on the fortuitous or unfortuitous occurrence of subsequent events.

[6.50] The cases already referred to (Dixon, Scott and Myer) show the compensation receipts

principle operating alongside other recognised principles of income. Indeed, there is an almost [6.50]

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The Tax Base – Income and Exemptions

unconscious juxtaposition by courts of this principle beside other principles, particularly the principle that a gain from carrying on a business is income (as in Myer), or the principle that an amount received periodically is income (as in Dixon, discussed in the second part of this chapter). In Phillips, for example, the payments were mediated through a partnership before they were received by Phillips. This has led some to suggest that the compensation principle is limited to receipts within the context of a business. It is also sometimes suggested that the compensation receipts principle can only operate for payments which are an obligation of the payer (such as court ordered damages or insurance payments). As you read the succeeding cases you ought to consider these questions: • Can the compensation principle extend beyond receipts in the context of a business? • Can the principle operate with respect to voluntary payments? • Where a receipt may be income according to either the compensation receipt or periodicity principle (see [6.410]), does it matter which is applied? Question

[6.55]

6.1

You may wish to reconsider the decision of the High Court in Hepples v FCT (1991) 65 ALJR 650 (see Chapter 4) in the light of the compensation receipts principle. You will recall that in the High Court, the ATO only argued that the sum received by Mr Hepples was taxable under capital gains tax, not that it was ordinary usage income. Might Hepples be taxable on the amount as a compensation receipt?

(a) Compensation Under Statute, as Insurance or Damages [6.60] Sydney Refractive Surgery Centre shows that the crucial factor in applying the

compensation receipts principle is to determine what the taxpayer is being compensated for (not what measure is used to quantify the amount of compensation). Where the compensation is paid because of a statutory or common law right or under an insurance policy, the court will interpret the statute or the insurance policy to find exactly what it is that the taxpayer is being compensated for. An example of this is the Full Federal Court decision in FCT v Slaven (1984) 1 FCR 11 where the Court was concerned with money paid pursuant to a statutory scheme designed to replace common law negligence actions for personal injuries. The taxpayer in Slaven received $4,360 as compensation for injuries she suffered in a motor vehicle accident. This amount was approximately what she would have earned during her absence from work. She was paid by the Motor Accidents Board pursuant to the Motor Accidents Act 1973 (Vic), which provided that amounts paid by the Board under s 25 of the Act were for “deprivation or impairment of [her] earning capacity”. The ATO submitted that the payments were income according to ordinary concepts and thus assessable income derived by the taxpayer under s 25(1) of the ITAA 1936 (s 6-5 of the ITAA 1997) because they were made to compensate for the income lost by the taxpayer by reason of the accident. The members of the Federal Court, Bowen CJ, Lockhart and Sheppard JJ, held that the payment was a capital receipt:

FCT v Slaven [6.70] FCT v Slaven (1984) 1 FCR 11 The starting point for the determination of the character of payments which the Board is liable to make under the Act, and which the recipient is 356

[6.55]

entitled to receive, must be the terms of that Act itself … What the Board is liable to pay to a person injured as a result of a motor accident is

Compensation Receipts and Periodic Receipts

FCT v Slaven cont. not described by s 25(1) as a payment for loss of income or in substitution pro tanto for income which would otherwise have been earned by the person. It is described, and consistently described, throughout the Act as amended as payment of an amount as compensation “for the deprivation or impairment of earning capacity” which the person has suffered … The Board is not empowered to determine the appropriate amount of payment to be made to the injured person by a formula based on lost earnings … The exercise in which the Board is required to engage by the Act is not merely one of assessing lost earnings. It is in fact an exercise in valuation. It is true to say that the amount of compensation payable to an injured person is quantified by a consideration of what the use of the lost or diminished earning capacity might be expected to produce. In some simple situations the amount of lost earnings may be a certain and ready guide to the amount of entitlement. But the Board’s task is essentially to determine the compensation payable to a person having regard to the deprivation or impairment of his earning capacity by reason of the injury. The distinction between loss of earnings and loss of earning capacity is well established; it is by no means fictional. Further, there is no statutory requirement that payments under the Act be on a regular or periodic basis. Regular periodicity of payment has been said to assist in the characterisation of payments as income … However, the regularity and periodicity of a payment will generally not be a decisive consideration …

[6.75]

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The Parliament of Victoria cannot determine by its own legislation whether the receipt of a statutory payment answers the description of income or capital in the hands of the recipient within the meaning of s 25 of the Assessment Act, a Commonwealth Act. But the purpose of a statutory payment, as disclosed by the terms of the statute itself, must be a powerful, though not conclusive, aid to the determination of the character of the payment and in particular as to whether its receipt constitutes income in the hands of a taxpayer. These considerations do not support the notion that payments made pursuant to determinations of the Board are in partial substitution for earnings which would have been earned but for the relevant accident. The essential character of those payments is, in our opinion, as compensation for loss or impairment of earning capacity. The receipt of those payments is a capital receipt. … Under the Act an injured person’s right to recover damages at common law in respect of the deprivation or impairment of his earning capacity arising by reason of the relevant injury is taken away if he is entitled to make a claim under s 25 in respect of that deprivation or impairment of earning capacity but does not make such a claim. As damages for personal injuries at common law (including a component of compensation for loss of earning capacity) are not assessable income under the Assessment Act, it would be odd if different revenue consequences were attracted to payments made under the Act as amended for loss of the same asset and, more particularly, as the injured person who recovers damages at common law is liable to repay to the Board the amount paid by it to him.

Questions

6.2

What circumstances led the Court to conclude that the payments in Slaven were not of an income nature? For what was the payment in substitution?

6.3

Would the result in Slaven have been different if the Motor Accidents Act 1973 had read (as it did prior to 1979) “where a person … suffers a loss of income … and makes an application … for payments … in respect of the loss of that income … the Board shall … pay to that person an amount [calculated at 80% of the person’s average weekly income]”? (See Tinkler v FCT (1979) 79 ATC 4641.) [6.75]

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The Tax Base – Income and Exemptions

6.4

As the amount involved is a capital receipt, how does the capital gains tax affect the result in Slaven? (See s 118-37(1)(b) of the ITAA 1997.) What is meant in that section by the words “compensation or damages you receive for any wrong, injury or illness you or your relative suffers personally”? Would this cover damages recovered for wrongful dismissal? What about the damages payment in Sydney Refractive Surgery Centre? How does the exclusion in s 118-37(1)(b) differ from the “wrong or injury you suffer in your occupation” referred to in s 118-37(1)(a)?

6.5

A taxpayer suffers the loss of an eye as a result of the negligence of the surgeon during an operation performed in 1996. The taxpayer sues the doctor for damages plus interest and costs. After several years, the taxpayer settles all actions against the doctor for $2 m. How much of the $2 m is “compensation or damages you receive for [the] wrong”? Would it make any difference if the taxpayer settled the action for $1.6 m plus $250,000 representing interest from the date of the operation until the date of settlement and $150,000 for legal costs? (See Whitaker v FCT (1998) 82 FCR 261; 38 ATR 219; 98 ATC 4285. See also s 51-55 of the ITAA 1997.)

6.6

The taxpayer was injured at work and received periodic payments under the State industrial injury laws. The law provided that after age 65, “the relevant authority must, on written request by the former employee make a determination that its liability to make further payments to the former employee be redeemed by the payment to the former employee of a lump sum”. In other words, the employee could elect to commute its entitlement into a lump sum. The lump sum payable was computed under the Act as the sum of the future payments likely to be made using standard life expectancy tables and discounted to a present value using a 3% interest rate. The employee made this election. Is the lump sum taxable? (See Coward v FCT (1999) 99 ATC 2166.) What if the taxpayer did not make the election and decided to receive periodic payments? (See Re Brackenreg and FCT (2003) ATC 2196.) The taxpayer was injured at work and received periodic payments under federal industrial safety laws. The law provided that the employee could request the redemption of the right to periodic payments by the payment of a lump sum. The employee has to make a case for the lump sum based on the benefits that having a lump sum will generate. The taxpayer successfully made a claim arguing that the lump sum would enable him to start a small home-based business which would reduce his dependency on future periodic payments. Is the lump sum taxable? (See Barnett v FCT (1999) 99 ATC 2444.)

6.7

[6.80] The application of the compensation receipts principle to payments made under an

insurance policy was considered by the High Court of Australia in Carapark Holdings Ltd v FCT (1967) 115 CLR 653. Carapark was the holding company for a group of companies which manufactured and sold caravans. Its income consisted of dividends and interest on loans to subsidiaries. It took out life insurance on nine key employees in the group and received a £10,000 payout when an employee of one of the subsidiaries was killed in a plane crash. The payment was used to establish a trust for the benefit of the employee’s widow and children – the first time the company had done this. The ATO treated the insurance proceeds as assessable income of the company and Kitto, Taylor and Owen JJ in the High Court agreed:

358

[6.80]

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Carapark Holdings Ltd v FCT [6.90] Carapark Holdings Ltd v FCT (1967) 115 CLR 653 What a taxpayer has done with an amount that he has received is in general of no materiality in determining whether his receipt of the amount was a receipt of income or of capital; but where the characterisation of the receipt requires consideration of the purpose for which the taxpayer entered into a contract which produced the amount, as is the case here as we shall point out, the application that he has made of it may be material as throwing light upon that purpose. … There seem to be only two possibilities worth considering. One is that when the insurance was being negotiated the motivating consideration on the part of the appellant was that in any of the events insured against the receipt of the policy moneys would place the appellant in a position to do exactly the kind of thing it did in this instance, namely, to extend an appropriate degree of generous treatment to the employee or his dependants. If any such notion existed, it was left to be further considered when the time should arrive. The only other possibility seems to be that as regards employees of subsidiaries the insurance was effected in order that in any of the events insured against the appellant should receive money to take the place of that which it would otherwise have derived from a continuance of the services of the employee to the subsidiary. In our opinion, if either of these two possibilities explains the insurance, the conclusion follows that the insurance moneys reached the hands of the appellant as income. … The reasons may be summarised by saying that, in general, insurance moneys are to be considered as received on revenue account where the purpose of the insurance was to fill the place of a revenue receipt which the event insured against has prevented from arising, or of any outgoing which

has been incurred on revenue account in consequence of the event insured against, whether as a legal liability or as a gratuitous payment actuated only by considerations of morality or expediency. True, in a case like the present the insurance money was not received by the appellant to take the place of those benefits on revenue account which it would have received if it had continued to enjoy [the employee’s services], for the appellant was not itself in enjoyment of those services. But it was in enjoyment, through the medium of dividends from the employing companies, of some or all of the profits of those companies which, on the one view of the purpose of the insurance, the services of the employees were helping to produce and which, on the other view of that purpose, the payments to injured employees or to dependants of deceased employees would necessarily reduce. So whichever of the purposes was the true purpose, the situation simply is that the appellant, rather than leave the employing companies to take out separate insurances designed to bring in money in place of profits which would be lost to them if any of the events insured against should occur, itself took out a single policy in its own name to provide directly against such loss of dividend income as it might itself suffer, really, though indirectly, in consequence of the death or disablement of any of the employees. Accordingly the insurance moneys which the appellant received in respect of the death of [the employee] must be considered as having been gained in the course of its business, using “business” in the broad sense which makes it relevant to the tax problem, that is to say as meaning the continuous course of conduct which the appellant was following for the derivation of income.

The taxpayer made one further argument in Carapark in support of its position that the insurance payment should not be characterised as an income receipt. This argument was based on the characterisation of the payment, but by reference to another asset – this time a capital asset – which the company argued it had insured. [6.90]

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The Tax Base – Income and Exemptions

The appellant submits that … although the effect of the death or incapacity of an employee of a subsidiary in relation to the appellant would be upon dividend income in the first instance, in the end its effects would be upon capital, because a fall in its dividends may be expected to result in a fall in the capital value of its shares in the subsidiary. Therefore, the argument concludes the insurance moneys were received on capital account. But the appellant was a holding

company. If it had been a dealer in shares, the value of the shares it held in the subsidiaries might have assumed prime importance in inferring the purpose with which steps were taken in the conduct of its affairs. As things were, however, dividend income mattered primarily for its own sake, and an insurance against events likely to affect income adversely was necessarily a purpose of income rather than of capital concern.

[6.100] Another case involving the assessability of an insurance payout – this time under a

policy taken out by the taxpayer to protect against the financial consequences of being incapacitated – was the judgment of the High Court in FCT v Smith (1981) 147 CLR 578. The taxpayer was a doctor who purchased personal disability insurance in case he was unable to perform his professional duties. The policy (further details of which are contained in the extract below) stated that it gave “monthly indemnity of $600 payable each month subject to proof of loss during any period of total disability”. He was injured in a car accident and received $2,112 which he disclosed as income and claimed a deduction of $91 for the premium. The ATO treated the payment as assessable income but denied the taxpayer a deduction for the premium. The High Court agreed that the payment was income but allowed the deduction for the premium. Gibbs, Stephen, Mason and Wilson JJ:

FCT v Smith [6.110] FCT v Smith (1981) 147 CLR 578 Counsel for the taxpayer argues that the moneys received under the policy represent payments made for the loss of a capital asset. That asset is the taxpayer’s ability to work as a medical practitioner, carrying with it the capacity to earn income. The policy, although the promise of the insurer is described in terms of an “indemnity” for disability, is not properly described as providing an indemnity against loss of income. There is no necessary correspondence between moneys receivable under the policy and the income loss suffered by the taxpayer. … From his review of the policy, Wickham J concluded that “this is clearly an insurance against loss of an ability”. So much may be conceded, as is also the proposition that capacity or ability to earn is a capital asset. But, with respect, these conclusions do not carry the taxpayer far enough to establish the contrary of the Commissioner’s assertion that the moneys paid under the policy were paid in substitution for income and therefore 360

[6.100]

take the place of a revenue receipt. If the ability to earn is the tree, and income the fruit thereof, a policy of insurance against impairment of the fruit-bearing capacity of the tree may well take the form of providing the fruit until such time as the tree recovers its proper role. The degree of correspondence, if any, between the moneys payable under the policy and the actual pecuniary loss of revenue suffered by the insured is a relevant factor, but it is not necessary to look for an indemnity measured with any precision against the loss. Any fruit is better than none, whether or not it represents adequate compensation for the loss. [Counsel for the taxpayer] points to some features of the policy to support his contention that the moneys paid under the policy do not bear a revenue character. No indemnity is payable in respect of the first 30 days of disability. If the disability continues beyond two years, then the monthly indemnity continues notwithstanding

Compensation Receipts and Periodic Receipts

FCT v Smith cont. that the insured is then earning an income at whatever proportions so long as it remains the case that he is disabled from performing “each and every gainful occupation for which he is reasonably suited by education, training or experience”. It is true that these features of the policy make it unlikely that the moneys received under the policy will bear any direct correspondence to the loss of earnings suffered by the insured. But do they fix those receipts with a character other than income? The existence of a qualifying period of 30 days is in our opinion entirely neutral in this regard. The fact that after a period of two years’ disablement during which the insured is unable to engage in any gainful occupation at all he may then engage in some occupation other than that for which he is suited without jeopardising the continued receipt of benefits under the policy does not give those receipts a character different from that which

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would have attached during a period without any earnings at all. Even after the period of two years has elapsed, the inference of loss still remains. The loss of “ability to earn” in one’s own calling is most likely to be reflected in an actual loss of earnings. … In our opinion the conclusion is inescapable that the purpose of the policy is to diminish the adverse economic consequences of injury by accident. It was to provide a monthly indemnity against the income loss arising from the inability to earn. The revenue character of the benefits is so clearly stamped upon them during the period of two years during which the insured is totally disabled from earning that the remote possibility of him enjoying some windfall thereafter by reason of his securing gainful employment of the kind prescribed is of no consequence. It follows from what we have said that the Commissioner is also entitled to include the benefits received by the taxpayer under the policy as assessable income pursuant to s 26(j).

[6.120] The next three cases differ from the ones just examined because they do not involve

enforcing rights to compensation that arise under statute or an insurance policy. Instead, they raise the question, how is an amount to be treated when it is received as damages for some loss or damage caused to the taxpayer’s reputation or the goodwill of its business? FCT v Spedley Securities Ltd (1988) 19 ATR 938 involves some of the key “players” of the heady days of the 1980s boom economy. The taxpayer was a merchant bank which had agreed to arrange a $65 m loan for Santos Ltd in return for a commission of 11/4% of the loan. The taxpayer had all but completed its work when changes to legislation made Santos reconsider the loan and it decided to terminate the deal. After protracted negotiations, Santos agreed to pay $200,000 to the taxpayer. According to the terms of the deed which settled the matter, the amount was paid “in full and final satisfaction, settlement and discharge of all actions, costs, claims, charges, demands and expenses whatsoever which Spedley now has … against Santos Ltd … connected with any advice, assistance or services provided or offered by Spedley to Santos Ltd … in connection with the … proposals to raise for Santos Ltd a loan” of $65 m and for refraining from suing Santos in the future. The taxpayer argued that the amount was not taxable as income because it was received as compensation for loss or damage to its goodwill – a matter which, unfortunately for Spedley, was not referred to in the deed – but in any event was a single lump sum that could not be apportioned and so the whole amount was a capital receipt. The ATO argued that this sum was assessable income of Spedley on two grounds – either the sum was paid as compensation for the lost commission on the loan, or else it was simply business income of Spedley under the Myer Emporium principle. The Full Federal Court dismissed the ATO’s appeal finding adequate evidence that, “Spedley’s most substantial [6.120]

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The Tax Base – Income and Exemptions

claim against Santos would be for damage to its reputation and goodwill and that this would be the primary ground of relief in any proceedings taken.” You may wish to contrast this result with the decision in Liftronic Pty Ltd v FCT (1996) 96 FCR 175. The taxpayer carried on business installing and servicing lifts in high-rise buildings. In 1988 the taxpayer changed suppliers and began acquiring its equipment from Hyundai. Unfortunately for Liftronic, virtually all of its customers then began experiencing difficulties with their lifts and news began to spread within the industry to other lift consultants, building owners and tenants, and even a UK company that had been considering making a take-over offer for Liftronic. Liftronic terminated its contract and sued Hyundai in the Supreme Court of NSW for the losses it suffered arising from the defective equipment supplied by Hyundai. The claim lodged with the Court had four main elements: lost sales during the two years after the termination while it found new suppliers; lost maintenance contracts arising from those lost sales; ongoing lost sales from its diminished reputation in the industry; and lost maintenance contracts from those lost sales. In the litigation, Liftronic led a great deal of evidence to prove the quantum of its losses by estimating the amount of its lost profits from the sales and servicing contracts it could not secure. The taxpayer won the case and recovered $2.2 m which the judge described as being for “loss of profits”. The ATO then assessed the taxpayer on the basis that this amount was income. The taxpayer argued that it had not sued for lost profits but for damage to its reputation and goodwill – that is, its income-earning potential. The ATO’s assessment was upheld on the basis that the damage to Liftronic was apparently too inconsequential: “here the breaches of Hyundai did not destroy the goodwill or earning capacity of Liftronic. [The business was] temporarily impaired during the period in which, through efforts made on the company’s behalf, they were restored… This restriction created a ‘hole in profits’ which the award of damages was intended to fill. It follows that, in my view, the amounts awarded as ‘loss of profits’ are properly to be characterised as income in accordance with ordinary concepts.” The taxpayer in Liftronic tried to assert that its action had recovered amounts that were of a capital nature because the damages compensated it for damage to its reputation, lost future contracts and so on. It failed, but the taxpayer in FCT v CSR Ltd (2000) 45 ATR 559 succeeded in making this case at least in part. The case is important because it ties nicely back to a point made in Chapter 2 – that once a receipt is shown to contain an element which is not ordinary income, it will not be possible to dissect and tax that part of the sum as ordinary income, unless some method of apportionment is apparent on its face. In this case, the taxpayer, CSR, was being sued for damages arising from its blue asbestos mine, which operated at Wittenoom in Western Australia from 1943 to 1966. The company attempted to claim against its insurance policy for these liabilities but its insurer, NZI, disputed that it had any liability for these claims. CSR began proceedings in the United States against NZI claiming indemnity under the policies and damages for breach of contract, breach of a duty of good faith and absence of fair dealing. Thereafter some procedural skirmishes occurred between the parties in the United States and the Supreme Court of New South Wales, and after protracted negotiations, CSR agreed to accept $100 m in settlement of all its claims against NZI. CSR claimed that when it settled the action against NZI it was giving up any residual rights to the indemnity which it might have had under the policies, any right to claim damages (including punitive damages) from NZI in these proceedings and the other proceedings that CSR was bringing against its other insurers, any right to damages for damage to CSR’s goodwill, business reputation, or credit rating, its right to claim damages for wrongful interference with 362

[6.120]

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CSR’s business, and so on. The taxpayer argued that these claims were real and had some prospect of success and, once these actions came into play, some of the $100 m (it was not possible to say how much) would not be ordinary income. And if some of the $100m was not ordinary income, then none of it was on the authority of McLaurin v FCT (1961) 104 CLR 381 and Allsop v FCT (1965) 113 CLR 341. The Court agreed, “the conclusion cannot be avoided that the consideration was a release of causes of action some of which would have generated receipts of a non-income nature. In our opinion, Allsop governs the issue under s 25 of ITAA 1936.” The ATO also put forward other arguments concerning the operation of ITAA 1936, s 26(j), which we will return to below. [6.125]

6.8 6.9

6.10 6.11

6.12

6.13 6.14

6.15

6.16

6.17

Questions

How does the approach of a court differ when the payment is an insurance payment from its approach when dealing with other payments? It seems that the High Court attaches some significance to the purpose for which the insurance policy was taken out. How does the Court determine the taxpayer’s purpose – is it objective or subjective purpose that is relevant? What effect does the deductibility of the premium have on the assessability of any receipt? Ought there to be any relationship? Consider again the taxpayer’s argument in DP Smith that it was for the damage to a capital asset that he was being compensated. What was that asset and how did the insurance company measure it? What significance attaches to the question of whether the payments received as compensation are recurrent and periodic? Compare Slaven with Smith and Phillips. Do you regard the results in the cases as consistent? Are they based upon distinctions rooted in substance or in form? How would Spedley Securities be decided if the facts arose after CGT? You might also consider what Spedley Securities and CSR suggest about wise tax practice in drafting the terms of settlements in litigation. How might you deal with any potential tax liability that arises out of the settlement? How would the CGT provisions apply to Liftronic, given that the measure of its loss was its lost profits – amounts attributable to sales contracts it was not able to make? How do you distinguish the outcome in Liftronic from that in Spedley Securities? How do you distinguish the outcome in Liftronic from Sydney Refractive Surgery Centre? The taxpayer in CSR fought the action on the basis that the payment was not ordinary income but conceded that the payment gave rise to a capital gain. Why do you think it was so important to CSR for the payment to be viewed as a capital gain rather than ordinary income? A taxpayer is a doctor with income replacement insurance (like Smith). He claims to be entitled under the policy to receive $4,000 per month on the basis that he is totally and permanently disabled for work. The insurance company disagrees and the doctor sues under the policy for the unpaid amounts plus interest. The parties settle the action and the doctor receives $140,000 in a lump sum. The taxpayer seeks a Ruling from the ATO that the amount was a capital receipt arising from the cancellation of the insurance policy and the surrender of his rights under it. The ATO issues a Ruling claiming that the amount was assessable as ordinary income and the AAT and Federal Court agree. Why? (See Sommer v FCT [2002] FCA 1205.) [6.125]

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(b) Compensation for Assets that are Damaged, Destroyed or Confiscated [6.130] We have seen that compensation receipts are income where they overtly replace

streams of expected payments which would be income – the dividends in Carapark, the wages in Phillips, the fees in DP Smith or the profits from unachieved sales and servicing contracts in Liftronic. Compensation will often arise when an asset is destroyed, seized or realised in some other fashion and rights arise to bring actions or enforce contractual obligations, but it would be a mistake to think that compensation for damage to an asset will not be ordinary income, as we will see below. Where the asset for which the taxpayer receives compensation forms part of the taxpayer’s business, the ubiquitous issue of characterisation arises – viewed in the context of the taxpayer’s business, what is the nature of the asset for which the taxpayer is being compensated? Alternatively, if the compensation is not ordinary income, how does the CGT system work in respect of any damages recovered or in respect of any insurance payment received by the taxpayer as a result of the loss? (i) Loss of trading stock [6.140] Specific provisions exist to include in a taxpayer’s assessable income an amount

recovered for damage to assets which are trading stock: see s 70-115 of the ITAA 1997. In fact, these provisions are possibly unnecessary. The High Court held in FCT v Wade (1951) 84 CLR 105 that an amount received by a grazier as compensation for the destruction of his diseased herd of cattle was assessable under ordinary concepts and usages – that is, under s 6-5. Section 385-100 of the ITAA 1997 and subsequent provisions provide a special concession to deal with the situation of a taxpayer like Wade – a farmer whose entire herd is involuntarily and unexpectedly destroyed. In the case of trading stock, the rules allow primary producers a choice, either to spread the unexpected gain over five years, or to apply the gain in reduction of the cost of any replacement trading stock that the taxpayer needs to buy. As we will see, there are similar rules to deal with the tax consequences arising from the involuntary loss or destruction of depreciable assets and CGT assets. (ii) Revenue assets [6.150] Where the asset being compensated for would be a revenue asset of the business, there

is authority that compensation for its loss is income. We have already seen this issue in cases such as Glenboig Union Fireclay Co v IRC (1922) 12 TC 427 (Chapter 5) and Heavy Minerals v FCT (1966) 115 CLR 512 (Chapter 5) and have observed that in order to perform the characterisation, the courts place great emphasis on the concept of “sterilisation” – how significant was the asset to the business, and how significant was the damage to that asset? Whether the compensation for the loss of a potentially significant business asset was income was considered by the House of Lords in Van den Berghs Ltd v Clark [1935] AC 431. The taxpayer company and a Dutch rival formed a cartel to divide between them the market for margarine. In addition to prohibitions on competition, their agreements provided for mutual profit-sharing. For many years Van den Berghs paid amounts to the Dutch company (which Van den Berghs treated as deductible business expenses) and received amounts (which it treated as taxable revenue). Eventually the cartel broke down after much conflict and the Dutch company wished to terminate the agreements. Van den Berghs agreed to release the 364

[6.130]

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Dutch company from the contractual arrangements provided it paid to Van den Berghs £450,000 “as damages”. Revenue authorities claimed that the amount was taxable as income. Lord MacMillan disagreed:

Van den Berghs Ltd v Clark [6.160] Van den Berghs Ltd v Clark [1935] AC 431 It is important to bear in mind at the outset that the trade of the appellants is to manufacture and deal in margarine, for the nature of a receipt may vary according to the nature of the trade in connection with which it arises. The price of the sale of a factory is ordinarily a capital receipt, but it may be an income receipt in the case of a person whose business it is to buy and sell factories. My Lords, the learned Attorney-General stated that he was content to take the agreements of 1927 as meaning what they say. The sum of £450,000 is accordingly to be taken as having been paid by the Dutch company to the appellants in consideration of the appellants consenting to the agreements of 1908, 1913 and 1920 being terminated as at 31 December 1927, instead of running their course to 31 December 1940. If the payment had been in respect of a balance of profits due to the appellants by the Dutch company for the years 1914 to 1927, different considerations might have applied, but it is agreed that it is not to be so regarded. Now what were the appellants giving up? They gave up their whole rights under the agreements for 13 years ahead. These agreements are called in the stated case “pooling agreements”, but that is a very inadequate description of them, for they did much more than merely embody a system of pooling and sharing profits. If the appellants were merely receiving in one sum down the aggregate of profits which

they would otherwise have received over a series of years the lump sum might be regarded as of the same nature as the ingredients of which it was composed. But even if a payment is measured by annual receipts, it is not necessarily itself an item of income. As Lord Buckmaster pointed out in the case of the Glenboig Union Fireclay Co.: “There is no relation between the measure that is used for the purpose of calculating a particular result and the quality of the figure that is arrived at by means of the test.” The three agreements which the appellants consented to cancel were not ordinary commercial contracts made in the course of carrying on their trade; they were not contracts for the disposal of their products, or for the engagement of agents or other employees necessary for the conduct of their business; nor were they merely agreements as to how their trading profits when earned should be distributed as between the contracting parties. On the contrary the cancelled agreements related to the whole structure of the appellants’ profit-making apparatus. They regulated the appellants’ activities, defined what they might and what they might not do, and affected the whole conduct of their business. I have difficulty in seeing how money laid out to secure, or money received for the cancellation of, so fundamental an organisation of a trader’s activities can be regarded as an income disbursement or an income receipt.

[6.170] Van den Berghs’ receipt was not ordinary usage income, but that is not the end of the

matter in a post-CGT world. Once we move past trading stock and revenue assets, a taxpayer must consider the impact of other provisions of the Act affecting the loss or disposal of capital assets. Two particular regimes need to be explored: the depreciation provisions for depreciable assets; and the CGT provisions for all CGT assets. These regimes are particularly important when the asset that is destroyed was insured.

[6.170]

365

The Tax Base – Income and Exemptions

(iii) Depreciable assets [6.180] The depreciation provisions will be examined more thoroughly later but their

purpose is to allow a taxpayer to deduct over time a portion of the cost of assets which waste when used to produce assessable income. When a depreciable asset is lost or destroyed, the taxpayer should be entitled to deduct any of its remaining unclaimed cost in the asset if it can no longer be used to produce income for the taxpayer. That outcome is provided for in s 40-285 – the taxpayer is required to make a balancing adjustment because the loss or destruction of a depreciable asset is a “balancing adjustment event” which requires a computation: s 40-295(1). The taxpayer is allowed to deduct the difference between the remaining unrecovered cost in the asset (referred to as “adjustable value”) and any amount that will be recovered when the asset is lost (referred to as the “termination value”). If the asset is uninsured and the taxpayer has no one to sue, this will mean that the taxpayer then recovers all the unrecovered cost in the asset – that is, the difference between the cost of the asset and the amount of depreciation already allowed. If the depreciable asset was insured, or the taxpayer successfully sues the person responsible for the loss of the asset, a special provision computes the taxpayer’s “termination value”: s 40-300(2) Item 8. It prescribes that the termination value is “the amount or value received or receivable under an insurance policy or otherwise for the loss or destruction”. In other words, if the payout under the insurance or the damages is less than the undeducted cost of the asset, the deficit is deductible: s 40-285(2). If the payout is more than the adjustable value, the excess will be assessable income: s 40-285(1). Note however, that a concession is offered later in Div 40 in the way that a positive balancing adjustment amount can be dealt with – that is, where the payout or damages exceeds the taxpayer’s remaining tax cost. Section 40-365 of the ITAA 1997 allows a taxpayer to treat the balancing adjustment as reducing its cost in a replacement item of depreciable plant purchased within one year. An example will show how this works. Assume a taxpayer has purchased a machine for $100,000 and it is totally destroyed by a fire after two years. Assume the undeducted cost of the machine at that time was $70,000 (that is, the taxpayer has claimed $30,000 as a depreciation deduction) and the taxpayer recovered $83,000 from its insurer. The taxpayer uses this money to fund the purchase of a replacement machine for $114,600. The taxpayer has a potential tax liability of $13,000 on the “disposal” of the first machine that occurred when it was destroyed, but s 40-365 will allow the taxpayer instead to claim depreciation deductions for the replacement machine based on a lower cost of $101,600 – that is, the real cost of $114,600 minus the balancing adjustment of $13,000. The $13,000 balancing adjustment is still recognised, but as reducing future depreciation deductions rather than increasing the current year’s assessable income. (iv) Structural assets [6.190] Finally, let us look at compensation for the loss or destruction of capital assets. Some

of the cases extracted in this chapter (such as Carapark) were decided before 1985 when taxpayers would not be taxed on receipts if they could successfully characterise them as compensation for the loss, destruction or surrender of a capital asset. Now, however, it is precisely because an asset is involved that the capital gains tax consequences of compensation payments need to be considered. Indeed, there are two related CGT issues that need to be examined: • What is the CGT treatment of loss or destruction of the CGT asset? 366

[6.180]

Compensation Receipts and Periodic Receipts

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• How does this treatment mesh with the CGT treatment of any insurance payout, damages or other recovery that the taxpayer receives? We will begin with the CGT asset. According to s 104-20 of the ITAA 1997, CGT event C1 occurs when a tangible CGT asset is “lost or destroyed”. In relation to intangible CGT assets, s 104-25 of the ITAA 1997 creates CGT event C2 which occurs when a taxpayer’s ownership of an intangible CGT asset ends by the asset being redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited, or by its expiry. If an asset is resumed by a government or is otherwise acquired by compulsory acquisition, the relevant CGT event is probably CGT event A1: s 104-10 of the ITAA 1997. For all of these CGT events, any compensation payment such as an insurance payment or an award of damages will be the capital proceeds from the event and a capital gain or loss may arise. If the asset was uninsured and no damages were recovered, presumably the taxpayer makes a capital loss of the cost base of the asset – although the odd drafting of s 116-30(1) of the ITAA 1997 may suggest that the taxpayer in fact is deemed to receive the market value of the (undamaged? – see s 116-30(3A)) asset. This ridiculous outcome is specifically modified for some kinds of CGT event C2 by s 116-30(3), but not for all CGT event C2, nor for CGT event C1. Where an asset is acquired by a compulsory acquisition, if the asset was insured, or if the taxpayer successfully sues for damages, a gain can potentially arise. In circumstances where a gain arises and the events which triggered the gain were involuntary, the gain can be deferred by the taxpayer using a rollover mechanism: see s 124-70 of the ITAA 1997. (Of course, if the taxpayer realises a capital loss, it will not want to defer recognising the loss and there is no requirement to defer the capital loss in these circumstances.) The rollover allows the taxpayer to defer any capital gain, provided the taxpayer incurs expenditure in acquiring a replacement asset or in repairing the destroyed asset within one year: s 124-75(1) of the ITAA 1997. If the taxpayer elects to roll over its capital gain, the effect of the rollover, as stated in s 124-85(2), allows the taxpayer to roll the gain into a replacement asset. An example is probably the best way to understand the computation that the sections require. Assume the taxpayer owns a post-CGT building which is totally destroyed by fire. The building cost the taxpayer $2.3 m to construct and was insured for its replacement value with escalation clauses in the policy which tie the payout to the cost of reconstructing a building of the same size. Assume the taxpayer receives $2.65 m under the policy so that there is a potential capital gain of $350,000. How this gain is treated depends on the relationship between three things: the amount of the capital gain; the amount recovered from the insurance company (referred to in s 124-85(2) as “the money”); and the amount spent on replacing or repairing the asset (referred to in s 124-85(2) as “the expenditure”). Intuitively, there are three situations to distinguish: the insurance does not cover the cost of replacing the building (Item 3); the insurance covers the cost of replacing the building and the taxpayer has more money left over than the amount of the gain (Item 2); and the insurance covers the cost of replacing the building and the taxpayer has less money left over than the amount of the gain (Item 1). • If the taxpayer spends $3 m constructing an enlarged replacement building, the insurance has not covered the cost of replacing the building. In this situation all of the gain can be rolled over. Section 124-85(2) states that the taxpayer makes no capital gain in this year, and instead its cost in the replacement building is reduced to $2.65 m – this is the effect of s 124-85(2) Item 3. [6.190]

367

The Tax Base – Income and Exemptions

• If the taxpayer decides to reduce the size of its accommodation and spends only $2.1 m of the $2.65 m it collected, it is making a saving in its investment – larger than the amount of the capital gain it made. In this case there is effectively no rollover. The section provides that the taxpayer makes a taxable capital gain of $350,000 and presumably has a cost in the new building of $2.1 m – this is the effect of s 124-85(2) Item 2 and arises because the gain ($350,000) is less than the amount by which the money ($2.65 m) exceeds the expenditure ($2.1 m). • If the taxpayer decides to reduce the size of its accommodation but still needs to spend $2.5 m of the $2.65 m it collected, it can take a partial rollover. It will make a taxable capital gain of $200,000 and will have a cost in the new building of $2.3 m – this is the effect of s 124-85(2) Item 1. The gain ($350,000) is reduced by the excess of the money ($2.65 m) over the expenditure ($2.5 m). So the gain reduces from $350,000 to $200,000: Item 1(a). The expenditure ($2.5 m) is also reduced by the difference between the gain ($350,000) and the saving in expenditure ($150,000): Item 1(b). In this example, and in many cases of loss or destruction to capital assets, there is another asset to be considered – the insurance policy. Without some special provision, a problem would arise in any insurance settlement because two assets are involved – the asset insured, and the insurance policy. When a taxpayer collects a payout under an insurance policy, the transaction could amount to CGT event C2 – the satisfaction of the rights that the insured holds under the intangible CGT asset. But the payout relates to the destruction of the insured asset and it should be viewed as the capital proceeds arising from the destruction of that asset. The potential confusion arising from the two assets could be dealt with in several ways. Section 118-300 solves the problem by ignoring the capital gain made on the performance of the contract of insurance. Instead, all of the CGT consequences arise for the underlying asset. This specific provision for insurance policies begs the question, what happens in analogous situations that do not involve insurance? What happens if the taxpayer recovers under a law suit payment for the loss or destruction of its asset? Is the person’s right to sue for damages, compensation or the price of goods a CGT asset separate from the underlying asset? There is no specific rule in the CGT provisions answering this question but the ATO has issued Taxation Ruling TR 95/35 which adopts the same principle as that adopted in s 118-300 – the compensation is regarded as relating to the underlying asset which is the subject of the suit, and it either forms part of the capital proceeds received in respect of the underlying asset for a seller, or reduces the taxpayer’s cost in the asset for a buyer. But where there is no underlying asset, the Ruling takes the view that the taxpayer makes a gain from the disposal of something referred to as a “right to seek compensation”.

Ruling TR 95/35 the disposal of any other asset, such as the right to seek compensation.

[6.200] 4.

368

If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an under-lying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for

[6.200]

5.

It follows that if the underlying asset disposed of was acquired by the taxpayer before 20 September 1985, the receipt of the compensation has no CGT consequences for the taxpayer. If the underlying asset was acquired by the

Compensation Receipts and Periodic Receipts

Ruling TR 95/35 cont.

11.

taxpayer on or after 20 September 1985, a capital gain or loss may arise on the disposal. Compensation for permanent damage to, or permanent reduction in the value of, the underlying asset 6.

7.

If an amount of compensation is received by a taxpayer wholly in respect of permanent damage suffered to a postCGT underlying asset of the taxpayer or for a permanent reduction in the value of a post-CGT under-lying asset of the taxpayer, and there is no disposal of that underlying asset at the time of the receipt, we consider that the amount represents a recoupment of all or part of the total acquisition costs of the asset. Accordingly, the total acquisition costs of the post-CGT asset should be reduced in terms of subsection 160ZH(11) [ss 11040(3), 110-45(3)] by the amount of the compensation. No capital gain or loss arises in respect of that asset until the taxpayer actually disposes of the underlying asset. If, in the case of a post-CGT underlying asset, the compensation amount exceeds the total unindexed acquisition costs (including a deemed cost base) of the underlying asset, there are no CGT consequences in respect of the excess compensation amount

9.

Compensation received by a taxpayer has no CGT consequences if the underlying asset which has suffered permanent damage or a permanent reduction in value was acquired by the taxpayer before 20 September 1985 or is any other exempt CGT asset.

Compensation for excessive consideration 10.

If a taxpayer is compensated for having paid excessive consideration to acquire an asset, the amount referable to the overpayment represents a recoupment of all or part of the total acquisition costs of the asset in terms of subsection 160ZH(11) [ss 110-40(3), 11045(3)].

Disposal of the right to seek compensation

12.

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If the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right. The cost base of the right to seek compensation is determined in accordance with the provisions of section 160ZH [Div 110]. The consideration in respect of the acquisition of the right to seek compensation, for the purposes of paragraph 160ZH(1)(a), includes the total acquisition costs incurred as a result of which the right to seek compensation arose.

Disposal of a notional asset 13.

Generally, the amount of compensation is received by a taxpayer in respect of either an underlying asset or the disposal of the right to seek compensation (created and disposed of in accordance with subsection 160M(6) [s 104-35] after the 25 June 1992 amendments). Accordingly, subsection 160M(7) [s 104-135] does not apply to the compensation. If the amount does not relate to either the underlying asset or the right to seek compensation, subsection 160M(7) [s 104-135] may apply to the amount received.

General concepts – Exempt assets 14.

If an amount of compensation is received in respect of an underlying asset which is an exempt asset (eg a principal residence or an asset acquired before 20 September 1985) there are no CGT consequences. However, a taxable capital gain may arise if: • there is an exempt underlying asset which has not been disposed of, or permanently damaged or permanently reduced in value; • the requirements of subsections 160M(6) or 160M(7) [ss 104-35, 104-135] are satisfied; and • if the consideration is received by the taxpayer in respect of the disposal of the newly created or notional asset, being the most relevant asset. [6.200]

369

The Tax Base – Income and Exemptions

[6.205]

Questions

6.18

In Sydney Refractive Surgery Centre, the ATO had advanced, but then abandoned, an argument that the taxpayer had made a taxable capital gain from CGT event C2 occurring. What is the basis for such a position in light of TR 95/35? Why do you think the ATO abandoned the argument?

6.19

Would it have made any difference to the result if Van den Berghs had made similar contracts with other manufacturers for different geographical and product markets and had surrendered only its rights under a contract covering the distribution of unrefined bulk margarine in Canada? (See Rolls Royce v Jeffrey [1962] 1 WLR 425 (Chapter 5); Commissioners of Inland Revenue v Burmah Oil Co Ltd (1981) 54 TC 200; and Moriarty v Evans Medical Supplies [1958] 1 WLR 66.)

6.20

What significance attaches to whether the taxpayer is permanently or temporarily deprived of the asset? (See London and Thames Haven Oil Wharves Ltd v Attwooll [1967] Ch 772.)

6.21

Assuming the facts of Van den Berghs occurred in Australia after 1985, how would capital gains tax operate: is there an asset; a disposal; what is the consideration in respect of the disposal; what is the relevant cost base?

6.22

Does it make any difference when an asset is disposed of whether the compensation receipts principle operates or the capital gains tax is allowed to operate? How are the income and capital gains provisions reconciled if the asset for which compensation is received is trading stock? What if the asset is a revenue asset of the business?

6.23

A taxpayer receives a payout from an insurance company upon the destruction of a depreciable asset. Can the amount received be income or a capital gain? (See s 118-24.) How does this impact upon the computation of the balancing adjustment under s 40-285? How would the provisions in s 40-365 operate if the insurance amount was assessable?

6.24

A taxpayer’s depreciable asset is destroyed due to the negligence of another. The taxpayer receives an award of damages for loss of the asset. Will this payment be included by s 40-285 in computing the taxpayer’s termination value?

6.25

How are the following situations dealt with for: (a) trading stock; (b) a CGT-only asset; and (c) a depreciable asset? Assume a taxpayer buys the asset for $1,000. It is destroyed after one year (when its written-down value is $800 in the case of plant). What happens if the taxpayer: (a) receives $900 and buys a replacement asset for $1,200; (b) receives $900 and buys a replacement asset for $700; (c) receives $700 and buys a replacement asset for $850; and (d) receives $700 and buys a replacement asset for $650?

6.26

How would TR 95/35 apply to Liftronic?

(c) Compensation for Allowable Deductions [6.210] At the beginning of this chapter we suggested that there should be two components of

the compensation receipts principle, the second being that an amount which recoups for the taxpayer an amount that has previously been allowed as a deduction, has an income character. While the second aspect is undoubtedly a sensible principle from a tax policy perspective (for reasons which we will discuss below), it is not a position that is expressed in the existing case 370

[6.205]

Compensation Receipts and Periodic Receipts

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law. It is possible that the refund or recovery of an amount which has previously been allowed as a deduction will result in an amount being included in assessable income, but there seems to be no general principle to this effect. In fact, the judges seem to go to great lengths to protest that the mere refund of an allowable deduction is not sufficient to generate income. In earlier editions of this book we commented that “this reluctance is very strange when it is realised that the principle being suggested is an easier one to justify than the Carapark proposition – in fact, the refund of an allowed deduction is just Carapark from a different perspective in time”. You may care to evaluate that comment in the light of the way the High Court deals with this observation in Rowe’s case, extracted below. When examining the following cases, look for the issues of apportionment which they raise. Apportionment is an issue we have already looked at in Chapter 2. You may also wish to consider how s 20-25(4) of the ITAA 1997 changes prior law. The assessability of the reimbursement of a previously deducted expense was considered by the High Court in HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537. The taxpayer in Sinclair paid timber royalties to the Forests Commission of Victoria “subject to protest”. The royalties were calculated according to a formula which the Commission had decided to impose under a statutory authority to collect licence fees. The taxpayer deducted the royalties from its assessable income. Eventually the taxpayer convinced the Commission that it had miscalculated the royalty and the Commission voluntarily made a refund, after negotiation, of £3,400. The ATO assessed the refund as income in the year in which it was received, an action which Taylor J in the High Court endorsed:

HR Sinclair & Son Pty Ltd v FCT [6.220] HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537 The problem in the appeal is whether in the circumstances disclosed by the case stated it was proper to take into account the receipt of the sum in question for the purpose of ascertaining the gross “proceeds” of the business conducted by the appellant during the year which ended on 30 June 1961. This question is a practical one and its answer cannot be made to depend upon what deductions were or were not allowed pursuant to the Income Tax and Social Services Contribution Assessment Act in assessing the taxable income of the appellant and, ultimately, its liability to tax in past years. This, it seems to me, is quite beside the point in considering the question under review. The character of the amount which the appellant received cannot, in the absence of some appropriate statutory provision, be thought to vary according to whether or not deductions were claimed and allowed of expenditure, which includes the sum now reimbursed. Indeed, the respondent ultimately conceded that the fact that the deductions had been allowed in past years could not affect the answer to the question.

However, it was contended that it would be more appropriate to treat the payment to the appellant as a diminution of its business outgoings in the earlier years rather than as assessable income for the year in question. Problems bearing some similarity to that which arises in this case have not infrequently been dealt with in this manner in England and, no doubt, it would in many cases be more equitable to reopen the earlier assessments and make the appropriate adjustments. But in England, where the relevant legislation permits this course, the matter seems to have been treated not so much as a question of business accounting as an appropriate method of adjusting the taxpayer’s liability to tax. However, there is no power to adopt this course in Australia except in circumstances which do not present themselves in this case and I do not think the English cases by any means require the conclusion that, under the provisions of the Australian Act, the refund in this case was not assessable income of the appellant in the year of its receipt. … [6.220]

371

The Tax Base – Income and Exemptions

HR Sinclair & Son Pty Ltd v FCT cont. There was a suggestion that the payment was made and received not merely as a voluntary refund but by way of compromise of past and future claims. In my opinion, however, there is no substance in this suggestion; the payment represents no more than a voluntary refund of part of the royalties which had been legally exacted. The refund was made because after protracted representations and negotiations the Commission conceded that it had, from time to time, incorrectly applied the formula … In these circumstances I can see no reason why the

amount should not be regarded as properly taken into account in determining the proceeds of the appellant’s business of the year in which it was paid. Its attempts – which in the end were successful – to obtain a refund of amounts which it contended had been exacted as the result of the misapplication of the formula were just as much an activity of the business as would have been an attempt to avoid an overcharge in the first instance and the amount recovered in the year ended under review must be taken to have formed part of the appellant’s income for that year.

[6.230] Another instance in which the taxpayer received the refund of a previously deducted

outgoing arose in Allsop v FCT (1965) 39 ALJR 201. In Allsop, the taxpayer paid fees for interstate haulage permits which were it claimed as tax deductions. The fees were later held to be unconstitutional. The taxpayer sued the NSW Government for £54,000 in an unusual legal action in which the company alleged that it had suffered damage because it had to pay unlawful fees and because its trucks were unlawfully detained for weighing and inspections. The action was eventually settled and both parties to the action signed a deed releasing each other from all existing and future potential claims upon payment by the NSW Government to Allsop of £37,500. The Commissioner included £36,500 in the taxpayer’s assessable income (this being the balance remaining after deducting the taxpayer’s legal costs). The High Court held that the money received by the taxpayer in the settlement was not assessable as income. Barwick CJ and Taylor J deliberately chose not to rely upon the compensation receipts principle:

Allsop v FCT [6.240] Allsop v FCT (1965) 39 ALJR 201 The respondent sought to support the assessment on one general ground and two particular grounds. The first, in effect, was that where a refund is made to a trader in one income year of an amount, or part of an amount, which he had expended on revenue account in an earlier year and which had been allowed as a deduction in assessing his taxable income, the amount of the refund constitutes income of the later year and, therefore, assessable income within the meaning of s 25 of the Income Tax and Social Services Contribution Assessment Act. Whether or not this proposition can be accepted without qualification is open to serious question. But since, in our opinion, the factual basis for such a conclusion 372

[6.230]

does not exist in this case so that acceptance of the proposition would not be decisive and as in any case the point was not fully argued, it is inadvisable for us to express any view on the matter. The primary question in the case is whether the payment to the appellant of the sum of £37,500 constituted, in the circumstances, a refund of part of the fees which had been paid by him. In our opinion it did not. There is sufficient in the case to enable it to be said that during the period in question there had been unlawful interferences with the appellant’s vehicles and his business operations and in respect of these

Compensation Receipts and Periodic Receipts

Allsop v FCT cont. matters he had valid claims against the Commissioner. His claim for a refund of the fees paid by him was not admitted by the Commissioner and the amount payable upon the execution of the release was the consideration not only for a release of his claim against the Commissioner in respect of the fees paid by him for permits but also for his release of all claims for anything done in purported pursuance of the State Transport (Co-ordination) Act. There is no suggestion that the release was illusory or that it was not designed to operate, or, that it did not operate according to its tenor and, that being so, we do not regard the allegations contained in the case stated as relevant matters for our consideration. But even if they are taken into

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consideration they would not affect the conclusion that the amount payable was an entire sum paid by way of compromise of all these claims and no part of it can be attributed solely to a refund of the fees paid by the appellant for permits. The particular grounds upon which the respondent relied were based upon the provisions of s. 26(j) and s. 72(2) of the Act. As far as s. 26(j) of the Act is concerned it is sufficient to observe that no part of the amount paid to the appellant was, as that section requires, received by him by way of insurance or indemnity. The conclusions that no part of the sum paid to the appellant under the deed of release constituted a refund to the appellant of such fees paid by him renders s. 72 on any view inapplicable to the present case.

[6.250] Careful reading of this case shows that the Court probably failed to distinguish

between the two distinct issues which arose. In Allsop there was an apparent apportionment issue which clouded the whole case. The apparent apportionment problem probably meant that no refund issue arose because any element of the payment which represented a refund was no longer discernible, but the case has become authority for the refund, as well as the apportionment, issue. You may wish to refresh your memory about the significance of apportionment issues by glancing back to Chapter 2 (especially McLaurin v FCT (1961) 104 CLR 381) and revising s 20-25(4). The rejection of any recoupment principle as an aspect of the meaning of income according to ordinary concepts and usages was reaffirmed by the High Court in FCT v Rowe (1997) 187 CLR 266. Rowe had been employed as a shire engineer but was suspended from duty and threatened with dismissal after a series of complaints were made against him. He incurred $24,000 in legal fees in order to be represented at an inquiry into the complaints. The taxpayer claimed a deduction for $24,727.99 for legal expenses in his return for the 1985–86 year of income which was allowed by the ATO. In 1989, the Queensland Government then made an ex gratia payment to the taxpayer of $24,748.24 for these expenses and the ATO sought to include the amount in Rowe’s assessable income. The High Court held by majority (Brennan CJ, Dawson, Toohey and McHugh JJ) that the amount was not income under ordinary concepts and usages.

[6.250]

373

The Tax Base – Income and Exemptions

FCT v Rowe [6.260] FCT v Rowe (1997) 187 CLR 266 Special leave to appeal was granted in this matter in order to test the existence of a principle of law for which the appellant contended. In the notice of appeal to this court it was expressed as a “general principle of law that an amount paid as compensation for or reimbursement of a deductible expense is income within ordinary concepts”. It must be said that there is no authority in this court (or, it would appear, in any other Australian court) directly supportive of the appellant’s general principle, in any of the shapes it bears. Indeed, the principle runs up against what was said in H R Sinclair & Son Pty Ltd v FCT… In the earlier decision of Allsop v FCT there is a passage in the judgment of Barwick CJ and Taylor J which casts doubt upon the suggested nexus between deductibility and assessability but, in the circumstances of the case, no concluded view was expressed. There are two somewhat related ideas involved here. See Cooper, Krever & Vann’s Income Taxation, 2nd ed, 1993, LBC, par 7-2. The first is that a payment which is compensation for an item that would have been assessable as income is itself assessable as income. This has been recognised in a number of cases; it is unnecessary to identify them all. The second idea is the principle contended for by the appellant, namely, that compensation for an amount previously allowed as a deduction necessarily constitutes assessable income. The argument that an amount which compensates the taxpayer for an item that has previously been allowed as a deduction necessarily has an income character is not reflected in the existing law. It has been suggested in Cooper, Krever & Vann’s Income Taxation, 2nd ed, 1993, LBC, par 7-11 that the reluctance on the part of courts to accept such a general principle is strange:

… when it is realised that the principle being suggested is an easier one to justify than the Carapark proposition – in fact, the refund of an allowed deduction is just Carapark from a different perspective in time. But there are different considerations operating in the case of allowed deductions; these stand in the way of an easy transition from one idea to the other. One consideration is that the court has said that what a taxpayer has done with an amount received “is in general of no materiality in determining whether his receipt of the amount was a receipt of income or of capital”. But the fundamental difficulty in the way of the “general principle” is that it diverts attention from the inquiry demanded by the Act, as that inquiry has generally been understood, namely, is the receipt income according to ordinary concepts? There are provisions in the Act whereby some refunds are assessable as income. The existence of specific provisions in the Act of this nature tells against the existence of a general principle. That is not to suggest any application of the expressio unius rule. The court has more than once emphasised the need to apply that maxim with care. Rather, as Hill J observed in the recent decision of Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171 at 176: It is difficult to see, as a matter of principle, why a payment which has the character of capital becomes income in ordinary concepts, just because the payment has its origin in the refund of a previous amount which had attracted a deduction. The symmetry which such a rule suggests ignores the fact that deductions may be available for amounts which have capital character. Not all deductions are on revenue account.

Having rejected the compensation receipts notion, the majority then considered whether the amount was assessable as a reward for service. 374

[6.260]

Compensation Receipts and Periodic Receipts

[6.270] The character of a receipt is assessed by reference to its character in the hands of the taxpayer, not the character of the expenditure which produces the payment to the taxpayer. The payment was in no sense a reward for his services during his employment by the Council, which had long since been determined. It was a

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recognition of the wrong done to him, and also of the fact that he had been forced to shoulder the task of sharing in an inquiry undertaken by the Government for public purposes. The payment was not a remuneration, but a reparation.

[6.280] The minority (Gaudron, Gummow and Kirby JJ) also rejected the notion of a

compensation receipts principle, but held that the amount was assessable as a reward for service. While the outcome of Rowe clearly decides that there is in Australia no ordinary concepts notion that the refund of an allowed deduction is income, both Sinclair and Rowe show that refunds can be assessable on other grounds – as the product of carrying on a business, or possibly as a reward for services. [6.285]

6.27 6.28 6.29

6.30

6.31

Questions

When (apart from pursuant to the application of statutory provisions) will the refund of an allowed deduction produce assessable income? The reasoning in Sinclair depends upon the business activities of the taxpayer. Does Allsop suggest some limits on the significance of the business context? What difference, if any, would it have made to the result in Allsop if the parties had deliberately allocated £30,000 to the reimbursed fees and £7,500 to the detention of the trucks? The taxpayer carries on business and receives an assessment for payroll tax in respect of wages paid to its employees. It claims an income tax deduction for the amount assessed. Under a scheme designed to increase exports, the taxpayer subsequently becomes entitled to a cash rebate of some of the payroll tax for wages paid to employees working on exported goods. Is the cash rebate assessable as ordinary income? (See Automatic Totalisators Ltd v FCT (1968) 119 CLR 666.) The taxpayer is a music distributor selling CDs, records and tapes in Australia. It receives from the ATO an assessment of $4 m for sales tax in respect of sales in prior years. The taxpayer believes that no sales tax is payable but pays $1 m under protest pending resolution of the dispute. In its income tax return for that year, the taxpayer claims an allowable deduction for the $4 m as assessed. After several years, the dispute is heard and the taxpayer succeeds, receiving a refund of the $1 m paid. What is the treatment of the $1 m refunded to the taxpayer? What is the treatment of the $3 m which the taxpayer has deducted (without actually paying), but is now relieved from having to pay? (See Warner Music Australia v FCT (1996) 34 ATR 171.)

[6.290] We now need to consider various statutory provisions that affect the common law

position. You will have noticed passing references in the cases to several sections in the 1936 Act which specifically provided that some refunds will be included in assessable income such as ss 26(j), 26(k), 26(l), 63(3), 53AA, 72(2) and 74(2). Some of these sections were mentioned in Sinclair, Allsop and Smith. The High Court in Rowe took the view that the existence of these provisions might, but probably does not, militate against a similar idea under ordinary concepts and usages. These provisions have now been consolidated into Div 20 of the ITAA 1997, which includes in a taxpayer’s income an “assessable recoupment”. The Division is intended to operate as a [6.290]

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supplement to any ordinary concepts notion: s 20-20(1). But the Division clearly extends beyond the ordinary usage notion, and also extends the scope of the statutory recoveries previously provided by the various provisions in the ITAA 1936. In other words, this is another area where the 1997 Act probably no longer expresses the “same ideas” as were expressed in the similar provisions in the ITAA 1936 for the purposes of s 1-3(2) of the ITAA 1997. This expansion comes about because the consolidated regime captures all the possible events that might be relevant and labels them all a “recoupment”. Consider, as an example, an amount paid by a purchaser of real estate to reimburse the vendor for rates that the vendor had paid in full earlier in the year. Under s 72(2) of the ITAA 1936 the vendor would include this amount in its income if it amounted to a “refund”. Is this adjustment made on completion of the sale a “refund” of those rates, or is it only the Council who can make a “refund”? Similarly in s 74(2) of the ITAA 1936, any election expenditure incurred by a candidate that was “reimbursed to the taxpayer or paid for him by any other person or by any organization” was included in assessable income. These precise terms, “refund” and “reimbursement” could be contrasted with the term used in s 69(2) of the ITAA 1936 which included in income a situation where a taxpayer’s expenditure on tax-related expenses was “reimbursed” to the taxpayer, “paid for” by another person, or “recouped” from another person. Under the new provisions in s 20-25, these different situations no longer matter. A taxpayer derives a “recoupment” if: • the taxpayer receives “any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery, however described”; • the taxpayer receives a “grant in respect of the loss or outgoing”; • some other person pays an amount on behalf of the taxpayer in respect of a loss or outgoing; or • the taxpayer disposes of its right to receive an amount as recoupment of a loss or outgoing. The two kinds of recoupments that are “assessable recoupments” are stated in ss 20-20(2) and 20-20(3). The first provision rewrites s 26(j) of the ITAA 1936: it includes in income the recoupment of a loss or outgoing that is or was allowable as a deduction, where the amount is received “by way of insurance or indemnity”. The second provision leads to the tables in ss 20-30(1) and 20-30(2) which provide a list of the particular deductions in the ITAA 1936 and ITAA 1997 which, if “recouped”, will give rise to an “assessable recoupment”: s 20-20(3). Essentially it consolidates the scattered inclusion provisions that were previously found outside s 26 of the ITAA 1936. Section 26(j) of the ITAA 1936 (now rewritten as s 20-20(2) of the ITAA 1997) was subject to some scrutiny in FCT v National Commercial Banking Corp by the Supreme Court of New South Wales (1983) 83 ATC 4208, and the Federal Court of Australia (1983) 83 ATC 4715. The bank had been a member of a consortium which had set up Bankcard in Australia in 1972 and its share of the establishment costs had been allowed as deductions. When other banks were subsequently admitted to participate in Bankcard, they were charged a fee which was calculated to recoup to the consortium members a portion of these costs. The ATO claimed that these fees were income to the bank and his submissions included an argument that relied upon s 26(j) and interpreted the word “indemnity” in that section as encompassing a situation where the agreement to indemnify the taxpayer arose after the taxpayer had already incurred the expense. The more usual idea of an indemnity is that the taxpayer has a contract already in place which protects her or him against a potential future expense. As Hunt J in the NSW 376

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Supreme Court put it, “in the present case, there is at most a reimbursement of a loss already incurred or of an outgoing already paid. The contracts by which the new banks became obliged to pay their fees for entry into the Bankcard scheme were concluded after each of the founder banks had paid the outgoings in question. A reimbursement, the taxpayer argues, is not an indemnity. I agree that a reimbursement is not the same as an indemnity, as a matter of the ordinary English usage of those two words. If the legislature had intended to include as assessable income that which merely reimbursed the taxpayer for outgoings already paid, then it could and, in my view, should have used the word ‘reimbursement’ and not ‘indemnity’.” [6.300] We looked at the CSR case earlier in this chapter and examined the ATO’s

unsuccessful argument that the $100 m received when it settled an action against its insurer was assessable as ordinary income. The ATO had a second argument for taxing CSR – that s 26(j) of the ITAA 1936 (now s 20-20(2) of the ITAA 1997) applied to the money. The argument was that the money CSR was collecting from its insurer was “received by way of insurance or indemnity for or in respect of [an] outgoing which is an allowable deduction”. In this case, the relevant outgoing was the payments that CSR had to make to its former workers and to others injured by its handling of the blue asbestos. The Court rejected the ATO’s argument noting that, “one amount received by the insured from the insurer may fall within the paragraph while another may not. The fact that a taxpayer receives a payment from an entity that is its insurer does not necessarily signify that the payment is received by way of insurance … It is not permissible to substitute, for characterisation of the particular amount received, a characterisation of the general relationship between the parties.” [6.305]

6.32

6.33 6.34

Questions

How do the approaches to the same problem of Hunt J (in National Commercial Bank) and the members of the Federal Court differ? If we accept the reasoning of Hunt J as correct, is that a sufficient reason for refusing to include the refund in assessable income? Should the ATO have been permitted to reopen the bank’s prior tax assessments to take away the allowed deductions? Why were both the common law position and the sections found to be inapplicable in Allsop and National Commercial Bank? Assuming that each court would adopt the same approach, what tax consequences would follow if the facts of National Commercial Bank arose today?

[6.310] Now let us consider whether this treatment of refunds makes sense from a tax policy

perspective. The position expressed in the cases and the interpretation of the sections means that the compensation receipts principle is only a problem for taxpayers who are in business. Other taxpayers can apparently reduce their tax in Year 1 by making deductible payments and need pay no compensating tax when the amount is refunded in Year 2. This must be fundamentally wrong. You may care to contrast this position with the treatment of bad debts in s 25-35 of the ITAA 1997 where a taxpayer is given a deduction in a later year (which reduces its tax) simply because it has included an amount in assessable income in an earlier year (which increased its tax) but which it never subsequently received. You may also wish to compare the position in Australia with the “tax benefit doctrine” developed in the United States. That rule has two elements: an inclusionary aspect which includes the refund of an outgoing in income if the outgoing originally caused a reduction in tax; and an exclusionary element which prevents the refund from being included in income where the prior outgoing did not produce a decrease in tax. In other words, in the United [6.310]

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States it is sufficient to generate a tax liability that the taxpayer has received the refund of an outgoing which was previously allowed as a deduction. The exclusionary element is now enacted in the Internal Revenue Code 1986 (US), s 111(a): Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior year to the extent to which such amount did not reduce income subject to tax imposed by this chapter.

Although expressed in the negative, s 111(a) is an explicit recognition of the tax benefit rule. Contrast the Australian position also with the position in the United Kingdom, which was discussed by Taylor J in Sinclair: the revenue is permitted to amend the taxpayer’s accounts of the year in which the expense was first deducted. Hill J had considered this doctrine in Warner Music Australia v FCT (1996) 34 ATR 171 but he considered he was “as a single judge … bound by the weight of prior authority to find that there is no such rule in Australia”. He said, “I am bound by [Australian precedent] to find that an amount will not be required to be included in assessable income merely because it constitutes a refund of (or a gain arising from the release of a liability in respect of) an amount which had been allowed as a deduction against the income of a previous year …”. The minority judges in Rowe’s case also considered whether the US tax benefit doctrine should be viewed as expressing a general rule in Australia. They concluded that: (i) the tax benefit rule appears to evolve from particular circumstances attending the operation of the United States federal income tax law, particularly with respect to amendment of assessments; (ii) it was found necessary to balance the inclusionary branch of the rule by the exclusionary branch, the latter achieving specific statutory recognition; (iii) as now developed, the rule has an operation by no means on all fours with that which might be expected of the principle propounded by the Commissioner; and (iv) the doctrinal foundation of the rule remains a matter of dispute in the United States Supreme Court. In our view, when so understood, the tax benefit rule provides too imperfect an analogy to support the proposition for which the Commissioner contends.

The majority agreed with these comments. There is of course another way in which this matter might be dealt with – the taxpayer might just lose their deduction. Indeed, there is one statutory provision which does just that. Section 51AH of the ITAA 1936 provides that an employee is not entitled to a deduction for an expense which has been reimbursed by his or her employer. The section does not make the reimbursement income. Instead, it insists that the initial outlay was not deductible. The reason is that the employee, no longer being “out of pocket”, has no loss which requires a deduction. However, the litigated cases in Australia have not sought to attack the matter in this fashion – the ATO has not sought to argue that the deduction is Year 1 was not allowable because it was recovered in Year 2. [6.315]

6.35

6.36

6.37

378

Questions

How should refunds of allowed deductions be treated? What are the relative advantages and disadvantages of the solutions adopted in the United States and the United Kingdom? Should (and could) any adjustment be made to the year of payment or should consequences be limited to the year of refund? (See s 170, especially s 170(3) of the ITAA 1936.) Amendments to s 170 upon the introduction of the self-assessment system make it easier for the ATO to amend tax assessments issued for earlier years. But is that power sufficient to allow the ATO to overcome this problem by rewriting the accounts of [6.315]

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6.38

CHAPTER 6

earlier years? You should consider the attitude of the courts to the strict allocation of events to accounting periods evidenced in such cases as Henderson v FCT (1970) 119 CLR 612 (Chapter 10) and Country Magazine v FCT (1968) 117 CLR 162 (Chapter 10). Assuming the payment is assessable, what should happen if an individual taxpayer had deducted $10,000 in Year 1 and the amount was refunded in Year 2 if: (a) the taxpayer had assessable income in Year 1 of $4,000 and $7,500 in Year 2; (b) the taxpayer had assessable income in Year 1 of $15,000 and would, apart from the refund, have a loss in Year 2 of $5,000; (c) the taxpayer had assessable income in Year 1 of $40,000 and, apart from the refund, would have had assessable income in Year 2 of $20,000; (d) the taxpayer is a company?

2. PERIODIC PAYMENTS [6.320] In this part of the chapter we examine another element in the idea of income

according to ordinary concepts – that an amount which is one of a number derived periodically has the character of income. Certainly a series of recurrent payments which the taxpayer relies on to meet her or his living expenses has the “look” of income. Government pensions and purchased annuities are examples of this kind of ordinary usage income. Whether or not it is sufficient to impart an income character that a payment is one of a recurrent series is a question that must be constantly kept in mind when reading the cases in this section. Recall that in FCT v Slaven (1984) 1 FCR 11 (above) the members of the Court said: “regular periodicity of payment has been said to assist in the characterisation of payments as income. … However, the regularity and periodicity of a payment will generally not be a decisive consideration”. Similar observations were made in C of T (Vic) v Phillips (1936) 55 CLR 144. For example, if regularity were sufficient to make an amount assessable as income, it would mean that a child who regularly received a payment of, say, $500 per month to help out with expenses while studying at university would be taxable on this amount. This very proposition was hotly debated in Stone’s case discussed below. On the other hand, we have in s 51-50 of the ITAA 1997 a rule which says that regular payments of maintenance between spouses are not taxable to the recipient, presumably because the drafter believed it needed to be said.

(a) Periodic Payments on Which to Live [6.330] There have already been examples in previous chapters where courts have relied upon

the fact that a payment was one of a series used by the taxpayer to meet living expenses to justify a conclusion that the payment was income. One of the earliest examples of the principle – that a recurrent payment which the taxpayer relies upon to meet living expenses has an income nature – is the decision of the High Court in FCT v Dixon (1952) 86 CLR 540 – a case we have already looked at in another context (Chapter 2). You will remember that the taxpayer, Dixon, volunteered for service in World War II and his former employer made voluntary supplementary payments to him to make up the difference between the military pay and his former salary. The mere statement of the facts in this way should suggest to you at least two by now familiar reasons for treating the payments as income – as a reward for service, or as compensation for lost income – reasons we have considered elsewhere already. The High [6.330]

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Court held that the supplementary payments were income with some members relying upon a further reason. Dixon CJ and Williams J observed:

FCT v Dixon [6.340] FCT v Dixon (1952) 86 CLR 540 In the present case we think the total situation of the taxpayer must be looked at to see whether the receipts of the taxpayer from Macdonald, Hamilton & Co. are of an income character …. From the taxpayer’s point of view it is not unlikely that when he decided to enlist in the armed services, he relied to some extent upon the intimation he received from his employers. The result was to keep his income up to the standard that would have been maintained had he not enlisted. We have advisedly used the word “income” because, from his point of view, the contribution made by his employers meant that the periodical receipts upon which he depended for the maintenance of himself and his

dependants remained at the same level as his civilian employment would have given. From his point of view therefore the word “income” would be clearly applicable to the total receipts from his military pay and allowances and from his civilian employers. Because the £104 was an expected periodical payment arising out of circumstances which attended the war service undertaken by the taxpayer and because it formed part of the receipts upon which he depended for the regular expenditure upon himself and his dependants and was paid to him for that purpose, it appears to us to have the character of income, and therefore to form part of the gross income within the meaning of s. 25.

Fullagar J concurred in the result but relied upon the compensation receipts principle observing: [6.350] What is paid is not salary or remuneration, and it is not paid in respect of or in relation to any employment of the recipient. But it is intended to be, and is in fact, a substitute for – the equivalent pro tanto of – the salary or wages which would have been earned and paid if the enlistment had not taken place. As such, it must

be income, even though it is paid voluntarily and there is not even a moral obligation to continue making the payments. It acquires the character of that for which it is substituted and that to which it is added. Perhaps the nearest parallel among the many cases cited to us is to be found in C. of T. (Vic.) v. Phillips.

[6.360] Two important applications of this notion arise for students in relation to scholarships

and in relation to alimony and maintenance payments. Special provisions in the Act exclude these amounts from the assessable income of recipients provided stipulated conditions are met: see s 51-10 Item 2.1A and s 51-35 of the ITAA 1997 for scholarships, and s 51-50 of the ITAA 1997 for alimony and maintenance payments. [6.365]

6.39

6.40

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Questions

A student receives a taxable government scholarship which contains components for fees, books and living expenses. Is the amount spent on fees deductible to the recipient of the scholarship? You may wish to revisit the question after reading the chapters on deductions. You may also be surprised by the answer that the ATO gave in IT 2405 until it was withdrawn in 1998. The taxpayer is an elite athlete and receives quarterly payments from the Australian Olympic Committee to assist her to meet her living expenses so that she can train [6.340]

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unhindered by distractions like earning a living. Are the amounts income because of the periodicity principle? One judge in the Federal Court has said yes (see Stone v FCT (2002) 51 ATR 297; [2002] FCA 1492) and three in the Full Federal Court said no (see Stone v FCT (2003) 130 FCR 299; [2003] FCAFC 145). The High Court dodged the issue in FCT v Stone (2002) 222 CLR 289; [2005] HCA 21, although they pondered aloud at para 66 whether periodicity alone would be sufficient, and whether the principle seen in Dixon’s case operated “apart from the particular context of past or present employment”. [6.370] The principle currently being examined is especially fraught with danger as it tends to

lead to an income concept defined in terms of flows rather than gain. Let us return again to the element of “gain” as an important element in the definition of income. Pensions and annuities are typically held by retired individuals anxious to have a substitute for the wages that ceased when they retired from the paid workforce. Pensions and annuities are commonly paid by former employers, insurance companies, the government, or superannuation funds to retired individuals for this purpose. For income tax, it is important to note that the whole of the pension or annuity is income according to ordinary concepts and taxable under s 6-5 of the ITAA 1997. This position is confirmed for annuities by s 27H of the ITAA 1936 which will include in assessable income the whole of “any annuity derived by the taxpayer during the year of income” and “the amount of any … supplement to an annuity”. An annuity is, however, a series of payments that were purchased by the taxpayer and so, because each annuity payment to the taxpayer contains a repayment of this purchase price, some mechanism is needed to allow the taxpayer to exclude from each recurrent payment an amount representing the “undeducted purchase price” of the annuity. Indeed the principal function of s 27H(1) and (2) is to exclude from assessable income in each year a portion of the annuity, because it is assumed the whole of the annuity is already taxable under s 6-5 of the ITAA 1997. The amount excluded by s 27H represents the purchase price of the annuity and is termed the “deductible amount”. It is the capital cost of the annuity amortised over the expected period of payments. Finding the “deductible amount” can often be a difficult procedure, as Egerton-Warburton v Deputy FCT (1934) 51 CLR 568 (below) shows, and in some circumstances, taxpayers can be taxed on the full amount of the annuity without any reflection of its cost. Such a result defeats the idea that the taxpayer should only be taxed on the amount of gain. In the same way, for pensions paid from complying superannuation funds, the contributions made to fund the pension will already have been taxed to some extent. Recall from Chapter 4 that employer contributions to superannuation funds and earnings on those contributions will be taxed in the hands of the fund at 15%. Consequently, an annuity paid by a superannuation fund (to a member who under 60 and so is taxable on the pension) out of those contributions and earnings will contain amounts already (lightly) taxed, and so the contributor is given a tax rebate of 15% under s 301-25 of the ITAA 1997 to compensate for the tax already paid by the fund.

(b) The Interaction of the Income Tax and Social Security Systems [6.380] One of the most important applications of the proposition that periodic payments are

income is in taxing many in the wide variety of social welfare payments made by the government to citizens – the aged pension, disability payments, family allowance payments, [6.380]

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unemployment benefits, pensions paid to former armed services personnel, and so on. The provisions dealing with these kinds of payments are in Div 52 of the ITAA 1997. Subdivision 52-A deals with amounts paid under the Social Security Act 1991, Subdiv 52-B with amounts paid under the Veterans’ Entitlements Act 1986 and Div 53 with amounts paid under other legislation. The function of Divs 52 and 53 is to make payments exempt from the tax that would otherwise apply – again, it seems their taxable status appears presumed, no doubt based on Dixon and the periodicity principle. In Divs 51, 52 and 53 of the ITAA 1997 there are a plethora of statutory provisions that render pension-type payments and supplements to pensions exempt from tax. In some cases, the exemption is confined to just the supplementary amount added to a basic entitlement. A few of the payments rendered exempt include: • scholarships (ss 51-10 of the ITAA 1997), though not basic Youth Training Allowance or Austudy; • supplements to the age pension (s 52-15 Item 1), but not the basic amount; • disability support pension (s 52-10 Item 6.2); • advance pharmaceutical supplement (s 52-10 Item 1) paid under the Social Security Act. Most of the larger benefits provided under the social security system are taxable, although on many occasions, the social security legislation will contain additional means-tested supplements to the basic payment, many of which will be exempt from income tax, or the taxable status will vary with the age of the recipient. For example, the following benefits are taxable in most circumstances: • the basic age pension (by implication from s 52-10 Item 2.1) and the basic age service pension for veterans (by implication from s 52-65(4) Item 1); • Newstart allowance (that is, unemployment benefit) (by implication from s 52-10 Item 19.1); • carer payment (by implication from s 52-10 Item 4); • sickness allowance (by implication from s 52-10 Item 23.1) and basic invalidity service pension for veterans (s 52-65 Item 7). It may seem strange to impose tax on any welfare payments – why not simply reduce the value of the pension and make it exempt – but there is some method to this procedure. Making pensions taxable can serve to assist the progressivity of the tax/benefits system when operating in tandem. Not all benefits are means-tested but taxing them can be a surrogate. Furthermore, while the pensions are taxable, they are also subject to special rebates designed to reduce the total tax collected on the benefit where the taxpayer has little other taxable income. This procedure is used as a targeting mechanism to recover some of the cost of social security payments where either the initial benefit cannot be means-tested, where the government wants to claw-back benefits from individuals with high but non-recurrent income from other sources which has not affected the means-testing computation, or where the government simply wishes to double-check the administration of the grant – for example, comparing the amount of income reported to one authority, the Tax Office, with the amount reported to Centrelink. Some rebates are designed to assist low-income taxpayers (s 159N of the ITAA 1936), low-income aged taxpayers who are entitled to pensions (s 160AAA of the ITAA 1936) or senior Australians (s 160AAAA of the ITAA 1936). But these rebates are subject to their own progressive tax rate scale because they are withdrawn at various rates for income that the recipient earns over a threshold. The effects of imposing tax on government benefits, the 382

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withdrawal of low-income rebates, and the general means-testing of pension entitlements, can often combine to impose very high marginal tax rates on taxpayers with low levels of taxable income in ways which have caused much anxiety to tax policymakers. This phenomenon, where very low-income taxpayers have high marginal tax rates, is often referred to as a “poverty trap” and was a major focus of the tax debates surrounding the competing Labor and Liberal tax packages put to voters in the 1998 election. It resurfaced as an issue in 2010 in the Henry Review of Australia’s future tax system. An argument based on this effect was put to the Supreme Court of South Australia in Keily v FCT (1983) 83 SASR 494. The taxpayer argued that her age pension was exempt income (or that if it was not, it should be exempt) because she was being taxed on it twice. She argued that she was taxed when the ATO included the pension in her assessable income, but that she had already been taxed on it because the pension was already reduced because she had other income – that is, the partial withdrawal of her full pension also constituted a tax. White J:

Keily v FCT [6.390] Keily v FCT (1983) 83 SASR 494 Mrs Keily has been an aged pensioner since she attained 60 years in April 1978. If her pension is taxable income (and she contended that it was not), her combined income from her pension and interest on her investments and her bank account was sufficient to justify the amount of tax levied in each year. For the whole of the two financial years in question, that is, from 1 July 1978 to 30 June 1980, she received an aged person’s pension under the Social Service Act now the Social Security Act. [The Commissioner’s representative] made submissions based upon the various provisions of the Act which satisfied me that an aged person’s pension may be taken into account in arriving at the total amount of “assessable income”, and that such pension is “not exempt income”, within the meaning of s. 25(1) of the Act. In the case of an aged person’s pension the generally accepted characteristics of income (recurrence, regularity and periodicity) are all present. In addition, the pensioner has a continuing expectation of receiving periodic payments, an expectation arising out of established government policy with respect to the support and welfare of aged citizens. Pension payments form part of the receipts upon which a pensioner depends for support. And a pension is

paid to the pensioner for that purpose. A pension, therefore, satisfies the criteria or characteristics of income. Mrs Keily did not challenge any of this. Her point accepted all of the above and proceeded upon the basis that it was unjust that she should be “taxed twice” on the same income. As I understand her argument, she said that the government had already “taxed” her by depriving her each fortnight of a proportion of her pension due to the fact that her investments and interest (or her interest alone) were high enough for some reductions to be made from the pension payments which she would normally expect to receive if she had not such investments or income. Instead of receiving a full pension each fortnight, she received only a part pension. The government’s retention of some of the normal unreduced pension payments which she would otherwise receive constituted a tax, in her submission. She argued that she was being financially penalised (in other words “taxed”) by reason of her receipt of income from investments. Having thus paid one form of “tax” by way of reduced pension, she was now, by these income tax assessments, called upon to pay “another tax” on the proportion of the pension which she did receive. This, she said amounted to double taxation. There is a kind of logic in her argument which at first sight attracts sympathy, however irrelevant it is in law. Mrs Keily supported her [6.390]

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Keily v FCT cont. argument by a vague appeal to some authoritative statement she had read somewhere that pensioners were entitled to a 50% rebate on their assessments or only paid tax on 50 cents in the dollar on the part pension which they did receive. She could not produce that authority or document or identify when or where she had read it. In my view, the short answer to Mrs Keily’s argument is that her pension payments are reduced, not by way of tax, but by reason of the defined qualifications for the receipt of such pensions. There is only so much money to go

around for the payment of pensions to various classes of claimants. The claims of each class are expanded or contracted for policy reasons. Some pensions are subject to tax and some are not, again for policy reasons. Her complaint is that the effect of having saved some money and of receiving a separate income is that she suffers, in a sense, a financial deprivation in the form of reduction of pension payments in comparison with those who have not saved and receive full pensions. That is a complaint about government policy in formulating the criteria for pension payments and in deciding to tax pensions. I am powerless to help her on the appeal as her complaint is no answer to the assessments.

[6.400] Mrs Keily was attempting to explain to the Court the well-recognised problem termed

a “poverty trap”. To understand the problem, consider this example. Assume a taxpayer is aged 66 and has a part-time job which adds a small amount to the weekly income. Now assume the taxpayer is offered a few extra hours work per week. The taxpayer might be very pleased with a few extra dollars, but taking the additional work needs to be very carefully considered. The loss of benefits (not to mention the tax) that the additional income may trigger can outweigh the benefit of the additional salary. For example, • If the taxpayer has a (taxable) age pension under the Social Security Act, additional income may cause the pension to be reduced under the Social Security Act by 50 cents for every extra dollar of income derived. The extra $1 of pre-tax private wages is offset by 50 cents less government pension so that the taxpayer’s net position is only 50 cents better off. • Next, the 50 cents would be subject to income tax, say at the rate of 19%, which is 9.5 cents. The extra $1 of pre-tax wages is now down to a net benefit of 40.5 cents. • Next, additional income could also reduce the Senior and Pensioners Tax Offset at the rate of 12.5 cents for each dollar of extra income (if the taxpayer is in the right income range). Because she has only 40.5 cents more in income, the rebate is reduced by 5 cents. The extra $1 of pre-tax wages is now down to a net benefit of 35.5 cents. • Similarly, the Low Income Tax Offset (LITO) starts being withdrawn at the rate of 1.5% for every dollar in excess of $37,000. If she is in this income band, her LITO will be reduced by 1.5 cents. The extra $1 of pre-tax wages is now down to a net benefit of 34 cents. • Further, she may be liable to start paying the Medicare levy at the “catch-up” rate of 10% for each dollar (if the taxpayer is in the right income range). Because she has only 34 cents more in income, the Medicare levy would be 3.4 cents. The extra $1 of pre-tax wages is now down to a net benefit of 31 cents. The 1999 personal tax reforms were meant to ensure that these detriments did not all occur over the same income range to create a high tax burden at the low end of the income scale. But if they do all coalesce, the taxpayer might face a marginal tax rate of almost 70% – in other words, he or she would only keep 30 cents out of every dollar of extra private income earned. A further example makes the high effective marginal tax rate on low income citizens even clearer. One very valuable benefit available to people who are poor, aged or receive pensions 384

[6.400]

Compensation Receipts and Periodic Receipts

CHAPTER 6

and other benefits is one of the many cards provided by a variety of government departments – for example, the Health Care Card (for low-income people), the Pensioner Concession Card (for aged and other pensioners) and the Commonwealth Seniors Health Card (for self-funded retirees). In addition to providing access to subsidised pharmaceuticals, the cards are often used by other government agencies, including agencies from other levels of government, and some organisations in the private sector as a surrogate to means-testing their own benefits. Consequently the holder of a card can sometimes be entitled to reduced costs for council rates, electricity and gas bills, telephone costs, bus and train fares, optometry and audiology fees, car registration, bulk-billing by some doctors, and so on. There is a threshold at which the Health Care Card for low-income persons is withdrawn; other cards have separate thresholds. There is no “taper” on withdrawals because of the nature of the benefit – the card is either held or it is lost. If the combined benefits of holding the card are worth (say) $1,000 per annum in concessions of various kinds, then a taxpayer’s disposable income could fall absolutely if he or she were to take on further overtime and cross the threshold. This is generally referred to as a “cliff” – earn $1 extra and it will cost you $1,000. [6.405]

6.41

6.42 6.43

Questions

Would it have made any difference to the result in Harris (Chapter 4) if the taxpayer had used the payments to meet regular living expenses? See FCT v Blake (1984) 84 ATC 4661. Does this position penalise taxpayers who are poor? Do the provisions in Divs 51, 52 and 53 affect the result in Keily? Recall the discussion of the central or parallel provisions analysis in Chapter 2 and consider whether the element of “undeducted purchase price” excluded from being income under s 27H of the ITAA 1936 is nevertheless income under the ordinary usage periodicity principle?

(c) Periodic Payments and Instalments of Purchase Price [6.410] Another issue which arises in some cases is whether an amount can be treated as

income under the periodicity principle where an asset is sold on terms which provide for a series of recurrent payments as the price – for example, the taxpayer sells a parcel of shares for a price of $10,000 per annum for the next 20 years. It has already been suggested in the cases considering income from property (such as Scoble v Secretary of State for India [1903] AC 299 and Vestey v IRC [1962] Ch 861 both extracted in Chapter 4) that a series of payments like this may contain an element of interest where there are instalments of purchase price. The periodicity principle may suggest another reason why the instalments of purchase price are taxable – the purchase price agreed upon was an in substance (and probably unintended) annuity payable by the purchaser to the seller. Both taxpayers and the ATO on occasions have seen fit to argue that the terms of the sale of an asset generated an annuity. There is of course no reason in principle why a sale should not be on terms, even implicit terms, that the purchaser pay to the seller an annuity as the purchase price for the asset. There is nothing in the terms of s 27H that limits its operation to annuities purchased from insurance companies. An example of a payment which was unexpectedly characterised as a private annuity arose in Egerton-Warburton v Deputy FCT (1934) 51 CLR 568. In this case, the father agreed to sell the family farm to his sons in return for payments (secured by mortgage) of £1,200 per annum to him payable by quarterly instalments, £1,000 per annum to his widow after his death payable by quarterly instalments, and £10,000 to the family after the death of both himself and his wife. The Commissioner included the whole of the payments received in the father’s [6.410]

385

The Tax Base – Income and Exemptions

assessable income. On appeal to the High Court, the father and sons argued that the payments were capital – instalments of the purchase price on sale of a capital asset – or, if they were not capital, that the father could exclude a portion of each payment as the undeducted purchase price of the annuity. The High Court held that the payments were income from a private annuity payable by the sons to the father and denied him a deduction for the undeducted purchase price. At the same time, however, the Court allowed the sons to deduct the entire amount of the annuity payments. (This latter aspect is considered below.) Rich, Dixon and McTiernan JJ:

Egerton-Warburton v Deputy FCT [6.420] Egerton-Warburton v Deputy FCT (1934) 51 CLR 568 The first question which arises for consideration is whether the annual payments to the father are income in his hands. It is contended that they are part of the consideration for a sale of the capital assets constituted by his farm and the chattels used in connection therewith. “But there is no law of nature or any invariable principle that because it can be said that a certain payment is consideration for the transfer of property it must be looked upon as price in the character of principal. In each case regard must be had to what the sum is. A man may sell his property for a sum which is to be paid in instalments, and when that is the case the payments to him are not income. Or a man may sell his property for an annuity. In that case the Income Tax Act applies. Again, a man may sell his property for what looks like an annuity, but which can be seen to be not a transmutation of a principal sum into an annuity but is in fact a principal sum payment of which is being spread over a period and is being paid with interest calculated in a way familiar to actuaries – in such a case income tax is not payable on what is really capital. On the other hand, a man may sell his property nakedly for a share of the profits of the business. In that case the share of the profits of the business would be the price, but it would bear the character of income in the vendor’s hands. In such a case the man bargains to have, not a capital sum but an income secured to him, namely, an income corresponding to the rent which he had before.” (Jones v. C.I.R. [1920] 1 K.B. 711 at 714-715 per Rowlatt J.). A transaction by which an owner of capital assets disposes of them for a consideration which includes annual payments may serve the double purpose of converting a capital asset into money 386

[6.420]

and of converting the money, which otherwise would be capital, into income. In other words, the annual payments are not necessarily deferred payments of principal, they may be income the right to which has been purchased by an outlay of capital. In the ordinary case of the purchase of a life annuity for cash, the annuity is income into which the capital laid out has been transformed. The Commonwealth Income Tax Assessment Act 1922-1933 contains no explicit provision which includes annuities in the assessable income. But para. (d) of the definition of “income” in s. 4 [see now ss 27H(1), (2) of the ITAA 1936] necessarily implies what indeed would follow from the character of an annuity, that the annual payments are income; for it expressly excludes so much of the annual payments as represent the purchase price of an annuity that is purchased. In the present case the sons, in consideration of the transfer of the property, agreed to pay, not a fixed gross sum, but two life annuities of different amounts, one in succession to the other, and a specified capital payment upon the dropping of both lives. The first annuity is for the life of the transferor, a period of uncertain duration; the second annuity, that payable to his widow, is not only for a period of uncertain duration, but depends upon the uncertainty of her surviving him … We think it is impossible to treat the annuity of £1,200 a year as mere instalments of purchase money. It is a true life annuity of an income character. Subject, therefore, to the operation of the exclusory provision of para. (d) of the definition of “income”, the annual payments made on account of the annuity constitute, in our opinion, assessable income of the father … Unless the

Compensation Receipts and Periodic Receipts

Egerton-Warburton v Deputy FCT cont. price is allowable or has been allowed as a deduction in calculating taxable income, that proportion, which is considered to represent the capital invested, is excluded by the paragraph from the assessable income of the year in which the payment is made to the annuitant. The present case may be regarded notionally, perhaps, as if the father had stipulated for a capital payment from the sons sufficient to purchase an annuity for his life of £1,200, and had then reinvested it with them as the purchase price of an annuity which they undertook to pay him. If the price were ascertained, the transaction, so regarded, might come within the provisions which would authorise the exclusion of so much

CHAPTER 6

of the annual payment as represented principal expressed in the price. The difficulty is that no definite or ascertainable capital sum is agreed upon between the parties. The purchase price of an annuity depends upon the annuitant’s expectation of life, which is not solely a question of age, and upon the adoption of a rate of interest adopted by the parties for its calculation, it is, we think, impossible to find in the transaction a purchase price for the annuity. The statutory provision gives an advantage in cases which conform to conditions established positivi juris. One of the conditions is that there must be an ascertained or ascertainable price. In our opinion the conditions cannot be satisfied in the present case. For these reasons we think that the payment received by the father forms part of his assessable income for the year under consideration.

[6.430] It must be conceded, of course, that the denial of any cost for the annuity would not

automatically follow today. (In fact the entire transaction would most likely be dealt with under the rules about taxation of financial arrangements in Div 230.) As the Court noted, the exclusion from each payment of a portion of the purchase price is a matter to be established by conforming strictly to the words of the section, and s 27H varies in many respects from the terms of para (d) of s 4 of the 1922 Act which excluded “that part of the annuity which represents the purchase price”. Nevertheless, Egerton-Warburton v Deputy FCT (1934) 51 CLR 568 is a salutary lesson in the pitfalls of family transactions. Another lesson in the operation of the annuity provisions is the decision of the High Court in Just v FCT (1949) 8 ATD 419. Just and his brother brought an action against Colonial Mutual Life Ltd and in settlement agreed to sell certain land to Colonial Mutual Life in return for a “rent charge” equal to 90% of the gross rent received on three shops on adjoining land for the next 50 years, payable monthly. The memorandum of transfer showed the value of the property transferred as £17,500 for stamp duty purposes. The Commissioner assessed the whole of the payments received by the Justs as income – the treatment of the outgoings from Colonial Mutual Life’s perspective were considered in Colonial Mutual Life Assurance Society v FCT (1946) 73 CLR 604 (extracted in Chapter 9 at [9.240]). Webb J:

Just v FCT [6.440] Just v FCT (1949) 8 ATD 419 It will be observed that the Justs are entitled to 90% of the rent to be received so that it is only when the rent is received that their claim arises. … But the Justs have no power of distress under ss 137 and 138 as those sections apply only where the rent charge is in arrear because the lessees or tenants have not paid their rents. The

encumbrance then does not create a rent charge within the legal meaning of that term as there is no power of distress. But I see no reason why the absence of the power of distress should turn these payments that would otherwise be income into capital payments, or into payments partly capital and partly income. Even if they are not [6.440]

387

The Tax Base – Income and Exemptions

Just v FCT cont. rent payments of any kind they are not necessarily capital payments or payments partly of capital and partly of income. … If £17,500 were indicated in the agreement, or in either document executed in pursuance thereof, as the purchase price of the land, and not merely as its value for stamp duty purposes, the payments under the encumbrance might be held to be instalments of the purchase price and interest on the balance of the purchase price outstanding although the instalments would be

[6.445]

uncertain and might over the period of 50 years amount to more or less than £17,500. But no purchase price is so indicated. Again if it can be said that notionally £17,500 was paid by the Colonial Mutual Life Assurance Society Limited for Justs’ land and was then paid by the Justs for annuities secured by the encumbrances, still s. 26(c) [see now s 27H(1), (2) of the ITAA 1936] does not apply as neither the agreement nor the other documents, indicate a rate of interest on the principal invested. I think the substance of the transaction is that the Justs bargained to have not a capital sum but an income.

Questions

6.44

What difference will it make if the Commissioner argues that the instalments of purchase price are caught under the periodicity principle rather than containing implicit interest. What if neither principle applies – would capital gains tax or Div 16E of the ITAA 1936 apply and, if so, with what result?

6.45

The reasons for the recipient reluctantly arguing that the purchase price is an annuity are obvious from the second argument in Egerton-Warburton: if the payments were an annuity at least some portion of each might be excluded from assessable income. Will the ATO still have an incentive to argue for or against the payments being an annuity after capital gains tax? For example, would the ATO be interested in arguing Just today even though the judgment favoured the Commissioner? Consider the capital gains tax and in particular s 116-20 of the ITAA 1997.

6.46

Would the same result on the second argument still follow if Egerton-Warburton were litigated today, and would it follow for the same reasons? Consider the definition of the “deductible amount” in s 27H(2) and that of the “undeducted purchase price” in s 27A(1) in light of the fact that the sons were allowed deductions for the whole of the payments made to the taxpayer.

[6.450] The decision of the Full Federal Court in Moneymen Pty Ltd v FCT (1991) 91 ATC

4019 is probably a good place to finish this chapter, since the judgment of Hill J combines both of the principles discussed here. In 1972 the company had entered into an agreement to supply milk to Caboolture Co-operative Association Ltd. The effect of the agreement was that Moneymen had a single purchaser, Caboolture, which had agreed to buy all the milk Moneymen produced for the next 20 years and to pay the current market price for the milk. In particular, Caboolture agreed to pay market price for all Moneymen’s milk whether or not Moneymen might have a production quota, even though, in the absence of a quota, Moneymen could only have expected to receive a lower amount referred to as the manufacture price, under the peculiarities of the Queensland milk marketing scheme. In 1974 the taxpayer ceased business and transferred the benefit of the milk supply contract to Maleny. The price for the transfer of the contract was expressed in a formula: basically one-seventh of the net price received by Maleny from Caboolture, payable monthly. The ATO assessed the taxpayer under s 25(1) of the ITAA 1936 but the taxpayer appealed, arguing that the payments were 388

[6.445]

Compensation Receipts and Periodic Receipts

CHAPTER 6

capital proceeds from the sale of a capital asset. Hill J found that the monthly payments were income to Moneymen either because the company had sold its capital asset for an income stream or because the amounts paid were compensation for the profits that Moneymen could be expected to derive from the contract if it had retained it:

Moneymen Pty Ltd v FCT [6.460] Moneymen Pty Ltd v FCT (1991) 91 ATC 4019 For the purpose of the present appeal it may be accepted, without the necessity of deciding the point, that the contractual rights of the appellant pursuant to the deed of indenture, were a “structural asset” rather than a “revenue asset” to adopt the classification of Professor Parsons in his work Income Taxation in Australia Law Book Company, 1985, paras 2-478ff. That is to say that the deed of indenture formed part of the “profit yielding subject” of the appellant in contradistinction to the contractual rights involved in cases such as Allied Mills Industries Pty. Ltd. v. F.C.T. and Heavy Minerals Pty. Ltd v. F.C.T. Nevertheless, it does not follow that the payments received by the appellant were received by it on capital account. A taxpayer may sell a capital asset for a stream of income, in which case the consideration he or she receives will be income in ordinary concepts. Such a case was Egerton-Warburton v. F.C.T. A similar conclusion was reached in Just v. F.C.T. The appellant sought to distinguish EgertonWarburton in a number of different ways. First, it was suggested that the comments of the High Court were dependent upon the fact that the payments there in question were related inter alia to the life of the father, appeared of uncertain duration and were “a true life annuity”, thus being of an income nature. In the present case, it was pointed out, that the payments were to continue only for the period of the indenture: approximately 20 years. That, however, is not a matter of great moment. An “annuity” is not only to be found where payments are referable to life. As the present use of the term, in the Act, as illustrated by s. 27H(1) makes clear, periodical payments, for a fixed term, may be an annuity.

More importantly, however, for present purposes, is not whether the periodical payments here in question should be termed “an annuity”, but whether there has been an agreement to pay a fixed gross amount by instalments or rather merely an agreement to make a number of annual payments (clearly having regard to the formula in the deed of defeasance, of uncertain amount). It is impossible to point to a purchase price that was ascertained at the time of the 13 February 1975 deeds, or indeed at any time thereafter. There was, of course, a right to commute the monthly payments existing in the assignee Maleny (not in the appellant). However, even if this right were exercised, the amount payable depended upon the “market milk” price not only as at the date payable at the date of expiration of the notice. In the present case there is much to be said for the view that there is another and related reason why the monthly payments should be seen as income in ordinary concepts. Here the monthly payments under the deed of indenture, viewed objectively, were but a substitute for the income which the taxpayer could have derived under the deed of indenture had it continued to produce milk and not assigned its rights to Maleny. The payments were calculated as a fraction (oneseventh) of the gross sale price of “market milk”. While no doubt the fraction of one-seventh was arrived at by way of commercial negotiation and left Maleny able to make a commercial profit over and above its costs of production, the formula suggests that the monthly payment was intended to compensate the appellant for some, at least, of the net profits which, had it continued to produce milk and sell to Caboolture, it would have derived.

[6.460]

389

THE TAX BASE – DEDUCTIONS 7. The Positive Limbs – Nexus Issues .................................................... 395

9. Current and Capital Expenses ........................................................ .. 487 10. Specific Deductions and Specific Deduction Restrictions ........ .. 519 [Pt3.10] A progressive income tax levied on the basis of each taxpayer’s ability to pay must be imposed on net gains, not gross receipts. Expenses incurred to earn gross proceeds must be deducted to arrive at a measurement of actual taxable capacity. Accordingly, s 4-10 of the Income Tax Assessment Act 1997 imposes a tax liability on “taxable income” which is calculated pursuant to s 4-15 by subtracting from total assessable income of the year all deductions of the year.

PART3

8. Personal and Non-Personal Expenses ............................................ .. 455

The principal deduction provision is s 8-1, which allows a deduction for a “loss or outgoing” provided it satisfies either paragraph in subsection (1) of the section. These two paragraphs are known as the “positive limbs” of s 8-1 because they permit deductions for expenditures. The two positive limbs in s 8-1(1) operate subject to four negative limbs in s 8-1(2). Even if an expenditure satisfies the positive limbs in s 8-1(1), no deduction is permitted if the expenditure is described in one of the negative limbs. Section 8-1 deductions are labelled general deductions: s 8-1(3). Deductions allowed under particular sections in the 1936 and 1997 Acts other than s 8-1 are known as specific deductions: s 8-5(3). Some specific deduction provisions allow deductions for expenses that would be allowed under s 8-1 in any case while others allow deductions for expenses that fall foul of one of the negative limbs in s 8-1(2). Section 12-5 provides a comprehensive list of specific deductions. A large number are found in Div 25 of the 1997 Act. To the extent a specific deduction would not be allowed under s 8-1, there is no risk of overlap between the specific deduction provision and the general deduction provision. However, to the extent an expense is deductible under both s 8-1 and a specific deduction provision, overlap is possible. In some cases, the sections would give rise to a deduction in different income years. The reconciliation rule in s 8-10 assigns the deduction to the “most appropriate” section. A rule of statutory construction is that where a general and a specific rule both apply to the same subject the specific rule should apply and this rule will probably operate for most deductible expenditures. The two positive limbs of s 8-1 raise a number of issues, including what is a “loss or outgoing” and whether the two limbs cover the same or different ground. Most important is the nexus they require between an outlay and assessable income. The language is ambiguous – instead of saying a deduction is allowed for expenses incurred to derive assessable income or for expenses incurred for the purpose of gaining or producing assessable income, the limbs speak of expenses incurred in 391

gaining or producing assessable income. The many nexus questions raised by this construction are explored in Chapter 7. The four negative limbs prohibit deductions for capital expenses, personal expenses, expenses incurred to derive exempt income and expenses for which a deduction is prohibited by a specific provision. The need for at least two of the negative limbs is questionable. The third negative limb, preventing a deduction for expenses incurred to gain or produce exempt income, is wholly redundant. Deductions are only allowed under the positive limbs if the outgoings are incurred in gaining or producing assessable income, which is defined in s 6-1 as either ordinary income or statutory income but not exempt income. The retention of this negative limb appears to be nothing more than an historical anomaly. It has been argued that the second negative limb, which denies a deduction for private or domestic expenses, also serves no purpose since a personal (private or domestic) expense cannot be said to be incurred to derive assessable income. If an expense is merely personal consumption for a taxpayer, it will not have a sufficient nexus with the derivation of assessable income. However, it has been suggested in some judicial decisions that in some circumstances a personal expense could satisfy the nexus requirements of the positive limbs. The second negative limb resolves any lingering doubt about the issue. The borderline between personal and non-personal expenses is explored in Chapter 8. There is no doubt that, but for the first negative limb, capital expenses incurred to derive assessable income or incurred by a business would be deductible under the positive limbs. The cost of a rental property acquired to derive rental income, the cost of shares acquired to derive dividends, and the cost of a machine to manufacture products are all incurred to derive an amount that will be included in assessable income. But, as will be seen in Chapter 9, in every case, the outgoing is a capital expense. The first negative limb denies taxpayers an upfront deduction under s 8-1 for these capital expenses. All such capital expenses should be recognised as deductible, either over time (for wasting assets) under Divs 40 or 43 of the 1997 Act, or through the capital gains measures as part of the cost base of an asset. Until recently, some capital expenses fell between the statutory deduction provisions and capital gains rules into “black holes”, and so were never recognised for tax purposes. The safety net provision in s 4-880 of the 1997 Act, adopted in 2001 and expanded in 2006, now provides recognition of those business capital expenses. [Pt3.20] Chapter 10 reviews the statutory deduction provisions in Div 25 and the capital allowance rules in Divs 40 and 43 of the 1997 Act. It also surveys some other concessional deduction or tax credit provisions for expenses such as charitable contributions, or research and development business expenditure. The general and specific deduction provisions all operate subject to restrictions set out in Div 26 of the 1997 Act. Some of these restrictions are probably redundant because they deny deductions for expenditures that would not qualify for a deduction under s 8-1 or a specific deduction provision in any case. For the most part, the retention of these restrictions is a matter of historical inertia, combined with the government’s reluctance to jettison any rule that might assist a court in denying a deduction in doubtful cases. Other restrictions in Div 26 are not concerned with the appropriate measurement of net income, but rather aim to achieve 392

a social or moral policy agenda, such as the prohibition on deductions for bribes. The Div 26 restrictions are reviewed in Chapter 10. It is important to realise that although the deduction issues have been segregated into four distinct chapters in this volume, there is some overlap between all of them and actual expenses often raise a number of parallel issues. For example, if a professional taxpayer incurred legal expenses to defend herself against charges that might affect her ability to practice or to retain employment, the Commissioner might argue in the alternative that the expense lacks a sufficient nexus with the positive limbs of s 8-1 to be deductible (see Chapter 7), that it is essentially a personal expense (see Chapter 8), or that it is intimately related with the structure or essence of the taxpayer’s business or employment and is thus a capital expense (see Chapter 9). If a taxpayer’s allowable deductions in a year of income exceed the taxpayer’s assessable income, the taxpayer will have no taxable income in the year: see s 4-15. The excess of deductions over income is known as a “tax loss” and for individuals this amount can be carried forward indefinitely under Div 36 of the 1997 Act and deducted against taxable income in future years, subject to some restrictions such as individual bankruptcy or death, or company and trust loss limitation rules.

393

CHAPTER 7 The Positive Limbs – Nexus Issues [7.10]

1. OVERVIEW OF THE POSITIVE LIMB NEXUS ISSUES................ ..................... 397

[7.20]

2. TAXES ............................................... .......................................................... 398

[7.30]

(a) Income Tax .......................................................................................................... 398

[7.40]

(b) Goods and Services Tax (GST) ............................................................................. 399

[7.50]

(c) Other Taxes ......................................................................................................... 400

[7.60]

3. NEXUS WITH INCOME DERIVATION: QUASI-PERSONAL EXPENSES ... ....... 401

[7.70]

(a) Fines .................................................................................................................... 401

[7.80] [7.90]

(b) Damages ............................................................................................................. 403 Herald and Weekly Times Ltd v FCT ............................................................................. 403

[7.100] [7.110] [7.130] [7.160]

(c) Legal Expenses .................................................................................................... FCT v Snowden and Willson Pty Ltd ............................................................................. Magna Alloys & Research Pty Ltd v FCT ....................................................................... FCT v Day ..................................................................................................................

[7.170]

(d) Expenses Incurred in an Illegal Business ............................................................... 410

[7.180]

4. THEFT LOSSES AND MISAPPROPRIATION OF FUNDS ............. ................... 410 Charles Moore & Co (WA) Pty Ltd v FCT ....................................................................... 411 C of T (NSW) v Ash .................................................................................................... 412

[7.190] [7.210]

[7.230]

404 405 406 408

[7.240]

5. OUTLAYS TO REDUCE COSTS .............................. ...................................... 414 W Nevill & Co Ltd v FCT ............................................................................................. 415

[7.260]

6. TEMPORAL NEXUS ...................................... ............................................... 416

[7.270]

FCT v Finn ................................................................................................................. 417

[7.290] [7.300]

(a) Expenses Incurred Prior to the Commencement of Income-Earning Process or Business ................................................................................................................ 418 Steele v DFC of T ........................................................................................................ 418

[7.320] [7.330]

(b) Expenses Incurred to Obtain an Employment Contract ........................................ 421 Spriggs v FCT and Riddell v FCT ................................................................................... 421

[7.340] [7.350] [7.370] [7.390]

(c) Expenses Incurred After the Derivation of Income ................................................ Amalgamated Zinc (de Bavay’s) Ltd v FCT ................................................................... AGC (Advances) Ltd v FCT .......................................................................................... Placer Pacific Management Pty Ltd v FCT .....................................................................

[7.410]

7. DUAL-PURPOSE EXPENSES AND APPORTIONING OUTGOINGS...... .......... 430

[7.410] [7.420]

(a) Dual Purposes and Apportionment ...................................................................... 430 Ronpibon Tin NL v FCT ............................................................................................... 431

[7.440] [7.450] [7.470]

(b) Transfer Pricing ................................................................................................... 434 Cecil Bros Pty Ltd v FCT ............................................................................................... 434 Europa Oil (NZ) Ltd (No 2) v IRC (NZ) ........................................................................ 436

[7.490]

(c) Ancillary Benefits .................................................................................................. 437

424 424 426 428

395

The Tax Base – Deductions

[7.500] [7.520]

FCT v South Australian Battery Makers Pty Ltd ............................................................. 437 FCT v Firth ................................................................................................................. 440

[7.540] [7.560] [7.590]

(d) Income Splitting .................................................................................................. 441 FCT v Phillips .............................................................................................................. 443 Ure v FCT .................................................................................................................. 446

[7.600]

(e) Mismatched Current Expenses Incurred to Derive Capital Gains .......................... 447

[7.620] [7.630] [7.640]

(f) Timing Manipulation ............................................................................................ 449 (i) Prepayments ........................................................................................................ 450 (ii) Timing preferred income ..................................................................................... 452

[7.650]

(g) Other Statutory Restrictions ................................................................................. 453

Principal sections ITAA 1997 s 8-1(1) (formerly s 51(1) of ITAA 1936)

Effect This subsection contains the positive limbs for “general deductions”. s 8-1(2) (formerly s 51(1) of ITAA 1936) This subsection contains the negative limbs for “general deductions”. s 25-45 This section provides a deduction for employees’ embezzlement, larceny, defalcation or misappropriation. s 26-5 (formerly s 51(4) of ITAA 1936) This section denies a deduction for fines and penalties. s 40-840 This section allows taxpayers to deduct some formerly black hole expenses by way of a project pool amortisation. s 40-880 This section allows taxpayers to deduct some formerly black hole expenses over five years. s 70-20 (formerly s 31(C) of ITAA 1936) This section limits deductions for trading stock acquired in a non-arm’s length transaction. s 110-25(4) (formerly s 160ZH(6A) of ITAA This section enables taxpayers to add previ1936) ously unrecognised interest payments to the cost base of assets. s 110-25(6) This section allows taxpayers to add legal expenses to protect title to assets to the cost base if the expenses are not otherwise deductible. ITAA 1936 s 51AAA

396

Effect This section denies a taxpayer a deduction for an expense incurred only to derive a capital gain.

The Positive Limbs – Nexus Issues

CHAPTER 7

1. OVERVIEW OF THE POSITIVE LIMB NEXUS ISSUES [7.10] As noted in Chapter 2 the general deduction provision, s 8-1 of the ITAA 1997, allows

a deduction for a “loss or outgoing” that satisfies one of the section’s positive limbs in s 8-1(1). The term “loss or outgoing” dates from the origins of Australian income tax law. Any loss or outgoing will be deductible under s 8-1(1)(a) to the extent that it is incurred in gaining or producing your assessable income (the so-called “first positive limb”) or under s 8-1(1)(b) to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income (the so-called “second positive limb”). This structure mirrors the requirements of the former s 51(1) of the ITAA 1936. A long-standing question regarding the positive limbs is whether both limbs are necessary or whether the first and second limbs actually cover the same ground. Prima facie, the second limb appears narrower than the first – while the first limb seeks a broad nexus between an expense and assessable income, the second limb seems to apply a tighter test, requiring an expense to be necessary to the operation of a business before it can be deducted. This factor has prompted some commentators to argue that the second limb is narrower than the first, so it catches nothing that would not be covered by the first limb in any case. Conversely, some have argued the second limb is broader than the first, as there may be expenses necessary to operate a business that have no direct nexus with the income-earning process of the business. This view is strengthened by the “business judgment” rule that says courts should not seek to second-guess business persons; that is, if a business concludes an outgoing is necessary to increase the business’s profits, the courts should not, with the benefit of hindsight, rule that the outgoing was not in fact necessary. The nexus required by both of the positive limbs is unclear, thanks mostly to the peculiar use of the preposition “in” – the limbs are not concerned with expenses incurred to derive assessable or for the purpose of deriving assessable income, but rather with expenses incurred in gaining or producing assessable income. Issues concerning nexus between outgoings and the derivation of assessable income required to satisfy the positive limbs of s 8-1(1) fall into five broad categories. The first nexus issue concerns the character of tax payments themselves, both income tax and other taxes, incurred by taxpayers in some context that relates the taxes to the derivation of assessable income. The second type of nexus issue concerns expenses that are incurred in consequence of an alleged criminal act or civil wrong. Included in this group are fines, civil court damages and settlements, and legal expenses. Although they are not consumption expenses, the ATO argues these outgoings are not relevant to the derivation of income. They are sometimes labelled “quasi-personal” expenses because when the courts deny deductions for these expenses, they describe them as outgoings incurred in the taxpayer’s personal capacity rather than her or his business capacity. It is often logically impossible to sustain this characterisation – more often than not the expenses are incurred by corporations which have no personal capacity. Underlying the decisions seems to be a concern as to the morality of a taxpayer incurring the expense in the first place, let alone deriving a tax advantage by seeking a deduction for the outlay. The third nexus issue arises where a taxpayer incurs a loss due to theft or misappropriation of funds. The ATO usually bases arguments in favour of the non-deductibility of these losses on their alleged insufficient nexus with income-earning activities; judicial decisions restricting [7.10]

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outgoings in this category draw upon a number of rationales, including the quasi-personal, moral concerns raised in the first group of special expenses. The fourth nexus issue concerns the question of temporal nexus required between an outgoing and the production of current income. This issue arises in cases where the taxpayer incurs expenses relating to income-generating operations that have not yet commenced or that have ceased. Finally, the fifth type of nexus issue is confronted in cases involving outgoings apparently incurred for dual purposes: the generation of income and the generation of another benefit, usually a tax advantage. Tax advantages include the diversion of income for income splitting or transfer-pricing purposes, the mismatch of fully deductible outlays incurred to derive partially assessable gains, the mismatch of ordinary expenses to derive “timing-preferred” income, and the mismatch of prepaid expenses incurred to derive future income. Transfer pricing involves the diversion of net income to a related business entity through overpaying for goods or services from the related entity (or having the related entity underpay for goods or services, as the case may be). Income splitting involves the diversion of assessable or net income from a high bracket taxpayer to a related low bracket taxpayer, so the total tax burden the income bears is reduced. The mismatch of prepaid expenses incurred to derive future income is based on a deduction for an outlay that did not really involve an economic loss. And The mismatch of ordinary expenses to derive “timing-preferred” income refers to techniques to deduct expenses incurred to derive income that does not have to be recognised for tax purposes as it actually accrues to an investor. After a period of indifference or even support for schemes based on exploitation of s 51(1), the ITAA 1936 predecessor to s 8-1, courts in a limited number of circumstances started to develop various “purpose” doctrines to combat splitting, transfer pricing, timing manipulation, and deduction/gain mismatch schemes. The legislature has acted in tandem, though often lagging behind the courts, to attack dual-purpose expenses with specific anti-avoidance provisions.

2. TAXES [7.20] Often taxes imposed will relate to the derivation of income. Apart from income tax

imposed on the income, a taxpayer may have incurred State or Territory payroll tax in respect of employees, stamp duties in respect of documents or the acquisition of certain assets and land taxes, or local government rates in respect of real property. Also, the price of goods and services acquired by the taxpayer will have included GST. In turn, the taxpayer may have included GST in the price of goods or services it supplied, later remitting the GST to the Australian Taxation Office (ATO). The issue is whether any of these taxes are deductible when calculating the person’s taxable income? There are only a handful of statutory provisions dealing with the deductibility or otherwise of tax payments. Surprisingly, there are almost no Australian reported cases on the issue, presumably because both the taxpayers and the ATO have adopted sensible and logical approaches to the question.

(a) Income Tax [7.30] Taxpayers who derive assessable income will be liable for income tax on that income

(assuming the taxable income after deductions is above the tax-free threshold). It would be 398

[7.20]

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difficult to argue income tax is an expense incurred in deriving assessable income and should be deductible under s 8-1(1)(a). However, a case could be made on a literal reading of the words in s 8-1(1)(b) that income tax incurred by a business is necessarily incurred in carrying on the business. If the business owner did not pay income tax, the assets of the business could eventually be seized by the ATO to cover the tax liability. Notwithstanding the possible literal interpretation of the second limb of the general deduction provision, no deduction is allowed for income tax. Income tax is seen as a charge against taxable income after assessable income has been derived and expenses incurred, not as a liability incurred in the process of deriving that income. While no deduction is available for Australian income tax, a different treatment applies where a taxpayer derives foreign-source income that has been subject to foreign income taxes. Australia has three rules for foreign-source income derived by resident taxpayers. Under the international tax rules, in some cases the foreign income is exempt from Australian tax and any foreign taxes imposed on the income become irrelevant for Australian tax purposes (eg Div 842 of the ITAA 1997). In other cases the foreign income is fully taxed in Australia but a credit against Australian income tax is allowed for foreign income tax imposed on the income (under Div 770 of the ITAA 1997). And finally, in some cases the income is taxed in Australia without a credit, but only the amount received after foreign taxes is included in assessable income. This last approach is conceptually equivalent to including all the pre-tax foreignsource income in assessable income and then allowing a deduction for foreign taxes imposed on the income. While the tax treatment of Australian income tax is left entirely to general principles, a statutory provision applies to one particular type of tax that some consider to be akin to an income tax or at least related to an income tax, namely the petroleum resource rent tax. This tax applies to “resource rents” or windfall gains enjoyed by oil producers. Section 40-750 of the ITAA 1997 allows a deduction for petroleum resource rent tax when it is paid.

(b) Goods and Services Tax (GST) [7.40] Australia has imposed a Goods and Services Tax (GST) on taxable supplies of goods

and services since 1 July 2000. The tax is a “consumption” tax, intended to be imposed on final consumers of goods and services. Unlike a retail sales tax, used in the United States and imposed only at the final consumer level, the GST can apply to supplies of goods and services throughout the commercial chain, from the first producer of raw materials, through manufacturer, wholesaler and retailer before finally being imposed on the final consumer. To prevent cascading of taxes along the chain, enterprises that are registered for GST purposes are allowed an “input tax credit” equal to the GST component of the price of goods acquired by them in the course of operating their enterprises. This credit may be offset directly against the registered taxpayers’ liability to remit GST on consideration received for the supplies they in turn make to their customers. Where the input tax credit exceeds a taxpayer’s GST liability, the difference will be refunded. Not all businesses are entitled to recover by way of refund or credit the GST they bear on the acquisition of goods and services. Only businesses registered for the GST are entitled to credits and not all businesses register – it is optional for smaller business below the GST registration threshold and many choose not to. Businesses that make a special category of supplies known as “input taxed” supplies, such as financial supplies or residential rental [7.40]

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The Tax Base – Deductions

accommodation, are also not entitled to recover GST on their acquisitions to the extent the acquisitions relate to input taxed supplies they will make. To the extent GST is recoverable by way of an input tax credit, it clearly is not borne by the taxpayer and accordingly, no deduction should be available for the GST component of the price of goods and services acquired by the taxpayer. Section 27-5 of the ITAA 1997 confirms this result by denying taxpayers a deduction for the GST component of the purchase price where the GST is recoverable by the purchaser. Section 27-20 has a similar effect with respect to the cost of revenue assets and s 27-80 expressly excludes recoverable GST from the cost base of depreciable property. GST-registered enterprises will include GST in the price of any goods or services they supply (other than exempt goods or services). This GST must be remitted to the ATO according to a payment schedule set out in the GST Act. While the tax is part of the gross proceeds realised by a GST-registered enterprise, in a sense the enterprise is merely a temporary custodian of the tax since it must remit it to the government on or before a specified remittance date. Rather than include gross proceeds in assessable income and then allow an offsetting deduction when the tax is remitted, the ITAA 1997 simply excludes the GST component of the proceeds from assessable income (s 17-5) and denies a deduction for GST payments (s 27-15). As businesses that are not registered for GST purposes or which make exempt supplies are not be able to recover by way of refund or credit the GST component of the purchase price for their acquisitions, the GST is part of the real cost of the acquisitions and as such should be deductible along with the rest of the cost of acquisition. No special provision applies to these expenses – they are deductible (if at all) under the same provisions – either s 8-1 or a specific deduction provision – in the same manner as the rest of the expense of the good or service acquired. As is the case with all other expenses, in some cases no deduction will be available and the expense will be included in the cost base of an asset and recovered when the asset is sold and the cost base is deducted from the proceeds of disposal to determine the capital gain or loss on the disposal. Final consumers are not entitled to recover any GST in the price of goods or services they acquire – it is considered part of the price of acquiring the good or services and like the rest of the price is a personal (and hence non-deductible) expense.

(c) Other Taxes [7.50] No special statutory rules apply to any other taxes that might be incurred by a

taxpayer. Where the expenses are incurred in the derivation of assessable income or in the course of a business deriving assessable income, they are likely to be s 8-1 or a specific deduction section. Some taxes such as stamp duties will be treated as part of the acquisition cost of assets to which they relate. Thus, financial duties, payroll taxes, land taxes or rates will normally be deductible as incurred. If the cost of the asset is not deductible when incurred or over time (as is the case, for example, with the cost of shares or land that is not trading stock), the cost and related taxes will be recovered when the asset is sold (as a deduction from the proceeds of disposal to calculate a capital gain or loss on the disposal).

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3. NEXUS WITH INCOME DERIVATION: “QUASI-PERSONAL” EXPENSES [7.60] Relatively early in the history of income taxation, the English courts added a gloss to

the statutory rules allowing deductions for business and investment outgoings, establishing a category of quasi-personal expenses that were related to moral behaviour or moral choices of which the courts disapproved. Three types of expenses fell into the category of quasi-personal expenses: fines, damages and legal expenses. As we shall see, Australian judicial decisions denying deductions for these outgoings are based on the same arguments and follow the English precedents. Recently, the ATO has attempted to use a similar argument to deny deductions for expenses incurred in the course of an illegal business. Quasi-personal expenses were treated as non-deductible either because of their alleged personal character or a supposed insufficient nexus with the production of assessable income. The “quasi-personal” label became attached to the expenses because of the explanation by the courts that these apparently business expenses were actually incurred by the taxpayers in a non-business capacity; the courts speak of taxpayers incurring the expenses in their personal capacity rather than their business capacity. The language employed by the courts is, to say the least, stretched and artificial. It is difficult enough to say a sole trader incurred an expense directly related to her or his business in a personal capacity where there is no personal consumption element involved. It is almost impossible to make the assertion in the case of a large corporation that has no personal capacity, whatever that may mean. This characterisation is not meant to be taken literally. More recent cases have explained the courts’ actual apprehension, namely that allowing a deduction for some types of expenses might undermine public policy objectives. The expenses in question are incurred by taxpayers for committing wrongs – activities that are prohibited by statute or common law and punishable by payment of a fine, penalty or civil damages. Taxpayers will also incur legal expenses with respect to the legal proceedings at which the financial punishment was imposed. In one sense, deductions for any of these expenses soften the blow for wrongdoing because it lowers the after-tax cost of the outgoing. It could be argued, therefore, that deductibility mitigates the punishment. Although it is not clearly articulated at all in the earliest cases, this concern over the mitigation of the costs of wrongdoing largely explains why the courts developed doctrines to prohibit the deduction of expenses that prima facie satisfy all the conditions of the positive limbs of s 8-1(1) or predecessor sections. In the case of all three types of quasi-personal expenses, there was a retreat from the original non-deductible rules as the courts took a more pragmatic view of modern business practices and recognised a wider range of expenditures as an integral part of income-earning processes. As we shall see, in the case of fines, the retreat was halted by statutory intervention; in the case of damages and legal costs it continues unabated.

(a) Fines [7.70] As is the case in so many areas of Australian law, the Australian jurisprudence on the

deductibility of fines is based on early English case law. The two leading English cases are IRC v Warnes & Co [1919] 2 KB 444 and IRC v von Glehn & Co Ltd [1920] 2 KB 553, where taxpayers were denied deductions for fines based on their alleged quasi-personal nature; in both cases the courts said the taxpayers had incurred the outgoings in some sort of personal capacity distinct from their capacity as traders. It was so widely assumed that the English [7.70]

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doctrines would apply in Australia that there were no attempts by taxpayers to overturn the precedents. This conclusion was confirmed in obiter in Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113, a High Court decision on the deductibility of damages. Some later judgments, such as the dissent by Webb J in FCT v Snowden and Willson Pty Ltd (1958) 99 CLR 431, contained suggestions that the non-deductibility doctrine was not immutable. However, the issue was not seriously examined in the courts until the 1980 Federal Court decision in Magna Alloys & Research Pty Ltd v FCT (1980) 49 FLR 183, where Deane and Fisher JJ in obiter considered and then rejected the doctrine that classified fines and penalties as quasi-personal expenses of a trader, suggesting that if a deduction for fines was to be denied, the denial should be based on a public policy argument. In 1984, encouraged by the comments of Deane and Fisher JJ in Magna Alloys, two taxpayers who had been denied deductions for fines incurred in the course of business operations appealed their assessments and the question was directly confronted for the first time in Australian courts by Kelly J of the Supreme Court of Queensland in Madad Pty Ltd v FCT (1984) 84 ATC 4115 and Ormiston J of the Supreme Court of Victoria in Mayne Nickless Ltd v FCT (1984) 84 ATC 4458. Both judges decided against the taxpayers, concluding fines and penalties were not deductible. Ormiston J not only relied on the traditional quasi-personal characterisation of the expenses to deny the taxpayer a deduction, but also adopted the public policy argument in favour of the non-deductibility of fines suggested by Deane and Fisher JJ in Magna Alloys. The suggestion that public policy concerns may justify the non-deductibility of fines was subject to some criticism in the academic literature. This literature pointed out that many “fines” could be considered a type of “user-fee”, imposing a charge on persons whose activities impose additional costs on government services. An example might be the “fines” imposed on overweight trucks which cause extra road damage. The criticism also noted that to the extent that activities giving rise to fines were inherently necessary to the operation of a business, fines had no deterrent effect. They merely added to the cost charged to the ultimate consumer of the business’ goods or services. Comments such as these and the important obiter suggestions of Deane and Fisher JJ in Magna Alloys led a number of observers to speculate that the decisions in Madad and Mayne Nickless might be reversed upon appeal. Aware of these comments and concerned that long-standing doctrines might be overturned, the government stepped in and announced a legislative prohibition on the deductibility of fines and penalties, currently enacted as s 26-5 of the ITAA 1997. As it turned out, the action may have been unnecessary – an appeal to the Full Federal Court by the taxpayer in Madad (1984) 15 ATR 1118 (the taxpayer in Mayne Nickless withdrew its appeal) failed when Fox, Fisher and Beaumont JJ upheld the traditional position, relying on both the long-standing quasi-personal doctrines and a public policy argument that the tax law should reinforce the prohibitions protected by fines by denying deductions for the fines. Questions

[7.75]

7.1

402

Will s 26-5 apply to a penalty paid as a result of an infraction of a law of a State of the United States or Province of Canada? Should it? Regardless of whether s 26-5 will apply, could the public policy arguments or the quasi-personal arguments that are used to deny deductions for fines apply to this outgoing? [7.75]

The Positive Limbs – Nexus Issues

7.2

7.3

7.4

7.5

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Will s 26-5 apply to a pecuniary penalty imposed upon a member of a profession by the body responsible for governing conduct of the profession? Should it? Regardless of whether s 26-5 will apply, could the public policy arguments or the quasi-personal arguments that are used to deny deductions for fines apply to this outgoing? Will s 26-5 apply to a penalty imposed on a football player by a football league tribunal? Should it? What about a payment which a cricket player makes after the players’ disciplinary body finds the player has breached the players’ voluntary code of conduct? State criminal legislation often authorises a court to impose an order requiring a convicted person to make a payment to compensate the victim of his or her crime, in addition to any penalty imposed on the person (which would be payable to the Crown). Will s 26-5 apply to compensation payments of this type? Should it? The taxpayer operated an illegal brothel and incurred regular expenses in the nature of bribes to police officers. She was assessed on the proceeds of her prostitution business and accordingly sought a deduction for the costs of the bribes. Are they a deductible expense? (See Minister of National Revenue v Olva Diana Eldridge [1964] CTC 545.)

(b) Damages [7.80] The quasi-personal characterisation of fines developed in early cases was paralleled by

a similar characterisation of damages. The similar treatment was no doubt motivated by the same concerns of the courts. The quasi-personal doctrines with respect to damages are most often traced to the House of Lords’ decision in Strong & Co Ltd v Woodifield [1906] AC 448. The taxpayer in Strong & Co was a brewery company that owned an inn. A customer sleeping in the inn was injured when a chimney fell on him and the taxpayer was consequently liable to pay damages to the customer. Lord Loreburn LC, with whose decision the remaining Law Lords concurred, denied the taxpayer a deduction for the expense, describing it as akin to a personal expense of the company, if such a thing were possible, because it was incurred as a result of their employees’ negligence and not in the course of their trading: “In the present case I think that the loss sustained by the appellants was not really incidental to their trade as inn-keepers, and fell upon them in their character not of traders, but of householders.” While Australian courts accepted the English quasi-personal characterisation of fines apparently without question, they took a far more pragmatic approach to the treatment of damages, analysing the question from the perspective of commercial realities – whether or not the expenses were planned or even desired, were they an inevitable consequence of modern business? The evolving Australian position is well illustrated in the Full High Court decision in Herald and Weekly Times Ltd v FCT. The expenses which the taxpayer sought to deduct are described in the judgment.

Herald and Weekly Times Ltd v FCT [7.90] Herald and Weekly Times Ltd v FCT (1932) 48 CLR 113 Full High Court Gavan Duffy CJ and Dixon J: The appellant publishes an evening newspaper from which it derives much of its assessable income. In the course of doing so, it is exposed to claims for defamation, some of which it settles upon terms which include a payment by way of

compensation, others of which it litigates successfully or unsuccessfully, and most of which involve it in law costs. … For the purpose of calculating its taxable income, the appellant claimed that this expenditure should be deducted

[7.90]

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Herald and Weekly Times Ltd v FCT cont. from the assessable income derived from the conduct of its evening newspaper. … None of the libels or supposed libels was published with any other object in view than the sale of the newspaper. The liability to damages was incurred, or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure. It is true that when the sums were paid the taxpayer was actuated in paying them, not by any desire to produce income, but, in the case of damages or compensation, by the necessity of satisfying a claim or liability to which it had become subject, and, in the case of law costs, by the desirability or urgency of defeating or diminishing such a claim. But this expenditure flows as a necessary or a natural consequence from the inclusion of the alleged defamatory matter in the newspaper and its publication. … … When it appears that the inclusion in the newspaper of matter alleged by claimants to be defamatory is a regular and almost unavoidable incident of publishing it, so that the claims directly flow from acts done for no other purpose than earning revenue, acts forming the essence of the business, no valid reason remains for

denying that the money was wholly and exclusively expended for the production of assessable income. The distinction between such a case as the present and Strong & Co v Woodifield, apart from any differences in the English and Commonwealth provisions, lies in the degree of connection between the trade or business carried on and the cause of the liability for damages. Lord Loreburn LC said: “In the present case I think that the loss sustained by the appellants was not really incidental to their trade as innkeepers, and fell upon them in their character, not of traders, but of householders.” The findings of Mann J show that claims for libel are an ordinary incident of the business of conducting a newspaper. The cases of IRC v von Glehn and IRC v Warnes & Co, which decide that penalties imposed for breaches of the law committed in the course of exercising a trade cannot be deducted, are distinguishable for a somewhat similar reason. The penalty is imposed as a punishment of the offender considered as a responsible person owing obedience to the law. Its nature severs it from the expenses of trading. It is inflicted on the offender as a personal deterrent, and it is not incurred by him in his character of trader. … In our opinion the appeal should be allowed and the assessment of taxable income reduced by £3,131.

Rich and McTiernan JJ agreed with this result in separate decisions while Starke and Evatt JJ dissented in separate decisions.

(c) Legal Expenses [7.100] The cases involving fines were carefully distinguished in the Herald and Weekly Times

case to allow the taxpayer a deduction for civil damages. A similar approach was taken with respect to legal expenses in FCT v Snowden and Willson Pty Ltd. The legal expenses in that case were incurred by a company seeking to clear its name against a number of allegations of improper conduct made against it. The taxpayer in this case was a speculative builder of houses on terms. The judgments appear to imply that facing allegations of dubious practices is almost an inherent feature of carrying on that particular line of business.

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FCT v Snowden and Willson Pty Ltd [7.110] FCT v Snowden and Willson Pty Ltd (1958) 99 CLR 431 Full High Court Dixon CJ: The question for decision is whether the taxpayer is entitled to a deduction from its assessable income for the year of income ended 30 June 1953 of an amount expended by the company in an attempt to meet by advertisements certain attacks made in the Legislative Assembly of Western Australia upon the conduct of its business and in its appearance by counsel before a Royal Commission subsequently appointed to inquire into the charges and any further complaints or allegations made to the Commissioner by persons who had dealt with the company …. If it were not for the word “necessarily” there would be no difficulty, in my opinion, in treating the expenditure in the present case as coming within the conception expressed by this part of s 51(1). In saying this I am pronouncing upon a question of fact rather than of law. But, as it appears to me, the carrying on of the business of the nature described brought with it the attacks against which the taxpayer company sought to defend itself. The attacks touched its business nearly; they disparaged the methods by which it was conducted; they were calculated to deter intending or likely customers from dealing with it and to destroy the faith of existing customers in their current relations with the company. No doubt it would be instinctive in the business man

or, perhaps, in any man, to defend himself and those associated with him in business against an attack of such a description on the manner in which they were pursuing their business activities. But the instinct is founded upon sound if intuitive conceptions of what must be done if they are not to suffer in their pursuit of custom and profit. Whether on the merits they were in a position to defend themselves successfully or whether, on the other hand, the attacks upon them lacked adequate foundation alike seem to me to be matters not to the point. … In the present case it appears to me that the taxpayer company could do nothing else but defend itself, if it was to sustain its business and continue carrying it on in anything like the same volume or according to the same plan. That seems to me to be enough. There is no analogy here to cases in which fines or penalties are incurred. There the character of the expenditure and the reasons why the law imposes a fine or penalty separate the expenditure from the conduct of the business. It is not to the point that the conduct penalised found its motive in business considerations. Nothing of the kind can be said of the expenditure now under consideration nor is any principle of public policy affected by allowing the deduction.

In separate judgments, both Fullagar J (with whom Williams J agreed) and Taylor J asserted that there was no analogy between fines and the payments incurred by the taxpayer in Snowden and Willson. Webb J dissented from the majority opinion, although he too would apparently have allowed a deduction for legal expenses in respect of some “illegal” activities. Webb J: It seems clear enough I think that an individual cannot claim as a deduction moneys spent in meeting a criminal or perhaps quasicriminal charge of which he has been convicted. But it is, I think, arguable that a company that spends money in the defence of its employees convicted of breaches of the law in the course of

its work would, at least in some cases, be entitled to treat such expenditure as an outgoing deductible under s 51(1). Carelessness or inadvertence of employees is incidental to the conduct of many businesses and in some cases it could result in breaches of the law and fines. I have in mind more particularly traffic offences.

[7.110]

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[7.120] The taxpayer in Snowden and Willson was not facing criminal charges – it was merely

defending its name before a Royal Commissioner, though there was a risk that criminal proceedings might follow the Royal Commission. The question of deductibility of legal expenses incurred by an employer in its defence and in the defence of employees charged with illegal activities arose in the Full Federal Court decision in Magna Alloys & Research Pty Ltd v FCT. In the event, the employer and its employees were found guilty of certain offences and required to pay fines. In light of the von Glehn and Warnes precedents mentioned in Herald and Weekly Times, the taxpayer did not seek a deduction for the fines it was required to pay. It did argue, however, that the legal expenses were not severed from the expenses of trading as had been asserted was true in the case of fines. The expenditures in Magna Alloys were incurred as a consequence of criminal proceedings brought against the taxpayer’s directors and the taxpayer (the latter were subsequently dropped) following the payment by the taxpayer of illegal secret commissions to boost sales of its products. The Court allowed the taxpayer to deduct the legal fees paid to defend itself and its directors.

Magna Alloys & Research Pty Ltd v FCT [7.130] Magna Alloys & Research Pty Ltd v FCT (1980) 49 FLR 183 Full Federal Court Deane and Fisher JJ: The requirement that the claimed outgoing be “necessarily” incurred in carrying on the relevant business does not, in the context, mean that the outgoing must be either “unavoidable” or “essentially necessary”. Nor does the word “necessarily” import a requisite of logical necessity. What is required is that the relevant expenditure be appropriate and adapted for the ends of the business carried on for the purpose of earning assessable income (see, Ronpibon Tin NL v FCT [(1949) 78 CLR 47]; FCT v Snowden and Willson Pty Ltd [(1958) 99 CLR 431]). For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily to be incurred (FCT v Snowden and Willson Pty Ltd). It is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically … . It is not necessary for the purposes of the present appeal to determine whether outgoings incurred in providing appropriate legal representation for an employee on criminal

406

[7.120]

charges directly arising from his activities in the course of a business are, without more, reasonably capable of being seen as desirable or appropriate in the sense we have indicated. The circumstances in the present case plainly involved elements transcending the mere provision of legal representation for those whose activities, on behalf of the taxpayer, had subjected them to criminal prosecution. The taxpayer’s own reputation was under public attack and throughout most of the actual criminal proceedings in the County Court of Victoria the taxpayer was named as a co-conspirator. The interests of the taxpayer were inextricably involved with those of its directors and agents and it was plainly in the taxpayer’s own interests that the directors and agents be properly represented. In these circumstances, the incurring of expenditure in providing adequate representation for the directors and agents was reasonably capable of being regarded as desirable and appropriate from the point of view of the pursuit of the business ends of the taxpayer’s business. …

The Positive Limbs – Nexus Issues

Magna Alloys & Research Pty Ltd v FCT cont. The overall position in the present case can, in our view, be accurately summarised by saying that the directors intuitively saw the outgoings as not only being required in their own interests but as being desirable and appropriate in the pursuit by the taxpayer of its business ends. As has been said, the outgoings were reasonably capable of being so regarded. It follows that, subject to any question of disqualification resulting from their nature, the relevant outgoings were, for the purposes of s 51(1), necessarily incurred by the taxpayer in carrying on its business. … The considerations which led us to conclude that the outgoings were, for the purposes of

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s 51(1) of the Act, necessarily incurred in carrying on the taxpayer’s business also lead, in the circumstances of the present matter, to the conclusion that they were not of a private or domestic nature. The expenditure was of company funds to provide legal representation for those associated with the taxpayer in respect of criminal charges arising from commercial activities on the taxpayer’s behalf. The occasion of the outgoings arose from the taxpayer’s commercial activities in the course of carrying on its business. The outgoings were capable of serving the business ends of that business and were seen by those responsible for incurring them as desirable and appropriate in the pursuit of those ends. Plainly, they were neither private nor domestic in nature.

[7.140] Brennan J agreed with the result in a separate judgment.

Prior to 1997, legal expenses that were incurred in carrying on a business for the purpose of gaining or producing assessable income but which were not otherwise deductible under s 51(1) could have been deducted under s 64A of the ITAA 1936, subject to a $50 maximum deduction cap. The concession, omitted from the 1997 Act, applied primarily to legal expenses that were capital in nature (ie that satisfied the positive deduction limbs but which were subsequently knocked out by the negative limb applying to capital expenses. A number of specific deduction provisions examined in Chapter 11 allow taxpayers to “expense” (that is, to deduct immediately) or to amortise (that is, to deduct over several years) specific types of legal expenses. For example, legal expenses incurred in respect of the management or administration of the income tax affairs of a taxpayer or compliance with income tax laws may be deducted under s 25-5. Legal expenses connected with the acquisition or disposal of an asset are usually characterised as capital outlays and are therefore not deductible under s 8-1 pursuant to the capital expense negative limb in s 8-1(2)(a). If the expenses are not addressed directly in one of the specific deduction provisions, they may be added to the cost of property under s 110-25(3) and recovered as part of the cost base when the asset is sold. As we shall see in Chapter 9, legal expenses incurred to defend a taxpayer’s title to property are also considered capital; these may be added to the cost base under s 110-25(6). [7.145]

7.6

Question

If the defendant directors in Magna Alloys had paid their own fines and then been reimbursed by the taxpayer, would the taxpayer be able to deduct the amount of the reimbursement? Would the directors be liable to tax on the amount of the reimbursement? Would the employer be liable for Fringe Benefits Tax on that amount? Would the employer be liable for Fringe Benefits Tax if it paid the expenses directly?

[7.150] The Magna Alloys decision removed the cloud that had hung over the status of legal

expenses incurred in respect of a business that generated assessable (though quite possibly [7.150]

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The Tax Base – Deductions

illegal) income. Would the rationale extend to individuals incurring expenses to protect their employment or services income if it was threatened by allegedly illegal activities? The question was considered by the Full High Court in FCT v Day, which involved a public servant.

FCT v Day [7.160] FCT v Day (2008) 236 CLR 163; 70 ATR 14; [2008] HCA 53 Full High Court Gummow, Hayne, Heydon and Kiefel JJ: The respondent was a senior compliance officer with the Australian Customs Service between 1997 and 1999. The Public Service Act 1922 (Cth), in force at the relevant time, provided that an officer may be charged with failure to fulfil his duty as an officer. In that event an inquiry was to be held, and the officer charged could be suspended from duty pending the hearing and determination of the charge. The officer holding the inquiry, if satisfied that the charge was made out, could direct that action be taken in relation to the officer the subject of the charge. Such action included deduction of salary, demotion or dismissal from the Australian Public Service (“the Service”). The respondent was charged with failure of duty in 1998 (“the first charge”) and in 1999 (“the third charges”). A second set of charges notified to the respondent is not relevant to this appeal. The respondent sought and obtained legal advice and representation in connection with the first and third charges (together, “the charges”). In his objection to the Commissioner of Taxation’s notice of assessment of his income to taxation, for the year ended 30 June 2002, the respondent claimed that $37,077 should have been allowed as a deduction from his assessable income. That figure represents the balance of the legal expenses incurred by the respondent with respect to the charges, after recovery of costs under an order of the Federal Court with respect to the first charge. On 19 April 2005 the Commissioner disallowed that objection. … The focus of this appeal is upon the requirement for deductibility of expenses in s 81(1)(a), that they be “incurred in gaining or producing … assessable income”. It is the Commissioner’s principal contention that the legal expenses were incurred in defending charges of conduct extraneous to the performance of the respondent’s income408

[7.160]

producing activities and therefore cannot be said to have been incurred in the course of gaining or producing assessable income.… The Commissioner submits that expenses of a legal nature have been held deductible where they were necessitated by an activity which was part of, or incidental to, the business of the taxpayer. An employee’s legal expenses, in connection with charges of misconduct, have been held deductible because they reflected the day-to-day aspects of the employment or because the employee could be said to be defending the manner of performance of his duties of employment. The expenses here in question were incurred in defending conduct outside the performance of the respondent’s duties, and cannot be said to have been incurred “in” or “in the course of” gaining or producing assessable income for the purposes of s 8-1(1)(a). The Commissioner accepts that the respondent was also under an obligation, imposed by s 56(d) of the Public Service Act 1922, not to engage in improper conduct, but submits that the observance of that duty was not itself an activity which was productive of the respondent’s income and was therefore not relevant. The Commissioner submits that a positive obligation to perform tasks of employment is different from one not to engage in certain other conduct, particularly where the conduct proscribed involves private misbehaviour.… Essential to the inquiry is the determination of what it is that is productive of assessable income. The dichotomy to which the Commissioner’s argument refers, that between proper conduct and that which is proscribed, may pose some difficulty in the delineation of tasks which the Commissioner would describe as falling within or without the scope of a person’s occupation. The present case furnishes an example. It is not clear where the Commissioner would place expenses incurred with respect to charges of inefficiency,

The Positive Limbs – Nexus Issues

FCT v Day cont. incompetence or negligence under s 56 [of the Public Service Act] in the carrying out by an officer of ordinary day-to-day tasks. It is not necessary to consider further the difficulties inherent in this aspect of the Commissioner’s argument. The dichotomy may be relevant in other spheres of the law, but is not useful to determine the question arising under s 8-1(1)(a), as to what it is that is productive of a person’s assessable income. It does little more than characterise conduct by reference to wrongdoing. In some cases a reference to conduct which is wrongful may be to that which is remote from a person’s occupation. In others, such as the present case, it will be to that which is a breach of a duty imposed by the employment itself. A determination as to what is productive of assessable income in a particular case may need to take account of any number of positive and negative duties to be performed or observed by an employee or other salary-earner. It is that determination which provides the answer as to whether the occasion is provided for the expenditure in question.… The respondent’s position as an officer subject to the Public Service Act 1922 obliged him to observe standards of conduct extending beyond those in the performance of tasks associated with his office and exposed him to disciplinary

CHAPTER 7

procedures within the Service which might have consequences for the retention of his office or his salary. What was productive of his income must be understood in this light. It is neither realistic nor possible to excise from the scope of the respondent’s service as an officer elements which may be associated with tasks and so identify them as income-producing. What was productive of his income by way of salary is to be found in all the incidents of his office in the Service to which the Act referred, including his obligation to observe standards of conduct, breach of which might entail disciplinary charges. The respondent’s outgoings, by way of legal expenses, followed upon the bringing of the charges with respect to his conduct, or misconduct, as an officer. He was exposed to those charges and consequential expenses, by reason of his office. The charges cannot be considered as remote from his office, in the way that private conduct giving rise to criminal or other sanctions may be.… The respondent’s duties as an officer of the Service, and the possible consequences to him of internal disciplinary proceedings and action with respect to the continuation or termination of his service, form part of what was productive of his assessable income in that capacity. Applying the inquiry as to connection posed by the section, as explained by Ronpibon Tin, the occasion of the legal expenses is to be found in his position as an officer. It follows that the expenses were properly allowable as deductions.

Kirby J dissented from the majority view concluding the expense lacked a sufficient nexus with the derivation of assessable income to be deductible (that is, was not incurred in the course of deriving assessable income) and further that it was a private expense. [7.165]

Questions

7.7

The taxpayer was an officer charged with criminal offences not related to his employment. As a result of the charges, he was suspended from his employment. It was clear that he would only be able to reassume employment duties if he were cleared of the criminal charges. Are his legal expenses deductible? See Schokker v FCT (1998) 38 ATR 91.

7.8

The taxpayer was a medical practitioner in private practice and was also employed by a government centre. She was charged with illegally holding herself out to be on duty at the centre when she was in fact at her private practice. The taxpayer incurred legal expenses to successfully defend herself against the charges. Are the expenses deductible? See Elberg v FCT (1998) 38 ATR 623. [7.165]

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The Tax Base – Deductions

(d) Expenses Incurred in an Illegal Business [7.170] It stands to reason that if income derived from an illegal business is assessable income,

losses and outgoings incurred in deriving that income would be deductible. Or does it? The issue arose for consideration by the Full Federal Court in FCT v La Rosa. The taxpayer in that case was a heroin dealer who was robbed of cash at a purchase rendezvous with another drug supplier. The cash was intended for payment for drugs. The ATO argued that the general deduction provision should be interpreted in light of public policy considerations, namely to support the enforcement of State and Federal criminal laws prohibiting the possession and selling of prohibited drugs. This could be achieved, the ATO suggested, by denying a deduction for the loss in this case while including gross proceeds of sale in assessable income. At first instance FCT v La Rosa (2002) 50 ATR 450 the Federal Court conceded there may be a public policy basis for denying a deduction for fines, but concluded this rationale did not extend further: The allowance of a deduction for monies expended on a criminal business, in circumstances where the income of that business is taxable, is consistent in principle and with the ITAA. Present authority supporting the imposition of a public policy limitation does not extend beyond instances of fines and penalties. No basis of principle is readily apparent to extend that basis. Courts should not do so in the absence of such apparent principle because to do so would arguably attract the aura of the function of legislation. There is no basis for doing so where there is no frustration of criminal enforcement. Such encouragement to criminal activity as a deduction may provide is not a frustration to criminal enforcement… (para 97)

This position was endorsed by the Full Federal Court in FCT v La Rosa (2003) 53 ATR 1: Allowance of a deduction for expenses incurred or losses sustained in the conduct of the drug dealing business does not frustrate the operation of the criminal law, nor will any sanction imposed by that law be diluted by the allowance of a deduction for business expenses or losses. Allowance of a deduction does not amount to a condonation of the taxpayer’s activities. (para 58)

The La Rosa judgment received wide publicity in the press, prompting the government to introduce s 26-54, which denies a deduction for “a loss or outgoing to the extent that it was incurred in the furtherance of, or directly in relation to, a physical element of an offence against an Australian law of which you have been convicted if the offence was, or could have been, prosecuted on indictment”. Ironically, the provision might not apply to the facts in La Rosa as the theft may not be incurred in furtherance of an element of the offence, as it took place after the drug dealing crime for which the taxpayer had been convicted took place.

4. THEFT LOSSES AND MISAPPROPRIATION OF FUNDS [7.180] The nexus requirements of the first and second positive limbs are especially tested in

the case of unusual or exceptional losses incurred by a taxpayer. Perhaps the most graphic examples of an unusual or exceptional loss that gives rise to the insufficient nexus argument are found in cases involving thefts from taxpayers or misappropriation of their funds. The ordinary presumption of the business judgment rule, to leave it to the taxpayer to decide what expenses are appropriate for his or her income derivation process, may be difficult to apply where an unusual and unexpected expense not planned by the taxpayer such as a theft or misappropriation of funds is encountered. While there is little theoretical basis for treating unusual and involuntary expenditures differently from others provided the initial nexus requirements are prima facie satisfied, the ATO sometimes seeks to deny deductions based on 410

[7.170]

The Positive Limbs – Nexus Issues

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an insufficient nexus argument or seeks to characterise the outgoing as a quasi-personal expense that should be non-deductible for policy reasons. The nexus arguments were canvassed in the High Court decision in Charles Moore & Co (WA) Pty Ltd v FCT.

Charles Moore & Co (WA) Pty Ltd v FCT [7.190] Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 Full High Court Dixon CJ, Williams, Webb, Fullagar and Kitto JJ: The taxpayer claiming the deduction conducts a departmental store in Hay Street, Perth. It was the practice every business morning for the cashier accompanied by another employee to take the previous day’s takings to the bank some 200 yards away and pay them in to the credit of the taxpayer. On the morning of 5 August 1952, while on their way to the bank unarmed, the two employees were held up at gun point and robbed. The money they carried consisted of cheques and cash forming the trading receipts of the previous day. A bag containing the cheques escaped [sic] but the bag containing cash, which amounted to £3,031, was stolen and never recovered, and the taxpayer was not insured against a loss of such a description. In the return of the taxpayer’s income for the year in which the robbery occurred the amount was claimed as a deduction from the assessable income, but the claim was disallowed by the Commissioner and the disallowance was upheld by a majority of a board of review. We are unable to concur in the view that the loss does not form an allowable deduction. We can see no reason why it should not be considered a loss incurred in gaining or producing the assessable income within The money they carried consisted of cheques and cash forming the trading receipts of the previous day. A bag containing the cheques escaped [sic] but the bag containing cash, which amounted to £3,031, was stolen and never recovered, and the taxpayer was not insured against a loss of such a description. In the return of the taxpayer’s income for the year in which the robbery occurred the amount was claimed as a deduction from the assessable income, but the claim was disallowed by the Commissioner and the disallowance was upheld by a majority of a board of review. We are unable

to concur in the view that the loss does not form an allowable deduction. We can see no reason why it should not be considered a loss incurred in gaining or producing the assessable income within s 51(1) … and we do not think that it should be regarded as a loss or outgoing of capital or of a capital nature. The words “incurred in gaining or producing the assessable income” means, as has been stated many times, “in the course of gaining or producing the assessable income”: W Nevill & Co Ltd v FCT; Ronpibon Tin NL v FCT. In the case of a large departmental store such as the taxpayer carries on, the ordinary course of business requires that, day by day and as soon as may be, the takings shall be deposited in the bank. It is as necessary to the conduct of the business as it is to place goods on the shelves or to deliver them to the customers. They are all operations in the course of gaining or producing the assessable income by means of carrying on the business. The assessable income to which the subsection relates is (apart from exemptions) the total amount of the receipts of an income nature derived during the 12 months forming the accounting period. … Banking the takings is a necessary part of the operations that are directed to the gaining or producing day by day of what will form at the end of the accounting period the assessable income. Without this, or some equivalent financial procedure, hitherto undevised, the replenishment of stock in trade and the payment of wages and other essential outgoings would stop and that would mean that the gaining or producing of the assessable income would be suspended. In Ronpibon Tin NL and Tongkah Compound NL v FCT, it is said: “For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end … In brief substance, to come within the initial part of [7.190]

411

The Tax Base – Deductions

Charles Moore & Co (WA) Pty Ltd v FCT cont. the subsection it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.” Properly understood the place which the banking of money takes in a merchandising business brings the operation within the principle thus stated. It is an essential, or at all events highly expedient, part of the conduct of the business, a necessary or recognised incident or concomitant, and is relevant as well as incidental to the end in view, the gaining of the assessable income. The “occasion of the loss” in the present case was the course pursued in banking the money. In C of T (NSW) v Ash (1938) 61 CLR 263, Rich J said: “There is no difficulty in understanding the view that involuntary outgoings and unforeseen or unavoidable losses should be allowed as deductions when they represent that kind of

casualty, mischance or misfortune which is a natural or recognised incident of a particular trade or business the profits of which are in question. These are characteristic incidents of the systematic exercise of a trade or the pursuit of a vocation” (at 263). Even if armed robbery of employees carrying money through the streets had become an anachronism which we no longer knew, these words would apply. For it would remain a risk to which of its very nature the procedure gives rise. But unfortunately it is still a familiar and recognised hazard and there could be little doubt that if it had been insured against the premium would have formed an allowable deduction. Phrases like the foregoing or the phrase “incidental and relevant” when used in relation to the allowability of losses as deductions do not refer to the frequency, expectedness or likelihood of their occurrence or the antecedent risk of their being incurred, but to their nature or character. What matters is their connection with the operations which more directly gain or produce the assessable income.

[7.200] Another situation in which a taxpayer suffered an exceptional loss after the

derivation of assessable income was considered by the High Court in C of T (NSW) v Ash, a decision which was cited in Charles Moore. The taxpayer in C of T (NSW) v Ash made payments to clients of his firm who had been embezzled by his ex-partner. The High Court denied the taxpayer in C of T (NSW) v Ash a deduction for the outgoing. The facts of C of T (NSW) v Ash are explained in the judgment.

C of T (NSW) v Ash [7.210] C of T (NSW) v Ash (1938) 61 CLR 263 Full High Court Latham CJ: In my opinion the deduction is not allowable because of its nature. In the first place, it is evident that the actual payment of £500 was made only because of the existence of the antecedent liability. Once the compromise was made, the amount agreed upon became a personal liability of the taxpayer secured over certain of his capital assets, and its discharge became a matter quite independent of his continuing to practise and quite unconnected with the earning of future income. … [T]he liability of the firm, considered as an independent accounting entity, arose entirely from the misapplication of the funds by one of the 412

[7.200]

members by whom it was constituted. If a proprietor of a business converts its funds to his own use or uses the opportunities the business affords to defraud its clients or customers, his resulting liability cannot be considered an outgoing of the business, still less an outgoing on revenue account. The determining considerations must therefore be the source and nature of the taxpayer’s liability for the frauds of the partner. His liability rests, of course, upon the legal responsibility of every partner for the acts of another partner done in the course of his authority as a partner. The responsibility springs out of the relationship, which involves the principles of

The Positive Limbs – Nexus Issues

C of T (NSW) v Ash cont. agency. Recognising this fact, the taxpayer’s counsel put his case on grounds akin to those which would support the allowance of losses and outgoings caused by the pilferings, misconduct or frauds committed by servants whose employment is a necessary part of any organised business and the risk of whose dishonesty may be regarded as incidental thereto. The contention represents the taxpayer as conducting a continuous practice throughout his professional career and as being impelled to secure the services of a partner as a means of increasing the income derived from his practice. Then, it is said, the partner, acting under the authority which for the purpose of producing assessable income the

CHAPTER 7

taxpayer had conferred upon him, proceeded to obtain the particular client for the firm and so found the opportunity to commit the fraud. In this way it is sought to stamp upon the act of the taxpayer from which his liability springs the characteristics of a thing done in the course of and for the purpose of producing assessable income. … In my opinion the loss inflicted upon the taxpayer by his fraudulent partner takes no place in the subsequent carrying on of his practice. It was simply a loss or depletion of his general resources as a result of his undertaking the risk of such a liability when by entering into partnership each partner armed the other with an authority under which he might impose liabilities upon him.

[7.220] The decisions in Charles Moore and C of T (NSW) v Ash may be analysed from a

number of perspectives. In both cases the outgoings were incurred outside the scope of normal business operations – they were unusual and probably unexpected and enjoyed no immediate, direct nexus with the derivation of income. It is not difficult to see why the ATO’s intuitive reaction in both cases was to deny the taxpayers the deductions they sought. Both cases carry hints of moral evaluation. While not all shopkeepers in Perth are confronted daily with the possibility of robbery, the risk is high enough that a merchant such as the taxpayer in Charles Moore faces a real chance of suffering the loss and is thus arguably blameless if it does happen. By way of contrast, the characterisation of the outgoing in C of T (NSW) v Ash as a quasi-personal expense not suffered in the context of the taxpayer’s income-earning business harks back to the characterisation of the fines in the early fines cases and the damages in the early tort cases. It is almost an implied assumption that the taxpayer must somehow be partly to blame if he chooses to form a partnership with someone who turns out to be a criminal. Section 25-45 now permits taxpayers to deduct losses incurred through embezzlement, larceny, defalcation or misappropriation by an employee of the taxpayer. The section does not apply to situations such as that in the C of T (NSW) v Ash case because the misappropriation of funds in that case was not the work of an employee of the taxpayer. It has been suggested that the failure to include thefts of the type encountered in that case in s 25-45 amounts to a legislative endorsement of the principles enunciated in that case. This view was reinforced in 2008 when the deduction was extended in s 25-47 to losses on thefts by employees of depreciable property owned by the taxpayer. While the holding in C of T (NSW) v Ash has been chipped away at the edges in other cases involving misappropriation of funds, it has stood for six decades without change in respect of the central issue in the case, outgoings to satisfy misappropriation of funds by a partner. In the mid-1990s, however, the holding was reviewed by the Supreme Court of Fiji in Sweetman v CIR (1996) 34 ATR 209 in a hearing in which a member of the Australian High Court sat as one of the three judges on the panel. The taxpayers in Sweetman were partners who refunded [7.220]

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The Tax Base – Deductions

to clients amounts misappropriated by a former partner. The Court allowed the partners deductions for the payments, making the following observation: “We make the following comments about the reasoning in FCT v Ash. The risk of misappropriation by a partner in a business or a profession is these days a natural incident of the carrying on of a business or profession and, in that respect, is not to be distinguished from the risk of theft by an employee in a business. That risk of loss is ‘inherent in the income-earning process of’ a business or a professional practice.” There have been no Australian cases dealing directly with this issue since the Sweetman case and there is debate as to whether C of T (NSW) v Ash would be reversed if similar facts were litigated today. [7.225]

7.9

7.10

7.11

7.12

7.13

7.14

Questions

If the thefts in C of T (NSW) v Ash had been committed by a third party thief or an employee, they likely would have been deductible. Why did the Court in C of T (NSW) v Ash presume dishonest employees or third parties are an ordinary incident of business while the dishonest partners are not? Is there any public policy or similar rationale for denying the taxpayer in C of T (NSW) v Ash a deduction for his outlays? For example, should the taxpayer take personal responsibility for having chosen a dishonest partner? The taxpayer in C of T (NSW) v Ash had included in his assessable income in earlier years amounts that, as events would transpire, he would not be able to keep. In effect, they had been indirectly stolen by his ex-partner. In this respect, his position was similar to the taxpayer in Charles Moore which had included amounts in assessable income it, too, would not be able to keep. Are the cases distinguishable? Should there be a distinction or is the approach in Sweetman to be preferred? An employee of the taxpayer’s accounting firm forged cheques payable to himself and then recorded the cheques in the company’s books as payments to the company’s suppliers. When the ATO discovered the misappropriation he issued amended assessments which denied the taxpayer deductions for the amounts which were actually paid to the dishonest employee of the accounting firm rather than suppliers. Will the ATO be successful? (See FCT v Levy (1961) 106 CLR 448.) In the course of a tax avoidance scheme, the taxpayer company was sold to new owners who illegally stripped the profits from the company. Can the company then claim a deduction under s 25-45 for the stripped amounts? (See EHL Burgess Pty Ltd v FCT (1988) 88 ATC 4517.) The judicial doctrines and narrow wording of s 25-45 may lead to some peculiar results. Compare, for example, the case of a taxpayer who brings home the day’s earnings, which are subsequently stolen from the house by a person who works at the taxpayer’s business with the case of a taxpayer whose domestic housekeeper visits his office and takes money out of the till. Presumably the first loss would be deductible, while the second may not. Is there any logic to these results?

5. OUTLAYS TO REDUCE COSTS [7.230] Outlays to reduce future costs, at first glance, appear to enjoy only a tenuous

connection with the positive limbs of s 8-1. By lowering future costs, such expenditures will increase future net profits. In terms of tax terminology, however, the outlay to reduce future expenses will increase taxable income, not assessable income, as required by s 8-1. 414

[7.225]

The Positive Limbs – Nexus Issues

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In the current commercial environment it is prudent for companies continually strive to reduce ongoing costs and incur expenditures to prevent future expenses. A common example is lump sum payments offered to employees to accept early retirement or retrenchment. Indeed, now such costs would probably be seen as an inherent cost of running a competitive business. This was not always the case, however, and when the issue arose in W Nevill & Co Ltd v FCT, the Commissioner relied upon the unusual nature of the outgoing as the basis for his non-deductible argument. The fact that expenses incurred to reduce future expenses increased taxable income instead of assessable income was another of the principal arguments relied upon by the Commissioner. The High Court concluded the expenses were deductible and the decision has become an important hallmark of the considerations that the courts will take into account when characterising unusual expenses. The taxpayer in Nevill incurred expenses in connection with the termination of a contract of employment of a managing director no longer required by the firm. The director was paid £2,500 in return for giving up his rights under a service contract which would have entitled him to £1,500 per year salary (plus a percentage of profits) for four and a half years. The taxpayer indicated that anticipated cost savings was a principal reason for the arrangement. The managing director had been hired shortly before the Depression and was unhappy about the taxpayer’s alternative proposal to reduce costs, namely by reducing the salaries of a number of key employees of the company. It appeared that friction had developed between the managing director and his co-manager, as well as between him and a number of other employees. Thus, the taxpayer argued that the arrangements were also intended to increase the “efficiency” of the company by eliminating a source of friction within the firm. The judgment of Dixon J illustrates the characterisation of the outgoing taken by the Court to decide in the taxpayer’s favour.

W Nevill & Co Ltd v FCT [7.240] W Nevill & Co Ltd v FCT (1937) 56 CLR 290 Full High Court Dixon J: [A]ccording to the language of the [deduction condition] paragraph, the money must be laid out for the production of assessable, not taxable, income. Upon this distinction the Commissioner bases a contention that no expenditure is deductible which has for its purpose the reduction or avoidance of outgoings as distinguished from the gaining of gross income. This statement may be literally true, but its application does not necessarily lead to the consequences the Commissioner deduces. For it is fallacious, in my opinion, to draw a distinction between the purpose of reducing or avoiding outgoings and the purpose for which the outgoing so to be reduced or avoided are incurred. Thus, in the present case, if attention is confined to the purpose for which the lump sum payment was made to the retiring director, it may be true that it was in order to save his future salary. Indeed, the case stated says that the main

object of the directors was to effect a saving of that salary, although at the same time they believed that by abolishing the system of joint control they would increase the efficiency of the company. But it is not correct to look only to the purpose actuating the expenditure in the state of facts in which it was resolved upon. The whole course of the transaction must be regarded. When an agreement was made by the company committing it to an annual expenditure for five years of £1,500 upon the managing director’s salary, that obligation was undoubtedly incurred “for the production of assessable income”. The company thus undertook an expenditure which, if it had gone on, would have been deductible. The purpose appears to me to govern the entire course of the transaction. On reconsideration, it appeared that the purpose would be better fulfilled by a rearrangement involving an expenditure made in commutation of that [7.240]

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The Tax Base – Deductions

W Nevill & Co Ltd v FCT cont. undertaken. Why should the original purpose be excluded from view and the immediate purpose alone be considered? A wide view should be taken of the meaning of s 25(e). For it is intended to apply to an infinite variety of sources of

income. When the expenditure avoided reduced has been or would be incurred for production of income, it appears to me that substituted expenditure comes fairly within description money exclusively laid out for production of income.

or the the the the

[7.250] In separate judgments, Latham CJ and Rich and McTiernan JJ agreed with this result.

Note that if the payments in a Nevill-type situation are excessive, the Commissioner could attempt to raise alternative arguments based on s 25-50, which seeks to limit the size of deductible retirement allowances to employees, and s 109 of the ITAA 1936, which re-characterises excessive remuneration as non-deductible dividends.

6. TEMPORAL NEXUS [7.260] A fourth group of expenses that raise a nexus question are those lacking a clear

temporal nexus with the production of current income. If an outgoing is not incurred contemporaneously with the derivation of income, or not long before or after that time, it will quite likely appear unusual or exceptional, given its unclear nexus with the production of income. The ATO has raised the nexus argument with expenses incurred both before a business generates income and after it has derived income. The temporal nexus problem arose in part thanks to UK precedents based on a somewhat different statutory regime, in part because of the construction of the general deduction section, and in part because of the artificial segmentation imposed upon business activities by the income tax system. While income tax legislation presumes economic activity can be divided into segments of one year’s duration, commercial reality recognises that business is a continuous affair. Some expenditures incurred by taxpayers carrying on a business are designed to generate assessable income within the same fiscal year; others may be starting costs incurred before the business is in a position to derive income and some may still have to be paid long after the business has derived income. Prior to the 1936 Act, the provisions dealing with assessable income, deductions and taxable income were all rolled into a single subsection, s 23(1). The section stated that in calculating the taxable income of a taxpayer the total assessable income derived by the taxpayer from all sources in Australia shall be taken as a basis, and from it there shall be deducted all losses and outgoings incurred in gaining or producing the assessable income (emphasis added). In the 1936 Act, the single rule was separated into three provisions: one defining taxable income, a second saying what went into assessable income and a third saying what was an allowable deduction. Due to a drafting oversight, the deduction provision retained a reference to expenses incurred to derive the assessable income. Quite clearly, the word “the” in the predecessor to s 8-1 was an unintentional drafting error from the original provision. But from 1936 until 1997, this misplaced modifier played a key role in the operation of the general deduction provision on the assumption that it established the necessary nexus between deductible expenditures and the derivation of assessable income. It has generally been assumed that the effect of the word is to restrict the deductibility of outgoings – taxpayers are not able to deduct outgoings connected to just any assessable 416

[7.250]

The Positive Limbs – Nexus Issues

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income – they must be referable to “the” assessable income. In its narrowest possible interpretation, the section could be read as authorising deductions for expenses incurred in a particular tax year in earning the assessable income derived in that same financial period. As explained above, this would surely lead to an absurd result. The suggestion has nevertheless been made. In Charles Moore (extracted above) the Court said: “The assessable income to which the subsection [s 51(1)] relates is (apart from exemptions) the total amount of the receipts of an income nature derived during the 12 months forming the accounting period.” A far more pragmatic view was adopted by the High Court in FCT v Finn (extracted further in Chapter 8).

FCT v Finn [7.270] FCT v Finn (1961) 106 CLR 60 Full High Court Dixon CJ: When the foregoing elements are considered in conjunction, they do seem to form a firm foundation for the conclusion that the expenditure was in truth incurred in gaining or producing assessable income. It will be noticed that in the statement of the conclusion the definite article “the” finds no place before the words “assessable income”. It is omitted because once again the suggestion appears in this case that the presence in s 51 of the definite article means that the words “in gaining the assessable income” imply that you must look only at an intent or purpose of gaining or producing the assessable income of the current year of income. It may be remarked that the argument based on the word “the” cannot be regarded as unaffected

by the use of the word “in”. For it is impossible to suppose that an expenditure directed to gaining future income cannot be allowed as a deduction unless its productive effect within the current year is seen or expected. If, therefore, the word “the” actually was read as limiting the expression that follows to assessable income of the current year, the consequence must surely be that the word “in” is to be read as importing no element whatever of purpose or motive and meaning no more than “in the course of” in a very general sense. The better view, however, is that s 51 as now drawn does not in either limb require a rigid restriction to the gaining or production of assessable income of the current year.

[7.280] While the structure of the original s 23(1)(a) and the successor s 51(1) could be read

as suggesting a need for a temporal nexus before deductions would be allowed for expenses incurred by a taxpayer, there is nothing in the structure of current general deduction provision, s 8-1, that suggests such a need. Section 8-1 simply requires a nexus between the outgoing and gaining or producing “your” assessable income, with no implication as to when that income should be derived. While some lower courts have sought to read an implied temporal nexus into the new provision relying on precedents based on one of the two earlier sections, it appears the courts are increasingly relaxed about the temporal nexus question, particularly where expenses are incurred in the course of an income-earning process or business. However, cases continue to arise where there is a temporal break between incurring an expense and carrying on a business.

[7.280]

417

The Tax Base – Deductions

(a) Expenses Incurred Prior to the Commencement of Income-Earning Process or Business [7.290] In FCT v Finn the High Court suggested there need not be a direct temporal nexus

between an outgoing and the income that results from it for the outgoing to be deductible. This approach accords with sound business logic – an ongoing business continually incurs expenses and quite often is unable to match particular outgoings to particular receipts in the same time period. In the case of an ongoing business, unless there is evidence of a tax minimisation problem, the ATO is unlikely to challenge outgoings on the basis of lack of temporal nexus because the expenses were incurred prior to the derivation of income. However, challenges are not uncommon where expenses are incurred prior to the commencement of an income-earning process or business. The question of temporal nexus prior to the commencement of a business was considered by the High Court in Steele v DFC of T. Prior to 19 September 1985, the taxpayer in Steele had acquired a property, “Tibradden”, used for agistment of horses. She intended to build and operate a motel on the property, and to construct townhouses for resale to investors. She also intended to continue operating the agistment business, which produced a small income. After difficulties with a partner she had brought into the venture, she sold her interest in the property. She claimed deductions for the interest expenses incurred over six years on borrowed funds used to acquire the property. The ATO denied a deduction and the taxpayer appealed to the AAT (unreported), which allowed an interest deduction only for an amount equal to the income from the agistment business. The taxpayer’s appeal to the Federal Court (Steele v FCT (1996) 31 ATR 510) was dismissed. There is some dispute as to the ratio of the Federal Court decision. In part, it appears to be based on a conclusion that interest expenses can, in some circumstances, be capital expense. In part, however, it appeared to be an endorsement of the AAT conclusion that the expense was incurred for dual purposes and the nexus between future income from the long-term object and the interest expense was too remote for the interest to be deductible. The taxpayer appealed unsuccessfully to the Full Federal Court and then appealed to the Full High Court, where a majority said the expenses would be deductible if the taxpayer could demonstrate she held the object of deriving income in the future from the expenditure. The question of fact was remitted back to the AAT.

Steele v DFC of T [7.300] Steele v DFC of T (1999) 41 ATR 139 Full High Court Gleeson CJ, Gaudron and Gummow JJ: In deciding whether, in the present case, the interest was an outgoing “incurred in gaining or producing the assessable income”, it is unnecessary to become involved in seeking to distinguish between the purpose of the taxpayer in borrowing the money and the use to which the borrowed funds were put. The respondent accepts the principle, referred to above, that an outgoing may qualify for deduction even though no assessable income to which the outgoing is shown to be “incidental and relevant” is gained or produced in the year in 418

[7.290]

which the outgoing is incurred, or at all. Bearing in mind that the assessable income referred to is the assessable income of the taxpayer generally, it seems difficult to deny the relevance of the outgoing presently in question. There are cases where the necessary connection between the incurring of an outgoing and the gaining or producing of assessable income has been denied upon the ground that the outgoing was “entirely preliminary” to the gaining or producing of assessable income or was

The Positive Limbs – Nexus Issues

Steele v DFC of T cont. incurred “too soon” before the commencement of the business or income producing activity. The temporal relationship between the incurring of an outgoing and the actual or projected receipt of income may be one of a number of facts relevant to a judgment as to whether the necessary connection might, in a given case, exist, but contemporaneity is not legally essential, and whether it is factually important may depend upon the circumstances of the particular case. As Lockhart J said in FCT v Total Holdings (Aust) Pty Ltd: [I]f a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective incomeproducing activities, whether those activities are properly characterized as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under s 51. … I say “generally” as some qualification may be necessary in appropriate cases, for instance, where interest is paid by a taxpayer as a prelude to his being in a position whereby he may commence to derive income. In such cases the requirement that the expenditure be incidental and relevant to the derivation of income may not be satisfied.

CHAPTER 7

This is consistent with cases which have decided that a taxpayer may be entitled to a deduction after a business has ceased, provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally. However, cessation of business may be of factual importance. The respondent placed reliance upon the concept of commitment as an aid to the formation of a factual judgment, in a case such as the present, as to the sufficiency of the relevant connection between outgoing and income. … There was no suggestion, for example, that she ever contemplated using the property for private or domestic purposes. That was never an option. As Carr J pointed out, whilst she was not financially committed to a motel development, and had not decided upon any particular development, she does not appear to have envisaged any use of or dealing with the property other than one which would produce assessable income. … [T]he resolution of the issue ultimately involves a judgment of fact, even though questions of law are involved. This means that the course proposed by Carr J, of remitting the matter to the Tribunal, is appropriate. This is not a case where, on the evidence, only one conclusion would be open to the Tribunal.

[7.310] Kirby J dissented from the majority opinion. Callinan J agreed with the majority on

substantive issues but proposed to decide the appeal in the taxpayer’s favour without remitting the matter back to the AAT. Steele appears to have opened the door to a looser nexus requirement between an outgoing and a future income-producing activity or business. However, by asserting that the matter nexus was ultimately one of fact, the Court left open the question of when a sufficient nexus will be established between current expenses and possible future income from a yet-to-be started enterprise. Often the ATO relies upon several arguments to deny a taxpayer a deduction for an outgoing that appears to be related to the derivation of future income. For example, an attack based on lack of temporal nexus with a yet-to-be-started enterprise will be compounded with one of dual purpose (the other purpose being tax minimisation, for example). Or, the ATO may argue that the expense is not deductible on the basis of insufficient temporal nexus and further that the outlay is a personal expense (discussed further in Chapter 8). In other cases, the ATO might argue the expense is not deductible on the basis of insufficient temporal nexus [7.310]

419

The Tax Base – Deductions

and further that it is a capital outgoing to the extent it is incurred to acquire or to create a new structure or business (discussed further in Chapter 9). An example of the ATO using multiple arguments to deny a deduction in a tax minimisation arrangement can be found in FCT v Ilbery (1981) 12 ATR 563. In that case the ATO argued the taxpayer should be denied a deduction because the expenditure was incurred in the form it was primarily for tax avoidance reasons and on the basis of insufficient temporal nexus. While the Court entertained the tax avoidance purpose argument, ultimately it decided in the ATO’s favour on the basis of an insufficient temporal nexus (the expense was incurred before the source of income had come into existence). The judicial developments in cases such as Steele have mitigated the potentially harsh results of a strict application of the temporal nexus doctrines to expenses incurred prior to commencement of an income-earning process but the potential for hardship remains and has prompted some partial statutory responses. One of the first moves in this direction was the adoption in 1998 of a measure to permit taxpayers to recognise over a period the cost of environmental impact studies: currently s 40-830 and s 40-840(2)(d)(iv). In mid-2001, in response to recommendations of the Ralph Review, the legislature inserted s 40-880 into the ITAA 1997 to partly overcome the temporal nexus problem and allow taxpayers to deduct over a period many business start-up costs. The scope of the section was expanded in 2006 and it now applies to expenses related to a business a taxpayer “proposes” to carry on within a reasonable time. These expenses are deductible over five years. [7.315]

7.15

7.16

7.17

7.18

7.19

420

Questions

The taxpayer invested in a prawn farming project, prepaying seven years’ licence fees for a prawn rearing pond. The payment was made before the pond had been constructed. Subsequently, the farm promoter went into liquidation and the taxpayer received no return on his investment. Would the taxpayer be able to deduct the expenditure under ss 40-840 or 40-880? (For a case predating ss 40-840 and 40-880 in which the ATO argued the expense was not deductible because it was incurred before the income-producing activity or business commenced, see FCT v Brand (1995) 31 ATR 326.) The taxpayer entered into an agreement with a company owned by the taxpayer and his spouse under which he would indemnify the company for losses for two years in return for the company paying the taxpayer a percentage of profits for several years after it came into profit. Is there a sufficient temporal nexus for the taxpayer to deduct amounts paid out under the indemnification agreement? (See Case 49/95 (1995) 95 ATC 422.) The taxpayer paid for the artificial insemination of cows in an exotic cattle breeding program. Can the taxpayer be carrying on a business of primary production long before the progeny will appear? (See Case 17/93 (1993) 93 ATC 214.) Will the expense be deductible under ss 40-840 or 40-880? The taxpayer incurred expenses for photocopying, postage, telephone calls, freight, and word processor depreciation to write a book, which was completed and published two years later. Is there a sufficient temporal nexus with the derivation of future royalties to enable the taxpayer to deduct the expenses? (See AAT Case 10,475 (1995) 31 ATR 1328.) The taxpayer borrowed funds to on-lend to a private company that had insufficient assets to borrow in its own capacity. The taxpayer agreed the company would not be required to pay interest on the loans until it was earning profits from the real estate [7.315]

The Positive Limbs – Nexus Issues

7.20

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development project it was undertaking. Is there a sufficient nexus between the taxpayer’s interest expenses and the future income to satisfy the temporal nexus test? (See Case 26/94 (1994) ATC 258.) Can a law graduate deduct the cost of acquiring a practising certificate under s 8-1? Can an accounting graduate deduct the cost of joining the Society of Accountants under s 8-1? Can either person deduct the expenses under s 40-840 or 40-880?

(b) Expenses Incurred to Obtain an Employment Contract [7.320] The ATO has long opposed deductions for expenses incurred to obtain an employment contract, arguing they lack a sufficient nexus with the derivation of assessable income as they are incurred prior to the process of deriving income, not in the course of deriving income. This view was based on the Full High Court’s decision in FCT v Maddalena (1971) 2 ATR 541, in which a part-time country rugby player sought to deduct travel expenses incurred in seeking a contract with a metropolitan club. The court regarded Maddalena as an employee, and as such had incurred the expenses “at a point too soon to be properly regarded as incurred in gaining assessable income”. The Court distinguished his situation from that of someone in business who had spent money to obtain contracts. Although the Maddalena decision has not been overruled, the High Court has recognised the changing nature of sporting employment contracts, which are no longer solely a contract of employment between the taxpayers and their clubs, but a tripartite contract involving their respective football leagues and their player rules, which allow sportspersons to receive income from non-playing activities. They distinguished Maddalena on its facts in Spriggs v FCT; Riddell v FCT [2009] HCA 22 finding that the taxpayers were “engaged in the business of commercially exploiting their sporting prowess and associated celebrity.”

Spriggs v FCT and Riddell v FCT [7.330] Spriggs v FCT; Riddell v FCT [2009] HCA 22 Full High Court French CJ, Gummow, Heydon, Crennan, Kiefel and Bell JJ 63. In this case, the Commissioner did not dispute that the non-playing activities from which each appellant earned income constituted a “business”. However, the Commissioner contended that, following Maddalena and in the light of the exclusion of “occupation as an employee” from the definition of “business” in s 995-1 of the ITAA 1997, it was necessary to separate the appellants’ Australian Rules football and rugby league playing activities, which could be characterised as employment, from their nonplaying activities. On this basis, the Commissioner argued that the management fees were not incurred in the course of earning income as employees, as they were incurred to obtain new employment contracts, as in Maddalena. Further, it was argued that they were not incurred in the

course of earning income from the non-playing businesses, because they were paid to the managers solely for procuring the new employment contracts, not for any purposes of the businesses, as characterised by the Commissioner. 64. The Commissioner’s arguments must be rejected. 65. It is possible to obtain and perform an employment contract as part of, and during the course of, running a business, as is illustrated by Commissioner of Taxes (Vict) v Phillips. In that case, Starke J described how the taxpayer carried on business, in partnership with his brother, as amusement managers and directors, and how, as part of that business, the taxpayer was employed as the governing director of a company which operated a theatre. Income under the employment contract was income of the business [7.330]

421

The Tax Base – Deductions

Spriggs v FCT and Riddell v FCT cont. and, accordingly, agreed periodic compensation payments to the taxpayer for cancellation of the employment contract was income of the business. For that reason, half of the compensation was to be included as part of the taxpayer’s assessable income. 66. Maddalena does not oblige the approach for which the Commissioner contended. As noted above, the Court there expressly considered that different results as to deductibility could follow if a taxpayer were conducting a business, as opposed to being only an employee. The Court concluded that Mr Maddalena’s contract with the rugby league club was a contract of employment and that expenses incurred in procuring that contract were not incurred in the course of earning income under that contract. In reaching that conclusion, it is plain that the Court concluded that Mr Maddalena was not conducting a business. That is not surprising, given the facts of the case: his activities as a rugby league player were part-time; there was no evidence as to any indicia of a business, a part of which was Mr Maddalena’s employment; in particular, nothing in the case suggested that Mr Maddalena conducted himself in a businesslike way, for instance by retaining a manager; and movement between clubs was more difficult and less structured than it is today. This explains the distinction drawn by Menzies J: [I]t is common knowledge that because a man is a successful professional he can earn fees from advertising and other sources which, of course, form part of his assessable income. Nothing I say in this judgment bears upon expenditure to earn such fees. Here it is the agreement with Newtown that the taxpayer spent money to secure. On the facts of Maddalena, there was nothing to suggest that the gaining of any such advertising and other fees were, together with employment by a club, part of a business. 67. The definition of “business” in s 995-1 of the ITAA, set out above, also does not require the result contended for by the Commissioner. That definition does not apply in respect of s 8-1(1)(a), 422

[7.330]

where the statute calls, not for the identification of a “business” as defined, but rather for the identification of the means of gaining or producing “income”. Moreover, the definition does not state that a contract of employment cannot form part of a business. What the definition provides is that a person will not be taken to be conducting a business merely because the person earns income under a contract of employment. Something more than that would be required for there to be a business. 68. The facts here are quite different from those in Maddalena. As noted above, it is not disputed by the Commissioner that the appellants’ non-playing activities constitute businesses. Having regard to the indicia of a business described above, it is plain that they do. It would be artificial on the facts here to separate the stream of income from those activities, from the stream of income from the appellants’ playing contracts with the clubs, as suggested by the Commissioner. The appellants’ promotional activities, exploiting their celebrity, were inextricably linked to their respective employments of playing Australian Rules football and rugby league. 69. Looking at their activities as a whole, the appellants were engaged in the business of commercially exploiting their sporting prowess and associated celebrity for a limited period. Those businesses were well established before the management fees were incurred. Neither of the appellants was exclusively or simply an employee of his club. They each exploited their sporting prowess and associated celebrity with different clubs over the years during which they played in the AFL Competition and the NRL Competition, respectively. There was a synergy between playing activities and non-playing activities, each of which was an income-producing activity. 70. The conduct of such a business by each of the appellants was anticipated in the framework provided by the playing contracts and the various other related documents described above. That framework contained numerous provisions governing the appellants’ rights to enter contracts with third parties in order to exploit their celebrity. 71. Furthermore, each of the appellants conducted the whole of his business in a commercial and business-like way, in particular

The Positive Limbs – Nexus Issues

Spriggs v FCT and Riddell v FCT cont. by retaining a manager. The appellants’ managers had duties which included, but went well beyond, the negotiation of playing contracts. The obligations imposed by the management agreements underscore the association between the appellants’ playing activities and promotional activities. 72. Even assuming that the management fees were paid solely for the service of negotiating the playing contracts, that service and the management fees were productive of both playing income and non-playing income, each flowing from the business of each appellant of exploiting his sporting prowess and associated celebrity. 73. There existed here sufficient connection between the outgoing, the management fees, and the gaining or producing of assessable income from the business of exploiting sporting prowess and associated celebrity, for the management fees to be deductible under s 81(1)(a) of the ITAA. They were incurred in the course of gaining or producing income from the appellants’ respective businesses… 74. The broad application of s 8-1(1)(a) of the ITAA, including its application to income derived from a business, means that, on the facts here, s 8-1(1)(b) adds little… 78. In the light of these conclusions, it is necessary to consider whether s 8-1(2)(a) of the ITAA, in respect of outgoings of capital or of a capital nature, is engaged. As already noted, on this point, the Full Court did not doubt the conclusion of the primary judge that that provision was not engaged. 79. The starting point is the frequently repeated statement of Dixon J in Sun Newspapers: There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner

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in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment. 80. The Commissioner contended that, in each case, the playing contract was a structural asset and that, as the management fee was paid to procure that playing contract, it was an outgoing of a capital nature. 81. That argument of the Commissioner must be rejected, even assuming that the management fees were paid solely for the service of negotiating the playing contracts. 82. As to the character of the advantage sought, namely the playing contracts, those contracts were revenue assets. They were not lasting assets, but were of a relatively short-term nature and subject to renewal. Each of the appellants entered into a number of playing contracts, with different clubs, in the course of his business. 83. As to the other matters mentioned by Dixon J in Sun Newspapers, the management fees were a recurrent expenditure, in respect of the playing contracts, which were revenue assets. The management fees did not secure a lasting asset. They were only incurred upon successful negotiation of the playing contracts. They formed part of the remuneration to the respective managers under the management agreements. Those agreements obliged the managers to provide services in several related respects, all of which were concerned with exploiting the appellants’ sporting prowess and associated celebrity on an ongoing basis. 84. For those reasons, the management fees were not an outgoing of capital or of a capital nature and s 8-1(2)(a) of the ITAA did not apply.

It is worth noting that if an employer pays the travel expenses of job candidates or pays the removal expenses of successful applicants, neither is a taxable fringe benefit; see Fringe Benefits Tax Assessment Act 1986, ss 58A, 58B. [7.330]

423

The Tax Base – Deductions

(c) Expenses Incurred After the Derivation of Income [7.340] Cases looked at previously such as Charles Moore and Ash involved temporal nexus questions relating to post-income derivation expenses. The temporal span in Charles Moore was not great; the taxpayer presumably suffered its loss on the same day it derived the income. The temporal dislocation in that case, and part of the reason the outgoing was unusual, was due to the fact that the “expense” was incurred after the income had been derived. The unusual alignment of cost and income derivation was starker in Ash where the events leading to the outgoings took place years earlier. Although this was not the principal ground for the decision in Ash, Latham J did indicate that the lack of a temporal nexus between the outgoings and assessable income was one of the factors behind his decision to deny the taxpayer a deduction for losses he suffered. There is a line of English authorities which suggest that under UK law, expenses are deductible only so long as the source continues to exist. The doctrines were imported into Australian law on the basis of the earlier deduction provision, s 23(1)(a). The key decision in this regard is the Full High Court decision in Amalgamated Zinc (de Bavay’s) Ltd. The taxpayer in de Bavay’s had carried on a mining operation and, as a result of lung diseases contracted by its miners, became liable for workers compensation payments to the miners and their dependants. The payment obligations continued long after the taxpayer had ceased the mining operations and changed its income-earning activities to the derivation of investment income. The ATO denied the taxpayer deductions for the continuing compensation payments, arguing that even if the deduction provisions did not require a year-to-year nexus between income and deductible outgoings, they did anticipate a continuity of business operations. Accordingly, he argued, the outgoings related to the former business were not deductible from the assessable income derived in the new enterprise, even though the taxpayer remained the same. The High Court agreed with the ATO.

Amalgamated Zinc (de Bavay’s) Ltd v FCT [7.350] Amalgamated Zinc (de Bavay’s) Ltd v FCT (1935) 54 CLR 295 Full High Court Dixon J: The taxpayer formerly carried on the treatment of tailings and ore and the production of zinc concentrates, but those operations it had discontinued some years before. It had sold its stocks and plant and shut up its office at Broken Hill. During the periods in question its sources of income consisted in shares in other companies, government securities and loans in which its funds had been invested and in a very small return from an institution it had joined the other mine-owners in establishing at Broken Hill. In these circumstances the Commissioner refused to allow the deduction of the taxpayer’s contributions to the compensation fund on the ground that they were not outgoings actually incurred in gaining or producing the assessable income. The liability to make the contributions was incurred by, or imposed upon, the taxpayer 424

[7.340]

in the course of, or in consequence of, operations conducted for the purpose of profit. But the payments are annually recurring, and they have extended into a period of time when those operations have entirely ceased and no further gain from them is receivable. … In a continuing business, items of expenditure are commonly treated as belonging to the accounting period in which they are met. It is not the practice to institute an inquiry into the exact time at which it is hoped that expenditure made within the accounting period will have an effect upon the production of assessable income and to refuse to allow it as a deduction if that time is found to lie beyond the period. And, in the case of expenditure for which the taxpayer contracted a liability during an earlier accounting period than that in which it has matured, it is not

The Positive Limbs – Nexus Issues

Amalgamated Zinc (de Bavay’s) Ltd v FCT cont. the practice to consider whether its effect upon the production of income of a still continuing undertaking has already been exhausted …. In the present case, the actual expenditure was met in the current year. But it was completely dissociated from the gaining or production of the assessable income of that year. The payment, in effect, did no more than keep down an annual charge arising out of a business which had closed. It is a charge of uncertain duration and of uncertain amount. It is not clear whether it is levied because no new owner has been found for the mine in respect of which it was imposed by the statutory scheme, or because the liability is considered to remain with the taxpayer notwithstanding a change of ownership of the mine. But these, in my opinion, are matters of no importance. What is important is the entire lack

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of connection between the assessable income and the expenditure. None of the assessable income arose out of the business in the course of which the taxpayer became liable to the charge. The sources from which the assessable income did arise included no operations in the course of which the payment was made. It was a payment independent of the production of the income, not an expenditure incurred in the course of its production …. An attempt was made to support the view that its metalliferous business notionally continued because one or two very trivial matters connected with the past unexpectedly arose during the years in question, and, in the following year, the taxpayer repaid a large overpayment which was found to have been made to it. But the very character of the incidents, their fewness and the triviality of all but the last, really serve to confirm and to illustrate the conclusion that the taxpayer’s metalliferous business had altogether terminated.

Latham CJ, McTiernan and Starke JJ in separate judgments, and Rich and Evatt JJ in a joint judgment, concurred with Dixon J. As a result, the taxpayer in Amalgamated Zinc (de Bavay’s) Ltd was never able to take its expenses into account for tax purposes, even though the assessable income from mining to which they related was fully taxed. [7.355]

7.21

Question

Could the taxpayer in Amalgamated Zinc (de Bavay’s) Ltd have tried to deduct the “present value” of the expected payments just before the business ceased?

[7.360] A similar approach under the 1936 Act’s general deduction provision, s 51(1), was

pursued by the High Court in Ronpibon Tin NL v FCT (1949) 78 CLR 47. The taxpayer in Ronpibon had operated a tin mine in Thailand (then called Siam) prior to World War II. When the Japanese occupied Siam, the manager and assistant manager of the mine were interned. Their dependants had previously returned to Australia. In lieu of salary to the interned employees, the taxpayer paid allotments to the men’s dependants for their support. The High Court denied the taxpayer deductions for these amounts, stating, “The company could in the circumstances hardly do otherwise than make the payments but from the point of view of the income-tax law they could not be regarded as business expenditure, unless with reference to the past tin-mining operations which the company had carried on in Siam or to future operations there which it hoped to resume”. Many commentators have suggested the scope of the temporal nexus doctrine, and in particular the requirement that the source of income to which the expense relates remain in existence, has been cut back considerably following the Full High Court decision in AGC (Advances) v FCT. The taxpayer in AGC (Advances) was a finance company which encountered substantial financial difficulties. A scheme of compromise and arrangement was entered into, pursuant to which a special manager was appointed to realise the company’s [7.360]

425

The Tax Base – Deductions

assets and make the proceeds available to the company’s creditors. The company’s finance operations were suspended as the manager carried out the scheme of arrangement until the company was sold to new owners, who changed the name of the company and its place of business before causing it to resume its finance operations. The company subsequently sought to deduct as allowable deductions instalments due to it under hire-purchase agreements that it had written off as uncollectable. The amounts in question related to transactions entered into prior to the scheme of arrangement and suspension of operations. Counsel for the ATO, relying upon the Amalgamated Zinc (de Bavay’s) Ltd precedent, argued that the amounts were not deductible because the break in the taxpayer’s business during the period of the operation of the scheme prevented the business being regarded as a continuing business. The Court rejected that argument, concluding that the business had continued, notwithstanding the break. The judgments went somewhat further than this simple conclusion, however, as the judgment of Barwick CJ reveals.

AGC (Advances) Ltd v FCT [7.370] AGC (Advances) Ltd v FCT (1975) 132 CLR 175 Full High Court Barwick CJ: It is not possible now, to construe s 51 to mean that the expenditures and losses to be deducted must relate precisely to the assessable income which is returned for a year in which the expenditures are made or the losses are suffered. In the application of this unduly condensed provision, it has not been possible to utilise the definite article so as to require the expenditure in question to have produced or to have assisted to produce the assessable income of the particular year of the expenditure. Nor can it be construed to require that the loss be similarly related to the assessable income of the particular year – see FCT v Finn and cases there cited. … It seems to me that the most that could be deduced from the construction of the section applied in Amalgamated Zinc (de Bavay’s) Ltd v FCT in relation to an expenditure is that where there has been a break in the carrying on of the business yielding the assessable income of the particular year that business must in its nature be substantially the same as that which was carried on at the earlier period of time. But in any case, in my opinion, Amalgamated Zinc (de Bavay’s) Ltd v FCT has nothing to say as to the deduction of losses. It is quite clear that a loss may not show up for years after money has been ventured in a business. The present is a very good illustration. The hire-purchase agreement was entered into, and after a period default is made not only in making the agreed instalments, but in 426

[7.370]

the return of the goods. A considerable interval of time may well elapse between the date of the hire-purchase and the realisation that neither the instalments nor the goods are recoverable. The loss from an accounting point of view must occur at the time when the appellant accepts the position that the debt is irrecoverable. If a hirepurchase company decided to wind up and to discontinue the granting of hire-purchase agreements in a particular year, and in a subsequent year the company in liquidation found itself unable to recover instalments of hire on the goods in circumstances which caused it to write the amount off as a bad debt, it seems to me not merely unjust but unacceptable to hold that it could not deduct that loss as a loss which it had incurred in the course of gaining assessable income. The problem of deciding whether any and if so what relationship should exist between the assessable income of the particular year and the loss, in my opinion, does not arise as it has done in relationship to any expenditure. It is clear enough, it seems to me, that in order to be a relevant loss it must be a loss of money which has been put out in order to gain assessable income. It may be, and I have no need to decide that question at the moment, that if a long period of years separated the two events and meantime the company had started a different business or become an investment company as in Amalgamated Zinc (de Bavay’s) Ltd v FCT, it may

The Positive Limbs – Nexus Issues

AGC (Advances) Ltd v FCT cont. be necessary if that decision is followed in such a case to say that the relationship between the two had ceased to be sufficiently proximate. It would suffice for my present purpose that I am not

CHAPTER 7

satisfied that, in order to be deductible, the loss which flows from carrying on a business carried on to gain assessable income need necessarily occur in a year when the company is actively carrying on that business.

In the course of his judgment, Mason J appeared to suggest he would overturn de Bavay, were the option open to him. Mason J: Looking at the question de novo, the case for saying that “the assessable income” in s 51(1) means assessable income of the taxpayer generally without regard to division into accounting periods is to my mind irresistible. There is every reason for thinking that the definite article was used so as to designate the income of the taxpayer generally rather than the income of the taxpayer in the year in question. It is inconceivable that Parliament intended to confine deductions to losses and outgoings incurred in connection with the production of income in the year in question and to exclude losses and outgoings incurred in connection with the production of income in preceding or succeeding years. True it is that the expression “in gaining or

producing” as it applies to assessable income may allow some expansion in the relationship which it would otherwise prescribe between the loss or outgoing and the production of income in the year in which the loss or outgoing was incurred, but the expanded relationship thereby suggested is hinged upon the notion that the taxpayer is conducting a continuing business, a concept which finds no expression in the first limb of s 51(1) for the ascertainment of the allowance of a deduction. The preferable course, so it seems to me, is to read the reference to assessable income in the first limb of s 51(1) as a reference to the assessable income of the taxpayer generally.

[7.380] In a separate judgment, Gibbs J concurred in the result. Unlike Mason J, however, he

did not reject the reasoning in de Bavay, distinguishing the case instead. De Bavay has since been cited as authority for the temporal nexus requirement in Freeman v FCT (1983) 14 ATR 457. The extent to which AGC (Advances) Ltd v FCT modifies the temporal nexus requirement of de Bavay’s case was the principal issue in the Full Federal Court decision in Placer Pacific Management Pty Ltd v FCT. The taxpayer in Placer Pacific had carried on a business of manufacturing conveyor belts. The conveyor belt business was sold, with the taxpayer agreeing to retain liability for any claims arising out of sales prior to the transfer of the business. A few months later a former customer launched a claim against the taxpayer that was ultimately settled. The ATO disallowed a deduction for the settlement payment and associated legal expenses, among other things on temporal nexus grounds. The taxpayer was unsuccessful in its appeal to the AAT and appealed to the Full Federal Court.

[7.380]

427

The Tax Base – Deductions

Placer Pacific Management Pty Ltd v FCT [7.390] Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253 Full Federal Court Davies, Hill and Sackville JJ: The High Court unanimously held [in de Bavay’s] that the amount of the contribution was not deductible in the year of income. The judgments recognise, at least to a limited extent, that the words “incurred in gaining or producing the assessable income” could not be interpreted as requiring that the outgoings sought to be deducted be designed to produce income in the year in which those outgoings were incurred. … Dixon J, while accepting that a wide meaning should be given to the expression “incurred in gaining or producing the assessable income”, read those words however, as referring to the assessable income from which the deduction was to be made. As the actual expenditure was, to use his Honour’s words, “completely dissociated” from the gaining or producing of the assessable income of the year in which the contributions were made, it was not deductible. It was for that reason that his Honour held that there was no connection between the “assessable income” (that is to say the income of the year in which the outgoing was met) and the expenditure. … Some forty years later the High Court came to consider, in the context of the present Act, the deductibility of losses written off by AGC (Advances) Ltd at a time when it had ceased to carry on its financing business. … In AGC … Mason J referred to De Bavay’s case and Ronpibon and said that in construing the first limb of s 51(1) it was open to the court to determine whether the words “the assessable income” should refer to the assessable income of the taxpayer in a particular year in which the expenditure was incurred or the assessable income of a taxpayer generally without regard to

division into accounting periods. In his Honour’s view the latter view was “irresistible”. … In our view AGC should be taken as establishing the proposition that provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later than the year in which the income was incurred [sic] and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility. There is no relevant distinction to be drawn between losses and outgoings. Provided the occasion for the loss or outgoing is to be found in the business operations directed to gaining or producing assessable income, that loss or outgoing will be deductible unless it is capital or of a capital nature. On the facts of the present case the occasion of the loss or outgoing ultimately incurred in the year of income was the business arrangement entered into between Placer and NWCC for the supply of the conveyor belt which was alleged to be defective. The fact that the division had subsequently been sold and its active manufacturing business terminated does not deny deductibility to the outgoing. A finding to the contrary would lead to great inequity. Many businesses generate liabilities which may arise in the considerable future. Such liabilities are sometimes referred to as “long tail liabilities”. To preclude deductibility when those liabilities come to fruition on the basis that the active trading business which gave rise to them had ceased would be unjust.

[7.395]

7.22

428

Is Placer Pacific distinguishable from de Bavay’s?

[7.390]

Questions

The Positive Limbs – Nexus Issues

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7.23

If the result in Amalgamated Zinc (de Bavay’s) Ltd would remain the same today under s 8-1 following AGC (Advances) and Placer Pacific, could the taxpayer take advantage of the capital gains provisions to recover any of the outlay as part of the cost basis for an asset? Has the taxpayer acquired anything as a result of the expenditure or merely satisfied an obligation?

7.24

The taxpayers took out a loan to establish a delicatessen. The business was sold at a loss and the proceeds applied to reduce the loan principal. However, as they were not sufficient to redeem the loan entirely, the taxpayers continued to incur interest expenses for a period after the sale of the business. Are the interest payments deductible? (See Brown v FCT (1998) 39 ATR 226.)

7.25

The taxpayer carried on business in partnership with her husband until his death, borrowing money from the ANZ Bank for the purposes of the business. The loan was secured against the family home. The partnership was allowed deductions for the interest expenses in the years in which the business operated. The business ceased on the death of the husband. After her husband’s death the taxpayer continued to make loan repayments and claimed deductions for the interest expenses. More than half her wages as a nurse were used to make the repayments. A few years later, the taxpayer borrowed funds at a lower interest rate from a mortgage provider to pay off the ANZ loan. The taxpayer claimed deductions for the interest payable on the substitute loan. Will the deductions be allowed? (See Jones v FCT (2002) 49 ATR 188.)

7.26

The taxpayer acquired land for the purpose of subdivision and sale. Only one subdivided lot was sold and the land was subsequently sold by the mortgagee. Five years later, a person who had contracted to purchase some lots from the taxpayer sued for breach of contract and was awarded damages. Can the taxpayer deduct the damages as a business expense given the passage of time from when it was actively selling the land? (See AAT Case 9605 (1994) 30 ATR 1001.)

7.27

The taxpayer entered into machine leases to operate a “mobile workshop” business. When the business became insolvent the lessors sold the leased equipment and called on the taxpayer to meet the shortfall in the balance owing under the leases. Is this expense deductible? (See Evenden v FCT [1999] AATA 731.)

7.28

The taxpayer borrowed funds to purchase an interest in a blueberry growing project. The project went into receivership and the taxpayer missed loan payments, triggering a condition in the loan agreement that collapsed the loan and required repayment of the interest and principal. The taxpayer failed to repay the loan and as a consequence, interest payments on this liability accrued. The ATO argued these interest obligations were attributable to an intervening event, the trigger in the financial contract, and not to the original business. Will the taxpayer be allowed to deduct the subsequent interest payments? See FCT v Guest (2007) 65 ATR 815; [2007] FCA 193.

[7.400] One often very large expenditure that was treated as non-deductible under s 8-1 on

the basis of insufficient temporal nexus was the cost of rehabilitating mining and petroleum extraction sites, as the expenditure can only be incurred after all income-producing activities have ceased. The legislature has addressed the problem with a statutory amendment and s 40-735 now allows a deduction for these costs.

[7.400]

429

The Tax Base – Deductions

7. DUAL-PURPOSE EXPENSES AND APPORTIONING OUTGOINGS (a) Dual Purposes and Apportionment [7.410] Taxpayers may incur an expense for the dual purposes of realising an economic gain

and deriving another benefit such as a personal consumption benefit. Expenditures that are, on their face, incurred only for the purpose of realising an economic gain may, in turn, be conceptually dissected into two types – expenses incurred to generate real gains that will be subject to taxation and expenses incurred to generate after-tax gains from transactions that may or may not yield gains in the real world. Exploiting tax rules to generate after-tax gains from transactions that involve little or no gain in the real world or, indeed, as we shall see in some cases, where there is a loss in the real world, can take many forms. The most common examples of dual-purpose outgoings designed, in part, to exploit aspects of the tax system, are found in income-splitting cases, transfer-pricing cases, mismatched deductions and gains cases, and timing manipulation cases. We saw in the Herald and Weekly Times case (extracted above) that the predecessor section to s 51(1) allowed taxpayers a deduction for expenses incurred wholly and exclusively for the production of assessable income. In the 1936 revision of the Act, “wholly and exclusively” was removed from the deduction provisions and replaced by the phrase “to the extent” in s 51(1). The current general deduction provision, s 8-1, contains the same words, as do many, though not all, of the specific deduction sections. The phrase “to the extent” offered the ATO and courts the possibility of apportioning dual-purpose outgoings, but the phrase contains no explicit apportionment formula. On what basis should dual-purpose expenses be apportioned? Consider, for example, a company that derives exempt income and assessable income. Should the cost of the company’s employees, rental for its office, and so forth be apportioned by using the ratio of assessable income to total income? Or should each outgoing be analysed to determine the extent to which it related to one type of income or the other? The former approach would clearly be the easiest – under this system, a taxpayer deriving $100 exempt income and $100 assessable income would be permitted to deduct half the costs of running the business. On the direct allocation system, the taxpayer would have to allocate each expense separately – the receptionist’s salary would be apportioned depending on how many telephone calls she answered related to the derivation of exempt income and how many related to the derivation of assessable income, and so forth. There is no doubt the ratio system would be far easier for all parties. Which system is correct as a matter of law was one of the issues dealt with by the High Court in Ronpibon Tin NL v FCT. As one of the first important Full High Court decisions considering the apportionment words of s 51(1), the predecessor to s 8-1, Ronpibon became and remains one of the most important authorities on the application of the provision and its apportionment formula. The taxpayer in Ronpibon derived both exempt foreign-source income from mines in Siam (as Thailand was called at the time) and assessable Australian-source income. The Commissioner apportioned the expenses incurred at the head office between amounts referable to the assessable income and amounts referable to the exempt foreign-source income. The apportionment was somewhat complicated by the fact that the taxpayer’s mines were confiscated by the Japanese following their invasion of Siam during the war. Among other things, the taxpayer claimed it was deriving no exempt income following the loss of its mines, so there was no reason to apportion head office expenses by regards to the amount related to 430

[7.410]

The Positive Limbs – Nexus Issues

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the mines. The High Court rejected this argument and then considered how the expenses should be apportioned. The appeal was heard with an appeal by another company in similar circumstances to the taxpayer, hence the references to the “companies” on occasion.

Ronpibon Tin NL v FCT [7.420] Ronpibon Tin NL v FCT (1949) 78 CLR 47 Full High Court In Melbourne, where each company had its registered office, expenditure was incurred in the central administration of the affairs of the respective companies. There were the directors’ fees, the expenses of management and the cost of cables, postages, stationery, audit fees and some minor incidental expenditure…. For example, for the 12 months ending 30 June 1941 the receipts of Ronpibon Tin No Liability from the proceeds of tin fell not much short of £100,000 while the interest from money invested did not quite reach £1,000. In dealing with the question what amount of the expenses incurred in Melbourne should be considered referable to the income from investments and allowed accordingly as a deduction from that income, forming as it did the only non-exempt or assessable income, the Commissioner took a short cut. He fixed two and one-half per cent of the income from investments as an adequate charge against that form of income and allowed as a deduction an amount so calculated. In doing so he followed a method which apparently he has found it convenient to employ in cases where it becomes necessary to apportion to income from investments part of the general expenses incurred by a company which has some other main purpose. … The charges for management and the directors’ fees are entire sums which probably cannot be dissected. But the provision contained in s 51(1), as has been already said, contemplates apportionment. The question what expenditure is incurred in gaining or producing assessable income is reduced to a question of fact when once the legal standard or criterion is ascertained and understood. This is particularly true when the problem is to apportion outgoings which have a double aspect, outgoings that are in part attributable to the gaining of assessable income and in part to some other end or activity. It is perhaps desirable to remark that there are at least

two kinds of items of expenditure that require apportionment. One kind consists in undivided items of expenditure in respect of things or services of which distinct and severable parts are devoted to gaining or producing assessable income and distinct and severable parts to some other cause. In such cases it may be possible to divide the expenditure in accordance with the applications which have been made of the things or services. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently. Of this directors’ fees may be an example. With the latter kind there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. It is an indiscriminate sum apportionable, but hardly capable of arithmetical or ratable division because it is common to both objects. In such a case the result must depend in an even greater degree upon a finding by the tribunal of fact. The reason why the Commissioner has adopted the practice of allowing two and onehalf per cent on income from investments as a deduction is no doubt because generally speaking it has been found to produce an adequate allowance and because he is forced by the exigencies of administration to provide his assessors with some fixed rule. But it is a more or less arbitrary expedient to which it is scarcely possible to resort judicially when the court is called upon to decide an appeal from assessment. The court must make an apportionment which the facts of the particular case may seem to make just, and the facts of the present cases are rather special. In making the apportionment the peculiarities of the cases cannot be disregarded. The taxpayers are companies. A directorate is necessary. The circumstances were such as to call for some consideration from time to time on the part of the directors of the [7.420]

431

The Tax Base – Deductions

Ronpibon Tin NL v FCT cont. investment of the money. Thus although the assessable income is only interest on government loans and fixed deposits, it is by no means a mere question of fixing a fair commission rate for handling the business. It is important not to confuse the question how much of the actual expenditure of the taxpayer is attributable to the gaining of assessable income with the question how much would a prudent investor have expended in gaining the assessable income? The actual expenditure in gaining the assessable income, if and when ascertained, must be

[7.425]

accepted. The problem is to ascertain it by an apportionment. It is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent. The question of fact is therefore to make a fair apportionment of each object of the companies’ actual expenditure where items are not in themselves referable to one object or the other. But this must be done as a matter of fact and therefore not by this Full Court. It will be enough for this court in answer to the question submitted in each case to make a declaration in accordance with the principles stated.

Questions

7.29

The Court rejected the use of arbitrary, predetermined criteria for apportioning outlays and suggested it should be done on a case-by-case basis as dictated by the circumstances in any particular instance. Most of the litigation since has turned on the questions of when and how taxpayers should apportion their outlays. How might expenses be apportioned? For example, assume a company pays a manager a salary of $50,000 each year and the manager’s efforts result in the derivation of $100,000 of assessable income and $100,000 of exempt income each year. Assume further that the time spent by the manager in the production of the exempt income amounts to 75 per cent of her working hours. Should her employer be entitled to a deduction for 25 per cent or 50 per cent of her salary or should some other figure be used?

7.30

Expenses such as directors’ fees can be apportioned on a de facto basis, as well as on a notional tax basis. For example, directors’ remuneration could be determined by reference to the exempt income and assessable income attributable to the directors’ efforts and the resultant directors’ fees could be paid by means of two separate cheques. Other expenses cannot be subject to a de facto apportionment. Consider, for example, the cost of a taxpayer’s airfare to Hong Kong where the taxpayer made the trip for equal purposes of pleasure and work. Either the airfare is paid or it is not – the taxpayer cannot break the outlay into two separate elements in the same manner as the directors’ fees could be. Does this difference preclude apportionment in the latter case?

7.31

The taxpayer was a friendly society that derived exempt income and assessable income. It incurred advertising expenses to enhance its corporate image and to sell a range of products, some of which yielded assessable income and some of which generated exempt income. How can the expenses be apportioned? (See FCT v Manchester Unity IOOF (1994) 94 ATC 4235 and 4309.)

[7.430] The fact situation in Ronpibon presented a relatively simple dual-purpose outlay

situation – a taxpayer derived exempt and assessable income from a single outlay and the question was how to apportion the expenditure between the two. In most dual outgoing situations, the dual purposes are not so readily apparent. On their face, most dual-purpose outgoings are prima facie incurred only to earn assessable income; the other purpose becomes 432

[7.425]

The Positive Limbs – Nexus Issues

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clear only if a transaction giving rise to the expenditure is considered in its entirety, and in the context of the taxpayer’s overall business and investment arrangements. As Ronpibon showed, dissection may involve some complications even in a case where the dual purpose is relatively straightforward because the taxpayer has derived exempt and assessable income. The problems multiply many times when the dual purpose relates not to the derivation of two classes of income, but rather to the realisation of an apparent benefit (the derivation of taxable income) and a tax benefit (a reduction in the taxes ultimately payable). The courts have had a difficult time grappling with the problem of apportionment when the taxpayer incurs an expense with the dual purpose of deriving assessable income and minimising tax. As we shall see, doctrines have varied between two approaches: a strict “legal rights” approach that looks only at the legal rights acquired with the expenditure and ignores the tax minimisation benefit; and a “purposive” approach that looks behind the legal rights acquired to the tax minimisation benefits intended and then looks for a way to dissect the payment into deductible and non-deductible portions. It is obvious that the courts have a responsibility to analyse a taxpayer’s outgoings in light of the apportionment formula in s 8-1. But it should be equally clear that it would be inappropriate for a court to analyse the effectiveness of or the necessity for an expense by relying on after-the-fact hindsight. For example, if a business mistakenly advertises on television when it should have advertised in the newspapers and, as a result, generates no sales from the advertising campaign, it would be wrong to deny them the cost of the ads because it turned out the outgoings were not necessary to the carrying on of the business. In the words of the Court in Ronpibon at 60: It is important not to confuse the question how much of the actual expenditure of the taxpayer is attributable to the gaining of assessable income with the question how much would a prudent investor have expended in gaining the assessable income. The actual expenditure in gaining the assessable income, if and when ascertained, must be accepted. The problem is to ascertain it by an apportionment. It is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent.

More than 30 years later, Deane and Fisher JJ expressed similar sentiments in Magna Alloys at 205: For practical purposes and within the limits of reasonable human conduct, it is for the man who is carrying on the business to be the judge of what outgoings are necessarily to be incurred. It is no part of the function of the Act or of those who administer it to dictate to taxpayers in what business they shall engage or how to run their business profitably or economically.

It has sometimes been argued, particularly in the 1970s, that statements such as these preclude the courts from examining an outlay to determine its purpose. This is not what the judges were suggesting in these remarks, however. The apportionment wording in s 8-1 clearly requires the ATO and courts to undertake a purpose analysis of an outgoing. But once the purpose has been determined and it is decided that the purpose satisfies one of the positive limbs of s 8-1, neither the ATO nor courts should consider the appropriateness of the size of the expenditure. This approach is sometimes labelled the “business judgment rule” – once a court concludes an expenditure or part of the expenditure satisfies the positive limbs of s 8-1, it should not question the wisdom of the expense. Drawing a line between expenditures to earn assessable income and expenditures incurred with other aims in mind is difficult in the context of the business judgment rule. The rule suggests that a court should not question the business judgment decision of a taxpayer who uses a $4,000 mahogany desk instead of a $400 laminated particle board desk. But what of the [7.430]

433

The Tax Base – Deductions

taxpayer who pays $4,000 for a particle board desk acquired from a shop operated by the taxpayer’s spouse or child? In this case, in the totality of the circumstances, should it be open to the court to respect the business judgment rule but still conclude the payment of $4,000 instead of $400 was made with dual purposes of acquiring the desk and shifting some taxable income to a close relative?

(b) Transfer Pricing [7.440] Many of the leading cases involving dual-purpose outgoings concern transfer-pricing

transactions. As we will see, these earlier cases gave rise to the “legal rights” doctrine, which presumed a court could not look beyond the legal effect of an expense to discover its dual, or indeed in some cases, real purpose. Transfer-pricing transactions usually involve a taxpayer overpaying for the acquisition of goods or services with the object of lowering the taxpayer’s taxable income and increasing the taxable income of a related party who is subject to a lower (or nil) tax rate. A key transfer-pricing precedent and one that helped establish the strict legal rights test doctrine applied to deductible expenses is the High Court decision in Cecil Bros v FCT. The Cecil Bros case involved a domestic transfer-pricing scheme. To transfer income from the taxpayer to a related company, the taxpayer interposed the related company between itself and a supplier. The interposed company added a considerable mark-up to the trading stock it on-sold to the taxpayer, generating large profits for itself and leaving very little room for profits by the taxpayer. The Commissioner relied on both the apportionment feature of s 51(1) and the general anti-avoidance provision in the Act, s 260, to limit the taxpayer’s allowable deductions to the amount paid by the interposed company for the trading stock. The taxpayer’s appeal to the High Court was heard by Owen J at first instance.

Cecil Bros Pty Ltd v FCT [7.450] Cecil Bros Pty Ltd v FCT (1962) 8 AITR 523 High Court Owen J: The first submission made in support of the Commissioner’s assessment was based upon s 51(1). It was contended that, of the total payments of £230,000 made by the taxpayer to Breckler Pty Ltd, the amount of £19,777 should not be regarded as an outgoing incurred in gaining or producing the taxpayer’s assessable income. The amount was paid, so it was argued, not as part of the purchase price of goods supplied but to provide Breckler Pty Ltd with income. I do not agree with this submission. The fact that the taxpayer paid more for its purchases than it would have paid had it dealt direct with the manufacturers or wholesalers in order that

434

[7.440]

Breckler Pty Ltd might make a profit out of the transactions does not, in my opinion, prevent the amount which it in fact paid from being regarded, for the purposes of s 51(1), as an outgoing incurred in gaining its assessable income. It seems to me that the contention really is that the taxpayer paid more for its goods than it should have. But “it is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent” (Ronpibon Tin N.L. and Tongkah Compound NL v FCT and the cases therein cited).

The Positive Limbs – Nexus Issues

CHAPTER 7

[7.460] Notwithstanding his conclusion that the taxpayer’s outgoings satisfied s 51(1),

Owen J decided in favour of the Commissioner by applying a general anti-avoidance provision, s 260 of the 1936 Act. The taxpayer appealed from the judgment of Owen J to the Full High Court. Responding to the appeal, the Commissioner made what turned out to be a grave tactical error. Rather than address the s 51(1) argument, the Commissioner only dealt with the s 260 issue. On appeal, the Full High Court Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430 concluded that even if the arrangements were seen as a tax avoidance arrangement, s 260 did not authorise the Commissioner to substitute a lower figure for that actually paid by the taxpayer so long as the evidence showed the higher amount had actually been paid by the taxpayer and was done so pursuant to a contract to acquire trading stock, not as a de jure gift to the interposed company, whatever its de facto effect. Because the Court did not address the possibility of apportionment under s 51(1), the original decision, that the legal effect of the outgoing only should be considered, stood. Had the Commissioner appealed on the s 51(1) question, he might well have been successful. As it turned out, the uncontested decision of a single judge became an important s 51(1) precedent. The transfer-pricing scheme in Cecil Bros was designed to shift profits to an interposed company from which they could be distributed to a number of family members for income splitting purposes. Prior to 1984, many transfer-pricing cases involved arrangements to shift profits from one profitable company to a loss company within the same company group. Companies within the same group (that is, controlled by the same ultimate owners) were treated as completely separate legal persons for tax purposes. Profitable companies in a group would seek to shift income to loss companies to absorb those losses, and transfer-pricing arrangements were usually the easiest way to achieve this. Subsequent to the Cecil Bros case, the Income Tax Assessment Act 1936 was amended to prevent transfer pricing through the acquisition of trading stock. The scope of the new provision, currently s 70-20, is very narrow – it applies only to purchases of trading stock. Thus, the statutory measure plays no effective role in countering similar schemes that rely on deductions for things other than trading stock. By way of contrast, the case that led to the adoption of the predecessor to s 70-20, Cecil Bros, became a leading precedent and opened the door to a wide range of tax minimisation arrangements. In 1984, measures were inserted into the 1936 Act to allow companies to transfer losses within a company group (now s 170-5 of the ITAA 1997). The combination of these measures either prevented or made unnecessary the Cecil Bros and loss-company types of transferpricing arrangements. There were many other reasons to engage in income diversion by means of excessive deductions, however, and taxpayers continued to rely upon the legal rights doctrine (looking only at the de jure effect of a legal contract) as the basis for many other transfer-pricing schemes. The legal rights doctrine reached its zenith in the decision of the Privy Council in Europa Oil (NZ) Ltd (No 2) v IRC (NZ). Europa Oil also involved a transfer-pricing scheme, this time engaged in by a New Zealand taxpayer. The Privy Council decision on the appropriate application of the New Zealand provision equivalent to s 8-1 became the leading precedent in

[7.460]

435

The Tax Base – Deductions

Australia, no doubt in part because the then Australian Chief Justice, Sir Garfield Barwick, was a member of the bench that decided the case. The dispute in Europa Oil (No 2) arose out of a transfer-pricing scheme in which the taxpayer oil company and its supplier jointly interposed a shell company in the Bahamas between the supplier and the taxpayer. The supplier undercharged the interposed company and the taxpayer overpaid for supplies so both parties could divert profits to the tax-free Bahamas. The Inland Revenue Commissioner tried to limit the New Zealand company’s deductions for the cost of the processed oil to the cost of the product to the Bahamas company. The Privy Council (with one dissent) allowed the taxpayer’s appeal.

Europa Oil (NZ) Ltd (No 2) v IRC (NZ) [7.470] Europa Oil (NZ) Ltd (No 2) v IRC (NZ) [1976] 1 WLR 464 Privy Council In this appeal, as in the previous appeal, the particular expenditure claimed to be deductible under the section consists of moneys paid by the taxpayer company under contracts for the sale of goods whereby the property in the goods was transferred by the seller to the taxpayer company. The moneys so paid were stated in those contracts to be the price at which the goods were sold; and since the goods were acquired by the taxation company as stock-in-trade for its business of marketing petroleum products in New Zealand, there is no question that, if those contracts had stood alone, the whole of the moneys payable under them would be expenditure by the taxation company that was deductible under [the equivalent of s 8-1]. Those contracts, however, did not stand alone. They formed part of a complex of interrelated contracts entered into by various companies that were members of the Todd Group or the Gulf Group in connection with the same goods. The question in both appeals can accordingly be stated thus: is the legal effect – as distinct from the economic consequences – of the provisions of the relevant interrelated contracts such that when the taxpayer company orders goods under the contract of sale and accepts the obligation to pay the sum stipulated in that contract as the purchase price, the taxpayer company by the performance of that

obligation acquires a legally enforceable right not only to delivery of the goods but also to have some other act performed which confers a benefit in money or in money’s worth on the taxpayer company or some other beneficiary? If the answer is no, the full amount of the sum stipulated as the purchase price is deductible under [the equivalent of s 8-1]. If the answer is yes, the sum stipulated as the purchase price falls to be apportioned as to part to expenditure incurred in purchasing the goods and as to the remainder to expenditure incurred in obtaining performance of the other act, which in the instant case would not be deductible. [Their Lordships considered the contract pursuant to which the taxpayer acquired the trading stock and concluded the answer to the question they posed for themselves was “no”.] In respect of these contracts the case is on all fours with Cecil Bros Pty Ltd v FCT in which it was said by the High Court of Australia: “It is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income”; to which their Lordships would add: it is not for the court or Commissioner to say from whom the taxpayer should purchase the stock-intrade acquired by him for the purpose of obtaining his income.

[7.480] At the time of the Europa Oil (No 2) case, the ITAA 1936 contained a provision,

s 136, designed to prevent international transfer pricing by limiting deductions for payments to related foreign companies to the arm’s length price that non-related taxpayers would pay for the same goods or services. It was thought that s 136 would prevent the result in Europa 436

[7.470]

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The Positive Limbs – Nexus Issues

from occurring in Australia, whatever the effect of the legal rights doctrine in other dual-purpose cases. However, the High Court later read down s 136 to render it virtually impotent in transfer-pricing cases. The section was later replaced by an expanded anti-transfer pricing regime, Div 13 of the ITAA 1936, which in turn has been replaced from 29 June 2013 in the ITAA 1997 by Subdivs 815-B to 815-D.

(c) Ancillary Benefits [7.490] The approach taken by the High Court and Privy Council in Cecil Bros and Europe

(No 2) respectively is known as the “legal rights doctrine” – it suggests a court should look no further than the actual legal rights acquired as a result of an outgoing to determine if it fully satisfied the positive limbs of the deduction provision. The approach was cemented into Australian law by the Australian High Court in a case that was to become an important precedent in the Australian context, FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645. The taxpayer in South Australian Battery Makers entered into a scheme involving three parties – itself, an associated company called Property Options, and the South Australian Housing Trust (referred to in the case as the Trust). Property Options was owned by nominees who held their shares on behalf of Chloride, the company which owned the taxpayer. Under the scheme, the taxpayer acquired rental premises from the Trust, and Property Options acquired an option to purchase the property for its market value. The Trust entered into an agreement that would lower the purchase price of the property to Property Options by the amount of excess rental payments made by the taxpayer (that is, over and above the ordinary rental price which would be charged by the Trust). The ATO denied the taxpayer deductions for the excess rent, treating them as capital outlays based on an argument that the “rental” payments should be apportioned into the part actually paid for accommodation and the part used to reduce the associated company’s purchase price.

FCT v South Australian Battery Makers Pty Ltd [7.500] FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645 Full High Court Gibbs ACJ: [I]t is abundantly clear that those who managed the affairs of the taxpayer knew that the grant of the lease was part of a wider scheme designed to benefit another or other companies in the group. They knew that part of the payments made as rent would in effect be credited against the purchase price of the land if in the end the option was exercised, as in all probability it would be. It seems right to say that the payments were made not only with the knowledge, but also with the purpose, that part might be treated as part of the price of a capital asset which Property Options would probably acquire. The question is whether in these circumstances it may be said that the acquisition of the capital asset was an advantage sought in part by the payments, notwithstanding that the taxpayer had no right to share in or

benefit from the capital asset if acquired, and that the payments gave the taxpayer no right to ensure that Property Options did acquire the asset. I have said that in deciding whether outgoings made by a taxpayer are of revenue or of a capital nature, it is necessary to consider “the character of the advantage sought”. In my opinion, in principle, that must mean the character of the advantage sought by the taxpayer for himself by making the outgoings. Of course, as I have already indicated, a taxpayer may derive an advantage if someone else, such as a subsidiary, acquires an asset. But the fact that someone else incidentally derives an advantage of a capital kind

[7.500]

437

The Tax Base – Deductions

FCT v South Australian Battery Makers Pty Ltd cont. in which the taxpayer does not share is not enough to give the outgoings the character of capital. … The outgoings in the present case were genuinely made in payment of rent. The only advantage that the taxpayer sought or gained for itself by making the payments was that which it obtained as lessee under the lease. There was nothing to suggest that the taxpayer could or would share in the advantage which Property

Options would derive from the making of the payments, and the taxpayer had no legal right, or for that matter any power, to ensure that Property Options did secure its rights under the option. The advantages gained by Property Options are therefore irrelevant in deciding upon the character of the advantage sought by the taxpayer in making the payments. That advantage was of revenue character, namely the interest of a lessee, it was to be enjoyed in the ordinary way that such an interest is enjoyed, and it was to be obtained by periodical payments. The outgoings were not of a capital nature.

In a separate joint judgment, Stephen and Aicken JJ agreed with Gibbs ACJ. Jacobs and Murphy JJ dissented in separate judgments. Murphy J said: The lease expressed the total payments to be for occupation. But the wording of the lease is not controlling; the niceties of conveyancing must not be allowed to obscure the real substance of the transaction. The lease was a transparent device which is not consistent with the real transaction evidenced by the negotiations and various steps which the taxpayer revealed with refreshing frankness. The fact that the taxpayer was the assignee and not the lessee does not alter the real transaction. The companies were not at arm’s length; they were all associates in what was described as “the Chloride group”. Companies, like natural persons, can act as agents and intermediaries. The substance is that the payment for occupation (the true rent) was the amount for which the Electricity Trust was willing to let the premises to Associated Battery Makers. The excess was not payment for occupation but was intended to confer a benefit on Property Options. Payment for such purpose was not intended by the legislature to be an allowable deduction under s 51(1). It would make a mockery of the legislative intent if the taxpayer is able to pay to another (who finds it convenient because it is non-taxable or otherwise) excess amounts for goods or services on the basis that the excess will be passed on as a benefit for an associate of the taxpayer. …

438

[7.500]

The substantial economic reality must be dealt with. As Dixon J expressed it in Hallstroms Pty Ltd v FCT: What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. If the option were held by the taxpayer and the excess payment would reduce the purchase price for it, it would clearly be a payment of a capital nature. This was the position at the time the taxpayer became the assignee, but a little later the arrangement was altered so that the option was given to Property Options. It is difficult to see that the taxpayer’s position improves if the benefit is not to flow to it but to an associated company. In my opinion, the payment was of a capital nature and it excluded by s 51(1) even if the benefit flows, not to the taxpayer, but to another. Literal interpretations of the Act have allowed tax avoidance devices to succeed and have encouraged their growth. While the Act is read literally, no amount of legislative amendment will be able to stem the proliferation of such devices which are inconsistent with the general legislative

The Positive Limbs – Nexus Issues

FCT v South Australian Battery Makers Pty Ltd cont. intent. The strictly literal approach departs from the traditional respect of the courts for the legislative will. …

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Literal compliance with the terms of an Act is not enough if the real result is contrary to the general intention of the legislature. This approach should be taken to tax Acts.

[7.510] The government’s response to the South Australian Battery Makers case was the insertion of a new subdivision comprising ss 82KH – 82KL. These complicated and confusing provisions prevent taxpayers from repeating the scheme successfully employed in South Australian Battery Makers and from engaging in certain similar arrangements. However, they did not establish any general principles on the distinction between revenue payments and capital purchase instalment payments in other contexts.

In the 1980s, in a number of income splitting cases extracted below, there appeared to be a retreat by courts from the strict legal rights approach that does not look at the true economic benefits acquired as a result of an outgoing. However, the Full Federal Court decision in FCT v Firth suggests there is a limit to the retreat from a strict legal rights approach. The taxpayer in Firth borrowed funds on a “protected equity investment loan”, more colloquially known as a capital protected loan. Under a capital protected loan arrangement, the borrower agrees to use the funds to purchase an asset (usually shares in publicly-listed corporations) from a list of acceptable assets, and the lender agrees the loan will be secured by the assets but otherwise on a non-recourse basis. This means that if the shares (assuming the security asset is shares) go up in value, the taxpayer can sell them when the loan matures, use the proceeds to pay off the principal, and keep the profits. If the shares fall in value, the lender must accept the shares in satisfaction for the loan principal so there is no risk of loss to the investor. To protect itself, the lender will normally charge a slightly higher interest rate than would otherwise be the case and use the additional amount to purchase “put” options on the shares. These options give the holder the right to require the person at the other end of the option agreement to purchase assets at a pre-determined price. The lender will enter into put options for all the shares used as security on the capital protected loans, with the put option price being the value of the shares when they are first acquired (that is, an amount equal to the loan principal). If the shares go down in value and the borrower hands them over to the bank in satisfaction of the borrower’s obligation to repay the principal, the bank can exercise the option and sell the shares for an amount equal to the loan principal. The taxpayer in Firth appealed his assessment after the ATO denied him a deduction for the full amount of interest paid on capital protected loans. The ATO pro-rated the payments into a portion he claimed represented the interest rate on an ordinary secured loan and the excess, which he claimed represented the price paid for the non-recourse guarantee (that is, the amount the lender presumably used to acquire put options to protect itself). The Full Federal Court rejected the ATO’s apportionment approach.

[7.510]

439

The Tax Base – Deductions

FCT v Firth [7.520] FCT v Firth (2002) 50 ATR 1 Full Federal Court Sackville and Finn JJ: The Commissioner’s submissions focused on the terms of the PEIL agreements. The submissions appeared to assume that the single factor elevating the interest rates above the “Benchmark” (however ascertained) was the limited recourse provisions of each agreement. Each agreement, however, contained many interrelated terms and conditions. The extent of the risk assumed by the lender was influenced, for example, by the particular stocks approved for the purposes of the agreement; the volatility of those stocks; the term of the loan; the fees payable by the taxpayer under the agreement; and the likely range of movement of the share market over the term of the loan. All of those factors would necessarily be reflected in the interest rate charged by the lender and agreed to by the taxpayer. Depending on the circumstances, an unsecured loan to an investor who intends to use the loan to acquire stocks might create as great or even a greater risk for the lender than a non-recourse loan to another investor who intends to invest in the same stocks. In our view, the aggregate of the terms and conditions of each PEIL agreement, including the non-recourse provisions, constituted the basis on which the lender advanced funds to the taxpayer for the purpose of enabling him to acquire capital assets or working capital (depending on one’s view of his activities). The relatively high interest rate doubtless reflected the lender’s assessment of the risk that it was incurring in making an advance on all the terms and conditions of the

agreement (as well as other commercial factors). There is, however, nothing in the agreement which suggests that any portion of the interest liability incurred by the taxpayer was attributable to a particular provision in the agreement. Nor is there anything in the agreement to suggest that the taxpayer’s purpose in incurring the interest liability was otherwise than to raise and maintain the borrowing. The provisions of each PEIL agreement, including those governing the taxpayer’s options concerning repayment and limiting the lender’s remedies, were integral elements of the loan itself. The non-recourse provisions, in particular, were not distinct from the loan or severable from it. That the taxpayer entered into the PEIL agreements doubtless evidences an intent on his part to have the benefit of a non-recourse loan rather than of some different type of loan facility and a willingness on his part to pay a higher rate of interest for a loan that included such a benefit. But insofar as the terms of the PEIL agreements reveal the taxpayer’s purpose in incurring the particular interest liability, they indicate no more than that his purpose was to raise and maintain the borrowing for the purpose for which the loan was being sought, that is to acquire Approved Stocks. There was no finding made that evidence extrinsic to the terms of the contract itself modified that purpose. There is, in consequence, no basis for s 8-1(2) of the ITAA 1997 applying so as to require apportionment of the interest liability incurred and discharged by the taxpayer.

[7.530] Hill J agreed with the result in a separate judgment.

The legislature responded to the Firth decision with the enactment of Div 247, which now apportions interest expenses on capital protected loans. Ironically, one effect of the amendment may have been to reinforce the judicial no-apportionment approach taken in Firth. Some observers have suggested that by addressing the narrow issue in Firth rather than enacting a broader generic solution to deal with all cases of dual benefits, the legislature in effect endorsed the strict legal rights approach adopted by the Court in Firth for any cases not covered by the Div 247 capital protected loans rule.

440

[7.520]

The Positive Limbs – Nexus Issues

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(d) Income Splitting [7.540] In a progressive tax system, higher taxes will be levied on one income derived by a

single person than on two incomes derived by two persons, even if together the two incomes equal that of the single person. Split incomes can shelter under two tax-free zones at the bottom end of the income tax rate scale and can enjoy the benefits of lower marginal rates twice. The most efficient way of splitting income for tax purposes is to divert it from a high bracket taxpayer to a lower bracket taxpayer before it is derived by the former person. However, there are some doctrinal and statutory impediments to splitting in this manner, particularly for taxpayers deriving income from labour. In these cases, taxpayers seek to split income by arranging for a high-income taxpayer to incur a deductible expense payable to a related lower-income taxpayer. Like transfer-pricing arrangements, income splitting only takes place if the person acquiring a good or service from a related party pays more than he or she would in an arm’s length transaction. In the transfer-pricing situation, the ultimate owners of two entities seek to achieve the best after-tax gain for the group of entities as a whole. In the income splitting case, there is no common ownership of the two parties. Rather, they are related by family or personal ties and the shift of taxable gains from one person to another minimises taxes only if one assumes the transferor will ultimately benefit from the transferred income. Of course, in one sense that assumption automatically follows from the shift – apart from charitable gifts, people do not regularly give large parts of their incomes to unrelated persons. The ATO relies on a number of provisions to combat direct income splitting – that is, overpayment for the provision of goods or services by a related person. The most important section is s 8-1, which in theory permits apportionment where a payment is made partly to acquire the good or service used to generate assessable income and partly to shift taxable income to a related person in a lower tax bracket. Apportionment of this sort would not be possible under the legal rights doctrine articulated in Cecil Bros and Europa Oil (No 2). However, as we shall see below, the Phillips case opened the door to apportionment in these circumstances. Two other key avenues used to combat direct income splitting are Pt IVA of the ITAA 1936 and s 26-35 of the ITAA 1997. Pt IVA, the general anti-avoidance provisions (GAAR) can be used where the dominant purpose of a transaction is to obtain a tax benefit. Section 26-35 allows the ATO to substitute the arm’s length price where a taxpayer seeks to deduct an inflated amount for the provision of goods or services from a relative. It is a potentially harsh provision in that it addresses the deductibility of the expense only, not its assessability to the recipient. In other words, the payer could be denied a deduction for the “gift” part of an excessive payment, but it could still be treated as assessable income to the recipient. The application of s 26-35 is examined further in Chapter 10. The simplest income splitting technique is a deductible payment by a high bracket taxpayer to a related lower bracket taxpayer. More sophisticated arrangements involve the use of interposed entities. Two variations are common. The first involves the interposition of an interposed entity, most commonly a trust, between a taxpayer and the source of income. The second involves the interposition of an interposed entity between the taxpayer and the intended recipient of diverted income. A taxpayer seeking to split consulting income with her spouse can be used to provide an illustration of the first type of arrangement. Rather than derive the income directly, the [7.540]

441

The Tax Base – Deductions

taxpayer could establish a trust or company to provide services to outside customers. The taxpayer and her spouse could then be employed by the entity and both could receive salaries, even though only the taxpayer actually provided the service to the customers of the entity. So long as the salaries to the taxpayer and her spouse equal the net income of the trust or company, there will be no taxable income derived by the entity and the gain will be split between the taxpayer and her spouse for income tax purposes. If a company is used, the taxpayer could arrange for herself and her spouse to be directors of the company and pay excessive remuneration to the spouse as directors’ fees in addition to, or as an alternative to, excessive salary. Section 109 of the ITAA 1936, dealing with excessive remuneration to an employee shareholder, is sometimes used to attack income splitting in this manner. The provision was originally adopted to prevent taxpayers avoiding company tax through excessive remuneration payments to employee shareholders. Changes to the company and shareholder tax system made this object no longer relevant, but the provision retains a residual purpose to combat income splitting. [7.545]

7.32

7.33

Questions

The taxpayer was a small family company, the sole shareholders and directors of which were Mr and Mrs P. The taxpayer paid Mrs P $5,600 in wages and $6,900 in director’s fees for the year. It appeared the $6,900 was calculated as the amount of personal expenditures the taxpayer had charged to a company account. Can the ATO use s 8-1 of the ITAA 1997 or s 109 of the ITAA 1936 to restrict the company from deducting the full amount of director’s fees? (See Case 23/94 (1994) 94 ATC 234.) The taxpayer company entered into an agreement with two director employees to purchase insurance bonds, the proceeds of which were payable to trusts in favour of the directors’ spouses. Is the amount paid deductible as part of the remuneration package of the directors or is the primary purpose to facilitate income diversion to the spouses? (See Gandy Timbers Pty Ltd v FCT (1995) 95 ATC 4167.)

[7.550] The second type of income splitting based on an interposed entity involves the

interposition of an entity between the taxpayer and the intended recipient of income splitting payments. This is particularly useful where the intended recipient cannot provide the goods or services required by the higher bracket taxpayer in his or her business. For example, a lawyer cannot overpay a spouse for secretarial services if the spouse has no legal secretarial skills. However, the lawyer could contract with a “service trust” to provide secretarial services, pay the trust far more than it incurred to hire a secretary, and effectively transfer the excess payment from the lawyer (who deducts the payments to the service trust) to the spouse (who receives a distribution of the profits derived by the trust, that is, the amount the trust charges the lawyer for secretarial services less the amount the trust actually pays to the secretary it hires). An arrangement of this sort was considered by the Federal Court in FCT v Phillips. The taxpayer in Phillips was an accountant whose firm had established a service trust to provide the firm with secretarial and other services. A prime aim of the trust arrangement was to facilitate income splitting with partners’ spouses. A second objective was to move the firm’s assets out of reach of creditors in view of the risks to partners demonstrated by a judgment against the firm. The service trust established by the partners to achieve these ends had as its beneficiaries members of the firm or their nominees, most often family members with lower income tax brackets than the accountants who established the scheme. The firm transferred all its plant 442

[7.545]

The Positive Limbs – Nexus Issues

CHAPTER 7

and office assets such as furniture to the service trust and terminated the employment contracts of all of its service and support staff such as stenographers. A management company operating on behalf of the service trust then offered the firm the use of its former furniture, equipment and employees on a service contract basis. From a practical perspective, the day-to-day operations of the firm had changed little. However, after the change, the firm was required to pay considerably more for its equipment and service staff than it had when it owned the equipment itself and employed the staff directly. Evidence did show that the expenses were not excessive compared to the cost of obtaining the employees’ services from an agency such as a temp agency. The excess of the payments by the firm less the amounts actually paid to the employees were profits to the service trust which were distributed to the beneficiaries of the trust for tax purposes. The key to the success of the entire diversion scheme in tax terms, therefore, was the deductibility of the expenses by the firm. The ATO relied upon the apportionment formula in s 51(1) of the ITAA 1936 to deny the taxpayer a deduction for that part of the expense that exceeded the costs incurred by the firm before it entered into the service trust arrangement. He sought to characterise the excess as an outgoing incurred for private or personal reasons. In response, the taxpayer argued that the appropriate benchmark was not the former costs incurred by the firm, but rather was the ordinary costs of such services had they been purchased from another separate firm. Bowen CJ and Deane J held in the taxpayer’s favour, relying on the Cecil Bros precedent.

FCT v Phillips [7.560] FCT v Phillips (1978) 36 FLR 399 Full Federal Court Bowen CJ and Deane J: It is important to distinguish between the purposes underlying the overall rearrangement of the manner in which the partnership of Fell and Starkey carried on its business, including the establishment and equipping of the trust, and the purpose of the subsequent incurring of liabilities and making of payments to the trust. The purposes underlying the overall rearrangement were, to no small extent, of a domestic or private nature. No attack is, however, made by the Commissioner on the effectiveness of that rearrangement. It is not suggested that the relevant assets were not in fact effectively transferred. It is not suggested that the relevant staff did not, in truth, cease to be employees of the partnership and become employees of the trust … After the rearrangement had been completed, the partnership itself possessed neither the staff nor the furniture or other plant necessary to enable it to carry on its accountancy business. The moneys paid or accrued due to the trust were in respect of services, furniture and other plant which the partnership clearly needed to enable it to carry on that business for the purpose of

gaining or producing assessable income. The Commissioner has not suggested that any agreement or arrangement relating to the provision by the trust of the relevant services and the rental of the relevant equipment was a sham. The findings of the learned judge at first instance that the agreed rates for the relevant services were realistic and not excessive and that the rate fixed for hire of plant and furniture likewise could not be said to be excessive have not been challenged before us. The rates of interest charged on moneys accrued due were plainly reasonable. In these circumstances, the payments and liabilities were, in the relevant sense, necessarily incurred in carrying on the accountancy business for the purpose of gaining or producing assessable income. It is not to the point that the reasonable commercial profits which the trust derived as a result of its contractual arrangements with the partnership could reasonably have been expected to have accrued to the partnership if the rearrangement had not been effected or that those profits would in due course, be credited or distributed either to a partner or to individuals, trusts or companies [7.560]

443

The Tax Base – Deductions

FCT v Phillips cont. with which one or more of the partners were associated. Nor, in the absence of any questions involving the effect of s 260 of the Act, is it to the point that the overall rearrangement had, with taxation and estate planning considerations in view, been effected to achieve, inter alia, those very results. There was not, in the present matter, any associated collateral advantage (in terms of either legal entitlement or commercial anticipation)

outside the ordinary internal administration of the trust which could properly be seen as a purpose for the making of the payments or the incurring of the liabilities. It is therefore, in the view we take unnecessary for the taxpayer to rely on the approach which found favour with the majority of their Lordships in Europa Oil (NZ) Ltd (No 2) v IRC, but which was rejected by Lord Wilberforce in his dissenting opinion. The decision in the present case is governed by the decision of the High Court of Australia in Cecil Bros Pty Ltd v FCT.

Fisher J came to a similar conclusion. He went on to emphasise the importance of the “commercial rates” aspect of the arrangements. Fisher J: In allowing the taxpayer’s appeal on the s 51 issue the trial judge based his decision on the ratio of Europa Oil (NZ) Ltd v IRC (NZ) by finding that the firm in engaging the management company and accepting the obligation to pay for the services did not acquire any legally enforceable right otherwise than to the performance of those services. It is my opinion that the trial judge was correct in this finding. However, I am also of opinion that the matter can be determined favourably to the taxpayer on another and perhaps more fundamental point, namely, that from the firm’s point of view the only purpose of the expenditure was the acquiring of assessable income or the carrying on of business for that purpose. There was no secondary purpose of benefiting the families of the partners, rather the benefits which accrued to these families were the incentive for the acquisition of the services from the management company rather than from elsewhere.

A crucially important circumstance in the present matter is the unchallenged finding of the trial judge that the charges paid by the firm were realistic and not in excess of commercial rates. The services were essential to the conduct of the firm’s business and the fact that the charges paid were commercially realistic raises at least the presumption that they were a real and genuine cost of earning the firm’s income and the cost of that alone. It strongly supports the view that the expenditure was exclusively for business purposes. Without doubt the cost of acquisition of the services was “necessarily incurred” in the sense that it was “clearly appropriate or adapted for” the production of the assessable income. Doubtless the converse would apply, namely, if the expenditure was grossly excessive, it would raise the presumption that it was not wholly payable for the services and equipment provided, but was for some other purpose. Such is not the case here.

[7.570] Although the taxpayer was successful in Phillips, the case is seen as an important

turning point in the interpretation of s 51(1). By implication, the decision established limits to the effect of the legal rights doctrine. Following Phillips, many tax advisers suggested that taxpayers could continue to overpay for goods or services for income splitting purposes, but the expense would be deductible only to the extent that the payment was commercially realistic. The ATO has endorsed this approach in Taxation Ruling TR 2006/2, indicating the ATO may deny deductions if there is no commercial rationale for the use of the interposed service entity. ATO guidance on “safe harbours” was also issued (see ATO, Your service entity 444

[7.570]

The Positive Limbs – Nexus Issues

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arrangements (2006) NAT 13086–04.2006). The legal rights doctrine was giving way to a “purposive” analysis of a taxpayer’s outgoing. [7.575]

Questions

7.34

In Magna Alloys the Federal Court concluded the directors had directed the company to pay their legal fees for the dual purpose of protecting the company’s interests and protecting their personal interests. In fact, if the case had arisen in a company law context, it may have been held that the directors had breached their duty to act for the benefits of the company and not their own benefit. Why did the Court not apportion or deny a deduction for the outgoings accordingly?

7.35

The taxpayer was a director and an employee of a family company as well as a director of other companies. In the income year, he received $600,000 in director’s fees from the other companies and paid these on to the family company, claiming a deduction for the amounts paid over to the family company. He argued the payments were required under an agreement with the family company to allow him to accept directorships only if the proceeds were paid over to the family company. Can he deduct the amounts paid to the family company? (See Service v FCT [2000] FCA 188.)

[7.580] In the direct and indirect income splitting arrangements described above, there was

arguably some commercial rationale for the expenditures made by the taxpayers; income splitting occurred only to the extent that the taxpayer tried to gift additional assessable income to the related person by overpaying for the goods or services acquired. In later and more extreme cases, taxpayers sought to rely on the legal rights doctrine to turn pre-tax losses into after-tax gains. Consider the following scenario, roughly based on the scheme in Ure v FCT: The taxpayer’s bank pays 10 per cent on long-term deposits and charges 12 per cent on similar term loans. The taxpayer borrows $1,000 from the bank at 12 per cent, which he lends to his spouse, charging her 1 per cent interest. The spouse deposits the money back in the same bank, earning 10 per cent interest on the deposit which, among other things, is used as security for the taxpayer’s loan. What are the pre-tax consequences of the transaction? The couple have borrowed $1,000 from the bank and invested it in the same bank. Over one year they will pay $120 interest to the bank and derive $100 interest from the bank, yielding a net loss for the entire transaction of $20. However, for tax purposes the taxpayer seeks to dissect the transaction into two components. Because he is on-lending the borrowed money to his spouse and charging her interest, he hopes to deduct his own interest expenses (claiming the costs were incurred to earn assessable income). He will pay tax on the interest received from his spouse and she will pay tax on the interest received from the bank. Let’s assume the taxpayer pays about 50 per cent tax on his last dollars of income and the spouse pays about 20 per cent on hers. What would the after-tax consequences of the transactions be if the tax effects turned out as the taxpayer planned? First, the taxpayer would deduct the $120 interest he paid, securing a $60 tax refund or saving as a result. Second, the taxpayer would pay $5 tax on the $10 interest he received from his spouse. Third, the spouse would deduct the $10 from her income, yielding a $2 tax refund. Finally, the spouse would pay $20 tax on the $100 interest she derives. Putting it all together we end up with:

[7.580]

445

The Tax Base – Deductions

– + – + – total

+

20 real world loss ($120 interest paid and $100 interest received) 60 taxpayer’s tax refund on interest payments to bank (50% × $120) 5 taxpayer’s tax liability on interest from spouse (50% × $10) 2 spouse’s tax refund on interest paid to taxpayer (20% × $10) 20 spouse’s tax liability on interest from bank (20% × $100) 17 after-tax gain

Thus, taking the income splitting arrangements in their totality, the taxpayer hopes to turn a $20 real world loss into a $17 after-tax gain. The actual facts in Ure were a little more complicated than those in this example, but the scheme followed this general formula. The Federal Court distinguished the Cecil Bros and Phillips precedents and required the taxpayer to apportion the outgoing.

Ure v FCT [7.590] Ure v FCT (1981) 50 FLR 219 Full Federal Court Deane and Sheppard JJ: One of the most difficult aspects of the problem of characterising an outgoing is the assessment of what, if any, weight is to be given to indirect objects which a taxpayer had in mind in incurring the outgoing. Such objects form part of the relevant circumstances by reference to which the problem of characterisation must be resolved. There is however no rigid principle which can be applied in determining what, if any, weight should be given to them. In the ordinary case, such as, for example, where the immediate object achieved by the outgoing is the production of assessable income which is commensurate with the amount of the outgoing or where it is clear that the outgoing was for the purchase of stock-in-trade or the acquisition of services or hire of equipment used in earning assessable income, indirect objects or motives of a personal or domestic character will plainly not prevent the characterisation of the outgoing as having been incurred in earning assessable income (see, for example, Cecil Bros Pty Ltd v FCT; FCT v Phillips). In other cases, the immediate object or effect of an outgoing will not suffice either to explain or to

446

[7.590]

characterise it. In such cases, indirect objects or motives can assume a sometimes decisive importance. In the present case, it would be a misleading half-truth to say that the object which the taxpayer had in mind or the advantage which he sought in incurring the liability to pay interest at rates of 7.5 per cent or more was the derivation by him of interest at the rate of one per cent per annum by re-lending the money which he borrowed. That was, no doubt, an object which the taxpayer had in mind: it was an advantage which he sought. In the circumstances, however, characterisation of the outgoing cannot properly be effected by reference to that object or advantage alone. The incurring of the outgoing can only be explained by reference also to less direct objects and advantages which the taxpayer sought to achieve and which plainly were of paramount importance. These indirect objects or advantages were, in so far as the taxpayer was concerned, not of an income-earning character in that they involved the provision of accommodation for the taxpayer and his family, the financial benefit of the taxpayer’s wife and a

The Positive Limbs – Nexus Issues

Ure v FCT cont. family trust and a reduction in the taxpayer’s personal liability to pay income tax. In the result, the outlays of interest can be seen as servicing a number of objects indifferently. The predominant, though indirect, objects were not concerned with earning assessable income for the taxpayer but were, for the purposes of s 51(1), of a private and domestic nature. The object of earning assessable income in the form

CHAPTER 7

of interest was present in a subordinate role. If, in these circumstances, apportionment were not possible and it were necessary to give a single characterisation to the whole of the interest which was paid, we would conclude that the interest could not be characterised as having been incurred in earning assessable income and that its primary characterisation was as being of a private or domestic character. It is however established that apportionment is, in these circumstances not only permissible but required.

Brennan J agreed with this result in a separate judgment. [7.595]

7.36

Question

It was mentioned earlier that one difficulty faced by the courts in apparent dualpurpose cases is to ascertain whether there were in fact dual purposes – to gain a tax advantage and to derive assessable income, or simply one purpose – to gain a tax advantage, with the derivation of assessable income simply being a by-product of the tax-minimisation scheme, not an objective in itself. Would Ure be one of those cases? If so, is the judgment correct? How might it be changed if it was concluded this was not a dual-purpose outgoing?

(e) Mismatched Current Expenses Incurred to Derive Capital Gains [7.600] While the positive limbs of s 8-1 and the negative limb in s 8-1(2)(c) address the

problem of expenses to derive wholly exempt (either explicitly or implicitly) income, there are no similar direct measures to deal with mismatches between wholly deductible expenses and “tax-preferred” income, that is, income more lightly taxed than most types of assessable income. The most important example of tax-preferred income in the context of deduction mismatches is capital gains. Capital gains raise a special problem as they are assessable, via Pt 3-1, but unlike other gains, they are only partially taxed when derived by individuals. A further problem raised by capital gains is the realisation system of recognising these gains. Because capital gains are not recognised for tax purposes until there is a disposal of an appreciated asset, taxpayers may defer tax indefinitely simply by deferring disposal of the property. Thus, deductions for expenses incurred to derive capital gains would open the door to two types of tax benefits: the mismatch of fully deductible expenses incurred to derive gains when only one-half the gain is taxed; and the timing benefits from early recognition of expenses and deferred recognition of resulting gains. Analysing potential mismatch problems involving expenses incurred to derive capital gains is complicated by the fact that in some cases expenses related to capital gains are incurred only to derive capital gains, while in other cases expenses related to capital gains may be incurred in part to derive capital gains and in part to derive ordinary income. For example, if a taxpayer borrows to acquire vacant real estate held for speculative purposes, the interest expense is incurred solely to derive future capital gains. The timing and income type mismatches noted above (interest is incurred now while capital gains will not be assessable until some future time and then only one-half the gain will be assessable if realised by an individual) clearly apply to [7.600]

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The Tax Base – Deductions

this type of transaction. By way of contrast, if a taxpayer borrows to buy a rental property, it is arguable that some of the expense was incurred to derive a capital gain in the future and some incurred to derive ordinary rental income, so the mismatch problem only partially applies. Prior to 1985, if a taxpayer incurred an expense solely to derive a capital gain, the positive limbs of s 51(1) prevented a deduction for the expense. This is because the taxpayer would derive no assessable income as a result of the outgoing. After the adoption of the capital gains provisions in 1985, capital gains became a type of statutory income and prima facie expenses incurred to derive only capital gains would satisfy the positive limbs of s 51(1). Section 51AAA was inserted into the ITAA 1936 to prevent taxpayers from mismatching current deductions for expenses (particularly interest expenses) incurred to derive deferred and preferentially taxed capital gains. The section was quite harsh in its application, imposing a complete deduction denial for expenses incurred solely to derive capital gains. The theoretically correct approach would be to match the deductions to the income recognition so if only part of the gain were assessable thanks to 50 per cent exclusion concession for capital gains realised by individuals, only 50 per cent of the interest expenses should be deductible. Similarly, as the taxpayer could defer recognition of gain until disposal of the asset, the deduction should have been similarly deferred and recognised only when the associated gain was assessable. For several years following the introduction of capital gains tax, the government resisted calls for a rule that would have allowed taxpayers to recognise interest expenses related to borrowings to acquire assets that would only yield capital gains. The Australian approach of complete denial of interest expenses related to speculative investments that did not generate current income was supported by overseas precedents. The object of these rules is to discourage non-productive speculative investments, particularly with respect to investments in land in or near urban centres, where the land is held idle until the development of surrounding lots has increased the value of the investment property. Eventually, however, the government caved in to a concerted lobbying effort by investors and in 1991 added the predecessor to s 110-25(4)(a) of the ITAA 1997 to enable taxpayers to add previously unrecognised interest payments to the cost base of assets for the purpose of calculating capital gains realised on the assets. This approach avoids the temporal mismatch of a current deduction offset by a future gain, but is extremely generous in the sense of allowing full recognition for interest expenses and only taxing half the resulting gain. The combination of s 51AAA denying a current deduction for expenses such as interest related to anticipated future capital gains and s 110-25(4)(a) allowing recognition for the expense by adding it to the cost base produced a satisfactory outcome where the taxpayer derived only capital gains. However, difficulties arose where the taxpayer incurred a dual-purpose expense, incurred to generate both capital gains and assessable income other than capital gains. Prior to the inclusion of capital gains in assessable income, there was an argument that apportionment of expenses incurred to derive ordinary income and capital gains which were then exempt from tax was possible under the predecessor to s 8-1. This argument was not possible once capital gains were included in assessable income. It has been suggested that where a taxpayer incurs expenses such as interest to derive both current income and an anticipated future capital gain, s 51AAA could be used to apportion the expense into a currently deductible portion and a portion for which no current deduction is possible, and since the adoption of the predecessor to s 110-25(4)(a) in 1991 the nondeductible portion could be added to the cost base of the assets acquired. However, the ATO 448

[7.600]

The Positive Limbs – Nexus Issues

CHAPTER 7

has taken the view that these provisions do not operate to achieve this result. The ATO’s view is that where an expense is incurred to generate both current income and an anticipated future capital gain, apportionment would only be possible if based on a specific statutory apportionment formula. In the absence of an apportionment measure, and assuming the arrangement is not part of an artificial tax minimisation scheme, the ATO will generally recognise the deductibility in full of current expenses incurred to derive current income from an asset and anticipated capital gains from a future disposal of the asset, even where the expenses exceed current income from the asset and are thus deducted from other employment, business, or investment income of the taxpayer. Thus, for example, if a taxpayer borrows to “negatively gear” a rental property investment (where the interest outgoings exceed the rent received), the ATO will allow the taxpayer to deduct the excess interest from other income derived by the taxpayer. In mid-1985, the legislature adopted a statutory apportionment formula in the form of specific matching provisions in ss 82KZC – 82KZJ of the ITAA 1936. Known popularly as the “negative gearing” provisions these measures had the effect of limiting deductions for interest expenses incurred in relation to rental real property to the amount of rental income generated by the property. Excess interest payments could be carried forward indefinitely, to be offset against future rental payments. Taxpayers were allowed to capitalise any unused interest payments and add them to the cost of the asset to reduce the capital gain upon eventual sale of the property. In mid-1987 the government abolished the negative gearing restrictions. The move was justified on tax expenditure grounds – while the matching rule made theoretical sense, the mismatching could be used as a tax expenditure to increase investment in rental housing accommodation, the government hoped, and thus alleviate a shortage of rental accommodation in Sydney. [7.605]

7.37

Question

Many persons criticised the negative gearing rules for their selective nature and argued that, if matching rules were to be adopted, they should be applied generally, to all assets capable of generating ordinary income gains and capital gains. Are they correct? On what grounds could the present system of no matching be justified?

[7.610] Apart from the brief flirtation with statutory apportionment in the 1980s, there has

been no serious attempt by Parliament to apportion outgoings incurred to derive both capital gains and ordinary income. The resulting mismatch is the basis for much tax planning by high-income individuals. Political pressure by a range of interest groups, including those representing professional tax advisers and the real estate industry, has discouraged either of the major political parties from considering reforms in this area.

(f) Timing Manipulation [7.620] Timing manipulation takes two forms: deferring the recognition of gains or

accelerating the recognition of expenses, and mismatching current expenses with “timing preferred” income. Both techniques enable a taxpayer to reduce taxable income in the current year at the expense of increasing it in a future year. In some cases, tax is deferred because income actually derived in one year is not recognised as derived until a future one. In other cases, tax is deferred because expenses are actually incurred in an economic sense in a future year but are deducted in the current year, meaning they will not be available for deductions in the year in which they are actually incurred in an economic sense. [7.620]

449

The Tax Base – Deductions

Deferring recognition of gains and accelerated recognition of expenses are often referred to as an “interest-free loan from the Commissioner to the taxpayer”. This is because deferred tax that would have otherwise been paid to the ATO but for the timing manipulation can be invested to generate new gains until the deferral period is over and the tax has to actually be turned over to the government. If a tax-effective transaction will allow a taxpayer to defer taxes on some other income such as employment income for a year or more, a break-even or loss transaction can be turned into an after-tax gain. Schemes designed to achieve this result are known as “tax shelters” as they shelter income from tax for some period. Many commercially marketed tax shelters offer promises of eventual returns; others are more candid, promising nothing more than your original investment back, plus whatever you’ve earned elsewhere by investing your tax dollars for the period for which you were able to defer paying them to the ATO. Many widely marketed timing manipulation schemes are based on accelerated deductions where taxpayers deduct expenses long before they have been suffered in a true economic sense. As might be expected, schemes based on the availability of accelerated deductions lead to significant investment distortions. As they promise after-tax gains where there are no gains to be made in the real world, they overcome all normal market factors and cause investment in sectors that would receive little or no investment if decisions were made on the basis of market forces alone. Concern over the economic consequences of these distortions has been an important factor behind legislative moves to reduce opportunities for timing manipulation; another cause, obviously, is concern over the tax minimisation opportunities to which it gives rise. If they are viewed as a type of “dual purpose” outgoings, timing manipulation expenses could be said to be incurred partly to generate assessable income and partly to obtain a tax benefit by deferring tax liability to a future year. However, timing manipulation differs from other dual-purpose outlays in one crucial manner. In other tax minimisation arrangements, anticipated tax savings flow directly from the deduction. This is the case, for example, with a transfer of taxable income to a related taxpayer by means of income splitting or transferpricing schemes. In the case of a timing manipulation arrangement, the tax benefit flows indirectly from the outgoing and results, because the time the expense is recognised is different from when the economic loss is incurred or the expense is incurred to derive income that accrues to the taxpayer before it is recognised for tax purposes. The indirect nexus between the expense and the tax minimisation objective in the case of timing manipulation often makes it difficult for the ATO to show a timing manipulation expense had dual purposes, and thus lacks sufficient nexus with income derivation required for it to be fully deductible under the positive limbs of s 8-1(1). (i) Prepayments [7.630] The most common type of timing manipulation is the prepayment of interest on a

loan or fees for services to be delivered for a period extending past the end of the income year. While the taxpayer may have paid an amount for several years’ benefits, he or she has not “incurred” the entire expense from an economic perspective. The taxpayer has suffered no loss in the real world, but rather has changed the form of her or his investment from cash to something else, namely a right to future services without paying further fees for those services 450

[7.630]

The Positive Limbs – Nexus Issues

CHAPTER 7

in a later period or a right to continue borrowing money without paying further interest in a later period. Only as the loan period or services gradually expires has the taxpayer really “incurred” the expense in an economic sense. Prepayments of interest or fees for services to be delivered in a future year are not recognised as deductible expenses for financial accounting purposes. For accounting purposes, the payment is offset in a taxpayer’s financial accounts by the acquisition of an asset (a right to future services for no additional fee or a right to future use of borrowed funds for no additional interest) so there is no net change in the taxpayer’s financial position as a result of the outgoing. But judicial doctrines as often as not ignore underlying economic or financial reality and instead focus on the form of payments rather than their effect. Interest – be it ordinary or prepaid – and fees for services – again, be they ordinary or prepaid – prima facie look like expenses that satisfy the positive limbs of s 8-1(1) and prepayments could therefore be deductible unless the ATO could establish a lack of nexus between the outgoing and the derivation of assessable income. One way of doing this would be to establish a dual motive for the payment – partly to derive assessable income and partly to minimise tax by deliberately choosing a prepayment form of expense. The ATO did enjoy some, albeit very limited, success in attacking prepayment schemes using these general arguments. For example, in FCT v Gwynvill Properties Pty Ltd (1986) 13 FCR 138, a majority of the Full Federal Court upheld the ATO’s appeal and denied the taxpayer a deduction for any part of a $1.5 m interest prepayment. The Court concluded that, based on the objective facts of the arrangement, including the fact that the lender knew the borrower would be immediately repaying the borrowed money by way of an interest prepayment and the purchase of the note, the interest payment did not satisfy the positive limbs of s 51(1) of the ITAA 1936, the predecessor to s 8-1(1) of the ITAA 1997. In other cases, however, the courts acknowledged the potential arguments and then decided for the ATO on other grounds. For example, in the first important prepayment decision to reach the Federal Court, FCT v Ilbery (1981) 12 ATR 563, the taxpayer was denied a deduction for a $14,000 interest prepayment on a $20,000 loan because the loan interest was paid three days before the taxpayer used the loan funds to acquire an income-producing property. Toohey J used the lack of temporal nexus (an expense incurred prior to the commencement of the income-earning process) to deny the taxpayer the deduction he sought. In FCT v Creer (1986) 86 ATC 4318 the taxpayer was denied a deduction for a rent prepayment on the grounds that the outgoing was capital in nature. In other cases, again, the ATO was wholly unsuccessful. For example, in Lau v FCT (1984) 84 ATC 4618 the taxpayer successfully deducted a prepayment of management fees for a 21-year period. By the mid-1980s, prepaid expense arrangements constituted the basis for a significant proportion of tax avoidance schemes. The schemes were widely marketed through legitimate investment prospectuses and cost the government millions of dollars of lost tax revenue (Treasury estimates put the figure at $35 m per year). The legislature finally intervened in 1988 with the enactment of prepayment measures that generally require the taxpayer to recognise prepayments over the life of the benefits acquired. The prepayments amortisation regime is described in more detail in Chapter 12.

[7.630]

451

The Tax Base – Deductions

(ii) Timing preferred income [7.640] The legislative restriction on the deductibility of prepaid expenses halted schemes

involving prepayments of the type encountered in Ilbery, Gwynvill and Creer but it did not eliminate timing manipulation schemes. New schemes emerged that were designed to provide deductions upfront while deferring derivation of income. Many of these schemes were built around the concessional treatment of annuity income compared to the treatment of a blended payment loan. Under a standard blended payment loan such as a car loan or a home mortgage loan, the borrower repays the lender with a series of regular and equal payments, each comprising some repayment of principal and interest on the outstanding balance of principal. In the early payments, much of the payment is interest and only a little is principal. Over time, more and more of the principal is paid off, so the interest payable on the outstanding loan decreases. As a result, the last payments are mostly comprised of repayments of principal with only a small part of each payment comprising interest. A fixed-term annuity is very similar to a blended payment loan – in fact, the tables used by financial institutions to compute the payment amounts for fixed-term annuities are the same as those used to compute payments on fixed-term blended payment loans. However, the tax rules were once very different. The original tax rules for annuities were designed for life annuities, where the payments were made for the life of the investor. Because the exact number of payments was unknown when the first payment was made, the formula used to compute the principal and interest components of blended payment loans could not be used for life annuities. Instead, the tax law provided for a notional principal–interest division calculated by dividing the principal invested over the number of payments that would be received if the annuitant lived for exactly the person’s life expectancy as determined by the official life expectancy table. This rule was later extended to fixed-term annuities by allowing the annuitant to divide the invested principal by the number of payments in the fixed-term annuity and to recognise the tax-free recovery of the invested sum equally over the life of the annuity. The rule is currently found in s 27H of the ITAA 1936. The different treatment of annuities and blended payment loans opened the door to many interesting tax minimisation techniques. The easiest was simply to borrow money on a fixed term blended payment loan to invest in an annuity that yielded a rate of return identical to the rate paid on the loan for the same period. The deductible interest in respect of the loan would be a higher percentage of the total payment for payments in the earlier years while the corresponding gain on the annuity would be spread out over the life of the annuity. One of the leading timing manipulation cases is FCT v Australia & New Zealand Savings Bank (1998) 39 ATR 419, where the taxpayer, a large bank, borrowed funds to buy an annuity from a State government body. Attacking the scheme on the basis of an insufficient nexus because of the taxpayer’s purpose in incurring the interest expenses proved difficult for the ATO. Eventually the ATO won, but not on the basis of a positive limbs nexus argument. The problem of mismatching deductions with timing-preferred annuity income that arose in the ANZ Savings Bank case has been addressed in part by changes to the annuity tax rules. Most commercial loans are now treated as the equivalent of blended payment loans and the annuity pro rata return of principal formula now only applies to a limited class of annuities issued by life assurance companies and analogous registered organisations. One of the most significant annuity timing manipulation decisions is that of the High Court in Fletcher v FCT (1991) 173 CLR 1. Although the actual scheme attempted in the case would 452

[7.640]

The Positive Limbs – Nexus Issues

CHAPTER 7

now be stopped by the application of the TOFA rules (see Div 230 of the ITAA 1997) to the annuities in the case, the ramifications of the decision remain important. Indeed, the significance of the case extends well beyond the confines of a timing manipulation situation – in its judgment, the High Court directly addressed the role of a taxpayer’s motive and purpose in the application of s 51(1) of the ITAA 1936, the predecessor to s 8-1(1) of the ITAA 1997, to tax minimisation arrangements. The High Court concluded that the outcome in Fletcher would turn on questions of fact and accordingly remitted the case to the AAT for finding of facts. However, in the course of their decision, the judges suggested that the primary end which the taxpayer subjectively had in view when incurring an expense, and not the mere legal rights acquired, might be decisive in determining whether the outgoing should be apportioned. One of the first Federal Court judges to consider the impact of Fletcher was Hill J in his decision in FCT v Studdert (1991) 91 ATC 5006, handed down only a few weeks after the Fletcher decision. The taxpayer in Studdert was a flight engineer who sought to deduct the cost of flying lessons he took. The ATO conceded the taxpayer might have a secondary object of improving his performance as a flight engineer but his predominant purpose was to retrain as a flight officer, a wholly different position. Hill J distinguished the High Court’s decision in Fletcher on the basis of it dealing with “an audacious tax avoidance scheme” and suggested once a taxpayer demonstrates a deductible purpose behind incurring expenses, it is not possible to apportion on the basis of the taxpayer’s dominant purpose. Not surprisingly, the ATO was not very impressed with the approach adopted by Hill J that appeared to downplay the relevance of primary motive so long as an acceptable secondary motive is present. Shortly afterwards, the ATO released Taxation Ruling TR 92/8 which argued that, at least for self-education expenses, it was important to consider whether a taxpayer’s dominant purpose in incurring an expense was a non income-producing purpose. The ATO rejected the apparent suggestion by Hill J that the High Court’s approach (looking at the dominant purpose even if the taxpayer had a subordinate purpose that would justify a deduction) just applied to instances of tax avoidance.

(g) Other Statutory Restrictions [7.650] Many of the cases extracted in this chapter prompted the adoption of statutory restrictions on deductions – Madad was followed by s 51(4), now s 26-5 (denying deductions for penalties); Cecil Bros by s 31C, now s 70-20 (limiting deductions for the trading stock acquired for an excessive price in a non-arm’s length transaction); and Ilbery by s 82KZMD (requiring taxpayers to recognise prepayments over the life of the payment). A number of other deduction restriction provisions have been adopted in response to cases in which taxpayers were able to satisfy the positive limb nexus tests and deduct amounts that, in tax policy terms, should not be deductible as current expenses. These are discussed further in Chapter 12.

[7.650]

453

CHAPTER 8 Personal and Non-personal Expenses [8.10]

1. INTRODUCTION........................................ ................................................. 456

[8.20] [8.30]

2. COMMUTING ......................................... ................................................... 458 Lunney v FCT ............................................................................................................. 458

[8.50]

3. CHILD CARE EXPENSES................................... ........................................... 461

[8.60]

Martin v FCT .............................................................................................................. 461

[8.80] [8.90]

4. EDUCATION EXPENSES................................... ........................................... 462 FCT v Hatchett ........................................................................................................... 463

[8.110]

5. TRAVEL EXPENSES....................................... ................................................ 466

[8.120]

FCT v Finn ................................................................................................................. 466

[8.130] [8.140] [8.160]

6. HOME OFFICE ......................................... ................................................... 468 Handley v FCT ............................................................................................................ 468 FCT v Forsyth ............................................................................................................. 470

[8.180]

7. CLOTHING............................................ ...................................................... 471

[8.190]

8. FOOD, DRINK AND ENTERTAINMENT ........................ ............................... 473

[8.190] [8.200]

(a) Entertainment to Employees and Third Persons ................................................... 473 FCT v Cooper ............................................................................................................. 473

[8.220]

(b) Entertainment by a Taxpayer to Himself or Herself ............................................... 476

[8.230]

9. HOBBY/BUSINESS EXPENSES............................... ....................................... 477

[8.240]

10. MEDICAL EXPENSES .................................... ............................................. 480

[8.250]

11. CHARITABLE GIFTS ..................................... .............................................. 481

[8.260]

12. SUBSTANTIATION ...................................... ............................................... 482

Principal Sections ITAA 1997 s 8-1(2)(b) (formerly s 51(1) of ITAA 1936) Div 30 s 32-5 Div 34 Div 900

Effect This negative limb prohibits deductions for private or domestic expenses. This Division allows a deduction for charitable gifts. This section denies deductions for entertainment expenses subject to limited exceptions. This Division contains restrictions on deductions for non-compulsory clothing. This Division contains substantiation rules for deductible expenses.

455

The Tax Base – Deductions

ITAA 1936 s 82(A)

Effect This section prevents a deduction for the first $250 of “expenses of self-education” otherwise deductible under s 8-1.

1. INTRODUCTION [8.10] The second negative limb, s 8-1(2)(b), prohibiting deductions for personal or private

expenses, is intended to prevent taxpayers from deducting personal consumption expenses for tax purposes. It has been argued that this limb is redundant in the sense that a personal expense will not satisfy either of the positive limbs of s 8-1 on general principles. In practical terms, this negative limb is often used as an extra peg on which a court can hang a decision to deny a deduction – “this expense does not satisfy either of the positive limbs of s 8-1 and, in any case, is a personal expense within the second negative limb”. It was noted in Chapter 7 that the line between personal expenses and non-personal outlays is far from bright. Virtually all outlays have some connection with the earning of assessable income. Indeed, even purely personal consumption expenses might be related to the gaining of income, to the extent that they enable the taxpayer to work. Deduction cases thus span a continuum of outlays from those very closely connected with the derivation of assessable income to those only marginally connected. Quite clearly some criteria are needed to limit taxpayers to deductions for expenditures with a sufficient nexus with the derivation of assessable income. If this were not the case, taxpayers would be able to deduct almost all consumption outlays so that taxable income would consist only of amounts that are derived and invested in some form of savings. The legislation provides no definition of personal and non-personal expenses but judges have intuitively recognised the need to impose close nexus requirements to limit the deductibility of outgoings incurred by taxpayers. They have accordingly devised judicial rules to restrict deductions for personal expenses. The legislature is motivated by similar concerns when it devises statutory rules on the deductibility or non-deductibility of various types of outgoings. A further consideration central to the legislature’s mandate is to devise easily administrable rules. In the context of legislation with almost universal application, there is a real need for clear, bright lines. At the cost of some unfortunate unfairness or some undesirable windfalls in individual cases, the legislature often seeks obvious, but necessarily blunt, distinctions capable of simple, widespread application. At one end of the continuum of income-related expenses are outgoings with only the remotest connection to the derivation of income. In this category would normally fall, for example, outgoings for food and shelter. Certainly, it is true that taxpayers cannot earn assessable income unless they eat and sleep; it is thus arguable that these expenses, to some extent, are incurred to earn assessable income. However, these expenditures must also be incurred even if the taxpayer does not earn assessable income. There is, therefore, no close nexus with the income-earning process. There is little controversy over the denial of deductions for outlays of this sort. Between the category of expenses that enjoy no close nexus with the production of assessable income and the category of expenses that are incurred only for that purpose are a 456

[8.10]

Personal and Non-personal Expenses

CHAPTER 8

large group of dual-purpose expenses. Expenses in this intermediate category are not consumed directly in the income-earning process, but would not be incurred if the taxpayer were not deriving assessable income. Taxpayers seeking to deduct these expenses argue that a “but for” test should apply – but for their income-earning activities, they would not incur the expenses. In these cases the ATO argues the appropriate test is: does the outlay have a direct nexus with the income-earning process; or is it an expenditure that puts the taxpayer in a position to carry out an income-earning activity? Thus, with outgoings such as commuting, child care, and so forth, at the heart of the taxpayers’ case is an argument that but for their income-earning activities, they never would have incurred the expenses, or, to put it another way, but for the expense they never could have earned the assessable income. Underlying the ATO’s case in these situations is an argument that the outgoing may have made it possible for the taxpayers to derive assessable income, but it was not incurred in the income-earning process itself. Where the statute is silent, taxpayers (and courts) rely on a number of tests and doctrines to categorise the large group of cases falling somewhere between the obviously personal and the equally obvious non-personal categories. It is impossible to assert with any conviction that clear doctrines and lines of reasoning have emerged and can be consistently relied upon to evaluate the probable characterisation of any given outgoing. However, advocates and many Administrative Appeals Tribunal members (and their predecessors on the various Board of Reviews) relying on leading precedents have sought to extract “tests” from those cases. The result is a series of so-called tests often raised in tax objections and relied upon, at least at lower levels of appeals against objections. The significance of any of these is questionable, but they nevertheless appear from time to time in both the cases and professional literature. The three principal tests are said to be: The “perceived connection” test. Taxpayers seeking to apply the “perceived connection” test argue there is a perceived connection between the outgoing and the eventual derivation of assessable income. Thus, for example, a taxpayer incurring an education expense might argue that by incurring the expense he or she will receive a higher pay. The test is based on a comment by Menzies J in FCT v Hatchett (1971) 125 CLR 494 (extracted at [8.90]): “there must be a perceived connection between the outgoing and assessable income”. There are suggestions in some later cases that Menzies J was merely restating older tests in new language and the test therefore had no independent status. The condition of employment test. Taxpayers relying on the condition of employment test contend their outlay was necessarily incurred pursuant to an order by the employer, which required the taxpayer to incur the expense (for example, for a uniform) before he or she could commence work. The ATO uses the test to characterise outgoings as personal if the taxpayer was not required to incur the expenses as a condition of employment. The test has been extracted from statements in many judgments, including that of Menzies J in FCT v Hatchett, where he said: “The taxpayer, in reliance upon the conditions of his employment, spent money to earn more”, and that of Dixon CJ in FCT v Finn (1961) 106 CLR 60 (extracted at [8.120]), where he said: “it was all done while he was in the employment of the government, earning his salary and acting in accordance with the conditions of his service”. Reliance on this test remains common. The essential character test. The essential character test seeks to establish a direct nexus between an outlay and the derivation of income. As such, it is used as the basis for rejecting the [8.10]

457

The Tax Base – Deductions

“but for” argument in favour of deductibility. While the test is attributed originally to Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344 (extracted in Chapter 7 at [7.190]), commentators say it was further developed in Lunney v FCT (1958) 100 CLR 478 (extracted below). The passage from which it is said to arise is found in the joint judgment of Williams, Kitto and Taylor JJ: “to say that expenditure on fares is a prerequisite to the earning of a taxpayer’s income is not to say that such expenditure is incurred in or in the course of gaining or producing his income. Whether or not it should be so characterised depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived.” It should be clear from this brief review that the so-called “tests”, to the extent they really exist, are at best the basis of arguments about the character of an outgoing, and far from definitive guides to deductibility.

2. COMMUTING [8.20] The dichotomy between the taxpayer’s “but for” concerns and the ATO’s distinction

between expenses incurred in an income-earning process and those incurred to put a taxpayer in a position to earning income is self-evident in the case of commuting expenses. The leading case is Lunney v FCT.

Lunney v FCT [8.30] Lunney v FCT (1958) 100 CLR 478 Full High Court Williams, Kitto and Taylor JJ: The question whether the fares which were paid by the appellants are deductible under s 51 should not and, indeed, cannot be solved simply by a process of reasoning which asserts that because expenditure on fares from a taxpayer’s residence to his place of employment or place of business is necessary if assessable income is to be derived, such expenditure must be regarded as “incidental and relevant” to the derivation of such income. No doubt both of the propositions involved in this contention may, in a limited sense, be conceded but it by no means follows that, in the words of the section, such expenditure is “incurred in gaining or producing the assessable income” or “necessarily incurred in carrying on a business for the purpose of gaining or producing such income”. It is, of course, beyond question that unless an employee attends at his place of employment he will not derive assessable income and, in one sense, he makes the journey to his place of employment in order that he may earn his income. But to say that expenditure on fares is 458

[8.20]

a prerequisite to the earning of a taxpayer’s income is not to say that such expenditure is incurred in or in the course of gaining or producing his income. Whether or not it should be so characterised depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived. … In the course of the argument we were referred to a number of [English] cases in which, from time to time, much the same problem has been discussed. … No doubt the legislative provisions which required consideration in these cases were not identical with s 51, but the process of reasoning by which they were decided consistently rejects the notion that expenditure incurred by a taxpayer in order to travel from his home to his place of business is, in any sense, a business expenditure or an expenditure incurred in, or in the course of, earning assessable income.

Personal and Non-personal Expenses

Lunney v FCT cont. Indeed they go further and refuse assent to the proposition that such expenditure is, in any relevant sense, incurred for the purpose of earning assessable income and unanimously accept the view that it is properly characterised as a personal or living expense. This view agrees with that which we, ourselves, entertain. Expenditure of this character is not by any process of reasoning a business expense; indeed, it possesses no attribute whatever capable of giving it the colour of a business expense. Nor can it be said to be incurred in gaining or producing a taxpayer’s

CHAPTER 8

assessable income or incurred in carrying on a business for the purpose of gaining or producing his income; at the most, it may be said to be a necessary consequence of living in one place and working in another. And even if it were possible – and we think it is not – to say that its essential purpose is to enable a taxpayer to derive his assessable income there would still be no warrant for saying, in the language of s 51, that it was “incurred in gaining or producing the assessable income” or “necessarily incurred in carrying on a business for the purpose of gaining or producing such income”.

Dixon CJ agreed with the result in a separate judgment, while McTiernan J dissented. In the course of his judgment, Dixon CJ seemed prepared to concede that a persuasive case in favour of deductibility could be established. However, he recognised the need for a bright line and suggested it would be appropriate to follow earlier Australian cases and analogous English authorities until such time as and when the legislature thought fit to intervene. He said: The relevant provisions of the English Income Tax Acts are not in the same terms as those of the Australian law, but the whole course of English authority involves a like conclusion. To escape from the course of reasoning on which the decisions proceed requires the taking of refined and rather insubstantial distinctions. I confess for myself, however, that if the matter were to be worked out all over again on bare reason, I should have misgivings about the conclusion. But this is

just what I think the court ought not to do. It is a question of how an undisputed principle applies. Its application was settled by old authority long accepted and always acted upon. If the whole subject is to be ripped up now it is for the legislature and not the court to do it. I therefore would answer the questions in the special cases that the sums respectively mentioned are not deductible either wholly or in part.

[8.40] As is so often the case, the Lunney decision appeared to draw a sharp line in the sand but in fact it raised more questions than it answered. The case dealt with travel between home and a place of employment. It did not address the case of travel from home to a place where an individual worked as an independent contractor. Nor did it address the case of travel from one place of employment to another, from one place of work to another, or one place of employment to a place of independent work or vice versa. It also did not address the situation where an employee transported tools or equipment in addition to him or herself. In the years after Lunney v FCT, the decision was distinguished and reinterpreted as lower courts developed a complex set of doctrines for cases where taxpayers travelled to work. A series of cases developed what became known as the “bulky tools” doctrine, largely derived from the FCT v Vogt (1975) 75 ATC 4073 where a musician was allowed to deduct the cost of travelling to work because he had to transport a large musical instrument, with the [8.40]

459

The Tax Base – Deductions

Court suggesting no deduction would have been allowed for a small instrument. Following that case, workers transporting “bulky tools” to and from work were often allowed deductions for the cost of commuting while deductions were denied to those who transported small instruments. A related doctrine was that applying to “itinerant” workers who were required to attend shifting places of work. Often their commuting expenses were deductible from the time they left home until they returned. The question of travelling expenses was revisited by the High Court in 2001 in FCT v Payne (2001) 46 ATR 228. The taxpayer in Payne sought to deduct expenses for travelling between Sydney Airport, from which he worked as a pilot, to his deer farm in country NSW. The majority of the High Court suggested that the expenses to travel from one place of work to another were analogous to commuting expense. Gleeson CJ, Kirby and Hayne JJ said: “These outgoings were occasioned by the need to be in a position where the taxpayer could set about the tasks by which assessable income would be derived. In this respect they were no different from expenses incurred in travelling from home to work.” The High Court denied the taxpayer a deduction for the expenses, a decision that was consistent with longstanding precedent and with the policy distinction between personal expenses (incurred to put a person in the position to start work) and s 8-1 deductible expenses (incurred in the course of work). However, the suggestion regarding the cost of travel between two different places of work as being non-deductible moved the government to amend the law, since the majority’s dicta flew in the face of many years of practice pursuant to which such deductions had been allowed. Section 25-100 was added to authorise a deduction for “transport expense to the extent that it is incurred in your travel between workplaces”, provided the taxpayer does not return home between jobs. [8.45]

8.1

8.2

8.3

8.4

460

Questions

Will s 25-100 apply to the taxpayer in FCT v Collings (1976) 76 ATC 4254? This taxpayer was required by her employer to make extra trips from home to work outside of normal work hours when a problem arose that required her particular expertise. What will the effect of s 25-100 be for a taxpayer who operates a business from his home and also has a regular job with an external employer if the taxpayer seeks to deduct the expenses of travelling to the other job on the basis that he is travelling between two places of business? (See Case B9 (1970) 70 ATC 42 and Case F43 (1974) 74 ATC 245.) The taxpayer worked for a government agency. As a result of a reorganisation, the taxpayer’s position in the city in which he worked ceased to exist and he was transferred to another city. He incurred a number of moving expenses, for which he was partially reimbursed by his employer, to move to the other city. He sought a deduction for the balance. Is the unreimbursed portion deductible? What are the consequences of reimbursement? (See Fullerton v FCT (1991) 91 ATC 4983.) What impact does s 25-100 have on those workers who operate from a home base to various work locations? Do they get a s 8-1 deduction for the cost of the first call-out and the last call on the way home?

[8.45]

Personal and Non-personal Expenses

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3. CHILD CARE EXPENSES [8.50] Variations of the income nexus test (is this an expense that was incurred in the

income-earning process or to put the taxpayer in a position to derive assessable income?), which were argued unsuccessfully by the taxpayer in Lunney, have been raised on a number of occasions in the context of child care expenses. A re-examination of the question is found in Martin v FCT, in which the taxpayer was denied the deduction she sought.

Martin v FCT [8.60] Martin v FCT (1984) 2 FCR 260 Full Federal Court Bowen CJ, Toohey and Lockhart JJ: The issue before the court is the entitlement of the taxpayer to a deduction from her assessable income, of expenses incurred by her with kindergartens, in caring for her child while she was at work. In the Supreme Court of New South Wales the taxpayer’s claim to a deduction was rejected and she appeals against that decision. A number of such cases have come before boards of review in recent years and indeed the present taxpayer’s claim was rejected by such a board before it came before the Supreme Court. The basis for the rejection of the present taxpayer’s claim was the decision of Mason J in Lodge v FCT (1972) 128 CLR 171… In the case now before this court, counsel for the taxpayer submitted that Lodge’s case had been wrongly decided and that this court could and should decline to follow it. Alternatively, he submitted that Lodge’s case was distinguishable from the present appeal on the facts …. The meaning and scope of s 51(1) have been considered in many decisions. It is enough, for present purposes, to refer to two only of those decisions. In Ronpibon Tin NL v FCT (1949) 78 CLR 47 at 56-57, the High Court said: For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be incidental and relevant to that end. The words “incurred in gaining or producing the assessable income” mean in the course of gaining or producing such income. … In brief substance, to come within the initial part of the subsection it is both sufficient and necessary that the occasion of the loss or outgoing should

be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income. In Lunney v FCT (1958) 100 CLR 478, Williams, Kitto and Taylor JJ rejected the proposition that expenditure which is a prerequisite to the earning of a taxpayer’s income is necessarily expenditure incurred in, or in the course of, gaining or producing the income. Their Honours said: Whether or not it should be so characterised depends upon considerations which are concerned more with the essential character of the expenditure itself than with the fact that unless it is incurred an employee or a person pursuing a professional practice will not even begin to engage in those activities from which their respective incomes are derived. The present appeal falls to be determined by a consideration of s 51(1) as construed by the High Court in Ronpibon’s case and Lunney’s case… It may be accepted that the placing of her child in a kindergarten (and the incurring of expenses thereby) was a prerequisite to the taxpayer’s employment. It was not suggested that any other course was open to her if she was to take on any of the three jobs in question. But it is clear, at least since Lunney’s case, that such a consideration is not of itself sufficient to attract the operation of s 51(1). And it was for that reason that in Lodge’s case Mason J rejected the taxpayer’s claim. The character of the expenditure in that case was found by his Honour to be neither relevant nor incidental to the particular work upon which Miss Lodge was engaged. In our view the same considerations operate to preclude acceptance of the taxpayer’s claim in [8.60]

461

The Tax Base – Deductions

Martin v FCT cont. the present appeal. The expenditure incurred in kindergarten fees was a prerequisite to the taxpayer’s employment in the sense that it allowed her to take on the jobs in question. But

there was nothing about the expenditure which was relevant or incidental to the work which she was engaged to perform. The expenditure was not incurred in, or in the course of, performing the work for which she was employed, that of a steno secretary.

[8.70] Legislatures in other jurisdictions have provided some recognition for the cost of child

care when computing the tax liability of persons utilising child care services. In the United States, taxpayers are entitled to a disappearing offset, which is reduced as the taxpayer’s income rises. Legislation in Canada now allows taxpayers in that country to deduct a portion of child care expenses. In Australia, although professional women’s organisations have in the past called for similar deductions to be allowed, such deduction provisions have been strongly criticised as the deduction has an inequitable upside-down effect. A deduction for child care expenses would effectively mean that the government is funding a higher percentage of the child care expenses of wealthy taxpayers (in the highest tax bracket), while picking up a much lower percentage of the costs of taxpayers in the lowest bracket or none of the costs of taxpayers with incomes below the taxable thresholds. As a result consecutive governments have tendered to provide relief for childcare costs through the social welfare systems. Even when a childcare tax offset was introduced in 2005 (s 61-470 of the ITAA 1997) it was quickly replaced from 1 July 2007 by a Family Assistance payment administered by Centrelink. This welfare subsidy for child care is complemented by s 47(2) of the Fringe Benefits Tax Assessment Act 1986, which exempts the provision to employees of child care facilities on the business premises of the employer from fringe benefits taxation. Questions

[8.75]

8.5

The taxpayer, whose offices were located in a city office tower, together with another large downtown-based corporation, leased a house several kilometres from the city centre to provide child care facilities to employees of the two companies. Will the premises satisfy the requirements of s 47(2), particularly in respect of being located “on business premises of the employer”? (See Esso v FCT (1998) 40 ATR 76.)

8.6

If a policy decision is made to subsidise child care through the tax system instead of by way of direct grants or allowances, should the tax expenditure be inserted in the Income Tax Assessment Act 1936 or should the current concession in the Fringe Benefits Tax Assessment Act 1986 be expanded?

4. EDUCATION EXPENSES [8.80] A class of outgoing which sometimes straddles the threshold between personal and

non-personal expenses is that of education expenses. To the extent educational expenses put one in a position to find employment by conferring necessary skills or expertise, they resemble child care expenses; they are a prerequisite for the earning of income, but not an intimate part of the income-earning process. Some education expenses can lead directly to the earning of more assessable income, however. The dichotomy between the various types of education expenses was explored in the High Court by Menzies J in FCT v Hatchett. 462

[8.70]

Personal and Non-personal Expenses

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FCT v Hatchett [8.90] FCT v Hatchett (1971) 125 CLR 494 High Court Menzies J: This is an appeal by the Commissioner of Taxation against a decision of the Taxation Board of Review which, upon a reference, decided by a majority that the taxpayer, a teacher in the employment of the Education Department of Western Australia, was entitled to certain deductions from his assessable income for the year ended 30 June 1967. The deductions in question were a sum of $89 paid in connection with the submission of theses for the purpose of gaining a Teacher’s Higher Certificate and the sum of $71 paid for university fees for subjects in the Faculty of Arts. The university fees were $90 of which $19 had been refunded by the Education Department …. A Teacher’s Higher Certificate serves to enable a teacher to transfer from Scale B to Scale A and in Scale A enables progression beyond the 11th grade. It is also a necessary qualification for some positions in large primary schools. Possession of a Teacher’s Higher Certificate also carries with it higher salary without change of status … The first matter for determination upon the foregoing statement of facts is whether the sums in question were outgoings incurred in gaining or producing the assessable income of the taxpayer. It is apparent that the expenditure in question had nothing to do with the assessable income of the taxpayer for the year in which it was incurred. The last thesis was submitted on 30 June 1967, and the grant of the certificate, with effect from 1 July 1967, had no effect upon the assessable income of the previous year. There was, however, a plain connection between the obtaining of the certificate and the assessable income of the taxpayer for the year ended 30 June 1968 and subsequent years. This will have to be considered. The payment of university fees, however, seems to me to fall into a different category. Any relationship between any assessable income of the taxpayer and the payment of university fees is problematical and remote. Having regard to the taxpayer’s lack of success in passing university examinations it is not possible to find affirmatively that there exists any connection between the payment of university fees in 1967 and the

earning of assessable income at any time in the future. The prospects of the taxpayer obtaining a university degree leading to his promotion to positions in the service for which a university degree is a prerequisite affords no ground for concluding that the Commissioner was in error in refusing to allow the fees paid as deductions. If these fees are deductible it must be on a simpler footing, namely that expenditure upon university study, which the department encourages teachers to undertake, is, without more, incurred in gaining assessable income as a teacher. The distinction I have drawn between the two expenditures under consideration means that it will be necessary to consider the payments separately for there are grounds for allowing as a deduction the expenditure to obtain the Teacher’s Higher Certificate which do not exist to support the claim to deduct the university fees paid. There is, however, one matter in common to both expenditures that I shall dispose of before turning to consider them separately. There has been some suggestion that to equip the taxpayer’s mind in order that he may have higher earning capacity is an affair of capital … This is, I think, a misunderstanding. It seems to me that it would be wrong to consider any of the expenditure here under consideration as an outgoing of capital or of a capital nature. An outlay is of that character when it is expended to obtain what can properly be described as capital in the economic sense …. In the field of taxation, as in the field of business, “capital” is used in contrast with “revenue”; it has no reference to a man’s body, mind, or capacity …. The question first to be dealt with is whether the outgoings to obtain the Teacher’s Higher Certificate were incurred in gaining the assessable income of the taxpayer. It is now beyond doubt that, in considering this question, consideration must be given to assessable income of future years as well as that of the year in which the outgoing occurs. The evidence to which I have referred establishes that the possession of a Teacher’s Higher Certificate would not only enable the taxpayer to earn more in the [8.90]

463

The Tax Base – Deductions

FCT v Hatchett cont. department in the future, it forthwith entitled him to be paid more for doing the same work without any change in grade. If the certificate had been obtained during a tax year, instead of at the end of a tax year as was the case, it would have entitled the taxpayer to greater earnings in that year. The taxpayer, in reliance upon the conditions of his employment, spent money to earn more. In these circumstances the out-goings necessary to obtain the certificate ought, I think, to be regarded as outgoings incurred in gaining assessable income …. My conclusion that the expenditure in gaining the Teacher’s Higher Certificate was incurred in gaining assessable income in the circumstances carries with it the conclusion that the expenditure was not of a private nature. It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive. So, for instance, the payment of medical expenses is of a private nature and is not incurred in gaining assessable income, notwithstanding that sickness would prevent the earning of income. I am satisfied that the payments here in question, falling, as I decide, into the first category, do not fall within the second. It is for the foregoing reasons that I decide that the $89, paid in connection with the submission of theses for the purpose of gaining a Teacher’s Higher Certificate, is a deduction authorised by s 51. The university fees paid were paid with the encouragement of the department; it contributed

towards them. This, however, is not, of itself, enough to bring the fees within s 51. Enlightened employers often encourage employees to improve their bodies and their minds, and assist them to do so. Such encouragement is not, of itself, enough to warrant the deduction of outgoings for these purposes. The test to be applied is a more stringent one, namely were the outgoings incurred in gaining assessable income? Here, I am not dealing with the general question whether the payment of university fees can ever afford a deduction from assessable income; I am dealing with the particular question whether the fees paid by the taxpayer in the circumstances already stated are deductible. As I have said, I am not able to find any connection between the payment of fees and the assessable income of the taxpayer beyond the circumstance, which I take to be self-evident, that a teacher who has pursued university studies is likely to be a better teacher than if he had not done so and is therefore more likely to obtain promotion within the department. In my opinion this general consideration is not enough to make the fees deductible; there must be a perceived connection between the outgoing and assessable income. Had the taxpayer paid fees for subjects in the faculty of law, it would, I think, have been obvious that the fees were not allowable deductions. In my view the payment of such fees would have as much connection with the taxpayer’s assessable income as the fees in fact paid. … The payment of university fees was, I think, expenditure of a private nature notwithstanding the assistance given by the department.

[8.100] A deduction for education expenses otherwise allowable under s 8-1 will be limited by

the operation of s 82A of the ITAA 1936 to outgoings exceeding $250. This restriction dates from a time when the first $250 of education expenses qualified for a tax offset under s 159T of the ITAA 1936. The restriction was intended to prevent taxpayers from enjoying a double tax benefit from the first $250 of education expenses. The legislature failed to modify s 82A of the ITAA 1936 when s 159T was repealed in 1985. Because of the limits on many tax offsets prior to their repeal (total recognisable expenditure had to exceed $2,000 and the offset only applied to the excess), most taxpayers did not qualify for the offset with the result then as now that the first $250 of education expenses were not the subject of any tax allowance. In 464

[8.100]

Personal and Non-personal Expenses

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Taxation Ruling TR 98/9: Deductibility of self-education expenses incurred by an employee or a person in business, the Commissioner stated that education expenses “necessarily incurred by the taxpayer for or in connection with a prescribed course of education” but are not deductible may still be used for the purposes of s 82A. For example, if a taxpayer incurred expenditure for childcare, which is not deductible under s 8-1, this amount may qualify for first $250 of education expenses under s 82A. [8.105]

Questions

8.7

The taxpayer was an assessor with the Taxation Office and enrolled in a tertiary course which aided him in his successful applications for promotion and consequent increases in salary. The taxpayer sought to deduct $92 for fees and related expenses incurred in respect of the course and $11 for expenses incurred in travelling by bus from his place of employment to the Institute where he attended the course. The ATO allowed the deduction for $92. Should the $11 also be deductible as ancillary to the costs of education? (See FCT v Lacelles-Smith (1978) 78 ATC 4162.)

8.8

Menzies J suggested in Hatchett that the costs of obtaining a degree in law would not be a deductible expense. Would that assertion be true in the case of a practising lawyer specialising in taxation law who undertakes part-time study in a Masters program in taxation law? What if the tax lawyer wanted to move into an additional area of practice and commenced part-time study in a Masters program in family law?

8.9

The taxpayer was a clerk at Newcastle Local Court. She had completed a course in legal studies but was not eligible for appointment as a solicitor unless she completed a pre-admission course and be formally admitted. Is the cost of the pre-admission course deductible? (See Case Z1 (1992) 92 ATC 101.)

8.10

The taxpayer was a qualified mining engineer employed as a mine manager. After accepting a place at an American university to study full-time for an MBA, he was retrenched. Following completion of the course, he was employed as a mine manager at a significantly higher salary. Are the costs of tuition, travel, and accommodation deductible? Is the situation similar or distinguishable from that in Hatchett? (See FCT v M I Roberts (1992) 92 ATC 4781.) The taxpayer was: (a) a flight engineer employed by Qantas. He sought a deduction for the cost of flying lessons which he said improved his proficiency as a flight engineer and which he believed would increase his prospects of promotion to a higher grade of flight engineer. The ATO argued the principal purpose of the lessons was to retrain as a flight officer, a different (and more important) position. Are the expenses deductible? (See FCT v Studdert (1991) 91 ATC 5006.)

8.11

(b)

8.12

a police officer working in the criminal investigation branch (CIB) who commenced a commercial helicopter licence course. Afterwards, she obtained a transfer to the police air wing before returning to the CIB. Are the expenses deductible? (See Case 48/93 (1993) 93 ATC 520.)

The taxpayer undertook Swedish studies in Australia and Sweden in order to read technical magazines in his field published in Sweden. The taxpayer had no other motive in learning Swedish and as a consequence of learning the language the taxpayer could do his duties more effectively after researching Swedish materials provided by his employer. Will the costs of the course in Sweden be deductible? (See Case 41/95 (1995) 95 ATC 361.) [8.105]

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The Tax Base – Deductions

8.13

8.14

8.15

A condition of entitlement to a Youth Allowance received by the taxpayer was that she be enrolled in full-time tertiary studies. The Youth Allowance payments were treated as assessable income and the taxpayer wished to deduct the cost of books and related expenses as expenses incurred to “derive” that income. Will the deduction be allowed? (See FCT v Anstis [2009] HCA 40.) The taxpayer was a senior journalist whose position required him to liaise with advertisers and interview people. He sought to deduct a speech therapy course taken to enable him to present himself better to people in the work environment. Will the expense be deductible? (See Case Z42 (1992) 92 ATC 381.) Would a HECS payment be allowable as a deduction? (See s 26-20.)

5. TRAVEL EXPENSES [8.110] One of the most frequently litigated areas of dispute in the context of personal and

non-personal business or employment outgoings is that involving travel expenses. The arguments raised in this context were reviewed in the Full High Court decision in FCT v Finn. Mr Finn was a senior architect in the Public Works Department of Western Australia responsible for building designs. He planned to use a combined long service leave and recreation leave entitlement to travel through Great Britain and continental Europe. He indicated to his employer that he would study overseas architectural trends while he travelled. The employer subsequently asked him to extend the travels to include a trip to South America and to make a survey of architecture there as well. His leave was extended to enable him to undertake the additional travel and the employer paid his return fare from England to South America. The taxpayer claimed to have been engaged exclusively in studying architecture during his trip. He took several hundred photographs and collected a great deal of material he said would be used for future reference. He conferred with leading architects in the cities he visited. The taxpayer sought to deduct his fares, hotel costs and sundry expenses, net of the employer’s contribution, under s 51 under the heading of “travelling expenses”.

FCT v Finn [8.120] FCT v Finn (1961) 106 CLR 60 Full High Court Dixon CJ: The deduction is claimed by a professional officer in the service of the Government of Western Australia. His claim is that he incurred the expenses of travelling in order the better to fit himself to perform the work which the Western Australian Government required of him, and therefore he became entitled to deduct them under the first limb of s 51(1) …. It was admitted on behalf of the Commissioner of Taxation that all the taxpayer’s activities abroad were devoted to architecture and its study. He kept a written record of what he did and of the buildings he visited and studied. It is clear that he covered a great deal of architectural ground, that he concentrated upon it for seven days a week throughout his tour and that he made voluminous notes, took numbers of photographs and made 466

[8.110]

many sketches and wrote up reports and records. In short there can be no question that all his available time was devoted to the advancement of his knowledge of architecture and the development of his architectural equipment, outlook and skill. If the point be whether the money claimed as a deduction were laid out for the improvement of his capacity to do the work for which he is paid, there could be no doubt that the whole expenditure was directed to that purpose. But the case for the Commissioner is that that is not the point or, at all events, it is a fact that is insufficient to support the claim for the deduction. In the first place, so it is contended for the Commissioner, the improvement of his capacity to do the work for which he is paid does not mean that he will be paid more, that his title

Personal and Non-personal Expenses

FCT v Finn cont. to be paid will be better secured or that any chance of promotion to a higher position will be increased and, if there be any chance of his present status being diminished, that that chance would be lessened or removed. Thus in no way, it is said, were the costs of his search abroad for better knowledge “incurred in gaining or producing the assessable income” derived from the State …. From the facts that have been stated above three or four conclusions may be drawn which perhaps may be considered to govern the question whether the expenditure was incurred in gaining or producing the assessable income. In the first place it seems indisputable that the increased knowledge the taxpayer sought and obtained of his subject and the closer and more realistic acquaintance he secured of modern developments in design and construction made his advancement in the service more certain, and that in respect of promotion to a higher grade these things might prove decisive. This was put clearly by the Principal Architect, though in a letter written ex post facto: “I understand from you that the Commissioner now desires to know whether the experience obtained and the large amount of data collected will result in an increase in your income. To me, it is obvious that this must increase your professional efficiency, and hence your value to this Department, and must materially assist your future advancement to a higher position in the Department with consequent increase in income.” In the second place, so far as motive or purpose is material, advancement in grade and salary formed a real and substantial element in the combination of motives which led to his going abroad. In the third place it is apparent that the heads of his Department, and indeed the government itself, treated the use which he made of his long service and other leave to study architecture, increase his professional knowledge and study modern trends, as a matter not only of distinct advantage to his work for the State but of real importance in at

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least one project in hand. In the fourth place it was all done while he was in the employment of the government, earning his salary and acting in accordance with the conditions of his service. He was in fact complying with the desires, and so far as going to South America was concerned, with the actual request of the government. His journey abroad and what he did while in Europe, as well as in South America in the following year of income, was therefore in a correct sense incidental to his employment and most relevant to it. When the foregoing elements are considered in conjunction, they do seem to form a firm foundation for the conclusion that the expenditure was in truth incurred in gaining or producing assessable income. … There remains the question whether the taxpayer’s expenditure upon his journey in gaining improved and up-to-date architectural knowledge is to be considered as falling within the exception of losses or outgoings of capital or of a capital, private or domestic nature. This question should be answered by a definite negative. The money was laid out by the taxpayer in the acquisition of better knowledge of a skilled profession. The pursuit of information concerning the modernisation or improvements in an art is part of the constant process of keeping up to date which skilled professions call upon those who practise them to pursue, though sometimes in vain. Had he dwelt nearer to the sources of such knowledge and information he doubtless would have visited them from time to time in his career. As it was he had been able to do so only once before and in the meantime had depended on literature. It is simply a false analogy to treat him in his visit abroad as engaged in the equivalent of the acquisition of something of an enduring nature and therefore capital. You cannot treat an improvement of knowledge in a professional man as the equivalent of the extension of plant in a factory. Unfortunately, skill and knowledge of most arts and sciences are not permanent possessions: they fade and become useless unless the art or the science is constantly pursued or, to change the metaphor, nourished and revived. They do not endure like bricks and mortar.

In separate judgments, Kitto and Windeyer JJ agreed with Dixon CJ. [8.120]

467

The Tax Base – Deductions

[8.125]

Questions

8.16

In a sense, the Finn case represents a relaxation of deductibility criteria when compared with the approach in Lunney or Martin. The taxpayers in those cases were at least able to make the “but for” argument – but for their employment, they would not have incurred the expense. By way of contrast, the taxpayer in Finn may very well have taken the trip he did, or at least the European portion of the trip, even if he had another job. Viewed in this context, does the decision make sense? Could it be used as the basis for reversing Lunney or Martin? How can those cases be distinguished from Finn?

8.17

The taxpayer made an overseas trip for business and pleasure. Approximately 50 per cent of his time was related to the business purpose for his trip and 50 per cent on sightseeing. How should the travel expenses be apportioned? Would the taxpayer be correct in arguing that the airfares would have been necessary even if there had been no personal sightseeing, therefore they should be deductible in full? (Compare Case K89 (1959) 10 TBRD 477 with Case S65 (1985) 85 ATC 469.) The taxpayer made a business trip and brought along his spouse for personal reasons. A room in the hotel in which he stayed cost $80 a night for a single and $100 for a double. Should he be allowed to deduct $80 or $50 (half the cost of the room he shared with his spouse) as a business expense? (Compare Case J53 (1977) 77 ATC 468 with Case S80 (1985) 85 ATC 589 and Case V15 (1988) 88 ATC 177.)

8.18

6. HOME OFFICE [8.130] The onus is always on the taxpayer to establish the requisite nexus with the

production of assessable income before an expenditure will be deductible under s 8-1. The courts tend to impose particularly strict standards on taxpayers in situations where the potential for abuse is significant. In fact, it has been suggested that in some types of cases the taxpayer should be required to establish an almost exclusively non-personal purpose for an expense before a deduction will be allowed. The concerns motivating those suggestions may help explain the conflicting judgments of a divided High Court in Handley v FCT. A majority of the High Court denied the taxpayer in Handley, a barrister, a deduction for expenses associated with his home office.

Handley v FCT [8.140] Handley v FCT (1981) 148 CLR 182 Full High Court Wilson J: The appellant is a barrister who in addition to his city chambers maintains a study in his residence. He uses the study for the purposes of his professional practice for something like 20 hours a week for about 45 weeks of the year. His total work commitment is 80 to 100 hours a week. There was no physical separation of the study from the remainder of the house, it being adjacent to the living room. Its use for other than professional purposes was infrequent and intermittent. The taxpayer claimed to deduct pursuant to s 51 of the Income Tax Assessment Act 1936 (the Act) a proportion of the interest paid 468

[8.125]

under a mortgage upon his home, and of municipal and water rates and of insurance premiums in respect of the premises …. In my opinion, the [taxpayer’s] appeal cannot succeed. The room used as a study does not cease to be part of the taxpayer’s home merely because as a matter of convenience he uses it for professional purposes for 20 hours per week during 45 weeks of the year. It is true that in choosing for purchase in 1969 this particular residence as a home for himself and his family the taxpayer was influenced by the fact that there was in it a room which he considered to be

Personal and Non-personal Expenses

Handley v FCT cont. suitable for use by him as a study. But it remained essentially part of his home. The payments for mortgage interest, rates and insurance premiums were of a kind which in the circumstances of this case cannot be apportioned between home and

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office expenses. They related to the building and/or land as a whole, and are not affected in any way at all by reason of the fact that the taxpayer performs professional work on the premises. They would remain the same whether or not he worked at home.

Murphy J also decided against the taxpayer. He argued for an even more stringent prohibition on deductibility: Murphy J: The taxpayer’s study was used so that he could do some of his work at home. The taxpayer, like most other income earners with a family, had to spend most of the week days away from home engaged in his earning activities. He therefore wished to spend his evenings and weekends amid his family in circumstances where he could work if he wished, rather than in his professional chambers. Any outgoing incurred for this purpose was of a domestic nature even if it were incurred in earning assessable income. … In my opinion it would make no difference if other members of the taxpayer’s family never entered the study and if it were exclusively devoted to his study of briefs or more general legal studies connected with his profession. Even if the barrister’s study were removed to a building adjacent to or near to his home, this may not be enough to change the domestic nature of the outgoings in connection with it. These are all questions of degree. In practice a strong pointer is whether there is some other place where the work could be done and whether the doing of it at home is really for the domestic convenience of the taxpayer. There are circumstances in which a barrister’s outgoings in connection with part of his home would not fall within the exception of outgoings of a private or domestic nature, for example if part of the home were actually used for professional chambers. If the part of a home used in gaining assessable income were in a real sense a place of business, this would in general mean that the outgoing (even if some apportionment were called for) would be allowable. Thus, the case is quite different from that of a doctor, a marriage celebrant, a caterer, an author or a solicitor who

uses part of his or her home as a place of business. This reference to place of business is not intended to be exhaustive; it may be sufficient but not necessary that the outgoing is referable to a place of business, for it to be an allowable deduction. Acceptance of the taxpayer’s claim could lead to curious or even absurd results. Many lawyers, to the annoyance of their domestic partners, do a lot of legal reading in the bedroom. Also there is much scientific and anecdotal evidence in favour of the view that intellectual work goes on subconsciously as well as consciously, even during sleep. Perhaps the next claim would be for deducting part of the upkeep of the bedroom, or even a claim for part of the upkeep of the garden in which a barrister thinks about the conduct of cases whilst resting or strolling. The words “to the extent” in the domestic exception in s 51(1) require apportionment in cases where the outgoing is not wholly allowable, because it is to some extent of a domestic nature. An example might be where part of a barrister’s home was used as professional chambers for several days only of the week and was used at other times for purposes of a domestic nature (income earning or not). In the present case apportionment is not required because the outgoings are entirely of a domestic nature. The appellant claimed that the allowance by the Commissioner of apportioned amounts for heating and cleaning of the study is inconsistent with the disallowance of the disputed amounts for interest and insurance. In my opinion there is force in this contention, but the correctness of the allowance for heating and lighting is not open for decision in this appeal. [8.140]

469

The Tax Base – Deductions

[8.150] Mason J agreed with Wilson and Murphy JJ that Stephen and Aickin JJ would have

allowed the taxpayer’s appeal. Stephen J said that to deny any deduction for the home office was contrary to the apportionment words of s 51(1). In the companion case to Handley, that of FCT v Forsyth, there was some discussion of the distinction between a private expenditure and a domestic expenditure.

FCT v Forsyth [8.160] FCT v Forsyth (1981) 148 CLR 203 Full High Court Wilson J: The relationship between the first part of s 51(1) and the exception of outgoings of a capital, private or domestic nature, was the subject of comment by Menzies J in FCT v Hatchett: My conclusion that the expenditure in gaining the Teacher’s Higher Certificate was incurred in gaining assessable income in the circumstances carries with it the conclusion that the expenditure was not of a private nature. It must be a rare case where an outgoing incurred in gaining assessable income is also an outgoing of a private nature. In most cases the categories would seem to be exclusive. With respect, I can readily accept his Honour’s statement. But it will be noted that it is confined to outgoings of a private nature. It is certainly not true of outgoings of a capital nature, as his Honour recognised ….

Nor, in my opinion, should it necessarily be true of outgoings of a domestic nature. I see no reason why it would not be a proper application of s 51 of the Act in the present case to say that if the proper conclusion on the facts was that the rent was prima facie an outgoing incurred in gaining or producing the assessable income then the exception with respect to outgoings of a domestic nature would operate to exclude it from deductibility. The meaning of “domestic” is “of or belonging to the home, house, or household” (Shorter Oxford English Dictionary). It seems to me to be plain, as a matter of common sense, that the taxpayer’s agreement with the trustees is “of or belonging to the home, house or household” and is therefore of a domestic nature notwithstanding that it provides for certain parts of the home to be occupied for professional purposes.

[8.170] The ATO’s views on the deductibility of home office expenses is set out in Taxation

Ruling TR 93/30: Deductions for home office expenses. [8.175]

8.19

Questions

Was Stephen J correct when he suggested in Handley that the majority judgment ignores the apportionment wording of s 51(1)? How can the concerns of Stephen J be reconciled with the concern that a taxpayer is seeking a deduction for a business expense that only the taxpayer can verify? Is a statutory formula desirable, perhaps? Consider, for example, the following provision from the United States Internal Revenue Code. Should Australia adopt something similar? 280A (a) Except as otherwise provided in this section, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit

470

[8.150]

Personal and Non-personal Expenses

CHAPTER 8

which is used by the taxpayer during the taxable year as a residence …. (c) (1) Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis –

8.20

(A)

[as] the principal place of business for any trade or business of the taxpayer,

(B)

as a place of business which is used by patient, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business, or

(C)

in the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

Assume a taxpayer was successful in claiming a deduction for expenses relating to part of his principal residence used for business activities. How will this affect his principal residence exemption for capital gains tax purposes? (See s 118-190.)

7. CLOTHING [8.180] What sort of criteria should be relied upon to characterise outgoings used to acquire

items that appear to be connected with a taxpayer’s employment or profession, but which could be of use to the taxpayer in a personal context? Most decisions involving deduction claims for clothing have been judgments of the Boards of Review or AAT; virtually no clothing cases have made it to the courts. Boards of Review have relied on a variety of tests to decide clothing cases. Some commentators classify these tests into two categories: those which consider whether the clothing is necessary and peculiar for the taxpayer’s employment; and those which consider whether the taxpayer’s clothing, though otherwise ordinary, would constitute an abnormal cost to the taxpayer. The former test could be used to permit a deduction for, say, a surgeon’s gown or police officer’s uniform. The latter test would apply in more unusual circumstances such as a winter coat used by a person working in a freezer room. Division 34 of the ITAA 1997 now denies a deduction for expenses incurred by employees to acquire, repair and clean non-compulsory uniforms and corporate wardrobes. A deduction is only allowed for non-compulsory uniforms or corporate wardrobes where the design of the uniform has been entered on the Registrar of Approved Occupational Clothing by the employer at the time the expense was incurred and the requirements of s 8-1 are otherwise satisfied. Division 34 does not deny a deduction for expenditure incurred in respect of compulsory uniforms or clothing other than uniforms if the expense would otherwise be deductible under s 8-1. The ATO’s views on deductible and non-deductible clothing expenses are set out in Taxation Ruling TR 97/12: Deductions for Clothing. [8.185]

8.21

Questions

In light of: (i) the “but for” argument which failed in Lunney and Martin; (ii) the “nexus with employment test” which was accepted in Finn; and (iii) the potential for abuse, which of the following types of clothing expenses do you think will give rise to allowable deductions: (a) The cost of jumpers, t-shirts, shorts and shoes used by a professional football player. (See Taxation Ruling IT 54.) (b)

The cost of clothes worn on duty by a plain-clothes police officer. (See Case 23 (1944) 12 CTBR 379.) [8.185]

471

The Tax Base – Deductions

(c)

(d)

The cost of stockings which a nurse in the Northern Territory was required to wear to work even though she would not wear them by choice given the heat. (See Case N97 (1981) 81 ATC 521.) The cost of a formal suit acquired by a part-time professional photographer to wear at weddings. (See Case V52 (1988) 88 ATC 402.)

(e)

8.22

8.23

The cost of black formal clothes purchased by a female barrister for court appearances. (See Mallalieu v Drummond [1983] BTC 380.) (f) The cost of clothes, dry cleaning and grooming expenses incurred by a senior fashion editor of a top fashion magazine. (See Case 16 (1993) 93 ATC 208.) (g) The cost of Oakley wrap-around sunglasses purchased by a police motorcycle patrol officer because the employer-provided glasses gave the taxpayer headaches when worn inside his open-face helmet. (See Case 10/94 (1994) 94 ATC 168.) The taxpayer was the personal secretary to the wife of the Governor of Queensland. Her position required her to expand her wardrobe and purchase high-quality clothing for daily use in her employment. The taxpayer attended the Governor’s wife on all her engagements and was often required to change her clothing two or three times a day. She argued that an initial set of clothes for the day would be normal but her additional purchases of clothes were made only because of the need for her to change several times a day for official functions. She conceded some of the additional clothes were used for private purposes on limited occasions and accordingly apportioned the cost of the clothing, claiming a deduction for only two-thirds of the cost. (a) Can an expense be apportioned in this way and partly deductible under s 8-1? (See FCT v Edwards (1994) 28 ATR 87. See also Taxation Ruling TR 94/22 Income Tax: implications of the Edwards case for the deductibility of expenditure on conventional clothing by employees.) (b) Will it make a difference if the person needed to change for professional appearance in a private sector capacity? The taxpayer was the CEO and a director of a company which she owned in partnership with her former husband. The taxpayer was required to make presentations at conferences and seminars and other functions which were attended by the company’s consultants and distributors, both in Australia and overseas. She changed her clothes at these seminars and conferences several times a day “in order to present the necessary image to the consultants and distributors”. Is the cost of clothing in excess of the cost she would have otherwise spent an allowable deduction? (See AAT Case [2006] AATA 100; (2006) 61 ATR 1192.) The taxpayer was a flight attendant who received assessable allowances from her employer for cosmetics and hairdressing, stockings, and shoes. She sought to deduct the cost of: • hairdressing conditioner, needed to offset the dryness of pressurised aircraft; • other hairdressing expenses incurred to be well-groomed as required by the employer; • moisturising skin cream, again needed to offset the dryness of pressurised aircraft; • other cosmetics needed to ensure she was well-groomed as required by the employer; • shoes one-half size larger than her normal size, needed because of swelling in the pressurised cabin; and • pantyhose conforming with the employer’s guidelines for matching with the company uniform.

472

[8.185]

Personal and Non-personal Expenses

8.24

CHAPTER 8

Which, if any, of these expenses are deductible? (See Mansfield v FCT (31) ATR 367.) The taxpayers were engaged in a variety of occupations that required them to work outdoors, including a farm manager, game fishing boat operator, teacher of maritime studies, surveyor and construction supervisor. They incurred a variety of sun protection expenses including the cost of sunglasses, sunscreen and sun hats. Are the expenses private and domestic outgoings? (See Morris v FCT (2002) 50 ATR 104.)

8. FOOD, DRINK AND ENTERTAINMENT (a) Entertainment to Employees and Third Persons [8.190] Food, drink and entertainment expenses can clearly be incurred for legitimate business reasons and equally clearly will invariably substitute for ordinary personal consumption of the beneficiary. The difficulties in locating when such expenses are incurred for purposes of earning assessable income is illustrated in the judgements of Hill and Wilcox JJ in FCT v Cooper (1991) 21 ATR 1616. In Cooper the full Federal Court had to consider whether the taxpayer was entitled a deduction for the cost of an additional food prescribed by his coach Roy Masters to consume each week in order to maintain his weight. The food prescribed included “at least” one dozen cans of beer a week in addition to his current intake.

FCT v Cooper [8.200] FCT v Cooper (1991) 21 ATR 1616 Full Federal Court Hill J notes: Food and drink are ordinarily private matters, and the essential character of expenditure on food and drink will ordinarily be private rather than having the character of a working or business expense. However, the occasion of the outgoing may operate to give to expenditure on food and drink the essential character of a working expense in cases such as those illustrated of work related entertainment or expenditure incurred while away from home. No such circumstance, however, intervenes here. In particular, the mere

fact that Mr Masters suggested or even directed Mr Cooper to eat particular food, does not convert the essential character of the food as private into a working expense. In my view, the expenditure in question fails to be deductible because its essential character remains private. The analogy with medication is not an apt one even if it be correct that such medication be deductible. The medication does not have the essential character of a private expense to start with. (p 1638)

Wilcox J, although dissenting also noted the difficulties: … Everything depends upon the ambit of the facts selected for inclusion in the description of essential character; so that the making of that selection predetermines the outcome of the case. Take the instance of a taxpayer visiting another city for business purposes. The taxpayer incurs expenditure for [1626] meals at his or her hotel. On one view, the essential character of the expenditure is the sustenance of the taxpayer. Such a purpose has no connection with the

derivation of assessable income; other than in the broad sense - irrelevant because it is applicable to everyone - that one must eat to live and, therefore, to work and to earn assessable income. However, the expenditure may also be characterised as being the cost of sustenance incurred by the taxpayer because of his or her absence from home on business. The difference between the two characterisations is that the latter takes account of the occasion of the [8.200]

473

The Tax Base – Deductions

FCT v Cooper cont. expenditure.

When

this

characterisation

is

adopted, a work-connection immediately appears and a deduction is granted. So in the present case. (p 1625)

[8.205] As well as these practical difficulties policy makers have had concerns, in particular in

respect of the subsidisation by the tax system of what are viewed as expenses incurred for predominantly social or personal benefit. These policy and practical concerns are reflected in the 19 September 1985 Ministerial Statement, Reform of the Australian Taxation System, where the then Treasurer Paul Keating. The Treasurer noted in announcing the removal of deductions for entertainment (Commonweath of Australia, Reform of the Australian Taxation System (1985), AGPS) that: One of the greatest difficulties in recent years in determining legitimate expense claims has been in the area of entertainment. A good deal of so-called business entertainment tends to be done on a reciprocal basis and is often undertaken for predominantly social or personal benefit rather than business purposes. In practice it is almost impossible for the Tax Office to separate those social activities from genuine commercial activities but it appears that the major part of expenses claimed have little or no genuine relevance to business activity.

It is the Government’s view that the general public should not have to subsidise through the tax system the social activities of higher income earners who seek tax deductions for entertainment expenses. Accordingly it has been decided to deny deductions for all entertainment expenses incurred after today. Reflecting the lagged nature of business tax payments, this measure will produce $310m in revenue in 1986-87 and $330m in 1987-88. (p 80) [8.210] Until this announcement the legislature’s responses to the problem of taxpayers

seeking deductions for expenses with high personal elements were ad hoc. They included the enactment of the predecessor to s 26-45, which denies taxpayers deductions for the cost of their club or leisure facility fees and the predecessor to s 26-50, which denies taxpayers deductions related to ownership or use of a leisure facility or boat. Taxpayers had been claiming a deduction such expenses. Another example is s 26-30 which prevents taxpayers from deducting the travelling costs of relatives who accompany them on a business trip. A related, but less comprehensive, measure aimed at the personal consumption element of automobile use is s 42-215. It sets a limit on the cost of a car that can be recognised for depreciation purposes. The removal of deductions for entertainment expenses was done by the enactment of predecessor to s 32-5 of the ITAA 1997, which prohibits the deduction of “entertainment expenses” except in certain specified instances. The relationship between s 8-1 and s 32-5 is not made entirely clear in either provision, but it is most likely that s 32-5 is intended to apply to deductions that would otherwise be deductible under s 8-1. In other words, the entertainment expenses to which s 32-5 applies would prima facie satisfy the nexus requirements of the positive limbs of s 8-1 and would not trigger the negative limb in s 8-1(2)(b), which applies to personal expenses. The drafting technique used in the entertainment deduction denial Division is typical of much tax legislation. Rather than target particular expenses, the provision covers a wide field, and specific exemptions are then carved out of the general rule. Thus, the definition of “entertainment” in s 32-10 catches almost every sort of “entertainment” conceivable – 474

[8.205]

Personal and Non-personal Expenses

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entertainment by way of food, drink, recreation, accommodation and travel. Moreover, in the spirit of comprehensive drafting, it appears to catch payments by a taxpayer for selfentertainment (there is some debate about this, as discussed further below), for entertainment of employees and for entertainment of anyone else. Payments are caught regardless of the context in which the entertainment is provided. Among the exceptions to the broad prohibition are ones for innocent taxpayers such as restaurants providing meals to customers (hence the need for s 32-40) and retailers utilising entertaining advertising such as Christmas window displays (hence the need for s 32-45 Item 4.2). Other exemptions include the exception for meals, accommodation and travel incidental to a person’s attendance at an eligible seminar (see s 32-35), the exception for the provision of an in-house sports or leisure activity recreational facility (see s 32-30 Item 1.5 and the definition of “recreation” in s 995-1) and the exception for meals and drink provided to employees at an in-house dining facility (see s 32-30 Item 1.1). The adoption of the predecessor to s 32-5 led to the establishment of in-house dining facilities at many legal and accounting firms and financial institutions, among other places. In theory, there would be no objection to the person providing the entertainment taking a deduction for the cost of the entertainment if the person receiving it (which may be the same person) included the value of the entertainment in his or her assessable income, or the benefit was otherwise taxed. This principle is recognised in part by a rule that taxpayers may deduct the cost of entertainment expenses where the provision amounts to the provision of a fringe benefit: see s 32-20. Division 9A of the Fringe Benefits Tax Assessment Act 1986, applying to “meal entertainment” fringe benefits, operates in conjunction with s 32-30 to provide taxpayers with an election between no deductibility for the expense and no fringe benefit, or full deductibility and assessment as a fringe benefit. If s 21A of the ITAA 1936 applied to all entertainment benefits provided to business associates (as opposed to employees), a similar approach could be taken with these benefits. However, the logistics of ensuring the other party will be paying tax on deductible expenses is simply too hard to manage, so the deduction denial is the simplest surrogate tax alternative where benefits are not provided to employees. The ATO’s interpretation of the provisions dealing with entertainment expenses is set out in Taxation Ruling TR 97/17: Entertainment by way of food and drink. [8.215]

Questions

8.25

The Australian legislation presumes that the consumption factor in entertainment benefits is sufficiently large to justify a complete denial of deduction. A similar approach has been adopted in the United Kingdom. Other jurisdictions such as the United States and Canada have experimented with pro rata formulae that limit the deductibility of entertainment expenses to a certain percentage of the outlay. Which approach is preferable?

8.26

Consider the following fact situations and decide whether the nominated paragraphs of s 32-30 to s 32-50 will apply: (a) An appliance store offers customers a free dinner in a nearby German restaurant if they buy a German television during a special German products promotion sale. (See s 32-45 Item 4.1.)

[8.215]

475

The Tax Base – Deductions

(b)

8.27

An appliance store offers free doughnuts and coffee to anyone visiting the store to see a new range of televisions. To be eligible for the free food and drink, customers must present a coupon printed in the company’s advertising brochure which was distributed to households within a two-kilometre radius of the store. (See s 32-45 Item 4.3.) (c) The taxpayer company pays an annual rental for a box at a cricket ground. The taxpayer’s name is prominently displayed on the front of the box, which is in view of television cameras covering the sporting events at the cricket ground. The taxpayer allows executives of the company and clients to use the box without charge. (See s 32-45 Item 4.3.) What is the effect of the apportionment wording in s 32-20? (See also TD 92/162.) The taxpayer regularly provided lunches to its executives in the boardroom. The meals were prepared in a kitchen off the boardroom. Do the meals fit within the s 32-30 Item 1.1? (See s 32-55 “in-house dining facility” and Taxation Ruling IT 2675.)

(b) Entertainment by a Taxpayer to Himself or Herself [8.220] Section 32-10 defines “entertainment” in circular terms: entertainment means

entertainment by way of food, drink or recreation. The so-called definition raises two issues. The first is whether entertainment necessarily involves entertaining someone else whether a taxpayer can entertain him or herself by, say, buying a meal. The second is whether entertainment is merely the provision of food, drink or recreation, or whether there must be an additional “entertaining” element to the benefit. The first issue was easily answered with the 1936 Act, which explicitly defined the “provision of entertainment” to include provision to oneself. This language is missing from the 1997 Act. However, as the exceptions to s 30-5 include two exceptions for meals provided by the taxpayer to him or herself (ie s 35-35 Item 2.1 provides an exception for meals in conjunction with a seminar and s 32-50 Item 5.1 provides an exemption for meals purchased with an overtime allowance provided in accordance with an industrial agreement), these sections clearly imply that a taxpayer can entertain him or herself. In respect of the second issue (whether “entertainment” connotes mere provision of food or does it suggest a subjective element of being entertained in the sense of deriving additional pleasure over and above the meal itself) there is some debate as to the meaning of the term and the various viewpoints are canvassed by the ATO in Taxation Ruling TR 97/17. The ATO’s view seems to be that some self-provided meals can constitute entertainment, but that entertainment also seems to require the additional element of pleasure over and above the simple eating of food for a meal to constitute entertainment. Perhaps the clearest pointers to the intended relationship between s 8-1 and s 32-5 and the subjective elements required of entertainment arise in the area of expenditures on accommodation and food in the course of business travel. The note to s 32-10 (which defines entertainment) says business travel expenses are not “entertainment”. This suggests the legislators clearly anticipated the expenditures being deductible under s 8-1 and sought to exclude the outgoings from s 32-5 to preserve the deductibility of these expenses. Certain allowances known as “living-away-from-home allowances” are exempt from fringe benefits taxation to the extent they compensate the taxpayer for the extra cost of food and accommodation over that which would normally be incurred by the taxpayer had he or she not been required to work away from home. Thus, to the extent the allowance is merely a reimbursement of expenses that would be incurred anyway, it is a taxable benefit. The logic 476

[8.220]

Personal and Non-personal Expenses

CHAPTER 8

behind this formula suggests a taxpayer who incurs meal costs while on a business trip should be allowed to deduct the cost of the meals only to the extent that they exceed the cost he or she would have incurred for a meal at home. However, provided the expense satisfies the requirements of s 8-1, the note to s 32-10 contemplates the entire outgoing falling outside the definition of entertainment (and thus being wholly deductible). Many industrial awards and individual contracts provide for the employer to provide employees with meal allowances in addition to ordinary wages. These may be designed to compensate employees for the cost of meals consumed at work when an employee stays back to work overtime or for meals consumed in the course of travel for the employer. Allowances, including meal allowances (other than living-away-from-home allowances specifically exempt from fringe benefits taxation) and travel allowances, are normally treated as ordinary assessable income. In order to claim an offsetting deduction, the taxpayer would have to show first that the expense was otherwise deductible under s 8-1, and either was not entertainment or was entertainment but was exempt from the operation of s 32-5. Just what meal expenses cross the initial threshold is not clear. The legislators apparently thought meals on travel would satisfy s 8-1 or they would not have indicated these meals do not constitute entertainment. Presumably they thought meals purchased while working on overtime also satisfied s 8-1 but in this case were entertainment, thus necessitating a specific exemption for this type of expense. Within these apparently arbitrary boundaries, drawing borders between deductible and non-deductible meals is a very difficult task. [8.225]

8.28

8.29

8.30

8.31

Questions

The taxpayer incurs expenses for accommodation and meals while attending a conference. Do ss 32-35 and 32-65 resolve the question as to whether the expenses are otherwise deductible under s 8-1 and, if so, whether they are entertainment? The taxpayer was a truck driver who received an allowance for overtime meals. The allowance satisfied the requirements for s 32-50 Item 5.1 and the taxpayer was accordingly allowed to deduct this amount. However, his meal expenses exceeded his meal allowance. If the initial amount is deductible under s 8-1, would the excess also be deductible under this section? If it would otherwise be deductible, does Item 5.1 imply the excess over the allowance is caught by s 32-5? (See Re Carlaw and FCT (1995) 31 ATR 1190 and AAT Case 10,700 (1996) 31 ATR 1375.) Are there cases in which consumption of food can be directly linked to the derivation of income? How would a court characterise the food expenses of a professional footballer whose coach advised him to consume additional food and drink (including steak, beer, potatoes and an energy drink) to maintain his weight, so he could play first-grade football and earn a higher income? (See FCT v Cooper (1991) 21 ATR 1616.) If the cost of the food is otherwise deductible, is it entertainment? The taxpayer was a movie projectionist who received a meal allowance to purchase food for consumption in the projection room (there being no meal break in the taxpayer’s shift). Is the cost of the meals purchased deductible under s 8-1? (See Case 29/94 (1994) 94 ATC 280.) If the cost of the food is otherwise deductible, is it entertainment?

9. HOBBY/BUSINESS EXPENSES [8.230] Administering the personal/non-personal borderline is particularly difficult in the

case of so-called hobby expenses, and in particular those incurred in respect of “hobby farms”. [8.230]

477

The Tax Base – Deductions

These are expenses related to an activity that on its face appears to be a legitimate enterprise whose purpose is ultimately to derive assessable income. However, the tax administrator may suspect (often with very good reason) that the activity is actually a hobby or recreation of the taxpayer and the expense is more properly characterised as a personal consumption expenditure. The ATO originally tried to prevent taxpayers from deducting expenses that appeared to be incurred in hobby-like activities by arguing the taxpayer’s activities did not amount to a business. However, as we saw in Chapter 5, this argument is often difficult to make – if owning a single goat can be income-earning activity, the ATO would be fighting an uphill battle trying to claim an apparent enterprise carried on over a period and comprising regular activities is not a business. Overseas experience has shown that the only satisfactory way of dealing with this problem is the adoption of a statutory formula that presumes expenses on hobby-like activities are personal in nature unless a profit is realised at some point. The formula is usually very generous and operates to the taxpayer’s favour in marginal cases, but seeks to prevent taxpayers incurring expenses on what are in essence personal hobby activities from deducting those expenses against income from genuine income-earning activities. The Australian rules, known as the “non-commercial loss” rules, generally follow overseas precedents. They are located in Div 35 of the ITAA 1997. The non-commercial loss rules quarantine business losses to income from the same type of business, with an indefinite carry-forward of excess losses.They apply only to an individual who is “carrying on a business activity in an income year, either on their own, or in a general law partnership” (s 35-5), as expenses incurred by companies or trusts are effectively quarantined at the company or trust level in any case. There must be a business carried on for Div 35 to apply. If the activity is a hobby then Div 35 has no application (see Gilbert v FCT [2010] AATA 882). It applies to each business activity carried on by a taxpayer separately unless those activities are businesses “of a similar kind” and can be grouped (s 35-10(3)). For example, wine producers run a mix of business from the same land often consisting of grape growing, wine making, cellar door and online sales portals, the café and complementary retail activities (art work and local produce), growing of olives and production and sale of olive products. If these activities are businesses “of a similar kind” they can be grouped. If not, then Div 35 applies to each activity separately. Having determined that an individual or a partnership is carrying on a business activity, and that activity result in a loss, Div 35 will defer that loss unless: • certain conditions set out in s 35-10(1)(a) are satisfied; or • an exemption applies; or • the Commissioner exercises the discretion in s 35-55. A taxpayer will be able to access their losses if they pass one of the following tests s 35-10(1)(a) tests: • Assessable income at least $20,000 (s 35-30); • Real property used worth at least $500,000 (s 35-40); • Other assets worth at least $100,000 (s 35-45); or • Profitable business in at least 3 of last 5 income years including the current income year (s 35-35). 478

[8.230]

Personal and Non-personal Expenses

CHAPTER 8

However, the conditions in s 35-10(1)(a) are only available to taxpayers whose meet the so-called “income requirement”. The “income requirement” is satisfied if a taxpayer’s “adjusted taxable income” (ie their taxable income, reportable fringe benefits, reportable superannuation contributions and total net investment losses) is less than $250,000 (ss 3510(2E) and 35-10(1)(a)). The two express exemptions apply where the taxpayer: • conducts a “primary production business” and earns less than $40,000 (excluding net capital gain) from all other sources; or • operates a professional arts business and earns less than $40,000 (excluding net capital gain) (s 35-10(4)). If a taxpayer cannot satisfy any of these four tests, or the taxpayer fails the “income requirement”, or the primary production exemption the only remaining avenue to access the losses from their business activities is to seek the Commissioner’s discretion under s 35-55. The Commissioner’s three discretions are: • where special circumstances exist (s 35-55(1)(a)); or • where taxpayers satisfy the “income requirement” (s 35-55(1)(b)); or • where taxpayers fail the “income requirement” (s 35-55(1)(c)). The scope of the Commissioner’s discretion to not apply Div 35 is somewhat narrow, limited to natural disasters and circumstances where the inherent nature of the business has resulted in a failure to meet a test or generate a profit. As the consequences of business choices made by an individual (for example, the hours of operation, the size or scale of the activity, and the level of debt funding) are circumstance that arise from the nature of the business activity, they are not grounds for the granting of a discretion (as illustrated in cases such as the decisions in Delacy v FCT [2006] AATA 198 and The Taxpayer and Commissioner of Taxation [2013] AATA 3). [8.235]

Questions

8.32

The taxpayer is a wheat farmer who owns a combine harvester. He supplements his farming income by carrying out contract harvesting on other farms in the area. Is the harvesting part of the same business activity as his farming or is it a separate operation?

8.33

The taxpayer operates a very large station on leased property. The property has a cost to the current owner of $6 m and is currently worth about $7 m. The taxpayer pays $200,000 rent each year to the owner of the property. Unfortunately, because of an extended downturn in beef prices, the farm has run at a loss (approximately $20,000 each year) for the four years since the taxpayer took over the property. He has survived by working as a mechanic in a regional factory four days a week, deriving $50,000 per year from this work. He seeks to deduct the $20,000 farm loss from his employment income. Will Div 35 affect his claim?

8.34

The taxpayer is a very wealthy lawyer who owns a small hobby farm outside of Melbourne. The farm cost $550,000, including the very luxurious residence, complete with two swimming pools, and stable where he keeps horses used by his children. The taxpayer lives on the farm on many weekends and for one month during the summer holidays. Almost one-half of the property has new growth trees on it (the area was logged some 20 years ago). He has submitted a tax return in which he indicated he is a tree farmer and accordingly seeks to deduct most costs associated with the farm from his income from legal practice. Will Div 35 apply to him? [8.235]

479

The Tax Base – Deductions

10. MEDICAL EXPENSES [8.240] Most medical expenses incurred by a taxpayer will be personal in nature. However,

some medical problems are directly attributable to a taxpayer’s employment or trade and, indeed, may be a necessary consequence of that profession – consider, for example, the medical injuries sustained by a professional boxer. The AAT in VBI v Commissioner of Taxation [2005] AATA 683 noted that as the treatment for physical or mental health is inherently of a private nature, psychotherapy expenses incurred by a nurse were private or domestic. The Commissioner adopts a similar view in respect of medical expenses incurred by a professional footballer in the treatment of injuries sustained while playing (see Income Tax Ruling IT 54: Expenditure incurred by professional footballers), and of the cost of vaccinations to protect against infectious diseases in the work place (see Taxation Ruling TR 95/8: Employee cleaners – allowances, reimbursements and work-related deductions). However, despite these rulings the Commissioner has ruled that: • medical expenses associated with medical examinations for the renewal of relevant licences by airline industry employees, including the cost of the travel to and from the medical practitioner, are deductible (without any explanation in Taxation Ruling TR 95/19: Airline industry employees – allowances, reimbursements and work-related deductions); and • that expenses associated with vaccination against an animal disease (Q fever) are regarded as arising from the carrying on a business which involves direct contact with cattle and consequently, the medical expenses are of a business nature and an allowable deduction in accordance with paragraph 8-1(1)(b) of the ITAA 1997 (ATO Interpretative Decision ATO ID 2002/775 Deductibility of vaccination expenses – sole trader). This was justified on the basis that the Q fever is an incident of working within the cattle industry rather than a more general risk to the public. The ITAA 1936 contains provisions to assist taxpayers incurring significant medical bills: s 159P provides taxpayers with a tax offset when medical expenses, other than expenses for cosmetic surgery, for themselves or for a resident dependant exceed specified indexed income threshold in an income year. Eligibility for the offset is dependent upon the taxpayer’s “adjusted taxable income for rebate purposes”. Transitional entitlement measures are also in place as this offset is being phased out and will not be available from 1 July 2019. A subsidy for consumers subscribing for private health insurance also exist aimed at shifting taxpayers to private health care and relieving pressure on the public health system. Under this subsidy taxpayers incurring expenses for eligible private health insurance have the choice of either receiving a tax offset for their private health insurance premiums, or an indirect payment to the insurer to reduce the premium payable by the insured person (Subdiv 61-G of the ITAA 1997). [8.245]

8.35

8.36

480

Questions

The taxpayer was a professional football player who underwent plastic surgery to repair facial disfigurement resulting from football injuries. He bore the expense out of his own pocket. Is the outgoing deductible? The taxpayer was a professional football player who was required to take out medical insurance as a condition of his employment. He sought to deduct the cost of insurance and “gap” payments for the difference between insurance coverage and the amount charged for various medical procedures. Are the expenses incurred in consequence of income-earning activities rather than incurred in gaining assessable income? (See Case 51/93 (1993) 93 ATC 542.) [8.240]

Personal and Non-personal Expenses

CHAPTER 8

11. CHARITABLE GIFTS [8.250] At one time, Parliament distributed a vast range of benefits to taxpayers by means of

personal tax deductions in the Income Tax Assessment Act. The deductions for personal expenses could not be justified by reference to any normal tax criteria, since they applied to outgoings quite distinct from the income-earning process. They constituted part of the government’s tax expenditure program, which subsidised taxpayers’ activities or expenses through the tax system. The use of tax expenditures was discussed in Chapter 1. The process of analysing tax expenditures is quite different from that of analysing ordinary deductions. Normally we ask a series of questions: is this a personal or non-personal expense; if it is personal, is it current or capital; if it is current, is it non-deductible because of some special doctrine; if it is capital, is it wasting or non-wasting, and so forth. The questions asked when analysing tax expenditures are expenditure or spending questions. There is no question whether the expense is or should be deductible – it clearly is by virtue of a specific concessional measure. Rather, we ask whether the government should be subsidising this particular form of activity and, if so, whether this is the fairest and most efficient way of assisting taxpayers. The personal expense tax deductions fared poorly when subjected to a tax expenditure analysis. In particular, the measures were strongly criticised because of their “upside-down effect”. Because they took the form of deductions, the level of subsidy resulting from a deduction rose with a taxpayer’s income. It was argued that subsidies should be equal across the board or even decline with rising income. In 1975, the subdivision containing most of these personal tax expenditures (ss 82AA and 82A – 82K of the ITAA 1936) was repealed and the deductions were replaced with tax rebate (offset) provisions (ss 159H – 159Z of the ITAA 1936). A large number of these personal tax rebates were repealed in 1985 when it was argued that the assistance provided by the tax rebates should be achieved through direct expenditure programs that could better target benefits to those in need. Today, the only personal expense tax offsets (rebates) are the phasing out medical expenses rebate and the private health insurance tax offset mentioned at [8.240]. One type of personal tax deduction that was not converted to a rebate is the deduction for charitable gifts in Div 30 of the ITAA 1997. The charitable gift tax expenditure differs from other personal tax expenditures in that the benefit of the tax-based subsidy does not flow to the taxpayer; rather, it goes to the beneficiary of the taxpayer’s gift. The effect of the subsidy is to lower the personal cost to the taxpayer by providing what amounts to a matching government grant. For example, if a taxpayer facing a 45 per cent marginal tax rate gives $100 to a charity, the taxpayer will be entitled to a $45 tax refund. The $100 gift thus costs the taxpayer only $55; the government has provided the other $45. Hence the matching grant characterisation – for every $55 donated by the taxpayer to the charity of her or his choice, the government contributes an additional $45. In effect, the taxpayer provides the entire $100 in the first instance and the government refunds its contribution to the donor taxpayer. If a taxpayer in the lowest bracket makes a gift of $100, the government refunds $15 to the taxpayer so the government effectively contributes $15 for every $85 contributed by the taxpayer. The “upside-down effect” of other personal deductions was strongly criticised because the effect of the deduction was to provide high subsidies to highest bracket taxpayers and low subsidies to lowest bracket taxpayers (and zero subsidies to the poorest, below the tax threshold). The criticism of deductions for charitable gifts is slightly different – the subsidy goes not to the taxpayer but via the taxpayer to the charity. Thus, the criticism of deductions [8.250]

481

The Tax Base – Deductions

for charitable gifts is based on the recognition that the government provides much higher matching grants for charities nominated by high-income donors than it does for charities nominated by lower income donors. The gift deduction is available for gifts to “a public benevolent institution” (see s 30-15(1) and s 30-45 Item 4.1.1), an undefined entity that would be determined by reference to common law precedents, as well as a large number of listed bodies which would satisfy the common law requirements and some that might not. Most litigation on s 30-15(1) turns on the meaning of a “gift” and the extent to which a donor seeking a deduction pursuant to this section is able to receive a direct or collateral benefit as a result of her or his gift. One of the leading cases on the question is the decision of Owen J of the High Court in FCT v McPhail (1968) 117 CLR 111. The taxpayer in McPhail sought a deduction, pursuant to the predecessor to s 30-15(1) and s 30-25 Item 2.1.10, for a contribution to a building fund for the private school attended by his son. The school had two schedules of fees for students – one schedule for students whose parents had not “gifted” a stipulated amount to the school’s building fund and a second schedule for students whose parents had “gifted” the required amounts. The fees set out in the second schedule were approximately the fees in the first schedule less the required building fund contribution. The taxpayer entered into a contract with the school which guaranteed that, as a consequence of his “gift”, his son’s tuition fees would be based on the lower amounts in the second schedule. Owen J agreed with the Commissioner that no deduction should be allowed for the building fund contribution, stating, “[T]o constitute a ‘gift’, it must appear that the property transferred was transferred voluntarily and not as the result of a contractual obligation to transfer it and that no advantage of a material character was received by the transferor by way of return”. The gift provisions were employed in a number of tax avoidance schemes in the 1970s in which taxpayers claimed deductions for charitable gifts in situations where substantial benefits were returned directly or indirectly to the taxpayers as a consequence of the donations. The Commissioner successfully fought these schemes in cases such as Cyprus Mines Corp v FCT (1978) 78 ATC 4468; Leary v FCT (1980) 80 ATC 4438 and FCT v Rabinov (1983) 83 ATC 4437 by reliance on the genuine gift requirement spelled out by Owen J in FCT v McPhail. In the meantime, however, the government had inserted s 78A to eliminate any doubt about the deductibility of donations where a benefit is received by the donor or an associate of the donor. [8.255]

8.37

Question

Canada has replaced its charitable deduction with a matching grant system. Should Australia do the same?

12. SUBSTANTIATION [8.260] It should be entirely unremarkable that there are provisions in the Income Tax

Assessment Act that require taxpayers to prove they incurred the expenses for which they are seeking deductions; intuition suggests the tax rules would provide that any taxpayer wishing to deduct the cost of an expenditure must have a receipt showing what was purchased and how much it cost. However, for the first seven decades of its operation, the Income Tax Assessment Act contained no general “substantiation” provisions to prevent a taxpayer from deducting the cost of an unsubstantiated or unproven expenditure. Under s 190, the onus of 482

[8.255]

Personal and Non-personal Expenses

CHAPTER 8

proving an assessment is inappropriate lies with the taxpayer, and it was thought that this provision would be adequate to enforce indirectly substantiation requirements. Without proper receipts, it was thought that a taxpayer could not satisfy the onus of proof established by that section. A change of approach came in the latter half of the 1980s – concurrently with the introduction of the fringe benefits tax, the predecessor denial of deductions for entertainment expense, and moves towards self-assessment. A number of factors lay behind the change, of which two were of particular importance. The first factor was the change in approach to dealing with indirect remuneration such as fringe benefits and entertainment expenses. As we have seen, prior to 1986 many types of fringe benefits were not taxed, notwithstanding the existence of s 26(e). Lax enforcement extended to the assessment of allowances provided to employees by their employers to cover employment-related expenses, particularly those related to travel and entertainment. The change to stricter accounting for employee benefits and the introduction of new rules to limit deductions for entertainment and related expenses meant more detailed record keeping was needed. This change afforded an ideal opportunity to back up the record keeping requirement with stricter rules regarding proof and purpose of expenditure. The second important factor behind the enactment of comprehensive substantiation rules was planned change to a “self-assessment” system. Under the former assessment system, it was feasible to allow taxpayers to claim deductions in the first instance and then consider the claim at the assessment stage, when returns were subject to a relatively thorough review. In the Australian model of a self-assessment system, taxpayers make first and final decisions on what is deductible and when it is deductible, decisions that are subject to review only if and when the taxpayers are audited. For obvious reasons, a self-assessment regime of this sort will work best where there are clearer guidelines and rules, so taxpayers will know what claims are allowed and which will be breaches of the rules. Specific substantiation rules help in that process. We have already encountered some substantiation rules in Chapter 4, in the context of the fringe benefits tax, in particular with regard to car benefits. The income tax substantiation rules are found in Div 28 (for car expenses) and Div 900 (for most other deductible expenses) of the ITAA 1997. Different substantiation requirements apply to different types of expenses. For almost all types of employment-related expenses, the taxpayer must obtain “written evidence”, a concept described in Subdiv 900-E. In addition, depending on the method chosen to deduct motor vehicle expenses, taxpayers may be required to maintain a log book (Subdiv 28-G) and odometer records (Subdiv 28-H). To claim deductions for travel expenses, taxpayers may be required to maintain “travel records” in the form of a diary (Subdiv 900-F). [8.265]

8.38

8.39

Questions

The taxpayer was a barrister who purchased at a local newsagency half a dozen yellow legal size writing pads for use in his work. He kept the cash register receipt the sales agent put into his bag, along with the pads. Can he deduct the cost of the pads? (See ss 900-115 and 900-125.) The taxpayer was a journalist who sought to substantiate claims for the cost of cassette tapes and accessories with receipts issued by the supplier to a friend of the taxpayer. Will the taxpayer be successful? (See s 900-115 and Case Z42 (1992) 92 ATC 381.) [8.265]

483

The Tax Base – Deductions

8.40

Can the ATO assess taxpayers on gross receipts if they fail to provide substantiation for claimed expenses? (See Martin v FCT (1993) 27 ATR 282.)

8.41

The taxpayer wished to deduct the following costs relating to his attendance at a conference in Toronto, Canada: airfare, hotel accommodation, taxis to and from airports at either end, and meals. The conference lasted three days. After the conference the taxpayer spent another two weeks in the Toronto area sightseeing. The taxpayer kept a diary of his attendance at the conference as set out in s 900-150. (a) One month after his return to Australia the taxpayer’s briefcase was stolen. The diary was in the briefcase. What result follows? (See s 900-205.) (b)

Assume the diary had not been stolen. What expenses are deductible to the taxpayer under s 8-1 in light of s 32-10 and ss 900-150 and 900-155.

(c)

Assume the taxpayer kept a record of his expenses, but retained no documentary evidence and prepared no diary. His employer reimbursed the taxpayer for his expenses based on the records he retained. What tax consequences follow? (See s 900-150 and Fringe Benefits Tax Assessment Act 1986, ss 20 and 24.)

[8.270] Many industrial awards and individual contracts provide for the employer to provide

employees with meal allowances in addition to ordinary wages. These may be designed to compensate employees for the cost of meals consumed at work when an employee stays back to work overtime or for meals consumed in the course of travel for the employer. Allowances, including meal allowances (other than living-away-from-home allowances specifically exempt from fringe benefits taxation) and travel allowances, are normally treated as ordinary assessable income. Often, however, the taxpayer who receives an allowance may be able to claim an offsetting deduction depending on what the allowance is spent. Meal expenses paid from a meal allowance raise a number of issues, some of which were noted earlier in this chapter: • are the expenses otherwise deductible under s 8-1 (that is, do they satisfy the positive limbs of s 8-1 and avoid the “personal” expense character caught by the second negative limb in s 8-1(2))? • if they are otherwise deductible, do they constitute self-“entertainment” within the meaning of s 32-20 and are subject to the deduction denial rule in s 32-5? • if they are otherwise deductible but constitute entertainment, is there an exemption to the deduction prohibition available in ss 32-30 to 32-50? If a meal expense has crossed through all these thresholds and still appears to be deductible, the last issue raised is whether the expense must be substantiated in accordance with Div 900 before a deduction will be allowed. The substantiation rules contain a number of exceptions for expenses associated with travel and meal allowances. Section 900-50 exempts domestic travel expenses where the taxpayer has received a travel allowance to cover the costs of those expenses from the substantiation rules, provided the ATO considers the amount claimed “reasonable”. The same rule applies to overseas travel allowances in s 900-55 except that taxpayers must obtain written receipts for accommodation expenses. In both cases, the ATO uses the travel allowances provided to civil servants as the benchmark of a “reasonable” expense. Other exemptions from substantiation apply to expenses for meals purchased in conjunction with overtime work where the taxpayer has received an allowance to cover the cost of such 484

[8.270]

Personal and Non-personal Expenses

CHAPTER 8

meals and some travel expenses where the taxpayer has received a transport allowance payment as provided under some industrial agreements prior to 1986 to cover the cost of the transport expenses: s 900-215. [8.280] Dealing with work-related expenses has proved to be a major administrative problem

for the ATO, which has been unable to peg back taxpayers claims through its audit activity. Reform proposals to limit work-related expenses, such as the 2010 Budget for an optional standard deduction, have failed to obtain political support.

[8.280]

485

CHAPTER 9 Current and Capital Expenses [9.10]

1. INTRODUCTION........................................ ................................................. 488

[9.20]

2. THE JUDICIAL TESTS ..................................... .............................................. 489

[9.20] [9.30] [9.40]

(a) Background ......................................................................................................... 489 AusNet Transmission Group Pty Ltd v FCT .................................................................... 491 Sun Newspapers Ltd v FCT .......................................................................................... 496

[9.60] [9.70]

(b) Protecting, Preserving or Enhancing Assets .......................................................... 498 Broken Hill Theatres Pty Ltd v FCT ............................................................................... 499

[9.110] [9.130] [9.150] [9.170]

(c) Long-term licences and restrictive covenants ....................................................... BP Australia Ltd v FCT ................................................................................................. Strick v Regent Oil Co Ltd ........................................................................................... FCT v Star City Pty Ltd ................................................................................................

[9.200]

3. PURCHASE PRICE AND REVENUE EXPENSE ..................... ........................... 507

[9.200] [9.210] [9.240]

(a) Purchase by Instalments or Obligation for Periodical Payments ............................ 507 Egerton-Warburton v Deputy FCT ................................................................................ 508 Colonial Mutual Life Assurance Society Ptd Ltd v FCT .................................................... 509

[9.250] [9.270]

(b) Purchase for a Lump Sum Plus Continuing Payments .......................................... 510 Cliffs International Inc v FCT ....................................................................................... 511

[9.290] [9.320]

(c) Purchase by Instalments or Finance Lease Payments ............................................ 513 Eastern Nitrogen Ltd v FCT ......................................................................................... 515

[9.340] [9.350]

(d) Interest on a Borrowing to Acquire a Capital Asset ............................................... 515 Steele v DFC of T ........................................................................................................ 516

[9.360]

(e) Purchase Price of a Revenue Asset ........................................................................ 517

502 502 504 506

Principal sections ITAA 1997 s 8-1(2)(a) s 40-880

s 110-25(2)(a) s 110-25(6) s 110-35(2)

Effect This negative limb prevents taxpayers from deducting capital expenses. This section allows taxpayers to amortise some business-related capital expenses over a limited time or the estimated life of the project to which they relate. This section allows taxpayers to add direct costs of acquisition to the cost base of an asset. Allows taxpayers to add costs preserving title to the cost base of an asset. This section allows taxpayers to add some incidental costs of acquisition to the cost base of an asset.

487

The Tax Base – Deductions

1. INTRODUCTION [9.10] This chapter examines the characterisation of expenses, losses or outgoings as

“capital” in nature as opposed to “revenue” or current, such that a deduction is prohibited for the expense under the first negative limb in s 8-1(2)(a) of the ITAA 1997. In a comprehensive income tax, once a nexus is established between the expense incurred and the derivation of assessable income (and the expense is not a personal outgoing), the only question should be “when is it deductible?” not “is it deductible?” The appropriate rule would be one that allows taxpayers to deduct the expense over time, as the benefit acquired with the expenditure is consumed. In contrast, in an expenditure tax (such as a cashflow consumption tax), all capital expenditures to derive assessable income are immediately expensed. Consider expenditure incurred to acquire a tangible or intangible asset such as land, a machine or a patent to be used in a taxpayer’s business. Before the acquisition the taxpayer had cash; after the acquisition the taxpayer has land, a machine or a patent, as the case may be, of the same value as the cash. However, to the extent that the taxpayer’s investment in the land, machine or patent “wastes” or declines in value over time due to use (as for a machine) or the passage of time (as for a patent which has a limited statutory life) the taxpayer should be able to recognise its cost as a deduction, as the asset is “used up” to produce assessable income. If the asset does not decline in value over time or usage (as is the case with land), the cost should only be recognised when the taxpayer disposes of the asset, in the course of calculating the capital gain or loss on disposal. In contrast, assume the taxpayer only leased the land or machine, or licensed the patent, for use in its business, in exchange for the payment of rent or royalties. Rent is generally paid in arrears – after the period during which the renter has used the asset. After paying the rent or royalties, the taxpayer has acquired nothing apart from extinguishing an accrued liability in relation to use of the asset in the past year. These expenses are revenue or current in nature and should be immediately deductible in the year to which the lease or licence relates. The courts have had great difficulty in distinguishing between current and capital expenditures in Australian tax law. Their task has been made more difficult because the Parliament has never enacted an explicit definition of capital expenditure in the statute. One option could have been to define current or capital outgoings with respect to the time period for value or use of benefits from the expenditure. For example, the provision could have said: (1) expenses will be classified as current or capital outgoings; (2) current expenses are expenses incurred to acquire benefits that are used up in the income year or shortly thereafter and are deductible in the year in which they are incurred; and (3) capital expenses are expenses incurred to acquire benefits with a life that extends well beyond the income year and are deductible over the life of the benefit or, if a non-wasting asset is acquired with the expenditure, when there is a disposal of the asset. However, even such a provision may have caused difficulties, as is illustrated in the recent case of AusNet (see [9.30] below) where the dispute turned mainly on whether the expenditure was really an integral part of the acquisition of a capital asset being a license to transmit electricity (even though the fees apparently related to particular years). Capital expenses are only deductible, or otherwise recognised in the tax law, if a specific provision allows it. Until capital gains tax was introduced in 1985, there was no way to recognise the capital cost of a capital asset such as land or shares. Further, while there has always been a provision allowing a depreciation deduction for the cost of some tangible capital assets (specifically plant and equipment), these provisions were historically quite 488

[9.10]

Current and Capital Expenses

CHAPTER 9

limited. The capital allowance rules in the tax statute have been expanded over time and have only recently provided reasonably comprehensive treatment of all capital business assets and expenditures. The capital allowance rules are discussed in Chapter 10.

2. THE JUDICIAL TESTS (a) Background [9.20] The courts stepped into the vacuum left by the legislature to devise a judicial notion of

a capital expense, using doctrines and tests derived from trust law, just as they did to distinguish ordinary income and capital gains on the receipts side. The doctrines that distinguish current (or revenue, as they are often called in the cases) expenses from capital expenses have little to do with economic theory and sometimes produce an inappropriate result from a tax policy perspective. In some cases, the tests worked in the taxpayer’s favour by allowing them to deduct up-front expenses that yielded ongoing benefits. In other cases, they created genuine hardship if expenses characterised as capital outgoings failed to fit into any other statutory deduction regime. Expenditures on wasting intangible assets (such as long-term contracts or licenses) have posed a particular dilemma for the courts. If the courts adopted tests that characterised these expenditures as current, taxpayers would be able to recognise expenses long before they suffered actual economic declines. On the other hand, if the courts adopted tests that characterised outgoings for wasting intangible benefits as capital, then in the absence of a specific provision allowing depreciation of the intangible, taxpayers would never be able to recognise it for tax purposes. The judicial tests used to distinguish capital and current expenses evolved through three distinct phases. In the first phase, outlays were characterised on the basis of their form. In the second phase, outgoings were characterised by reference to their effect. In the third phase, Dixon J (as he then was) emphasised the purpose for which an expenditure was made. The approach of Dixon J, which subsequently became the dominant approach, was first clearly articulated in Sun Newspapers Ltd v FCT (1938) 61 CLR 337 (see [9.40]). At the heart of the first approach to distinguishing current and capital outlays on the basis of form of the expenditure, was a distinction between recurrent and lump sum payments. That distinction is generally attributed to the decision of Lord Dunedin in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529, who said at 536: “capital expenditure is a thing that is going to be spent once and for all, and income [current] expenditure is a thing that is going to recur every year.” The distinction was modified in Ounsworth v Vickers Ltd [1915] 3 KB 267, in which Rowlatt J concluded that emphasis on annual payments was misleading and that the distinction should be made between those outlays incurred to meet continuous expenses and those made once and for all (at 273). While this test had the advantage of simplicity, it enjoyed no firm conceptual foundation. The recurrent/single payment test was soon criticised by Viscount Cave LC in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 who pointed out that there may be cases in which payments, although made once and for all, are current expenses which should be deductible in the year incurred. He concluded that although the fact that a payment was made once and for all was a material consideration, it was not necessarily a persuasive criterion. He proposed instead an approach focusing on the effect or benefits produced by the expenditure. Viscount Cave LC explained at 213-214: [9.20]

489

The Tax Base – Deductions

[W]hen an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is a very good reason … for treating such an expenditure as properly attributable not to revenue but to capital.

Under the effect test, if an expense was incurred for a benefit that would expire during the tax period or shortly thereafter, it was treated as a current expense. On the other hand, if the expense purchased an asset conferring an enduring benefit on the taxpayer (that is, lasting significantly past the tax period), it was a capital expense. This test bears some similarity to the economic or tax policy criterion of an expenditure to acquire benefits with an enduring life beyond the current year. However, it was not always easy to determine whether an asset or advantage wasted quickly or provided an enduring benefit; or whether the expenditure played a direct role in the acquisition of the asset or long-term benefit or was coincidently incurred at the same time an asset was acquired. The courts looked for characteristics that would help flag the nature of the benefit and thus the outlay incurred to acquire it. A number of criteria emerged as useful, though never conclusive, guides to the capital or current nature of an expenditure. These included the regularity or frequency of payments, the relation of the outlay to the “circulating” or “fixed” capital of the taxpayer and the possible finality of this type of expenditure such that the taxpayer might not need to incur similar expenses in the future. The third stage of current/capital distinction tests, the expenditure purpose approach, had been argued in a number of earlier cases before it was refined and endorsed by Dixon J in Sun Newspapers. The expenditure purpose test distinguished between outlays related to an income-earning process and those related to an income-earning structure. The clear articulation of the doctrine by Dixon J in Sun Newspapers led to that case becoming and remaining the leading precedent for distinguishing current and capital expenses, although other tests continue to be referred to from time to time. [9.25] The full High Court has recently had occasion to consider the concept of capital

expenditure in AusNet Transmission Group Pty Ltd v FCT [2015] HCA 25; 2015 ATC 20-521. This case was appealed from Gordon J in the Federal Court, to the Full Court of the Federal Court (in both courts it was known as SPI PowerNet Pty Ltd v FCT), and then via special leave to the High Court. The plurality of judges found for the Revenue, that the expenditure in question was capital. However, in the Federal Court, Davies J dissented and in the High Court, Nettle J dissented. It seems that the current/capital distinction remains one on which judicial minds may disagree. Perhaps, as Greene MR observed in IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482 at 488, “in many cases it is almost true to say that a spin of the coin would decide the matter almost as satisfactorily as an attempt to find reasons”. The case of AusNet arose out of the privatisation of the State of Victoria’s electricity supply industry. The State-owned electricity transmission company, PowerNet Victoria, which was incorporated under the Electricity Industry Act 1993 (Vic) sold its assets to the taxpayer under an “Asset Sale Agreement” in 1997. The assets included an electricity transmission licence on which statutory charges of $177.5 million were imposed under the Electricity Supply Act. The Asset Sale Agreement stated that AusNet as purchaser was obliged to pay these statutory charges. AusNet sought to deduct the charges under s 8-1 of ITAA 1997; the Commissioner argued that the charges were capital expenditure.

490

[9.25]

Current and Capital Expenses

CHAPTER 9

AusNet Transmission Group Pty Ltd v FCT [9.30] AusNet Transmission Group Pty Ltd v Federal Commissioner of Taxation [2015] HCA 25 Full High Court French CJ, Kiefel and Bell JJ: The evaluative [1926] AC 205 at 213 cautioned that this criterion judgment required to distinguish between is not decisive in every case. expenditure on capital or revenue account is The fact that a payment is recurrent is not made under the guidance of approaches determinative of its character. The payment by developed in decisions of this Court over many instalments of a charge, imposed as a condition years. Those approaches have necessarily been upon the grant of a liquor licence reflecting its expressed with a degree of generality sometimes monopoly value, was held by the Court of Appeal criticised for unpredictability in the outcomes in Henriksen v Grafton Hotel Ltd [1942] 2 KB 184 they yield. However, as Dixon J observed in to be a capital outlay. Du Parcq LJ, citing Hallstroms Pty Ltd v Federal Commissioner of Viscount Cave LC, said: “Here each sum in Taxation (1946) 72 CLR 634 at 646, the courts, question was part of a total amount paid to having been given by the income tax law “a very general conception of accountancy, perhaps of acquire the right to trade for a period of years. At economics”, have proceeded with the task “in the date when that period began the possession the traditional way of stating what positive factor of that right was essential before trading could be or factors in each given case led to a decision begun. In these circumstances, I am of opinion assigning the expenditure to capital or to income that each sum paid must be considered part of a capital outlay.” Referring to that decision, the as the case might be”. The distinction between capital and revenue Privy Council in BP Australia Ltd v Federal expenditure is readily discerned in cases close to Commissioner of Taxation (1965) 112 CLR 386 the core of each of those concepts. A once and for observed that: “Without the license the business all payment for the acquisition of business could not be carried on. There was also an premises would be treated as an outlay of capital. element of monopoly.” The term “an element of A rental payment under a lease of the same monopoly” might today be understood in terms premises would be treated as an outgoing on of enhanced market power where the revenue account. The distinction is not so readily requirement for a licence, not freely given to all apparent in penumbral cases. They may require a comers, constitutes a barrier to entry for potential weighing of factors including the form, purpose competitors into the relevant market. In Royal Insurance Co v Watson [1897] AC 1 the and effect of the expenditure, the benefit derived from it and its relationship to the structure, as purchaser of an insurance business agreed, as distinct from the conduct, of a business. Some of part of the purchase arrangements, to pay a fixed those factors may point in one direction and salary to a continuing employee with an election some in another. Definitive and specific criteria to commute the salary to a gross sum and are not, and never have been, in abundance in terminate the employment. The salary, whether Australia, nor in the decisions of the courts of the or not commuted, was found to be part of the United Kingdom in the late 19th century and the consideration for the purchase of the business first half of the 20th century which have been and thereby an outgoing of a capital nature. referred to from time to time in this Court’s Lord Halsbury LC put it thus: “The result is that decisions. Lord Dunedin suggested in 1910 that a one of the companies sells to the other, and part distinction between a once and for all payment of the consideration which was contemplated by and a recurrent payment may be “in a rough way both parties, and in respect of which the bargain … not a bad criterion of what is capital was made, and without which it would not have expenditure … as against what is income been made, was the manager, and all that was expenditure” [Vallambrosa Rubber Co Ltd v Inland incident to the manager, in respect of the Revenue [1910] SC 519 at 525]. Viscount Cave LC payments to be made to him, whether made at in British Insulated and Helsby Cables v Atherton once or made in this form of commutation”. The [9.30]

491

The Tax Base – Deductions

AusNet Transmission Group cont. key factor in characterisation in that case, which is of considerable significance in the present appeal, was that the contested payment was part of the consideration for the acquisition of the business. In the ordinary course, a lump sum paid to an employee to procure his or her resignation would be on revenue account “made for the purpose of organizing the staff and as part of the necessary expenses of conducting the business” [W Nevill & Co Ltd v Federal Commissioner of Taxation (1937) 56 CLR 290]. The significance attached to the purchase price of a business by the Privy Council in Tata Hydro-Electric Agencies, Bombay v Income-tax Commissioner, Bombay Presidency and Aden [1937] AC 685 was debated in the submissions on this appeal. The contested outlay in that case was a payment by the assignees of an agency business of a percentage of certain commissions, in discharge of an obligation owed by the assignor to certain third parties. … the passage quoted was consistent with the approach adopted in this Court to the characterisation of expenditure as being “of a capital nature”. So much appears from the discussion below of the judgment of Fullagar J in Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation (1953) 89 CLR 428, which referred to Tata. The fact that a payment can be viewed as part of the consideration for the acquisition of a business or capital asset weighs heavily in favour of its character as a capital outlay. However, as also appears from Cliffs International Inc v Federal Commissioner of Taxation (1979) 142 CLR 140, the question must always be asked – was the payment made “for” the acquisition? The proposition is well established that expenditure of a kind ordinarily treated as being on revenue account in one set of circumstances may be treated as on capital account in another set of circumstances. An example is found in the decision of the Scottish Court of Session in Law Shipping Co v Inland Revenue [1924] SC 74. The expenditure of substantial sums on repairs to a ship which had been necessary at the time of its purchase was treated as capital. The need for repairs meant that the ship when purchased was a less valuable asset than if it had been in repair. 492

[9.30]

Analogical reasoning suggests that the Transmission Licence, bringing with it as it did the burden of the charges … was on that account a less valuable asset than it would have been if PNV had paid the charges before transfer. Both parties in this appeal relied upon wellknown passages about the characterisation of capital and revenue outlays in the judgment of Dixon J in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337. The contested expenditure by Sun Newspapers secured, from its potential competitor, a noncompete covenant which was limited in duration and spatial coverage. Although, as Rich J held at first instance, it was a wasting asset, that did not deprive it of its capital character. Its purpose was “to buy out opposition and secure so far as possible a monopoly”. As Latham CJ said, the payment obtained “a very real benefit or advantage … namely, the exclusion of what might have been serious competition”. Dixon J said that the distinction between capital and revenue account expenditure corresponded with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay. Acknowledging the infinite variety of business structures, his Honour said that some might comprise little more than the intangible elements constituting goodwill. Implicit in that observation was the uncontroversial proposition that an intangible asset might, according to its nature and function in the conduct of the business, be properly characterised as forming part of the structure of the business and the cost of its acquisition as a capital cost. Dixon J in Sun Newspapers analysed the question of characterisation by consideration of three factors: (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by

Current and Capital Expenses

AusNet Transmission Group cont. making a final provision or payment so as to secure future use or enjoyment. He later observed in Hallstroms that the distinction also depends upon “what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process”. The advantage may not comprise any “rights” at all. In holding in John Fairfax & Sons Pty Ltd v Federal Commissioner of Taxation (1959) 101 CLR 30 that the corporate taxpayer’s legal costs in a contest over control of another company were of a capital nature, Dixon CJ said: “It is not in my opinion right to say that because you obtain nothing positive, nothing of an enduring nature, for an expenditure it cannot be an outgoing on account of capital.” The competition in that case, as Fullagar J put it, was “for a capital gain or advantage”. It should be added, however, that the emphasis placed by Dixon J on the “practical and business point of view” does not mean that it is unnecessary to examine the legal rights (if any) obtained by the expenditure. The real question, as Gibbs ACJ identified it in Federal Commissioner of Taxation v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645, may be “not to determine the character of the advantage sought, once it has been identified, but to decide what was the advantage sought by the taxpayer by making the payments”. If one advantage paid for was the acquisition of a capital asset “the fact that the payments were called ‘rent’, and were made periodically, would not necessarily prevent them from being in part outgoings of a capital nature”. It might be thought that that observation has considerable relevance to the present case. The assumption by AusNet of liability to pay the [statutory] charges by operation of law upon the transfer of the licence to it and by the contractual promise to pay the charges was an integral part of the consideration it had to provide in order to acquire the assets of the transmission business, which necessarily included the Transmission Licence. The observation of Gibbs ACJ was reflected in GP International Pipecoaters Pty Ltd v Federal

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Commissioner of Taxation (1990) 170 CLR 124, in which the Court said “the chief, if not the critical, factor” is the character of the advantage sought by the expenditure. In Colonial Mutual Life, payments by the purchaser of an income producing property of a percentage of the rents derived from it, made as part of the consideration for the acquisition of the property, were held to be on capital account. … How they were calculated, how and when they were payable and whether they might cease to be payable for a time, did not matter. Fullagar J said: “If they are paid as parts of the purchase price of an asset forming part of the fixed capital of the company, they are outgoings of capital or of a capital nature.” His Honour formulated the questions commonly arising in such cases as: “(1) What is the money really paid for?–and (2) Is what it is really paid for, in truth and in substance, a capital asset?”. Williams ACJ treated the case as indistinguishable from Tata Hydro-Electric and applied what Dixon J had said in Sun Newspapers. His Honour adopted as the relevant question: “Are the sums in question … capital outlays, are they expenditure necessary for the acquisition of property or of rights of a permanent character the possession of which is a condition of carrying on the trade at all?” Webb J also treated the outgoings as “expenditure for the acquisition of a capital asset … and not expenditure in the working of that or any other asset with a view to making it income-producing, although this asset is to be used for rent-production”. AusNet pointed to the treatment by this Court, in Commissioner of Taxation v Morgan (1961) 106 CLR 517, of the apportionment of municipal and water rates reimbursed by a purchaser of land to the vendors, who had paid the annual levy covering a period beyond the date of transfer of the land to the purchaser. The apportionment was treated as paid on revenue account. It is important, however, to note the factors upon which the Court focussed in that case, including the separateness of the payment from the purchase price and, importantly, its variability dependent upon the time of settlement. AusNet also relied upon Cliffs International (1979) 142 CLR 140. The contested expenditures in that case were royalty payments on iron ore mined by the taxpayer which were paid to the [9.30]

493

The Tax Base – Deductions

AusNet Transmission Group cont. vendors of shares acquired by the taxpayer in a mining company which held certain tenements. The payments were held to be on revenue account and thereby deductible. Barwick CJ said that the fact that the promise to make the payments was part of the consideration for the acquisition of the capital asset did not necessarily mean that they were of a capital nature. The promise to make the payments was part of the consideration given for the purchase of the shares: “[b]ut they were acquired without making the payments in question. The recurrent payments were not made for the shares though it might properly be said that they were payable as a consequence of the purchase of the shares.” The Chief Justice did not find the facts in Colonial Mutual Life analogous although he did not say why and expressly left open the correctness of that decision. He effectively found that the payments were not made “for” the shares. Jacobs J, also in the majority, acknowledged that in Colonial Mutual Life the recurrent payments could hardly be regarded otherwise than as part of the cost of the acquisition of the freehold. Accepting that each case turned on its own facts and circumstances, he said of the case before him: “The preponderating factors are that the payments were in respect of a depreciating asset, that they were recurrent over the life of the asset if the asset was used throughout its life and that the amount of the payments were proportioned to the use made of the asset. These factors in my opinion clearly outweigh the other factors which might support a contrary view.” Murphy J, who formed the third member of the majority, found that there was a strong analogy with an agreement to pay rent as part of the consideration for acquisition of a lease. Gibbs and Stephen JJ dissented, holding that the case was covered by the principle on which Colonial Mutual Life was decided. The majority judgments do not disclose a common proposition applicable to this case. More recently, in Federal Commissioner of Taxation v Citylink Melbourne Ltd (2006) 228 CLR 1, payment of a fixed annual “base concession fee” as part of the consideration given by the taxpayer to the State of Victoria for the concession

494

[9.30]

to construct and operate a toll road system was held to be deductible. In rejecting the proposition that the payment was on capital account, Crennan J, with whom Gleeson CJ, Gummow, Callinan and Heydon JJ agreed, observed that the taxpayer did not acquire permanent ownership of the roads or associated land. Her Honour said: “Unlike periodic instalments paid on the purchase price of a capital asset, the concession fees are periodic licence fees in respect of the Link infrastructure assets, from which the [taxpayer] derives its income, but which are ultimately ‘surrendered back’ to the State. Accordingly, they are on revenue account.” The [statutory charges in this case] being of an ad hoc character imposed for a time-limited purpose, could not be described as “periodic licence fees”. Periodic fees were payable in respect of the Transmission Licence but pursuant to a separate provision of the Electricity Act. Undue emphasis on the purpose of the charges is apt to direct the inquiry away from the critical question – from AusNet’s perspective what was the character of the advantage sought? – or, as Fullagar J put it in Colonial Mutual Life, what was the money really paid for? AusNet did not pay the charges in order to reimburse the State for excess revenue it might generate as licence holder. From a practical and business point of view, the assumption of the liability to make the expenditure was calculated to effect the acquisition of the Transmission Licence and the other assets the subject of the Asset Sale Agreement. The Transmission Licence was an intangible asset, but was properly viewed as part of the structure of the business. Without it, acquisition of the rest of the assets was pointless. If it were revoked after acquisition, the whole business structure would collapse. … As the Commissioner submitted, upon completion of the Asset Sale Agreement, AusNet was under a present legal obligation to make the payments at the times specified in the Order in Council. No further or other matter was necessary for the liability to crystallise. The case was distinguishable from Cliffs International, where the relevant royalty payments were contingent upon the removal of iron ore from the relevant reserves.

Current and Capital Expenses

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Justice Gageler, in agreement, adopted the language in Hallstroms that the distinction between an outgoing of a capital nature and of a revenue nature is “the distinction between the acquisition of the means of production and the use of them”, which “depends on what the expenditure is calculated to effect from a practical and business point of view”. This depends, Gageler J concluded, on the particular facts and circumstances of the case. As the transmission charges were required to be made in order to acquire the transmission licence, this was sufficient to render them capital in nature and further construing of the Asset Sale Agreement was not necessary. We will discuss Nettle J’s dissent after considering Cliffs International at [9.270]. [9.35] We now move back in time more than 75 years, to the still-leading case of Sun

Newspapers, referred to in AusNet. The taxpayer in Sun Newspapers was a newspaper publisher that had a history of amalgamating with or purchasing companies producing competing papers and then closing down the competing papers. In 1932, the Sun newspaper’s principal competitor was another evening paper called the World. The Sun management had weathered the World’s competition but the threat of future competition posed by the rival paper became intolerable when the publisher of the World announced plans to replace the World with a successor called the Star which was proposed to be sold for two-thirds the price of the Sun. To forestall the appearance of an inexpensive successor to the World, the taxpayer approached the proprietors of the World and purchased all their rights to that paper. The owners of the Sun also acquired the right to use the plant and equipment used in the publication of the World for a three-year period, as well as an undertaking that the former publisher of the World would not establish a new newspaper during that three-year period. As soon as the agreement was finalised, the new owners ceased publication of the World. While the agreement stipulated that the vendor’s entire interest in the World would pass to the purchaser, the actual payments were tied to the use of the vendor’s equipment for three years and its three-year covenant not to compete. The agreement attributed no part of the consideration to the transfer of interest in the asset really sold, the World. The taxpayer then attempted to depreciate the purchase price over the three years of the subsidiary agreements. The taxpayer claimed the outlays were for a limited period (three years) and were not made to secure an asset but rather to increase profits by reducing competition during the life of the agreement and forestalling the appearance of the Star. Even if the taxpayer’s characterisation of the transaction were accepted and it was amortised in the taxpayer’s financial accounts over three years, there was no general amortisation provision in the tax legislation. Thus, the only options open to the courts were either to characterise the expense as “revenue” and allow a full deduction for the outgoing in the year in which the expense was incurred, or treat it as a “capital” outgoing so it would never be deductible. When the case first came before a single judge of the High Court, Rich J noted the purpose of the transaction “was to buy out opposition and secure so far as possible a monopoly”. The benefit of the expenditure had an indefinite lifetime and the acquisition was, in his eyes, clearly a capital outlay. On appeal to the Full High Court, Latham CJ similarly concluded that the taxpayer had acquired a non-wasting capital benefit as a result of the purchase. He stated that [9.35]

495

The Tax Base – Deductions

the acquisition payments “did not result in obtaining a new capital asset of a material nature, but they did obtain a very real benefit or advantage for [the Sun]”. An alternative approach to the problem was offered by Dixon J in his judgment.

Sun Newspapers Ltd v FCT [9.40] Sun Newspapers Ltd v FCT (1939) 61 CLR 337 Full High Court Dixon J: The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss. The business structure or entity or organisation may assume any of an almost infinite variety of shapes and it may be difficult to comprehend under one description all the forms in which it may be manifested. In a trade or pursuit where little or no plant is required, it may be represented by no more than the intangible elements constituting what is commonly called goodwill, that is widespread or general reputation, habitual patronage by clients or customers and an organised method of serving their needs. At the other extreme it may consist in a great aggregate of buildings, machinery and plant all assembled and systematised as the material means by which an organised body of men produce and distribute commodities or perform services. But in spite of the entirely different forms, material and immaterial, in which it may be expressed, such sources of income contain or consist in what has been called a profit-yielding subject … As general conceptions it may not be difficult to distinguish between the profit-yielding subject and the process of operating it. In the same way expenditure and outlay upon establishing, replacing and enlarging the profityielding subject may in a general way appear to be of a nature entirely different from the continual flow of working expenses which are or ought to be supplied continually out of the returns or revenue. The latter can be considered, estimated and determined only in relation to a period or interval of time, the former as at a point of time. For one concerns the instrument for earning 496

[9.40]

profits and the other the continuous process of its use or employment for that purpose. But the practical application of such general notions is another matter. The basal difficulty in applying them lies in the fact that the extent, condition and efficiency of the profit-yielding subject is often as much the product of the course of operations as it is of a clear and definable outlay of work or money by way of establishment, replacement or enlargement. In the case of machinery, plant and other material objects, this is illustrated by the commonplace difficulty of saying what is maintenance and what are renewals to be referred to capital. But for the same or a like reason it is even harder to maintain the distinction in relation to the intangible elements forming so important a part of many profit-yielding subjects. For example, a profitable enterprise such as the sale of a patent medicine may depend almost entirely on advertisement. In the beginning the goodwill may have been established by a great initial outlay upon a widespread advertising campaign carried out upon a scale which it was not intended to maintain or repeat. The outlay might properly be considered to be of a capital nature. On the other hand the goodwill may have been gradually established by continual advertisement over a period of years growing in extent as it proved successful. In that case the expenditure upon advertising might be regarded as an ordinary business outgoing on account of revenue. More often than not an outlay of capital in establishing an organisation or obtaining an asset of an intangible nature does not produce a permanent condition or advantage. Its effects are exhausted over a period of time. In such cases the commercial practice of writing off the expense against revenue over a term of years or making a reserve to replace exhausted capital lessens the importance of the contrast. But in the assessment of income for taxation purposes severe limitations

Current and Capital Expenses

Sun Newspapers cont. are placed upon the application of such a practice, the allowance of which is exceptional. In the attempt, by no means successful, to find some test or standard by application of which expense or outgoings may be referred to capital account or to revenue account the courts have relied to some extent upon the difference between an outlay which is recurrent, repeated or continual and that which is final or made “once and for all”, and to a still greater extent upon a distinction to be discovered in the nature of the asset or advantage obtained by the outlay. … But the idea of recurrence and the idea of endurance or continuance over a duration of time both depend on degree and comparison. As to the first it has been said it is not a question of recurring every year or every accounting period; but “the real test is between expenditure which is made to meet a continuous demand, as opposed to an expenditure which is made once and for all” (per Rowlatt J, Ounsworth v Vickers Ltd [1915] 3 KB 267 at 273). …. Recurrence is not a test, it is no more than a consideration, the weight of which depends upon the nature of the expenditure. Again, the lasting character of the advantage is not necessarily a determining factor. In John Smith & Son v More [1921] 2 AC 13 the coal contracts which Lord Haldane and Lord Sumner thought were acquired at the expense of capital had a very short term. By reselling coal bought under the contracts the taxpayer made his profit. “But,” said Lord Haldane, “he was able to do this simply because he had acquired, among other assets of his business, including the goodwill, the contracts in question. It was not by selling these contracts, of limited duration though they were, it was not by parting with them to other” (coal) “masters, but by retaining them, that he was able to employ his circulating capital in buying under them. I am accordingly of opinion that, although they may have been of short duration, they were none the less part of his fixed capital.” Again, the cases which distinguished between capital sums payable by instalments and periodical payments analogous to rent payable on revenue account illustrate the fact that rights

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and advantages of the same duration and nature may be the subject of recurrent payments which are referable to capital expenditure or income expenditure according to the true character of the consideration given, that is, whether on the one hand it is a capitalised sum payable by deferred instalments or on the other hire or rent accruing de die in diem, or at other intervals, for the use of the thing. There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment …. The facts of the present case show the following features: (i) The expenditure was of a large sum incurred to remove finally the competition feared from the Star and actually experienced from the World. (ii) It could be regarded as recurrent only in the sense that the risk of a competitor arising must always be theoretically present and that the reality or imminence of the risk depends upon circumstances which can never clearly be foreseen. (iii) The chief object of the expenditure was to preserve from immediate impairment and dislocation the existing business organisation of the taxpayers. (iv) The impairment or dislocation feared involved a lowering of selling price, a loss of circulation, a change in advertising rates and a re-organisation of selling and production arrangements all of a lasting character, that is, the changes would be of indefinite duration and their effects would continue until they disappeared under influences brought by the future the exact nature of which could not be foreseen. (v) The transaction involved the acquisition for a cash consideration of the right to enjoy for three years all the property tangible and intangible of an existing undertaking, that is, the acquisition of a going concern for a period, a thing recognised as a capital asset. The advantage in terms of profit was not to be obtained by the use of the [9.40]

497

The Tax Base – Deductions

Sun Newspapers cont. undertaking but by putting it out of use; but in itself it remained a capital asset.

strengthening and preserving the business organisation or entity, the profit-yielding subject, and affecting the capital structure.

In these circumstances I think that in principle the transaction must be regarded as

[9.50] In Sun Newspapers Dixon J reached the same result using his process/structure

doctrine that the rest of the Court reached using more traditional doctrines. However, in the next case in which he sought to apply his approach, Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, Dixon J found himself in a dissenting position. The taxpayer in Hallstroms was a refrigerator manufacturer who had copied a design feature in a competitor’s refrigerator when the competitor’s patent expired. When the competitor subsequently commenced proceedings to have the patent renewed, the taxpayer incurred legal expenses in opposing (successfully) the renewal. A majority of the High Court, applying the traditional tests, concluded the outgoing was revenue in nature. Latham CJ explained that, prior to the legal action, the taxpayer enjoyed the right to manufacture the product and after the action it continued to enjoy that right. Rather than acquire a new enduring benefit, he concluded, the taxpayer had simply preserved its existing rights. In contrast, applying his process/structure approach, Dixon J came to the opposite conclusion. He argued the expense was “concerned with the reform of or the more effective establishment of the organisation by which income will be produced (the profit-yielding subject) and not with the means whereby that organisation will be used for that purpose”.

(b) Protecting, Preserving or Enhancing Assets [9.60] The joint judgment of the High Court in AusNet (above [9.30]) referred to another

electricity privatisation case, which concerned franchise fees payable by distribution companies under a different provision of the Electricity Supply Act. In United Energy v FCT (1997) 78 FCR 169, the Full Court of the Federal Court held that these were payments of a capital nature as being in substance a purchase price for the business which conferred the monopoly right to distribute and sell electricity in the defined area, establishing freedom from competition, in contrast to annual licence fees payable under the licence to sell electricity in Victoria. Sundberg and Merkel JJ invoked Broken Hill Theatres v FCT, in which Dixon CJ cemented his structure/process test as the dominant interpretation doctrine for capital expenditure, in a joint judgment. The taxpayer operated the sole movie house in Broken Hill and incurred legal expenses in successfully opposing the application by another company to open a competing theatre. Evidence accepted by the Court revealed that the competitor was free to make a fresh application the following year, so the benefit of the outgoing might last no more than one year, and also revealed that the taxpayer had incurred similar expenses on a number of previous occasions. Under the approach taken by the majority in Hallstroms, the expense most likely would have been characterised as a revenue expense – applying the logic that was used by the majority in that case, the expenditure restored or preserved the taxpayer’s assets or position 498

[9.50]

Current and Capital Expenses

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but did not noticeably enhance or add to them. But the elevation of the process/structure approach used by Dixon J in his dissent to the doctrine followed by the majority led to the opposite result.

Broken Hill Theatres Pty Ltd v FCT [9.70] Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423 Full High Court Dixon CJ, McTiernan, Fullagar and Kitto JJ: On the strength of these facts it was argued that the business of the taxpayer company at Broken Hill was of a special character and that the opposing of such applications ought to be regarded as an ordinary incident of the carrying on of such a business from year to year. The recurrent character of expenditure has been said more than once to be an element which may throw light on the question whether that expenditure is or is not an outgoing of a capital nature. But, in our opinion, the expenditure in the present case cannot be regarded as “recurrent” in the relevant sense. At the time when it was made, nobody could say whether Boulus or anybody else would or would not make another application in two or five or ten years’ time. The expenditure in connection with each application between 1938 and 1948 was made on a particular and isolated occasion. Similar occasions might or might not arise in the future. Experience might suggest a probability that similar occasions would arise, but no such consideration could affect the essential nature of expenditure, which was incurred in each case for the purpose of preserving and protecting the company’s business. In the Sun

Newspapers case, Dixon J said: “Recurrence is not a test, it is no more than a consideration the weight of which depends on the nature of the expenditure.” His Honour proceeded: “Again, the lasting character of the advantage is not necessarily a determining factor.” The recurrence of a threat of competition was less likely in the Sun Newspapers case than in this case, but it was none the less a present possibility. It was much emphasised in argument that no new asset was brought into existence by the company’s expenditure, that “the defeat of the application did not clothe the appellant with any fresh right” (per Williams J in Hallstroms Pty Ltd v FCT). But this was true in what is regarded as the leading case on the subject, the British Insulated Cables case. And Dixon J in Hallstroms’ case gives several other instances in which the expenditure brought no tangible asset into existence and gave the taxpayer no new right, and yet was held to be an outgoing of a capital nature. The advantage of being free from Boulus’ competition and of all other competition for 12 months is just the very kind of thing which has been held in many cases to give to moneys expended in obtaining it the character of capital outlay.

[9.80] As a result of the Broken Hill Theatres case, Australian tax jurisprudence shifted away

from the approach followed by other Anglo countries which treated expenses incurred to preserve title or protect a position, rather than enhance or add to it, as current (revenue) expenses. It also created a significant category of black hole expenses that created considerable unfairness in the tax law. In 1985 the problem was imperfectly addressed by way of the cost base provisions in the capital gains tax. The response now appears as the fifth element of the cost base of a CGT asset in s 110-25(6) (expenditure to establish, preserve or defend title over an asset) or, in some cases, in the fourth element in s 110-25(5) (expenditure to increase or preserve the value of an asset). However, the approach of recognising these expenditures in cost base of a CGT asset is unlikely to help the taxpayer in Hallstroms (had the dissenting approach of Dixon J prevailed) or in Broken Hill Theatres. The taxpayer in Hallstroms had a right to use a particular process to manufacture refrigerators because another party’s patent had expired: this right is almost [9.80]

499

The Tax Base – Deductions

certainly not a CGT asset as defined in s 108-5. Similarly, the right of the taxpayer in Broken Hill Theatres to operate without a competitor is also unlikely to be a CGT asset. An alternative is to argue that these sorts of expenditure operate to protect or enhance the value of the taxpayer’s goodwill, which is a CGT asset, and so can be included in the cost base of the goodwill. However, fitting the expenditure into the actual wording of the cost base measures as they would apply to goodwill may be difficult (consider whether s 110-25(5) or (6) could be of assistance). Even if the expenses could be added to the cost base of goodwill, so long as the taxpayer stays in business and retains its goodwill, there will be no opportunity to recognise the cost. [9.90] Another example of an expenditure found to be capital, that was not recognised in the

tax statute of the time, is found in the Full High Court decision in John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30. The taxpayer, a newspaper proprietor, was allotted shares in another company via an allotment that an existing shareholder claimed was improper. The share allotment related to defence of a takeover bid. The existing shareholder commenced legal action arguing that the allotment was improper and seeking a rectification of the share register to remove the taxpayer. The taxpayer incurred legal expenses as a party to the action and sought to deduct those expenses. In separate judgments, five members of the High Court disagreed. The taxpayer, relying on earlier doctrinal analysis, argued the expense was to preserve title to an asset and this was a revenue outgoing, but a majority of the Court, using the process/structure analysis in Sun Newspapers and Broken Hill Theatres, found it was a capital outlay. As Menzies J explained: “These were affairs of capital, relating as they did to the profit bearing subject rather than its operation.” Fullagar J agreed that the outlay was capital in nature but relied on a different logic, namely that it was part of the acquisition cost of the shares. For situations such as Broken Hill Theatres, where there may be no CGT asset recognised, the legislature finally responded to the problem in 2001 by adding two new “black hole” depreciation regimes (s 40-880) to the capital allowance rules described at [10.260]. Even where it may be invoked in respect of “defensive” type expenditures, the cost base rule in s 110-25(6) clearly leads to the wrong result from a policy perspective if there is no enduring benefit from the expenditure. The potential unfairness for taxpayers of the Broken Hill Theatres doctrine has led some courts to distinguish somewhat similar fact situations and characterise some “defensive” type expenditures as incidents of ordinary business, as for the legal expenses incurred by the taxpayers in Snowden and Willson at [7.110] or Magna Alloys at [7.130]. [9.100]

9.1

9.2

500

Questions

If John Fairfax were heard today, could the legal expenses be taken into account in cost base of the shares? Are they includible under the first element (adopting the approach of Fullagar J), or under the fifth element (defending the title that had been acquired (adopting the approach implicitly accepted by the rest of the Court)? If s 110-25 cannot apply, is the expense deductible under any other provision of the tax law? The taxpayer was a manufacturer of fertilizers and pesticides that had obtained a licence from a US company to sell products incorporating a “slow release” process developed by the US company. The inventor of the process later commenced an action against the US company and that company informed the taxpayer that if the action was successful, the rights of the taxpayer under the licensing agreement would be severely curtailed. The taxpayer joined the action in defence of the US firm. The action was [9.90]

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Current and Capital Expenses

subsequently settled. Are the legal expenses incurred by the taxpayer deductible? FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281 Full Federal Court. 9.3

9.4

9.5

9.6

A commercial broadcaster created a new cricket series and awarded the broadcasting rights to Channel 9. Another broadcaster challenged the validity of the agreement to give cricket broadcasting rights to Channel 9. (a)

Would the legal expenses of defending this action be deductible? (See PBL Marketing v FCT (1985) 85 ATC 4416.)

(b)

If not, if all events including the original acquisition of the business took place today, could they add the cost of litigation to a cost base under s 110-25(6)?

The taxpayer operated the sole commercial AM radio station in the Mildura area. It offered a “horizontal range of programs” which were “intended to provide something for everybody”. A change in the Broadcasting Act 1942 made it possible for the Broadcasting Tribunal to grant supplementary FM radio licences to taxpayers holding AM licences, in addition to de novo FM licences to new broadcasters. The taxpayer feared that commercial FM competition would force it to abandon its horizontal program range and extensive local coverage. To preclude the threat to its monopoly position, the taxpayer applied for a supplementary FM licence. It demonstrated that it did not regard the licence as a beneficial asset; rather, the licence was regarded as a detriment that by itself would cost money. However, acquisition of the licence was seen to be essential to the survival of the existing radio station. (a)

Are the legal costs incurred in the licence application process deductible? (See Sunraysia Broadcasters Pty v FCT (1991) 91 ATC 4530.)

(b)

If not, can they be added to the cost of an asset under s 110-35(2) as an incidental cost of acquisition or under s 110-25(2)(a) as a direct cost of acquisition?

The supplier to a manufacturer registered the manufacturer’s trade name, gave a verbal assurance that the manufacturer could continue to use the name, and then sued the manufacturer for infringement of trademark. (a)

Are the expenses incurred by the manufacturer to defend the action current or capital outlays? (See AAT Case Re Pech and Federal Commissioner of Taxation [2001] AATA 573.)

(b)

If they are capital, could they be added to a cost base under s 110-25(6)?

The taxpayer sold shares in a subsidiary that was facing potential warranty claims on some previously manufactured products. The purchaser of shares in the subsidiary insisted the vendor (the taxpayer) provide an indemnity for all costs the subsidiary might incur in respect of warranty claims relating to sales at the time the taxpayer owned the company. The taxpayer agreed and later had to pay the purchaser amounts equal to the warranty payments by the subsidiary. (a)

Are the costs deductible? (See FCT v Email Ltd (1999) 42 ATR 698.)

(b)

If not, can they be recognised as an adjustment to the proceeds of disposal under s 116-50?

[9.100]

501

The Tax Base – Deductions

(c) Long-term licences and restrictive covenants [9.110] Unfortunately, the Sun Newspapers structure/process approach did not always lead to

consistent results. This was particularly apparent in cases involving outlays for wasting intangible benefits such as licence agreements or covenants under contracts. It was explained earlier that in the absence of any statutory depreciation regime for expenditure on wasting long-term intangible benefits, any judicial characterisation would be wrong as a matter of tax policy. To treat the expenditure as currently deductible would be too generous to the taxpayer while to label it capital, and hence never deductible, would be too onerous. Faced with this dilemma, the judges in BP Australia Ltd v FCT and Strick v Regent Oil Co Ltd characterised outgoings under different legal arrangements, but intended to achieve largely the same end result, as revenue expenses in one case and capital outgoings in the other. The cases were decided consecutively by the same judges, sitting first as the Privy Council in the BP case and then as the House of Lords in the Regent Oil case. [9.120] The taxpayer in BP Australia Ltd v FCT was a petrol wholesaler which entered into

“tied house” agreements with several service stations. Prior to the agreements the service stations retailed several types of petrol from several different wholesalers. Under the agreements, the service stations agreed to sell the taxpayer’s petrol exclusively in return for a lump sum payment from the taxpayer. The Privy Council concluded the outgoings were revenue in nature and deductible as incurred. In so doing, the Privy Council reversed the decision of the High Court of Australia (1964) 110 CLR 387, which had relied upon the same precedents to find in favour of the Commissioner.

BP Australia Ltd v FCT [9.130] BP Australia Ltd v FCT (1965) 112 CLR 386 Privy Council Privy Council: One may approach the problem by considering the first of the matters mentioned by Dixon J [in Sun Newspapers], namely the character of the advantage sought, and in this both its lasting qualities and the fact of recurrence may play their parts. Under this head one might also take account of the nature of the need or occasion which calls for the expenditure. The need or the occasion came from the fact that marketing in the petrol trade in 1951 changed its nature suddenly but for sound commercial reasons. … The advantage which BP sought was to promote sales and obtain orders for petrol by up-to-date marketing methods, the only methods which could now prevail. Since orders were now and would in future be only obtainable from tied retailers, it must obtain ties with retailers. Its real object, however, was not the tie but the orders which would flow from the tie. To obtain ties it had to satisfy the appetite of the retailers by paying out sums for a period of years, whose amount was dependent on the 502

[9.110]

estimated value of the retailer as a customer and the length of the period. The payment of such sums became part of the regular conduct of the business. It became one of the current necessities of the trade …. Their Lordships agree with Owen J in thinking that if regard was had to “the whole picture” the expenditure was recurrent. To find whether expenditure is of a recurrent nature one must take a broad view of the general operation under which the expenditure was incurred. Here it was made to meet a continuous demand in the trade. Prima facie matters connected with the ever recurring question of marketing and customers, though not themselves recurrent in an identical form, share the same quality of recurrence possessed by matters “connected with the everrecurring question of personnel”. What additional indication is given by the actual length of the agreements? That must be a question of degree. Had the agreements been only for two or three year periods that fact would

Current and Capital Expenses

BP Australia Ltd v FCT cont. have pointed to recurrent revenue expenditure. Had they been for 20 years, that fact would have pointed to a non-recurring payment of a capital nature. Length of time, though theoretically not a deciding factor, does in practice shed a light on the nature of the advantage sought. The longer the duration of the agreements, the greater the indication that a structural solution was being sought. In this case the periods varied between three and 15 years, but the average appears to be something just under five years and the predominant number of agreements was for a five-year period. The case was argued before their Lordships as in the courts below on the footing that five years was the length of the tie and neither side sought to make any differentiation because a few of the ties were very much longer. That length of time appears to be neutral, and in itself indicates neither capital expenditure nor revenue by its mere length. It therefore does not add effectively to the argument either way. The question must be decided by other weights in the balance. In support of his argument that this was an enduring benefit [counsel for the taxpayer] stresses the fact that BP secured a valuable chose in action namely the contractual obligation of the retailer to order from BP and to allow them to advertise at his station. Once an asset outlives its year of acquisition, its proper place, he contends, must be in the balance sheet as a capital asset. …. The plant and machinery and tools of a factory and other tangible assets are prima facie durable objects and part of the structure within which the profit yielding process is carried out. By convention and practice they are placed in the balance sheet and their diminution in value is acknowledged and accommodated by a system of capital depreciation for revenue purposes. No such clear practice or convention exists with respect to choses in action and their Lordships cannot accept the contention that a chose in action must be a capital benefit if its value outlives the year of accounting.

CHAPTER 9

Finally, were the sums expended on the structure with which the profits were to be earned or were they part of the money earning process? … consideration of the nature of the benefit sought and obtained by BP would on the various tests suggested by the authorities seem to point to the expenditure being revenue rather than capital. The second of the considerations suggested by Sir Owen Dixon [in Sun Newspapers], namely the manner in which the benefit was to be used, relied on and enjoyed by BP, points in a similar direction. The benefit was to be used in the continuous and recurrent struggle to get orders and sell petrol. The agreements were not strictly “bundles of orders” but they were the basis of them and made orders inevitable. The retailer was bound to sell none but BP’s petrol and to increase the sale of its products to the best of his ability. This means that in practice he was bound to give orders for petrol which BP was bound to supply. Although the price and time of delivery were not specified these would be implied by law as reasonable. No fresh consensus between the parties was necessary. All that was needed was that the retailer should specify from time to time what quantity he required. Thus the agreements merged in and became part of the ordinary process of selling. These facts point to the expenditure being a revenue item. The third consideration suggested by Sir Owen Dixon, namely the method of payment, does not point very clearly in either direction. An advance payment for a period is not unusual in many revenue matters (for example, purchase of stock). These payments were not current payments made annually over the period of benefit but on the other hand it was clear that they would have to be made again at intervals of a few years. In a durable company of this nature recurrent five yearly payments certainly cannot be said to have a “once for all” quality. … The case is not easy to decide. But on a balance of all the relevant considerations the scales appear to incline in favour of the expenditure being revenue and not capital outgoings.

[9.130]

503

The Tax Base – Deductions

The Privy Council appear to have been influenced by the treatment of the outgoings as revenue items in the taxpayer’s financial accounts, although they saw this approach as only “slightly preferable” to the opposite, as they recognised that the expenditure really needed to be amortised over time. Their Lordships said: One of the matters to be considered is how the sum in question should be treated on the ordinary principles of commercial accounting. The sums paid to the retailers in the present case were put by BP’s accountants in the profit and loss account. Had they been put in the balance sheet together with the choses in action for which they had been paid, the latter would have been inappropriate capital assets. They would necessarily have to be written down in the first and every succeeding year by one third or one fifth, (or whatever was the figure appropriate to

the length of the tie) if the balance sheet was to be honest. And they would have to be written down out of money which had borne tax although the depreciation had gone directly to earn the taxable profits during the period. On the other hand it may be fairly said that to put the whole sum into one year’s expenses is also misleading. But at least it evens out fairly over a period of years as do major repairs or renewals (for example, the Rhodesia Railways case (1928) 14 TC 34) or other intermittently recurring revenue expenditures.

[9.140] The legal arrangements between the parties in Strick v Regent Oil were somewhat

different from those in BP, although the expenditure was intended to achieve the same object of an exclusive petrol sales contract. The taxpayer, Regent Oil, secured the exclusive sales ties by a lease premium arrangement. The petrol retailers leased their stations to the oil company for a number of years (ranging from 10 to 21 years in most cases) for a lump sum lease premium. The oil company then sub-leased the stations back to the retailers for a nominal amount for the period of the original lease less three days. It was a condition of the sub-lease that the retailer sell the oil company’s product on an exclusive basis. The House of Lords held the expenditure to be capital.

Strick v Regent Oil Co Ltd [9.150] Strick v Regent Oil Co Ltd [1966] AC 295 House of Lords Lord Reid: Where the wasting asset is a right to some benefit for a period of years and the consideration given for it is the payment of an annual sum during the continuance of the right there is generally no difficulty. Rent payable under a lease or under an agreement for the hire of a machine is treated as a proper debit against incomings and the same must, I think, apply to an annual (or quarterly or monthly) payment for a tie. The difficulty begins to arise when a lump sum is paid to cover several years. If that is so,

504

[9.140]

then it is not so much the nature of the right acquired as the nature of the payment for it that matters. It was argued that a rent and a premium paid under a lease are paid for different things – that the premium is paid for the right but that the rent is paid for the use of the subjects during the year. I must confess that I have been unable to understand that argument. Payment of a premium gives just as much right to use the subjects as payment of a rent and an obligation to pay rent gives just as much right to the whole

Current and Capital Expenses

Strick v Regent Oil cont. term of years as payment of a premium. A lessee who only pays rent has the same right to assign the rest of the term – perhaps for a large capital sum if values have gone up – as has the lessee who has paid a premium. But his right to assign is less valuable in so far as the amount of the rent to be paid in future is greater than it would be in a case where a premium has been paid. Both lessees are liable to have their rights terminated if they do not fulfil their obligations under the lease – but not otherwise. Suppose that in order to achieve a continuing advantage like a tie, the taxpayer makes a series of agreements each for three years and each for a lump sum. Then if the lump sum payments are allowed as revenue expenses the effect will be that in the first year of each agreement the profit will be too small but in the next two years it will be rather too large, and so on. So over each period of three years there will be a fair result. But

CHAPTER 9

on the other hand suppose that the taxpayer makes an agreement for a tie for 20 years or more then the lump sum will presumably be much larger, and the distortion in the first year much greater if the payment is allowed as a revenue expense; and, even if one could assume fairly constant conditions for so long a period, it would be only after 20 years that a fair result would be reached. That would seem to justify refusing to treat a payment covering so long a period as a revenue expense. And on more general grounds I must say that I would have great difficulty in regarding a payment to cover 20 years as anything other than a capital outlay. … I would regard a payment which has to be made every three years to retain an advantage as a recurrent payment, whereas for practical purposes I would not think that the fact that another payment will have to be made after 20 years if the situation does not change in that time would prevent the first payment from being regarded as made once and for all.

[9.160] Applying Lord Reid’s analysis, it might be possible to change the character of

payments to acquire long-term benefits by substituting more frequent payments. In two recent casino licence cases, this strategy was attempted by taxpayers, without success. In Jupiters Ltd v Deputy FCT (2002) 50 ATR 236, the taxpayer operated a casino in Brisbane and entered into an agreement with the Queensland Government under which the Government promised not to allow a competitor casino to operate within 60 km in return for “special rent” payments. Although the payments were regular, the Full Federal Court concluded they were capital in nature. The benefit acquired was “to secure the advantage of exclusivity and freedom from competition”, a benefit the Court characterised as an enduring quality, going to the goodwill (ie structure) of the taxpayer’s business. In FCT v Star City Pty Ltd, the taxpayer sought to deduct on revenue account a lump sum which was specified in the contractual documents to be a prepayment of “rent” for land. The land in question was to be the site of the only casino in Sydney. While the contract between the casino and the state government characterised the payment as rent, separate background documentation made it clear that the value of the rent was tied to subsidiary understandings that the taxpayer would enjoy an exclusive licence to operate a casino and much of the value of the rental rights was economically inseparable from the licence. The ATO’s case thus turned on its ability to convince the Court to look beyond the lease contract to the background materials. On a detailed characterisation of the lease contract, including its surrounding circumstances and background, the Full Court of the Federal Court overturned the court at first instance and concluded that the payment was capital in nature.

[9.160]

505

The Tax Base – Deductions

FCT v Star City Pty Ltd [9.170] FCT v Star City Pty Ltd [2009] FCAFC 19 Full Federal Court Goldberg J: The starting point for my consideration is that the Court is not limited to the words and text of the leases, or indeed any of the Transaction Documents in characterising the nature of the prepayment and the advantage sought by its payment. The determination of that characterisation is to be undertaken from a practical and business point of view. … In Commissioner of Taxation v Cooling (1990) 22 FCR 42, Hill J (with whom Lockhart and Gummow JJ agreed on this point) considered the submission of the Commissioner that the form of the transaction entered into by the parties was determinative of the character of the receipt in the hands of the taxpayer. Hill J noted the Commissioner’s reliance on the reasoning of the House of Lords in Inland Revenue Commissioners v Duke of Westminster [1936] AC 1 to the effect that the legal effect of the covenant between the parties determined for revenue purposes the character of the payments made. Hill J said at 53: This however does not mean that in determining the legal effect of a contract between parties (and therefore the characterisation of the payment made under it as being income or capital), regard may not be had to the whole factual matrix of which the contract forms part.

[9.175]

9.7

The primary judge [in this case] correctly identified the relevant principles to apply in determining whether the amount of $120 million was an item of revenue or of capital and in determining the character of the advantage sought and the characterisation of the prepayment to the Authority. In particular the primary judge observed that an examination of the character of the advantage sought was assisted by asking two questions: What was the prepayment really paid for; and, is what it was really paid for, in truth and in substance, a capital asset? … I consider that when her Honour came to apply these principles to the facts and documents before her, she fell into error by focusing on the rights created under the documents, in particular the leases, and did not give sufficient regard to what the prepayment was calculated to effect from a practical and business point of view. Dowsett J, in agreement, concluded that “However one looks at it, it is impossible to avoid the conclusion that the up front payment of rent was offered, paid and received as part of the wider bid made for the purpose of winning the bidding contest for the package, including the award of the licence and the benefit of the exclusivity arrangements.”

Questions

The taxpayer operated a security monitoring service. It regularly purchased three-year contracts for security services from subcontractors who had sold the services to homeowners. Over half the customers did not renew the service at the end of the contract. The taxpayer sought to deduct the cost of acquiring contracts as revenue outgoings, claiming they were regular payment to secure customers, to add incrementally to its customer base and thus to expand its business and obtain revenue from the customers. The Commissioner argued the expenses were capital outgoings related to the taxpayer’s business structure as it was in the business of providing monitoring services, not buying and selling contracts. Will the Commissioner succeed? See Tyco Australia Pty Ltd v FCT (2007) 67 ATR 63.

[9.180] The capital gains tax provisions provide some response to the problem of wasting

intangible benefits such as licence agreements or restrictive covenants, although they do not allow amortisation of these intangible assets over time. Under the CGT rules, the cost of 506

[9.170]

Current and Capital Expenses

CHAPTER 9

acquiring an asset such as contractual rights is added to the first element of the cost base of the asset under s 110-25(2). The expiry or termination of the asset gives rise to CGT event C2 (s 104-25). The difference between the cost and the capital proceeds (zero in most cases) gives rise to a capital loss equal to the expenditure. Thus, if the facts in Regent Oil were to occur today in Australia, at the end of the lease period, the taxpayer would be able to recognise the amount it paid to secure the leases as a capital loss. No doubt the taxpayers in Jupiters and Star City would also try to recognise their license outlays as capital losses using this technique, although in Star City, the licence agreement was for 99 years so it might be waiting a while before it can claim its loss. The taxpayer is prejudiced in this approach by the timing mismatch between the income produced by the expenditure and the capital loss recognition. Consider again the taxpayer in Regent Oil. The lease arrangements entered into by the taxpayer in that case generated income that was assessable over the entire contract. Had it been allowed to recognise the cost of the premium paid to enter into the lease as a capital loss at the end of the lease, it would have obtained relief years after it had been assessed on the gains attributable to the expense. Further, capital losses are only deductible from capital gains. If the taxpayer’s operations only generate ordinary business income, capital expenses incurred to derive those amounts may never be recognised. [9.185]

9.8

9.9

Questions

The taxpayer was a property owner who paid a lump sum amount to his tenant to secure the tenant’s agreement to terminate a lease in order to enter into a new and more profitable lease yielding a higher rental return. (a) Is the expense a current or capital outgoing? (b) Would the answer be different if the compensation payment were made periodically by way of instalments? (See Kennedy Holdings and Property Management Pty Ltd v FCT (1992) ATR 321.) (c) If it is a capital expense, would it: give rise to an asset that would eventually yield a capital loss on expiry of the asset; or be added to the cost base of another asset and eventually be recognised as a reduced capital gain or a capital loss on disposal of that asset; or be amortised under s 40-830? The taxpayer manufactured tobacco products and belonged to an industry association that mounted a public relations campaign to prevent passage of legislation that would have increased tobacco licence fees and placed restrictions on the advertising and sale of tobacco products, and the sponsorship of sporting and cultural events. The taxpayer sought to deduct its contributions to the association to fund the campaign as a current expense. (a) Was the outgoing a current or capital expense? (See FCT v Rothmans of Pall Mall (Australia) Ltd (1992) 23 ATR 620.) (b)

If it is a capital expense, would it be recognised for tax purposes today?

3. PURCHASE PRICE AND REVENUE EXPENSE (a) Purchase by Instalments or Obligation for Periodical Payments [9.200] Whenever a taxpayer purchases an asset by instalment payments, the transaction

actually involves two components in an economic sense. The first is the acquisition of an asset and the second is payments on a “loan” of the purchase price, with each payment being partly [9.200]

507

The Tax Base – Deductions

principal and partly imputed interest to compensate the vendor for the fact that the purchase price is being paid over an extended period. If payment is extended in this way, the sale “price” will be increased by the imputed interest component. However, if the transaction is interpreted as a sale by instalments, it is likely that the courts will treat the entire payment as a capital outlay to acquire a capital asset. An early example of a judicial analysis of periodical payments for a capital asset is the Egerton-Warburton case, which has already been discussed from the perspective of the vendor (see [6.410]). Recall that the taxpayers in Egerton-Warburton were a father (the vendor) and two sons (the purchasers). The father had transferred his income-producing property (farming land and orchards) to his sons in return for a life annuity to him and his wife should she survive him. Upon the death of the survivor of the taxpayer and his wife, the sons were to distribute £10,000 to the surviving daughters of the taxpayer. The annuity payments were guaranteed by a charge on the property. The documentation between the father and his sons showed the father as the vendor of a farm and the children as purchasers with the annuity being consideration for the purchase. The High Court in Egerton-Warburton accepted the parties’ characterisation of the transaction as a purchased annuity and so the entire proceeds would be treated as income. The Court then considered how the payments should be characterised from the sons’ point of view. Under the tax statute at that time, to be deductible an expense had to be both on revenue account and “wholly or exclusively” for the production of assessable income.

Egerton-Warburton v Deputy FCT [9.210] Egerton-Warburton v Deputy FCT (1934) 51 CLR 568 Full High Court Rich, Dixon and McTiernan JJ: We turn to the question, whether this payment made to him by the sons forms a deduction of which they may avail themselves in equal shares in their respective assessments. … We do not think the annual payments made by the sons are outgoings of their capital. The payments may properly be considered as made by them on revenue account. But it is another thing to hold that the sums paid are expended wholly or exclusively for the production of assessable income … [this contention] is founded upon the circumstances that the annuity is charged upon the land used to earn the assessable income, that the charge was incurred as a condition attending the acquisition of the land, and that various provisions of the charge resulted in its being virtually compulsory to use the land for farming or orcharding. … These circumstances are relied upon as showing that the annuity is a charge incurred in order to enable the sons to obtain possession of the land for the purpose of earning assessable income therefrom, and paid in order to enable them to retain such possession for that purpose. 508

[9.210]

The annual value of business premises has always been held a proper allowance in the nature of a disbursement or expenses which must be deducted in ascertaining the balance of profits of a trade conducted thereon. It is thus fully recognized that revenue loss or expenditure suffered by a taxpayer through appropriating land to the purposes of trade is a proper allowance against trade profits. In the case of income from property, it is difficult to suppose that an obligation to pay an annual charge incurred as a necessary condition of acquiring the property does not amount to a deductible expenditure as money laid out for the production of assessable income. In such a case as the present, the land is a necessary implement for the production of income, and an expenditure, not being an outgoing of capital, which the taxpayer incurs in order to obtain the implement, seems naturally to fall under the description of money laid out for the production of income. So far as the taxpayer is concerned it is an expenditure incurred to create his assessable income.

Current and Capital Expenses

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[9.220] The “revenue” nature of the payments in Egerton-Warburton is hardly discussed by

the court, which appears satisfied that their annual nature establishes them as on revenue account (applying the capital/current expenditure test of the recurrent form of the payment). The full assessment of the annuity payments as income in the father’s hands was matched in the result, by the full deductibility of the payments to the sons, without regard to the fact that the sons obtained an enduring asset as a result of these recurring annual payments. A convenient legal hook to establish full deductibility was the charge over the property to protect the annuity payments – if the sons did not continue with the annuity payments, they would lose their income-producing property. [9.230] A variation of this problem arose in Colonial Mutual Assurance Society Ltd v FCT,

relied on in AusNet extracted at [9.30]. Colonial Mutual deals with the other side of the transaction in Just v FCT (1949) 8 ATD 419 ([6.440]). The taxpayer in Colonial Mutual was a life assurance company which acquired a piece of land adjoining land it already owned. As consideration for the sale of the land, the vendors were to receive, over a period of 50 years, 90% of the rents received from the tenants of certain shops on the land. Once again, the payments were secured by a charge on the property. In this case the High Court concluded the payments were on account of capital, as purchase payments by the taxpayer for the acquisition of its interest in the shops.

Colonial Mutual Life Assurance Society Ptd Ltd v FCT [9.240] Colonial Mutual Life Assurance Society Ptd Ltd v FCT (1953) 89 CLR 428 Full High Court Fullagar J: Nothing turns, so far as I can see, on the precise effect at law or in equity of the so-called rent charge. All that seems to me to matter for present purposes is that the moneys which the company has undertaken to pay are simply the price of the land which the company is purchasing from Just Brothers. This is made very clear by both documents, and whether the indebtedness of the company, as it accrues from time to time, is secured or unsecured seems irrelevant for present purposes. … It is incontestable here that the moneys are paid in order to acquire a capital asset. The documents make it quite clear that these payments constitute the price payable on a purchase of land, and that appears to me to be the end of the matter. It does not matter how they are calculated, or how they are payable, or when they are payable, or whether they may for a period cease to be payable. If they are paid as parts of the purchase price of an asset forming

part of the fixed capital of the company, they are outgoings of capital or of a capital nature. It does not indeed seem to me to be possible to say that they are incurred in the relevant sense in gaining or producing assessable income or in carrying on a business – any more than payment of a lump sum would have been so incurred if the purchase price had been a lump sum payable on transfer. The questions which commonly arise in this type of case are (1) What is the money really paid for? – and (2) Is what it is really paid for, in truth and in substance, a capital asset? … In the particular circumstances [of EgertonWarburton] the annuity was not regarded as part of a purchase price payable by the sons to the father for the land. The nature of the transaction itself had been closely examined by the court … the transaction was not an ordinary business transaction but bore “all the marks of a family settlement”. There was nothing to show that the full value of the property transferred was [9.240]

509

The Tax Base – Deductions

Colonial Mutual Life Assurance cont. represented by the consideration constituted by the various payments. The sum of £10,000 evidently amounted to a post mortem distribution to children as beneficiaries of the father’s property. It may well have been that the effect was to invest the sons with a substantial interest which was not exhausted by the payment of the charges upon it. Seen as being in substance a family settlement, the transaction in spite of its form, could not be treated as meaning that the sons were paying for the land a true price which was represented in part by the annuity payable to the father. It resembled rather a gift of the land to the sons charged during the father’s lifetime with an outgoing analogous to interest on a mortgage and charged with a capital sum payable at the father’s death.

No such considerations are present in the case now before us. Here we have a transaction of a purely business nature, in which it may be safely assumed that two parties, bargaining on equal terms, had full regard to the value of the land and the probable value of the consideration. According to the documents the periodical payments are the price for which the land is being bought, and no reason can be suggested for not giving to the documents their full literal effect. The transaction might perhaps have taken a form under which parts of the total payments to be made were or could be, treated as interest on deferred payments of a price. But it did not take any such form. As matters stand, the total of the payments is simply the total price of the land.

Kitto J and Taylor J concurred with the reasons given by Fullagar J and Williams ACJ and Webb J agreed with the result in separate judgments.

(b) Purchase for a Lump Sum Plus Continuing Payments [9.250] Determining the exact value of an asset to be sold may be difficult. This is often the

case, for example, in the sale of mining rights where the parties are not in agreement over the amount of minerals to be found on the site, or in the sale of a business, where the purchaser has doubts about the vendor’s claims regarding expected future profits. It is quite common for the parties to resolve such doubts by nominating a “conditional” or “contingent” price which transfers to the vendor some of the risk regarding the vendor’s claims about the property. For example, the vendor might sell a mining property for $x million plus 20 cents per tonne for every tonne in excess of a nominated amount, or a business owner might sell a business for a fixed figure and 10% of the profits for five years after the sale. This kind of payment structure adopted in a sale of business sales, where the purchase price for the business comprises a lump sum plus an obligation to pay a portion of business profits over a period of years subsequent to the sale, is called an “earn-out” clause. It is clear that the original payment for the mine or business in these examples is a capital outgoing for the purchase of an asset. But what of the later payments, based on production or profits? On the one hand, they appear to be part of the purchase price of an asset. On the other hand, these payments closely resemble revenue expenses such as royalties, as they are periodic and connected with the ongoing business operations. [9.260] This issue was considered by the Full High Court in Cliffs International Inc v FCT,

which was distinguished by the majority in AusNet in [9.30] but relied on by Nettle J in dissent. The facts in Cliffs International arose out of a sale of prospecting and mining rights held by a company called Basic. The taxpayer, Cliffs International, was a subsidiary of a 510

[9.250]

Current and Capital Expenses

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mining company which wished to prospect and, if sufficient ore was discovered, mine the areas for which Basic held the prospecting rights. The owners of Basic, Howmet and others, were willing to sell the mining rights but wished to do so by way of a sale of shares in Basic rather than a transfer of the prospecting rights held by Basic. The mining company agreed and arranged for Cliffs International to acquire the shares in Basic. The contract for sale of the shares required Cliffs International to make an “initial payment” of $200,000 and, in the event of ore being discovered and mined, to make additional “deferred payments” of 15 cents per ton of iron ore mined and transported from the property. Iron ore was duly discovered and Cliffs International organised a consortium to mine the ore. Cliffs International collected a royalty of 15 cents per ton from the consortium and passed the funds on to the former owners of Basic. In a split (3:2) decision, the Full High Court allowed Cliffs International to deduct the 15 cents per ton deferred payments pursuant to the predecessor to s 8-1.

Cliffs International Inc v FCT [9.270] Cliffs International Inc v FCT (1979) 142 CLR 140 Full High Court Barwick CJ: The Commissioner maintains, and the Federal Court has held, that those recurrent payments to Howmet and Mt Enid of 15 cents per ton of iron ore mined and transported were outgoings of a capital nature. It is said that they constituted part of the purchase price of a capital asset sold to the appellant by Howmet. In support of this contention, the language of cll 4 and 5, which I have quoted, is relied upon and, in particular, the use of the description “deferred payments” in relation to the recurrent sums. Reliance is placed by the Commissioner upon the decision of this court in Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428. The taxpayer submits that the payments were outgoings necessarily incurred in the gaining of its income from the mining of iron ore by the consortium and, though the promise to make them was part of the consideration for the agreement to transfer the shares, they do not thereby become capital payments but are analogous to the payment of rent agreed to be paid on the grant of a lease at a premium or to royalties agreed to be paid on the grant for a money sum of a licence to use a patent. The description given such payments by the parties cannot decide their quality. The nomenclature applied by the party or parties cannot foreclose the examination of what in truth the receipts or payments relevantly are.

But I ought at once to point out that the description “deferred payments” is quite obviously inapt. Clause 5 itself created no present debt for the amounts to be paid. It did not merely provide a manner of discharge in the future of a debt presently incurred. From any point of view, no conclusion could be founded upon or, in my opinion, could be aided by the description “deferred payments” applied by the parties to the sums which might thereafter become due pursuant to the appellant’s promise in cl. 5. I say “might become due” because none of the payments might ever be due. The appellant did not undertake to mine iron ore. Indeed, there was then no certainty that the appellant would ever have or control the right to do so. It was only in the eventuality that iron ore was drawn from the temporary reserves by or at the instance of the appellant that cl 5 would be activated so as to result in an obligation to make the stipulated payments. It is proper to point out, and to do so with emphasis, that by making the recurrent payments the appellant acquired nothing which it did not already have. The question is not of what relevant quality was the thing or right acquired by the payments: for nothing at all was thus acquired. It is, of course, true that, if it mined or procured the mining of iron ore from the area of the temporary reserves, the appellant was contractually bound to make the payment. It is also true that its [9.270]

511

The Tax Base – Deductions

Cliffs International cont. promise to make the payments in the events which occurred formed part of the consideration given for the acquisition of the shares. But they were acquired without making the payments in question. The recurrent payments were not made for the shares though it might properly be said that they were payable as a consequence of the purchase of the shares. Whilst there is a sense in which the promise to pay an amount rated to the tonnage of iron ore extracted from the temporary reserves in events then contingent and uncertain could be regarded as part of the cost to the appellant of the shares, I cannot think that the payments when made, having become payable because of supervening events can properly be regarded as part of the purchase money for the shares in Basic. As I have indicated, the fact that the promise to make the payments formed part of the consideration for the transfer of the shares does not mean that, when made, they were paid for the shares. The matter may be approached in another, though perhaps not so dissimilar a way. The vendors for the transfer of their shares took a cash price and stipulated for a share of the proceeds of mining iron ore, if that eventuated. For its part, the appellant by agreeing to make the recurrent payments was prepared to admit the vendors of the shares to participation in the result of the mining of the iron ore. They were made, and necessarily made, by the appellant as disbursements in its business. They were none the less so by reason of the fact that the appellant had agreed to make them: nor does the fact that the agreement to make them formed part of the consideration for the purchase of the shares make them payments of a capital nature. It does not seem to me to matter greatly what description is applied to such recurrent payments by the appellant. That they were in the nature of royalties I have no doubt. If an analogue is felt to be of assistance, an analogy may be found in the grant of a licence to use a patent upon payment of a cash price and a continuing royalty on what might be produced by employment of the patent. The promise to pay the royalties is, in my opinion, in such a case 512

[9.270]

part of the consideration for the grant of the licence but neither the receipt nor the payment of the royalty is for that reason a capital receipt or payment. The reasoning in Egerton-Warburton v Deputy FCT strongly suggests the conclusions at which I have arrived. The payments were, in my opinion, disbursements by the appellant in the course of its business and were not of a capital nature. In this connection, I should say that I do not find the facts in Colonial Mutual Life Assurance Society Ltd v FCT analogous to those of the present matter, or so closely to resemble them as to make what the court said and decided in that case definitive of this. Being of that view, I have no need to explore those reasons or to express a concluded view as to their acceptability. Suffice it to say that that case … depended upon its own facts and is, in my opinion, clearly distinguishable from this. Jacobs J: I have not been able to discover a case where payments have been held to be outgoings of a capital nature when all the following features are present: (a) the asset right or advantage was of a depreciating character and of limited life; (b) the obligation to make the payments in question continues throughout the life of the asset right or advantage or the entitlement of the taxpayer to the asset right or advantage; (c) the amount of the payments is recurrent; and (d) the amount of the payments is not fixed but is dependent on the use made of or profits derived from the asset right or advantage. In Colonial Mutual Life Assurance Society Ltd features (c) and (d) were present but not features (a) and (b); for the asset in question was freehold property and the obligation to pay was to last for fifty years. The best known example is the lease for a term of years where the consideration is a premium and a rental. The premium is a capital outgoing, the rental a revenue outgoing. This can be explained upon the basis that the premium is the price of the initial grant and that the rental is the recurrent price of use and occupation. That is true but it does not gainsay the fact that the obligation to pay both premium and rental springs from the one agreement. It shows that out of one agreement may spring obligations to make

Current and Capital Expenses

Cliffs International cont. payments some of which are capital outgoings and some of which are revenue outgoings. Each case depends on its own facts and circumstances but it may be stated that when the consideration for a depreciating asset right or advantage of limited life is a series of regular recurrent payments related to the life of the asset right or advantage then it is very likely that the recurrent payments will be found to be outgoings on revenue account. Particularly is this so when the amount of the payments is related to the use made of the asset right or advantage. In the present case the question can be asked of a particular payment – was it calculated to effect a discharge of the obligation to pay for the shares (or the shares together with the existing rights over the reserves) or was it calculated to

CHAPTER 9

effect payment for the exercise of the right to mine the ore in respect of which the payment is made? The fact that the parties to the option agreement described the payments as “deferred payments” is entitled to some weight but in the light of Mr Dohnal’s evidence of the course of negotiations it cannot be regarded as a factor of great consequence. The fact that there was an absolute transfer of the shares is also entitled to some weight but, for reasons I have stated, this factor cannot in the circumstances be regarded as of great weight. The preponderating factors are that the payments were in respect of a depreciating asset, that they were recurrent over the life of the asset if the asset was used throughout its life and that the amount of the payments were proportioned to the use made of the asset. These factors in my opinion clearly outweigh the other factors which might support a contrary view.

In a separate judgment, Murphy J agreed with the conclusion of Barwick CJ and Jacobs J. Gibbs and Stephen JJ dissented in separate judgments. [9.280]

9.10

9.11

Questions

The judgment of Jacobs J in Cliffs International appeared to turn on the wasting nature of the asset acquired by the taxpayer. Recall that the asset actually acquired was shares in a company. Was Jacobs J correct in characterising the asset in this manner? If the taxpayer had not been allowed to deduct the “deferred payments”, would it have ever been able to recognise the expenses for tax purposes? Does your answer to this question help explain the judgment of Jacobs J? Would the answer be different if it acquired the shares in Basic after 19 September 1985?

(c) Purchase by Instalments or Finance Lease Payments [9.290] Rental payments under a lease agreement for use of an asset, and periodic payments

made on an instalment basis for the cost of acquiring the asset, differ in legal form but may have similar effects as a matter of economic substance. This is particularly so where the asset is wasting in character and where the rental, or instalment, payments continue over the full effective life of the asset or there is an option to purchase the asset at residual value at the end of the lease. Instalment sales may operate in one of two ways. First, they may be based on a transfer of ownership from the outset with payments extending over time. Alternatively, they may be based on a transfer of possession followed by a series of payments with legal title being transferred at the end of the payment period, often with an additional “purchase price” of a small amount at the time ownership changes. In an economic sense each payment has two components. One is a partial payment of capital to acquire the property and the other is interest on the outstanding balance of the purchase price. [9.290]

513

The Tax Base – Deductions

If instalment payments were able to be dissected in this fashion for tax purposes, the interest component of each instalment payment would be deductible as a revenue expense and the part representing the purchase price would be recognised as a non-deductible capital outlay for the acquisition of an asset (though if it were a depreciating asset, the cost of the asset might give rise to capital allowance deductions over the life of the asset under Div 40 of the ITAA 1997). Lease payments are solely for the use of the asset and at the end of the rental period, the lessee has nothing to show for the payments except the possession already finished. Where the asset is non-wasting, such as land, the lessee clearly does not acquire that asset even if the lessee has had the use of it over a long term. For wasting assets, accountants distinguish between a lease that is a genuine rental arrangement (an operating lease) and a lease that amounts to a sale in economic substance (a finance lease). The lease that amounts to a sale is labelled a “finance lease” because the transaction is re-characterised for accounting purposes as a sale by the lessor to the lessee, with the lessor lending the lessee/purchaser the purchase price. Under this characterisation, each payment by the lessee is a payment on a loan, not a rental payment. The loan is treated as a “blended payments” loan similar to a mortgage or car loan in which the borrower repays principal and interest over the life of the loan. The interest portion is treated as a deductible expense for accounting purposes while the principal portion is a non-deductible repayment of the loan. Two tests are commonly used for accounting purposes to determine whether a lease is an operating lease or a finance lease. The first test is to see whether the lease provides for the lease property to be transferred to the lessee at the end of the lease for a nominal amount or an amount less than its true market value at that time. Where this happens, it can be assumed that part of each rental payment is for the purchase price. The second test is to see whether the lease applies for most of the effective life of the asset and whether the economic risks of ownership have been effectively transferred from the lessor to the lessee. Indications would include conditions that the lessee is responsible for maintenance of the asset, for insuring the asset, and so forth. The accounting approach contrasts with the judicial approach which generally respects the legal form of a transaction. Thus, as a general rule courts treat instalment payments for the acquisition of an asset as entirely part of the purchase price even though part of each payment is clearly imputed interest from a commercial perspective. Similarly, as we saw in the South Australian Battery Makers case (see [7.500]), using the “legal rights” test, a court might treat all of a “rental” payment as deductible rent even where the payment reduced the eventual purchase price for the rented property. The anti-avoidance provisions brought in to overcome the result in South Australian Battery Makers would now prevent taxpayers in the same situation from fully deducting “rental payments” that include a thinly disguised purchase price component. However, the measures set down no general principles and the ATO’s attempts to bring tax law more in line with accounting principles have met with little success. [9.300] The Eastern Nitrogen case concerned a sale-leaseback arrangement. The taxpayer

wished to raise funds for its operation. Instead of entering into an ordinary loan agreement, the taxpayer “sold” its ammonia plant, which was fixed to its premises, to a bank and then “repurchased” it by way of a “leaseback” which was a finance lease. The taxpayer never parted with possession of the plant. The Court held that, legally, ownership had passed to the bank and so characterised the “leaseback” as a genuine operating lease, rather than as a finance lease. This was despite the fact that ownership of the plant did pass back to the taxpayer at the end of the lease period. For accounting purposes, the payments by the taxpayer 514

[9.300]

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Current and Capital Expenses

would be characterised as blended loan repayments, with part of each “lease” payment treated as a repayment of principal on a notional loan and part of each payment treated as interest on the notional loan. The ATO sought a similar outcome for tax purposes, characterising each lease payment as partly revenue and partly capital. The attempt failed when the Full Federal Court seized upon every possible contingency in the arrangement to reject the ATO’s argument that the “lease” amounted to a sale on credit.

Eastern Nitrogen Ltd v FCT [9.320] Eastern Nitrogen Ltd v FCT (2001) 108 FCR 27; [2001] FCA 366 Full Federal Court Carr J: It is quite true that the appellant expected that it would, having observed its obligations under the Agreement for Lease, be offered the opportunity to repurchase the ammonia plant at the residual value. Objectively or subjectively the strong likelihood of being given that opportunity can be seen from the evidence to have been a matter of considerable importance to the appellant. The ammonia plant was a key component of its production facility. In the sense that the more that was paid in rent, the less that had to be paid for the ammonia plant at the end of the lease, some part of the rent might be regarded as being “on account” of or partially in reduction of what was probably to become the repurchase price for that plant. But, in my view, that advantage was too indirectly connected with the annual payments of the rent. By “indirectly connected” I mean that there is lacking the sufficiently immediate connection for the payments of rent to be linked to the reduction in repurchase price. On the authorities there needs to be more than a causal relationship in the “but for” sense. Too many things might have

happened between payment of the rent (it should be remembered that these appeals concern rent paid in the first two years of the lease) and whatever transpired at the end of the lease for the connection to be sufficiently immediate, despite the confident expectation of all concerned that a repurchase would occur. The relevant technology might have changed, making it worthwhile physically to redeliver the plant to the financiers and pay them the residual value. The plant might have been destroyed by accident. Another entity in the appellant’s corporate group might have purchased it from the financiers at the expiry of the lease. The appellant could have become insolvent and, by default, have caused the financiers to terminate the lease. Those factors contribute in one sense to the indirectness to which I have referred. But there is, in my opinion, another equally if not more important aspect of indirectness. Even if all had gone as the parties contemplated and the repurchase had occurred, the rent payments were not immediate enough in time or quality to the capital benefit.

[9.330] Lee J and Sundberg J agreed with Carr J in separate judgments. Some specific rules

relating to finance leases in the tax statute are discussed in [10.580]. However, these specific rules still do not incorporate a general principle into the tax law that would recognise the accounting treatment of finance leases for tax purposes. Finance leases and sale-leaseback arrangements are widely used in businesses and continue to be effective for tax purposes.

(d) Interest on a Borrowing to Acquire a Capital Asset [9.340] As was explained in Chapter 7, interest is typically treated as a revenue or current

expense, and is deductible where it is incurred to derive assessable income from business or an investment. Interest payments are regular, periodical and bring no enduring benefit as they are paid in arrears and the benefit to which they are related – use of borrowed money – expires as soon as the interest is paid. However, if interest expense is incurred at the start-up phase of a [9.340]

515

The Tax Base – Deductions

business or profit-making venture, it may be difficult to attribute the interest expense to an income-earning process. Further, a question arises as to the tax treatment of interest for acquisition of a capital asset. This issue was explored by the High Court in Steele v DFC of T (see also [7.300]). Prior to the commencement of capital gains tax, the taxpayer in Steele had acquired a property, “Tibradden” used for agistment of horses. She intended to build and operate a motel on the property, and to construct townhouses for resale to investors. She also intended to continue operating the agistment business, which produced a small income. After difficulties with a partner she brought into the venture, the taxpayer sold her interest in the property. She claimed deductions for the interest expenses incurred over six years on borrowed funds used to acquire the property. The ATO denied a deduction and the taxpayer appealed to the AAT (unreported), which allowed an interest deduction for only a small portion of the expense incurred, which was equal to the income from the agistment business. The taxpayer’s appeal to the Federal Court (Steele v Commissioner of Taxation (1996) 31 ATR 510) was dismissed when the Court upheld the AAT conclusion that the expense was incurred for dual purposes and the nexus between future income from the long-term project or future business enterprise and the interest was too remote to qualify for a deduction and hence the interest expense was an affair of capital. The taxpayer appealed to the Full Federal Court which would have allowed the taxpayer a deduction only up to the amount of income from agistment. The Court concluded the remainder of the outgoing lacked a sufficient nexus with future income to satisfy the positive limbs of s 51(1) and was also on capital account because it related to the acquisition of a capital asset. The taxpayer appealed to the Full High Court.

Steele v DFC of T [9.350] Steele v DFC of T (1999) 41 ATR 139 Full High Court Gleeson CJ, Gaudron and Gummow JJ: The question is whether interest outgoings which, by hypothesis, were incurred in gaining or producing assessable income, in the sense outlined above, were outgoings of a capital nature. As was explained in Australian National Hotels Ltd v FCT, interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan. According to the criteria noted by Dixon J in Sun Newspapers it is therefore ordinarily a revenue item. This is not to deny the possibility that there may be particular circumstances where it is proper to regard the purpose of interest payments as something other than the raising or maintenance of the borrowing and thus, potentially, of a capital nature. However, in the usual case, of which the present is an example, where interest is a recurrent payment to 516

[9.350]

secure the use for a limited term of loan funds, then it is proper to regard the interest as a revenue item, and its character is not altered by reason of the fact that the borrowed funds are used to purchase a capital asset. The fact that the asset has not yet become, and may never become, income-producing may be relevant to a decision as to whether the case falls within the first limb of s 51(1). However, once it is determined, or accepted by hypothesis, that the interest is, during the relevant year, an outgoing incurred in gaining or producing the taxpayer’s assessable income, (even though no assessable income is derived during that year, and no such income may ever be derived), the circumstance that the capital asset has produced no income is not a reason to conclude that the interest is an outgoing of a capital nature. There are cases where the necessary connection between the incurring of an outgoing

Current and Capital Expenses

Steele v DFC of T cont. and the gaining or producing of assessable income has been denied upon the ground that the outgoing was “entirely preliminary” to the gaining or producing of assessable income or was incurred “too soon” before the commencement of the business or income producing activity. The temporal relationship between the incurring of an outgoing and the actual or projected receipt of income may be one of a number of facts relevant to a judgment as to whether the

CHAPTER 9

necessary connection might, in a given case, exist, but contemporaneity is not legally essential, and whether it is factually important may depend upon the circumstances of the particular case. The resolution of the issue ultimately involves a judgment of fact, even though questions of law are involved. This means that the course proposed by Carr J, of remitting the matter to the Tribunal, is appropriate. This is not a case where, on the evidence, only one conclusion would be open to the Tribunal.

Kirby J dissented. Callinan J agreed with the majority that the interest expense was of a revenue nature and would have decided the appeal in the taxpayer’s favour without remitting the matter back to the AAT. [9.355]

9.12

Question

The taxpayer purchased shares in a mining company under a contract based on the value of the purchased company as at 1 January 1983. The sale agreement provided for the vendor to ensure that the purchased company would retain all profits derived after 1 January 1983 and not distribute them to its shareholder, the vendor. The sale agreement established a price equal to the 1 January 1983 value plus interest calculated from that date to the date of actual settlement and payment. The interest component was not to exceed the net income of the purchased company during that period. The taxpayer sought a deduction for the interest while the ATO argued it was a capital payment equal to the increased value of the company attributable to the profits it retained. Is the so-called “interest” charge really interest? Will the taxpayer be successful? (See FCT v Broken Hill Pty Co Ltd (2000) 45 ATR 507.)

(e) Purchase Price of a Revenue Asset [9.360] If the purchase price of a capital asset is non-deductible because of its capital nature,

how is the purchase price of a revenue asset treated? Recall that revenue assets are assets which generate ordinary income assessable under s 6-5, or a deductible loss under s 8-1, when sold, although they are not trading stock (see [5.470]). Intangible assets such as contract rights (as in Heavy Minerals at [5.540]), or shares and securities of banks and investment companies (as in London Australia Investment at [5.740]) may be treated as revenue assets. Gains on sale of revenue assets are taxed on a profit and loss basis. In this approach, outgoings are recognised as a cost upon realisation of the gain (that is, on disposal of the assets) and no deduction is allowed when the asset is first acquired, notwithstanding the revenue characterisation of the asset and transaction. This approach is necessary because there are no re-inclusion provisions applicable to revenue assets as there are for trading stock. As a revenue asset will also, usually, be a CGT asset as defined in s 108-5, the cost will also be treated as cost base and potential capital gain or loss is generated on sale. Section 118-20 is intended to prevent double taxation by reducing the capital gain to the extent an amount is included in assessable income under another provision. Section 8-10 prevents double [9.360]

517

The Tax Base – Deductions

deductions and presumably would prevent deduction of a capital loss, as well as a s 8-1 deduction, in respect of a loss incurred on disposal of a revenue asset. As explained in Chapter 12, in the case of trading stock, taxpayers are allowed, under Div 70 of the ITAA 1997, an initial deduction for the cost of acquisition of the trading stock and then are required to re-include an amount in assessable income in respect of stock still on hand at the end of the tax year.

518

[9.360]

CHAPTER 10 Specific Deductions and Restrictions on Deductions [10.10]

1. INTRODUCTION........................................ ................................................. 521

[10.30]

2. SPECIFIC DEDUCTIONS .................................. ........................................... 522

[10.40]

(a) Redundant Provisions .......................................................................................... 522

[10.60]

(b) Charitable Donations .......................................................................................... 523

[10.65] [10.80] [10.100]

(c) Repairs ................................................................................................................. 524 FCT v Western Suburbs Cinemas Ltd ............................................................................ 524 W Thomas & Co Pty Ltd v FCT .................................................................................... 526

[10.110]

3. CAPITAL ALLOWANCES ................................... ............................................ 528

[10.120] [10.130] [10.150] [10.170] [10.185] [10.190] [10.220]

(a) General Capital Allowance Regime ....................................................................... (i) What is a depreciating asset? ................................................................................ Ruling TR 2004/16 .................................................................................................... Wangaratta Woollen Mills Ltd v FCT ............................................................................ (ii) Who can claim a capital allowance? ..................................................................... (iii) Calculating the capital allowance ........................................................................ (iv) Balancing adjustments ........................................................................................

[10.230]

(b) Farming, Mining and Other Projects .................................................................... 537

[10.250]

(c) Business Related Costs ......................................................................................... 538

[10.270]

(d) Buildings ............................................................................................................. 539

529 529 530 532 533 534 536

[10.280] 4. LOSSES AND TIMING RULES ............................... ....................................... 540 [10.280]

(a) Tax Losses ............................................................................................................ 540

[10.290] [10.310] [10.350]

(b) Bad Debts ........................................................................................................... 541 Point v FCT ................................................................................................................ 541 BHP Billiton Finance Ltd v FCT ..................................................................................... 543

[10.380]

(c) Prepaid Expenses ................................................................................................. 545

[10.390] 5. BUSINESS TAX CONCESSIONS ............................. ..................................... 545 [10.410]

(a) Small Business ..................................................................................................... 546

[10.430]

(b) Discount for Unincorporated Businesses .............................................................. 547

[10.440]

(c) Research and Development Tax Incentive ............................................................ 547

[10.450] 6. STATUTORY RESTRICTIONS ON DEDUCTIONS .................. ........................ 548 [10.460] [10.480]

(a) Personal and Quasi-Personal Expenses ................................................................. 548 Stewart v FCT ............................................................................................................ 549

[10.500]

(b) Penalties and Illegal or Immoral Expenses ............................................................ 550

[10.510] [10.520] [10.530]

(c) Deduction Denial as a Surrogate Tax on Benefits ................................................. 551 (i) Club and leisure facilities ...................................................................................... 551 (ii) Entertainment expenses ....................................................................................... 551 519

The Tax Base – Deductions

[10.540] [10.550]

(iii) Luxury car depreciation cap ................................................................................ 551 (iv) Collateral business benefits ................................................................................. 551

[10.560]

(d) Personal Services Regime ..................................................................................... 552

[10.580]

(f) Finance and Leveraged Leases .............................................................................. 552

Principal Sections ITAA 1997 s 8-10

Div 25 s 25-10 s 25-35(1) Div 26 s 26-35 s 32-5 Div 35 s 36-15 s 40-25 s 40-30(1) s 40-30(4) s 40-40 s 40-70 s 40-75 s 40-180 s 40-190 s 40-215 s 40-285 s 40-323 s 40-830 s 40-880 s 43-15 s 85-10(1) s 110-45(1B)

520

Effect Requires taxpayers to claim a deduction under the most appropriate provision where it is allowed by more than one section. Specific deductions of a revenue nature. Deduction for the cost of repairs. Deduction for bad debts that are written off. Prohibits or limits deduction of particular kinds of expenditure or loss Arm’s length rule where goods or services are acquired from a relative. Denies deduction for entertainment expenses. Quarantines non-commercial losses (hobby losses). Carry-forward of tax losses. Deduction of an amount equal to the decline in value of depreciating assets over the income year. Depreciating asset. The parts of some composite asset may need to be depreciated separately. When a person holds a depreciating asset. Capital allowance deductions using the diminishing value method. Capital allowance deductions using the prime cost method. The “first element” of cost of a depreciating asset. The “second element” of cost of a depreciating asset. Excludes deductible expenses from cost of depreciating assets. Balancing adjustment where there is a disposal of a depreciating asset. Imposes a cap on the value of a car that can be depreciated. Deduction of capital expenditure in a “project pool”. Deduction of business related costs of a capital nature. Deduction for construction expenditure on capital works including buildings. Limits deductions by contractors deriving personal service income. Excludes deductible expenses from the cost base for CGT purposes.

Specific Deductions and Restrictions on Deductions

ITAA 1997 s 110-55(9) s 118-24 Div 250 s 328-180(1) Div 355

CHAPTER 10

Effect Excludes deductible expenses from the reduced cost base for CGT purposes. Excludes depreciating assets from the CGT regime. Recharacterises certain lease transactions as if they were loans and sales of property. Small businesses can deduct immediately expenditures for assets costing less than $1,000. Research and development tax offset.

1. INTRODUCTION [10.10] Section 8-1(3) of the ITAA 1997 defines deductions allowed under s 8-1 as general

deductions. Section 8-5 defines deductions allowed under another provision as specific deductions. Many specific deductions are in Div 25 of the ITAA 1997. They are also elsewhere in the income tax law, most importantly in Div 36 (tax losses), Div 40 (capital allowances for depreciating assets) and Div 43 (depreciation of buildings and capital works). Some specific deductions provide for expenses which may not be deductible under s 8-1 but, for policy or political reasons, have been enacted into law. There are a number of concessional deductions which implement government policy to support particular activities or investments. Examples include the deduction for gifts to certain charities and other not-for-profit organisations in Div 30 of the ITAA 1997 and accelerated depreciation deductions for primary production assets in Div 40. Other concessions such as the subsidy for research and development are now established as tax offsets instead of deductions. One growing area of tax concessions relates to small business, although some of these concessions are intended as temporary “stimulus” packages rather than permanent tax law changes. In 2015, the company tax rate was reduced to 28.5%, and other small business concessions were introduced. In Div 328, special rules for business deductions apply. These are discussed at [10.390]. [10.20] The income tax law also contains provisions that restrict or prohibit deductions for

particular types of expense or loss. Many of these restrictions are in Div 26 of the ITAA 1997. Some restrictions seek to achieve broader social, moral or economic objectives, while others are aimed at particular tax avoidance schemes. Several provisions are designed to prevent double deductions, or recognition of expenditure under two or more separate regimes in the tax law. In most cases, duplicated recognition arises because a deduction is allowed under the general rule in s 8-1 and also under a specific deduction. Where this happens, s 8-10 restricts taxpayers to one deduction, to be taken under the section that is “most appropriate”. If the general rule in s 8-1 would allow a deduction and a specific provision would deny it, the deduction denial provision has priority, as a result of s 8-1(2)(d). There is no reconciliation provision to deal with a deduction that would be allowed under a specific deduction provision but denied under a deduction denial provision. However, s 8-5(2) hints that the deduction denial provision should have priority. [10.20]

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2. SPECIFIC DEDUCTIONS [10.30] Many specific deductions are in Div 25 of the ITAA 1997. Some of these rules were

introduced where a judicial decision has found that there is not sufficient nexus with work or business income, so that the s 8-1 positive limbs are not satisfied. Examples include the deduction for the cost of travel between workplaces (s 25-100) which was enacted to overcome the High Court decision in FCT v Payne (2001) 46 ATR 228 and the deduction for the cost of managing tax affairs (s 25-5). Specific deductions also provide for capital allowances and timing rules that are intended, on the whole, to bring the income tax law into closer alignment with a “comprehensive” income tax. Divisions 40 and 43 of the ITAA 1997 provide capital allowance deductions for depreciation on tangible and intangible capital assets and some other capital expenditure, usually over the life of the asset. Other specific deduction rules adjust the tax accounting system to ensure the correct measurement of taxable income. These provisions spread a deduction for expenses over the period to which an expense relates (the “prepayment” expense rules) or provide a deduction to “correct” the tax accounting system, for example the bad debt deduction in s 25-35 or the rules permitting carry forward and deduction of tax losses in Div 36. Some specific deductions are concessional in nature and operate to deliver a subsidy to a particular type of personal expenditure or industry. Governments have often used tax deductions to subsidise preferred activities. Other specific provisions allow an immediate deduction for expenses for benefits that arguably enjoy a longer life, and so in a comprehensive income tax, would ideally be deducted over time under the capital allowance regime. In some cases, the upfront deduction is allowed because the life of the benefit is uncertain. This is probably the case for the s 25-60 deduction for election expenses. In theory, an unsuccessful candidate should be allowed an immediate deduction for election expenses while a successful candidate should recognise the outgoings over his or her elected term (assuming that the elected official would derive assessable income, such as a salary, from the office). A similar issue arises for some expenses that are deductible under s 8-1, such as advertising expenses for a business, which are intended to, and likely have, a longer-term impact in many cases. The rationale for other immediate write-offs is not as clear. For example, s 25-20 allows an immediate deduction for lease document expenses, which should be amortised under a comprehensive income tax over the life of the lease. Concessional deductions may be analysed as “tax expenditures” that deliver government spending in support of a particular sector, activity or investment. See [1.130] for more on tax expenditures. In some cases, for example in respect of environmental rehabilitation costs, a concessional deduction is intended to correct a perceived market failure that prevents the desired amount of investment flowing to a preferred activity. In other cases, for example the charitable tax deduction, the subsidy supports social or cultural activities considered to be for the public good. However, concessional deductions also appear to be frequently enacted as spending programs to achieve political support from particular interest groups.

(a) Redundant Provisions [10.40] A number of specific deductions are in the tax law for historical reasons and appear to be redundant because they relate to outgoings that would probably be deductible under s 8-1 in any event. Redundancy of tax provisions continues to plague our income tax law, despite the 1997 tax law rewrite and a major exercise in 2006 to remove redundant provisions. 522

[10.30]

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Section 8-10, requires taxpayers to deduct the expense under the provision that is “most appropriate”. It is usually considered that this means the specific provision applies, based on the general rule of statutory interpretation that where both a specific and a general provision apply to the same situation, the specific provision is normally the most apt. However, this may not always be the case: consider the wording and note to s 25-55(1) about payments to professional and trade associations. One redundant provision is s 25-40. As explained in Chapter 3, profits from profit-making schemes were assessed, prior to capital gains taxation, under s 15-15 of the ITAA 1997. Section 25-40 is the matching rule that allows a deduction for a loss incurred in a profit-making scheme. However, such a profit is assessable as ordinary income following the principle in FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692, and presumably a loss would be deductible under s 8-1. Section 25-40 explicitly, and unnecessarily, excludes losses on the sale of assets acquired on or after 20 September 1985. Today, both inclusion and deduction sections are rarely used. Originally, almost none of the specific deduction provisions contained apportionment language limiting the deduction to the extent that the taxpayer derived assessable income or otherwise satisfied the negative limbs in s 8-1. This flaw allowed taxpayers to deduct personal expenses under specific provisions that never would have been allowed under s 8-1. For example, under the predecessor to s 25-10 (repairs), taxpayers were able to deduct fully the cost of repairs to property where the property was partly to derive assessable income and partly for personal use. Apportionment language has now been added to most specific deductions but not all. See, for example, s 25-15, which allows a deduction for amounts paid in consequence of a taxpayer’s failure to comply with a lease obligation to make repairs to premises. [10.50]

10.1

Question

Which of the following specific deductions apply to expenses that would be deductible under s 8-1 in the absence of a specific provision? (a) s 25-5 tax-related expenses; (b) s 25-10 repairs; (c) s 25-15 amount paid for lease obligation to repair; (d) s 25-25 borrowing expenses; (e) s 25-30 mortgage discharge expenses; (f) s 25-45 loss by theft; (g) s 25-50 pensions, gratuity or retiring allowance to former employees; (h) s 25-55 membership fees to join a trade, business or professional association; (i) s 25-100 travel between workplaces.

(b) Charitable Donations [10.60] The deduction for donations to charitable institutions has existed in the federal

income tax law since it was first enacted in 1915. Charities and other not-for-profit organisations are exempt from income tax under Div 50 of the ITAA 1997, while the charitable deduction is in Div 30 of the ITAA 1997. The charitable gift deduction in s 30-15 applies for gifts or contributions of $2 or more to eligible “deductible gift recipient” (DGR) organisations. Subdiv 30-B lists eligible recipients and includes conditions, such as a requirement to operate in Australia, and rules requiring [10.60]

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The Tax Base – Deductions

DGR organisation to operate on a not-for-profit status with appropriate governance. Deductions are allowed for gifts and contributions directly to eligible organisations, and also to public or private ancillary funds which satisfy requirements about contributions to eligible organisations. Gifts of cash or (with some valuation requirements) property are eligible. Unlike many other countries, there is no threshold or cap on tax-deductible gifts in Australia, and the concession is in the form of a deduction and not a tax offset. However, a gift deduction cannot generate or contribute to a tax loss, by virtue of the limit in s 26-55(1)(ba). The effect of the charitable gift deduction is that the government “co-contributes” a portion of the donation. For example, a taxpayer on the 45% marginal tax rate who contributes $100 to a DGR organisation essentially only pays $55, with the remainder being contributed by the government. The Tax Expenditures Statement estimated the revenue foregone from the charitable deduction to be in excess of $1.1 b in 2014-15. The charitable tax exemption and deductible gift provisions were recently the subject of review recently with two different motivations: first, governmental awareness of the growing significance of the not-for-profit sector and second, government concerns about abuse of the tax concession. The Gillard government established an independent national regulator of the charities sector, the Australian Charities and Not-for-profits Commission (ACNC), which has successfully increased regulation and contributed to building, protecting and enhancing public trust and confidence in the sector. However there has not yet been a consolidation and reform of the gift deduction rule. The ATO continues to be the regulator of DGR organisations and while many registered charities also have DGR status, the two categories are not coextensive. Status as a DGR organisation is generally more restrictive, while some organisations may have DGR status but not be exempt charities.

(c) Repairs [10.65] Repairs are deductible pursuant to s 25-10, where the expense is of a current

(revenue) nature. This is most likely a redundant provision, as the cost of repairs would most likely be deductible under s 8-1 in any case on general principles. While the lifespan of a repair may vary, it is usually presumed to have a limited lifespan and the costs of repairs appear more similar to ordinary maintenance expenses than to the cost of acquiring a new capital asset. [10.70] A repair may require the acquisition of replacement components or new fixtures.

Given the obvious tax advantages of repairs over replacements, taxpayers may seek the former characterisation over the latter. The approach of the courts and the factors they take into account when resolving disputes of this type are well illustrated in the High Court decision in FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102. The taxpayer owned a cinema, the ceiling of which was in need of repair. The relevant facts are set out in the judgment of Kitto J.

FCT v Western Suburbs Cinemas Ltd [10.80] FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 High Court Kitto J: Now, what the objection alleged plainly enough was that a portion of the ceiling of the Melba Theatre was considered by the company’s architects to be, and in fact it was, in a dangerous condition; that it could have been repaired with celotex if that material had been available, or 524

[10.65]

with fibro; but, because celotex was not available and to effect repairs with fibro would have been costly and not completely satisfactory, the company decided to replace the whole ceiling with a new fibro ceiling; this replacement cost [£3000] which is not claimed to be an allowable

Specific Deductions and Restrictions on Deductions

Western Suburbs Cinemas cont. deduction; but the company claims that a lesser amount of £603 is an allowable deduction, that amount being the estimated cost which would have been incurred in repairing the ceiling if it had in fact been repaired instead of being replaced. To decide whether a particular item of expenditure on business premises ought to be charged to capital or revenue account is apt to be a matter of difficulty, though the difference between the two accounts is clear enough as a matter of general statement. In this case the work done consisted of the replacement of the entire ceiling, a major and important part of the structure of the theatre, with a new and better ceiling. The operation seems to me different, not only in degree, but in kind, from the type of repairs which are properly allowed for in the working expenses of a theatre business. It did much more than meet a need for restoration; it provided a ceiling having considerable advantages over the old one, including the advantage that it reduced the likelihood of repair bills in the future. [The taxpayer’s objection] is supported, as I understand the argument, by alternative propositions: first, that £603 would have been the cost of repair, if repair had been decided upon, and that for that reason it is right that £603 should be treated as chargeable to income account; and secondly, that if the work actually involved in the replacement of the ceiling be considered in detail, it will be found that some things that were done would have had to be done even for the purpose of repair, and accordingly when the amount that was expended is analysed it will be found to include some items which would have entered into the cost of repair if the company had contented itself with repair. The answer to the first proposition is that when a taxpayer has two courses open to him, one involving an expenditure which will be an allowable deduction for income tax and the other involving an expenditure which will not be an allowable deduction, and for his own reasons he chooses the second course, he cannot have his income tax assessed as if he had exercised his

CHAPTER 10

choice in the opposite way. Section 53 [former s 25-10] is concerned with expenditure which was in fact incurred, not with expenditure which could have been incurred but was not.… The cases of Highland Railway Co v Balderston (1889) 2 TC 485 and Rhodesia Railways Ltd v Income Tax Collector, Bechuanaland [1933] A.C. 368 which were relied upon in the Board of Review, provide no support for the view that where an actual expenditure is not an allowable deduction a notional expenditure may be. … The second of the two cases cited also related to a railway line. Parts of the line were renewed so as to bring it back to normal condition but not so as to make it capable of giving more service than the original line. The Privy Council held that the expenditure was not of a capital nature, for although steel sleepers had been used in place of wooden sleepers, the renewals effected constituted no improvement. … It is true, as one member of the Board of Review has pointed out, that from the report it appears that two additional steel sleepers per rail length were introduced in carrying out the work, and the cost of these additional sleepers, which were regarded as an improvement, was charged by the appellant to capital and was not included in the sum claimed as a deduction. That does not make the case an authority for any principle of apportionment applicable here; it only shows that on the facts of that case the parties found it possible to segregate the cost of repairs actually effected which were chargeable against income from the cost of improvements actually effected which were chargeable against capital. The second proposition relates to some evidence given by Mr Roberts to the effect that if the ceiling had been merely patched up some of the same items would have entered into the cost as entered into the cost of the new ceiling. The capital or income character of expenditure actually incurred depends upon the nature of the purpose for which it was incurred. If a total expenditure is of a capital nature, so is every part of it; you cannot take a portion of the work done, such as the erection of a scaffolding and, closing your eyes to the purpose for which it was in fact erected, attribute to the cost of that portion an income nature for no better reason than that the same scaffolding would have been erected in [10.80]

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Western Suburbs Cinemas cont. order to serve a purpose which, if it had existed, would have made the total expenditure an income charge.

should be allowed, the decision of the Board of Review should be set aside, and the Commissioner’s decision to disallow the respondent company’s objection should be restored.

In the result I am of opinion that, however the case is approached, the Commissioner’s appeal

[10.90] Where a taxpayer has acquired a used asset, “initial repairs” may be required to put it

into a condition suitable for the income-earning process for which it was purchased. The cost is usually treated as a capital outlay, analogous to part of the cost of the asset. This approach assumes that the price of the property was discounted by the cost of repairs that the purchaser would have to make before the property could be used. In other words, the ATO presumes that under normal circumstances a purchaser would acquire property suitable for use (in which case the seller would have incurred the repair costs and added them to the sale price of the property) and that a purchaser would agree to take unrepaired property in part to obtain the tax advantages potentially available if the initial repairs could be treated as deductible outlays. An argument along these lines was made before the High Court in W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. The taxpayer had acquired a building which required extensive repairs before it could be put to the use for which it had been purchased. The ATO denied deductions for the costs of repairs and repainting the building.

W Thomas & Co Pty Ltd v FCT [10.100] W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58 High Court Windeyer J: Expenditure upon repairs is properly attributed to revenue account when the repairs are for the maintenance of an income-producing capital asset. Maintenance involves the periodic repair of defects that are the result of normal wear and tear in operation. It is an expense of a revenue nature when it is to repair defects arising from the operations of the person who incurs it. But if when a thing is bought for use as a capital asset in the buyer’s business it is not in good order and suitable for use in the way intended, the cost of putting it in order suitable for use is part of the cost of its acquisition, not a cost of its maintenance. … The principle is obvious without the need for any supporting authority. I may nevertheless quote as a clear exposition a passage from the judgment of Woodhouse J in the New Zealand case of Collector of Inland Revenue, Cook Islands v AB Donald Ltd (1965) 9 AITR 501 at 506. … His Honour said:

526

[10.90]

Nobody would doubt that to maintain such an asset which otherwise would deteriorate by its use in operations directed to produce income is a revenue charge. Work of this sort is done to preserve the asset, and following the work the character of the asset is left unchanged. But equally clearly the initial purchase of the asset involves an outlay of capital – it is a part of the organisation of capital by the taxpayer to enable income-producing activity to be carried out. How then must one label an expenditure which remedies some flaw in the asset existing at the time of purchase? To me there can be only one answer. To the extent that such initial defects are restored, the result is an improvement in the quality of the asset purchased, and, in my opinion, there has been an outlay of capital. To treat this outlay as a revenue loss is no more justified, in my opinion, than to treat the

Specific Deductions and Restrictions on Deductions

W Thomas cont. value of the improvement as an income gain. Defects may arise gradually over an extended period or develop from unexpected or sudden causes, but in so far as they have matured by the time of purchase by the new owner, they affect the quality of the asset he has acquired. Any subsequent need to remove them must be regarded as a legacy inherited by him as part of his bargain. It follows, therefore, that I take the view that the restoration of defects in an asset cannot be classed as a revenue charge unless the defects have arisen out of the taxpayer’s application of that asset in his search for income and unless the work is limited to those defects and does not become enlarged into such a reconstruction that a permanent improvement in quality has been effected. Applying the principle to the present case it seems to me that the expenditure of £5,082 upon repairs upon the Berry Building in the year ended 31 October 1961 was of a capital nature. It seems to me immaterial that when the taxpayer acquired the building it did not know of some of its defects, those in the basement floor for example. That means only that the cost of obtaining an asset suitable for its purpose was greater than had been expected. It is equally

[10.105]

10.2

10.3 10.4

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immaterial that some parts of the work of repair were done progressively as parts of the building were taken into actual use. Expenditure of a capital nature does not cease to be so because made for work the doing of which was spread over a period of weeks or months and paid for as it was done. It is perhaps possible that some part of the expenditure might perhaps on a more close analysis than the evidence permits be shown to contain elements that would, if they could be separated, be a justifiable charge to revenue account. There are always some difficulties in applying in a strict way the concept of repairs, as limited to those resulting from a taxpayer’s own operations, to work such as painting that is periodically done not merely to make good defects but also to prevent defects developing. A stitch in time is as much a repair as would be the nine it saves. And the cost of it may be in the same category as would the cost of nine. It may be too that the need for some of the work done on the building in the second half of 1961 was contributed to by the use that the taxpayer had made of it during the first half of that year. But I can see no basis for apportioning between capital and revenue the actual expenditure that was incurred on any of the items listed in the statement. Looked at as a whole, each was I consider expenditure of a capital nature. As Kitto J said in FCT v Western Suburbs Cinemas Ltd (1952) 86 CLR 102 at 109, “if a total expenditure is of a capital nature, so is every part of it.”

Questions

The roof of the taxpayer’s rental property was constructed with a type of concrete tile believed to be obsolete. The premises began leaking and a builder advised that the roof was beyond repair. The taxpayer was advised that the cheapest solution to the problem was to substitute a tin roof. This was installed on the old framing without the framing being realigned, for a cost of $3,741. Should the outlay be characterised as the cost of repairs or as a capital outlay? (See AAT Case 12 (1987) 18 ATR 3056.) Would it have made any difference to the result in Western Suburbs Cinemas if the roof had been progressively replaced over five years? The taxpayer operated a ship repair business. Ships to be repaired were hauled out of the water on cradles that lowered into the water on tracks set on a long ramp, known as a slipway. The piles on which the slipway rested deteriorated. The original piles were timber but the appropriate type of timber was no longer available so the engineering company carrying out the work used concrete piles. Evidence was introduced to show that the concrete piles were not superior to the original wooden ones (and in some ways [10.105]

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were inferior) and cost no more. Was the cost of renovation a repair or the cost of a new asset? (See Lindsay v FCT (1961) 106 CLR 377). 10.5

The taxpayer incurred expenses to encase wooden piles on a wharf in concrete to stop marine organisms from further damaging the piles. Is the work a repair or an improvement? (See BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65.)

10.6

The High Court in AusNet (see [9.30]) commented approvingly on a “repairs” case in which the court found that in some circumstances, an expenditure may be on capital account although otherwise it would be of a revenue nature: Law Shipping Co v Inland Revenue 1924 SC 74. What was the rationale for capital characterisation of repairs in that case?

3. CAPITAL ALLOWANCES [10.110] Under a comprehensive income tax, an outgoing to acquire a short-term benefit or

short-lived asset, expiring mostly in the year in which the outgoing was made, would be immediately deductible, as a current (revenue) expense. An outgoing to acquire a benefit or asset lasting for a longer period of time would be recognised over the life of the benefit obtained, as a “capital” expense. The key question from a tax policy perspective is, how long does the economic benefit last? If the benefit does not waste, no deduction should be allowed and instead the expense should be taken into account when determining the cost base of the asset upon eventual disposal. Thus, as a matter of tax policy, expenditure would be recognised as a deduction over the time period in which the benefits acquired with the expenditure expired, or over the period in which a wasting asset acquired with the expenditure depreciated or declined in value. In contrast, the basis of the judicial test to distinguish revenue, or current expenditures, from capital expenditures, is the distinction between expenses related to income-earning processes and expenses related to income-earning structures, discussed in Chapter 9. Without specific statutory rules, the capital expenses would not be recognised at all. The income tax statute has always had some rules for depreciation of the cost of capital assets but these are imperfect and have historically been quite limited; consequently, the income tax only approximates the comprehensive tax policy benchmark. Today, most capital allowance rules are in Div 40 of the ITAA 1997, incorporating common terminology and foundation rules. However, buildings are dealt with separately in Div 43 and Div 40 contains a number of different regimes applicable to different kinds of capital asset investment or expenditure. Financial arrangements are dealt with elsewhere in the statute (see Chapter 12 for more discussion). Section 40-215 of the ITAA 1997 excludes from the cost of an asset for capital allowance purposes any amount that is deductible under a provision outside the capital allowance system. A more limited reconciliation provision in s 43-70(2) applies to outgoings in respect of the construction of capital works. Another “cost” reconciliation provision is s 82 of the ITAA 1936, which prevents double deduction of expenses incurred to acquire a revenue asset, the sale of which will give rise to ordinary income or to a loss deductible under s 8-1 or s 25-40 of the ITAA 1997. Where an expenditure incurred by the taxpayer in connection with the revenue asset has been allowed or is allowable as a deduction, then it cannot be taken into account in ascertaining the taxable profit or deductible loss arising from the sale of the asset. Two provisions apply where a deductible expense is incurred to acquire an asset subject to the CGT provisions. Usually, s 118-24 ensures that the CGT rules will not apply to a Div 40 528

[10.110]

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asset (unless it is partly or wholly used for a non-taxable purpose). However, buildings and capital works eligible for Div 43 deductions may be CGT assets subject to capital gains tax on sale. Section 110-45(1B) prevents double recognition of a cost when the disposal of a capital asset gives rise to a capital gain, while s 110-55(9) prevents double recognition when disposal would give rise to a capital loss. Section 110-45(4) prevents double recognition in the case where the taxpayer deducts expenditure under Div 43 that was actually incurred by another entity (a previous owner who incurred the original construction cost).

(a) General Capital Allowance Regime [10.120] Division 40 of the ITAA 1997 contains a general capital allowance rule for most tangible and some intangible assets. The operative provision is s 40-25, which allows taxpayers to deduct an amount equal to the decline in value of any depreciating assets they held at any time in the income year. The capital allowance rules apply, as their name suggests, where an expenditure is capital and hence not deductible under s 8-1. Two important conditions are placed on the deduction: it is only available for the period of time during which the taxpayer holds the depreciating asset; and it is only allowed to the extent to which the asset was used for a taxable purpose. Thus, if a taxpayer acquires an asset halfway through the year, only half the decline in value for that year can be deducted as a capital allowance. Similarly, if the asset is used only half for the purpose of gaining assessable income and half for personal purposes, only half the decline in value for that year can be deducted.

(i) What is a depreciating asset? [10.130] A “depreciating asset” is defined in s 40-30(1) as any asset that has a limited

effective life and which can reasonably be expected to decline in value over time. The wide scope of the general rule is subsequently scaled back to exclude land (probably unnecessarily, as land is unlikely to decline in value over time), trading stock (dealt with in Div 70) and intangibles unless specifically listed. [10.140] One issue under Div 40 is determining if an asset comprises an amalgam of separate

components or is an entire depreciating asset. Is a truck a truck or is it an assembly of many separate assets – wheels, tyres, light globes, an oil filter, an air filter, etc? Section 40-30(3) provides that whether a composite item is itself a depreciating asset, or comprises a number of components that are separate depreciating assets, is a question of fact and degree which can only be determined in light of all of the circumstances. So long as the separate components and the whole asset have approximately the same effective lives, taxpayers will be generally indifferent to this question. However, if the separate parts had a shorter effective life than the whole asset, taxpayers would enjoy a significant tax advantage by re-characterising the asset as a collection of separate assets. The depreciation rate for depreciating assets found in a building is generally much faster than the more conservative rate of depreciation for the building itself (which is usually 2.5 percent per annum over 40 years). The potential tax advantage of characterising parts of a building as separate shorter-life assets are therefore considerable. Improvements to land, or fixtures, are treated by s 40-30(3) as assets separate from land, whether removable or not, opening up the possibility that these will be eligible for capital allowances under Div 40. These assets are prima facie subject to Div 43 if part of a building or [10.140]

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capital improvement to land. However, some unduly complex provisions confirm that if improvements or fixtures qualify as “plant”, defined in s 45-40 (Div 45 specifically relates to leased plant) via s 43-70(2)(e), then they are eligible for a Div 40 capital allowance. The statutory definition of “plant” extends beyond the ordinary meaning of the word to include “articles, machinery, tools and rolling stock” and a range of other specific fixtures and improvements. This provision reintroduces the notion of “plant” which previously existed in the tax statute, and which has been the subject of many court decisions. An example is provided in Ruling TR 2004/16 which explains the ATO’s approach to deductions for plant in residential investment properties, drawing on Australian and English case law. The ruling concludes that items such as kitchen cupboards and insulation batts are not “plant” and hence are only depreciable under Div 43, but that cooking stoves are “machines” under the extended definition of “plant” and hence are depreciable under Div 40. An outright deduction is provided for depreciating assets with a cost of $300 or less where the asset is used to produce assessable income but not used in a business: s 40-80(2).

Ruling TR 2004/16 Plant [10.150] 23. … the result of the relationship between Division 40 and Division 43 is that a deduction under Division 40 will not be available for a capital works item in a residential rental property unless the item is both plant and a depreciating asset and the other conditions of Division 40 are met. 24. For the purposes of the ITAA 1997, “plant” has the meaning given by section 45-40. That inclusive definition is identical in effect to the definition of plant in former section 42-18 and expresses the same ideas as the definition of plant contained in subsection 54(2) of the Income Tax Assessment Act 1936 (ITAA 1936) (except that “articles” were then separate from plant rather than included in the definition of plant as they are now). 25. Although there have been no Australian court decisions on the extent to which there is plant in a residential rental property, there have been a number of decisions by the Administrative Appeals Tribunal (AAT) on the issue. It is necessary, therefore, to consider the application to the present context of the general principles on the meaning of plant set out in court decisions … 26. In the context of a residential rental property, the relevant aspects of the definition of plant are: • the ordinary meaning of plant; • articles; and 530

[10.150]

• machinery. The ordinary meaning of plant 27. Since plant is defined in an inclusive manner, plant has its ordinary meaning as well as including the items listed in the definition. Over the years that “ordinary meaning” has gradually diverged from its natural or dictionary meaning. 28. Many of the issues as to the ordinary meaning of plant in the present context centre around whether a residential rental property is, or whether what could loosely be described as the fixtures and fittings commonly included as part of a residential rental property are plant. 29. That which is merely the “setting” for the particular taxpayer’s income earning activities is not within the ordinary meaning of plant. Whether “buildings, structures or the like, or parts of them” that are more than merely “setting” come within the ordinary meaning of plant depends upon “whether the function performed by the thing [the building, structure, or part of it] is so related to the taxpayer’s operations or special that it warrants it being held to be plant.” 30. [citing various AAT cases] “In the context of residential income-producing properties, the distinction between that which is ‘setting’ and that which is ‘plant’ remains valid. … Thus, ‘the starting point … is that a residential property will almost invariably (in the absence of exceptional

Specific Deductions and Restrictions on Deductions

Ruling TR 2004/16 cont. circumstances) be the setting of the incomeproducing operations and will therefore not be “plant”. That which forms a “part of the fabric” of the property, in a metaphorical sense, or in other words, that which is an “integral part of the structure of the premises” is therefore also not plant … It is to be regarded as a part of the “setting” of the income earning activity.’” 31. A passage from Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396, which includes references to “the purpose, in other words, is to make the building a complete building” and “the construction of the building as a building of the general type to which it belongs would be incomplete without them”, has been taken to establish a “completeness test”. However … the statements in that passage from ICI are not statements of law, but are findings of fact. Thus, whether a structure is incomplete without the relevant item is not of itself a test to determine whether the item forms part of the structure. 32. The English cases on the ordinary meaning of plant do, however, suggest that the question of incompleteness of the structure without the relevant item is a relevant consideration when determining whether the item forms part of the structure. In IRC v Scottish Newcastle Breweries Ltd [1982] 2 All ER 230, Lord Lowry made the distinction between something that is part of the premises and something that merely embellishes them. In Wimpy International [1988] STC 149 Hoffman J considered that the question whether something had become part of the premises was not “the same as whether it has become part of the realty for the purposes of the law of real property or a fixture for the purposes of the law of landlord and tenant.” That view accords with the Australian cases which clearly indicate that

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fixtures may be plant. [Pearce v FCT 89 ATC 4064; (1988) 20 ATR 113; Negative Instruments Pty Ltd v FCT (No. 2) (1994) 29 ATR 429]. Further, Hoffman J usefully provided guidance as to some relevant matters to be considered to determine the question of fact and degree as to whether an item forms part of the premises or retains a separate identity. These are: • whether the item appears visually to retain a separate identity; • the degree of permanence with which it has been attached; • the incompleteness of the structure without it; and • the extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period. No one of those factors is necessarily conclusive and the relative importance of each will vary depending on the nature of the item. 33. Where the item does not form part of the premises it will come within the ordinary meaning of plant where, as set out in paragraph 29, the function performed by the item is so related to the particular taxpayer’s income-earning activities or special that it warrants being held to be plant. It is considered that such an occasion is likely to be rare in the context of a residential rental property. This is because there is unlikely to be the required close relationship between the function performed by the item and the particular landlord’s rental income earning activities. 34. Passages from leading cases such as Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1 and Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396 demonstrate the closeness of the relationship that must exist between the function performed by an item and the particular taxpayer’s incomeearning activities for the item to be plant.

[10.160] One successful attempt by a taxpayer to achieve the advantage of breaking a

composite asset into separate parts with shorter effective lives is in Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1. The taxpayer conducted the business of dyeing and spinning worsted yarn. The building in which the dyeing operations were conducted had been specially constructed to facilitate the dyeing process. The “floor” of the building contained the large [10.160]

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The Tax Base – Deductions

vats in which the yarn was dyed and the flat part of the floor between vats was covered with special tiles on which the dyed materials could be drained. The north and south walls of the building contained an elaborate ventilation and heating system and the interior of all walls was covered with special coatings which helped regulate the moisture level in the building. The internal side of the roof housed more ventilation equipment and the structural supports for an overhead monorail crane. The walls, roof and ventilation louvres, fans and heaters associated with them were designed to operate as an integral whole to ventilate the vapours produced by the dyeing process.

Wangaratta Woollen Mills Ltd v FCT [10.170] Wangaratta Woollen Mills Ltd v FCT (1969) 119 CLR 1 High Court McTiernan J: In Broken Hill Pty Co Ltd v FCT (1968) 41 ALJR 377 at 381, Kitto J said that the word “plant” … includes every chattel or fixture which is kept for use in the carrying on of the mining operations, not being (in the case of a building) merely in the nature of a general setting in which a part of those operations are carried on … most of the structures that the appellant has erected on sites set free by demolitions are in the nature of plant. I do not exclude buildings simply because they are places where operations are carried on. I do exclude those which merely provide shelter for persons as they work and for their equipment, for example, offices; the prefabricated rigid-frame building which houses the new pipe shop, the construction store, the blacksmith’s store, and the painters’ and lubrication engineers’ workshop; the change houses and the works canteen; but I regard as plant the buildings which are more than convenient housing for working equipment and (considered as a whole, that is, without treating as separate subjects for consideration the iron roofing and cladding of buildings where the main structural members are specially adapted to the needs of the processes to be carried on inside) play a part themselves in the manufacturing processes, that is, the holding bay for the basic oxygen steelmaking installation as well as the very specialised building which because of its in-built equipment forms part of that installation, and also the casting pit (but not the slag pit).… 532

[10.170]

I am of opinion that the appellant’s dyehouse is “in the nature of a tool” in the trade and does “play a part” itself in the manufacturing process. It is much more than a convenient setting for the appellant’s operations. It is an essential part in the efficient and economic operation of the appellant’s business. The complex ventilation system including the cavity wall does more than merely clear the atmosphere. Its structure is an active tool in preventing spoiling of material, and in enabling the operatives to carry out their tasks. It would be completely unnecessary in almost every other industry and quite useless to any buyer except a dyer. The protective coatings and tiling are essential in preserving the whole “tool”. It is as unreal to dissect the paint or tile from its foundation as it is to separate the paint from a workman’s tool of trade. The drains do not just remove waste liquids, they remove volatile liquids which would disrupt the process as much as vapours escaping from the vats. If boiling liquids were left uncovered in the building, in vats or drains, the whole process would quickly become unworkable. I think therefore that the dyehouse should be regarded as a single unit of plant and not a collection of bricks, mortar, paint, timber etc., each of which is to be separately examined. It is not merely a special factory; it is a complex whole in which every piece is essential for the efficient operation of the whole. I would however except from the description of “plant” what might be referred to as the external “cladding” of the dyehouse, that is the external walls including the single walls at the east and west ends and the roof as distinct from the ceiling, but not the controlled louvres or the cowlings in the roof. The cladding really does nothing more than exclude

Specific Deductions and Restrictions on Deductions

Wangaratta Woollen Mills cont. the elements; and, whilst I am not convinced of the validity of this distinction, nevertheless it is clearly supported by prior decisions on this sort of question.

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articles used by the taxpayer for the purpose of producing assessable income, except for such a proportion of the item headed “new dyehouse” as relates to the external walls and the external roof as specified above.

I am therefore of opinion that all the items claimed … should be considered as plant or

[10.175] A capital allowance deduction applies for listed intangible assets. Eligible intangibles

include mining rights and information, copyright, patents and registered designs, spectrum and telecommunications rights, and certain computer software (s 40-30(2) and s 40-95(3)). As for composite assets, there is an incentive for taxpayers to allocate value to acquired intangible assets so that a capital allowance deduction is available. For example, when a taxpayer purchases an entire business, if value is not appropriately allocated to a depreciating intangible asset, it will most likely be allocated to goodwill, a capital asset which will be treated instead under the CGT provisions and is not eligible for a capital allowance. There are several cases in which taxpayers have sought, usually unsuccessfully, to inflate the value of depreciating assets such as copyright. For example, in Primary Health Care Ltd v Commissioner of Taxation [2010] FCA 419, the Federal Court denied the taxpayer a capital allowance for copyright that it claimed subsisted in patient records it claimed to have acquired from various doctors’ practices. The Court concluded that only limited copyright existed in the patient records and that no separate consideration was paid for the transfer of any copyright, so there was no depreciable cost in any event. [10.180]

Questions

10.6

The taxpayer purchased a large road train truck for $250,000 and then asked the seller to list each of the truck’s components separately on the bill of sale – for example, 18 tyres, 12 spark plugs, one oil filter, 20 light globes, one engine block, three litres brake fluid, etc. Assuming many of the components would be immediately deductible or quickly depreciable if they were purchased separately, would the taxpayer be able to claim the fast write-offs if he acquired the components in the form of a fully assembled truck? (See s 40-30(4) and FCT v Tully Co-operative Sugar Milling Association Ltd (1983) 14 ATR 495.)

10.7

How will a suspended ceiling comprising special acoustical tiles be characterised? What about electrical wiring and the conduits in which the wiring is laid? (See Imperial Chemical Industries of Australia and New Zealand Ltd v FCT (1970) 120 CLR 396.) Can a taxpayer claim a deduction under s 40-25 for the decline in value of rights to virtual land which they start to hold upon payment of a capital amount to the provider of an online role-playing game? See ATO Interpretive Decision ID 2009/28.

10.8

(ii) Who can claim a capital allowance? [10.185] A capital allowance under s 40-25 is allowed for the “holder” of a depreciating

asset, as defined in s 40-40. Most commonly, the “holder” will be the owner of the depreciating asset at law, under s 40-25 Item 10. Originally, only the owner of property was eligible to deduct capital allowances. This was extended in the 1990s to “quasi-owners”. [10.185]

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The Tax Base – Deductions

The concept of a “holder” allows recognition of taxpayers who are, in substance, the “economic” owners of an asset even if they are not the owners at law. So, in relation to a lease of plant to a lessee, where the plant is fixed to the factory but the lessor has the right to recover the asset, the “holder” who can claim depreciation is the lessor and not the lessee who actually uses the plant (s 40-40 Item 4). Note that the “holder” of a depreciating asset is the partnership itself and not the partners (although at law, they are the legal owners of the asset) (s 40-40 Item 7). [10.187]

10.9

Question

The taxpayer in Eastern Nitrogen v FCT (2001) 45 ATR 474 sold its fertiliser plant to a bank and “leased” it back under a five-year lease – see [9.310] for the facts and issue in the case. The leaseback to the taxpayer did not provide the taxpayer with a binding legal right or obligation to repurchase the plant for its residual value but that was expected to occur and that is what actually happened after the five-year period. Which party – the bank or the taxpayer – is entitled as “holder” to capital allowances on the plant in respect of this finance lease? Is the taxpayer entitled to capital allowance deductions in respect of the plant under s 40-40 Item 6 (compare Example 2 in s 40-40)? What is the “cost” that is depreciated?

(iii) Calculating the capital allowance [10.190] Section 40-25 allows taxpayers to deduct an amount equal to the decline in value of

the depreciating asset, calculated based on its cost and effective life. Taxpayers are free to adopt their own estimate of effective life (s 40-105) but run the risk of audit and penalties if the estimates prove unrealistic. If taxpayers follow the ATO’s estimate (authorised by s 40-100 and set out in an annually released Ruling, the latest being TR 2016/1), they are protected by this “safe harbour” and are immune from penalties. The effective life for intangible assets such as copyright or patents is set out in s 40-95(7) with reference to the legal life of these “statutory” intellectual property assets. Historically, this effective life could not be self-assessed; however, since 1 July 2016, self-assessment for the cost of acquisition of these intangible assets is permitted as part of a reform following the Turnbull Government’s Innovation Statement of December 2015. The goal is to encourage the acquisition and faster exploitation of new intellectual property by Australian businesses. A licence of intellectual property is treated as a separate depreciating asset with an effective life being the term of the licence (s 40-85(7) Items 6, 7). Historically, Australia’s depreciation regime set “accelerated” effective lives for most tangible assets, which provided a significant subsidy for this kind of business capital expenditure – especially assisting capital-intensive mining and manufacturing industries. An accelerated deduction is beneficial in the earlier years of the investment, although the tax will eventually be paid in later years of use of the asset by the taxpayer, when the deduction is no longer available. As a result, accelerated deductions are often described as an “interest-free loan from the Commissioner”. Following the Review of Business Tax in 1999, the government cut the company tax rate to 30% and removed most “accelerated” effective lives from the tax law. This change made the tax law more neutral in its treatment of services industries compared to mining and manufacturing. However, “capped” effective lives have crept back into the statute, providing targeted subsidies in response to lobbying by particular industry interest groups: see s 40-102. These subsidies cost significant revenue and undermine the comprehensiveness of the tax law as a whole. 534

[10.187]

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[10.195] The next step is to ascertain the “cost” of the depreciating asset under Subdiv 40-C.

The “first element” of cost is amounts paid to start holding an asset (s 40-180), or market value if acquired, for example, as a gift or from an associate. The “second element” includes amounts paid after the taxpayer has started holding the asset, “for each economic benefit that has contributed to bringing the asset to its present condition and location from time to time”. If a taxpayer expends money on “initial repairs” to a capital asset it has acquired, or on improvements, relocation and preparing an asset for operation, for example in new premises, this will be included in the “second element” of the cost of the asset for depreciation purposes under s 40-190. Similarly, if a repair to an asset a taxpayer already owns and operates involves the acquisition of a replacement asset or a capital improvement to the asset, then under Div 40 the expenditure will be added to the cost of the asset which is then depreciated from that point in time in the same way as the original cost. [10.200] Taxpayers have the choice of two depreciation methods: a “prime cost” method

(s 40-75) and a “diminishing value” method (s 40-70). The prime cost method provides for equal recognition of cost of an asset over its effective life. For example, if the effective life of an asset is 10 years, a taxpayer measuring the decline in value of the asset using the prime cost method would deduct 10 % of the cost of the asset each year. The remaining undeducted amount to be depreciated after each year is termed the “adjustable value” of the depreciating asset. The diminishing value method is most commonly used. It assumes that an asset declines in balance more rapidly during the initial years after acquisition and slower thereafter. It therefore allows the taxpayer to recognise 200 % of the depreciation allowed under the fixed rate system and to continue to apply the same percentage to the undeducted balance remaining each year. For example, if the effective life of the asset is 10 years, a taxpayer measuring the decline in value of the asset using the diminishing value method would deduct 20% of the cost in the first year, and then 20% of the remaining undeducted amount (the asset’s “adjustable value”) in the following year, and so forth. Subdivision 40-E allows “pooled” treatment of low-value assets (costing less than $1,000). The cost of pooled assets can only be depreciated using the diminishing value method. Section 40-440 explains how to work out “the decline in value of depreciating assets in a low-value pool” and this decline is then deductible pursuant to s 40-25, which allows a deduction for the decline in value of “a depreciating asset”. On acquisition of a new asset, the cost is added to the pool “adjustable value”. When there is a disposal of an asset, in most cases, no balancing adjustments rules for individual assets are needed, as the proceeds are simply subtracted from the pool balance (and subsequent capital allowance deductions are automatically adjusted accordingly). [10.210]

Questions

10.10 What happens if a taxpayer acquires an asset part way through a year? (See s 40-70(1) and s 40-75(1).) 10.11 Which industries or assets are favoured by the “capped” effective lives in s 40-102? 10.12 The taxpayer acquired a van that was used 50 % for personal use and 50 % for business use. How should the taxpayer depreciate the cost of the van? (See s 40-25(2).) 10.13 The taxpayer offered trail rides and horse riding lessons. Is the cost of the horses depreciable? (See s 40-30.) [10.210]

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The Tax Base – Deductions

(iv) Balancing adjustments [10.220] Whether a taxpayer calculates effective life using the taxpayer’s own estimate or the ATO’s, the chosen life will be at best an educated guess. Accordingly, a mechanism is needed to account for the difference between actual economic decline in value of the asset, and the tax deduction allowed under Div 40, at the time of disposal or termination of use of the asset. If a depreciating asset is sold for more than its adjustable value, the taxpayer has deducted too much and recognised more of the cost than has actually been “used up” so that some of the capital allowance should be recaptured. If a depreciating asset is sold for less than its adjustable value, the taxpayer has not deducted enough – the property was consumed at a faster rate than the rate at which the taxpayer recognised its cost – so that an additional capital allowance should be permitted. The reconciliation of actual decline in value with the capital allowance deduction is accomplished through a balancing adjustment under s 40-285. Section 40-285(1) requires a taxpayer to include as income the excess of “termination value” over “adjustable value” of the asset, recapturing excess depreciation deductions. Section 40-285(2) allows an additional deduction being the excess of “adjustable value” over “termination value” to taxpayers whose deductions did not fully reflect the decline in value of the asset. Termination value is defined as the actual proceeds of disposal in an ordinary arm’s length sale (s 40-305(1)(b) Item 1) or, say, insurance received on destruction of an asset, and is market value in most other cases. The balancing adjustment is on revenue account. Overlap with the CGT regime is prevented by s 118-24, which carves out depreciating assets used for a taxable purpose from that regime. However, the CGT regime remains relevant if the asset was partly used for non-taxable purposes. A positive balancing adjustment is reduced under s 40-290 if the asset was used only partly to derive assessable income (and was thus only partly depreciable). The partial reduction is matched to CGT event K7 (s 104-235) where the proceeds of disposal exceed the asset cost. Section 118-24 does not apply to CGT event K7. Thus, when capital allowance deductions can only be claimed against part of the cost of an asset, the excess of proceeds of disposal over cost will be partly treated as a balancing adjustment and partly as a capital gain which may be eligible for the CGT 50 % discount if other conditions are satisfied. [10.225]

Questions

10.14 The taxpayer acquired an asset for an original cost of $100, depreciated it to an adjustable value of $50 and sold it in an arm’s length transaction for $150. What is the balancing adjustment? Is there any capital gain or loss? 10.15 The taxpayer acquired business assets that included furniture, computer facilities, motor vehicles and some plant for a single overall purchase price. The taxpayer adopted as the purchase price of the furniture, computer facilities and motor vehicles the written-down (“adjustable”) values of these assets and attributed the remainder of the cost to the plant, yielding a depreciable cost for the plant well in excess of its adjustable value under the previous owner. The taxpayer sought to depreciate the plant applying the higher cost it nominated. Is this allowed under s 40-195?. (See AAT Case 10,267 (1995) 31 ATR 1027 which considered the issue under former depreciation rules.) 10.16 Prior to the introduction of capital gains taxation, the taxpayer acquired a refrigerator from a related party for $100,000. At the time, the refrigerator was worth $30. Two weeks later the refrigerator was sold to another related party for $100, producing an apparent “loss” of $99,900. The taxpayer claimed a balancing adjustment deduction in 536

[10.220]

Specific Deductions and Restrictions on Deductions

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the amount of this loss. Was it successful under the applicable regime? See F & C Donebus Pty Ltd v FCT (1988) 19 ATR 1521. Would this be possible under the current regime? (Consider s 40-180(2) Item 8). 10.17 The taxpayer in BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65 fully depreciated the cost of a unit of plant costing $1.8 m. It ceased using the plant and sold an element used in the plant for $1.6 m but retained the actual plant itself. Can the taxpayer claim a balancing adjustment deduction? (Consider s 40-285 and s 40-295.) 10.18 The taxpayer acquired a depreciating asset for $1,000 and had depreciated it to an adjustable value of $500 before it was destroyed in an accident. The taxpayer received $800 insurance proceeds as a result of the destruction and applied the proceeds towards the cost of a replacement asset, again purchased for $1,000. How will the balancing adjustment provisions apply to the taxpayer? (See s 40-365).

(b) Farming, Mining and Other Projects [10.230] Australia has a history of special capital allowances for farming and for mining and

exploration; the latter costs have long been immediately deductible or depreciable over an accelerated time period of up to 10 years. Many concessions for mining were wound back in the business tax reform of 1999, however, some have remained or crept back into the tax law. Special rules for small business are discussed at [10.410]. Division 40 contains special capital allowance regimes for the following: • Software developed in-house (Subdiv 40-E), depreciable in a pool over 5 years; • Primary production depreciating assets including water facilities, horticultural plants, grapevines, and fencing which is now immediately deductible (Subdiv 40-F) and other capital expenditure of primary producers such as electricity and telephone connections (s 40-645) and landcare expenses (s 40-630) (Subdiv 40-G); • Expenditure on resource exploration or prospecting (immediately deductible under s 40-730); various mining construction activities; payments of petroleum resource rent tax; mine site rehabilitation and environmental protection activities (Subdiv 40-H) and mining farm-in/out arrangements is immediately deductible (Subdiv 40-K); • Carbon sink tree planting; this was introduced as part of the package for the carbon emissions trading scheme, now repealed (Subdiv 40-J); • Capital expenditure on a “project” especially (but not only) mining projects, depreciable over the life of the “project” in a “project pool” (Subdiv 40-I). Under Subdiv 40-I, the “project pool” includes expenditure in carrying on mining or quarrying operations, mineral processing and transport. It also includes expenses that may not otherwise be deductible, such as on feasibility studies and environmental assessments (s 40-830), or amounts paid to create or upgrade community infrastructure that is owned by a local government and not the taxpayer: see s 40-840(2)(d)(i). This rule would apply where, say, a logging or mining company contributes money to a local government to build a bypass road around a town so its trucks would not have to drive through the centre of the town. Depreciating assets such as plant and equipment used in a “project” are eligible for capital allowances in the usual way. All other capital expenditures are allocated to the project pool which is depreciated on a diminishing value basis at a 200% rate over the life of the project (s 40-830). The project life may be estimated by the taxpayer and may be recalculated at later times. If the project is abandoned, sold or disposed of, the remaining amount in the project pool and any capital expenditure in the final year are immediately deductible. [10.230]

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The Tax Base – Deductions

(c) Business Related Costs [10.250] We saw in Chapters 7 and 9 that judicial doctrines caused some business expenses to

become “black hole” expenses, never recognised for tax purposes. Today, s 40-880 provides a rule for deduction of business related costs that would not be otherwise deductible, as they are of a capital nature, incurred “too soon” and do not form part of the cost of a depreciating asset. In general, these expenditures are deductible in equal proportions over 5 years. This rule was introduced after much lobbying by industry, and discussion of the problem in the Review of Business Tax and other policy reviews. One “black hole” category comprises expenses that fail the temporal nexus requirement as they were incurred before the income-earning process had commenced or after it had ceased. A second category is those expenses that produced no recognisable asset or long-term benefit that could be recognised under the capital allowance regime but which are nevertheless “capital” under judicial doctrines and so are not deductible under s 8-1. The introduction of capital gains tax in 1985 partly addressed the “black hole” problem by allowing taxpayers to recognise capital expenditures in the cost base of a capital asset, which then generated a capital loss on the expiry of the asset. The cost base rules also recognise expenses incurred to “establish, preserve or defend title” to an asset under the fifth element of cost base, and capital expenditure with the “purpose or expected effect” to “increase or preserve the asset’s value” or related to “installing or moving the asset”. However, recognition of black hole costs as a capital loss is not ideal, because it defers recognition until the end of the asset and even then might never be recognised if the taxpayer has no offsetting capital gains. [10.260] In its original form, s 40-880 was limited to enumerated types of business costs.

After further for reform by the business community, since 2006 it has provided a five-year write-off for “business capital expenditure” where the business was, or is, proposed to be carried on for a taxable purpose. Note that s 40-880 requires a “business” to be carried on, proposed, or previously carried on, to which the expenditure is related. In contrast, the first limb of s 8-1, and s 40-25 (capital allowances), only require a purpose of producing assessable income. Section 40-880(5) establishes the deduction as a “last resort” rule, where no other provision – including the CGT cost base rules – can recognise the expenditure and a deduction is not prohibited by any other provision. An exception relates to certain capital expenditures that might enhance goodwill and hence be included in cost base of that CGT asset, which can nonetheless be deducted over 5 years by virtue of s 40-880(6). The terms of s 40-880 raise a number of interpretive issues, some of which are dealt with in Ruling TR 2011/6. [10.265]

Questions

10.19 Jemima has a bus charter business and seeks to expand it by purchasing another bus. She finds a second-hand bus in another State and buys an airfare so she can inspect it before committing to the purchase. Jemima inspects the bus and concludes that it is not suitable. She does not go ahead with the purchase. Is the cost deductible under s 40-880? What would have been the treatment had Jemima purchased the bus? (See TR 2011/6 Example 5). 10.20 XYZ Pty Ltd carries on a medical research business. The shareholders’ involvement in the business includes providing medical expertise to the company. Because of other commitments one of the shareholders has been and will continue to be unable to devote resources to the business. The directors of XYZ Pty Ltd decide that in the interests of 538

[10.250]

Specific Deductions and Restrictions on Deductions

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the business the ownership of the company should be restructured to replace the inactive shareholder with a private equity investor. To facilitate the restructure XYZ Pty Ltd paid $200,000 to the shareholder as an incentive to agree to the sale of his shares to the equity investor. Is this expenditure deductible under any provision? (See TR 2011/6 Example 8).

(d) Buildings [10.270] Buildings and other capital works are depreciable under a long-standing rule now in

Div 43 of ITAA 1997. Although rewritten, this rule has not been amended for some decades. The deduction under Div 43 is for a portion of a taxpayer’s “construction expenditure”: see s 43-15. Construction expenditure is defined as capital expenditure incurred in respect of the construction of capital works (s 43-70(1)), while s 43-20(1) defines “capital works” to include a “building”. However, as discussed above, it does not include expenditure on “plant”: see s 43-70(2)(e). Section 40-45(2) makes clear that Div 40 will not apply to “capital works”. The “construction expenditure” deduction is calculated under s 43-210 for current buildings. The formula in s 43-210 for calculating the “construction expenditure” deduction uses the rates set out in s 43-25. The construction expenditure for a building is reduced by the capital works allowance that was available for the building each year since the building was constructed (whether or not a deduction was claimed by anyone): s 43-230. The amount remaining after the available deductions is (inaccurately) known as the “undeducted construction expenditure” and the deduction formula in s 43-210 sets the deduction for a year as the lesser of the amount otherwise deductible for the year and the undeducted construction expenditure. Thus, at the end of the presumed life of the building, no deductions are available even if no one has previously claimed deductions. Division 43 contains no balancing adjustment rule apart from one that applies when a building is destroyed: s 43-250. In other words, the Act presumes buildings are always worth their adjustable value and any amount realised over that on the sale of a building and land is referable solely to the land. The depreciable value of the building “rolls” over to the purchaser, who may continue to depreciate it from that value. The rollover mechanism is achieved in a roundabout way. As the “construction expenditure” is not tied to any particular taxpayer and the expenditure thus does not need to have been incurred by the current owner of a building, it passes to the purchaser with the building itself. The formula in Div 43, based on original expenditure without regard to the cost of the current owner, suffers from a significant administrative shortcoming. It can only work if the vendor of a property tells the purchaser what the original construction expenditure was and when the building was first used. At a high revenue cost, the ATO has had to make concessions to taxpayers unable to obtain this information by allowing them to “estimate” the amounts using a surveyor: see Ruling TR 97/25. [10.275]

Questions

10.21 The taxpayer commenced construction of a 50-storey office tower. It completed construction to the third floor when a severe downturn in the economy led to a withdrawal of working capital from its bankers and shareholders. It ceased construction and for 12 years, until construction recommenced, it derived assessable income by operating a parking garage in the basement of the building which had been completed. Can it claim capital allowance deductions for part of its costs? (See s 43-30.) [10.275]

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The Tax Base – Deductions

4. LOSSES AND TIMING RULES (a) Tax Losses [10.280] Taxable income is determined under s 4-15 of the ITAA 1997 by subtracting

deductions for the income year from assessable income for the income year. Section 4-15 states that if deductions exceed assessable income, there is no taxable income, while s 36-10(4) defines the excess of deductions over assessable income as a tax loss. Under Div 36 of the ITAA 1997, taxpayers who suffer a tax loss are able to carry the loss forward and utilise it to offset income of years where assessable income exceeds allowable deductions. Section 36-15 provides a mechanism for carrying forward unused losses to future years. Losses may be carried forward until death for individuals and indefinitely for companies and trusts. This rule corrects, to some extent, the artificial one-year tax accounting period that is adopted in our income tax law for the measurement of taxable income. However, carry-forward losses are not indexed and so lose value over time if they are not utilised. The income tax legislation in many countries provides for loss carry-back in addition to loss carry-forward. The previous government enacted a one-year carry-back loss rule, however this was repealed for revenue reasons. Capital losses may also be carried forward indefinitely but are quarantined to capital gains, as discussed in Chapter 12. Carried forward tax losses are absorbed against both assessable and exempt income but not against “non-assessable non-exempt income”. Some deductions, such as the charitable donation, cannot give rise to a tax loss. [10.285] While tax losses may be carried forward indefinitely, various limits apply to the use

of company and trust losses. Where a business is carried on by a company or a trustee, it is the company or trustee, and not the shareholder or beneficiary, that suffers any tax losses. These tax losses can be carried forward but if there is no profit, they may be “sold” to another taxpayer, eg by means of a sale of shares in the company or, perhaps, creating a beneficial interest in the trust. The new owner can then route assessable income through the loss company or loss trust and offset the income for tax purposes. At one time there existed a thriving market in tax loss companies. Company and trust losses have been restricted by limitations related to continuity of ownership, or same business operation, of the entity, with the aim of restricting the trading and use of losses. These rules for companies are discussed in Chapter 15, and for trusts in Chapter 13. The consolidated group regime, also discussed in Chapter 15, has a key policy goal of restricting the use of tax losses by group companies. As explained in Chapter 8, the ATO also faces a number of problems trying to restrict deductions for expenses related to business-like hobby activities such as the “Collins Street” or “Pitt Street” farmers. These are expenses related to activities carried on for the personal enjoyment or hobby of a taxpayer but which can be presented as a business for the purpose of deducting expenses incurred to carry out the activity. The “non-commercial loss” rule in Div 35 of the ITAA 1997 quarantine losses from hobby or micro-business activities to income derived from those same activities. The excess of deductions over income from the activities is considered to be a loss attributable to personal consumption until such time as the quasi-hobby business shows itself to be a real (ie profitable) business. At that point, unused losses from previous years may be carried forward and used to offset the business profits. This restriction on deductions is discussed in more detail in [8.230]. 540

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Note that such “negative gearing” of expenses is still permitted on investments in rental real estate, in particular interest on mortgage debt and capital allowances for buildings and fittings. Rental property expenses of rental investors may be deducted against salary or other sources of income.

(b) Bad Debts [10.290] Where a taxpayer accounts for income on an accrual basis, as is the case for most

business taxpayers, amounts will be included in assessable income that may never be received. For example, a customer may acquire goods or services on credit and although an invoice is used and legal steps taken to pursue the debt, the customer may never pay. If it becomes certain that an amount previously included in assessable income will not actually be received, a mechanism is needed to adjust the initial overstatement of income by allowing an offsetting deduction. Section 25-35(1)(a) of the ITAA 1997 is designed to achieve this adjustment. As noted above, many specific deductions in Div 25 are “redundant” because a deduction would likely be allowed under s 8-1 in any event. Is that the case for s 25-35(1)(a)? [10.300] Section 25-35(1)(a) allows taxpayers to deduct bad debts that are written off during

the year of income. This condition was the subject of dispute in Point v FCT. The taxpayer had established a company and funded the company’s operations by means of contributions of capital (for the shares in the company) and loans to the company. Over subsequent years the company lent some money to the taxpayer. The amounts owed by the company to the taxpayer exceeded the amounts owed by the taxpayer to the company by some £70,000. In late 1963 a provisional liquidator was appointed who reached an agreement with the company’s creditors for a rearrangement of the company’s debts with a view to making the company attractive to a purchaser as a loss company (that is, a company with accumulated losses which could be used by the new owner to offset future assessable income). The arrangements required the taxpayer to release the company from the debts it owed him. He did so in a deed executed in May 1964. Sometime between September 1964 and April 1965 a clerk in the firm of accountants who kept the taxpayer’s books made an entry showing that the company’s indebtedness to the taxpayer was a bad debt and had been written-off as irrecoverable as of 30 June 1964. The taxpayer first attempted to deduct the bad debt in the year ending 30 June 1964 and then in the year ending 30 June 1965. Both deductions were denied by the Commissioner, whose approach was upheld by Owen J in the High Court.

Point v FCT [10.310] Point v FCT (1970) 119 CLR 453 High Court Owen J: I turn first to the appellant’s claim to a deduction for the year ended 30 June 1964…. The entry purporting to write off [£X] as a bad debt was not made until many months after the end of that year and, in my opinion, the Commissioner rightly refused to apply [the bad debt rule]. For the appellant, however, it was argued that the words in the section, “written off as such during the year of income”, are not to be

given what appears to me to be their plain meaning and that the section is sufficiently complied with if the debt is not written off “during the year of income” but at some later date, provided that the writing off relates back to the year of income. I am unable to accept this proposition. “During the year of income” means, in my opinion, “in the course of the year of income”. No doubt if a debt is written off as bad [10.310]

541

The Tax Base – Deductions

Point cont. after a year of income has passed, it will be allowable as a deduction in the year in which the writing off takes place, provided of course that the other conditions laid down by the section are fulfilled. It was also contended that the execution by the appellant of the deed of release of 25 May 1964 constituted a writing off of the debt then due to the appellant by the company. I cannot agree with this contention. The release was to become effective if and when the court approved of the scheme and in any case, what the section contemplates is that there is at the time of writing off an existing debt which, so far as can reasonably be foreseen, has become of little or no value. The effect of the release of a debt is to extinguish it, to put an end to its existence and not to reduce the value of it as an asset in the form of a debt owed

[10.320]

to the taxpayer. As to the year ended 30 June 1964 there was, in my opinion, no writing off of the amount in question during that year. I go now to the year ended 30 June 1965. For the reasons I have stated, I am of opinion that when the court approved of the scheme to which I have referred, the deed of release executed by the appellant became effective, the debt [of £X] ceased to exist and there was therefore no debt remaining which could be written off. In those circumstances the “writing off” entry in the appellant’s books which was in fact made many months after the deed had become operative served no purpose. Accordingly I am of opinion that the appellant cannot maintain his claim to be entitled to a deduction under s 63 for the year ended 30 June 1965. It follows that his claim with respect to the year ended 30 June 1966 must also fail.

Questions

10.22 The taxpayer in Point was unable to deduct the loan in the 1963–64 year (the year in which he forgave the loan) because it had been forgiven in that year but had not been written off in that year. He was unable to deduct it in the next year because it had already been forgiven, and so ceased to exist before it was purportedly written off. It appears that, in the end, he was never able to recognise the loss. But was that really the case? Recall that his shares in the company were ultimately to be sold to an outside buyer. What would be the effect on the price of those shares of the taxpayer releasing the company of its debt to him? Did he, in fact, recover some, or all of his money in the end? 10.23 Small businesses, for example individuals providing professional services, may account for tax purposes on a cash basis. Can a cash-basis taxpayer ever utilise s 25-35(1)(a)? What would happen if a cash-basis taxpayer received a cheque on 30 June and the following week it was returned by the bank as a non-sufficient-funds cheque? [10.330] A separate adjustment is needed for banks and finance companies whose businesses

consist of lending money. An unpaid loan would ordinarily be an affair of capital, but for a taxpayer in the business of lending money such losses are an unavoidable and necessary incident of ordinary business operations. Accordingly, s 25-35(1)(b) provides a deduction for bad debts written off by a taxpayer in the business of lending money. There is no requirement in s 25-35(1)(b) that the deducted amount must first have been included in assessable income. Businesses that rely on s 25-35(1)(b) merely have to show they lent the money and will not be repaid. Taxpayers in the business of money-lending can write off both principal and interest of bad debts against current income under this provision: see FCT v National Commercial Banking Corp of Australia Ltd (1983) 72 FLR 116 (Full Federal Court). The terms of s 25-35(1)(b) are independent of the terms of s 25-35(1)(a) and should be read separately. 542

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[10.340] Whether a taxpayer is in a “business of money-lending” is a question of fact. A

practice grew up of large corporate groups establishing a finance company for the group, which would raise funds externally and on-lend to other companies in the group. In some instances, the finance company may seek to recognise and deduct bad debts in relation to the intra-group loans. This has led to some very significant deductions, and consequent losses claimed by taxpayers that have been contested by the ATO. The courts have almost without exception upheld the taxpayers’ claims. In BHP Billiton Finance Ltd [2010] FCAFC 25, the Full Federal Court upheld the taxpayer’s claim that the group finance company was in the business of money-lending and was eligible to claim a deduction for $2 b of bad debts in relation to intra-group loans. A similar result was achieved for the Fosters group in FCT v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49 and in FCT v Tasman Group Services Pty Ltd (2009) 180 FCR 128. In BHP Billiton Finance, the taxpayer lent a very substantial sum of money to a mining project within the group which ultimately was closed down and its value written down to nil. Under loss grouping rules in prior tax law, the resulting losses in the finance company could be utilised against profits elsewhere in the corporate group. Edmonds J wrote the main judgment, with which Sundberg J and Stone J both agreed.

BHP Billiton Finance Ltd v FCT [10.350] BHP Billiton Finance Ltd v FCT [2010] FCAFC 25 Full Federal Court Edmonds J: Finance was incorporated on 29 August 1975 as a wholly owned subsidiary of BHPB “for the purpose of borrowing funds to re-lend to Group companies”. Its Memorandum of Association records one of its objects is “to carry on the business of financier in all its branches both within and outside Australia”. … From the early 1990’s, virtually all external borrowings of the BHPB Group to fund activities and projects of the BHPB Group were undertaken by Finance. Finance raised money from financial institutions outside the BHPB Group by way of loan facilities, the issue of commercial paper and medium term notes. Each year, the BHPB board set the borrowing limits and the borrowing program to be carried out by Finance for the next 12 months. … In respect of each loan agreement in evidence, Finance was the borrower with its obligations guaranteed by BHPB. During the 1990’s, Finance’s board comprised senior executives from the BHPB Group. … Finance did not have its own staff. It utilised the services of BHPB for which it paid management fees. The fees reflected the proportion of time BHPB personnel spent in providing services to Finance.

The fact that Finance was the vehicle which financed the Group entities selected by BHPB as the vehicles through which the Group’s investment decisions were executed, does not make Finance’s business an appendage to the business of the Group as a whole; any more than it makes Finance a mere conduit of BHPB’s business. As the primary judge observed … what was said by the Full Court in Commissioner of Taxation v Bivona Pty Ltd (1980) 21 FCR 562 at 569 fully responds to that submission: The respondent’s activities consisted principally of the borrowing and lending of money. By far the greatest proportion of its income consisted of interest on moneys lent and its largest outgoing was interest on moneys borrowed from overseas. There was no suggestion that any of the relevant transactions were shams. Even if it were right to describe the role of the respondent in its activities of lending money, as counsel for the Commissioner did, as a “conduit” for its parent company or other members of the group, that begs, not answers, the question whether the activities of the

[10.350]

543

The Tax Base – Deductions

BHP Billiton Finance cont. respondent are correctly characterised as its principal business consisting of the lending of money. This is not a case where Finance’s activities of borrowing and lending money were ancillary, subservient or subordinate to some other business carried on by Finance, such as that of a holding company: cf., Federal Commissioner of Taxation v Total Holdings (Australia) Pty Ltd [1979] FCA 30; (1979) 43 FLR 217. Its activities of borrowing and lending were its only activities; and it had no equity, direct or indirect, in the companies in the Group to which it lent. There is more than a hint in the ATO’s submissions… that each loan transaction should be moved by a profit motive before it can be regarded as part of a continuing business of lending money. But such an argument was rejected, correctly in my view, by Barwick CJ in Investment and Merchant Finance Corporation Ltd v Federal Commissioner of Taxation [1971] HCA 35. … The evidence establishes, as the primary judge found, that Finance’s activities involved the borrowing of money and the lending of that money to companies in the Group; that these activities were carried on over a substantial number of years on a regular and systematic basis; that the amounts borrowed and the amounts lent involved very substantial sums of money; that the amounts lent were invariably lent at a rate of interest higher than the rate at which it borrowed those funds; that in consequence, over a period from 1986 to 2002 it derived interest income in excess of $34 billion, accounting profits after tax in excess of $2.8 billion and aggregate taxable incomes in excess of $4.4 billion; more telling, in only two of

those 17 years did it suffer a taxable loss – in 1994 ($23,127,060) and in 2000 ($1,659,815,608). Contrary to the ATO’s submission, Finance did establish what was the ordinary course of its business of lending money … So understood, the loans to DRI and TM had the following features consistent with the ordinary course of that business: (1)

The loans were made to entities which were wholly-owned companies in the Group in order to fund projects and operations approved by the board of BHPB;

(2)

each loan was made in accordance with Finance’s standard lending terms for inter-company loans; and

(3)

the loans were recorded in the books and records of Finance in the same way as its other loans and moneys were advanced and interest capitalised and recorded using the same systems and by reference to the same activities ordinarily employed by Finance; and

(4)

the loans were made using a practice and procedure that was entirely consistent with and similar to that adopted by Finance in respect of virtually all of its other loans and which had generated very large profits for Finance (and which the Commissioner taxed in its hands).

The Commissioner’s further contention that DRI “was always forecast to suffer substantial losses” and that there was no “expectation on the part of Finance that DRI would be able to repay the loan”, must also be rejected. In my view, there was no error in the primary judge’s findings that the DRI loan and the TM loan were made by Finance in the ordinary course of its business of lending money.

[10.360] In the alternative, Edmonds J concluded that the bad debt losses would be

deductible on revenue account under s 8-1. The court also rejected an argument from the ATO that Part IVA would prevent this deduction. Since enactment of the special tax regime for consolidated groups (Pt 3-90 of the ITAA 1997), this particular analysis for intra-group loans would no longer be relevant because separate subsidiaries in a consolidated group are each treated as part of the head company. The use of losses is one of the main policy reasons why the consolidated group regime was enacted. Further, the bad debt deductions of companies are 544

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subject to the same continuity of ownership and same business test limitations as other company losses and are subject to debt forgiveness rules. See further Chapter 15. [10.370] In the early 1990s, many lenders sought to enable their borrowers to enter into

“debt-equity” swaps, instead of simply writing off debts as bad. Under this arrangement, the lender accepts shares in the borrowing company in lieu of debt repayment. Section 63E(3)(a) of the ITAA 1936 was enacted to provide a “bad debt” deduction for any loss suffered on a debt that is cancelled and written off in exchange for the provision of equity in the debtor. The loss is measured as the difference between the value of the debt cancelled and the value of the equity provided. Section 63E(3)(b) prevents the taxpayer from also taking a deduction under s 8-1(1) or s 25-35 for the same loss. Section 63F limits a swap loss under s 63E to the extent it has been previously allowed under s 8-1, s 25-35 or even s 63E itself. The loss, or any income from disposal of such debt or equity, is treated as on revenue account of the lender.

(c) Prepaid Expenses [10.380] It is usually advantageous for a taxpayer to claim a deduction earlier rather than

later, and so a practice developed of “prepaid” expenses. Specific rules apply to these expenditures which would be characterised as revenue outgoings under ordinary judicial process/structure tests and thus usually be deductible immediately. These timing rules essentially require the prepaid expense to be recognised over the life of the benefit obtained, or a fixed time period. They are discussed in Chapter 12 at [12.530] et seq.

5. BUSINESS TAX CONCESSIONS [10.390] The income tax law contains various concessions for small or start-up businesses,

aimed at supporting entrepreneurship and innovation. Some concessions aim to simplify compliance for small business, while others aim to stimulate new investment, sometimes as a temporary fiscal stimulus for the economy. There is considerable debate about the extent to which such concessions targeted at new or small business activity lead to any additional, productive investment in the desired sectors. It seems likely that business tax concessions have the effect of distorting the timing of business investments rather than the overall quantum of such investments. Concessional deductions are also costly to administer, for taxpayers and for the tax administration, as taxpayers may seek to re-characterise activities or assets to qualify for the deductions. Taxpayers also enter into complex arrangements such as syndication to enable the benefits of the deductions to be sold or transferred from tax-exempt investors to taxable ones, or from more lightly taxed persons to higher bracket taxpayers. Usually, small business concessions in Australia have taken the form of deductions or tax offsets. However, the Abbott government enacted a lower company tax rate for eligible small business companies, now 28.5% (instead of 30%), together with other small business concessions. The definition of small business varies depending on the particular measure but most concessional rules apply to small business entities with an aggregated turnover of less than $2 m.

[10.390]

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The Tax Base – Deductions

(a) Small Business [10.410] The Div 328 “small business entity” regime offers small business taxpayers access to

greatly accelerated depreciation for their eligible depreciating assets. A “small business entity” is a business with annual turnover of less than $2 m (s 328-110) tested on an associateinclusive basis. Small business entities are eligible for an outright deduction for expenditures on depreciating assets costing less than $1,000. Section 328-180(1), which allows the immediate deduction, picks up the definition of a “low cost asset” from s 40-425(2) (these are one of the types of assets that taxpayers, other than small business taxpayers, can add to a low-value asset pool) to define expenses that qualify for the immediate write-off. As a fiscal stimulus, the threshold below which this provision applies was increased from $1,000 to $20,000, effective from 12 May 2015 until 30 June 2017 (when it reverts to $1,000). Small business entities are also eligible for accelerated depreciation through the use of a general small business pool for assets with effective lives of less than 25 years, which is depreciated at a 30 % rate (over 4 years); and a long-life small business pool for assets with effective lives of 25 years or more which is depreciated at a 5 % rate (over 20 years). Since the depreciation pools will contain assets with different lives, the single pool rate is, in theory, generous for some assets and not fast enough for others. However, these rates will be concessional for most assets. A further concessional rule applies whenever the value of a pool declines to less than $1,000, when the remaining balance of the pool can be deducted in full. Effective 1 July 2015, new small businesses and individuals are eligible for an immediate deduction for business start-up costs including professional advice or services, government fees and charges, and costs of raising capital, under s 40-880(2A). [10.420] Investment or development allowances are upfront deductions for eligible

investments available to taxpayers in addition to ordinary deductions such as capital allowances. Australia used investment allowances for much of the period from the mid-1970s until mid-2002. The allowances were designed to encourage investment in new plant and equipment, but were controversial because they cost a lot in revenue foregone, and it proved impossible to show that taxpayers had actually acquired more useful equipment because of the allowance than they would have without the allowance. At the same time, because of the loose definitions of eligible equipment, there was evidence that the allowance had subsidised the acquisition of many types of property for which there was little or no justification for government subsidies. Complicated claw-back measures were needed to prevent taxpayers from acquiring eligible property, taking the investment allowance deduction and then selling the property. Governments tend to have short memories of the difficulties with investment allowances and their probable ineffectiveness. In times of economic downturn, they often reach out to investment allowances as a means of subsidising business purchases without evaluating the potential benefits of the subsidy against other direct spending options. In 2008, as a response to the global financial crisis, the Rudd government introduced a “temporary business tax break” (inserted in Div 41 of the ITAA 1997). It applied for the 2008–09, 2009–10 and 2011–12 income years provided an immediate deduction for between 10 % and 50 % of the cost of acquiring eligible tangible depreciating assets that cost $10,000 or more (this excludes intangibles such as intellectual property, as well as land and trading stock). 546

[10.410]

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For example, on the acquisition of an asset costing $10,000, a company entitled to a 10 % allowance would receive a tax reduction of $1,000 (10 % of the cost) × 30 % (the company tax rate) = $300. The cost for purpose of capital allowances of the business asset acquired was not adjusted, so the entire $10,000 could also be depreciated, in effect leading to a n investment allowance on top of the depreciation deduction of part of the cost of acquisition.

(b) Discount for Unincorporated Businesses [10.430] To match its lower company tax rate for small business companies, the Abbott

government also introduced a measure to provide a tax discount for unincorporated businesses, for example individuals operating as a sole proprietor, in partnership or in a trust. The tax discount rule in new SubDiv 328-F, provides a tax offset (not a deduction) for individuals who run small businesses with an aggregate annual turnover of less than $2 m. The maximum amount of the tax offset is $1000 in an income year. In working out the “net small business income” of the individual, certain deductions such as those for tax-related expenses, charitable gifts or personal superannuation contributions are disregarded.

(c) Research and Development Tax Incentive [10.440] The income tax law has had concessional rules to encourage research and

development (R&D) since the 1980s. The first rule was a deduction introduced in 1985 (s 73B of the ITAA 1936). Until recently, the R&D deduction provided for more than the actual expenditure on research and development to be allowed as a deduction. The R&D tax deduction originally provided for 150% of the cost of research and development, since reduced to 125%. However, the deduction could rise to 175% based on increases in R&D spending. Accelerated depreciation was also available for depreciating assets used in R&D operations. The R&D incentive has been restructured in Div 355 of the ITAA 1997 as two R&D tax offsets. From the start, the R&D concessions were the subject of considerable debate. The recent reforms followed a report, Venturous Australia, which sought to tighten the focus of the tax concession, especially the definition of R&D, while also strengthening it in some respects. The process of review continues, with the Government releasing in 2016 the results of yet another Review. No proposals for reform were available at the time of writing. Critics of the R&D tax concessions have argued that they have led to no more research and development activity than would have taken place in their absence and that they acted mostly as a windfall to those who would have incurred research and development activity anyway, and to those who were able to re-characterise expenses as research and development expenses. These criticisms may still be warranted despite the change in form of the R&D tax concession. Structuring the concession as a tax offset may reduce opportunities to “game” the tax deduction, although a refundable tax offset also provides some tax planning opportunities. Recently, the generosity of the R&D tax incentive has been further reduced. The R&D tax incentive is currently a refundable tax offset of 45% (equivalent to a 150% deduction) for eligible entities with annual turnover less than $20 m and a non-refundable tax offset of 40% (equivalent to a 133% deduction) for businesses with turnover of $20 m or more. The 40% offset is reduced to the company tax rate of 30% for R&D expenditures exceeding $100 m in a year. Minimum R&D expenditure of $20,000 in a year is generally required. Entities may be able to carry forward unused R&D offset amounts to future years. [10.440]

547

The Tax Base – Deductions

The R&D incentive is jointly administered by the federal Department of Industry and the ATO, and R&D activities must be approved and registered before the incentive can be claimed. The tax offsets are calculated based on “notional deductions” comprising expenditure on “core” R&D activities (see the definition in s 355-25) and “supporting” R&D activities (defined in s 355-30). Note the list of exclusions from “core” R&D in s 355-25(2) and how this fits with the definition of “supporting” R&D. It also applies to capital allowances for depreciating assets used in R&D and certain funding contributed to cooperative research centres with universities. The R&D tax incentive is restricted primarily to companies that are Australian residents, but it may apply to a company that is resident of a foreign country with a double tax agreement with Australia, that carries on business through a permanent establishment in Australia. Because the R&D tax incentive applies only to companies, it is effectively recaptured if the company is profitable and seeks to distribute franked dividends to shareholders, as the tax-sheltered income within the company cannot be franked. See further Chapter 14.

6. STATUTORY RESTRICTIONS ON DEDUCTIONS [10.450] A number of provisions that restrict or prohibit deductions are collected together in

Div 26 of the ITAA 1997. They also appear in Div 32 (entertainment expenses), Div 35 (non-commercial losses) and Div 85 (personal services expenses) and scattered elsewhere in the statute. Several provisions restrict particular deductions by companies including excess remuneration paid to shareholders or associates (s 109 of the ITAA 1936); interest on convertible notes that are essentially equity interests (Div 974 of the ITAA 1997) (both discussed in Chapter 14); and interest on excessive debt or “thin capitalisation” (Div 820 of the ITAA 1997; see Chapter 17).

(a) Personal and Quasi-Personal Expenses [10.460] Some provisions prohibit deductions for expenditures that have a personal character.

It is arguable that many of these provisions are redundant because the expenses would not satisfy the positive limbs of s 8-1(1) or would in any case fall afoul of the negative limbs of s 8-1(2), particularly s 8-1(2)(b), which denies a deduction for expenses of a “private or domestic nature”. [10.465]

Questions

10.24 Indicate which of the following deduction prohibitions might be arguably redundant: s 26-5 penalties under Australian or foreign law; (a) (b) s 26-20 HECS contributions; (c) s 26-30 expense incurred in respect of a relative’s travel; (d) s 26-35 amounts paid to a related entity; (e) s 26-40 costs incurred to maintain your family. 10.25 The taxpayer was a lawyer who was subject to disciplinary hearings instituted by the disciplinary panel of the Law Society of the State in which he lived. Will s 26-5 apply to the penalty he is required to pay to the Law Society? 10.26 The employee of the taxpayer was asked to make a business trip to Hong Kong. He indicated he would only go if the employer paid for his wife to accompany him. The 548

[10.450]

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employer agreed and paid the spouse’s airfare. Will s 26-30 apply to the employer? If not, why would a gap for this type of situation have been left in the section? [10.470] Section 26-35 of the ITAA 1997 allows the ATO to substitute the arm’s length price

where a taxpayer seeks to deduct an inflated amount for purchasing goods or services from a relative or where wages are paid in a family business. By virtue of s 26-35(4), if an amount is not deductible under this rule, then the recipient is not assessable on it. Section 26-35 relies on a judgment by the ATO as to a “reasonable” amount payable in the circumstances. The factors which should be considered by the ATO were considered by Menzies J of the High Court in Stewart v FCT (in relation to the predecessor provision, s 65 of the ITAA 1936).

Stewart v FCT [10.480] Stewart v FCT (1973) 3 ATR 603 High Court Menzies J: The appellant is one of a partnership of three doctors. The partnership income tax returns for the years 1966, 1967, 1968 and 1969 claimed as deductions, moneys paid to the wife of each partner for her services in being on duty to answer the telephone and to assist patients during the times when her husband was rostered for out-of-hours’ duty. The primary case for the appellants was, in substance, that the wives were paid less than they were entitled to have been paid by virtue of one or other of two Wages Board determinations: first, that of the Doctors Wages Board, and secondly, that of the Ironmongers Wages Board, and accordingly, the Commissioner was bound to accept what was paid as reasonable. I am far from being satisfied that either Wages Board determination applied to the doctors and their wives by reason of the arrangement between them but I can and do decide this appeal without exploring that intriguing problem. … [T]he Commissioner was required, under s 65 of the Act, to consider for himself whether the payments actually made to the wives were more than was reasonable in the particular circumstances and to allow as a deduction no more than was, in his opinion, reasonable in those circumstances. The circumstances are obviously so far removed from anything which could have been in the contemplation of the Wages Board in making the determinations relied upon that it appears to me that the determinations could not control the Commissioner. …

It appears that surgery hours, during which all three doctors were working, were roughly 40 hours per week and out-of-hours’ duty when one doctor was on call amounted roughly to 30 hours weekly, mostly at night. To pay an amount equivalent to about onesixth of the doctors’ net income for the whole of their work to their wives for their services in respect of the times when the doctors were out on call could appear to the Commissioner as going beyond what was reasonable. The matter can be looked at in another way. The wives were living normal lives in their homes subject only to their being at home during certain hours – mainly at night – to answer the telephone, etc. It was, I think, open to the Commissioner to form the opinion that the $40 per week was too much to allow as a deduction for services that had a character all of their own. The reasonableness of what was paid is substantially a matter of impression and it is the Commissioner’s opinion that has been made decisive. To succeed, the appellants must show that that opinion was erroneous and this they have failed to do. By what standard – if actual Wages Board determinations are not decisive – could the Board of Review conclude that the Commissioner was in error in allowing but $20 per week? It is certainly not apparent that he was.

[10.480]

549

The Tax Base – Deductions

[10.490] In some cases, the border between personal and work or business expenses is not

obvious. Provisions that restrict deductibility in these cases must balance the different elements and spell out somewhat arbitrary, but easily administered, conditions for deductibility or non-deductibility. An example is Div 34 of the ITAA 1997, which limits deductions of employees for expenditure on “non-compulsory” uniforms. As was seen in Chapter 8, expenditures for clothing are usually characterised as non-deductible personal expenses under s 8-1. The general principle would not be displaced if an employer “mandated” the wearing of particular types of clothing, unless the particular type of clothing was essential to employment. So, an employee could not deduct the cost of a suit simply on the basis that the employer required all employees to wear suits to work, but a police officer could deduct the cost of a uniform. Division 34 prevents employees from deducting the cost of a non-compulsory uniform unless it is registered by the federal Industry Secretary. Registration is available only if the uniform meets a strict set of conditions concerning the business logo, colours, and so forth. However, a deduction may still be allowable for occupation-specific and protective clothing. The object is to prevent abuses by denying deductions for clothing that employees may also wear as leisure clothing or when not at work.

(b) Penalties and Illegal or Immoral Expenses [10.500] We saw in Chapter 7 that the courts have, over time, shifted their views on expenses

related to wrongs or illegal acts arising in the course of deriving assessable income. Tort damages, for example, were once considered “quasi-personal” expenses incurred outside the income-earning process, and hence not deductible. However, damages, for example in respect of the tort of defamation, have been held to be fully deductible if incurred in the course of a business (eg Herald & Weekly Times, see [7.90]). Similarly, legal expenses incurred in defending criminal charges have been held deductible in Magna Alloys at [7.130] and in Day at [7.160]. The judgment in Magna Alloys hinted that an appeal court might some day reverse the judicial ban on the deductibility of fines incurred in the course of a business and the La Rosa case at [7.170] showed that expenses incurred in the course of criminal business activities are deductible under ordinary principles. Political sensitivities have caused the legislature to intervene to confirm the traditional judicial doctrine preventing deductions for fines and to overturn the judicial doctrine allowing deductions for expenses incurred in criminal activities. International treaty obligations are relied on to prevent deductions for bribes. The relevant statutory measures are: • s 26-5 deduction denial for penalties; • s 26-52 deduction denial for bribes to foreign public officials; • s 26-53 deduction denial for bribes to public officials; • s 26-54 deduction denial for expenditure related to illegal activity.

550

[10.490]

Specific Deductions and Restrictions on Deductions

CHAPTER 10

(c) Deduction Denial as a Surrogate Tax on Benefits [10.510] Some provisions that deny or limit deductions for businesses or employers have the

effect of operating as a surrogate, or de facto, tax on benefits. Recall that prior to the introduction of the fringe benefits tax, many benefits provided to employees escaped tax (see Chapter 4). Similarly, prior to enactment of s 21A of the ITAA 1936, benefits provided to business associates escaped tax (see Chapter 3). The denial of a deduction for the cost of such benefits or payments to the provider forces the provider to pay additional tax. The deduction denial can act as a rough surrogate for taxing the recipient of the benefit, particularly if the payer and recipient’s tax rates are closely aligned. (i) Club and leisure facilities [10.520] Two of the original deduction denial provisions used as a surrogate tax on the

recipient of benefits were s 26-45 (recreational club expenses) and s 26-50 (leisure facility expenses). A similar rule prevents deductions for boating activities unless used as trading stock or in a business (s 26-47). These sections all assume that the personal consumption element of such an expenditure greatly outweighs any supposed business or income-earning purpose for the expense. The deduction denial also extends to the cost of club fees paid by employees or others (most likely to be business associates). With the adoption of the fringe benefits tax, the rationale for the prohibition on deductions for club or leisure facility fees dissipated in relation to employees. Accordingly, s 26-45 and s 26-50 now contain exclusions so they will not operate where the expenditure is incurred to provide a fringe benefit. (ii) Entertainment expenses [10.530] The most significant deduction denial provision that substitutes for the taxation of

benefits in the hands of recipients is Div 32 of the ITAA 1997 which deals with entertainment expenses. Section 32-5 prohibits a deduction for losses or outgoings in respect of providing entertainment, including food, drink, recreation, and related travel or accommodation (see the examples in s 32-10). This provision denies a deduction for entertainment expenses provided to taxpayers themselves, to employees, or to business associates. The main exception from this prohibition is entertainment expenses provided that are assessed as fringe benefits: see s 32-20. Another exception relates to “in-house dining facilities” (s 32-30), which has been a key driver in the development of in-house cafes and luxury chefs in law and accounting firms as well as other large businesses. (iii) Luxury car depreciation cap [10.540] A somewhat different provision designed to accomplish a similar end is s 40-230.

This section limits the cost of a car that can be recognised for capital allowance provisions, currently to a cap of $57,180 (for the 2009–10 year; indexed to inflation). To the extent the cost of a car exceeds the depreciation cap, it is considered a personal benefit to the user and the denial of capital allowance deductions for that part of the cost exceeding the cap imposes a surrogate tax on the car owner. (iv) Collateral business benefits [10.550] Section 51AK of the ITAA 1936 attacks a different sort of problem, namely that of collateral business benefits. This provision applies where a taxpayer incurs a deductible [10.550]

551

The Tax Base – Deductions

business expense and, as a consequence of the outgoing, derives a collateral business benefit that will not be used in the income derivation process. Common examples include incentive gifts used to promote products. Rather than lower the cost of its product as a promotional measure, a publisher of a trade magazine might provide new subscribers with a “gift” such as a watch or a radio. It is therefore arguable that some of the expense was not for a deductible purpose but instead is related to obtaining the collateral benefit. In this case, s 51AK will reduce the deductible amount of the subscription by the value of the “free” gift received by the taxpayer.

(d) Personal Services Regime [10.560] The “personal services income” (PSI) regime in Divisions 84 to 87 of the ITAA 1997

requires an individual who earns income from personal services to lower their tax payable by operating through a company (with a lower company tax rate) or a trust (which could be used as an income-splitting vehicle). The personal services income must be attributed directly to the individual unless certain conditions are satisfied. The assessment of personal service income under the regime is discussed in [4.1220]. The PSI regime also contains restrictions on deductions. Division 85 of the ITAA 1997 limits deductions for certain expenses of independent contractors who derive personal services income, with the objective of putting independent contractors on the same footing as employees by ensuring that contractors deriving personal service income would not be entitled to deductions to which employees are not entitled. The kinds of expenses for which deductions are prohibited are indicated by the example in s 85-10 (for example, expenses for travel between home and work). However, s 85-10(2) goes on to say that subsection (1) “does not stop you from deducting” expenses described in a following list. While subsection (2) does not say the expenses are deductible (it only says subsection (1) will not prevent a deduction), it is possible that subsection (2) will be read as implicitly suggesting the expenses are deductible. In addition, deductions for rent, mortgage interest, rates and land tax on the taxpayer’s or an associate’s residence (s 85-15), and for payments to associates including superannuation contributions (ss 85-20 and 85-25) are prohibited. It is not clear that Div 85 serves much purpose. Commentators have argued that under general principles and the ordinary interpretation of s 8-1, independent contractors were not able to access any deductions that employees could not access. In any event, the deductions are not denied if the independent contractor satisfies the test for conducting a “personal services business” in Div 87.

(f) Finance and Leveraged Leases [10.580] Arrangements were historically devised to enable taxpayers to disguise capital

purchase price payments as deductible outgoings of a revenue character. One of the most notorious of these schemes was that found in the South Australian Battery Makers case at [7.500]. In South Australian Battery Makers the taxpayer successfully deducted part of the capital cost of a building by converting part of the purchase price into rent. A series of narrow anti-avoidance rules denying a deduction were adopted in ss 82KJ, 82KK and 82KL of the ITAA 1936, with s 82KJ directly aimed at the South Australian Battery Makers-type scheme and some variations of it. 552

[10.560]

Specific Deductions and Restrictions on Deductions

CHAPTER 10

We saw in Chapter 9 at [9.290] that a finance lease in substance is a sale of property on credit, financed by a loan from the vendor. The lessee claims a tax deduction for the nominal “lease payments”, but accounting principles would treat these payments made by the purchaser as repayments of a purchase price loan and interest, with only the interest component recognised as a deductible expense. The flip side to finance lease payments being fully deductible to the borrower/lessee is fully assessable payments to the lender/lessor. In addition, the lender/lessor would be eligible for capital allowances if the lease relates to a depreciating asset. Where both parties are taxable companies, there is not much to object to in this arrangement, as the additional tax payable by the lessor offsets the additional deduction to the lessee. However, where there is an asymmetry between the borrower/lessee and the lender/lessor – in particular, if the lessee is tax-exempt, has carry-forward tax losses or is a non-resident – there is the potential for the parties to arbitrage the tax benefits of a lease arrangement. First, if the lessee or end-user of the leased asset is tax exempt, it would not be able to utilise the capital allowances as a result of owning the asset but the tax-exempt lessee may realise some of the benefits of the lessors’ depreciation deductions in the form of lower lease (financing) payments. Second, tax-exempt State bodies may want to enter into lease arrangements to disguise the extent of their borrowings, as was done by the Victorian Government in the early 1990s as part of its attempts to “borrow” outside the Loan Council limits to which it was subject. The legislature has responded to the question of finance leases used by tax-exempt bodies in a piecemeal fashion. An initial response, adopted in 1982, applied to “leveraged leases” where the lessor funded the purchase of depreciable property using non-recourse debt. Further measures were adopted in 1984 for other finance leases to tax-exempt government bodies (Div 16D of the ITAA 1936). The Review of Business Tax recommended in 1999 that finance leases be treated generally as sale and loan transactions for tax purposes (as they are for accounting purposes) and in 2001 the government introduced a broad regime, Div 240 of the ITAA 1997, to re-characterise finance leases and other transactions in this way. However, vigorous lobbying by the finance industry led the government to withdraw the proposal and Div 240 was enacted applying to hire-purchase arrangements only. In 2007, Div 250 of the ITAA 1997 was enacted to replace Div 16D of the ITAA 1936, but still with fairly limited scope. Division 250 applies to finance lease assets put to a “tax preferred use” meaning the entity that uses the asset is tax-exempt or a non-resident that uses the asset outside of Australia. Where Div 250 applies, the arrangement will be treated as a notional sale of the asset from the lessor to the lessee funded by a notional loan to the lessee so each “lease” payment will be re-characterised as a payment partially of interest and partially of principal repayment on the notional loan. The lessor is accordingly not allowed any capital allowance deductions for the asset and includes the interest component only, instead of the full lease amount, in assessable income. The lessee is the notional “owner” of the asset, but would not be eligible for capital allowances in any event (or to claim deductions on the lease payments) because it is tax-exempt or derives exempt income.

[10.580]

553

ALLOCATING INCOME AND DEDUCTIONS TO PERIODS – TIMING 12. Statutory Accounting Regimes .................................................... .. 609 [Pt4.10] Our discussion so far has focused on one part of the picture – whether an amount is assessable (Part 2) and whether an outgoing is deductible (Part 3). There is also a time dimension – when is the amount assessable and when is it deductible? Allocating the income and deductions from events to each time period is an important part of the tax process for obvious and a few not-so-obvious reasons. The following chapters examine the rules which do this allocation to periods. Chapter 11 examines the “common law” of timing – the rules that have developed as succeeding generations of judges have interpreted the text of the income tax laws to find what it says about timing matters. As we will see, these rules can differ depending on the kind of income or expense involved and the circumstances of the particular taxpayer.

PART4

11. Tax Accounting ............................................................................... .. 557

Chapter 12 then examines the various statutory regimes which supplement or supplant these judicial glosses. There are important and highly detailed statutory regimes for income from transactions with trading stock, transactions involving certain kinds of financial arrangement and when to recognise capital gains and losses, to mention just a few. We have already taken up the issue of timing at a number of points in previous Parts, for example, capital allowance provisions for depreciable assets discussed in Part 3 involve inherent timing rules allocating the cost of the asset to various periods as it is depreciated. Some problems and potential manipulation of timing rules were also discussed there and these issues come up again in this Part 4.

555

CHAPTER 11 Tax Accounting [11.10]

1. GENERAL ISSUES IN TAX ACCOUNTING....................... ............................. 559

[11.10]

(a) Introduction ........................................................................................................ 559

[11.20] [11.30] [11.50] [11.60]

(b) Periodic Accounting – The Annual Accounting Requirement ................................ 560 G S Cooper, Tax Accounting For Deductions ................................................................. 560 (i) Arbitrary effects and compensating schemes ......................................................... 562 (ii) Tax deferral .......................................................................................................... 562

[11.70] [11.80]

(c) Relevance of Financial Accounting Principles ........................................................ 563 Taxation Review Committee, Full Report (Asprey Report) ............................................... 563

[11.100]

2. CASH ACCOUNTING FOR INCOME AND DEDUCTIONS ........... ................ 565

[11.100] [11.110] [11.130] [11.150] [11.170]

(a) Choosing the Appropriate Accounting Method .................................................... Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case) ......................................................................................................................... Henderson v FCT ........................................................................................................ FCT v Firstenberg ........................................................................................................ Ruling TR 98/1 ..........................................................................................................

[11.190] [11.210]

(b) Recognising Income ............................................................................................ 573 Brent v FCT ................................................................................................................ 574

[11.230] [11.240]

(c) Recognising Outgoings ........................................................................................ 576 Ruling TR 97/7 .......................................................................................................... 576

[11.250]

3. ACCRUALS ACCOUNTING FOR INCOME AND DEDUCTIONS ....... ........... 578

[11.260] [11.260] [11.270] [11.300] [11.320] [11.340] [11.350]

(a) Recognising Income ............................................................................................ (i) Advancing the recognition of income ................................................................... Henderson v FCT ........................................................................................................ FCT v Australian Gas Light Co ..................................................................................... Ballarat Brewing Co v FCT ........................................................................................... (ii) Deferring the recognition of income .................................................................... Arthur Murray (NSW) Pty Ltd v FCT .............................................................................

578 578 578 580 581 582 583

[11.370] [11.380] [11.390] [11.410] [11.430] [11.450] [11.460]

(b) Recognising Deductions ...................................................................................... (i) Advancing the recognition of deductions ............................................................. FCT v James Flood Pty Ltd ........................................................................................... Nilsen Development Laboratories Pty Ltd v FCT ............................................................ FCT v AGC Ltd ............................................................................................................ Coles Myer Finance Ltd v FCT ...................................................................................... (ii) Deferring the recognition of deductions ..............................................................

585 585 586 587 589 591 592

[11.470] [11.480] [11.500]

(c) Change of Accounting Method ............................................................................ 594 Henderson v FCT ........................................................................................................ 594 Country Magazine Pty Ltd v FCT ................................................................................. 596

[11.510]

4. ACCOUNTING FOR PROFITS AND LOSSES ..................... ........................... 597

[11.520]

R W Parsons, Income Taxation In Australia ................................................................... 598

565 566 568 569 570

557

Allocating Income and Deductions to Periods – Timing

[11.530] [11.540] [11.560]

(a) When Does Profit and Loss Accounting Apply? ..................................................... 599 FCT v Whitfords Beach Pty Ltd ..................................................................................... 600 FCT v Citibank Ltd ...................................................................................................... 601

[11.570]

(b) What Items Enter the Calculation of Profit? .......................................................... 603

[11.580]

(c) When Should Profits be Recognised? ................................................................... 604

[11.590]

(d) Deemed Costs in Calculating Income or Profit ..................................................... 605

Principal Sections ITAA 1936 s 17

ITAA 1997 s 4-10

–

s 4-15

s 19

ss 6-5(4), 6-10(3)

s 25(1)

s 6-5

s 25A

s 15-15

s 63

s 25-35

s 51(1)

s 8-1

s 51(3)

s 26-10

s 82

–

558

Effect This section imposes tax upon the taxable income derived by a taxpayer during the year of income. This section defines “taxable income” as the balance remaining after subtracting the allowable deductions from the assessable income of the year of income. This section supplements the operation of cash basis accounting by providing that income may still be deemed to have been derived by a cash basis taxpayer, notwithstanding that it was not received by the taxpayer, if it was nevertheless reinvested, accumulated, or dealt with at the taxpayer’s expense. This section includes in assessable income the gross income derived by a taxpayer in the year of income. This section requires taxpayers to include in assessable income the profits of profitmaking schemes. This section gives an allowable deduction to an accruals basis taxpayer who has included in a prior year’s assessable income an amount which is not eventually received. This is the principal section which allows a taxpayer to deduct losses and outgoings incurred in the year of income. This section confirms the results in James Flood and Nilsen by denying a deduction for annual and long service leave payments until paid. This section prohibits a taxpayer from claiming the same expense once as an allowable deduction and again as a subtraction in calculating the amount of an assessable profit.

Tax Accounting

ITAA 1936 ss 82KZL to 82KZO

ITAA 1997 –

s 170(9)

–

CHAPTER 11

Effect These sections require the pro-rating of prepaid revenue expenses over the life of any benefits procured by the payment or over 10 years, whichever is the shorter. This section permits the reassessment of profits emerging where the initial calculations are later found to have been erroneous.

1. GENERAL ISSUES IN TAX ACCOUNTING (a) Introduction [11.10] In earlier chapters we have been looking at the additions and subtractions which

define the income tax base – the amounts that comprise the net figure upon which tax will eventually be levied. We are now leaving the definition of the tax base to consider a second issue. The focus of this chapter and the next is the rules of tax accounting and the way they operate to allocate items of assessable income and allowable deductions to particular periods. While the allocation of amounts to periods is the prime object of the tax accounting rules, the answers to timing questions inevitably affect the determination of how much income has been derived and how much tax will be paid. This chapter will explore these twin effects of the tax accounting rules: the allocation of income and deductions to discrete periods, and the quantification of the taxable income of a period. The next chapter concentrates on a few of the specific regimes stipulated in the ITAA 1936 and ITAA 1997. At first glance, tax accounting might seem to be a matter of simple arithmetic with the generally unstated implication that it is, therefore, of little importance and something that only accountants can – or need – understand. It might also be assumed that tax accounting bears only on the timing of income, and not the amount of income or the amount of tax payable. All of these beliefs are mistaken. It is possible – indeed, it is almost inevitable – for two taxpayers with the same income over the same period to pay different amounts of tax simply because they earn their income in different periods or operate their accounts in different ways. Indeed, the importance of timing questions has increased now that the base of the income tax has been substantially broadened. Previously the key question asked in tax planning was: Will this amount be taxed at all? Now the important questions are: When and how will this amount be taxed? Similarly, in deductions cases, the consequence of classifying an outgoing as either a revenue or capital expense will often lie primarily in the time at which it is subtracted – immediately, apportioned over a period or in the distant future. In other words, the timing of events, rather than the occurrence or absence of effects, is fundamentally important to our tax system as a consequence of the tax reforms which began in 1985. It is important to note at the outset that there is not one tax accounting regime but many. Different regimes are applicable to categories of taxpayers, and different regimes may apply to various types of income or outgoings of the same taxpayer. So the answer to the question – how much is the taxpayer’s income – will turn on both the nature of this taxpayer and the nature of this income event. [11.10]

559

Allocating Income and Deductions to Periods – Timing

(b) Periodic Accounting – The Annual Accounting Requirement [11.20] The system of accounting adopted by the ITAA, with some exceptions, is periodic

rather than transactional. This means that, in order to calculate the amount of tax payable, a taxpayer must look at each accounting period separately and consider, and then record, each event within that period in isolation. The other alternative – which we did not adopt – would have been to look at the results of transactions or entire ventures, and only after the venture was completed. The periodic approach is evident in many of the provisions of the Act. It underlies the sections requiring an annual calculation of taxable income and an annual assessment of the tax payable. Section 4-10 of the ITAA 1997 imposes the obligation to pay income tax upon the “taxable income for the income year”, taxable income being defined in s 4-15 to be (in most cases) the balance remaining after making deductions from all assessable income. This subtraction presupposes that the assessable income derived by a taxpayer can be allocated to a year of income, and similarly that the allowable deductions incurred can be allocated to a year, and hopefully that these two processes can be done with some degree of certainty. The periodic calculation of taxable income must be a somewhat arbitrary process as it is based upon a more or less arbitrary period. As one American writer puts it, “tax liability is determined in the context of two points of time, normally the time required for the earth to move in its orbit around the sun” (J Chommie, The Law of Federal Income Taxation, St Paul, West Publishing, 1973, p 225). Uncertainty and inequity are introduced by requiring taxpayers to disclose their income in these small steps. Identifying total gain could be more accurately done over a lifetime – that is, if the tax system waited until an individual died, the business was wound up, or just waited until each venture was completed – before calculating any gain, but it is impractical for a government to operate a tax system on this basis. Revenue requirements dictate that taxes be collected at regular intervals and this necessitates an allocation of income and deductions to periods. It was suggested above that the timing rules will inevitably have the consequence that taxpayers with the same lifetime income will pay different amounts of tax. This comes about because a periodic calculation is required but incomes fluctuate between periods. The most obvious examples of these distorting features include the progressive rate scale, changes in the tax rates between periods, changes in the status of the taxpayer over time (for example, the acquisition of a dependent spouse or child or a change in resident status), limitations on the ability to use losses, and the quasi-conclusive assessment process which prevents the ATO reopening previous assessments of tax after the expiry of a sufficient period. Not only do these features inevitably impinge differently upon taxpayers with identical lifetime incomes, but the tax accounting rules can feed back into the characterisation process affecting the treatment of items merely by allocating and recording them. G S Cooper explained this process in the following manner:

G S Cooper, “Tax Accounting For Deductions” [11.30] G S Cooper, “Tax Accounting For Deductions” (1985) 5 Australian Tax Forum 23 Tax accounting seems to have only one main goal or object – the allocation of income and deductions to their appropriate tax period so that the annual assessment of the tax payable by the 560

[11.20]

taxpayer for that year can be made – but other ancillary consequences for the deductibility of amounts and the quantification of deductions may follow as incidents of this allocation. This

Tax Accounting

G S Cooper, “Tax Accounting For Deductions” cont. section commences with an examination of two of those consequences – the way that tax accounting rules can ultimately affect the deductibility of expenses, and the way that they can vary the amount which might otherwise be thought deductible. 1. Defining deductibility The first ancillary consequence suggested is that the tax accounting rules can affect the decision whether an expense is deductible. This can occur in two ways: first, because deductibility is always contingent upon the taxpayer allocating the expense to the correct period; and, secondly, because an expense even when allocated to the correct period in accordance with the rules, may then cease to be sufficiently connected to the earning of income. (a) Deduction “swallows” The time at which a deduction is recognised is inextricably tied up with the quantification of the taxable income of a taxpayer. If the subtraction of an allowable outgoing is not taken in the appropriate year, it will cease to be an allowable deduction because it will not be subtractable in any other year. This seems to be the meaning implicit in the comment of Deane J in the Federal Court in FCT v Nilsen Development Laboratories Pty Ltd (1979) 79 ATC 4520 who said: a taxpayer is ordinarily no more entitled to select the period in respect of which entitlement to a deduction arises than he is to select the period in which income is derived. To qualify, at this late stage, the generality of what has been said in the James Flood case by a narrow assessment of ratio decidendi would arguably involve the great body of employer taxpayers losing entitlement to the benefit of a deduction in respect of payments actually made to the extent to which it was now held that they had been properly deductible at some prior time. There are many examples to be found in the case law where the failure to account for an expense in its proper year meant that it was denied any subtraction. The principle was applied to the deduction of bad debts in Point v FCT

CHAPTER 11

(1970) 70 ATC 402l. The taxpayer executed in May 1964 a release of a debt owed to him which became effective in July. In September 1964 the taxpayer made an entry in his accounts that the debt was written-off retrospectively as at 30 June 1964 and claimed a deduction for the debt in his 1963 to 1964 return. Owen J held that the moment at which a debt became deductible under s. 63 was the moment at which the debt, being then a bad debt, was written-off in the sense of a manual entry in the accounts of the taxpayer – that was the tax accounting event and as that event did not occur in that tax year but in the next, no deduction was currently available. The judge also went on to hold that neither was an amount deductible in the next year when the amount was written-off because in that year there was not a bad debt – the effect of the release executed in the prior year had been to extinguish the debt. [A similar result occurred in] Elder Smith & Co Ltd (1932) 47 CLR 471. These cases hold in common that a deduction can only be obtained if an expense is allocated to its appropriate accounting period. The effects of this proposition could be avoided simply by ensuring that the expense is correctly allocated initially or is re-allocated to the next accounting period if that is the correct period but the taxpayer will run the risk of the imposition of penalties for the error and the limitations of the quasi-conclusive assessment procedures will preclude allocation to a prior period. This suggested principle that the timing rules impinge upon deductibility has some obvious limitations: it probably would not apply to provisions made for future expenses if there is no obligation to make a provision and claim it as a current expense and it would certainly not apply if it is not possible for the taxpayer to do so. At present there appears in Australia to be no tax principle requiring such a deduction though financial accounting and the accounting obligations of the Companies Code [in s. 269] regard provisions as axiomatic. (b) Timing and characterisation: contemporaneity A second principle can also be extracted from the cases: the allocation of an expense by the tax accounting rules to a particular period can have the effect of permanently denying deduction in [11.30]

561

Allocating Income and Deductions to Periods – Timing

G S Cooper, “Tax Accounting For Deductions” cont. that accounting period because the expense, even when considered in its correct period, is then not relevant to the earning of income. This is

the basis of the contemporaneity doctrine: if the principles of tax accounting divorce a deduction too far from the derivation of the related income, that fact alone may be sufficient to deny deductibility to the outgoing.

[11.40] The contemporaneity principle has been discussed above (Chapter 9). The issue of

“deduction swallows” was recognised by the ATO in Ruling IT 2613, unhelpfully labelled, “Changed Basis of Accounting for Expenditure”. The Ruling confirms that if a taxpayer has not claimed a deduction in the year in which the deduction was incurred, it cannot claim the deduction in a later year when the liability was discharged. Instead, the ATO indicated that it would permit the taxpayer to correct the prior year’s tax assessment to claim the deduction in the earlier year, subject, of course, to the limits set forth in s 170 of the ITAA 1936. (i) Arbitrary effects and compensating schemes [11.50] The undesirable effects of the annual calculation are mitigated to some extent by

special provisions in the Act. If the taxpayer makes a loss of $80 in Year 1 and an income of $100 in Year 2, it should properly be taxed only on $20 – the amount of gain realised over the two years. Division 36 of the ITAA 1997 (formerly s 80 of the ITAA 1936) allows losses from one period to be carried forward and offset against the income of later years – the taxpayer should pay tax on the combined result of the two years, not just a single year, if the allocation of income and deductions results in a loss in the first and a profit in the second. If the taxpayer makes an income of $100 in Year 1 and a loss of $80 in Year 2 again, it should properly be taxed only on $20. However, Australia currently has no rules which allow losses to be carried back, in order to claim a refund of the tax paid in Year 1. (A regime to this effect for companies did exist briefly but was repealed in 2014.) Instead, the taxpayer will have to wait until Year 3 to see if the loss can be used. Divisions 392 and 405, and the Income Tax Rates Act 1986 (Cth) allow certain types of taxpayers such as primary producers, authors, artists, performers, athletes and inventors to average their income over more than one year. These regimes recognise the fact that these taxpayers have very “lumpy” income profiles. It used to be the case that the Income Tax Rates Act 1986 provided a special rate of tax payable on capital gains which treated a net capital gain as if it had been derived equally over five years. And tax assessments can in some cases be reopened under s 170. All of these regimes are themselves subject to limitations; for example, there are restrictions on the ATO’s powers to amend an assessment unless it acts within two years or four years of the date when the tax became payable under the original assessment; the ability to carry forward losses is limited in the case of companies if the shareholders change; losses cannot currently be carried back; and income averaging is only available to some taxpayers. These limitations make the ameliorating effects of these provisions less effective than they might be. (ii) Tax deferral [11.60] There are benefits which flow from advancing the incurring of deductions and

deferring the derivation of income. These benefits flow from the time value of money and are particularly important in periods of high and fluctuating interest rates and inflation. 562

[11.40]

Tax Accounting

CHAPTER 11

The concept of a tax deferral can be understood by analogy to some other devices: a deferral of tax is equivalent to an interest-free loan by the government to the taxpayer of the tax payable. Alternatively, it can be understood as an effective reduction in the tax rate because the taxpayer’s liability is transformed from an obligation to pay $2,000 tax into an obligation to pay (the present value of) $2,000 in three years time. [11.65]

11.1

11.2

11.3

11.4

Questions

The value of tax deferral to a taxpayer depends upon interest rates, the rate of inflation and the length of time that the tax can be deferred. If a taxpayer can defer the inclusion of $10,000 in taxable income from Year 1 to Year 3 (interest rates being constant at 11.5% and inflation at 9% per annum) what would be the value of the deferral? What would happen if the taxpayer could advance the subtraction of an allowable deduction from Year 3 to Year 1? The taxpayer anticipates income of $10,000 in Year 1, and a loss of $8,000 in Year 2. How valuable is it to the taxpayer to be able to defer the income from Year 1 to Year 2? Does it make any difference if the taxpayer expects the result of Year 3 to be taxable income of $5,000 or a further loss of $5,000? Incentives to manipulate the period for recognition will also arise if tax rates change between periods. What incentives follow if the tax rates rise or fall between periods and how do they impact upon the value of tax deferral? Where both parties to a transaction operate their accounts on the same basis and the transaction has complementary consequences for each (it represents assessable income for one and an allowable deduction for the other), their conflicting interests will generally ensure that advancement and deferral will not be manipulated. But what will happen if these assumptions are relaxed? What might happen if the parties are taxed at different rates – say 50% for the party seeking an allowable deduction for a payment of $5,000 and 30% for the party who will be assessed on the $5,000?

(c) Relevance of Financial Accounting Principles [11.70] In many cases, the Act will eventually tax a different amount than a financial

accountant would calculate as periodic profit (which, as the old joke states, would be a different amount from that calculated as periodic profit by another financial accountant, or perhaps even the same accountant but on another day). The extent to which the tax accounting rules should mirror financial accounting is a perennial issue and was considered by the Asprey Committee in Chapter 8 of its report.

Taxation Review Committee, Full Report (Asprey Report) [11.80] Taxation Review Committee, Full Report (Asprey Report) AGPS, Canberra, 1975 The first and overriding principle, in the Committee’s view, is that income tax should be levied on true profits flowing from the business or professional activity during its whole period of operations. If this is not achieved the rates of tax, be they progressive as for individuals or proportionate as for companies, become meaningless and misleading as an indication of the weight of tax. The true after-tax profits

remaining and available for maintenance or expansion of the activity cease to be readily apparent and become distorted. Further, meaningful international comparison of the incidence of tax on business operations is made very difficult and the results are subject to qualifications which often cannot be quantified. Additionally, if the base is not true profits, ostensible concessions or incentives in specific [11.80]

563

Allocating Income and Deductions to Periods – Timing

Taxation Review Committee, Full Report (Asprey Report) cont. areas may in fact be excessive or alternatively of less value than the figures suggest. The Committee has received, as have previous committees charged with inquiries into income tax, numerous submissions on the ascertainment of net incomes of business and professions. Most submissions point to the failure of income tax legislation to allow deductions for expenses which, under normal commercial practice, are deducted in arriving at profits before income taxation. In some cases a deduction for the expense is not available for income tax purposes; in others it is available in an accounting period other than that in which it is normally charged using generally accepted accounting principles. In the end result, the profits subject to tax tend to be higher than those determined for commercial purposes. It has again been proposed that the overstatement of net income arising from business activities would be avoided if the Income Tax Assessment Act were to be amended to provide that, subject to certain specific provisions, net income for tax purposes should be the profits

determined on a commercial basis by applying generally accepted accounting principles. At first blush such a scheme may appear to have attractions, but these fade on closer examination. There has, it is true, been considerable progress in recent years towards the acceptance, by companies particularly, of authoritative statements on accounting principles which should be followed in arriving at disclosed profits. However, it is clear that many instances remain within the authoritative standards where alternative procedures continue to be available, and in many types of business organisation the standards accepted generally by the larger publicly-listed companies have yet to be attained. In addition, to place the basis for determination of net income on which taxes are to be levied outside the jurisdiction of the revenue-raising authority could not be seriously considered in Australia and has not been adopted, to the Committee’s knowledge, in any other country. The proper approach therefore must be to seek to narrow, as far as is possible, the differences between net income as determined under the revenue legislation and as determined by commercial standards.

[11.90] But the debate will not just die. Similar arguments were again put to the Review of

Business Tax during 1999. Chapter 4 of its report contained two recommendations for the closer alignment of tax and financial accounting: Recommendation 4.23 “that appropriate regard be had to accounting principles in the development of taxation legislation for the Integrated Tax Code”; and Recommendation 4.24, “that the Australian Taxation Office work with the accounting and tax professions to identify differences between the accounting and taxation treatments of profits with a view to better aligning these treatments where the differences are inappropriate”. It is hard to see any substantial implementation of these recommendations in practice. It is a matter of some debate just how far the rules of tax accounting should or could mirror the rules of financial accounting. Clearly, there could be substantial savings in compliance costs if a taxpayer could simply use its existing financial statements to provide the calculation of its taxable income (at least, those taxpayers who prepare formal financial statements). But two reasons are usually advanced for the law remaining distant from financial accounting. One, identified by the Asprey Committee and the Review of Business Taxation (RBT), is the subjectivity, flexibility and judgment necessary in financial accounting. The notions of conservatism and materiality in financial accounting are out of place in tax law. 564

[11.90]

Tax Accounting

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The other is that financial accounting and tax accounting serve different purposes: financial accounting exists to provide information to a range of people from which inferences about many matters can be drawn. It is implicit that the needs of the audience are important in choosing the information that is recorded, the way it is recorded and consequently the inferences that can be drawn from the accounts. Tax accounting exists as an integral part of a tax system which has as one goal the equitable and efficient allocation of the total revenue burden across the entire community. What runs through many of the cases is the tension between the desire for conformity to financial accounting on the one hand and, on the other, the hesitance of lawyers to relinquish control of the calculation of the tax base to the exercise of judgment which is inherent in accounting. Nevertheless, there are some instances where the tax legislation does explicitly adopt the position shown in the audited financial accounts as the basis for a tax rule. There is clearly a saving in compliance costs from relying on accounts that already exist for another purpose and the tax policymakers may be prepared to rely on the accounting treatment if the accounting expresses what the tax rule would try to achieve combined with the audit requirement to give a degree of assurance that the accounting treatment has not been manipulated. For example, the thin capitalisation rules, which determine whether a taxpayer can deduct all of their interest expenses, use values for assets and liabilities based on the amounts shown in the company’s financial accounts. And the Taxation of Financial Arrangements rules (TOFA, discussed in more detail in Chapter 12) allow taxpayers in some cases to use the results shown in their financial accounts as the amount of income or deduction arising from some types of financial instruments.

2. CASH ACCOUNTING FOR INCOME AND DEDUCTIONS (a) Choosing the Appropriate Accounting Method [11.100] There are two basic methods of accounting: the cash basis and accruals (or earnings)

basis. Under the cash method, income and deductions are recognised and recorded only when cash is received or paid out by the taxpayer. Under the accruals method, accounting events are recorded and recognition occurs when the taxpayer has a right to claim income or comes under an obligation which will eventually need to be satisfied by payment. The qualities of each method were floridly described by Goldberg J in Knight-Ridder Newspapers v United States (1984) 743 F 2d 781 who commented: These … accounting methods … could be said to emblemise the polar nature of the human spirit. The cash method – simple, plodding, elemental – stands firmly in the physical realm. It responds only through the physical senses, recognising only the tangible flow of currency. Money is income only when this raw beast actually feels the coins in its primal paw; expenditures are made only when it can see that it has given the coins away. The accrual method, however, moves in a more ethereal, mystical realm. The visionary prophet, it recognises the impact of the future on the present, and with grave foreboding or ecstatic anticipation, announces the world to be. When it becomes sure enough of its prophecies, it actually conducts life as if the new age has already come to pass. Transactions producing income or deductions spring to life in the eyes of the seer though nary a dollar has moved.

Each method would inevitably disclose different amounts both as income and deductions if we compared the results of applying each method to the same period, and so taxpayers would be able to vary the amount of their taxable income if they were free to choose either method [11.100]

565

Allocating Income and Deductions to Periods – Timing

without constraint. In this section we will explore this choice issue: which system is appropriate for particular taxpayers; what factors control that choice; and how much latitude is allowed to the taxpayer to choose the method that suits her or him best. We will begin to answer these questions by looking first at circumstances where cash accounting is appropriate. Cash accounting is the basis appropriate for most wage and salary income and the expenses incurred in deriving it, and, perhaps, for some small businesses which provide services and there is little or no trading stock. The differences between cash accounting and accruals accounting can be seen in several places in tax law – for example in the treatment of book debts (that is, amounts of income that are owed to a taxpayer but have not been received), work in progress (amounts that will be due for work done but are yet to be quantified) or holding deposits and prepayments (amounts that have been received for work that has not yet been performed and might not be performed). The High Court first considered this question of the choice of the most appropriate accounting method in Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case). In the years just prior to his death, Dr Carden had prepared his tax accounts on a cash basis, disclosing as income only amounts received by him during the year. Consequently, after his death there were outstanding accounts which were later paid to his executor and were received as corpus of the estate and therefore non-taxable capital sums – a result since overturned by s 101A of the ITAA 1936. The ATO argued that the late doctor should have prepared his accounts on an earnings basis so that all the income would have been derived before his death. Dixon J disagreed. His judgment also contains some interesting observations on other matters such as the correct relationship between financial and tax accounting.

Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case) [11.110] Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case) (1938) 63 CLR 108; 1 AITR 416; 5 ATD 98 The substantive question whether to assess Dr Carden’s professional income upon the basis of receipts was not in accordance with law … The question whether one method of accounting or another should be employed in assessing taxable income derived from a given pursuit is one the decision of which falls within the province of courts of law possessing jurisdiction to hear appeals from assessments. It is, moreover, a question which must be decided according to legal principles … But it is, I think, a mistake to treat such a question as depending upon a search for an answer in the provisions of the legislation, a search for some expression of direct intention to be extracted from the text, however much it may be hidden or obscured by the form of the enactment. Income, profits and gains are conceptions of the world of affairs and particularly of business … 566

[11.110]

But in nearly every department of enterprise and employment the course of affairs and the practice of business have developed methods of estimating or computing in terms of money the result over an interval of time produced by the operations of business, by the work of the individual, or by the use of capital. The practice of these methods of computation and the general recognition of the principles upon which they proceed are responsible in a great measure for the conceptions of income, profit and gain and, therefore, may be said to enter into the determination or definition of the subject which the legislature has undertaken to tax. The courts have always regarded the ascertainment of income as governed by the principles recognised or followed in business and commerce, unless the legislature has itself made some specific provision affecting a particular matter or question.

Tax Accounting

Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case) cont. In the present case we are concerned with rival methods of accounting directed to the same purpose, namely the purpose of ascertaining the true income. Unless in the statute itself some definite direction is discoverable, I think that the admissibility of the method which in fact has been pursued must depend upon its actual appropriateness. In other words, the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer’s true income. We are so accustomed to commercial accounts of manufacturing or trading operations, where the object is to show the gain upon a comparison of the respective positions at the beginning and end of a period of production or trading, that it is easy to forget the reasons which underlie the application of such a method of accounting to the purpose of ascertaining taxable income. Although the field of profit-making which it covers in practice is probably much greater than any other among the manifold forms of income or revenue, it is a system of accounting which does not represent the primary or basal position from which an investigation of income for taxation purposes begins. Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form … The reasons which underlie the practice of estimating for taxation purposes the income from trade or manufacture by means of a commercial profit and loss account consist in the impracticability of computing income in any other way and in the adoption for fiscal purposes of recognised commercial principles. The computation of profits from manufactures and trading has always proceeded upon the principle that the profit may be contained in stock-in-trade and “outstandings” … The result is that a tax upon the profits or income of such a business must be understood as a tax upon the profits or income computed according to the system, because, according to common understanding and commercial principles, that is the method of determining the

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profits. The basis of a trading account is stock on hand at the beginning and end of the period and sales and purchases. In such an account book debts represent what before sale was trading stock and it is almost inevitable that they should be taken into consideration upon an accrual and not a cash basis. But nearly all income tax legislation is against the practice which obtains commercially of making a reserve for bad debts or discounting the amount of book debts by a percentage for bad or doubtful debts. Specific provision is usually made for the deduction from the book debts accruing during the accounting period of such debts only as have proved to be bad during that period and have been writtenoff. Usually the deduction is authorised also of book debts included in a previous accounting period which in the year under assessment prove to be bad and have been written-off. Then book debts written-off as bad which in a subsequent accounting period are nevertheless paid are to be brought in as receipts of that subsequent period … The distinction, if not opposition, between the mode of accounting sometimes called the accrual system and that based upon actual receipt and disbursements is widely known. The foundation of the accrual system is the view that the accounts should show at once the liabilities incurred and the revenue earned, independently of the date when payment is made or becomes due. It plainly is not applicable to every pursuit by which income is earned … The considerations which appear to me to affect any such question are to be found in the nature of the profession concerned and, indeed, the actual mode in which it is practised in a given case. Where there is nothing analogous to a stock of vendible articles to be acquired or produced and carried by the taxpayer, where outstandings on the expenditure side do not correspond to, and are not naturally connected with, the outstandings on the earnings side, and where there is no fund of circulating capital from which income or profit must be detached for actual enjoyment, but where, on the contrary, the receipt represents in substance a reward for professional skill and personal work to which the expenditure on the other side of the account contributes only in a subsidiary or minor degree, [11.110]

567

Allocating Income and Deductions to Periods – Timing

Commissioner of Taxes (SA) v Executor Trustee & Agency Co of SA Ltd (Carden’s case) cont. then I think according to ordinary conceptions the receipts basis forms a fair and appropriate foundation for estimating professional income. But this is subject to one qualification. There must be continuity in the practice of the profession … For the reasons I have given I think that Dr Carden’s professional income was properly assessed upon actual receipts. To state the case at

its lowest, actual receipts formed a basis the choice of which was clearly lawful and proper. The special cases contain very little certainty about the payments of fees, I should have thought that a receipts basis of accounting would alone reflect truly the income and for most professional incomes it is the more appropriate. But to a great degree the question whether income of a particular kind can be properly calculated on one basis alone or upon either, must depend upon the nature of the source of income.

[11.120] This test expressed by Dixon J – that the taxpayer must use a system that gives “a

substantially correct reflex of the taxpayer’s true income” – involves a question of fact, and like all questions of fact, raises enormous difficulties of administration. Perhaps it was not surprising that after Carden’s case the ATO adopted the position that the income of all professional people should be accounted for on a cash basis. Such a position was obviously easy to administer but was challenged before the High Court as incorrect as a matter of law in Henderson v FCT. Henderson’s case involved the proper method of accounting for the share of a partner in the profits of a large firm of accountants. Barwick CJ observed:

Henderson v FCT [11.130] Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 Sections 90 and 91 of the Act required the appellant to pay income tax upon the full amount of his share of the income derived by partnership in each year of tax. In the years ended 30 June 1965 and 30 June 1966 respectively the partnership determined its profits on the basis of fees earned and accounts incurred during the year. It made its returns of partnership income on the same, that is, on an earnings basis. It distributed to its members, 19 in all, the whole of this profit for each year by way of salary and bonuses, borrowing money to the extent to which its cash receipts for the year were inadequate to enable it to make this distribution. The appellant returned as his assessable income the amount thus received by him in each of these years from the partnership. But the Commissioner was of the opinion that in respect of these tax years a “cash received and accounts paid” basis was the proper basis on which to ascertain the income of the partnership. Accordingly he assessed the appellant on the footing that he derived income in each of those tax years to the 568

[11.120]

extent of his entitlement to a share of the partnership income so ascertained … At relevant times the partnership employed a total of 295 persons of whom about 150 were qualified accountants. Fees earned for the year ending 30 June 1965 amounted to $1,181,166 and in the year ending 30 June 1966 to $1,374, 000. Bad debts in the year ending 30 June 1965 amounted to $98 and in the year ending 30 June 1966 to $541. Its disbursements, excluding salaries to partners, for the year ending 30 June 1965 amounted to $1,045,358 and for the year ending 30 June 1966 to $1,074,567. The accountancy practice which it conducted in various centres was said to be the largest in Western Australia and one of the largest in Australia. It is apparent, in my opinion, that what such a business earns in a year will represent its income derived in that year for the purposes of the Act. The circumstances which led the majority of the court to conclude in Carden’s case that a cash basis was appropriate to determine the income of

Tax Accounting

Henderson v FCT cont. the professional practice carried on by the taxpayer personally are not present in this case … The Act by s. 17 levies income tax upon the amount of taxable income derived by the taxpayer in the year of tax. The taxable income results from the application of the provisions of the Act to what is in fact the assessable income of the taxpayer: that in the case of a taxpayer resident in Australia is the whole of the income which is not expressly exempted by the Act, which the taxpayer has derived during the year of tax from any source whether within or beyond Australia. That assessable income when ascertained must be expressed in a figure. There cannot in fact be alternative figures for such assessable income. The figure determined as that income may be the result of estimation, as well as of calculation, and its determination may involve the acceptance of opinions, expert or otherwise.

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In the long run it may be the outcome of an exercise of judgment. But however arrived at, the result is a figure, the assessable income in fact of the particular taxpayer for the year of tax … The issue on such an appeal is what in fact is the assessable income of the taxpayer derived in the relevant year of tax. No doubt where the Commissioner’s figure is the result of the application of some method of computation to figures not otherwise in dispute, the contest may appear to be one as to the appropriate method of computation of the income derived: and the determination of such a method of computation will resolve the issue, which is what is the amount of the assessable income derived. But unless the method of computation yields what is in fact the correct figure for that income it cannot be said to be appropriate in the circumstances or to be not inconsistent with the provisions of the Act. Whilst opinion may differ as to that fact, ultimately the opinion of this court will determine it.

[11.140] Again the ATO changed its practice, now assessing the income of professionals

under an accruals basis. This led to another challenge and again the ATO lost. In FCT v Firstenberg, McInerney J in the Supreme Court of Victoria concluded that the ATO had misunderstood the law laid down by the High Court in Henderson’s case.

FCT v Firstenberg [11.150] FCT v Firstenberg [1977] VR 1; (1976) 6 ATR 297; 76 ATC 4141 The taxpayer had from 1949 onwards practised as a solicitor in Melbourne on his own account, never in partnership with another solicitor. He had never employed a qualified employee or law clerk, his only employee at all relevant times having been a secretary/typist/telephonist … The present case is one where the figures (in the taxpayer’s books of account) are not in dispute. The “accruals basis” applied by the Commissioner yields one figure of the assessable income derived by the taxpayer; the receipts basis, applied by the taxpayer yields a different figure … It follows that it is for this court to say which method is more calculated to yield the correct figure for the amount of assessable income derived by the taxpayer in the relevant year of

income. It is clear from the Commissioner’s file that he rejected the taxpayer’s return only because he considered that he was bound by the decision in Henderson’s case to do so, and that he at no time applied his mind to the appropriateness in the individual facts of the taxpayer’s case, of using a “receipts” basis rather than an “accruals” basis … It is apparent, from a review of the cases cited [referring to Carden’s case and Henderson’s case] that the concept of “income derived” is one which will often take its content I the context in which it has to be applied, and that it may have very different content and significance when applied to the financial operations of a huge multi-national corporation, or a large trading company or business, or a large professional [11.150]

569

Allocating Income and Deductions to Periods – Timing

FCT v Firstenberg cont. partnership respectively than it would in the case of a one-man professional practitioner. I have come to the conclusion that in the case of a one-man professional practitioner the essential feature of income “derived” is receipt, and that, to adopt the phrase cited with such evident approval by Dixon J in Carden’s case – “receivability without receipt is nothing” … In the first place I think that Henderson’s case did not purport to lay down any rule that there was only one method – namely, the accruals method – of computing the taxable income of a taxpayer … I am not, in the case before me, dealing with the return of assessable income of a member of a large partnership carrying on a practice of the type considered in Henderson’s case where a considerable amount – possibly the great bulk of the work done by and in the name of the partnership was done by employees. Nor am I concerned with the proper method of computation of the assessable income of a member of a firm of solicitors practising their profession on a scale comparable with that of the firm of accountants in Henderson’s case. How far Henderson’s case is of general application I need not and do not seek to determine. My only concern is with the question whether a return of assessable income of this taxpayer, based on fees received, and not on fees earned, during that year of income.

In the relevant year the taxpayer conducted a one-man practice in which the exercise by him of his own personal professional skill and experience – his personal exertion – was the source of the income derived by him. The receipts of the practice during the relevant year represented in substance a reward for the professional skill and work of the taxpayer. The services rendered by his secretary/typist/telephonist – in return for the salary paid to her may be regarded as having contributed in a lesser and probably “only in a subsidiary or minimal degree” to the professional work for which the fees or costs were charged to and paid by the various clients for whom that professional work was performed. It is apparent also that there was, in the professional practice carried on by the taxpayer, “no fund or circulating capital from which income or profit must be detached for actual employment” … I am of the view that the “accruals basis” is, in the case of a practice such as this taxpayer’s, an artificial, unreal and unreasonably burdensome method of arriving at the income derived. The provisions of s. 63 as to bad debts do nothing to remove this impression. The books of account kept by the taxpayer were adequate for ascertaining the income received by him in any year of income. His return of income received, based on the information contained in those books, constituted a full and complete statement of the total income “derived” by him during the year as income and ought to have been accepted by the Commissioner, for the Commissioner was, by that return, enabled to make an assessment of the taxable income derived by the taxpayer.

[11.160] The ATO has expressed its understanding of the result reached in these cases in

Ruling TR 98/1, although how much reliance can be placed on this document is unsure – para 3 of the Ruling says it “is not intended to be prescriptive; rather it should be used as a guide”.

Ruling TR 98/1 [11.170] Accounting Method 18. The receipts method is likely to be appropriate to determine: • income derived by an employee; 570

[11.160]

• non-business income derived from the provision of knowledge or the exercise of skill possessed by the taxpayer; and

Tax Accounting

Ruling TR 98/1 cont. • business income where the income is derived from the provision of knowledge or the exercise of skill possessed by the taxpayer in the provision of services. 19. As a general rule, the receipts method is appropriate to determine income derived from investments. However, there are exceptions to the general rule. 20. The earnings method is, in most cases, appropriate to determine business income derived from a trading or manufacturing business. 21. In cases not clearly within the descriptions at paragraphs 18 to 20 … in the majority of cases we expect that the earnings method would be the most appropriate method of determining the income that has been derived for tax purposes. 22. Where a taxpayer has business income from more than one business activity, a separate evaluation should be made for each activity and a determination made as to which method is appropriate for the accounting of that income. In most cases, the same method is likely to be appropriate for income from all of these business activities. Fine distinctions are not necessary where the differences between the various business activities are not significant. … Business income: the in-between cases 52. Many taxpayers derive business income of a type that is not clearly covered by the nontrading, or trading, distinction. For such taxpayers the factors listed at paragraphs 53 to 59 may be particularly relevant. Generally, we consider that the circumstances mentioned in paragraphs 53 to 59, if significant, indicate that the earnings method should be used, except in those circumstances where it is an “… artificial, unreal and unreasonably burdensome method of arriving at the income derived”. Size of business 53. The larger the business structure, the more likely is the reliance on employees and capital equipment to generate income and the more likely the earnings method of accounting is appropriate. In this regard, the size and function of any related entity should be taken into consideration.

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Circulating capital and consumables 54. Income may be generated by circulating capital or consumables and not by the taxpayer’s services. 55. Where a taxpayer relies, to a significant extent, on circulating capital or consumables to produce income it is likely that the appropriate method for determining income is the earnings method. Similarly, where a taxpayer’s employees directly generate significant income, the earnings method is likely to be appropriate to account for that income in the relevant year. Also, where other variable costs of the taxpayer’s business have a direct relationship, and significantly contribute, to the income produced, that income should be brought to account using the earnings method. Capital items 56. The reliance placed by the taxpayer on the use of capital items, such as plant and machinery, to produce income is relevant. This is particularly so where expenses relating to the capital items have a direct relationship to the income produced. The greater the reliance, the greater the likelihood that the earnings method is the appropriate accounting method. Credit policy and debt recovery 57. The debt collection policy of a taxpayer, who readily gives credit, and who relies on amounts owing by debtors to support drawings or other payments, is a relevant indicator. For example, where a taxpayer has formal procedures for extending credit and collecting debts, the earnings basis is likely to be the more appropriate accounting method. The opposite conclusion could be reached where, subject to other factors, a taxpayer did not usually provide credit, the likelihood of debt recovery was low and recovery was generally not pursued. Books of account 58. The ITAA does not prescribe the books of account that a taxpayer carrying on a business must keep. All that is required is that the records kept “… record and explain all transactions and other acts”: s. 262A(1) ITAA 1936. 59. However, where the books of account are kept, the way they are kept is relevant but not [11.170]

571

Allocating Income and Deductions to Periods – Timing

Ruling TR 98/1 cont.

[11.175]

determinative to the question of when income has been derived.

Questions

11.5

The factors identified by the courts as controlling the choice of tax accounting method include the existence of a large volume of bad debts, the possession of trading stock, the size of overheads and the size of undertaking. Why are these factors relevant and how do they affect the choice? Can you identify any important differences in the list that the ATO has prepared in Taxation Ruling TR 98/1?

11.6

An accountant carried on business as a sole practitioner. He employed several members of his family as clerks but rarely any other qualified accounting staff. He billed most clients for work when a matter was completed, although one or two clients were billed quarterly. Is he permitted to account for the income of his practice on the cash receipts basis? (See FCT v Dunn (1989) 20 ATR 356; 89 ATC 4141.)

11.7

The taxpayers were pathologists who practised in partnership. The partners paid a service company to provide the services that the partnership required such as providing large items of diagnostic equipment, secretarial and courier services, use of premises to see patients, and employing nurses and technicians. The annual turnover of the practice was about $2 m per annum. The taxpayer argued that the income of the partnership could still be calculated on the cash basis because it simply sent out invoices and paid fees to another company for these extensive services. Should the existence of the service company make a difference to the accounting of the practice? (See Barratt v FCT (1992) 36 FCR 222; 23 ATR 339; 92 ATC 4275.)

[11.180] The position reached in these cases applies only in so far as the Act does not provide

some other more specific rule for recognising income or deductions. Attention therefore needs to be paid to the specific sections of the Act under which an amount is alleged to be included in income or allowed as a deduction. Three different types of rules can be seen: • Section 27H of the ITAA 1936, for example, relies upon common law notions by including supplements to annuities “derived” by the taxpayer. Similarly, s 25-10 allows a taxpayer to deduct an amount “incurred” as a repair. So, that statutory test does not appear to require something different from the common law test. The interesting question is whether such sections just confirm accrual accounting where an accruals basis is otherwise appropriate, or whether they actually mandate accrual accounting for taxpayers for whom cash would be appropriate. • Some other sections specifically limit the taxpayer, even accruals basis taxpayers, to a cash basis for particular types of income or outgoings. For example, s 25-15 allows the taxpayer to deduct only an amount it “pays” for failing to meet an obligation to keep the property in good repair. • Finally, some sections adopt unusual tests. Some sections such as s 15-2 of the ITAA 1997 and s 44(1) of the ITAA 1936 look to the actions of the payer (ie the payment or provision) to determine whether the recipient has derived income, while s 25-35 of the ITAA 1997 looks to the making of an entry in the taxpayer’s accounts (writing off a debt), and so on. Other very specific accounting regimes are also examined in the next chapter. 572

[11.175]

Tax Accounting

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(b) Recognising Income [11.190] The previous discussion tried to distinguish taxpayers for whom the cash or receipts

method is the more appropriate method of recognising income from those for whom accruals is the more appropriate. As the derivation of income by a taxpayer for whom a cash basis is appropriate will depend upon the receipt of cash, the next question must be: what amounts to cash “receipt”? The answer to this question really involves two issues: where cash is not tendered, what is equivalent to cash; and has there been receipt? [11.195]

Questions

11.8 11.9

Has there been a derivation if the taxpayer receives a cheque? What if the taxpayer receives a promissory note payable with or without interest in 90 days? Does it make any difference if the taxpayer negotiates the note to a factor or uses the note as security to obtain an advance? 11.10 In the case of a barter transaction, how much income is realised? 11.11 In the case of bank accounts, amounts of interest are credited to taxpayers’ accounts at particular dates in the bank’s systems, but the amounts might not be entered in the taxpayer’s passbook until a later date. When is the amount of interest derived? 11.12 What happens if the amount credited is never received by the taxpayer because, for example, the institution is put into liquidation? In the case of the collapsed Victorian building societies (Pyramid, Geelong and Countrywide societies) taxpayers probably reported interest credited to their accounts only to find when they tried to withdraw it that the interest (and even their principal) was not recoverable. The ATO issued Ruling IT 2604 (it has since been withdrawn as it is no longer needed). The Ruling effectively treated the interest as not income until it was withdrawn by the taxpayer from the account (and adopting a principal-recovered-first rule for withdrawals). Is this correct? How else might the unpaid interest have been dealt with? 11.13 An employee receives a cheque for $1,200 for wages on 28 June. She deposits the cheque into her bank account on the same day. On 4 July she is informed that the cheque has been dishonoured and her account is debited. Did she derive income in the year ending 30 June? If so, would she be entitled to a bad debt deduction in the next tax year? For the ATO’s view, see Taxation Determination TD 92/201. [11.200] The second issue is the extent of any exceptions to the requirement of receipt. The

issue usually arises when courts face the dilemma whether a cash basis taxpayer can prevent derivation, and hence tax, by avoiding or diverting the receipt of income. This possibility is dealt with to some extent by the operation of ss 6-5(4) and 6-10(3) of the ITAA 1997 (formerly s 19 of the ITAA 1936) and the possible operation of a supplementary common law doctrine of constructive receipt. Similar statutory rules are now often being added in other parts of the Act such as s 307-15 (superannuation benefits are treated as received if they are applied at the taxpayer’s direction) or s 775-110 (for transactions with foreign currency). Both of these ideas supplement the requirement that a cash basis taxpayer has not derived income until the taxpayer has received cash or something equivalent to cash. The issue whether a taxpayer had derived income despite not receiving cash arose in Permanent Trustee Co of NSW Ltd v FCT (1940) 6 ATD 5. A deceased taxpayer had lent money to his former partner and to the partnership upon which interest was accruing according to the terms of the loan. The lender never received any interest payments. Upon the dissolution of the partnership, the parties to the loan executed a deed confirming the loans and that the interest was outstanding, and providing security for the principal and interest. The Commissioner assessed [11.200]

573

Allocating Income and Deductions to Periods – Timing

the deceased on the interest. Rich J, in the High Court, discussed the scope for s 19 to create a derivation of income even though cash had not been received. He said s 19 did not apply: The object [of s 19] is to prevent a taxpayer escaping tax though his resources have actually been increased by the accrual of the income and its transformation into some form of capital wealth or its utilisation for some purpose. If, when the deceased entered into the deed of dissolution of partnership, he had obtained an investment for the moneys due to him including interest adequate to cover it, providing him with the equivalent in a capital form of everything due to him, the case might not have been very different from that of a man who obtains a cheque for interest from the debtor and hands it back to him as part of a new investment on fixed mortgage on adequate security. But here the facts show that the deceased got nothing except a new obligation to pay in exchange for an existing obligation to pay. He was no nearer getting his money or of transferring it into anything of any value. His debtor could neither pay nor secure payment of the debt to him except by charging it on property already heavily mortgaged and quite incapable of producing a surplus out of which the amount representing interest could be paid … The facts in this case show that there was not “an actually realised or realisable profit”. All that happened in this case was to change a forlorn hope of interest into a still more forlorn hope of capital.

How much interference with the passage of income to the taxpayer is needed before either the doctrine of constructive receipt or s 19 will operate? This issue arose in Brent v FCT, which we have already looked at in Chapter 4. The taxpayer was the wife of Ronald Biggs, one of the Great Train Robbers, and she sold her exclusive life story to a media network for $62,250. The terms of the sale provided that she was to be paid $10,000 on signing an agreement (which was to be held by her solicitor on trust for the company until the agreement was signed), $40,000 on signing the manuscript, and $15,250 30 days after signing the manuscript. The $10,000 was paid to her solicitor but no further amounts were ever paid – no explanation for her generosity appears in the report. When the deal was reported in the press, the ATO immediately issued an income tax assessment for $39,983 tax, claiming that the whole $65,250 was current income as a reward for services. Gibbs J in the High Court agreed that the payment was assessable as a reward for services but found that the whole of the amount promised was not yet taxable. He first considered whether the cash or accruals basis was most appropriate to her in respect of this income.

Brent v FCT [11.210] Brent v FCT (1971) 125 CLR 418; 2 ATR 563; 71 ATC 4195 In the present case the taxpayer did not carry on a business or profession. She had no stock-intrade. Her expenditure did not correspond with, or materially contribute to, her earnings. What she received, and was entitled to receive, was a reward for personal services. If the whole of the amount receivable was treated as income in the year in question, and part of that debt proved bad, there was not likely to be any income in a future taxation year against which the bad debt could be written-off. There is no commercial practice, or principle of accountancy, that requires the whole of the amount due to the appellant in a 574

[11.210]

case such as the present to be brought into account for the year in which it was earned. In all the circumstances of the case it seems to me that the true income derived by the appellant was the amount that she actually received in the year in question … He then considered the Commissioner’s alternative argument that even if the taxpayer was entitled to account on a cash basis, nevertheless the whole of the sum promised had been dealt with by the taxpayer and so was assessable even though not received in the current year.

Tax Accounting

Brent v FCT cont. In an alternative argument in support of the assessment, counsel for the Commissioner relied upon s. 19 of the Act … It was submitted on behalf of the Commissioner that the appellant had failed to show that the balance of the money due to her had not been dealt with on her behalf or in accordance with her directions. However, the evidence is simply that the appellant did not ask for payment and that the company refrained from making payment. On the evidence I decline to hold that the company held the balance of the money pursuant to a request by the appellant not

CHAPTER 11

to pay it. However, even if the company had deferred payment at the request of the appellant, s. 19 would not have applied. Income is not “dealt with”, under s. 19 when all that happens is that a debtor refrains from paying his debt at the request of the borrower … In the present case, even if the money had been retained at the request of the appellant, her position would have remained exactly as it was; the income would not have been used on her behalf and the company would have remained under an obligation to pay it to her. There is not the slightest ground in the present case for applying the provisions of s. 19.

[11.220] The issue of constructive receipt arose in Brent because of her unexplained failure to

seek payment, but it is also predicated upon the finding that the money was salary income, not merely that it was income. The tax accounting consequences might have been different if the Court had found that the $62,250 was income either from the sale of her copyright, or the proceeds of her business as an author. [11.225]

Questions

11.14 Consider the position of a taxpayer who directs their employer to withhold 90% of her or his gross salary each week and pay it instead to another – say the bank or supermarket. Has the taxpayer successfully avoided deriving income even though undoubtedly enjoying the benefit of income? What if the amount is instead to be paid into a superannuation fund as a salary sacrifice? See TR 2001/10. 11.15 Consider the position of a taxpayer who directs their employer to withhold 90% of their gross salary each week and pay it instead to another – say the bank or supermarket. Has the taxpayer successfully converted income (taxable to him or her) into a fringe benefit (taxable to the employer)? (See AAT Case 11,523 (1996) 34 ATR 1165; Case 1/97 (1997) 97 ATC 101.) 11.16 It will also be noticed that Brent did not, at least initially, receive the first instalment of $10,000 – it was paid to her solicitor and then to a second solicitor and yet she was held to have derived this amount. Why was she held to have derived the $10,000? 11.17 The newspaper did eventually pay Brent $15,266.55 – the balance of $65,250 after deducting the tax of $39,983.45 – in July 1970. How much income did she derive and when? 11.18 A garnishee order is an order permitting a judgment creditor to seize a debt owed by a third party to the judgment debtor in satisfaction of the judgment debt. The two debts most usually seized by creditors are bank accounts and wages, extracted directly from the bank or employer. Is an employee still liable to pay tax on wages which were never received by the employee but were seized by a judgment creditor direct from the employer? 11.19 One form of income splitting was the so-called “doctors’ receivables scheme”. It involved specialist medical practitioners who operated on a cash basis assigning their outstanding bills to a spouse and directing the patient to pay the spouse rather than the [11.225]

575

Allocating Income and Deductions to Periods – Timing

doctor. The doctor would then claim not to have derived income because cash was never received for the bill. Is this effective? If not, when does the doctor derive the income – when the bills are assigned or when the patients pay them to the spouse? (See AAT Case 4611 (1988) 19 ATR 3895; Case V142 (1988) 88 ATC 891.) 11.20 What is the impact of CGT on the viability of the doctors’ receivables scheme?

(c) Recognising Outgoings [11.230] The logical corollary of the cash accounting regime for income should be a cash

accounting regime for deductions which recognises outgoings when cash is paid by the taxpayer. But there is a view that there is no place for cash accounting in recognising allowable deductions. Instead, it is argued, all deductions are to be accounted for on a basis which is effectively an accruals basis. The argument is that deductions are claimed when they are “incurred” and this word has a precise and specific meaning – unlike the word “derived” – established by the cases, and that meaning effectively imports accrual accounting. See, for example, the discussions in BT Colditz, “Tax Accounting”, in R Krever (ed), Australian Taxation: Principles and Practice, Longman, Melbourne, 1987, pp 191-193; R Woellner, T Vella and R Chippendale, Australian Taxation Law, CCH Limited, Sydney, 1987, p 654; but compare RW Parsons, Income Taxation in Australia, Law Book Co Ltd, Sydney, 1985, para 11.174. Such a position would make Australia unlike most other jurisdictions such as Canada, the United States or the United Kingdom where cash accounting has application for both income and deductions. We do not propose to attempt to resolve this debate – there is too little authority on either side to make one view “correct”. The ATO has acknowledged this debate in Taxation Ruling TR 97/7 and has ruled that, as a matter of administrative convenience, taxpayers can use cash accounting for their deductions if they wish to, and if they insist, the ATO will accept income reported on a cash basis and deductions on an accruals basis, provided the transition to such a combination is handled in a particular way.

Ruling TR 97/7 [11.240] Timing of Deductions 1. This Ruling sets out the views of the Australian Taxation Office on whether the word “incurred”, in s 8-1 of the Income Tax Assessment Act 1997 (ITAA), has the same meaning for taxpayers who return their income on a receipts basis as it does for those taxpayers who generally return their income on an earnings basis … 10. The ATO recognises that there is a difference of opinion about the meaning of “incurred” for taxpayers who use a cash based accounting system, and who do not keep elaborate books of account. This Ruling explains that, in certain circumstances, such taxpayers are able to claim relevant expenditure prior to the outgoing actually having been paid. 576

[11.230]

11. However, many small business taxpayers use a cash received and expenditure paid basis both for their accounts and for taxation purposes. Additionally, many non-business taxpayers use a cash received and cash paid basis for taxation purposes: few maintain an elaborate accounting system. 12. It has long been established practice, where the receipts basis is the appropriate method to account for income, to accept the returns lodged by taxpayers, notwithstanding that both income and expenses have been accounted for on a cash receipts basis. However, we have insisted that this basis should be adopted consistently year by year, and that there be no doubling up of deductions. That is, you cannot

Tax Accounting

Ruling TR 97/7 cont. claim an unpaid expense in one year on the basis that it has been incurred, and then claim again in a subsequent year when it is paid. 13. In the interests of practical administration, there is no intention to disturb this practice. 14. If taxpayers now want to claim deductible outgoings incurred but not claimed in a previous year, they can seek amendment(s) of their assessment(s), subject to the four year limitation set by subsection 170(3) Income Tax Assessment Act 1936 (refer Taxation Ruling IT 2613).

[11.245]

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Alternatively, as a transitional measure to avoid unnecessary compliance costs, where a taxpayer has incurred a deductible outgoing in the 1995/96 year, but not claimed that deduction in the return because it was unpaid, the Commissioner will accept a claim for the deduction when it is actually paid in the 1996/97 year, in addition to other outgoings actually incurred in the 1996/97 year. A taxpayer who adopts this approach in 1996/97, or seeks amendments as outlined above, whether in 1996/97 or later, is expected to continue to claim deductions on this same basis for subsequent years.

Questions

11.21 When will a taxpayer have incurred expenses which are met by drawing a cheque, presenting a credit card, delivering an IOU or making a pay-by-phone arrangement using a credit card number? 11.22 The doctrine of constructive receipt deems a taxpayer to have received income when it is dealt with on the taxpayer’s behalf. How would tax accounting deal with a set-off? For example, if a bank appropriates interest payable on a savings account in reduction of the overdraft on another account, will the customer taxpayer have derived the interest income and “paid” the interest expense, and if so, when? (See Taxation Ruling TR 93/6.) 11.23 Will the result be any different if the taxpayer instructs the bank to pay the interest directly to a third party such as a supplier of goods? Will the taxpayer have incurred the expense, and if so, when? 11.24 What treatment will apply to a revenue outgoing (say, an account for goods sold and delivered) paid by the executor of the deceased who operated on a cash basis? 11.25 The taxpayer enters an arrangement with its bank under which the taxpayer borrows a single amount of money which is notionally “split” between two loan accounts. One account is for private purposes and the other is for the taxpayer’s business. The taxpayer directs in the loan documents that any interest repayments made by the taxpayer are to be applied by the bank to reduce the private loan first, and then the business loan only when the interest on the private loan is repaid. During the initial period, the interest on the business account accumulates and is added to the principal (even though the taxpayer’s total outstanding debt does not increase). The taxpayer claims a deduction for the capitalised interest on the business loan, even though no repayments are made in respect of that loan. Assuming the interest on the business loan was deductible, when would it be deductible? (The deductibility issue is answered in Hart’s case, but the timing issue is not – see Taxation Ruling TR 98/22 and TD 2008/27.)

[11.245]

577

Allocating Income and Deductions to Periods – Timing

3. ACCRUALS ACCOUNTING FOR INCOME AND DEDUCTIONS [11.250] The earnings or accruals basis is the method of accounting used by most businesses,

companies, trading trusts and large partnerships in respect of their trading income and deductions. You will remember that under accruals accounting, unlike cash accounting, payment or receipt is not an event with accounting consequences – it merely confirms the entries already made.

(a) Recognising Income (i) Advancing the recognition of income [11.260] According to accruals accounting, income should be recognised in the period in

which it is “earned” rather than when it is received. The distinction being made is clear (though it might not be quite so easy to judge when earning is to occur) and in a sophisticated system of accounting obviously the earning notion must be preferable. But the ability to recognise income when it is earned comes at the expense of certainty. One virtue of cash accounting is that the correct time for recording events (receipt or payment) is reasonably obvious. Accruals accounting, on the other hand, looks to some point of time other than receipt and, as a result, introduces uncertainty into the calculation process. A degree of judgment must be exercised in at least two respects: first, in reaching a conclusion that the eventual receipt is sufficiently certain that it can be said to be “realised”; and second, in allocating the anticipated receipt to a period in which it is said to be earned. When the amount is both realised and earned, it warrants being included in the current accounts. The first problem we need to examine is the realisation requirement. At what point should income be recognised if the time of derivation is advanced prior to receipt? For example, assume the taxpayer is a lawyer who undertakes to do some work for a client. Should the taxpayer be treated as deriving income: (a) when he or she has undertaken some work toward the task; (b) when he or she would be entitled to send a bill for the work done to date but has not yet done so; (c) when a bill for the work is eventually sent to the client; or (d) when the bill is due to be paid (even though it has not been paid). In Henderson one issue considered by the High Court was whether any amount of income ought to be included in the accounting firm’s tax accounts to represent “work in progress” – that is, the work done to date but for which no bill has yet been prepared, let alone sent.

Henderson v FCT [11.270] Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 In ascertaining earnings, only fees which have matured into recoverable debts should be included as earnings. In presenting figures before his Honour allowance was made for what was termed “work in progress”. But this, in my opinion, is an entirely inappropriate concept in relation to the performance of such professional services as are accorded in an accountancy practice when ascertaining the income derived by the person or persons performing the work. 578

[11.250]

When the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned and it or they will be income derived in the period of time in which it or they have become recoverable. But until that time has arrived, there is, in my opinion, no basis when determining the income derived in a period for estimating the value of the services so far performed but for which payment cannot

Tax Accounting

Henderson v FCT cont. properly be demanded and treating that value as part of the earnings of the professional practice up to that time and as part of the income derived in that period. Consequently, in determining the income of the partnership in either of the years in question for the purposes of assessment of tax,

CHAPTER 11

only accrued fees may be included in that income. I have used the word “recoverable” to describe the point at which income is derived by the performance of services. I ought to add that fees would be relevantly recoverable though by reason of special arrangement between the partnership and the client, time to pay was afforded.

[11.280] The ATO has issued a Ruling TR 93/11 which takes the view in para 3 that: … the question of when professional fee income is derived under s. 25(1) ITAA needs to be determined by reference to the facts of each case, and especially by reference to the terms of the contract or arrangement entered into between the professional person and the client. In particular, it is necessary to determine when, on a proper construction of the contract or arrangement, a recoverable debt is created such that the professional person is not obliged to take any further steps before becoming entitled to payment. A fee is “recoverable” in the relevant sense even if time to pay has been allowed.

The Ruling then goes on to examine the results for contracts where a recoverable debt arises only on issuing a final bill, when the work is complete (even if unbilled) and when the fee is earned progressively. The Ruling does not, however, state how these contracts are to be distinguished. It also takes the view that, “a statutory impediment [such as exists in many consumer protection laws] to a professional person commencing legal proceedings for recovery of fees does not defer the time at which he or she derives the income”. [11.285]

Questions

11.26 A real estate agent locates a buyer for a particular parcel of land. Under the terms of the agency arrangement, the seller becomes liable to pay the agent a commission if the agent locates “a ready and willing buyer who purchases the property”. On 1 June a buyer signs a contract to purchase the property and pays a deposit of 10% of the price to the agent which is held in its Trust Account on behalf of the vendor and purchaser until completion. The agent is permitted to deduct its commission from the deposit and forward the balance to the vendor on completion of the sale. The sale is completed on 1 August. In which year did the agent derive its commission? (See Taxation Ruling TR 97/5.) 11.27 What would happen, so far as the taxation of the real estate agent is concerned, if the buyer defaulted and the whole of the deposit was remitted to the seller as liquidated damages? [11.290] In Henderson the firm had not completed the services which their clients had sought

as at 30 June, neither had it quantified the value of the work in progress nor asked its customers to pay. A similar situation arose in FCT v Australian Gas Light Co, although in this case the taxpayer had, at least, delivered to the customer the service for which it would be entitled to send a bill – its financial accounts probably showed an estimate of how much had been delivered by the end of each year. The company provided gas services to households and the ATO argued that the company should have disclosed as income some amount representing gas which had been consumed by the households as at 30 June. The company claimed that no income had been derived because it had not yet taken the necessary reading from the [11.290]

579

Allocating Income and Deductions to Periods – Timing

consumers’ gas meters nor had it sent bills to the customers. Bowen CJ, Fisher and Lockhart JJ agreed that in these circumstances no income had been derived in respect of this supplied but unquantified, and definitely unbilled, gas.

FCT v Australian Gas Light Co [11.300] FCT v Australian Gas Light Co (1983) 15 ATR 105; 83 ATC 4800 Large numbers of consumers are involved so that meter readings and accounts sent out based thereon are cyclical or staggered over different days throughout the year and this is an important feature of the case. Although procedures and systems have been devised for the reading of meters and billing of accounts it has not during the relevant period, and both before and since, been possible to ensure that meters are read at the end of every quarter or month as the case may be. Many factors over which there is no control can cause billing periods to vary such as weather, staff absences, leave granted at short notice, industrial disturbances, leap years, need to get ahead of schedule for special purposes, data processing failures, loss or delay of documents in transit, inability to gain access to premises to read meters, reading errors, meter failure or behaviour, customer and meter movements, and the need to make the optimum use of reading personnel and strength …

required of them under their obligation to supply gas during this period, they should bring to account as additional sales that value or estimated value of the unbilled gas. The Commissioner placed particular emphasis on the fact that the property in the gas supplied through meters during this time had passed, and passed beyond recall, to the customers … The registration of a customer’s gas meter is prima facie evidence of the quantity of gas supplied and determines the quantitative basis on which he is obliged to pay. The reading of the meter and the giving of notice to the customer of what is registered are more than mere procedure. They are conditions precedent to the making of demand for payment. A gas company is obliged to commence and continue the supply of gas subject to certain exceptions including the failure of a customer to pay his gas bill …

The consequences are that as at 30 June in any year there will be a large number of domestic consumers whose quarter will not have expired, whose meters accordingly will not have been read and who will not receive accounts until after the close of the quarter, sometime in the ensuing period up to a quarter less a few days in the next financial year, whereupon payment normally follows after some 14 days.

It is true that the taxpayers could physically read all meters within their respective districts on 30 June; but, apart from the obvious commercial impracticability of such a course, there are legal restraints imposed on them from demanding payment for gas consumed up to that date. First, the taxpayers are obliged to supply for a quarterly period. The relationship between each taxpayer and its domestic consumers is governed by statute and regulation which, in the light of the tariff, obliges it to supply for a quarterly period …

As at 30 June in the relevant years there was what was described in the evidence and by the primary judge as “unbilled or unpaid revenue” or, expressed in terms of supply, “unbilled gas” which had been paid for by the customer and in respect of which no moneys had been received by the taxpayers up to 30 June of the relevant year … There is no doubt that what the transactions with consumers produce is income, but the question for decision is when is that income derived? The Commissioner submitted that, as the taxpayers had done all that was

The consequences of the exceptional manner in which the taxpayers operate is that as at 30 June in each year their claims against consumers for current liabilities for gas supplied have not matured into recoverable debts. The method of accounting adopted by the taxpayers was in our opinion dictated by obligations imposed upon them, both in their dealings with customers and with the Board which fixed their tariff or rates for domestic consumers. Furthermore, payment cannot be required of customers until their meters have been read and

580

[11.300]

Tax Accounting

FCT v Australian Gas Light Co cont. accounts rendered. Thus the taxpayers contend that they cannot regard the amounts for which

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customers are contingently liable on 30 June each year as recoverable debts. Their method of accounting is in accord with this conclusion.

[11.310] One obvious situation where the uncertainty of eventual receipt may indicate that

there is as yet no income realised, would be where the whole of an amount is still subject to a variety of contingencies. But what should happen if there are contingencies which, if they occur, will only affect some portion of the amount? One example of this kind of problem would be volume discounts or discounts for prompt payment. What happens if the seller delivers goods in June and charges a price, but the price will decrease if the buyer has purchased more than a certain quantity by 31 December? Another example would be a discount for prompt payment – for example, goods are sold and delivered on 15 June for a price of $10,000, but if the buyer pays the invoice within 30 days, the price is $9,000. In Ballarat Brewing Co v FCT the company was a brewer and sold its products with a discount for prompt payment (and for complying with dubious restrictive trade practices). The discount was almost never refused or withdrawn, even if the precise terms for the discount had not actually been met. The company disclosed as income only the expected net price on each invoice but the Commissioner argued that the company should disclose the gross price and claim (later) a deduction for any discount allowed. This would, of course, have advanced the taxpayer’s tax liability. In the High Court, Fullagar J agreed with the taxpayer’s method of tax accounting.

Ballarat Brewing Co v FCT [11.320] Ballarat Brewing Co v FCT (1951) 82 CLR 364; 5 AITR 151; 9 ATD 254 The matter seems to me to be a matter of arriving at the correct figure for a primary item in the relevant calculation, the correct figure to ascribe to “sales” for the relevant accounting period. The question does not depend upon any express provision to be found in the Act. It depends upon the conceptions of business and the principles and practices of commercial accountancy … Which figure – the Commissioner’s or the company’s – represents, or more nearly represents, the truth and reality of the situation? The company’s figure brings into account what the company will, in the light of all past experience and policy, almost certainly receive in respect of book debts – no more and no less. The Commissioner’s figure brings into account sums which the company will certainly, or almost certainly, not receive in respect of book debts. A trading account and profit and loss account based on the latter figure would be misleading,

and there is nothing in the Act which requires the assessment of income on the basis of accounts which would be misleading in this respect … [Counsel for the Commissioner] invited me to suppose a case in which such discounts or rebates as we have here were habitually not allowed in fact, and suggests that such a case could not be different from the present case. But, in my opinion, that case would be entirely different from the present case. In that supposed case the truth and reality of the position would be revealed by bringing into account the gross prices for which the goods were sold, because it would be the gross prices which would certainly, or almost certainly, be realised. Here it is the net prices only which will certainly, or almost certainly, be realised … It might perhaps be suggested that, in calculating the amount in issue, some allowance should be made for the possibility of [11.320]

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Allocating Income and Deductions to Periods – Timing

Ballarat Brewing Co v FCT cont. “disallowance” of discounts. I think, however,

that, on [the witness’] evidence, the amount which it would be proper to allow for this possibility would be negligible.

[11.330] The ATO has issued Taxation Ruling TR 96/20 which takes the view that the vendor

derives “the full invoice price” when goods are sold with a discount for prompt payment. In deference to Ballarat Brewing Co v FCT, however, the Ruling says, “the only exception to this general proposition is if facts are on all fours with Ballarat Brewing Co – there must be virtual certainty in the light of past experience and policy that the amount of the discount will not be received by the trader” (para 8). Similarly, the buyer is viewed as entitled to deduct the full invoice price (para 11). If the buyer qualifies for the discount: the debt created by the sale is recognised as a revenue asset under account receivables and replaces the previous revenue asset of trading stock. If the offer of a discount is accepted, the account receivable will be satisfied by the receipt of a lesser amount. The difference between the amount receivable and the amount actually received represents a revenue loss incurred on the disposal of the account receivable asset. A trader should therefore, claim at the time the account receivable is satisfied, the discount amount as an allowable deduction under s. 51(1).

And for the buyer, “if … the liability is extinguished by the payment of an amount less than the amount of the liability, the amount of the difference gives rise to a revenue gain because it has the character of income under ordinary concepts”. [11.335]

Questions

11.28 Examine s 25-35 of the ITAA 1997 to see what happens if the amount eventually received by an accruals basis taxpayer differs from the amount recorded in a prior period. When is this likely to be inadequate protection for a taxpayer? 11.29 Statutory prohibitions commonly prevent lawyers or medical practitioners from suing for their fees until after the expiry of an extended period (say, six months). Can their income be realised under an accruals basis before this period elapses? (See Barratt v FCT (1992) 36 FCR 222; 23 ATR 339; 92 ATC 4275.) If you think not, should they then be permitted to operate on a cash basis? 11.30 The taxpayer sells goods and delivers an invoice to the buyer claiming the price within 30 days. The buyer disputes that it owes the full invoiced amount and has paid nothing by the end of the tax year. The matter is settled in the next tax year and the seller collects some but not all of its money. Did the taxpayer derive the entire (but disputed) amount in the year when the invoice was rendered? (See BHP-Billiton Petroleum (Bass Strait) [2002] FCAFC 433; 51 ATR 520.) (ii) Deferring the recognition of income [11.340] Part of the flexibility of accruals accounting arises because it recognises income

before its receipt, but that is only part of the story. Receipt can succeed or precede the earning of an amount of income, and the tax accounting rules have imported from financial accounting a mechanism to defer the recognition of income until after it is received. In other words, there may be no derivation of income even though an amount of money has been received. This possibility was first approved by the High Court in Arthur Murray (NSW) Pty Ltd v FCT. The taxpayer provided dance lessons. It sold courses of tuition ranging from five to 582

[11.330]

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Tax Accounting

1,200 hours of instruction and usually received payment in advance, either in a lump sum or by instalments. Upon receipt of an advance payment, the company credited the amount to an account styled “Unearned deposits – Untaught Lessons Account” and then periodically transferred amounts to the “Earned Tuition Account” as lessons were taught. Although the contract with the customers provided that no refunds were given, occasionally the company would make partial refunds. It claimed that only the amounts transferred to the “Earned Tuition Account” were income and hence assessable. The High Court unanimously agreed.

Arthur Murray (NSW) Pty Ltd v FCT [11.350] Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; 9 AITR 673; 14 ATD 98 The ultimate inquiry, of course, must be whether that which has taken place, be it the earning or the receipt, is enough by itself to satisfy the general understanding among practical business people of what constitutes a derivation of income. A conclusion as to what that understanding is may be assisted by considering standard accountancy methods, for they have been evolved in the business community for the very purpose of reflecting received opinions as to the sound view to take of particular kinds of items. This was fully recognised and explained in Carden’s case, especially in the judgment of Dixon J; but it should be remarked that the court did not there do what we were invited to do in the course of the argument in the present case, namely to treat the issue as involving nothing more than an ascertainment of established bookkeeping methods. A judicial decision as to whether an amount received but not yet earned or an amount earned but not yet received is income must depend basically upon the judicial understanding of the meaning which the word conveys to those whose concern it is to observe the distinctions it implies. What ultimately matters is the concept; book-keeping methods are but evidence of the concept … In a case like the present the circumstances of the receipt do not prevent the amount received from becoming immediately the beneficial property of the company; for the fact that it has been paid in advance is not enough to affect it with any trust or charge, or to place any legal impediment in the way of the recipient’s dealing with it as he will. But those circumstances nevertheless make it surely necessary, as a matter of business good

sense, that the recipient should treat each amount of fees received but not yet earned as subject to the contingency that the whole or some part of it may have in effect to be paid back, even if only as damages, should the agreed quid pro quo not be rendered in due course. The possibility of having to make such a payment back (we speak, of course, in practical terms) is an inherent characteristic of the receipt itself. In our opinion it would be out of accord with the realities of the situation to hold, while the possibility remains, that the amount received has the quality of income derived by the company … In so far as the Act lays down a test for the inclusion of particular kinds of receipts in assessable income it is likewise true that commercial and accountancy practice cannot be substituted for the test. But the Act lays down no test for such a case as the present. The word income being used without relevant definition, is left to be understood in the sense which it has in the vocabulary of business affairs. To apply the concept which the word in that sense expresses is not to substitute some other test for the one prescribed in the Act; it is to give effect to the Act as it stands. Nothing in the Act is contradicted or ignored when a receipt of money as a prepayment under a contract for future services is said not to constitute by itself a derivation of assessable income. On the contrary, if the statement accords with ordinary business concepts in the community – and we are bound by the case stated to accept that it does – it applies the provisions of the Act according to their true meaning.

[11.350]

583

Allocating Income and Deductions to Periods – Timing

[11.360] This same kind of issue commonly arises in other commercial contexts, most notably

when dealing with warranties. Many products are sold subject to a warranty given by the vendor to rectify any faults appearing in the goods within a given period. In most cases, the purchaser still pays the price in full and relies on its contractual rights to enforce performance by the seller (although in the case of major construction contracts, it is not uncommon for the buyer to retain part of the price as additional security until the warranty period expires). The tax question that these transactions raise is this: is there any tax recognition in the year of sale for the future costs of meeting the warranty? In theory, if there were to be some recognition, there are two ways that the tax system might deal with warranties. One would be to exclude some of the income from the sale proceeds until the warranty expires, and the other is to claim a deduction for some estimate of the likely future expense. Either would allow the seller to defer recognising income from the cash received pending performance of its obligations under the warranty. This is the same logic as that in Arthur Murray (NSW) Pty Ltd – in that case, the receipt of cash does not reflect the taxpayer’s true income as it has received cash, at least in part, for providing services in the future. In the case of warranties, the receipt of cash does not reflect the taxpayer’s true income, as it still has to provide some of the services (under the warranty) in the future. Of course, the tax system could choose to do nothing in the year of sale: recognise the income from the sale in full in that year, and then require the taxpayer to claim deductions for meeting its warranty claims in succeeding years as they are made. In Ruling IT 2648, the ATO has indicated its view. The Ruling treats the entire price as derived when the goods are sold and permits the seller to claim deductions for costs incurred in meeting warranty claims only in future years as claims are made. In the other case described, where the purchaser retains part of the price until performance of the warranty claims, the ATO also indicated in the same Ruling that it will treat the entire price as derived at the time of sale, not when the balance is eventually paid. This matter of customer warranties was considered by the Privy Council in IRC (NZ) v Mitsubishi Motors (NZ) Ltd (1995) 31 ATR 350; 95 ATC 4711. The Privy Council adopted the second method of dealing with warranties and allowed the taxpayer to claim a deduction for its estimated cost of having to make repairs in the future on the new cars it sold with a 20,000 km warranty. The Privy Council took the view that the amount was sufficiently capable of reasonable estimation for it to be deductible in the year in which the car was sold. They did not go on to address the taxpayer’s alternate argument that it did not derive the full amount of the sale price if the car was sold. But they did note that if Mitsubishi “had actually made a separate charge for the warranty, there would be no difficulty about treating that income as earned over the warranty period rather than at the moment of sale”. While their Lordships were careful to distinguish the Australian and New Zealand income tax laws, the result in this case will no doubt encourage some taxpayers to challenge the ATO’s Ruling (or change their pricing practices). A similar issue arises in the case of conditional sales or arrangements which provide sale or return terms. For example, many distributors such as newsagencies, bookshops or clothing stores operate on the basis that they “only have to pay for the goods they sell”. Typically, while they pay for all the goods that are delivered to them at the time of delivery, they can return for 584

[11.360]

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full credit any merchandise that the retailer thinks is not going to sell. In this case, does the seller derive income when cash is received, or only when the distributor makes a sale, given that the seller may have to refund the price to the distributor? In Taxation Ruling TR 97/15 the ATO takes the view that the seller derives its income when the goods are delivered under such an arrangement. Any provision in the seller’s accounts to reflect the potential liability to refund the price is not deductible. Instead, the seller may claim a deduction under s 8-1 for a loss suffered when it remits the cash to the distributor. [11.365]

Question

11.31 The taxpayer provided preventative treatment against pest infestations with a 10-year warranty. The taxpayer performed treatments on houses built by speculative builders and received cash from them for the services. It treated part of the cash received as “unearned income”. Because the houses were unlikely to be owned by the builders for more than a short period, and because the builders never effectively assigned the benefit of the warranty to the purchasers, it was unlikely that the taxpayer could ever have been obliged to meet its warranty obligations. Could the taxpayer defer the income until the warranty elapsed? (See AAT Case 5181 (1989) 20 ATR 3694; Case W61 89 ATC 558.)

(b) Recognising Deductions [11.370] If accruals accounting for income recognises amounts as income before and after they are paid, accruals accounting for deductions should similarly allow deductions to be obtained by a taxpayer before or after an amount is paid. Financial accounting recognises expenses through the concept of “matching” – a two-step process which requires finding when an amount of income has been earned and then deducting the expenses which have produced that income. The recognition of expenses is therefore a subsidiary result of recognising income in the period and then matching to it the related expenses. This matching procedure will often require the accountant to deduct expenses which have not yet been paid. In theory, the tax accounting rules also permit this result, but the courts’ judgments in this area will often make any deduction difficult to obtain until payment is made.

(i) Advancing the recognition of deductions [11.380] Where an invoice has been paid, the deduction for the amount involved is probably

“incurred” for tax purposes, but can an expense be incurred before payment? The recognition of a deduction before any amount is paid by the taxpayer, is acknowledged as a possibility in many of the judgments, but similar problems to those examined above for income arise. The issue for the courts is to identify a point in time at which the taxpayer’s obligation is viewed as sufficiently certain; once that point has been passed, the expense is regarded as incurred and therefore deductible. In a sense, this is the equivalent of the need to find that income is sufficiently certain for it to be regarded as realised. For example, in FCT v James Flood Pty Ltd the company sought to deduct £578 representing a provision for future annual leave and sick pay obligations. Under the relevant award, 14 days annual leave entitlement accrued after 12 months continuous service. The taxpayer tried to deduct an amount representing the portions of the expected leave payment – say 50% of the expected payment for an employee who had worked six months as at 30 June. The High Court disallowed the deduction. [11.380]

585

Allocating Income and Deductions to Periods – Timing

FCT v James Flood Pty Ltd [11.390] FCT v James Flood Pty Ltd (1953) 88 CLR 492; 5 AITR 579; 10 ATD 240 The majority of the members of the Board [of Review] were of opinion that on this basis the taxpayer had, prior to 30 June 1947, incurred an outgoing in respect of the annual leave of his employees and, although the outgoing would not fall to be discharged until after that date, it was allowable as a deduction pursuant to s. 51(1). The view taken was that it was a definite pecuniary liability arising out of the employment of the employees and that it was impossible to escape it, although in the case of individual employees contingencies might occur which would deprive them of the right to payment. As the liability arose from the employing of the men at work during the accounting period prior to 30 June 1947, it was an outgoing which should be charged against the assessable income of the year then ending. The considerations which affect the correctness of this view must all arise from the provisions of the award. The argument before us, however, took a more general form. It was based to a great extent upon a conception of annual leave in the abstract as a period of leisure to which the employee became progressively entitled de die in diem as he worked and for which correspondingly the employer became progressively liable to pay as part of the cost of labour employed from day to day, actual payment only being deferred to the period of leave or the sooner determination of the employment. However serviceable generalised conceptions may be in relieving overburdened assessors and tax accountants of the need of examining particular situations, all a court can decide is the case before it. And as the nature and incidence of the liability in the case before us obviously depends on the provisions of the award it is that instrument we should consider and not the validity of some independent general proposition. Now in dealing with that instrument it is necessary at the outset to observe that under the award an employee may fail to become entitled to annual leave for a number of reasons. He may die, his employment may be terminated because of his own fault, there may be a strike, or he may be 586

[11.390]

guilty of absenteeism and be unable to rely on grounds of exception or excuse. From the employer’s point of view there is a further possibility. He may never become liable to give his employees two weeks’ leave on full pay because he may sell his business. There is a special provision which places the obligation in such a case upon the purchaser of the business. No doubt in that case the impending obligation would result in a diminution of the price of the business but that is a different thing from discharging the obligation. It may be true that all these reasons which, so to speak, would intercept the accruing right of an employee to be paid by the taxpayer are all of a particular character, but it is difficult to say in the face of them that there is a definite obligation to make a payment, incurred in respect of each completed month on that month being completed. Further, it is to be noticed that when the employment of a man is terminated without his fault before he has served 12 months the amount he received in respect of each completed month of service is not necessarily one-twelfth of the full two weeks’ pay for annual leave. The two things are calculated at different periods and the rates of pay may not be the same. A most important feature of the award is that leave must be taken and that it must be taken at a time which ex hypothesi in this given case falls outside the year of income. The payment is made to the employee in respect of that period of leave and forms part of his ordinary wages. The award therefore clearly regards the payment as something made in respect of the two weeks when leave is actually taken. Prima facie it prohibits the substitution of a money payment for the leave. The prima facie position is qualified only in the case of an employee who lawfully leaves his employment or whose employment is terminated without his fault. These considerations all seem to point to the conclusion that in the case of no given employee who has not completed his 12 months’ continuous service before 30 June 1947 could it be said that the taxpayer had incurred an

Tax Accounting

FCT v James Flood Pty Ltd cont. outgoing consisting in a proportion of the pay which would become payable to him should he do so, that is payable on the occasion when he took his annual leave … For under our law the facts must satisfy the expression “losses and outgoings incurred”. These words perhaps are but little more precise than the word “established” or the expression used above “definitively committed”. But they do not admit of the deduction of charges unless, in the course of gaining or producing the assessable income or carrying on the business, the taxpayer has completely subjected himself to them. It may be going too far to say that he must have come under an immediate obligation enforceable at law whether payable presently or at a future time. It is probably going too far to say that the obligation must be indefeasible. But it is certainly true that it is not a matter depending upon proper commercial and accountancy practice rather than jurisprudence. Commercial and accountancy practice may assist in ascertaining the true nature and incidence of the item as a step towards determining whether it answers the test laid down by s. 51(1) but it cannot be substituted for the test. To repeat what has been said before in relation to an analogous provision in the Act of 1922 to

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1934: “To come within that provision there must be a loss or outgoing actually incurred. ‘Incurred’ does not mean only defrayed, discharged, or borne, but rather it includes encountered, run into, or fallen upon. It is unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application. But it does not include a loss or expenditure which is no more than impending, threatened, or expected.” Nothing that was decided in W Nevill & Co Ltd v FCT [(1937) 56 CLR 290] was intended to imply that a liability to pay an ascertained sum is never incurred until the sum becomes due and payable … It is one thing, however, to say that it is not necessary, for the purposes of s. 51(1), that an actual disbursement should have taken place. It is another thing to say that in the present case the taxpayer had incurred a loss or outgoing in the year of income in respect of the pay of its men during the annual leave to be taken in the ensuing accounting period by employees whose service had not as yet qualified them for annual leave. In respect of those employees there was no debitum in praesenti solvendum in futuro. There was not an accrued obligation, whether absolute or defeasible. There was at best an inchoate liability in process of accrual but subject to a variety of contingencies.

[11.400] Not surprisingly, taxpayers regarded James Flood as a defeat, but one which held

out some hope of future victory for recognising a deduction for the anticipated leave payments. One taxpayer re-litigated a refined version of the James Flood case in Nilsen Development Laboratories Pty Ltd v FCT. The taxpayer sought a deduction only for leave payments for those employees who had actually completed the entire 12 months service period which entitled them to take leave (even though the employees had not yet taken their leave). Obviously the taxpayer’s obligation to make these payments was less conjectural than in James Flood, because these employees had served the full 12 months. But Barwick CJ found that no deduction for these anticipated leave payments was deductible.

Nilsen Development Laboratories Pty Ltd v FCT [11.410] Nilsen Development Laboratories Pty Ltd v FCT (1981) 144 CLR 616; 11 ATR 505; 81 ATC 4031 Some employees of the taxpayer had during or prior to the year of income in question become entitled to long service leave and some employees

had during that year become entitled to annual leave. But, though so entitled, no arrangements had been made for any such leave to be taken in [11.410]

587

Allocating Income and Deductions to Periods – Timing

Nilsen Development Laboratories Pty Ltd v FCT cont. the year of income. Consequently, none of those employees had in that year become entitled to be paid money either in respect of long service or in respect of annual leave. Their entitlement to be given leave in due course had become indefeasible, though the amount of the wages to be paid to them whilst on leave of either kind when the time came for it to be taken was not finally and unalterably fixed … What the taxpayer in substance claims to deduct from its gross income is an amount allowed in its commercial accounts to represent an estimate of what it would be bound to pay the employees if they had been on leave during the year of income less any amount which had been allowed in such account in earlier years in relation to that item. This is spoken of in argument as representing an “accrued liability”, not in the sense of a present liability but in the sense of liability which is now certain to arise in the future, that is, as a money sum in the least amount which would inevitably have to be paid in the future … Much discussion took place in the argument of these appeals and indeed in the judgments of both courts below as to the rationale and applicability of this court’s decision in FCT v James Flood Pty Ltd. Whilst this case may be said to afford useful guidance in the general area with which this case is presently concerned, I would not think that either the conclusions of that case or the reasons expressed therefore necessarily dispose of the problem now presented. In particular, I do not feel confident myself that the use of the word “accrual” in the reasons for judgment in that case was so accurate that its use could be translated into the present circumstances. To my mind, the court in truth in that case could have reached its conclusion directly on the ground that, in the case of award provisions such as were thus in question, only actual payment for leave being taken could support a claim for deduction under s. 51(1) …

In my opinion, it is abundantly clear from the terms of the Metal Industry Award and those of the Metal Trades (Long Service Leave) Award that the primary obligation placed on the employer by their terms is to give the employee who has served the requisite amount of time leave away from the employment whilst maintaining its continuity. Assuming the employer’s business continues and the employee remains alive, a pecuniary liability to the employee will undoubtedly arise when, but not before, the employee enters upon a period of leave, be it annual or long service. When the employee has served a period of employment which qualifies him for leave, whether it be annual or long service, it may thus confidently be said that sooner or later he must be given leave and that when he enters upon his leave a liability will then, and for the first time, arise for the employer to make a payment of money to him. It was suggested in argument that a liability to make such a payment was accruing during the time the employee was serving the period qualifying him for leave. But, in my opinion, it is not a precise or proper use of language to so describe the circumstance that an employee is becoming progressively qualified by length of service to be able to require that he be given leave of one sort or another. In my opinion, no liability is “accruing” in a proper sense of the word during the time that the employee is serving his qualifying period nor has it accrued when he has served that qualifying period. All that then can really be said is that it has become certain that, in due course when further events occur, that is to say, the time for the taking of leave is fixed and the period of leave is entered upon, a liability to pay money will arise. It is quite wrong, in my opinion, in this connection to treat any liability as either accruing or having accrued at any time prior to the time when the employee enters upon the leave, whether it be annual or long service.

[11.420] In case there was any room left for doubt, the Act was amended in 1978 by the

addition of what is now s 26-10 of the ITAA 1997, confirming that leave payments are not deductible until paid. 588

[11.420]

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It is instructive to contrast the result in Nilsen Development Laboratories with that reached by the Federal Court in FCT v AGC Ltd. In AGC, the taxpayer borrowed funds from the public upon terms, described in the judgments, which deferred its obligation to pay the accruing interest until the end of the loan when the debenture was redeemed. It sought a deduction for the accruing interest even though the amounts would not have to be paid for several years. On one construction of the terms of the borrowing, no interest was earned or payable until the debentures were eventually redeemed, which would seem to make relevant the reasoning of Barwick CJ in Nilsen, but all the members of the Federal Court permitted the deduction, distinguishing Nilsen. Toohey J observed as follows.

FCT v AGC Ltd [11.430] FCT v AGC Ltd (1984) 2 FCR 483; 15 ATR 982; 84 ATC 4642 The issue here is whether a borrower on the terms of such a debenture is entitled to a deduction under s. 51(1) of the Act for interest debited annually in its accounts … In challenging the decision of the Supreme Court of New South Wales that the amounts of interest raised in the taxpayer’s accounts fell within s. 51(1), the Commissioner made two principal submissions. The first was that the interest was not an outgoing incurred in the relevant year of income because the taxpayer “had not completely subjected itself to such interest”. The second was that no deduction may be allowed under s. 51(1) for the face value of interest payments which may not be payable for up to 20 years in the future. The taxpayer contested both propositions. Whatever the proper resolution of this appeal, the question to be answered is no abstract one. Nor is it a question to be answered by reference to the position of the parties on maturity or on redemption … It is well established that an outgoing may be incurred though the sum in question has not been paid or the liability discharged … It is also well established that an out-going may be incurred in the sense that a taxpayer may completely subject himself to a liability even though the liability is defeasible … In the light of the authorities, it is necessary to look more closely at the relationship between the taxpayer and those lending money to it under deferred interest debentures. In the Commissioner’s submission, by the terms of the contract between borrower and lender, interest was neither earned nor credited under redemption. Debentures could not be redeemed by the investor or his legal personal

representatives, with any legal entitlement to accrued interest, until after five years. Accordingly, it was said, forbearance by the investor for a minimum period of five years was a condition precedent to the taxpayer’s liability to pay interest … It is quite true that, by the terms of the special condition, stock is expressed to “earn and be credited with interest at redemption”. I do not think it is possible to read this expression disjunctively; syntax is against such a construction. As a matter of contract, investors may be held to the terms of the special conditions. But the question now before the court is not one of the circumstances in which an investor is entitled to be paid interest. The question is whether during the relevant income year the taxpayer subjected itself to a liability to pay interest under the deferred debentures. In my view it did so. Whether the debentures earned or were credited with interest prior to redemption in the sense in which that expression is used in the special conditions is a relevant consideration but it is not a determining one. If, before redemption, an investor was credited with interest or a debenture was expressed to earn interest, there would be little doubt of the taxpayer’s entitlement to treat the interest so credited or earned as an outgoing incurred in the year in which it was credited or expressed to be earned. But it is another thing to say that because interest is neither credited nor expressed to be earned the taxpayer is under no present liability to pay interest. On the issue of a deferred interest debenture the taxpayer became liable to pay to the stockholder interest in accordance with the [11.430]

589

Allocating Income and Deductions to Periods – Timing

FCT v AGC Ltd cont. terms of the debenture and any other relevant documents. If, in the unlikely event that the stockholder held the debenture for 20 years, it would mature and interest would be paid accordingly. If, in the more likely event, at some time in year six or thereafter the stockholder required redemption of the stock, again interest would be paid in accordance with the special conditions. The same is true in the event of the personal representatives of a deceased stockholder requiring redemption. In each case interest is payable as from the date of investment. The taxpayer’s liability to pay interest in respect of the first year of investment cannot be described as merely “impending, threatened or expected”. It is in truth, in the language of some of the decisions, a debitum in praesenti solvendum in futuro … Nilsen stresses the need for a presently existing liability before there can be an outgoing incurred within s. 51. But the case is distinguishable from the matter now before this court. It was concerned with the entitlement of employees to long service and annual leave and the obligation of the taxpayer to pay employees during the period of such leave. In Nilsen there was no accruing liability on the part of the employer, simply an obligation to pay wages

when employees became entitled to and took leave. In the case now under appeal the taxpayer’s obligation to pay interest under deferred debentures arose when the debentures were issued though subsequent events would determine the precise amount of interest to be paid. Taxpayers are required, by the terms of the Act, to make returns on an annual basis. This court should be slow to disallow a method of calculating the amount of an outgoing if what is claimed is fairly referable to the year in question. In my view, the amount claimed by the taxpayer as interest on deferred interest debentures for the year ended 30 September 1978 was an out-going incurred by the taxpayer in the relevant year. It was calculated in accordance with sound accounting practice, designed to give a true picture of the taxpayer’s financial operations, and it was an approach not precluded by the language of the Act. It is insufficient objection to that approach to say that it is not known when interest will in fact be paid. The amount claimed as a deduction was, in terms of s. 51(1), incurred in the relevant year in the sense that the taxpayer subjected itself to a method fairly designed to reflect the extent of the liability for the year in question.

[11.440] A common method of debt finance for large company groups is issuing short-term

bills of exchange and promissory notes. These instruments promise to pay to the holder of the bill a stated amount at a later date. The bills are then sold into the market and an amount of money is raised. The discount – that is, the difference between the amount received by the drawer and the amount it must pay upon maturity of the notes to the holder – is a substitute for interest and is deductible to the borrower. Although such notes are commonly issued for a period of less than a year, it often happens that the period from issuance to redemption stretches across two income years. In such a case, when does the borrower “incur” the expense of the discount: when the notes are issued; when they are redeemed; or on a pro-rata period over the life of the note? This issue was explored by the High Court in Coles Myer Finance Ltd v FCT. The taxpayer wanted the acceleration of its deduction like AGC – the discount should be deductible when it drew the bill and assumed liability to pay the holder. The ATO argued that the discount was only deductible when the holder was eventually paid. Much to the surprise of both sides, the High Court decided the discount should be pro-rated over the term of the bill. In a joint judgment, Mason CJ, Brennan, Dawson, Toohey and Gaudron JJ said:

590

[11.440]

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Coles Myer Finance Ltd v FCT [11.450] Coles Myer Finance Ltd v FCT (1993) 176 CLR 640; 25 ATR 95; 93 ATC 4214 The acceptance by this court of the jurisprudential analysis of s. 51 does not compel the conclusion that, once a taxpayer subjects itself in the year of income on revenue account to a present legal liability to pay in a future year of income an amount which generates, or gives rise to, a net loss or outgoing, the net loss or outgoing is deductible in full in the year of income. The relevance of the present existence of a legal liability on the part of the taxpayer to meet the bills and notes at a future date is that it establishes that the taxpayer has “incurred” in the year of income an obligation to pay an amount which gives rise to a net loss or out-going, being the recurrent cost of acquiring working or circulating capital. But there remains the question: how much of that net loss or outgoing is referable to the year of income? Although the legal liability to pay is incurred in the year of income, the amount in question is not payable until the subsequent year of income and, more importantly, the net loss or outgoing represents the cost of acquiring funds which the taxpayer puts to profitable advantage in both years of income. The cost is incurred by the taxpayer with a view to acquiring funds with which to engage in its profit-making activities during the currency of the respective bills and notes. As between the drawer and the holder of a note or bill, the burden of the liability incurred by the drawer increases with the passage of time between the discounting of the note or bill and its maturity. In ascertaining what is the taxpayer’s net income or profit for a particular year of income, it is proper to set against the taxpayer’s gross income or profit for that period the net losses or outgoings referable to that period. Under s. 51(1) a loss or outgoing is a deduction

only to the extent to which it is incurred in gaining or producing the assessable income. That provision has been described as: a statutory recognition and application of the accountancy principle which all the accountants who gave evidence referred to as the matching principle, to use the words of Menhennitt J in RACV Insurance Pty Ltd v FCT. Apportionment of the cost over the 2 years of income therefore accords with both accounting principle and practice and the statutory prescription. The correctness of this approach may be illustrated by example. Let us suppose that the taxpayer raises finance by long term rather than short term bills, drawing bills which mature 10 years after the date on which they are drawn and discounting them immediately. The amount of the discount would be very substantial having regard to the very long life of the bills so that the deduction of the difference between the face value of the bills in the year in which they are drawn and the amount realised by discounting the bills, if permitted, would lead to a distortion of the taxpayer’s operations on revenue account in the year of income in which the bills are drawn and would open the way to inflating very considerably the amount of allowable deductions under s. 51 for that year. Once the court rejects the approach adopted by the Full Court of the Federal Court and as well the primary argument of the taxpayer that the entire cost is an allowable deduction in the year of income, it follows that the total cost should be apportioned and, having regard to the relatively short life of the bills and notes, the apportionment should be on an accounting straight line basis over the term of the relevant note or bill.

[11.450]

591

Allocating Income and Deductions to Periods – Timing

[11.455]

Questions

11.32 How well does the position expressed in AGC mirror that expressed in Australian Gas Light? 11.33 Section 25-35 of the ITAA 1997 protects the taxpayer if the amount already recognised as income is less than the amount eventually received. What protection is there for the revenue if the amount eventually paid is less than the amount already deducted? 11.34 According to the articles of association, the remuneration of the directors of a company is to be determined annually by a resolution of the Annual General Meeting, which is usually held after the end of the year of income. Invariably in practice, the shareholders simply ratify the recommendation of the Board. Can the company deduct the amount that the Board will recommend as directors’ fees from its income in the year during which the directors served, or must it wait until the year in which payment is authorised by the AGM? (For the ATO’s view, see Ruling IT 2534.) 11.35 Company A and Company B are each public companies and obliged to have their accounts audited. The contract between Company A and its auditor provides for a fee of $100,000 payable at stated intervals during the contract as the audit is completed. The contract between Company B and its auditor provides for a fee of $100,000 payable immediately, although the auditor will accept payments at intervals during the contract as the audit is completed. In each case, the audit is not complete by the end of the year in which the contract is signed. In which year is the company entitled to its deduction? (For the ATO’s view, see Ruling IT 2625.) 11.36 The company placed advertisements in newspapers and magazines on behalf of its clients. Under its contract with its clients, the taxpayer was liable to the media proprietor and then charged the client a fee for the service. Under the standard industry contract terms, once the taxpayer had “booked” an advertisement, it would still have to pay for any advertisement withdrawn within 30 days of publication. Is the taxpayer entitled to a deduction for the cost of bookings which have become “non-cancellable” at the end of the year of income? (See Ogilvy & Mather v FCT (1990) 21 ATR 841; 90 ATC 4836.) Would it make any difference if the taxpayer prepaid for the advertisement and was claiming a refund? (ii) Deferring the recognition of deductions [11.460] The cases in the previous section described one campaign in the war by revenue

authorities against tax deferral – limiting the ability of a taxpayer to obtain a tax deferral by advancing the time at which a deduction is recognised. But the battle can be fought on two fronts. The question discussed now is whether the ATO could require the taxpayer to defer the recognition of an allowable deduction until a later period. In other words, is there an Arthur Murray principle for deductions? If there were such a principle it would operate to spread into succeeding periods expenses admittedly paid (and incurred in the sense defined by the courts) in the current period – so-called prepaid expenses. The prepayment of an expense is a simple, common and (usually) effective method of minor tax planning. The taxpayers will pay (usually on 30 June) rent or interest or other deductible expenses which will relieve them of the obligation to pay any further amount for the next (say) five years. Indeed, they will often obtain a discount from the supplier for the early payment. Ought the taxpayer to be able to deduct the whole of the payment as a current expense? Financial accounting, as the evidence given in AGC displayed, requires both advancement and deferral of deductions to match expenses with the related income. 592

[11.455]

Tax Accounting

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If no Arthur Murray principle existed for prepaid expenses, some remarkable tax planning opportunities would arise. Consider, for example, a taxpayer who in 1998 borrowed $10,000 to prepay the rent on some income-producing premises for five years. In 1999 the taxpayer evicts the tenant and uses the house as her residence. What would happen to the deduction if it had been allowed in full in 1998? Until May 1988 Australian tax jurisprudence had not generated a deferral rule for prepaid expenses. In BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615; 14 ATD 1 the possibility of a rule which would recognise expenses over the life of the asset they acquired, even though they had already been fully paid, was mentioned by the Privy Council, but not pursued. Later Australian pronouncements in some cases effectively meant that taxpayers could deduct any revenue expense when it was paid, regardless of the fact that accruals was the appropriate method of tax accounting and that it would generate benefits for subsequent periods. For example in FCT v Lau (1984) 6 FCR 202; 16 ATR 55; 84 ATC 4929 the ATO sought to prevent the deduction of a management fee which lasted for 21 years, though not by arguing that it should be amortised over that period. Neither was this solution sought in cases such as Creer v FCT (1985) 16 ATR 246; 85 ATC 4104 or Gwynvill Properties v FCT (1986) 13 FCR 138; 17 ATR 344; 86 ATC 4512. Instead, the ATO argued that the prepayments were not deductible at all. Prepaid revenue expenses might be deferred until a later period by statutory spreading regimes such as Div 16E of the ITAA 1936, but these rules were limited to special situations – they were not rules of general application. It was only as part of the Economic Statement of May 1988, that the government decided to enact a legislative deferral rule for prepaid expenses similar to the Arthur Murray mechanism for income. The mechanism is contained in ss 82KZL – 82KZO. Immediate deductibility is only available where: the benefits acquired by the prepayment will waste within 12 months of payment for some taxpayers (or the end of the current year for others); the expense is less than $1,000; or the payment is required by court order or legislation. In all other cases, the prepaid expense is spread over the period during which the taxpayer benefits from the expenditure (or 10 years if that is shorter). Observe, however, that the provision seeks to defer the expense until it expires – not, for example, until the revenue it generates is derived, as financial accounting would do. Immediately after the decision in Coles Myer Finance Ltd v FCT, some commentators discerned that such a common law spreading rule had now been found in the idea that the taxpayer was entitled to deduct only the portion of the discount that was “properly referable” to each tax year. That is, they took the view that, until this decision, the taxpayer’s discount had been deductible when the bill was drawn, but the High Court had spread the deduction back into subsequent periods. Such an outcome raised inconvenient questions about how to treat, for example, a premium on an insurance policy which lasts into the next tax year, or the rent for July paid during June. In Woolcombers Pty Ltd v FCT (1993) 25 ATR 487; 93 ATC 4342, Lee J proposed that the principle in Coles Myer Finance might be limited to situations where “the loss or outgoing [was] so anomalous to the revenue operations of the taxpayer as to effect a distortion in the result of those operations in the relevant income year”. Interestingly, the ATO does not accept the view of Lee J, but neither does it see a wide application for Coles Myer Finance Ltd. Its view is found in Ruling TR 94/26, which states that “the principles in Coles Myer Finance will generally apply to, financing transactions, a liability accruing daily, or a liability accruing periodically” (para 22). In other words, [11.460]

593

Allocating Income and Deductions to Periods – Timing

prepayment of a one-off expense appears of itself to be insufficient in the ATO’s view to reallocate the outgoing to a subsequent period. Question

[11.465]

11.37 When, having regard to s 82KZM and Coles Myer Finance, would the following expenses be deductible: (a) a payment of $200,000 to induce an employee aged 50 into early retirement (see W Nevill & Co Ltd v FCT (1937) 56 CLR 290; 1 AITR 67 in Chapter 7); (b) a payment of the sort in Hallstroms Pty Ltd v FCT (1946) 72 CLR 634; 3 AITR 436 assuming (with the majority of the High Court) that the expense was not capital (see Chapter 7); (c) a payment of the sort in BP Australia Ltd v FCT (1965) 112 CLR 386; 9 AITR 615; 14 ATD 1 (see Chapter 7)?

(c) Change of Accounting Method [11.470] If the pronouncement of Barwick CJ in Henderson v FCT is correct, that there can

only be one method of tax accounting which will disclose a substantially correct reflex of the taxpayer’s taxable income, then it must be possible for taxpayers to change from one method to another in respect of the same income-earning activity in succeeding years as that activity changes. Indeed, it is probably required. Henderson’s case involved a change from a cash basis to an accruals basis by the partners in a firm of accountants. The taxpayer was permitted to make the change, and as a result a large amount of income for unpaid outstanding bills went untaxed. The income was not taxed because, the Court held, in the cash basis year the firm derived only what was received, and in the accruals year the firm derived what was earned represented in the face value of bills sent out, and no adjustment was required in between. So the bills outstanding at the end of the year were derived neither in the cash year nor the accruals year. Windeyer J had attempted to overcome this consequence by effecting a hybrid accounting scheme to apply for the changeover year but Barwick CJ rejected this possibility.

Henderson v FCT [11.480] Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 [Windeyer J] thought that in respect to this year the amount of fees earned but uncollected at the end of the year ended 30 June 1964, less the amount of unpaid obligations to the extent to which the fees were collected during the year ended 30 June 1965, should be added to the net fees earned during that year in order to arrive at the income derived by the partnership in that year. The occasion which prompted this course was that the partnership had computed its income for the year ended 30 June 1964 upon a cash received basis, the partnership had made its taxation return on that footing and the appellant 594

[11.465]

had returned his income accordingly. The Commissioner had accepted these returns and assessed the appellant to income tax on the basis of them. Fees outstanding at the end of that year were thus not brought to tax in that year. If the partnership income were computed for the year ending 30 June 1965 upon an earnings basis and the relevant earnings were confined to the earnings of that tax year, those fees outstanding, which amounted to a considerable sum in the order of $179,000, if no other action should be taken, would be collected without ever being brought to tax …

Tax Accounting

Henderson v FCT cont. There cannot be any warrant in a scheme of annual taxation upon the income derived in each year of taxation for combining the results of more than one year in order to obtain the assessable

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income for a particular year of tax. Once it is decided that the partnership income derived in the year in question will be the net amount of its earnings of that year, it is, in my opinion, only the earnings of that year which can be included in the computation.

[11.490] Henderson v FCT displayed the consequences of effecting a change from cash to accruals – there was an income fall-out. The Full Federal Court has, however, pointed to one limitation to the scope for the application of Henderson in its decision in Dormer [2002] FCAFC 385; (2002) 51 ATR 353. The case concerned an accountant who had carried on business alone, but decided to admit two partners and trade as a partnership from 1 July. Under the terms of the agreement, the taxpayer was required to invoice all current clients for work done up to 30 June and he would remain entitled to collect these bills – the debts were not sold to the new joint venture. During the next tax year he collected some of these debts and claimed that they were not assessable because of Henderson: in the year in which the invoices were sent he operated on a cash basis and so no income arose; in the next year when the invoices were collected, the partnership operated on an accruals basis and so the amounts were not derived in that year. The Full Court disagreed and distinguished Henderson: … the Henderson approach does not apply to this case. It was critical to Henderson that the receipts in issue were derived from the conduct of the same business (the accountancy partnership) as was then operating on an accrued earnings basis. That was not the situation in the present case. The business carried on by the appellant as from 1 July 1997 (the accountancy partnership) was a different business from that undertaken by the appellant, as a sole trader, before that day. It is true that both businesses were accountancy practices and that the later business used the same premises and, substantially, the same employees as the first; but that is immaterial if the businesses were, in law, different businesses.

Other complications can arise from a change of accounting method between years. Consider a taxpayer who introduces an Arthur Murray-type accounting basis to defer the recognition of its income. The consequence of introducing this change was demonstrated in Country Magazine Pty Ltd v FCT. The company was a publisher. In its own financial accounts it had used Arthur Murray-type accounting by entering an amount called “subscriptions in advance” as a deduction against current income. For tax purposes, however, it had added back the deduction, effectively recognising all subscription receipts as current income (this is marked as * in the example below). After Arthur Murray, it attempted to change its tax accounts to mirror its own accounts. In order to do so it wanted to exclude from income the amounts for subscriptions that had already been taxed in prior years (this is marked as ** in the example below). The accounts looked something like this (although figures have been changed for simplicity): Accounting Profit and Loss Account: 1964–65 Sales Prior subscriptions in advance Subscriptions in advance Profit

$70,000 0 (10,480)* $59,520 [11.490]

595

Allocating Income and Deductions to Periods – Timing

Reconciliation Statement: 1964–65 Profit as per Profit and Loss Account Subscriptions in advance Taxable income Accounting Profit and Loss Account: 1965–66 Sales Prior subscriptions in advance Subscriptions in advance Profit Reconciliation Statement: Taxable Income for 1965 to 1966 Profit as per Profit and Loss Account Deduction for prior subscriptions already taxed Taxable income

$59,520 10,480 $70,000 $80,000 10,480 (13,000) $77,480 $77,480 (10,480)** $67,000

The ATO denied that the amount ($10,480** in the example) could be allowed as a deduction in 1965 to 1966 even though it had already been taxed in the prior year. Kitto J agreed.

Country Magazine Pty Ltd v FCT [11.500] Country Magazine Pty Ltd v FCT (1968) 117 CLR 162; 10 AITR 573; 15 ATD 86 The argument in support of the appellant’s case has been put in various ways, but I do not think that any of them has substance. First it is said that money received cannot be income in more than one year … I can only say that I know of no authority for it and I can see no logic in it … Then the appellant contends that the Act discloses an intention that an amount which, in an assessment, is (even mistakenly) included in a taxpayer’s assessable income of one year of income shall not be included in his assessable income of another such year. This argument does not suggest that there is an estoppel against the Commissioner in such a case; it is purely an argument as to the interpretation of the Act. I must reject it, however, for the reason that I can find nothing in the Act to indicate any such intention … Finally it was argued that the Arthur Murray case is to be distinguished on the ground that it shows only what is the result of applying ordinary commercial and accountancy practice in a case which is uncomplicated by the special feature of the present case, namely that the taxpayer treated the $10,480 as income in its 1965 return. It is said that ordinary principles concede to a recipient of money for the future supply of goods, or for 596

[11.500]

future services, a discretion to treat the money as income immediately upon its being received, and that the appellant, by making its 1965 return as it did, exercised that discretion in a manner which the Commissioner was bound to accept as determining the matter for income tax purposes. If there be such a discretion, I should have thought that the appellant exercised it, not by what it did in its income tax return, but by treating the $10,480 in its own profit and loss account as an item to be excluded in the ascertainment of the profits of the business for the 1965 year … The Commissioner, in my opinion, is right in the broad answer that he gives, namely that the taxpayer cannot turn what is assessable income of one year into assessable income of a different year by including it in the wrong year’s return. The Act requires that he include it in his return for the year of income in which he derived it as income, and he is not excused from doing so by the fact that, under a mistaken view as to when he derived it as income, he included it in his return for an earlier year. Likewise the Act obliges the Commissioner to assess tax in respect of all income which the taxpayer in fact derived in each year, and it gives him no discretion to leave any

Tax Accounting

Country Magazine Pty Ltd v FCT cont. such income out of the assessment on the ground that the taxpayer mistakenly included that income in his return of the previous year and was taxed accordingly. If there is any remedy for the mistake it must be by means of an amendment of

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the previous year’s assessment. Whether that assessment may or should be amended is a question which must be answered by reference to the specific provisions of the Act relating to amendments; but in its application to the appellant it is not a question which arises on this appeal.

[11.505]

Questions

11.38 The decided cases have so far concentrated upon the effect of the change of accounting method on the taxpayer’s income. Based upon the approach in the cases, what results will follow from recognising the taxpayer’s allowable deductions? For example, what would happen if the taxpayer operated on an accruals basis in Year 1 and became liable for an expense in that year but changed to a cash basis in Year 2 before the expense was actually paid? What should be the result? (For the ATO’s view about this, see Taxation Ruling TR 97/7.) 11.39 What will happen in the reverse situation where the expense is paid in Year 1 by an accruals basis taxpayer and then the asset which the expense acquired expires in Year 2, by which time the taxpayer has changed to cash? What should be the result? (For the ATO’s view about this, see Taxation Ruling TR 97/7.) 11.40 The taxpayer was an insurance company. It apportioned premiums received using Arthur Murray accounting to defer recognition of part of the premium relating to insurance coverage for future years. Apportionment was based on an analysis of risk exposure for future years. Following a review by an external consultant of its method for calculating risk exposure, the taxpayer changed its method of apportioning reserves. The new method adopted had the effect of increasing income recognition in earlier years (for which assessments had been based on the old apportionment system) and decreasing income recognition in the year of assessment under dispute. The effect of the change, therefore, was to leave out of assessable income forever part of the premiums that had been received in earlier years. The ATO argued that the taxpayer should be allowed to change apportionment methods only on a prospective basis in respect of premiums that had not already been partly recognised under the original system. Can the case be distinguished from Henderson v FCT? (See Commercial Union Australia Mortgage Insurance Co Ltd v FCT (1996) 69 FCR 331; 33 ATR 509; 96 ATC 4854.)

4. ACCOUNTING FOR PROFITS AND LOSSES [11.510] The basic scheme of the ITAAs, as was noted above, is to apply periodic rather than

transactional accounting. This is usually called receipts and outgoings accounting, as it involves subtracting from gross receipts of assessable income all outgoings which are allowable deductions where both have been allocated to the same year of income. Running parallel with these observations are cases where the calculation is transactional rather than periodic and where no amount is included in assessable income until subtractions have been made from it. That is, only a net figure is included in assessable income or allowed as a deduction. This part of the chapter examines when and how this accounting for profits and losses occurs under the Act. [11.510]

597

Allocating Income and Deductions to Periods – Timing

While the receipts and outgoings accounting described earlier in the chapter is undoubtedly the most common method of accounting, net profit and loss accounting is not unorthodox. Most of the debate surrounds the circumstances when profit and loss accounting is appropriate in the absence of any statutory direction. Some accounting for profits and losses has an explicit statutory basis. For example: • s 15-15 of the ITAA 1997 (formerly s 25A of the ITAA 1936) includes in assessable income the “profit arising” from isolated instances of purchase development and sale or from profit-making schemes; • s 26BB of the ITAA 1936 includes in income the amount of any “gain” on the disposal or redemption of a traditional security. In both of these cases, it is a net amount that is included in income – that is, an amount already reduced by subtracting appropriate costs. In addition, there are some mechanisms in the ITAAs, the only purpose of which is to cope with profit and loss accounting. For example, s 82 of the ITAA 1936 dictates that a taxpayer cannot deduct an amount as an allowable deduction if it has subtracted the amount as a cost in calculating a net profit or loss. Another provision which recognises profit and loss accounting is s 170(9) of the ITAA 1936. Where a taxpayer is required to estimate the profit that will emerge from a transaction which will take several years to complete and to pay tax on a portion of the profit before the transaction is complete, there is the possibility that the estimate will be wrong. If the early estimates prove to be wrong, s 170(9) permits the earlier income tax assessments to be reviewed. These provisions apparently operate whether or not the profit and loss accounting is performed under a specific section such as s 15-15 or under the ordinary usage notion. The meaning and application of a common law idea of profit and loss accounting is described below. In this extract Parsons describes both the distinction between profit and loss accounting and receipts and outgoings accounting, and some circumstances where it has so far been held to apply even in the absence of authority under a specific provision of the ITAA 1936.

R W Parsons, Income Taxation In Australia [11.520] R W Parsons, Income Taxation In Australia, Law Book Co Ltd, Sydney, 1985, paras 11.7 to 11.11 Though somewhat grudgingly, tax accounting has come to recognise a basic distinction between accounting for receipts and outgoings and accounting for specific profit or loss. Assertions that were commonly made to the effect that tax accounting under the Assessment Act was a matter of accounting for receipts and outgoings except where the Assessment Act specifically provided otherwise are no longer heard, though assertions continue to be made which would regard accounting for profit or loss as exceptional and accounting for receipts and outgoings as the general rule. Specific provisions of the Assessment Act, the most significant being s. 26(a) (the predecessor of s. 25A(1)) had always required 598

[11.520]

profit or loss accounting. International Nickel Australia Ltd (1977) 137 CLR 347 involved a recognition that items which are income by ordinary usage might be accounted for on a specific profit basis, though there had been such a recognition as far back as New Zealand Flax Investments Ltd (1938) 61 CLR 179. And there had been recognition in the decisions in Australasian Catholic Assurance Co Ltd (1959) 100 CLR 502 and, though implicitly, in Investment and Merchant Finance (1971) 125 CLR 249 and in London Australia Investment Co (1977) 138 CLR 106 and so-called banking and life insurance cases concerned with profits on investments. The most recent recognition is by the High Court in

Tax Accounting

R W Parsons, Income Taxation In Australia cont. Whitfords Beach Pty Ltd (1982) 150 CLR 355 though it is again implicit: the court was not asked to consider questions of tax accounting. The recognition is in the conclusion that the item of income by ordinary usage arising from the isolated business venture carried out by the taxpayer was of the same kind as the item of income that might arise under s. 26(a). A number of situations are identified where the appropriate accounting is concerned with what might be called a specific profit or loss. A number are listed above. An addition to the list would be an isolated business venture, as in Whitfords Beach. All these situations are “instances of specific businesses and transactions … where nothing but the net profit could be regarded as a revenue item”, which Dixon J in New Zealand Flax Investments Ltd anticipated might be found. They do not include the situation of dealing in trading stock [since] a code of accounting for dealings in trading stock has been adopted by express provisions in ss 28ff. That code in its terms adopts receipts and outgoings accounting, but adapts that accounting so that it achieved much the same as would be achieved if specific profit or loss accounting had been left to apply. There is one common feature of the listed situations. There has been a cost in the form of an outlay in the acquisition of a revenue asset, or in the discharge of a liability on revenue account,

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and the asset is realised to yield proceeds or there have been proceeds from the assumption of the liability. Profit or loss which is the item of income or deduction is the positive or negative balance of proceeds over cost. This common feature yields a principle which will go to determine the boundary between the regimes of specific profit or loss accounting and receipts and outgoings accounting. The principle would assert that the cost of acquiring a non-wasting revenue asset, or of discharging a revenue liability, is not an outgoing deductible under s. 51(1). It is not an outgoing: it is no more than an outlay. And the proceeds of a non-wasting revenue asset or a liability on revenue account are not a receipt that is income. The relevant item of income or loss will be the balance – positive or negative – of proceeds over cost. Specific profit accounting achieves a matching of expenses and receipts by deferring any allowance for the cost of an asset until a calculation of specific profit or loss falls to be made. It may require in some circumstances that an anticipated receipt be brought into the calculation of a profit or loss though the receipt would not yet be brought to account if receipts and outgoings accounting were applicable. Bringing in an anticipated receipt and the allowance of costs at that time will have the effect of advancing the time of realisation of a profit. There may be held to be a realisation to the extent of the proportion that cash receipts are of the amount of the receivable, or to the extent that total cash receipts have come to exceed cost.

(a) When Does Profit and Loss Accounting Apply? [11.530] Profit and loss accounting is a parallel, but rival, system of accounting to receipts

and outgoings accounting. So the first question must be, “when is it appropriate to use profit and loss accounting in preference to receipts and outgoings accounting?” Examples of its use can be seen in the lines of cases referred to in Chapter 5 where it is applied to the activities of: • banks and insurance companies; • some investment companies; • land developers; • isolated business ventures; and • taxpayers carrying out long-term construction contracts. [11.530]

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Allocating Income and Deductions to Periods – Timing

In all of these situations, according to Parsons, we are dealing with a revenue asset or a liability on revenue account, and the accounting for these assets or liabilities is on a profit or loss basis. One example already referred to, and which we have already looked at in another context in Chapter 5, is FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031. You will remember that in 1954 the company had purchased 1,500 acres of undeveloped land outside Perth so that the shareholders could have continued access to their fishing shacks on the beach. Not surprisingly the land became very valuable and in 1967 the existing shareholders sold their shares to three property development companies for $1.6 m. Immediately thereafter Whitfords Beach, under the direction of its new shareholders, embarked upon the subdivision, development and sale of the land, selling the first lots in 1971. The ATO assessed Whitfords Beach according to the report of the case “to income tax on profits from the sale of the lands that emerged during the years 1972, 1973, 1974 and 1975”. The ATO appears thus to have accepted that receipts and outgoings accounting was not appropriate for this venture. The High Court did not devote significant attention to the method of accounting concentrating instead upon the question whether the proceeds of sale were of an income nature. Some scattered observations on the accounting issue can be collected from the judgments. Gibbs CJ observed:

FCT v Whitfords Beach Pty Ltd [11.540] FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 A profit made on the sale of an asset may be treated as assessable income within the Act for one of a number of reasons. In the first place, if the profit should be regarded as income in accordance with the ordinary usages and concepts of mankind, it will be assessable income within s. 25(1) of the Act … The profit on the sale of an asset may be assessable income within s. 26(a), even though it would not ordinarily be regarded as income and would not fall within s. 25(1) of the Act … In practice in some (if not most) cases it has been found unnecessary to determine whether the profits in question were assessable under s. 25(1) or s. 26(a); it was enough to decide whether or not they were taxable … Although in many cases the assessment will be the same whether the case is regarded as falling within s. 25(1) or s. 26(a), there may be cases in which a different result will be arrived at depending on which provision is held to be applicable … I am not persuaded that a difference will result from the fact that s. 25(1) refers to gross income

and s. 26(a) to profit, for I agree with Mason J. In Commercial & General Acceptance Ltd v FCT, that gross income includes “a net amount which is income according to the ordinary concepts and usages of mankind, when the net amount alone has that character, not being derived from gross receipts that are revenue receipts” … I have concluded that the profits were income within ordinary concepts and taxable accordingly. Wickham J, at first instance, answered the first question raised for the determination of the court as follows: Question: Does any part of the proceeds of sale of the subject land constitute assessable income of the taxpayer, and if so on what ground? Answer: Yes, all of the proceeds were assessable under the provisions of s. 25. For the reasons I have given I consider that the answer was correct, assuming as I do that “proceeds” was intended to mean profit.

[11.550] The result of the case was that the company was deemed to derive income only in the

amount of the profit that the venture generated over its life, starting at the time of the change 600

[11.540]

Tax Accounting

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of ownership. A clearer description and application of net profit accounting, this time in relation to a building contract, is given in the New Zealand case HW Coyle Ltd v IRC (NZ) (1980) 11 ATR 122; 80 ATC 6012. The ATO has accepted the use of net profit accounting as an alternative to receipts and outgoings accounting for building contractors in Ruling IT 2450 below. The question of when profit and loss accounting is to be used in lieu of receipts and outgoings accounting has now received some fuller judicial analysis in the judgment of Hill J in FCT v Citibank Ltd (1993) 44 FCR 434; 26 ATR 423; 93 ATC 4691. The taxpayer and several related finance companies provided finance by means of car fleet leasing arrangements. Under car leasing deals, the financier buys the vehicles that the customer wishes to use and then leases them to the customer for an agreed rent. At the end of the lease, the customer can usually buy the car for a stated price referred to as the residual. (As Hill J pointed out this is not strictly a lease at law and the payments are not rent; rather the arrangement is formally a chattel bailment.) The taxpayer in this case accounted for its income from vehicle leasing by using the method referred to in the Accounting Standard AASB 17. The taxpayer calculated its profit at the beginning of the lease as the difference between the total lease payments plus the amount of the residual, less the value of the leased property at the beginning of the lease. The difference was treated as “finance revenue” – ie akin to interest – and was brought to account progressively over the term of the lease. Because the customer paid an undifferentiated sum, the finance component of each payment was calculated on an actuarial basis by applying an implicit interest rate to the balance of the bank’s investment in the asset. This is a form of net profit accounting – the taxpayer sought to bring to account only a portion of each rental receipt. Receipts and outgoings accounting would have included in assessable income the gross amount of each rental payment in full and the residual when paid, but allowed the taxpayer a deduction each year for depreciation of the vehicle and interest on any money borrowed to acquire it. Both net profit accounting and receipts and outgoings accounting would likely have produced the same amount of income in total, albeit the time profile under each system would have been different. The ATO had issued a (non-binding) ruling, Ruling IT 2162, which allowed taxpayers to use this method. But the principal reason that the taxpayer used this profit method of accounting for its income was the former s 57AF of the ITAA 1936 (now s 40-230 of the ITAA 1997). This provision, which was enacted in 1980, imposes a cap on the figure that a taxpayer can use to base its depreciation deduction in respect of a car. The profit emerging computation adopted by the taxpayer excluded from the expected cash in-flows “the fair value of the leased property at the inception of the lease” – in other words, the value of the car unrestricted by s 57AF. If the taxpayer was required to use net profit accounting, it would effectively have avoided encountering this section because the taxpayer was never actually claiming “depreciation”. Hill J held that the taxpayer was not entitled to use this form of profit accounting:

FCT v Citibank Ltd [11.560] FCT v Citibank Ltd (1993) 44 FCR 434; 26 ATR 423; 93 ATC 4691 The present case requires a determination to be made as to whether the gross income of the respondents comprises, as the Commissioner

contends, the rentals received by the respondents or, as the respondents contend, only the profit

[11.560]

601

Allocating Income and Deductions to Periods – Timing

FCT v Citibank Ltd cont. amounts calculated in accordance with the financial or actuarial method. There are many cases where gross income equates with net profits. Examples include the net profits of finance and banking companies: Colonial Mutual Life Assurance Society Ltd v FCT; Chamber of Manufactures Insurance Ltd v FCT; FCT v Employers’ Mutual Indemnity Association Ltd and cases discussed therein; the profits of an investment company where the shares in question are not trading stock: London Australia Investment Company Ltd v FCT; exchange gains and losses where the moneys advanced themselves are capital: Avco Financial Services Pty Ltd v FCT; the sale as a business activity of property originally not purchased for the purpose of resale at a profit or as trading stock: FCT v Whitfords Beach Pty Ltd; and profits made as a regular incident of a taxpayer’s business where plant is disposed of: FCT v GKN Kwikform Services Pty Ltd; Memorex Pty Ltd v FCT. What all these cases have in common, and what indeed is a necessary requirement of bringing into assessable income a net profit, is that the gross receipts used in the calculation of net profit was itself not income in ordinary concepts. That this is a requirement for a net profit being treated as gross income emerges clearly from the judgment of Mason J, initially in Commercial and General Acceptance Ltd v FCT and subsequently in Whitfords Beach. In the former of these cases his Honour said: There is a problem in accommodating the language of s. 25(1) to the notion that an amount of net profit forms part of gross income. Is the reference in the sub-section confined to the gross receipts only of the taxpayer which possess the character of income or does it also include a net amount having that character, provided that the net amount is not itself derived from gross income? The expression gross income in relation to a taxpayer conveys the sense of entire income of a taxpayer. No doubt in the context of the Act that income is to be ascertained in the first instance by reference to the gross income receipts of 602

[11.560]

the taxpayer, but in my view it also includes a net amount which is income according to the ordinary concepts and usage of mankind, when the net amount alone has that character, not being derived from gross receipts that are revenue receipts. The respondents’ submissions can only succeed therefore if the rent derived by them from the leases is not of itself gross income. It is conceded by the respondents that only one amount can be gross income and that the Act does not permit of a choice between, alternatively, bringing into account, in a case such as the present, the rental receipts or bringing into account the net profit. It may be conceded as the respondents submit, that characterisation of an amount as income may well in a particular case require a careful analysis of the business of the taxpayer said to derive that income. It may also be accepted that in determining whether a particular item has the character of income the question in each case will be the character of the receipt in the hands of the recipient. But neither of these propositions compel the conclusion that the periodical reward received by a taxpayer, whose business is borrowing and turning funds to account by lending them or otherwise engaging in financial transactions of the present kind, will not be income. Rent received on a chattel lease by a company carrying on a business such as that carried on by the respondents is as much income in ordinary concepts as is rental from premises. If the respondents were to enter into possession of a security and rent that security out, it could not be said that the rent received by it in the course of its business was any the less income or that it should account in respect of the financial transaction of loan by reference to its net profit. An analogy might be made to the purchase of an annuity and the receipt by the purchaser of instalments of that annuity. The argument of the respondents parallels that made to the High Court in Egerton-Warburton v DCT where a taxpayer deriving an annuity sought to include only that part of the annuity receipts as represented its actual interest. The argument was rejected. Unless the Act operated to provide to the taxpayer a deduction (and on the facts of that

Tax Accounting

FCT v Citibank Ltd cont. case it then did not), the whole of the annuity receipt was income and not only such part of it as represented the interest component. It is no answer to say, as senior counsel for the respondents said, that that case would be decided differently today. To point to the fact that there is an “interest component” in the gross receipts does not provide authority for the exclusion of those gross receipts from assessable income and the inclusion in their place of the net figure. The gross rental

CHAPTER 11

receipts are income because they represent a return from property put out to an income producing use by the respondents and have the character of periodicity. Indeed it is difficult to see how it would be possible to argue that the rental receipts had the character of capital … I am accordingly of the view that the proper method of accounting to be adopted in determining the taxable income of the respondents was not to treat as assessable income the profit component of each of the car leases but to treat as assessable income the gross rentals and to deduct therefrom any available allowable deductions, including depreciation.

[11.565]

Questions

11.41 Why should taxpayers such as building contractors and land developers need to account only for profits? 11.42 Could receipts and outgoings accounting be applied to the activities of building contractors?

(b) What Items Enter the Calculation of Profit? [11.570] Assuming we have concluded that profit and loss accounting is appropriate to apply

to a taxpayer for a transaction, the next question must be “what amounts enter the calculations to determine the profit or loss?” This is actually two questions: are some amounts able to be included in calculating the profit that would not be allowed as a deduction (fines, entertainment and so on); and, which amounts that are otherwise deductible must be absorbed into the cost of the asset, rather than allowed as current deductions (interest, wages and so on)? The simple answer to the first question would be to say that if (and only if) an amount is an allowable deduction under receipts and outgoings accounting, it may be subtracted in calculating profit or loss. That cannot, however, be accurate. For example, there is a problem recovering some cost for assets that have been acquired in another context which are then contributed to an isolated business transaction. Consider the position of the taxpayer in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031. When the land was purchased, no cost was deductible on a receipts and outgoings basis as it was a capital asset, and yet the proceeds of sale of parcels of that land produced receipts that were assessable income. Fortunately, the parties agreed that some deemed cost for the land should be subtracted from the proceeds of sale although they were unable to agree how much it was or when valuations were to be made. But that deemed cost is not an allowable deduction under receipts and outgoings accounting – there is no outgoing, merely the notional conversion of an asset from a capital asset to a revenue asset. Or consider the answer that the taxpayer in Citibank thought correct. It purported to use profit emerging accounting so that it could subtract the cost of the luxury car as a cost in calculating its net profit, rather than have to apply receipts and outgoings accounting where it would have been limited by the luxury car depreciation rules. As it turned out, the Court did not need to answer the question directly [11.570]

603

Allocating Income and Deductions to Periods – Timing

(that is, whether the excess could be claimed as a cost when it could not be claimed as depreciation) because the Court decided the case on the basis that the taxpayer had to use receipts and outgoings accounting. [11.575]

Question

11.43 Would any of these items be included in the calculation of a profit/loss (as either an addition or subtraction): (a) a provision for annual and long service leave for employees; (b) clients’ entertainment expenses; (c) a fine or penalty paid by the employer?

(c) When Should Profits be Recognised? [11.580] One virtue of net profit and loss accounting is that it approximates accounting over

a lifetime – albeit the life of a venture rather than the life of the taxpayer – but this introduces fresh distortions. If a venture will last for more than one year there is a problem whether to recognise some of the expected gain or loss in each of the years or to wait until the venture is completed and only then to account for the result. Obviously the former procedure has advantages and may be more accurate where expectations can be confidently relied upon. But that element of uncertainty makes financial accountants suggest that it is often better to wait until the venture is complete. Financial accounting practice in the construction industry distinguishes between two ways of accounting: the completed contract method; and the percentage of completion method. Under the completed contract method, profit is recognised only when the project is substantially complete, any remaining costs are known and potential risks are insignificant. Under the percentage of completion method, profit is recognised in proportion to the progress made performing the contract during each period in which construction occurs. According to the Accounting Standards, the percentage of completion method provides a better measure of periodic accomplishment than the completed contract method, but the percentage of completion method is subject to the risk of error in making estimates, particularly in respect of revenue and costs. Measuring the degree of performance under the percentage of completion system can be done in three ways: physical estimates or surveys of the work performed to date; the proportion of the expected total costs incurred to date; and the proportion of total expected billings made to date. The procedures in the Accounting Standard may strike some as rather vague, but there are examples in cases of some antiquity where procedures such as these have been used for income tax purposes. In Perrott v DCT (1925) 40 CLR 450 the billings basis of accounting was adopted by the High Court. The taxpayer in Perrott bought a parcel of property with the intention of keeping a portion and subdividing and selling the balance, but later changed his mind and decided to sell the whole parcel. He then subdivided the property and proceeded to sell the subdivided blocks on the terms of 25% cash and the balance in equal yearly instalments with interest at 6%. Perrott’s accountant prepared a financial account for the year ending 30 June 1920 which showed as expenses the total amount of the purchase price paid and payable by the appellant, and the amount of the expenses connected with the sale of subdivision, and as revenue the total amount of purchase money of the subdivision blocks sold before 30 June 1920 and the value of the blocks remaining unsold. A balance was then shown of £33,185 1s 5d representing a gross profit of 26.136% on the total amount of the purchase money. Appended to the account was a statement by the accountant: “the sales, as shown 604

[11.575]

Tax Accounting

CHAPTER 11

above, contain 26.136% on the annual instalments.” The tax accounts disclosed as income sums of £8,741, £461 and £3,846 which were arrived at by taking 26.136% of the instalments of purchase-money received by the appellant in the years ending 30 June 1920, 30 June 1921 and 30 June 1922 respectively. The taxpayer later sought to argue that the amounts in the tax accounts could not represent income until all expenses had been recouped. Starke J observed: … according to [counsel for the taxpayer] no part of [the instalments received] could be treated as income until the appellant recouped himself the whole of his capital outlay on the land. The appellant or his accountant allocated £9,248 of that sum to profits or income – it was afterwards reduced to £8,741 – and stated the basis of his apportionment in a document [the financial accounts]. The method is based upon sensible business considerations and the Commissioner and the learned judge were entitled, in my opinion, to act upon that method as a basis of assessment.

The ATO has now issued Ruling IT 2450 which acknowledges profit and loss accounting, termed an “estimated profits basis”, as a choice for taxpayers, but as yet only explicitly for long-term construction contracts. The Ruling also requires percentage of completion accounting instead of completed contract accounting. [11.585]

Questions

11.44 Consider the position of Whitfords Beach Pty Ltd v FCT (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031. Should it have been assessed on profits when individual lots were sold or only when the sale of the whole development was completed? 11.45 In AAT Case 5181 (1989) 20 ATR 3694; Case W61 89 ATC 558, the taxpayer provided treatment against pest infestations, offering a 10-year warranty with its service. In its income tax return, it tried to defer recognition of part of the fee it received when the contract was entered, relying upon the decision in Arthur Murray. Would the taxpayer have been entitled to the result it sought by using percentage of completion accounting instead? 11.46 The taxpayer manufactured equipment for hospitals and under the terms of its contracts it invoiced clients for progress payments as various stages of completion were reached. The taxpayer put 10% of these payments into an Arthur Murray-style suspense account, labelling the amounts “deposits on uncompleted contracts”. The taxpayer claimed that these payments had not been earned and so was not taxable on them. Was the taxpayer correct? (See Case V95 (1988) 88 ATC 631.)

(d) Deemed Costs in Calculating Income or Profit [11.590] This last section of the chapter is devoted to our last question of general tax

accounting principle: in what circumstances can a taxpayer claim deductions from income (or subtractions from profit) for notional costs involved in earning income? The question may seem a little obscure but we have already come across this question by implication in discussing earlier cases; we now wish to explore it a little more fully here. The problem can arise in different ways, although the same issue is involved in each case. Some examples may help make the issue clearer. Assets moving into the tax system. Consider an asset which will be a revenue asset of a taxpayer but which was acquired at no actual cost to the taxpayer. It may have been acquired at no cost perhaps because it was a gift to the taxpayer. But as a revenue asset will generate ordinary income on sale, can a cost of market value be attributed to the asset? In this case, the reason for attributing a deemed cost of market value to an asset actually acquired at no cost would be to protect the value of the gift element from tax – if the taxpayer has no cost in the [11.590]

605

Allocating Income and Deductions to Periods – Timing

asset, then the whole of the proceeds will be income, as we are dealing with a revenue asset of the taxpayer, but there is no actual cost to the taxpayer to subtract. Gibbs J in Curran v FCT (1974) 131 CLR 409 used the example of a motor vehicle bequeathed to a car dealer who then puts the car on the showroom floor. Assets moving between categories in the tax system. Another instance of the same problem is where there is an actual cost to the taxpayer but not a cost that is recognisable at the time that it is incurred. For example, the cost of the land in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 was actually incurred by the company, but when incurred it was a capital cost, not deductible from income. Another example would be a taxpayer who acquires and uses a car as a private vehicle but, after a few years, buys another car for private purposes and uses the old car in the business. Can the taxpayer start claiming depreciation deductions for the old car and if so, from what amount? Protecting exemptions from tax. In Curran’s case (1974) 131 CLR 409 the problem arose in yet another form. In that case, the former s 44(2) of the Act said that if a shareholder received a dividend in the form of a bonus share issue out of capital profits, the dividend was exempt income. If the shareholder was a share trader and taxable on the profits made on the sale of such a bonus issue, Barwick CJ observed that the value of the exemption for the bonus issue would be illusory: the value of the bonus issue would just be taxed as profit (though not as a dividend) when the bonus issue was sold, unless the taxpayer was given a deemed cost in the bonus issue to offset against the sale proceeds. So the High Court, by majority, gave the taxpayer a deemed cost for the bonus issue. The result of this case led to some of the most egregious tax planning in the 1970s and to the loss of an enormous amount of tax revenue. The damage it caused cannot be overestimated and perhaps this is why the High Court eventually found it necessary to overrule Curran in John v FCT (1989) 116 CLR 417; 20 ATR 1; 89 ATC 4101. Preventing double taxation. Consider the position of a taxpayer who derives an asset as income – say, a share allotted to an employee under an employee share scheme, or an investor who receives an asset as one part of the return on its investment. In either situation, the taxpayer will be liable to pay tax on the value of the asset it receives. What happens when the taxpayer sells the asset? The taxpayer cannot point to any cash outlay and say, this is what the asset cost me because the asset was not purchased with cash. But the taxpayer must be allotted a cost in the asset if the sale of the asset will generate either further income or a capital gain. Failure to give the taxpayer a cost for the amount already taxed will lead to double taxation of the same income – once when it was received and again when the asset was sold. The question in each of these instances is the same: in which circumstances is it appropriate to create a notional cost to a taxpayer? It seems clear (and was acknowledged in the joint judgment in John v FCT (1989) 116 CLR 417; 20 ATR 1; 89 ATC 4101) that a cost must be “manufactured” in some circumstances, although that proposition cannot be taken for granted. For example, Brennan J cast some doubt on this idea in John v FCT (1989) 116 CLR 417; 20 ATR 1; 89 ATC 4101, where he said at ATR 19: As a shareholder incurs no further expenditure in acquiring bonus shares, there is no reason to treat the amount credited in payment of the bonus shares as an allowable deduction. The only provision to which a claim for allowance of a deduction might be referred is s. 51 and that section has no application when there is no loss or outgoing in fact incurred by a taxpayer … A value of trading stock as though it had been purchased is not an allowable deduction. 606

[11.590]

Tax Accounting

CHAPTER 11

Although his Honour seems to be trying to refuse any deductions (or subtractions) for notional costs, there is a reasonably long history of cases granting such relief. The problem arose often in relation to s 26(a) in the calculation of the profit from carrying out a profit-making scheme, just as in determining the profit on resale of an asset received as a gift. For example, in Bernard Elsey Pty Ltd v FCT (1969) 121 CLR 119; 1 ATR 403; 69 ATC 4126 the taxpayer decided to embark upon a profit-making scheme using an asset which it already owned but had previously intended to use as a capital asset of the business. This case thus involved an asset moving into the tax system. The scheme involved the construction of shops and other buildings upon its land, selling a portion of the developed site and retaining other sites either for lease or for sale. Windeyer J in the High Court said the computation of the amount of profit was “difficult”, but found that the taxpayer could claim as a cost the market value of the land he ventured into his profit-making scheme, not just some of the price he had paid several months earlier: That profit should be ascertained by deducting from the amount realised by the sale of the shops all outgoings incurred in the carrying out of a profit-making undertaking. These outgoings were not merely the sums the taxpayer paid out or the debts it incurred. They include the value of any property which it had embarked in the carrying out of the undertaking. The main thing of that kind was the land on which the shops were built. The taxpayer put this into the venture. It should be brought to account at its value at the time. It is a misconception to suppose that this value at that date is to be ascertained by taking an average from the price paid for a larger area some 14 months earlier.

The same problem had been considered just prior to the decision in Bernard Elsey by the High Court in FCT v McClelland (1969) 118 CLR 353; 1 ATR 31. It raised the deemed cost issue in the context of a gift transaction, in this case an inheritance. Barwick CJ had observed in obiter: “if the inheritor adventures the inheritance as the capital of a business … the income of the business will be taxable … according to ordinary concepts of income. No part of the value of the inheritance will be deductible in determining that income. The inheritance is then but the capital of the business.” But in the later decision in FCT v NF Williams (1972) 127 CLR 226; 3 ATR 283; 72 ATC 4188, he qualified this observation with the comment: I ought to mention that in saying in McClelland that … no part of the value of the inheritance will be deductible in determining the income of that business, I had in mind a business which yielded recurrent income and not merely profit, in the sense of the difference between the total sum put into the venture at its inception and the total raised by its close. In the latter case, as for example, the building of houses for sale on inherited land, the value of the land at the time it is adventured into such a “business” would be a deduction against the total return.

The identification and creation of a deemed cost in these circumstances seems reasonably obvious and necessary in order to extract and tax just the profit arising from the venture computed from the time the venture has started.

[11.590]

607

CHAPTER 12 Statutory Accounting Regimes [12.10]

1. INTRODUCTION........................................ ................................................. 613

[12.20]

2. TAX ACCOUNTING FOR TRADING STOCK ..................... ........................... 613

[12.30] [12.40]

(a) Deduction and Re-inclusion Provisions ................................................................. 613 J Rowe & Son Pty Ltd v FCT ......................................................................................... 616

[12.60] [12.70] [12.80] [12.90]

(b) Measuring the Value of Trading Stock .................................................................. (i) Taxpayer’s options ................................................................................................ (ii) Obsolescence and special valuations .................................................................... (iii) Changing valuation methods ..............................................................................

618 618 619 620

[12.100] [12.110] [12.130] [12.150] [12.160] [12.180] [12.200]

(c) Determining Cost Price for Trading Stock ............................................................ (i) Surrogates for tracing the purchase price ............................................................. Australasian Jam Co Pty Ltd v FCT ............................................................................... (ii) Cost for processed trading stock .......................................................................... Philip Morris Ltd v FCT ................................................................................................ Ruling IT 2350 ........................................................................................................... FCT v Kurts Development Pty Ltd .................................................................................

620 620 622 624 625 627 629

[12.220]

(d) Determining Market Selling Value and Replacement Price .................................... 630

[12.230] [12.240] [12.250] [12.260]

(e) Acquisitions and Disposals of Trading Stock ......................................................... 631 (i) Trading stock and transfer pricing ......................................................................... 631 (ii) Disposals inside and outside the ordinary course of business ................................ 632 FCT v St Hubert’s Island Pty Ltd ................................................................................... 633

[12.280] 3. CLASSIFYING ASSETS AS TRADING STOCK ..................... ........................... 634 [12.290] [12.300] [12.310] [12.320] [12.330] [12.340] [12.350] [12.360] [12.370] [12.390] [12.400]

(a) What is Trading Stock? ........................................................................................ 634 (i) Land ..................................................................................................................... 634 FCT v St Hubert’s Island Pty Ltd ................................................................................... 635 (ii) Shares .................................................................................................................. 638 (iii) Other intangibles ................................................................................................ 638 (iv) Work in progress ................................................................................................. 639 Henderson v FCT ........................................................................................................ 639 (v) Spare parts and consumable stores ...................................................................... 640 Ruling TR 93/20 ........................................................................................................ 641 Ruling TR 98/7 .......................................................................................................... 642 Ruling TR 98/8 .......................................................................................................... 644

[12.420] [12.430] [12.440]

(b) Converting Assets Into and From Trading Stock ................................................... 644 (i) Can property cease to be trading stock? ............................................................... 645 (ii) Can an asset that was not trading stock become trading stock? ........................... 645

[12.450] 4. SIMPLIFIED ACCOUNTING FOR SMALL BUSINESSES ENTITIES....... ........... 646 [12.460]

(a) Access to Small Business Entity Concessions ......................................................... 647

[12.470]

(b) Accounting for Trading Stock .............................................................................. 648 609

Allocating Income and Deductions to Periods – Timing

[12.480]

(c) Depreciating assets .............................................................................................. 649

[12.490] 5. ACCOUNTING FOR INTEREST AND SIMILAR AMOUNTS ........... ................ 649 [12.500]

(a) Income and Deductions Arising from Financial Arrangements .............................. 651

[12.510]

(b) Standard Timing Rules ......................................................................................... 653

[12.520]

(c) Elective Timing Rules ........................................................................................... 658

[12.530] 6. PREPAID EXPENSES AND AVOIDANCE SCHEMES................. ...................... 661 [12.540] [12.550] [12.560] [12.570]

(a) Prepayment Rules ................................................................................................ (i) Prepayment rules for SBE taxpayers and individuals’ non-business deductions ...... (ii) Prepayment rules for non-SBE businesses and other taxpayers’ non-business deductions ................................................................................................................ (iii) Prepayments in relation to managed investment schemes ..................................

662 663

[12.580]

(b) Avoidance-Based Timing Rules ............................................................................. 665

664 664

[12.610] 7. ACCOUNTING FOR CAPITAL GAINS AND LOSSES................ ..................... 667 [12.620]

Reform of the Australian Tax System, Draft White Paper AGPS, Canberra, 1985 ............. 667

[12.640] [12.650] [12.660] [12.690]

(a) Calculating Net Capital Gains and Losses ............................................................. (i) Calculating capital proceeds arising on a CGT event ............................................. (ii) Calculating the cost base ..................................................................................... (iii) CGT discounts ....................................................................................................

[12.700]

(b) Reconciling Capital Gains and Income Gains ....................................................... 678

669 669 671 676

[12.710] 8. ACCOUNTING FOR HIRE PURCHASE, EQUIPMENT LEASING, LUXURY CAR LEASING ............................................... .......................................................... 679 [12.740] 9. ACCOUNTING FOR TRANSACTIONS IN FOREIGN CURRENCY....... ........... 681 [12.750] 10. ACCOUNTING FOR GST ................................. ......................................... 684

Principal Sections ITAA 1936 s 6(1)

ITAA 1997 s 70-10

s 25A

s 15-15

s 28(1)

s 70-35

s 28(2)

s 70-35(2)

s 28(3)

s 70-35(3)

610

Effect This section contains the definition of “trading stock”. This section taxes the profits of profitmaking schemes using a profit-emerging system of accounting where the asset involved is not trading stock. This section requires that the value of trading stock on hand at the end of a year be taken into account in calculating taxable income. This section includes the excess of the closing value of stock on hand over the opening value of any stock in assessable income. This section allows the excess of the opening value of stock over the closing value of stock as a deduction.

Statutory Accounting Regimes

ITAA 1936 s 29

ITAA 1997 s 70-40

s 31

s 70-45

s 36(1)

s 70-90

s 51(2)

s 70-25

s 51(2A)

s 70-15

s 160L

s 118-25

–

Div 328

Div 16E

–

–

s 230-15

– –

ss 230-45, 230-50, 230-530 Div 230-B

–

ss 230-185, 230-190

CHAPTER 12

Effect This section requires that the closing value of stock at the end of one year be the opening value of the next year for the stock. This section permits the taxpayer to value stock at cost, market selling value, replacement price, or to apply for a special valuation. This section includes the value of trading stock in the taxpayer’s assessable income where the stock was disposed of outside the ordinary course of the taxpayer’s business. This section confirms that a taxpayer may deduct expenditure incurred in the purchase of trading stock. This section defers the deduction for the cost of purchased trading stock until it comes to be “on hand”. This section excludes assets which are trading stock from the potential application of capital gains tax. This Division contains optional provisions which modify some tax accounting rules and trading stock accounting requirements for small business taxpayers. This Division taxes both the issuer and holder of a qualifying security on an accruals basis over the life of the security on the deferred interest payable under the security. This section makes gains and losses from financial arrangements assessable income or an allowable deduction. These sections define a “financial arrangement”. This Division requires a taxpayer to report the gain or loss from a financial arrangement over the life of the arrangement if the gain or loss is sufficiently certain, or on realisation of the gain if it is not. These sections require a taxpayer to reconsider whether to apply an accrual or realisation accounting to a financial arrangement and to adjust the amounts expected to the events that have occurred.

611

Allocating Income and Deductions to Periods – Timing

ITAA 1936 –

ITAA 1997 Div 230-G

–

Divs 230-C – 230-F

ss 82KZL – 82KZO

–

ss 82KJ – 82KL

–

s 160ZD

s 116-20

s 160ZF

s 116-45

s 160ZH

s 110-25

s 160ZJ

Div 960

s 160ZK

s 110-55

s 160ZA(4)

s 118-20

–

Div 240

Sch 2E

Div 242

–

Div 775

612

Effect This Division is a final reconciliation of the amount of gain or loss from the financial arrangement triggered at the time a balancing adjustment occurs. These Divisions permit a taxpayer to use various elective methods (fair value, hedge treatment, etc) in lieu of the basic accrual/realisation method. These sections require the pro-rating of prepaid revenue expenses over the life of any benefits procured by the payment or over ten years, whichever is the shorter. These sections deny or postpone deductions for expenses incurred in some tax avoidance transactions. This section defines the capital proceeds (consideration in respect of a disposal) for capital gains tax purposes. This section permits the adjustment of the consideration in respect of a disposal where the anticipated consideration is not received. This section defines the elements which enter the calculation of the cost base of an asset for capital gains tax purposes. This section establishes the procedure for indexing items in the cost base of an asset. This section details the reductions that are taken into account when determining the reduced cost base of an asset. This section reduces the amount of a capital gain by the amount included in the assessable income of the taxpayer under another provision. This Division recasts an instalment sale or a hire purchase of goods as an immediate sale of the goods, with the supplier lending the unpaid instalments to the user. This Division recasts the lease of a luxury car as an immediate sale of the car with the financier lending the unpaid instalments to the user. This Division deals with transactions that occur in a foreign currency.

Statutory Accounting Regimes

ITAA 1936 –

ITAA 1997 Divs 17, 27

CHAPTER 12

Effect These Divisions set out adjustments to the amount of income, gain, deduction or cost arising from the GST components of amounts paid and received.

1. INTRODUCTION [12.10] We have referred in earlier chapters to the importance of the specific tax accounting

rules imposed by various sections in the ITAAs. In this chapter we will consider some of these specific regimes which affect the timing choices available to taxpayers and their accounting for income and deductions. The regimes we will look at are: • the accounting system for items which are trading stock; • the special accounting rules for interest, discount, premiums and other amounts equivalent to interest; • special rules in relation to prepaid expenses; • calculating the amount of capital gains; • accounting for the income of financiers from hire purchase transactions • accounting for transactions that occur in a foreign currency; and • accounting for GST and its impact on the calculation of taxable income.

2. TAX ACCOUNTING FOR TRADING STOCK [12.20] To the extent that a taxpayer’s business includes assets classified as trading stock, the

tax accounting for the income of the business will be controlled by the trading stock provisions in Div 70 of the ITAA 1997 (formerly ss 28 – 37 and 51(2) – (2A) of the ITAA 1936). In this chapter we consider first the mechanics of the regime and how it affects the taxpayer’s accounting, and then the range of assets caught by it. It should be borne in mind that the trading stock provisions will not cover all the assets of a business (in particular, it will not cover the revenue assets of the business) and the demarcation between the trading stock sections, receipts and outgoings accounting, and net profit and loss accounting can be difficult to determine. In this chapter we will look first at the accounting issues for assets which are trading stock and will then consider which assets will be classified as trading stock (and so subjected to the accounting).

(a) Deduction and Re-inclusion Provisions [12.30] We have already seen that the gross proceeds of the sale of certain business assets have an income character. But because the gross proceeds of sale of items of trading stock is not entirely profit, their cost needs to be subtracted from gross revenue at some stage in order to calculate taxable income. Section 70-25 of the ITAA 1997 (s 51(2) of the ITAA 1936) confirms this subtraction. The cost of stock must be deducted at some stage in order to disclose the net profit that is gain – the question is when? A fundamental principle underlying the deduction provisions in the Act is that deductions should only be available where a taxpayer actually suffers an economic decline as the result of an outgoing. Thus, there is no deduction for outlays where the taxpayer has merely converted [12.30]

613

Allocating Income and Deductions to Periods – Timing

one asset (cash) into another asset (some form of property or long-term benefit) of equal value. The Act might have permitted deducting the cost of stock at the beginning: either in the year that it is paid for or when the taxpayer comes under an obligation to pay for it. The reason this is not done is that not all trading stock is sold by the end of a taxpayer’s fiscal year. Any that remains with the trader is, in a sense, simply a conversion of assets, from cash to items of trading stock and until the assets are sold, the taxpayer has suffered no loss. So, permitting the taxpayer to deduct the cost of stock when the stock was acquired would distort the profit calculation – the outlay on stock is not really a decline in the taxpayer’s economic position. Indeed, as was noted by the High Court in Rowe & Son Pty Ltd v FCT (1971) 124 CLR 421, allowing a deduction for the cost of stock when it was purchased would allow the taxpayer to reduce taxable income at will simply by purchasing more stock at the end of each year of income. The trading stock accounting system follows from the financial accounting goal of matching the cost of the stock with the revenue from its sale. The matching principle would recognise the cost of stock as a deduction in the same period that the proceeds of sale are included in income. The way of matching the outgoing on trading stock with subsequent gains is to ensure that expenditures for trading stock are deductible only when the trading stock is sold. This is the system which is used to calculate profits on profit-making schemes under s 15-15 of the ITAA 1997 (s 25A of the ITAA 1936) and to calculate any capital gain on the sale of an asset under the capital gains provisions (Pts 3-1 and 3-3 of the ITAA 1997). But applying similar measures to trading stock would be a cumbersome and complex process; taxpayers would have to identify the cost of each separate item of trading stock sold during a year. While that may be feasible for taxpayers with relatively small numbers of easily identified stock – Renoirs or vintage Rolls Royces – it would be almost impossible for most. The solution settled upon by the framers of the Act was to adopt the normal accounting conventions used to measure the cost of trading stock and legislate provisions duplicating the logic behind the normal accounting rules. The resulting system, which is to be found in Div 70 of the ITAA 1936, is far simpler and more efficient than a direct matching formula which tries to isolate the profit on each transaction. 1.

It starts with an immediate deduction under s 8-1 of the ITAA 1997 for the cost of all trading stock. The availability of the deduction is confirmed (but not granted) by s 70-25 of the ITAA 1997. 2. At the end of any year, the taxpayer will usually have sold some of the stock it purchased during the year and other stock will be unsold. Any unsold trading stock is added back to the taxpayer’s assessable income under s 70-35 of the ITAA 1997. The amount not added back will represent the cost of trading stock actually sold during the year and continues to be deductible in the current year. 3. The amount added back at the end of the closing year is then subtracted as the first item at the beginning of the opening year under s 70-40 of the ITAA 1997. That amount is a deduction for the stock brought forward into the new year.The scheme is meant to ensure that the deduction for the cost of buying trading stock is deferred from the year the stock was bought to the year in which it is sold. It does this, in effect, by a system that replicates what would happen if all the stock unsold at the end of the year was sold by the taxpayer on the last day of the year of income (usually at its original cost to the taxpayer), and then repurchased on the first day of the next year at the same price: an amount for this sale price is included in the assessable income of the closing year, and then subtracted as a cost of 614

[12.30]

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the opening year. The process is repeated each year until the item of stock disappears. Some simplified hypothetical accounting entries would look like this: Trading account for 2015–16 Sales Less Opening stock Less Purchases Plus Closing stock

$125,000 (22,000) (68,000) (90,000) 25,000 (65,000) $60,000

NET PROFIT Trading account for 2016–17 Sales Less Opening stock Less Purchases Plus Closing stock

$135,000 (25,000) (70,000) (95,000) 23,000 (72,000) $63,000

NET PROFIT

Strictly speaking, s 70-35(2) and (3) do not isolate opening and closing stock as separate entries but deal only with a net figure: the difference between opening and closing stock. The tax accounts should, therefore, appear as: Tax account for 2015–16 Assessable income Sales Excess of closing stock over opening stock

$125,000 3,000 128,000

Allowable deductions Purchases TAXABLE INCOME Tax account for 2016–17 Assessable income Sales Allowable deductions Excess of closing stock over opening stock Purchases TAXABLE INCOME

(68,000) $60,000

$135,000 (2,000) (70,000) (72,000) $63,000

The goal of this system is simple – it is designed to defer the deduction for trading stock to the period in which the stock is sold. The mechanism used to achieve it is this three-step deduction, re-inclusion and re-deduction system. While the operation of the three-step system [12.30]

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Allocating Income and Deductions to Periods – Timing

seems clear enough, it was drafted around three different terms: the deduction was given when the taxpayer “incurred” the expense for stock (s 8-1); the re-inclusion was for the “value” of stock (s 70-35); and the final deduction occurred when the stock ceased to be “on hand” (s 70-35). Consequently, the mechanism might fail to accomplish its goal if these terms did not fit together to form a seamless web. Indeed, if such a system is not used or its components do not work together properly, major distortions can arise. In J Rowe & Son Pty Ltd v FCT, the High Court considered the distortions which could arise if the income from selling trading stock was recognised on a cash basis – that is, if stock could cease to be “on hand” so that its cost was now finally deductible, and yet the proceeds of sale were not included in income. The taxpayer in Rowe was a retailer of furniture and electrical goods usually selling on credit, the price (which was secured by a bill of sale) being payable over three years or longer and bearing interest at 11% per annum. The company experienced severe problems with bad debts – almost 75% of all credit customers would default at some time during each year – and goods were often repossessed from customers. When goods were sold on credit, the company claimed the cost of goods as an allowable deduction but included in its assessable income only the amounts actually received from the customer or payable by customers in that year. The ATO claimed that the whole of the purchase price, even though it was not payable for three years, should be included in assessable income. Menzies J in the High Court highlighted the distortion which the taxpayer’s method of accounting would generate.

J Rowe & Son Pty Ltd v FCT [12.40] J Rowe & Son Pty Ltd v FCT (1971) 124 CLR 421; 2 ATR 497; 71 ATC 4157 The taxpayer conducts a business of buying and selling goods and the provisions of the Act relating to stock in trade apply to it. It is not necessary to set out their terms; it is sufficient to point out that these provisions require trading stock to be taken into account in determining both assessable and taxable income. When the value of trading stock is higher at the beginning than at the end of a tax year, the excess is an allowable deduction in calculating the taxable income of that year. The foregoing provisions assume that stock on hand at the beginning of the tax year and not on hand at the end of that year will be accounted for. It is implicit in the foregoing provisions that the proceeds of any sale of stock in the ordinary course of business will be brought into account in the year in which it is sold. The problem then is to determine what are the proceeds of sales in the year in which the taxpayer sells items of trading stock to customers upon terms and takes a bill of sale to secure payment in the manner already stated. 616

[12.40]

In a system of annual accounting, ordinary business considerations would indicate that what becomes owing to a company for trading stock sold during a year should, in some way, be brought into account to balance the reduction of trading stock which the transaction effects. Any other method of accounting would lead to a misrepresentation of the trader’s financial position. Furthermore, the taxpayer’s system of accounting produces the odd result that as turnover increases by the sale of more and more trading stock, income falls, because, when regard is had to receipts only, then but a small proportion of the proceeds of each sale on terms is brought into account in the year of sale. The value of an item of trading stock would disappear to be replaced, for instance, merely by the deposit paid by the purchaser. We were informed that if the turnover of the taxpayer were to increase at the rate of 20% per annum, its method of accounting would ensure a continually falling annual income. Nevertheless, it is said on behalf of the taxpayer that, for income tax purposes, it is not only unnecessary but it is incorrect to bring into the

Statutory Accounting Regimes

J Rowe & Son Pty Ltd v FCT cont. annual account as assessable income any instalments of purchase price, for goods sold upon terms, which are neither received nor receivable in the course of the year of sale. The basis of this contention is that income is not derived until it is received. As a general proposition this is far too large. Acceptance of the taxpayer’s contention would, of course, largely destroy the accepted

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basis for the taxation of most trading and business concerns. It is accepted that, for taxation, as well as for business purposes, the income of such a business is derived when it is earned and the receipt of what is earned is not necessary to bring the proceeds of sale into account. The acceptance of this basis of accounting is recognised by the provisions of [s 25-35] the Act relating to the writing off of bad debts which have been brought to account by the taxpayer as assessable income of any year.

[12.50] Other problems have been exposed in a series of cases involving transactions that

create mismatches at earlier stages in this three-step process. Again, they show the distortions that can arise if the three components do not mesh properly. • In FCT v Raymor (1990) 24 FCR 90; 21 ATR 458; 90 ATC 4461, the taxpayer had paid for trading stock that was not to be delivered until the following income year. The Full Federal Court allowed the taxpayer a deduction for the “cost” of the trading stock even though there would be no re-inclusion at the end of the year because the stock was not “on hand” at the end of the year. • The same problem was examined by the Full Federal Court in All States Frozen Food Pty Ltd v FCT (1990) 20 ATR 1874; 90 ATC 4175 which involved stock purchased while still at sea, although in this case the Court held that the goods were “on hand” as the taxpayer had accepted bills of lading and was therefore the owner of them, even though the goods were not yet in its possession. • A more ambitious example arose in FCT v Woolcombers (1993) 27 ATR 302; 93 ATC 5170. In this case the ATO attacked the initial deduction rather than the operation of the re-inclusion provision. The taxpayer purchased wool from growers under forward contracts at a time when the wool was still on the sheep’s backs and promised to pay either a fixed price per bale or a price within a range when the wool was delivered. It sought to deduct from its income an estimate of its liabilities under contracts executed during the year, even though it would not pay for the wool until after delivery. Neither had it yet sold any of the wool purchased under these contracts. The Full Federal Court held that the cost for its wool was “incurred” when the contracts were entered into. The legislature’s response was not to modify the re-inclusion provision. Rather, the initial deduction provision now operates so that the deduction only becomes available in the year in which trading stock becomes “on hand”: see s 70-15 of the ITAA 1997. The decision in FCT v Energy Resources of Australia (2003) 135 FCR 346; [2003] FCAFC 314 shows another mismatch. In this case the problem arose from the interaction of the trading stock rules with the statute of limitations in tax matters: s 170 of the ITAA 1936. The taxpayer had undervalued the closing stock for the year and took action to remedy the situation – it sought to have its return amended to increase the value of closing stock. It also sought to increase the value of its opening stock for that year because that too was wrong. The ATO agreed to increase the value of closing stock, but not to increase the value of the opening stock. It did so because this would have made the opening stock value for the year different from the closing stock value of the previous year, and because of the statute of limitations, it [12.50]

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was not able to change the return of the previous year. The result was to increase the income of the accessible year – by having a low (unadjusted) cost for opening stock and a high-income inclusion for (adjusted) closing stock. The Full Federal Court allowed the taxpayer to increase the value of the opening stock even though the prior year’s return could not be amended and the effect was to omit some income. But as Allsop J saw it, this was just the effect of having a statute of limitations in tax matters: “[the Commissioner] submitted that the [taxpayer’s reading of the trading stock rules] emphasised artificially the isolated year of income. This is not so when one takes into account the necessary effect of [the tax statute of limitations]. In some fashion, and to some extent, the effect of cutting off past years from re-assessment will lead to windfalls and burdens which are anomalous. Sometimes the taxpayer will be favoured; sometimes the revenue. It will depend on the particular facts.” [12.55]

12.1 12.2

Questions

In J Rowe & Son Pty Ltd v FCT, the ATO did not require the taxpayer to recognise the unpaid interest component as income immediately upon the sale. Why was this? The taxpayer in Rowe put forward another method of tax accounting as an alternative to the one it used and to that proposed by the ATO. It submitted that it could recognise immediately an amount equal to its “costs” (that is, the cost of its stock), and the profit should be allocated on a “profit emerging basis” equally over the life of the contract. You may care to consider this submission in the light of the discussion of FCT v Citibank Ltd (1993) 44 FCR 434; 26 ATR 423; 93 ATC 4691 in Chapter 11.

(b) Measuring the Value of Trading Stock [12.60] The deduction and re-inclusion mechanism effectively defers the subtraction of the

cost of trading stock until it ceases to be on hand. But the amount that is included in the assessable income at the close of the year (the excess of opening value over closing value) is not limited to the cost of the stock. Rather, it is the “excess of the value at the end of the year of income over the value at the start of the income year” of all the taxpayer’s stock on hand: see s 70-35 of the ITAA 1997. In finding this “value”, a taxpayer has several options from which to choose, and there are additional statutory schemes for allocating amounts for stock in special situations. These various values attributable to the value of closing stock can significantly affect the taxpayer’s income. Obviously, most taxpayers will prefer to have the smallest value recognised for closing stock, as this will increase assessable income the least. But by manipulating the closing value, taxpayers can advance the recognition of anticipated losses or defer the recognition of anticipated gains and achieve de facto income averaging. (i) Taxpayer’s options [12.70] The basic statutory rule applicable to the closing valuation of trading stock is found

in s 70-45 of the ITAA 1997. At the taxpayer’s option, trading stock may be valued either at its cost price, market selling price or replacement price. In conditions of rising prices, cost will generally defer recognition of most profit, replacement value will defer recognition to a somewhat smaller degree, and market selling value will anticipate most of the profit that can be expected on realisation. Both financial accounting and the tax accounting rules of some jurisdictions would regard this as a generous rule. Conservative accounting principles would typically require the taxpayer to value closing stock at the lower of its cost or realisable (ie market) value. (This is 618

[12.55]

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the basic rule in the relevant accounting standard.) This more limited choice permits the taxpayer to advance the recognition of anticipated losses but not profits. Although the provision in tax law is based on old accounting practice, in the context of the income tax legislation it is something of an anomaly, always working to the benefit of taxpayers. In terms of income tax policy, the purpose of closing valuation is to re-include in income the allowable deduction for something which is not yet an outgoing – the stock which was not sold. In theory, therefore, closing value should be based exclusively on cost, as that will equal the previously allowed deduction. If taxpayers are able to value at replacement cost or market value, they will be able to recognise a gain or loss (depending on whether the costs or market values of trading stock have risen or fallen during the year) before they have disposed of the asset. It is perhaps for these reasons, and to get some greater consistency with financial accounting, that the Review of Business Tax recommended that “trading stock be valued at the lower of cost or net realisable value”, although with an “irrevocable election … to value classes of trading stock assets at market selling value” (Recommendation 4.17). The Report noted: Taxpayers can currently elect to value each item of trading stock on one of several bases at the end of each year. The method of valuation can change from year to year for an individual item of stock, subject to the requirement that the opening value for an item is equal to its previous closing value… This degree of flexibility provides the scope for taxpayers to manipulate the valuation of trading stock for tax minimisation purposes… For trading stock the default valuation option will be the lower of cost or net realisable value, the accounting method of valuing inventories. This will allow for reductions in the value of trading stock assets due to obsolescence or deterioration. The concept of net realisable value is the same as for accounting (Accounting Standard AASB 1019 Inventories). Broadly, it means the estimated proceeds of sale net of all further costs of completion (where applicable) and costs of selling.

As the Review notes, the current procedure is also an anomaly given the realisation basis of our income tax system which normally requires a taxpayer to alienate an asset before measuring any gain or loss. Thus, for example, s 15-15 of the ITAA 1997 and CGT both triggered by the disposal of an asset, not a rise or fall in the value of property retained by the taxpayer. The trading stock valuation provisions allow taxpayers who have realised other taxable gains to offset some of their tax liability by claiming a loss on the fall in value of unsold trading stock, while taxpayers with other losses will recognise early some of the gains yet to be realised to utilise the losses and lower their tax. With rapid changes in the pace of technological advances, the replacement value and market value of some types of trading stock may decrease. Those are exceptions to the norm, however, and for most types of trading stock under conditions of moderate inflation, replacement value and market value will likely exceed original cost. (ii) Obsolescence and special valuations [12.80] In addition to the general valuation rules, specific provisions are applicable to special

situations where the choice of cost, market value or replacement value would be inappropriate or not feasible. An example is the case where a taxpayer’s trading stock becomes obsolete or consists of discontinued lines and spare parts for which there may only be a sporadic market. In these cases s 70-50 of the ITAA 1997 allows the taxpayer to elect to value trading stock at an amount lower than that which would be obtained by applying any of the options in s 70-45. [12.80]

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Another example where the general valuation rules in s 70-45 of the ITAA 1997 are inappropriate or difficult to apply, is the case of new livestock from natural reproduction. The actual outlay for these new animals is, of course, zero. However, s 70-55 permits a primary producer to elect to use any cost price up to the market value of the livestock, subject to a minimum value prescribed by regulation. (iii) Changing valuation methods [12.90] Taxpayers are given a great deal of latitude in valuing their stock. The reference in

s 70-45 of the ITAA 1997 to valuing “each item” of stock suggests that every asset may be valued separately and by a different method, and it appears that methods of valuation can change annually. Virtually the only obligation of consistency is across years: s 70-40 requires the closing value allocated to stock to be the opening value of the next year.

(c) Determining “Cost Price” for Trading Stock [12.100] If the taxpayer chooses to value its closing stock at its “cost”, it might be thought to

be relatively easy to identify the cost of goods still on hand at the end of a year and of those that were sold. But unless a trader deals exclusively in a few easily identifiable assets – Renoirs and vintage Rolls Royces again – it may be quite difficult to determine whether the assets sold during the income year were those acquired during that year or those acquired in previous years. It would obviously be very difficult to expect a timber merchant to track each piece of timber into and out of its yard. But the determination of which goods were bought, at what price and which were sold, can make a great difference to a taxpayer’s taxable income if the cost of trading stock fluctuates. One could hazard guesses about the status of trading stock on hand at the end of a year from the nature of the business – for example, one could presume that a supermarket would restock shelves by moving the old stock to the front and putting the new stock at the back. The remaining groceries on hand at the close of the income year will be the newer, more expensive stock. On the other hand, one could presume that a cement dealer, who dumps its next shipment on top of its existing cement heap is more likely to have old, less expensive stock remaining at the end of the year. Accounting has conventions to hazard guesses about the cost of stock on hand where goods are fungible and prices change. Not surprisingly, tax accounting has adopted them (with some caution) to solve the same problem. (i) Surrogates for tracing the purchase price

First-in-first-out and last-in-first-out [12.110] The accounting terms for the two assumptions made above are FIFO and LIFO

respectively: first-in-first-out and last-in-first-out. In other words, all remaining stock is valued at the cost of the earliest stock purchased still on hand because the last stock purchased is presumed to have been sold (LIFO), or else the remaining stock is valued at the cost of latest stock purchased because it is the first stock purchased which is presumed to have been sold (FIFO). When costs are rising, taxpayers favour the LIFO presumption over the FIFO presumption – LIFO allows them to deduct from assessable income the high current cost of trading stock and re-include in assessable income the less expensive cost of old trading stock. But although 620

[12.90]

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that presumption may be accurate for many types of traders, income tax procedure in Australia is to value closing trading stock on the FIFO basis. Support for the FIFO rule comes from the High Court decision in Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566; 10 ATD 217. Australasian Jam actually concerned a dispute over another valuation method, but the decision of Fullagar J made it quite clear that, where the taxpayer admitted that old stock was sold first, the valuation of remaining stock should be based on the cost of the most recently manufactured products. The case for a FIFO valuation system as an appropriate rule for some businesses was reinforced by the Privy Council decision in MNR v Anaconda American Brass Ltd [1956] AC 85 dealing with a similar issue in the Canadian Income Tax Act, 1985. Despite its endorsement by the Privy Council, the FIFO rule has many critics. In times of rising prices, the effect of valuing all remaining stock at the price of the newest stock automatically includes in assessable income a large amount on which tax must be paid – it is virtually the equivalent of including stock at replacement prices. This can lead to cash flow problems until the stock is actually sold and the sale price received, preventing the taxpayer from purchasing other stock. The problem was considered so serious in the United Kingdom, where it was christened “the Doomsday Machine”, that special relief was introduced into their Income Tax Act. It proved, however, to be a poor remedy and was repealed in 1984. No solution was apparently considered better than a poor solution. From a theoretical perspective, the LIFO system has similar drawbacks which are sufficient to render it unacceptable for Australian tax purposes. While it may occasionally reflect reality, as in the case of the coal dealer or even Anaconda American Brass, it requires that the taxpayer keep perpetual records of sales and purchases so that the extent to which the most recent deliveries have been cleared can be determined. It does have the advantage that it tends to disclose a level of profit which is maintainable over time.

Average cost and standard cost [12.120] Although the FIFO and LIFO conventions are the most common, financial

accounting has other ways of determining the cost of stock, some of which are acceptable for tax accounting. There are many novel valuation methods but we need only examine average cost and standard cost, both of which have been accepted for Australian income tax purposes in some cases. Under the average (weighted) cost method, the cost of stock on hand at the end of the year is determined by taking the different prices paid for stock over the period and finding an average cost according to the quantity of stock bought at each price. The standard cost method is described in Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566; 10 ATD 217. The situations where the standard cost method is useful can best be illustrated with the following example. A jam manufacturer produces 20 different varieties of jams. Some raw materials such as sugar go into all the jams, while others such as strawberries and grapes only go into particular jams. Rather than calculating the actual cost for each type of jam remaining in stock at the end of the year, the taxpayer may estimate the values by taking the average cost of all the jams and multiplying it by the total number of jars remaining. However, standard costing will only be acceptable if the average costs are based upon a realistic estimate of actual costs attributable to remaining trading stock, as the taxpayer in Australasian Jam Co discovered. [12.120]

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The taxpayer used a standard costing method to value its closing trading stock of jams and similar products. It arrived at its standard cost in 1914 and continued to use the same standard cost for more than 30 years following the original determination. When the Commissioner became aware of the details of the taxpayer’s valuation system, amended assessments were issued. The Commissioner also used a standard cost valuation system, but based his calculations on the costs incurred each year, not the costs incurred by the taxpayer when it had originally adopted the standard costing method. In addition to his comments on standard costing, the judgment of Fullagar J in the High Court contains many important observations on the operation of the trading stock provisions.

Australasian Jam Co Pty Ltd v FCT [12.130] Australasian Jam Co Pty Ltd v FCT (1953) 88 CLR 23; 5 AITR 566; 10 ATD 217 It is on s. 31 that the present cases primarily turn. The section in terms allows to the taxpayer considerable freedom of choice. He may adopt one method of valuation for one part of his stock, and another method for another part. And he is not bound to adhere from year to year to any method of valuation for any part of his stock: he may change the basis as to the whole or any part of his stock from year to year at will. On the other hand, the section is imperative in that it requires him to adopt for each article of his stock one or other of the three prescribed bases of valuation. He is not at liberty to adopt some other basis of his own … As long ago as 1914 or even earlier, the company, for fairly obvious business reasons, adopted the practice of taking into its accounts, at the beginning and end of each trading period, its stocks of jams, canned fruits and tin plate, at “standard” values. The practice was followed not only in the keeping of its accounts for its own purposes but also in the returns furnished to the Commissioner for purposes of income tax. The unit in the cases of jams and canned fruits was a dozen tins or cans, and in the case of tin plate what is called a “base box” … The values adopted by the company in or before 1914 have never been changed, and in all the years now in question the company’s opening and closing stocks of jams, canned fruits and tin plate, were taken into account at 4 shillings per unit, 5 shillings per unit, and 20 shillings per unit respectively … The basis of the Commissioner’s calculations was, as I understand it, as follows. With regard to jams, he began by accepting for the first income 622

[12.130]

year (1936-1937) the company’s own opening stock figure. Then for that and each succeeding income year he endeavoured to arrive at a closing stock figure which would represent as nearly as possible actual cost. From figures supplied by the company, and in no way challenged before me, he worked out the cost per dozen tins of each of 20 varieties of jam manufactured by the company. In the first year the lowest cost of any variety was 4s 5d, and the highest 5s 8d. He then added the 20 figures together and divided by 20, to arrive at an “average” cost for the 20 varieties of 5s 3d. This method would, of course, give an accurate result only if exactly the same number of tins of each of the 20 varieties were held in stock, and this was very far from being the case. It is not unlikely, however, that any error would be in favour of the company and in any case, as I have said, I did not understand the Commissioner’s figures as such to be disputed. The result was to show a gradual increase in cost from year to year … The same method was adopted with regard to canned fruits and with the same result, though the company’s own figure of 5 shillings per dozen tins was not exceeded by the Commissioner’s figures until 1940 to 1941, when his calculations produced a figure of 5s 3d … In this connection a question of some difficulty may arise under s. 31, to which some argument was directed before me. The words “cost price” in the section are perhaps not literally appropriate to goods manufactured, as distinct from goods purchased, by a taxpayer, but I feel no difficulty in reading them as meaning simply “cost” … Regarded as a matter of business discretion and wise management, the policy of stock

Statutory Accounting Regimes

Australasian Jam Co Pty Ltd v FCT cont. valuation adopted by the company appears to me to have been unexceptionable. But, for the purposes of income tax, s. 31 seems to me, as I have said, to be imperative and to require the closing value of trading stock to be based, in the case of each article, on one or other of three specified bases. And the conclusion seems to me to be inescapable that the company did not, for purposes of income tax, adopt any one of the three specified bases. The evidence suggests that the figures actually adopted were originally based on, or at any rate related to, actual cost. But the company adhered to those figures after they had ceased to bear any relation to actual cost, and after they had come to represent in effect a “standard” or more or less arbitrary “value”. I do not think it possible to say that the company’s returns, on which the original assessments were based, complied with the requirements of s. 31 … The other argument for the appellant company did not assert compliance with s. 31, but was directed rather to showing that the Commissioner’s amended assessments were excessive, because a valuation might have been made on the basis of market selling value, and a valuation so made would have shown far lower values of closing stock than those at which the Commissioner arrived. But this argument also appears to be based on a foundation that is not really tenable. It did not appear to me to be applicable in any case to the tin plate. But it was said that the company sold during each year as much of its jams and canned fruits as it could sell,

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and that the stock which was left on hand at the end of the year represented a “surplus”, the market selling value of which could only be ascertained by supposing the whole to be offered for sale en bloc on the last day of the accounting period. If one supposes such a sale – by auction or otherwise – I am quite prepared to accept the evidence that much lower values than those taken by the Commissioner would have been realised. But it is not to be supposed that the expression market selling value contemplates a sale on the most disadvantageous terms conceivable. It contemplates, in my opinion, a sale or sales in the ordinary course of the company’s business – such sales as are in fact effected. Such expressions in such provisions must be interpreted in a common sense way with due regard to business realities, and it may well be – it is not necessary to decide the point – that, in arriving at market selling value, it is legitimate to make allowance for the fact that normal selling will take place over a period. But the supposition of a forced sale on one particular day seems to me to have no relation to business reality … In relation to jams, but not in relation to canned fruits or tin plate, certain figures were put before me as showing the prices that might have been obtained on export, and arriving at market selling value by deducting from export price the estimated cost of taking from store to the fob point. Again it is not, in my opinion, correct to arrive at market selling value by reference exclusively to an export price. But the figures given relate, in any case, only to a part of the stock in question.

[12.140] It is important to recognise that all these systems – FIFO, LIFO, average cost and

standard cost – are imperfect substitutes for ascertaining the unknowable – some actual cost for the particular items which remain on hand at the end of the year. They each have their own distorting effects and will undoubtedly produce different results. The effect of each system is generally that in conditions of rising prices, LIFO will underestimate profits bringing in the lowest price, FIFO will tend to overestimate profits bringing in the largest price, and average cost will be somewhere in the middle.

[12.140]

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[12.145]

12.3

Questions

Lest there be any sceptics who doubt the effects of these rules to determine the amount of tax payable, consider this problem. Trader Ltd purchases and sells in the following way.

April May June

Purchases Quantity 1,000 1,000 1,000

Sales Price $1.00 $1.10 $1.20

Quantity 500 1,200 1,200

Price $1.20 $1.30 $1.30

At the end of these three months, therefore, Trader has bought 3,000 and sold 2,900. Determine the cost of the stock and the value of stock on hand (and the opening stock of the next year) using FIFO and LIFO.

12.4

Now perform the same calculations using average (unweighted) cost.

(ii) “Cost” for processed trading stock [12.150] The discussion above looked at retailers and wholesalers who acquire fully finished

trading stock and want to determine the “cost” of their inventories. Manufacturers and others who substantially process their trading stock before they sell it are in a much more difficult position. From a tax point of view, the goods sold by manufacturers and processors are their trading stock, but unlike retailers they do not start off with an item of largely finished trading stock. Instead, they commence with an assortment of raw materials which, through the application of labour and various processes, they convert into trading stock. A particular issue arises primarily for manufacturers to determine what elements in addition to raw materials should be included in the costs of a manufacturer’s stock when the manufacturer chooses to value stock at “cost”. What value should be attributed to a manufacturer’s closing stock if it chooses to value its inventory at cost? It should obviously include the cost of raw materials, but should the final figure also include other costs such as the cost of wages attributable to the labour input in the product? In theory, there is good reason why it should. The manufacturer will have deducted those wages as business expenses under s 8-1 of the ITAA 1997. But if the outlays have merely been transformed from cash into more processed and thus more valuable trading stock, and the trading stock remains on hand at the end of the income year, the manufacturer has suffered no real loss and an offsetting inclusion is called for. This is exactly the same reasoning that led us earlier to defer the original cost of purchased stock until it is sold. However simple the answer appears to be in theory, the practice inevitably turns out to be much more complicated. The largest problem is to distinguish which costs should be attributed to the value of the finished product so that they are deferred until the stock ceases to be on hand, from those costs which can be deducted immediately. Take, for example, the cost of electricity to heat and light a factory, and rates paid to the local council in respect of the land occupied by the factory. Without these expenditures, factory employees would not have been able to work; the outlays were necessarily incurred as an expense of production. At the same time, however, the costs might have been necessary even if no manufacturing took place. In many cases it must heat and light the building for the benefit of many employees not involved in the manufacturing process – sales staff, office staff, and so forth. Should these expenses be apportioned so that part is reflected in the cost of trading stock? In so far as the reason for the 624

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deduction and re-inclusion, at least for tax accounting, is to match costs to revenue, some of these expenses should be included in the cost of stock – the wages paid to the workers processing the raw materials are now presumably reflected in the increased value of the processed items. Again, the taxpayer has probably not significantly changed its position: even though the amount of its cash at the bank may have declined, the increased value of stock on hand and work in progress should more than offset. Financial accounting has grappled with this issue of valuing the closing stock of manufacturers, and determining and deciding which costs must be included in the value of stock. Obviously, most taxpayers will prefer to use a method for income tax purposes that will require fewer costs to be absorbed into the closing value of stock on hand and hence will include a smaller amount in assessable income as the value of stock on hand. The corresponding corollary is that amounts not absorbed into the value of stock will be deducted as current expenses rather than deferred until stock is sold. Financial accounting expresses a preference for absorption costing. The current accounting standard on inventory – AASB 102 – says that the taxpayer must include in the cost of inventory the “costs of conversion” of the inventory – that is, the “fixed and variable production overheads that are incurred in converting materials into finished goods.” It differentiates the fixed and variable costs: Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour (para 12).

The next question is, does tax law require the same treatment? One of the most thorough legal discussions of the issue is found in Philip Morris Ltd v FCT. It suggests that absorption costing is required for tax accounting so that some remote costs must be included in the value of unsold stock. In Philip Morris Ltd v FCT, the company, which manufactured cigarettes, included in the value of its closing stock only the price of materials and the wages of employees who processed those materials. It did not include anything for factory overheads, or the wages of employees who worked as fixers adjusting (but not operating) machines, or inspectors. Justice Jenkinson in the Supreme Court of Victoria disagreed with the company’s treatment:

Philip Morris Ltd v FCT [12.160] Philip Morris Ltd v FCT (1979) 10 ATR 44; 79 ATC 4352 It ought, I think, to be kept in mind that in enacting those trading stock provisions [as was said in Australasian Jam] “the legislature has itself made some specific provision affecting a particular matter or question” known to bear upon the ascertainment of income … Recognising that the “computation of profits from manufacture and trading has always proceeded upon the principle that the profit may be contained in stock-in-trade and ‘outstandings’”, Parliament has defined the extent to which assessable income shall vary in response to

variation in the value of trading stock and has specified the methods by which valuation may be made. In those circumstances my concern cannot be merely to consider, as the courts in England do, which of the methods of valuing the appellant’s trading stock “is better calculated … to reveal the full amounts of the profits or gains of the company” … My concern must rather be to seek to understand what method the legislature has directed to be applied in valuation of trading stock.

[12.160]

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Philip Morris Ltd v FCT cont. That understanding cannot be derived by determining what meaning is now – or was at the commencement of the Income Tax Assessment Act 1936 – accorded to a word or a phrase in the Act. The expression “cost price” in s. 31(1) does not now have – nor had it in 1936 – a meaning, in the common usage of accountants or men of business, of relevance to the valuation of a manufacturer’s finished goods on hand. Concerning the valuation of such goods it is to a conception, not to an exposition of usage, which the reasoning of Fullagar J in Australasian Jam Co leads: a conception which he, not Parliament, expressed by the word “cost”, and by the expression “actual cost” … The exclusion of fixed costs from the value of manufactured goods on hand and the corresponding inclusion of those costs in the expenses of the period in which the stock was manufactured require a conception of “cost” as in itself a measure of the gains of the business. Although the emphasis in [an article cited by his Honour] is heavily laid upon prediction of future gains or losses, the value selected from closing stock by the application of the direct costing method is also calculated to provide in itself, a measure of gain by the business during the period which is ending. The value is the expression of an allocation of expense between that period and the next and the direct costing method justifies itself, not as accurately indicating what the article has cost the manufacturer to make, but as accurately indicating what contribution to the manufacturer’s gains for the year in which it was manufactured the holding of the article at the end of the year has made. But in my opinion the conception which is expressed in s. 31(1) by the words “cost price” or, in the case

of a manufacturer’s stock, “cost” is merely a measure of a value at a particular time which does not purport itself to measure any gain. The gain or loss is to find expression only in the amount by which the aggregate of closing stock values exceeds or falls below the aggregate of opening stock values. This is in my opinion indicated by the provision in s. 31(1) of a choice of methods by which to value each article of trading stock at the end of the year of income. The development of the conception of cost in relation to manufacturer’s trading stock which direct costing theory and practice involves is therefore, in my opinion, a departure from the conception which I think that s. 31 expresses. The concept expressed by the words “cost price” in s. 31(1) in my opinion is, in its application to an article of trading stock manufactured by a taxpayer, directed to ascertainment of the expenditure which has been incurred by the taxpayer, in the course of his materials purchasing and manufacturing activities, to bring the article to the state in which it was when it became part of his trading stock on hand. Analogy between acquisition by purchase, which the expression “cost price” plainly contemplates, and acquisition by manufacture suggests as much, although the analogy is imperfect; and I have not found elsewhere in the provisions relating to the valuation of trading stock a contrary indication. Because the calculation of expenditure of that kind is made for successive periods of a year, the ascertainment of expenditure referable to one of very many identical manufactured articles is, I think, ordinarily to be achieved by allocating to each of the articles manufactured during a year an equal share of the year’s expenditure incurred in manufacturing them all.

[12.170] This position was endorsed by the ATO in Ruling IT 2350. In that Ruling the ATO

states the following:

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Ruling IT 2350 [12.180] 6. It is the official view that the absorption cost method is the correct means of ascertaining the cost of trading stock on hand at the end of a year in manufacturing business. 7. Under the absorption cost method there are three elements to be taken into account in determining the cost of an article of trading stock manufactured by a taxpayer: (a)

Material Costs – the cost of materials used to manufacture the particular article.

(b)

Direct Labour Costs – the cost of labour used directly in the manufacturing operations.

(c)

Production Overheads Costs – all production costs other than materials and direct labour costs.

8. Production overheads costs are sometimes described as factory overheads, indirect manufacturing costs, manufacturing overheads or manufacturing expenses. There are two categories of production overheads: (a)

(b)

Variable Production Overheads – production costs which vary with the volume of production, for example, factory light and power, stores and most indirect labour. Fixed Production Overheads – production costs which remain relatively constant from period to period irrespective of any variation in the volume of production, for example, factory rent, insurance, depreciation, etc.

9. For the purposes of subs. 31(1) the cost price of manufactured trading stock on hand at the end of a year includes not only material and direct labour costs but also an appropriate proportion of production overheads costs without which the trading stock on hand would not be produced at all. The same elements of cost should be taken into account in ascertaining the cost of work in progress at the end of a year. 10. In apportioning production overheads costs in practice it is necessary in the first instance to ascertain the extent to which they may have been incurred for non-manufacturing purposes. Only that part of the total production overhead costs relating to the manufacturing operations

should be absorbed into product cost. Next, it is necessary to ascertain the proportion of production overheads costs attributable to work in progress at the end of a year. The balance of production overheads costs would relate to finished goods and the amount to be allocated to manufactured goods on hand at the end of a year of income would normally be determined by the application of the formula: (Finished goods on hand/Finished goods produced during the year) x Production Overhead Costs to be absorbed 11. In respect of manufacturing businesses generally the following production overheads costs should be taken into account when valuing the cost of manufactured trading stock on hand and work in progress by the absorption cost method: • Factory light and power. • Factory rent, expenses.

maintenance

and

repair

• Factory rates and taxes. • Insurance of factory, plant and machinery. • Indirect labour and production supervisory wages, including: – holiday pay, sick pay and tea money; – long service leave (actual amounts paid); – workers compensation; – payroll tax. • Indirect materials and supplies. • Royalties in respect of any production process. • Tools and equipment not capitalised. • Quality control and inspection. • Factory administration expenses. • Raw materials – handling and storage. • Depreciation on factory, factory plant and equipment. 12. The following expenses are not considered to be production overheads costs: • Marketing expenses. • Storage expenses. • Advertising expenses. [12.180]

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• Employee benefits, such as:

Ruling IT 2350 cont.

– training; • Selling expenses.

– profit sharing;

• Other distribution expenses.

– employee shares;

• Interest and other financial expenses.

– first aid stations;

• Research and experimental engineering and including development.

– cafeteria;

• Income taxes.

expenses, product

– recreational facilities. • Costs attributable to strikes, rework labour, scrap and spoilage.

• General administrative expenses.

[12.190] In a subsequent ruling, Ruling IT 2402, the ATO added that FBT was not regarded

as a production overhead which had to be absorbed. The most recent re-statement – TR 2006/8 – is much less precise but still to same effect. The Ruling says: 3

… the cost of each item of trading stock includes all direct and indirect expenditure incurred in relation to the item in bringing the item to its present location and condition up to the time that the item is located in its final selling location. 4. This valuation methodology is generally known as absorption costing. Absorption costing requires that freight, insurance and other costs incurred in the normal course of operations in bringing items of trading stock to their point of sale be added to the invoice cost (net of GST input tax credits and any other recoverable taxes and duties) of the items to determine their cost. The previous discussion has focused on the costs associated with bringing manufactured goods into their current state at the end of the tax year. But there is no reason why this kind of issue is limited to goods – the same issue can also arise with respect to land that is trading stock and is being developed by the taxpayer. This issue about what costs must be absorbed into trading stock that happens to be land arose in FCT v Kurts Development Pty Ltd (1998) 39 ATR 493. The taxpayer purchased unsubdivided acres which it would then subdivide and sell as individual lots. The relevant council would insist as a condition of giving its approval to the subdivision that the company construct communal roads, parks, install sewerage, drainage, electricity and telephone services to provide services for each lot. These are referred to in the court’s judgment as the Infrastructure Costs. In addition, the taxpayer would also have to pay amounts to relevant authorities for them to do adjoining works – to lay the pipes that would join to the taxpayer’s sewer lines, roads, phone lines and so on. These are referred to in the court’s judgment as the External Costs. The council would also insist that the land on which these communal works would be done (the roads, parks, and so on) would be transferred to the council or the relevant public authority (for phones, water and so on) and not remain in private hands. In the judgment, this land is referred to as the Infrastructure Land. The transfer of the Infrastructure Land would occur by virtue of the registration of the plan of subdivision. The taxpayer had apparently been treating the purchased acres as trading stock (which had the effect of deferring the deduction for the cost of that part of the land until it was sold as we have seen) but in the current year was claiming a deduction for: (a) the cost of the Infrastructure Land which had to be transferred to the council because that land was now no longer part of its “trading stock on hand”; and (b) for the External Costs. The ATO argued that the proper accounting was for the taxpayer to treat: (a) the cost of unsubdivided acres; 628

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and (b) the External Costs, as forming the cost of the land remaining on hand at the end of the year – ie the individual lots. This treatment had two effects: first, the External Costs were deferred from the year in which they were outlaid until the year when the lots were sold; and second, the cost of purchasing the Infrastructure Land transferred to the council was also not deductible in the year in which the plan of subdivision was registered. In other words, the purchase price for the entire area and all development costs would be viewed as forming part of the cost of the individual subdivided lots to be recovered only when the lots were sold. The Full Federal Court agreed with the ATO. Emmett J began by observing that the thing which was the taxpayer’s trading stock should be viewed as the acres which then became the individual lots:

FCT v Kurts Development Pty Ltd [12.200] FCT v Kurts Development Pty Ltd (1998) 39 ATR 493 The development business of the tax-payer involves a process of transmogrification or metamorphosis of broadacres. That is to say, the broad-acres are converted into individual subdivided lots. The taxpayer’s contentions would lead to the conclusion that there are two categories of trading stock resulting from that process, being the individual subdivided lots and the Infrastructure Land. However, the reality is that the individual subdivided lots have a value which includes the road access and other services constructed on the Infrastructure Land. It may be that an experienced developer will know what proportion of the broadacres will become Infrastructure Land. However, at the time of acquisition, that part of the broadacres which is to become Infrastructure Land is not identifiable. It cannot be said, in any economic or real sense, that that part of the broad-acres which is subsequently identified as Infrastructure Land is ever a separate asset of the taxpayer which can be treated, on its own, as an “article of trading stock” as contemplated by s. 31 ITAA 1936. It would therefore be artificial to treat the Infrastructure Land as a separate asset of the taxpayer. Once it is accepted that the Infrastructure Land is never at any stage a separate article of trading stock, the issue concerning Infrastructure Costs is resolved quite simply. The taxpayer’s business involves converting one form of trading stock into a different form of trading stock. One cost of so doing is the Infrastructure Costs. Another cost is the cost of the Infrastructure Land. Those costs are, therefore, properly to be

characterised as part of the cost price of the resultant individual sub-divided lots. Once the taxpayer has exercised the option of valuing trading stock at cost price for the purposes of s. 31(1) ITAA 1936, those costs are part of the value of the individual subdivided lots for the purpose of s. 28 ITAA 1936. That analysis also resolves the question concerning the External Costs. It does not matter that the External Costs are remote from the individual subdivided lots. Nor does it matter whether they are directly related to or directly connected with the individual subdivided lots. The question is whether the External Costs are properly to be characterised as part of the cost price of the individual subdivided lots. They are all expenses which had to be incurred in order to create the individual subdivided lots. But for that expenditure, the individual subdivided lots would not have been created. For that reason, the External Costs are also part of the cost price of the individual subdivided lots. The individual subdivided lots which are created upon registration of the plan of subdivision are part of the trading stock of the taxpayer. All of the costs incurred by the taxpayer in creating those individual lots must be regarded as part of their cost price. There is no justification for drawing a distinction between direct costs of the lots on the one hand and general costs of the development on the other hand. Equally, there is no justification for treating the Infrastructure Costs as “wasted” or treating the Infrastructure Land as a “waste product”. All of those costs are necessarily incurred in order to bring into [12.200]

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Allocating Income and Deductions to Periods – Timing

FCT v Kurts Development Pty Ltd cont.

existence the individual subdivided lots. They are all properly to be regarded as part of the cost price of the individual subdivided lots.

[12.210] In addition to goods and land, there are also services. The same issue presumably

arises if the taxpayer has spent money on performing services for its client, but has yet to invoice the client for the services. Should the wages of staff and other expenses just be deducted in the year that they are paid, or should they be deferred until the taxpayer renders an invoice and derives the relevant income? It is the same issue, but there is no equivalent regime for requiring taxpayers who provide services to absorb (and thus defer) the recognition of expenses, despite recommendation 4.3 of the Review of Business Tax. [12.215]

Questions

12.5

Is there any aspect of the reasoning in Phillip Morris or Kurts Development which suggests that these ideas should not apply to the work in progress of a services firm?

12.6 12.7

What treatment should be given to the costs of maintaining stock in saleable condition? Identify whether these costs are fixed or variable: (a) depreciation of plant and equipment; (b) repairs and maintenance;

12.8

(c)

long service leave;

(d)

workers compensation insurance premiums;

(e)

payroll tax;

(f)

superannuation.

During the year, Manufacturer Ltd incurs the following expenses in the course of its business: (a) stock purchases $12,000; (b)

factory staff wages $38,000;

(c)

wages of administrative staff $25,000;

(d)

machine repairs and maintenance $3,000;

(e)

advertising and selling expenses $3,000;

(f)

electricity $7,000;

(g) depreciation on machines at 20% per annum $3,000; (h) rent, council and water rates on factory $5,000. The company manufactures 12,000 units during the year and sells 10,000. What is the cost of the closing stock using: first, direct costing; and second, absorption costing? Assuming it sold each unit of stock during the year for $15, what is the taxable income of the year under each assumption?

(d) Determining Market Selling Value and Replacement Price [12.220] The second method of valuation open to a taxpayer (and one which avoids all of the

confusing issues of LIFO v FIFO, and absorption costing), is to include, instead of cost, the market selling value of closing stock. The principal issue looked at in Australasian Jam Co was the appropriateness of standard costing and whether the standard cost should change as the cost of inputs changed. A secondary argument raised by the taxpayer was the meaning of 630

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market selling value in s 31(1) of the ITAA 1936. The taxpayer argued that the Commissioner’s valuation was excessive because the taxpayer always had the option of valuing at market selling value, which it claimed would have led to a much lower closing valuation. That claim was based on a rather unique interpretation of the phrase “market selling value”, an interpretation decisively rejected by Fullagar J. A note to s 70-45 of the ITAA 1997 points out that market selling value may not be the same as “market value”. It is also not the same as the financial accounting concept of “net realisable value”. The third method of valuation permitted under s 70-45 is “its replacement value” – that is, how much would the taxpayer have to spend if it had to replace the stock? [12.225]

Questions

12.9

Market selling value may be susceptible to more ordinary but still ambiguous meanings. For example, if a shoe store valued its stock at market selling value, would that include or be reduced by the commission that would be payable to the salesperson? The Accounting Standards use the term “net realisable value” and define it to mean the estimated proceeds of sale, less all costs to be incurred in marketing, selling and distribution to customers. Is this the same meaning as market selling value? 12.10 For a manufacturer, does replacement price mean the price at which the goods could be bought, or what it would cost the manufacturer to reproduce the goods? For a trader, would it mean the price at which they could be bought from a wholesale supplier or from a trader at the same level in the production cycle and, in either case, would it include delivery costs?

(e) Acquisitions and Disposals of Trading Stock [12.230] The deduction for the cost of stock is available when expenditure is “incurred”,

subject to the deferral in s 70-15 of the ITAA 1997 discussed above. The meaning of “incurred” has already been examined in the previous chapter. (i) Trading stock and transfer pricing [12.240] The deduction available for the acquisition of trading stock can be used by traders as

a simple way to divert profits to related taxpayers who enjoy lower tax rates than the trader (or no tax at all in some cases). By overpaying for trading stock and lowering the profit margin between cost and sale proceeds, a trader can transfer to the supplier the profits he or she might otherwise have realised upon resale of the stock. Motivations for income diversions of this type vary. Individuals may use transfer pricing as an income splitting technique, to divert profits to a spouse or child in lower tax brackets. Multinational companies may use it as a means of diverting profits to offshore (that is, foreign) subsidiaries located in tax havens. Domestic companies may use it to transfer profits to related companies, with accumulated losses to be offset against those losses. Where companies are ultimately owned by the same people but not part of a formally consolidated corporate group, the incentive to do this has been restored by the repeal of the loss transfer system that used to exist in Div 170 of the ITAA 1997. The legal basis for trading stock transfer pricing schemes rests on the decision of the Full High Court in Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430; 8 AITR 523; 13 ATD 261. As explained above, that decision has helped establish the “legal obligation” doctrine used to deny the Commissioner apportionment of excess expenses incurred for the dual purpose of income diversion and acquisition of trading stock or, as the case was subsequently applied, for [12.240]

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Allocating Income and Deductions to Periods – Timing

any other service or product used in the production of assessable income. As a belated response to the Cecil Bros case, the government added s 31C to the ITAA 1936 in 1977 (now enacted as s 70-20 of the ITAA 1997). The provision specifically authorises an adjustment of the price where taxpayers have overpaid for trading stock supplied by persons with whom they were not dealing at arm’s length. In so far as it applies to acquisitions of trading stock from related offshore suppliers, s 70-20 is reinforced by Div 815 of the ITAA 1997, which attempts to reconstruct all transactions between related domestic and foreign taxpayers as if they had been between arm’s length parties. (ii) Disposals inside and outside the ordinary course of business [12.250] A taxpayer disposing of trading stock in the ordinary course of business, that is, by

selling the trading stock to an unrelated customer, will be assessed on the proceeds of disposal pursuant to s 6-5 of the ITAA 1997. The cost of the trading stock will be deductible under the combined operation of ss 8-1 and 70-35. The time at which the deduction for the cost of stock is taken is decided by a finding that the stock has ceased to be “on hand”. What happens when the taxpayer is remunerated for the disposal of trading stock but the transaction is one that occurs outside the ordinary course of the taxpayer’s business? This could happen, for example, where a taxpayer abandons a particular product line and sells its remaining stock in bulk, or if it sells the entire business including the trading stock on hand at the time of sale. Or, it could arise when the trading stock of a taxpayer is subject to compulsory acquisition by a health authority or agricultural authority, albeit with compensation, or when a trader transfers trading stock to an insurance company following a flood or fire. These cases are analogous to ordinary sales of trading stock and should result in the same tax liability. There was authority, however, in Commissioner of Taxation (WA) v Newman (1921) 29 CLR 484 that amounts received in a stock liquidation sale were not the proceeds of carrying on the business and were thus not taxable. This result is now overcome through the operation of s 70-90 of the ITAA 1997 which includes the “value” of the transferred trading stock in the taxpayer’s assessable income in the year of disposition. Special provisions in Div 385 of the ITAA 1997 are applicable to a limited range of extraordinary dispositions by primary producers. While most traders seek to turn over trading stock in as short a period as possible, primary producers normally dispose of livestock when it reaches the appropriate age for marketing. If a primary producer’s entire herd is disposed of in one season as a result of, for example, a cattle tick eradication campaign, the profits may be recognised over five years to average the proceeds and prevent a bunching problem which might push the taxpayer into a higher tax bracket. Further provisions to alleviate the bunching problem associated with involuntary dispositions of livestock appear in Div 385. Whether trading stock is disposed of in the course of business or otherwise, measuring the proceeds of disposal poses no difficulty when the taxpayer has received cash or the equivalent in goods or services for the transfer. From the taxpayer’s perspective, the only issue is usually whether the proceeds will be assessed under s 6-5 or s 70-90. What are the proceeds of disposal if a taxpayer receives no compensation for the transfer as is the case, for example, when a trader makes a gift of trading stock? Prima facie, the trader has received nothing for the disposal. However, s 70-90 of the ITAA 1997 in effect deems a taxpayer in these circumstances to have received the market value of the transferred trading 632

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stock. The presumption established by the provision, that the transferor enjoyed a benefit equal to the value of the trading stock, is arguably not unreasonable. As the trader always had the option of selling the stock and gifting the proceeds instead of simply transferring the stock, it could be argued that he or she realised a benefit equal to the forgone profits. To preserve the integrity of the provision, s 70-105 treats testamentary dispositions in the same manner as inter-vivos transfers covered by s 70-90. Another obvious case in which the deemed proceeds aspect of s 70-90 of the ITAA 1997 should have effect would be trading stock consumed by the trader or their family. Indeed, the ATO routinely publishes a ruling outlining how much stock he suspects the owner of a grocery store, bakery, butcher shop and so on will have taken from the shelves and eaten with the family – see TD 2008/32. But what about disposals of trading stock by making a donation of the stock to a charity, or what about trading stock given away as prizes or promotions? Whether the section also applies to distributions of trading stock by a liquidator winding up a company was the second issue argued before the Full High Court in FCT v St Hubert’s Island Pty Ltd. The St Hubert’s Island company was formed to acquire and develop two small islands but the project eventually proved to be unsuccessful and the company went into voluntary liquidation. The liquidator transferred the land to the principal shareholder in specie to discharge debts owed to the shareholder and as a final distribution. The ATO assessed the company to tax under s 36 of the ITAA 1936, arguing that the land was trading stock that was disposed of outside the ordinary course of the taxpayer’s business. Mason J upheld the assessment.

FCT v St Hubert’s Island Pty Ltd [12.260] FCT v St Hubert’s Island Pty Ltd (1978) 138 CLR 210; 8 ATR 452; 78 ATC 4101 The respondent [submitted] that the disposition now contemplated by s. 36(1) does not extend to a transfer of assets in specie by a liquidator of a company to its sole shareholder. It seems to me that, measured against the generality of the language of s. 36(1), these considerations are too frail to support the conclusion which the respondent seeks to sustain. Next, it was submitted that, to fall within the subsection, a disposition must be a voluntary disposition. The response to this contention is that the disposition by the liquidator to [the shareholder] was a voluntary disposition. It was not deprived of its character as such a disposition

by the circumstance that the liquidator was under a duty to make the transfer by virtue of s. 264 of the Companies Act 1961. Finally, it was contended that as a disposition by a liquidator of a company in favour of a shareholder falls within the statutory definition of dividend contained in s. 6(1) of the Act it should not be regarded as a disposition for the purposes of s. 36(1). I do not see that there is any inconsistency involved in treating a transfer by a liquidator as a disposition within s. 36(1) as well as regarding it as a distribution constituting a dividend within the meaning of the statutory definition contained in s. 6(1).

[12.270] The former s 36(1) of the ITAA 1936 determined the tax consequences to the

taxpayer who was disposing of the trading stock; it had no effect on the recipient. This has been changed in the rewriting of the trading stock provisions by the TLIP project. Now s 70-95 of the ITAA 1997 deems the entity acquiring the asset to do so at its market value. [12.275]

Questions

12.11 What happens if stock is given away as a prize in a promotional drive by the taxpayer? [12.275]

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Allocating Income and Deductions to Periods – Timing

12.12 What happens if the taxpayer disposes not of the trading stock but of an interest in a partnership which has trading stock? See s 70-100 of the ITAA 1997. 12.13 Is the election under s 70-100 of the ITAA 1997 available to the taxpayer if the taxpayer: (a) sells the business to a company; (b) sells the business to a trading trust structured as a unit trust in which the taxpayer has 25% of the total units; (c) (d)

sells the business to a discretionary trust in which the taxpayer is one of three beneficiaries; sells the business to a discretionary trust in which the taxpayer is a discretionary beneficiary and the default beneficiary?

3. CLASSIFYING ASSETS AS TRADING STOCK [12.280] The previous discussion has concentrated upon the effects of the accounting rules

for trading stock, namely that the cost of stock is deferred until the stock is sold, and then determining which costs must be absorbed and which may be immediately expensed. Now the discussion can consider what might be thought to be the first order question: which assets are subject to this accounting regime? In other words, what is trading stock? The answer to this question raises several issues which need to be considered: is the asset trading stock or an item of plant; is it trading stock or a consumable store or a semi-processed item or a spare part; is the asset trading stock or is it one for which net profit and loss accounting is appropriate; and can an asset become or cease to be trading stock?

(a) What is Trading Stock? [12.290] Trading stock is defined in a non-exhaustive fashion in s 70-10 of the ITAA 1997 to

include “anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange, in the ordinary course of a business”. Financial accounting uses the term “inventory” but that may be wider than trading stock. The essence of the test is whether the item is one that is intended to be sold in the ordinary course of the business. Therefore: • an asset which might be sold but only in extraordinary circumstances cannot be trading stock; • an asset held by a taxpayer whose activities do not amount to a business, such as the home unit owned by an investor, cannot be trading stock; and • questions can arise about whether and when raw materials, packaging materials, spare parts, consumables and so on, which are not held for sale per se, are within the definition of trading stock. We will look at a few problem areas. (i) Land [12.300] It has only recently been formally considered whether land can properly be treated

as trading stock for income tax purposes. The definition seems to be written with goods in mind, not land. Indeed, in FCT v Kurts Development, Emmett J remarked that, “the expression ‘article of trading stock’ as found in s 29 and s 31, is hardly apt in relation to land”. 634

[12.280]

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Most land transactions were assessed as isolated transactions under either limb of s 25A of the ITAA 1936 (now partly reenacted as s 15-15 of the ITAA 1997) which assumed that the characterisation as trading stock was not possible, as it was observed on numerous occasions that s 25A had no operation for the trading stock of a business. Alternatively, where the land was considered to be part of an ongoing business, it was often treated as a revenue asset of the business, so that the proceeds of sale were income, but were assessed using net profit accounting. The issue whether land, particularly unsubdivided land, could be trading stock was finally decided by the Full High Court in FCT v St Hubert’s Island Pty Ltd, when the facts of the case precluded the ATO from relying upon s 25A. The case raised in tandem several important issues: what is the meaning of trading stock in the Act and, in particular, could land be trading stock; was there a distinction between raw materials and trading stock; could an asset become trading stock; what is the relationship between s 15-15 of the ITAA 1997 and the trading stock provisions; how should s 70-90 of the ITAA 1997 operate? You will recall that the taxpayer in St Hubert’s Island went into liquidation and the liquidator distributed to the principal shareholder land that the company had previously acquired for the purpose of subdivision. At the time of the transfer, the taxpayer had not completed the preparations to the land necessary for subdivision and sale. If the land were trading stock, s 70-90 would deem the taxpayer to have sold it for its market value at the time of the transfer. The ATO applied s 70-90 and appealed to the Full High Court which decided in favour of the ATO. Stephen J dissented from the majority, although not because he believed that land could never be trading stock. His judgment contains many observations on the scope of trading stock for the Act.

FCT v St Hubert’s Island Pty Ltd [12.310] FCT v St Hubert’s Island Pty Ltd (1978) 138 CLR 210; 8 ATR 452; 78 ATC 4101 The first matter to be decided is whether or not the land was trading stock within s. 36(1). This resolves itself into two parts, a broad question whether land may ever be trading stock for the purposes of the Income Tax Assessment Act and, in particular, of s. 36 of the Act, and a quite narrow one, whether in the circumstances of this case this particular land was trading stock. Section 36(1) itself provides no clear answer to the broad question, save in the negative sense that there is nothing in its wording opposed to the inclusion of land in the term trading stock … The terms in which this statutory meaning are expressed throw little light upon whether land may be trading stock. I do not regard its use of the word “anything” as limiting the definition to chattels. “Anything” is a word of the widest meaning, as apt to describe land as to describe chattels; indeed it can also be applied appropriately enough to intangibles …

There is another aspect of this statutory meaning of trading stock which is of present relevance. It is whether it is a true definition, giving to trading stock when used in the Act an exclusive meaning, so that anything falling outside it will not be trading stock although answering that description according to common usage; or whether, on the contrary, it operates as merely expansive of what would otherwise be conveyed by the ordinary meaning of trading stock. In deciding this question one notes, at the outset, that the statutory meaning, by including in trading stock things acquired not only for purposes of sale or exchange but also for purposes of manufacture, enlarges the ordinary meaning of the term … The inclusion of live-stock effects a further enlargement of the meaning of trading stock … Nevertheless, in the case of a subsection constructed as is s. 6(1), using both “means” and “includes”, a meaning which is expressed in [12.310]

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Allocating Income and Deductions to Periods – Timing

FCT v St Hubert’s Island Pty Ltd cont. terms of “includes” and which may be seen to be at least partially expansive in its operation should not, I think, be treated as an exclusive definition, but rather as operating cumulatively upon the ordinary meaning of the word or phrase in question and conferring added meaning for the purposes of the Act … Since s. 36 itself contains nothing suggesting that trading stock is necessarily inapplicable to land and since the term, both in its ordinary meaning and in the extended meaning given by s. 6(1), is wide enough to include, in appropriate circumstances, land, I reject the taxpayer’s submission that land can never be trading stock for the purposes of the Act and, in particular, of s. 36. I am fortified in that conclusion by three

considerations … To exclude from the concept of trading stock the parcels of land in which a dealer in land trades would be to make such a discrimination solely by reference to the particular subject matter traded in; yet it is with the trader’s income that the Act is concerned and not with the particular subject matter in which the trade is carried on … Only by taking account of stock-in-trade in the conventional way can a correct reflex of the trader’s income for the accounting period be obtained. Within the framework of the Australian tax system, with its assessment of tax upon the excess of assessable income over allowable deductions, it is the provisions of ss 28 to 31 which ensure such a correct reflex in the case of stock-in-trade. To remove from the operation of these sections transactions of one type of trade, trade in land, would be anomalous.

Nevertheless, Stephen J dissented from the majority because of the importance he attached to the fact that the land was still undivided and thus was not in the state in which it was intended to be sold. This is an issue we will return to examine again. I would not myself regard it as always conclusive of the question whether land owned by such a taxpayer as the respondent is trading stock according to the ordinary meaning of the term, that the land is not, at the relevant time, available for sale in subdivided lots. For assets of a taxpayer to form part of his trading stock they will, I think, generally speaking, require to possess the character of being substantially in the state in which the taxpayer intends to trade in them. For this reason the particular trade of the taxpayer will be critical. To a trader in broad acres his stock of broad acres will be trading stock, but if his trade, and by this I refer to that which he sells, is in subdivisional lots it will generally only be subdivided lots that qualify as his trading stock and they will become a part of that stock when, by whatever processes of improvement may be involved, they come substantially to answer the description of that which he trades in …

636

[12.310]

[T]he present case is not, I think, one in which, on this appeal, this court should entertain the view that, by the time of its transfer to [the shareholder], this land, although not yet subdivided, had reached a state in which it was trading stock in the ordinary meaning of that term. It was, in my view, clearly not in that state when acquired by the taxpayer. Despite the extensive work carried out on it while owned by the taxpayer, the parties apparently treated it as still devoid of any of the characteristics of subdivided land when it was transferred to [the shareholder]. In the circumstances his Honour was, in my view, entitled, in the absence of any evidence that it fell within what I have suggested as a possible exception to the general position, to conclude that it was not then trading stock as ordinarily understood.

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Mason J agreed with the conclusion that land could be trading stock and formed part of the majority, finding that this land was, despite its undeveloped condition, nevertheless trading stock. As applied to the business of a manufacturer of goods, accountants and commercial men by their use of the expression trading stock denote not only the goods which he has manufactured and holds for sale but his stock of raw materials, components and partly manufactured goods … The recognition by accountants and commercial men that raw materials used for the purpose of manufacture in a manufacturing business and partly manufactured goods form part of the trading stock of the business … enabled the value of raw materials and partly manufactured goods to be included in the value of trading stock at the beginning and end of an accounting period and by this means it led to the making of a more accurate calculation of the profit earned or the loss sustained in that period. It is not easy to see how an accurate calculation of profit or loss could be made unless the value of raw materials and partly manufactured goods was taken into account. Of course the value might be taken into account, even though by different means. Partly manufactured goods may be dealt with as “work in progress”, as indeed they are sometimes, but this expression is no more than an alternative description except in so far as it is intended to introduce different methods of valuation. If trading stock according to its ordinary meaning denotes land as well as goods and

[12.315]

commodities, it must follow that land may form part of the trading stock of a business before it has been converted into the condition in which it is intended to be sold. Just as raw materials and partly manufactured goods form part of the trading stock of a manufacturer, so also virgin land which has been acquired by a land developer for the purpose of improvement, subdivision and sale in the form of allotment, subdivision and sale in the form of allotments will form part of his trading stock. If the statutory definition of trading stock in s. 6(1) were an exclusive and comprehensive definition it might be possible to draw a distinction between land and goods and to assert that the presence of the word “manufacture” in that definition has a restricted effect so as to exclude land acquired for the purpose of improvement and development antecedent to sale, thereby overcoming the argument that land so acquired is nonetheless land acquired for the purpose of sale within the meaning of the definition. But the statutory definition is inclusive only and no distinction should be drawn between goods on which work is to be done before they are converted into the condition in which they are intended to be sold and land on which work is to be done before it is converted into the condition in which it is intended to be sold.

Questions

12.14 Every item of trading stock will be an asset for CGT purposes and so trigger CGT if sold for a profit. How is trading stock accounting reconciled with CGT? See s 118-25. 12.15 Is there a proposition (similar to one that has already been asserted in another context) that an asset can only be characterised as trading stock “in the hands of the taxpayer” – that there is no such thing as trading stock in the abstract? 12.16 What was the character of the Infrastructure Land in Kurts Development? Was it part of the taxpayer’s trading stock when purchased? What happened when it was transferred to the Council or relevant authority? [12.315]

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(ii) Shares [12.320] As we noted above, the definition of trading stock seems to be written with goods in

mind and so shares, which are intangible assets, would also seem to present a problem. It was suggested by Williams J in Modern Permanent Building & Investment Society (in liq) v FCT (1958) 98 CLR 187 that trading stock only applied to tangible assets and not choses in action. Prior to 1985, capital gains realised on assets held for more than one year were exempted from income taxation, although there was some residual doubt, discussed above, about how far s 25A of the ITAA 1936 applied to tax capital gains. At the same time, dividends were fully taxed in the hands of individual shareholders, with no credit for company taxes paid on the distributed profits when they were first realised by the company making the distribution. Taxpayers owning private companies which had accumulated considerable profits were well advised to sell the companies and realise the value of the underlying retained earnings as a tax-free capital gain rather than extract them as taxable dividends. They could do so by selling their shares in the company for an amount that represented their original capital contribution to the company plus the value of the retained earnings remaining in the company. Eventually, the purchaser of the private company would remove the retained earnings from the company in the form of dividends – hence the term “dividend stripping” to describe the entire operation. If the purchaser were another company, the dividends would usually not be taxable to it because of the (then) inter-corporate dividend rebate (discussed in more detail below). Whether or not the purchasers would ultimately be taxed on the retained earnings they extracted as dividends, they could extract further tax advantages from the transaction if they could generate an allowable deduction for a loss by revaluing the shares. This was only possible if the shares could be classified as trading stock – a proposition long held in doubt because of their traditional classification as capital assets and the view that trading stock only applied to tangible assets and not choses in action. However, the Full High Court decisions in Investment and Merchant Finance Corporation Ltd v FCT (1971) 125 CLR 249 and Patcorp Investments v FCT (1976) 140 CLR 247 eliminated any doubt that, in the hands of a share trader, shares were trading stock. Dividend stripping schemes were ultimately countered with a number of anti-avoidance provisions, most of them applicable to the dividends received by the purchaser. In addition, s 52A of the ITAA 1936 was introduced to have effect with regard to the acquisition of the shares as trading stock. Section 52A could be used by the ATO to deny the purchaser the deduction that would otherwise be allowed where evidence suggested the purchase was likely to be part of a dividend stripping scheme. (iii) Other intangibles [12.330] Some taxpayers deal with types of intangibles other than shares in much the same

way as tangible items of trading stock. A factor, for example, will purchase the book debts of another taxpayer at a discount and will make its gain to the extent that it can collect from the debtor more than the price paid. Some debts will be realised by collection, some by resale, and some will be compromised or written off. You may wish to consider the similar process of discounting bills of exchange by banks such as occurred in Willingale v International Commercial Bank Ltd [1978] AC 834. [12.335]

12.17 Are the debts of a factor trading stock? 638

[12.320]

Questions

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12.18 If not, how will the profit made by the factor be accounted for? What would be the accounting if each debt is trading stock? 12.19 What will happen if the factor compromises a debt? Assume that the debt has a face value of $10,000, that it was purchased by the factor for $8,000 and she accepts $5,000 from the debtor in full satisfaction of the debt. How will the taxpayer obtain a deduction for the loss if trading stock accounting applies? (iv) Work in progress [12.340] The questions to be considered here are: when, during its manufacture, does an item

cease to be raw materials and become trading stock; and what items associated with manufacture must also be treated as stock? Work in progress is an example of the first problem, and spare parts an example of the second. We have already come across the first issue in the extracts from St Hubert’s Island Pty Ltd where the High Court split on the importance of the fact that the land was still not subdivided. There is another area where this issue of work in progress arises: that is in the treatment of taxpayers who provide services, and who have performed some services during the tax year, but have not yet rendered an account for the work. For them, the work done to date is “work in progress”. Whether, and if so, how, the value of work in progress features in tax accounting, seems to be a function of the type of business that the taxpayer carries on. It is generally accepted that the work in progress of a taxpayer producing tangible assets is part of the trading stock of the taxpayer’s business and, under the absorption costing principles exemplified in Philip Morris Ltd, the expenses associated with its production must be treated as costs of the stock and so brought into account in calculating the taxpayer’s taxable income. Expenses for raw materials would be deducted under s 8-1 of the ITAA 1997 and then re-included in the taxpayer’s assessable income by s 70-35 until such time as the stock is sold. In theory, similar rules should apply to the work in progress of a taxpayer whose business is providing services rather than tangible goods for sale. The matching principle would suggest that an accruals basis taxpayer should be required to recognise expenses incurred in providing the services when he or she bills the customer. Prior to that point the taxpayer has not suffered a loss as a result of the outgoings, merely the conversion of cash into billable hours. The problem from a policy perspective is that there is no statutory formula equivalent to s 70-35 of the ITAA 1997 which has the effect of requiring accruals basis taxpayers to include unbilled hours in assessable income even though the expenses may have already been deducted. The ATO attempted unsuccessfully to tax work in progress where the business involves rendering services in the ubiquitous Henderson v FCT. Barwick CJ in the High Court made the following observation:

Henderson v FCT [12.350] Henderson v FCT (1970) 119 CLR 612; 1 ATR 596; 70 ATC 4016 In ascertaining earnings, only fees which have matured into recoverable debts should be included as earnings. In presenting figures before his Honour, allowance was made for what was termed “work in progress”. But this, in my

opinion, is an entirely inappropriate concept in relation to the performance of such professional services as are accorded in an accountancy practice when ascertaining the income derived by the person or persons performing the work. [12.350]

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Henderson v FCT cont. When the service is so far performed that according to the agreement of the parties or in default thereof, according to the general law, a fee or fees have been earned and it or they will be income derived in the period of time in which it or they have become recoverable. But until that time has arrived, there is, in my opinion, no basis when determining the income derived in a period for estimating the value of the services so far performed but for which payment cannot properly be demanded and treating that value as

[12.355]

part of the earnings of the professional practice up to that time and as part of the income derived in that period. Consequently, in determining the income of the partnership in either of the years in question for the purposes of assessment of tax, only accrued fees may be included in that income. I have used the word “recoverable” to describe the point at which income is derived by the performance of services. I ought to add that fees would be relevantly recoverable though by reason of special arrangement between the partnership and the client, time to pay was afforded.

Questions

12.20 Would the work in progress of a builder be trading stock? If so, when does it cease to be “on hand”? Does it make any difference whether the builder is a “spec builder” or a contract builder? 12.21 What would happen if there is likely to be a loss upon sale of the asset? How can this loss be anticipated through the value attributed to work in progress? (v) Spare parts and consumable stores [12.360] One final distinction that needs to be drawn is that between trading stock on the one

hand, and spare parts and consumable stores on the other. Consider, for example, the business of a motor vehicle retailer. In addition to selling vehicles by retail, it is common for the dealer to have a service and repairs division (at least sufficient to meet consumers’ claims under the vehicle’s warranty) and perhaps also to run a spare parts business selling brand name parts to other repairers and direct to the public. What is the treatment appropriate for, say, a spark plug which might either be applied by the dealer in servicing a vehicle or sold to some third party? The answer depends upon whether the spark plug is treated as trading stock or as a consumable store. We have already seen that the treatment for trading stock would require that the cost of the spark plug be deferred until it is sold. In contrast, the treatment of consumable stores is that they are “expensed” – that is, their cost is deductible when bought and not subject to re-inclusion. It has long been accepted by the ATO that “a deduction should be allowed for the cost of spare parts in the year of income in which they were purchased … where it was established, having regard to the nature of the business carried on, that spare parts were purchased in quantities sufficient to enable the business to be carried on efficiently … [but] the position would need to be reconsidered in a case where a substantial quantity of spare parts in excess of normal requirements was being built up” (Taxation Ruling IT 333). This distinction between trading stock and spare parts is drawn in Taxation Ruling TR 93/20 which tries to categorise the treatment of computer parts held by a firm which will then use them indiscriminately for multiple purposes: for resale and to use in repair work, both under warranty and on contract. The Ruling tries to deal with several issues: how can the firm determine which parts are held for which purposes; what is the nature of parts that are determined to be held for particular purposes; and other issues. The Ruling states: 640

[12.355]

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Ruling TR 93/20 agreement). In these cases the computer supplier retains ownership of the equipment.

[12.370] A – Are the parts trading stock? Parts that are trading stock 3. Spare parts held by a computer supplier are generally trading stock if they are used by the supplier in one or more of the following ways: (a)

Direct sale to customers.

(b)

Repair of equipment, with a separate charge being imposed for the working part supplied (eg over-the-counter repairs).

(c)

Repair of a customer’s equipment under a maintenance agreement under which a periodical maintenance charge is made but generally no additional charge is made each time a part is supplied to the customer. Under the agreement, title to a working part passes to the customer at the time of installation and title to a non-working part passes to the computer supplier at the time it is removed from the customer’s equipment.

(d)

Repair of a customer’s equipment under warranty. No separate charge is imposed on the customer at the time the working part is supplied. Title to a working part passes to the customer at the time it is installed and title to a non-working part passes to the computer supplier at the time of removal.

(e)

Repair to new or used computer equipment purchased for the purpose of selling that equipment.

(f)

Manufacture of computer equipment for sale.

Parts that are not trading stock 4. Spare parts held by a computer supplier are not trading stock if they are used by the supplier in one or more of the following ways: (g)

(h)

Repair of equipment owned and used by the computer supplier as part of its business operations (for example, in its administration, internal accounting, training) – as parts held exclusively for repairs to the capital asset of a business. Repair of the supplier’s equipment which has been rented or hired to other parties (other than under a maintenance

(i)

Manufacture of computer equipment to be owned and used by the computer supplier in its business operations. Expenditure incurred in purchasing these parts is expenditure incurred in purchasing a capital asset and is of a capital nature. B – Multiple purpose acquisitions 5. If a person carrying on business as a computer supplier: (a)

can identify, when acquiring a particular computer spare part, that it is acquired for purposes of manufacture, sale or exchange (ie a trading purpose); and

(b)

is able to track individual parts until disposal, it must treat that part as trading stock. Similarly, if the computer supplier can identify some other purpose for the acquisition of a particular part and is able to track it until disposal, it must apply the appropriate taxation treatment to that part. 6. In most cases, however, computer suppliers hold all spare parts in one pool regardless of their ultimate or intended use. If a computer supplier is unable to identify with certainty at the time of acquisition the ultimate intended use to which the part being acquired will be put, either of the following methods may apply at the option of the computer supplier: Method 1 Whether parts are trading stock of the computer supplier depends on the dominant purpose of the acquisition of the parts. We would accept that, as a rule of thumb, if 80% or more of the pool of parts is to be used under maintenance agreements, all spare parts held by the computer supplier may be treated as trading stock even though 20% of parts are used for non-trading stock purposes; Method 2 If the computer supplier maintains sufficient records to enable it to identify the actual percentage use of spare parts for trading and non-trading purposes respectively, it may treat as trading stock the percentage used for trading purposes. This method is only available if [12.370]

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the records of the computer supplier are able to support the apportionment.

Ruling TR 93/20 cont.

[12.380] One qualification to the treatment of spares is that the supply of stores should not

exceed normal operational requirements. If it does, the expense on the stores may not be deductible under s 8-1 of the ITAA 1997. The authority for this proposition is Guinea Airways Ltd v FCT (1949) 83 CLR 584; 5 AITR 58; 9 ATD 197. In that case the taxpayer claimed a deduction for the value of its stock of spare parts used to repair its aircraft. The stockpile was destroyed but, because the taxpayer had accumulated a large supply (so that it could survive any delays in shipping), the High Court held that the loss was a capital loss. This is the basis for the ATO’s distinction in Ruling IT 333 (above) that in some cases, surplus parts held to repair particular machines may be treated as part of the cost of the machine for depreciation purposes. This same issue arises in the treatment of other aids to manufacture of business such as stationery or packaging materials. The ATO has issued two rulings trying to differentiate the supplies which will be subject to accounting as trading stock, from those that can be immediately expensed. Taxation Ruling TR 98/7 deals with whether packaging items held by a manufacturer, wholesaler or retailer are trading stock. Taxation Ruling TR 98/8 deals with whether materials and spare parts held by a taxpayer supplying services are trading stock.

Ruling TR 98/7 [12.390] 10. We take the view that the ordinary meaning of trading stock encompasses an aggregate of packaging items which a taxpayer has on hand if: (a)

the taxpayer is in business trading in “core” goods; and

(b)

the items are closely associated with the “core” goods sold in the sense that the items either: (i) form part of the “core” goods sold; or (ii)

(c)

bring the “core” goods into the form, state or condition in which they are sold, or intended to be sold, to the customer; and

the items are disposed of by the taxpayer (that is, property in them passes) in conjunction with the sale of the “core” goods.

Packaging items held trading in these items

12. Packaging items held by a taxpayer who is, or will be, engaged in business trading in “core” goods, and who obtains the items for purposes of sale of the “core” goods in the ordinary course of the business, may come either within the ordinary meaning of the term trading stock or within the statutory definition, extending as it does to “anything produced, manufactured, or acquired” (“obtained”) “for purposes of … sale … in the ordinary course of a business”. The packaging items in these circumstances are trading stock if: (a)

the taxpayer is, or will be, engaged in business trading in “core” goods; and

11. Packaging items held by a taxpayer who is, or will be, engaged in business trading in these items (whether as a manufacturer, wholesaler or

(b)

the items are closely associated with the “core” goods sold in the sense that the items either:

[12.380]

a

Packaging items held by a taxpayer trading in goods other than these items

taxpayer

642

by

retailer and whether or not the items are returnable packaging items in the hands of a customer) and who “produces, manufactures, or acquires” the items for sale in the ordinary course of the business are trading stock as defined in section 70-10.

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Ruling TR 98/7 cont. (i)

form part of the “core” goods sold; or

(ii)

bring the “core” goods into the form, state or condition in which they are sold, or intended to be sold, to the customer; and

(c)

the items are disposed of by the taxpayer (that is, property in them passes) in conjunction with the sale of the “core” goods. This will be so whether the taxpayer is a manufacturer, wholesaler or retailer of the “core” goods. 13. We take the view that the word “sale” in the expression “held for purposes of … sale” in the definition of trading stock in section 70-10 pertains not only to the subject – matter of the sale (or the contract of sale) but also relates to the process or activity of selling the things obtained by the taxpayer. Packaging items are obtained and held “for purposes of … sale” of “core” goods if the items form part of the “core” goods or bring them into the form, state or condition in which they are to be sold. Items which do not form part of the “core” goods, or which do not bring the “core” goods into the form, state or condition in which the taxpayer sells them, or intends to sell them, are not sufficiently closely associated with the “core” goods to be trading stock. 14. The level of distribution in which the taxpayer is trading is a relevant factor in determining whether packaging items bring “core” goods into the form, state or condition in which they are to be sold, and thus, whether the items are trading stock. Although packaging items used by a manufacturer might be different from those used by a retailer, the items each uses, if they come within the description in paragraph 12 of this Ruling, are trading stock. A manufacturer, for example, ordinarily packs,

wraps up or secures “core” goods for sale to a wholesaler or a retailer in quantities commercially expedient for the wholesaler’s or retailer’s business. These may be larger quantities, for instance, than those in which the retailer might in turn sell the “core” goods to consumers. Packaging items in which a manufacturer brings “core” goods into the form, state or condition in which the manufacturer sells, or intends to sell, “core” goods could be different, therefore, from packaging items in which a retailer brings those goods into the form, state or condition in which the retailer sells, or intends to sell, the goods. Packaging items held for purposes of manufacture 15. Packaging items held by a taxpayer who carries on business as a manufacturer and who obtains the items for purposes of manufacture of other goods in the ordinary course of business, incorporating the items in the process of manufacture of the other goods, are trading stock as defined in section 70-10. For instance, a manufacturer of baby powder may purchase and hold tins in which to incorporate the final product in the ordinary course of business, namely, tins of baby powder. Returnable packaging items 16. Returnable packaging items are not trading stock as defined in section 70-10 if they are held by a taxpayer who is, or will be, engaged in business trading in “core” goods but who does not dispose of, or pass property in, the items to its customers. Returnable packaging items held by a taxpayer are not trading stock whether the items are: (a)

obtained to make them available to customers; or

(b)

have been returned by customers for re-use.

17. Returnable packaging items are likely to be depreciable plant or articles for the purposes of section 42-15.

[12.390]

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Allocating Income and Deductions to Periods – Timing

Ruling TR 98/8 sale in the ordinary course of a business providing services for reward. This is so if, for instance: (i) the materials or spare parts are sold or disposed of under a contract in which a separate charge is made for the materials and spare parts supplied; and

[12.400] 5. Materials and spare parts held by a taxpayer who produces, manufactures, or acquires them for supply to customers are trading stock within the ordinary meaning of the term if: (a)

the taxpayer is, or will be, carrying on a business providing services to customers for reward; and

(b)

the materials or spare parts are supplied by the taxpayer to the customer in the course of, and as an essential part of, performing the services; and

(c)

the materials or spare parts are separately identifiable things before and after the services are provided which retain their individual character or nature, that is, they are not used up or significantly changed in performing the services; and

(d)

the materials or spare parts are to be disposed of, that is, property in them is to pass to the customer.

6. Materials and spare parts also fall within the extended statutory meaning of the term trading stock in section 70-10 if they are either: (a)

“produced, manufactured, or acquired” (“obtained”) and are held for purposes of

(ii)

(b)

the materials or spare parts are separately identifiable things before and after the services are provided which retain their individual character or nature, that is, they are not used up or significantly changed in performing the services; or

obtained and are held for purposes of exchange in the ordinary course of a business if, for instance, the spare parts are supplied in return for a customers’ defective parts.

7. Materials or spare parts that are supplied by a taxpayer to customers, but only as a minor and incidental aspect of providing services to the customer, are not trading stock.

[12.410] Interestingly, para 3 of Ruling TR 98/8 states that “materials” refers to “articles of

any kind required for making or doing something in the course of providing services but does not extend to consumable stores”. In other words, it offers no assistance in how to make this distinction.

(b) Converting Assets Into and From Trading Stock [12.420] The question now to be considered is one of metamorphosis. Can an item which was

not purchased as trading stock become trading stock, and can an item which was trading stock cease to be trading stock, even though the taxpayer has not sold it? In part, this question involves a question about realisation – is this an area where tax consequences can occur in the absence of a realisation transaction by a taxpayer? The implications of the answers to these questions will soon become obvious. The ITAA 1936 was somewhat oblique about whether it was possible for an asset to become trading stock or vice versa. There was some indication that it was not possible in the definition of “trading stock” in s 6 of the ITAA 1936. “Trading stock” was defined as: “anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange …”. Such a definition suggests that the taxpayer had to acquire an item as trading stock for it to be trading stock. The question has been squarely addressed in the ITAA 1997. 644

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(i) Can property cease to be trading stock? [12.430] What would be the tax consequences if property that was originally acquired as

trading stock changed its status and was no longer held as the stock of a business? This could be the case, for example, with a share trader who ceases trading business but retains some shares for investment purposes; or a land developer who changes their intention with regard to a block of land originally acquired for subdivision and instead decides to build a home for their children on the property. Let us start with the easy assumption that the taxpayer resolves behave in such a way that it would change trading stock into a capital asset and then disposes of the asset in the same year. The disposal of an asset which once was trading stock may trigger a tax liability even though it may escape the application of s 6-5 of the ITAA 1997 by virtue of the fact that the taxpayer has ceased to trade as a business – of course it is by no means clear that s 6-5 is inapplicable to this situation, but let us assume that it cannot apply. In as much as an item of trading stock is acquired for the purpose of resale at a profit, might profits realised upon the sale of what used to be trading stock fall under the charging provision in s 25A of the ITAA 1936 (assuming the asset was acquired prior to 20 September 1985)? Or might property acquired after that date be subject to the charging provisions of CGT? A special provision exists to deal with this possibility: s 70-90 of the ITAA 1997. The applicability of s 70-90, in the form of its predecessor s 36(1) of the ITAA 1936, was considered by the High Court in FCT v Murphy (1961) 106 CLR 146 and by Ryan J in the Supreme Court of Queensland in Kratzmann’s Hardware Pty Ltd v FCT (1985) 16 ATR 274; 85 ATC 4138. The position reached as a result of cases such as Murphy and Kratzmann’s Hardware was said to be a rule that “once trading stock, always trading stock”. In the UK this problem had been examined in Sharkey v Wernher [1956] AC 58 where the taxpayer notionally appropriated a horse which had formerly been trading stock and applied it for private purposes. The costs of the horse had been deductible and so the House of Lords held that the market value of the horse at the time of conversion should be included in income – in effect there was a deemed sale by the owner to herself in another capacity. However, it now appears that s 70-90 is no longer intended to dictate the consequences of such a change. Instead, it looks like the rule is now in s 70-110 of the ITAA 1997. It provides that “if [a taxpayer] stops holding an item as trading stock but still [owns] it” the taxpayer is deemed to have sold the item for its cost and immediately reacquired it. While the rule does not tell us when an item stops being held as trading stock on hand, we now know that the consequence will be the inclusion of the cost of the asset in the taxpayer’s income. Notice, however, that this rule will most likely mean that any profit on the resale will be taxed as capital gain – the taxpayer can now deduct the cost of the stock as it is no longer on hand and then includes the same amount in income. The net immediate effect is nil and tax is postponed to be paid (as CGT) when the asset is actually sold. (ii) Can an asset that was not trading stock become trading stock? [12.440] Similar problems may arise when the change is in the other direction – if an asset

which was not trading stock when it was purchased can become part of the trading stock of a business. If the asset had remained a capital asset, its cost would have been subtracted from the sale proceeds on disposal because of the calculations in the CGT. But if it changes its character and becomes trading stock, how is its cost to be subtracted, and will any cost which can be identified then be subtracted from the year of purchase, the year of change or the year of sale? [12.440]

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Ideally, the value of the asset at the time it is notionally appropriated to stock, and commences to be trading stock “on hand”, would be the cost of the asset for ss 70-35 and 8-1 of the ITAA 1997 and thus dealt with in the same way as if the asset had been purchased. This proposition – that the value of the asset becomes its deemed cost – has been accepted for the purposes of s 25A of the ITAA 1936 in cases such as Official Receiver v FCT (Fox’s case) (1956) 96 CLR 370; 6 AITR 331; 11 ATD 119 and Bernard Elsey Pty Ltd v FCT (1969) 121 CLR 119; 1 ATR 403; 69 ATC 4126. Of course, this position could also be achieved by treating the asset as a revenue asset of the business and applying net profit accounting to any sale, but that solution implicitly denies that the asset can change its character into trading stock. Prior to the ITAA 1997, there were no judicial precedents that might provide guidance as to whether assets could become trading stock, although as we noted above, the former definition of trading stock in s 6 of the ITAA 1936 and cases such as FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355; 12 ATR 692; 82 ATC 4031 suggested that this probably was not possible. Indeed, the construction of the transaction as involving a revenue asset rather than trading stock may imply that an asset could not become trading stock. Again the ITAA 1997 now deals with the consequences of such a change but does not prescribe it. Two alternative rules are provided in s 70-30 of the ITAA 1997 (and s 104-220 of the ITAA 1997) for assets which become trading stock. Where an asset that is not trading stock of a taxpayer becomes trading stock, the taxpayer is deemed to have disposed of the property at either its cost or its market value at the time of the change in status. It is the taxpayer’s choice which value to adopt: 1.

2.

If the taxpayer elects to carry the asset forward at cost, the difference between the gross proceeds of sale and its original cost will be taxed as ordinary income under s 6-5 when it is eventually sold. If the taxpayer did not pay for the asset, s 70-30(4) provides special rules limiting the taxpayer’s cost. If the taxpayer elects to revalue the asset to its current market value, s 104-220 of the ITAA 1997 then provides that a CGT event occurs. The taxpayer will trigger a capital gain if the asset’s market value at the time of change is more than its cost. This captures the increase in value arising while the asset was held as a capital asset (and, importantly, if the asset was acquired prior to 20 September 1985, any gain resulting from a CGT event is exempt from tax). Any further increase in value will be taxed under the income tax provisions when the stock is sold.

[12.445]

Question

12.22 In Curran v FCT (1974) 131 CLR 409, Gibbs J considered that a taxpayer who inherited a car would be entitled to a deemed cost of market value if he later put the car on his car yard and sold it. How does s 70-30(4) of the ITAA 1997 affect this view?

4. SIMPLIFIED ACCOUNTING FOR SMALL BUSINESSES ENTITIES [12.450] In Chapter 11 we examined rules about the appropriate accounting method for

taxpayers to use, exemplified in cases such as Carden, Henderson, Firstenberg, Barrett, Dunn and so on, and in this chapter we have so far examined the rules about the effects of trading stock accounting on taxpayers whose business assets include trading stock. Some of the ordinary tax timing rules are varied for taxpayers who elect to use the so-called Small Business Entity (SBE) rules in Div 328 of the ITAA 1997. 646

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The current SBE rules are an elaboration of the Simplified Tax System (STS) rules which emerged from recommendations in Chapter 17 of the final report of the Review of Business Taxation, A Tax System Redesigned. The STS rules were a deliberate concession to small business, but there is also a genuine intuition behind all small business regimes that it is inappropriate to subject small business to the same degree of tax compliance obligations that can be expected of the NAB, BHP-Billiton or Woolworths. Many countries offer concessions from compliance rules to the small business sector to relieve the burden of tax reporting and filing – the Australian system also changes the tax base for these taxpayers. This policy goal is made explicit in s 328-50. The original STS rules were replaced in 2007 with the SBE rules as part of a process of coordinating a number of different concessions for small businesses that had been added at various places in the Act but which had different access conditions. The table in s 328-10(1) gives you a list of the provisions – some in the GST legislation, FBT Act and Taxation Administration Act 1953 – that all now employ the common term “small business entity”. Notice that there are other rules, such as the indirect value shifting rules and tax-preferred entity rules, which are turned off or varied for small business entities, even though that fact is not listed in the table: see ss 727-470(2), 250-20; and still not all small business measures use the SBE test: see s 165-115GC(4) which switches off the loss duplication rules for small taxpayers but uses a different test. Notice also s 328-10(2) which refers to the shorter statute of limitations period for small business entities. We examine here three of the principal changes from the ordinary rules that are offered to SBEs. They are listed in the table in s 328-10(1): 1.

optional relief from some of the trading stock end-of-year adjustments in Subdiv 328-E: Item 6;

2. 3.

optional access to accelerated depreciation in Subdiv 328-D: Item 5; and concessionary application of the prepayment rules. This is found in s 82KZM of the ITAA 1936: Item 7. The CGT concessions for small businesses listed in Items 1–4 are examined in Chapter 4.

(a) Access to Small Business Entity Concessions [12.460] Each of the provisions listed in s 328-10 offers a taxpayer a potential concession if it

is a “small business entity” as defined in Subdiv 328-C. Taxpayers do not elect to be SBE taxpayers. Rather, they qualify (or not) as an SBE for an income year by meeting the tests in Subdiv 328-C and they then choose which of the various concessions they want to adopt. In general terms, in order to be a small business entity for an income year, the taxpayer must carry on a business in that year and its annual turnover must be less than $2 m: s 328-110. The precise rules are by no means this simple – there are other rules which modify every part of our simple summary. For example, a taxpayer is still treated as carrying on business if it is in liquidation: s 328-110(5). There are other more complicated provisions about calculating the $2 m turnover threshold: • the $2 m turnover threshold will be met if last year’s turnover was under $2 m: s 328-110(1)(b)(i); • the $2 m turnover threshold is typically counted looking just at last year’s turnover, but the rules permit a taxpayer to downsize – to be a SBE if it projects at the beginning of the year that this year’s expected turnover will be under $2 m: s 328-110(1)(b)(ii); [12.460]

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• however, the taxpayer cannot be an SBE taxpayer based on a projection about this year if it exceeded $2 m turnover threshold for the last two years: s 328-110(3); • in fact, the taxpayer can also be an SBE if it turns out that the $2 m turnover threshold is actually met for this year, even though it was not predicted: s 328-110(4); • turnover for these purposes only counts ordinary income, not statutory income, and only ordinary income that is earned in the ordinary course of carrying on the business: s 328-120(1); • adjustments are made to the calculation of a taxpayer’s turnover to deal with the effects of GST and transactions with related entities: s 328-120(2), (4). In order to prevent any advantage from business splitting, the turnover of related taxpayers is also counted toward the $2 m limit. This is the notion of “aggregated turnover” referred to in s 328-110(1)(b) and defined in s 328-115. There are highly elaborate rules to define which other taxpayers – connected entities and affiliates – are to be grouped with the small business: ss 328-125, 328-130. Notice that SBE status applies on a year-by-year basis. Transition can cause potential problems and so there are rules within the operative sections to deal with the effects of a change in each individual area – for example, s 328-220 adjusts the taxpayer’s depreciation calculation between years.

(b) Accounting for Trading Stock [12.470] One benefit of qualifying for the STS regime is the opportunity for slightly less onerous end-of-year adjustments for the taxpayer’s trading stock. The principal provision is s 328-285 which provides: You can choose not to account for changes in the value of your trading stock for an income year if: (a) you are a small business entity taxpayer for that year; and (b) the difference between the value of all your trading stock on hand at the start of that year and the value you reasonably estimate of all your trading stock on hand at the end of that year is not more than $5,000.

The drafting is a little odd – what does it mean to “account for changes in the value of your trading stock”? The apparent intention of the provision is that if the value of the taxpayer’s closing trading stock is less than $5,000 more than the value of its opening stock, the taxpayer does not add back the value of its closing stock. It is apparently intended instead that the taxpayer adds back only the amount of its opening stock. In fact, these two effects are actually stated in s 328-295. Section 328-295(2) provides that if the difference in value is less than $5,000, “the value of all … trading stock on hand at the end of the year [is] equal to the value of all … trading stock on hand at the start of the year”. And in the next year, the opening value of the taxpayer’s trading stock is stated by s 328-295(1) to be the same amount as the closing stock. So for example, assume the taxpayer opens for business on 1 February and buys $10,000 worth of stock during the next five months. By the end of the tax year (Year 1) it has sold 60% of the stock (ie it estimates that the cost of the stock it still has on hand is only $4,000). The taxpayer can deduct the full $10,000 cost of its inventory (s 8-1, confirmed by s 70-25) and no amount is added back to the taxpayer’s assessable income under s 70-35(2) because the taxpayer satisfies the $5,000 test in s 328-285. The taxpayer begins tax Year 2 with trading stock with a cost of $0 (not the $4,000 of actual opening stock) (s 328-295(1)). If during the 648

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next tax year (Year 2) it buys $20,000 of stock (which it deducts) and at the end of Year 2 it estimates it has only $7,000 of the stock left, it must now make the required adjustment under s 70-35(2). Notice that even though the difference between the real cost of the opening stock and the cost of the closing stock is only $3,000, in fact the adjustment is required because the value of the opening stock for trading stock accounting was set at $0 by s 328-295(2), so the $7,000 closing value exceeds the $0 opening value by more than $5,000. If these rules had not been elected, and the taxpayer elected to value stock at cost, the taxpayer would have added back the cost of the closing stock of $4,000 for Year 1, begun Year 2 with a deduction for opening stock of $4,000 and ended the year with closing stock of $7000. In effect, the taxpayer has moved $4,000 worth of deduction from Year 2 to Year 1 and has enjoyed a financial benefit equal to the present value of its tax rate multiplied by $4,000 for one year. The table below shows the effect: SBE

Ordinary rules

Year 1 Sales (say) Less Purchases Less Opening stock Less Closing stock Taxable income

30,000 (10,000) (nil) nil 20,000

30,000 (10,000) (nil) 4,000 24,000

Year 2 Sales (say) Less Purchases Less Opening stock Plus Closing stock Taxable income

60,000 (20,000) (nil) 7,000 47,000

60,000 (20,000) (4,000) 7,000 43,000

Notice that in each case, the taxpayer has made a profit of $67,000 over the two years. The effect of the SBE trading stock adjustment is that $4,000 less of it is treated as earned in Year 1. This shows just how insignificant the concession actually is – the most benefit a taxpayer can enjoy is accelerating a $5,000 deduction (worth, $1,500 to a company) by a year or two.

(c) Depreciating assets [12.480] Subdivision 328-D is the other main provision of the SBE rules. It provides a special pooling regime for calculating the depreciation deduction which small business entities may decide to apply. These provisions are discussed in Chapter 10.

5. ACCOUNTING FOR INTEREST AND SIMILAR AMOUNTS [12.490] This part of the chapter examines the special statutory regime for calculating the

income and deductions arising from certain kinds of financial instruments. The kinds of instruments we are addressing here range from the relatively familiar – loans agreements, promissory notes – to the less familiar world of modern financial engineering using derivative instruments such as forwards, swaps and options. [12.490]

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We need to begin with some history. Consider again the decision in the AGC case discussed in Chapter 11. AGC – and before it Alliance Holdings Ltd (see Alliance Holdings Ltd v FCT (1981) 21 ATR 509; 81 ATC 4637) – were issuing deferred interest debentures to customers under which the company would borrow money on terms that required the company to pay the accruing interest to the customer, but the date for payment was deferred until the last day of the term of the loan. The company was deducting the accruing interest in each year, but the lenders were collecting that interest in cash only at completion of the loan. One of the benefits to the company in issuing these securities arose from the value of the immediate deduction for interest to be paid with deflated dollars. The bonds issued by those companies were particularly popular with cash basis taxpayers who would retain the debenture until just prior to its redemption and then sell it for a price which included the accrued but unpaid interest, and then claim that the proceeds of sale were a capital receipt on the sale of an asset. Another financial product, “DINGO Bonds”, also operated to take advantage of these benefits. Again, the investor deposited funds – in this case by purchasing a bond issued at a discount. The taxpayer would collect the face value at maturity and again any income was not recognised until the date of collection, even though the discount had been compounding during the term. The instruments played on both the timing rules and tax base rules. The government responded to these practices in 1986 with Div 16E of the ITAA 1936. The intent of Div 16E was to require a statutory form of accruals accounting for the income and deductions accruing on certain securities represented by deferred interest, and by other equivalent amounts such as discounts and premiums. Division 16E was curious legislation because it had no effect upon the income tax base. Rather, it just affected timing – it tried to reproduce the treatment that would be afforded by accruals accounting to both the lender and borrower. In other words, it adopted the result the borrower in the AGC case had won, but made sure the lender was taxed on the same basis. Division 16E operated until 2010, when it was replaced with a more comprehensive and more powerful regime for taxing financial arrangements (TOFA). The TOFA legislation will gradually supersede Div 16E. TOFA is more ambitious legislation in that: • like Div 16E, it changes the time at which amounts of income or deduction arising under financial arrangements are recognised (although the rules are slightly more ambitious than Div 16E in deciding which amounts are going to have their timing changed); and • in most cases, it stipulates that gains and losses arising under a financial arrangement and from dealings with instruments are assessable or deductible as statutory income or deductions, rather than as capital gain or loss. (This removes the possibility that some amounts arising under instruments might be capital in nature – recall Lomax v Peter Dixon in Chapter 3.) However, Div 16E is not being repealed because it will continue to apply to the holders or issuers of instruments on foot at the time the TOFA rules commence, and so for the next few years there will be two sets of rules for dealing with gains and losses of financial instruments – Div 16E of the ITAA 1936 and Div 230 of the ITAA 1997. Nevertheless, because Div 16E will eventually wither away, we will focus here on TOFA. Notice, finally, that not everyone has to worry about the TOFA rules. These rules exist principally for two situations: • financial arrangements which involve the deferral of income along the lines of the AGC and Alliance Holdings transactions and still have more than 12 months to run; and 650

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• financial arrangements issued, held or traded in by the “big end of town”, especially retail and investment banks. The rules in s 230-455 provide the mechanism for these exclusions. Anyone can opt in, but only these two groups must apply TOFA. This means it will be quite common for one side of a transaction to have to apply the TOFA rules, but for the other party to be outside these rules and to apply ordinary tax timing rules. In the discussion that follows, for the sake of simplicity, we will focus initially on the position of the lender under one of the simplest kinds of financial arrangement – a loan issued at a discount. In fact, for most individuals, this is the only time they will have to worry about what TOFA does to the ordinary tax accounting rules – s 230-455(1)(e) ensures that individuals only have to apply TOFA to arrangements that are “qualifying securities” with at least 12 months left to run, and a zero-interest bond is a typical example. A “qualifying security” is defined in s 159GP(1) of the ITAA 1936 to mean, principally, a security for a term of more than one year which offers an “eligible return” to the holder. Section 159GP(3) defines a security to have an eligible return where the sum of all the payments to be made by the borrower other than periodic interest, are reasonably likely to exceed the issue price of the security. In other words, the security carries with it a premium on redemption or was issued at a discount, or else, because payment of accruing interest is deferred to later years, the interest is not sufficiently “periodic”.

(a) Income and Deductions Arising from Financial Arrangements [12.500] We will start with the income and deductions rules. Assuming the relevant

thresholds in s 230-455 are met, or they are not met but the taxpayer opts into TOFA, the TOFA regime will apply to every transaction which involves a “financial arrangement”, a term defined in ss 230-45, 230-50 and 230-530. There are also a number of exceptions in Subdiv 230-H, largely to prevent overlap with existing regimes. We do not need to explore here the extent of the coverage of the regime; it is sufficient to note that it will apply to most loans, promissory notes, bills of exchange, foreign currency and derivatives (forwards, swaps and options) held or issued by large taxpayers. The operative rule which makes amounts assessable income is s 230-15 which provides, “your assessable income includes a gain you make from a financial arrangement”. The reference to a gain you make “from a financial arrangement” is presumably intended to mean amounts which arise from issuing, holding, trading in, redeeming or cancelling financial arrangements. This notion of “gain” from a financial arrangement is the verbal formulation of the notion that interest, discount and premiums are assessable. It is not meant just to refer to the gain made on selling or redeeming the instrument. This is quite important and easy to miss. Interest arising under a financial arrangement is no longer assessable per se, at least so far as the TOFA rules are concerned. What will be assessable under TOFA is the “gain” – part of which is made up of the interest received – from the financial arrangement, and that entire amount of gain will be computed and allocated to individual income years by the TOFA rules. As we just said, the reference to “gain” is presumably intended to refer both to flows from the arrangement and to amounts received on the sale or redemption of the arrangement. So far as gains on the disposal of financial arrangements are concerned, Subdiv 230-H applies. It creates a balancing adjustment regime on the disposal of financial arrangements. The system set out in the table in s 230-445 compares the taxpayer’s outflows (typically payments made to acquire the arrangement under Step 2(a)) with cash inflows (the sale proceeds under Step 1(a)) [12.500]

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and amounts (usually of interest) taxed to the taxpayer while holding the instrument (Step 2(b)). Where the balancing adjustment amount arising on a disposal is positive (the taxpayer bought it for $10,000 and sold it for $12,000), the additional amount ($2,000) is “taken … to be a gain you make from the financial arrangement” and is thus included in assessable income under s 230-15. Notice that there is no income v capital issue here – the gain is simply included in income whether it is a revenue or capital gain. There are a number of exceptions to the inclusion rule in s 230-15. Section 230-25(1) excludes gains made in deriving exempt or NANE income. There is a further exclusion in s 230-25(3) for gains made on financial arrangements that are “private or domestic”. Division 230 also contains the necessary provisions to allow various amounts to be deductible, again with special extensions and exclusions. Section 230-15(2) restates the tests in s 8-1 of the ITAA 97 to allow deductibility: You can deduct a loss you make from a financial arrangement, but only to the extent that: (a) you make it in gaining or producing your assessable income; or (b) you necessarily make it in carrying on a *business for the purpose of gaining or producing your assessable income.

If you compare this section to s 8-1, the obvious omission is any reference to a limit on deductibility because the loss or outgoing is capital in nature. The omission of a limit on deductibility because the outlay is “capital” will remove some problematic distinctions that exist in current law. This formulation would, for example, render moot the debate about those instances which might survive the decision in Steele’s case where interest could be considered to have a capital nature. It will also remove the argument that some losses made on the discharge of structural liabilities would be capital in nature. Note, however, that the current limit on deducting capital losses made on the sale or redemption of traditional securities under s 70B(4) of the ITAA 36 is retained by s 230-320. But removing a “capital or of a capital nature” limitation does not solve all questions. Rather, it explicitly puts in focus the circumstances when interest might be non-deductible because it is insufficiently connected to earning income or carrying on the business. The lack of adequate connection might occur because of a lack of temporal nexus – obvious examples would be cases such as Riverside Road or Brown. The basic framework for deductibility is supplemented in s 230-15(3) which provides that a loss from a financial arrangement can also be deducted if it is made in earning foreign-source, non-assessable, non-exempt dividend income and arises from a debt interest issued by the taxpayer. Again, this requirement replicates the current test for the deductibility of interest expense under existing law in s 25-90. Section 230-25 contains the limitation that a loss on a financial arrangement made in gaining exempt income or NANE income is not deductible. It also provides that a loss made on a financial arrangement used to raise finance for a private or domestic purpose is similarly not deductible. Again, this reproduces the test under current law. These operative rules – especially s 230-15(1) and (2) – create the impression that Div 230 is meant to be a complete statement of the tax treatment of amounts arising under financial arrangements. The argument would be that s 6-5 and s 8-1 have no role, because s 230-15 does the work of making interest assessable and deductible. This is not the drafter’s intention, however. Rather, it seems ss 6-5 and 8-1 continue to operate, but their effect is deferred to Div 230. This is seen in s 230-20 and s 230-25 which are based on the assumption that ss 6-5 and 8-1 and other sections would continue to operate to tax interest income or permit interest 652

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payments to be deducted. Hence, ss 230-20 and 230-25 prevent these sections from operating again on amounts that have already been included in performing TOFA computations. The same issue arises with respect to CGT – transactions with financial arrangements could generate capital gains or losses for many non-bank taxpayers. Here, however, a more robust approach has been taken. Section 118-27 switches off completely the operation of CGT for capital gains and losses made on CGT assets that are financial arrangements at the time that the relevant CGT event occurs.

(b) Standard Timing Rules [12.510] The second aspect of the TOFA rules is the timing rules – that is, the rules which

prescribe when the gain or loss arising from the financial arrangement is to be recognised for tax purposes. The principal timing regime in the TOFA legislation is the basic and mandatory regime in Subdiv 230-B which taxes the gain or loss either on an accruals basis over the life of the instrument, or at realisation. Accrual or realisation? The decision whether the taxpayer must report income during the life of the instrument or can wait until an amount is actually received depends on whether or not a particular amount arising under the instrument is “sufficiently certain”: s 230-100(2), (5). To see the kind of distinction being envisaged, consider the following three bonds issued by a company and held by a large financial institution: • The first bond is issued at a discount: the institution pays $10,000 for a bond which does not bear interest but which provides that the borrower will pay $12,000 to the holder of the bond in two years. The discount of $2,000 is “sufficiently certain” – it is known in advance and cannot fluctuate – and so it is spread over the life of the bond. • Compare this bond: the institution pays $10,000 for a bond which does not bear interest but provides that the borrower will pay to the holder of the bond in two years, the sum invested × the increase in the consumer price index over the two years. The exact amount of gain on this bond is not entirely certain, but is it “sufficiently certain”? Section 230-115 amplifies the basic term “sufficiently certain” in a number of ways. Subsection (2) says an amount is sufficiently certain if it is “fixed” or if it is “determinable with reasonable accuracy” – a reasonably accurate guess is sufficient. Other provisions assist by telling the taxpayer to make some simplifying assumptions: subss (4) and (5) say, in effect, you should assume that interest rates will continue to be at their current rate and that the rate of change to the CPI will continue at a constant level; s 230-105(2)(a) says to assume the taxpayer will continue to hold the instrument for its full term. Thus it seems reasonably clear, making these simplifying assumptions, that the gain from this bond can be determined with “reasonable accuracy” and will have to be spread as well – the taxpayer will have to assume that the CPI would continue to increase at its then current rate (say 10% per annum) and so it will have to assume that in two years it will receive $12,000. The gain of $2,000 would have to be spread over the life of the bond. (Notice that there are rules in s 230-190 which permit the taxpayer to correct its position during the life of a financial arrangement if assumptions turn out not to be accurate – say, CPI turns out to be 8% in one year.) • Compare finally this bond: the taxpayer pays $10,000 for a bond which does not bear interest but provides that the borrower will pay to the holder of the bond in two years the sum invested × the rate declared by the company for payment of dividends in each year. Thus, if the company declares no dividend, the noteholder would receive back just the amount invested; if the company declared a dividend of 6 cents per share in each year, the noteholder would receive $11,200. A number which depends upon corporate profitability, [12.510]

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the discretion of directors and the approval of shareholders is probably not “sufficiently certain” because no reasonably accurate prediction can be made (even with the help of the simplifying assumptions), and so the noteholder would not have to anticipate any of the expected increase in the value of the bond during its life. The taxpayer will include the gain of $1,200 in its income when the bond is repaid (or sold). How much is accrued in each year? Where the taxpayer is required to accrue amounts, just how much of the “sufficiently certain” gain on the first two instruments ($2,000) has to be reported in each income year? The rules about this process are in s 230-125 ff. Section 230125 suggests this is a three-step process: work out the life of the instrument (s 230-130(1)), work out how much of the gain or loss is appropriate to periods within the life of the instrument, and then, if those periods straddle an income year, how much belongs in each year. The most significant part of this process is in s 230-135 which says that the gain or loss is ordinarily to be allocated using “compounding accruals” calculated on at least annual rests and with equal payment periods. The equivalent rules in Div 16E ran to several pages; the rules in TOFA are quite deliberately flexible and non-prescriptive. To see what is envisaged, consider a bond like the first discussed above – this example comes from the explanatory memorandum which accompanied the TOFA Bill. Assume on 1 July 2015 the taxpayer pays $100 to buy a bond that pays no interest but will pay $120 at maturity in four years time. The taxpayer must calculate the discount rate – that is, the interest rate at which the $120 in four years is worth $100 today. The standard formula for doing this is 120/(1 + r)4 = 100. That rate is 4.66% per annum. Notice that this is the rate if it is assumed that the calculation is done based on four equal annual periods of one year, the minimum that s 230-135 requires. This rate is then applied to the principal that is actually invested in the first year, and then notionally reinvested each year after that. The result is the gain of $20 spread over the four-year period and the taxpayer includes the relevant amount in its income each year: Year ending 30 June 2016 30 June 2017 30 June 2018 30 June 2019 Total

Principal $100.00 $104.66 $109.54 $114.65 $120.00

Interest $4.66 $4.88 $5.11 $5.35 $20.00

Notice that the system does not simply divide the $20 evenly over the four years and allow the taxpayer to report $5 income per year, even though this would seem quite a satisfactory outcome so far as the revenue is concerned. In fact, para 230-125(2)(b) says that taxpayers may also use “a method whose results approximate those obtained using [compounding accrual]” but the explanatory material which accompanied the TOFA bill says a simple even division of the gain on a daily basis would be acceptable for “short term arrangements” or arrangements which pay interest at least annually. This example is very simple because the bond was purchased on 1 July 2015. Unfortunately, taxpayers do not often organise their affairs so conveniently. This is where the third step of the three-step mechanism in s 230-125(c) comes into play. What happens if the taxpayer bought the bond on 30 September 2015? There are a couple of options – the taxpayer might include the amounts on each anniversary of buying the bond, but this would mean no amount was 654

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included in the first year’s income for the nine-month period from 1 October 2015 to 30 June 2016. Section 230-170 addresses this situation. It says in effect that the taxpayer cannot make assumed calculation based on annual periods and wait until each anniversary. Subsection (2) directs the taxpayer to spread some of the first year’s interest ($4.66) between the period from October to June (say, 9/12ths) and the rest for the period from July to the end of September (say, 3/12ths). And, of course, the same thing would have to happen each year thereafter with each year’s interest. This might lead the taxpayer to be a bit more ambitious about doing these calculations and, say, make the calculations based on quarterly rests using an interest rate of 1.15% per quarter: Quarter ending

Principal

Interest

31 December 2015 31 March 2016 30 June 2016 30 September 2016 31 December 2016 31 March 2017 30 June 2017 30 September 2017 … etc … 30 September 2019 Total

$100.00 $101.15 $102.31 $103.49 $104.68 $105.88 $107.10 $108.33

$1.15 $1.16 $1.18 $1.19 $1.20 $1.22 $1.23 $1.25

$118.71 $120.00

$1.37 $20.00

Assessable income at 30 June

$3.49

$4.84

This example is also a bit simpler than reality because the taxpayer bought the bond on 30 September 2015, the last day of a quarter. What would happen if the taxpayer bought the bond on, say, 20 September? The taxpayer could do the same calculations as above for quarters running from the 21st of each month, but this would omit any income for the period from 21 to 30 June. It may also not sit well with the taxpayer’s own internal systems which might run on a quarter or calendar month. Section 230-135(4) does allow the taxpayer to adjust the calculation for truncated periods – the period from 21 to 30 September for example – and then apply even, say, quarterly periods thereafter. Changing circumstances. We mentioned above that the rules can require a taxpayer to calculate income and deductions based on guesses about the future. Sections 230-185 and 230-190 deal with some of the consequences of those guesses being wrong or overtaken by subsequent events. Section 230-100(2)(b) says that a taxpayer must decide whether to apply the accrual method or realisation method “at the time when you start to have the arrangement.” Section 230-185 requires the taxpayer to revisit this decision during the life of the arrangement if there is a “material change to the terms and conditions of the arrangement”. Subsection (2) gives examples of the kinds of changes that will trigger a “re-assessment” of the appropriate methodology to apply. In other words, in some cases, a taxpayer may have to start or stop applying its original accounting method during the life of the instrument. Notice, however, that the material changes being referred to all appear to be changes to the terms of the arrangement; the taxpayer apparently cannot switch off accrual accounting just because the borrower is in financial difficulties and payment now appears unlikely. [12.510]

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Section 230-190 deals with a slightly different issue – what happens if the taxpayer has been accruing amounts based on the assumption that over the four-year term of the bond, the CPI will remain at 10%, but the CPI turns out to be 8% in the second year? There are a number of ways in which such a situation might be handled in theory (short of actually amending last year’s tax return). The taxpayer might be given a special deduction in Year 2 to reverse the impact of the over-inclusion that happened in the first year and be allowed to adjust the amount to be included in Year 2; the taxpayer might have to leave Years 1 and 2 alone, but be able to revise down the amounts to be included in income for years 3 and 4 because of the over-inclusion in Years 1 and 2; or the taxpayer might have to wait until the end of the arrangement and make the adjustment then, when it receives, say, $118 instead of the $120 it had expected when the bond was acquired. The rule in s 230-190 allows the taxpayer to re-estimate the amount of gain or loss if “circumstances arise that materially affect the amount or value or timing of financial benefits that were taken into account …” and to do so “as soon as reasonably practicable after you became aware of the circumstances …” Subsection (3) gives as examples of sufficient material events changes in market conditions, cash flows becoming known and debts turning bad. Subsection (4) makes it clear that the lender cannot re-estimate future gains just because the borrower is in financial difficulties. The adjustment is made using the second of the possible solutions described above – adjusting down the amounts for future years, or as the statute puts it in subs (5)(b), the “reapplication of the accruals method … to make a fresh allocation of the part of the redetermined gain … that has not already been allocated to intervals ending before the re-estimation … to intervals ending after the re-estimation …” In fact there is a third regime in the TOFA system which also adjusts predictions and reality, this time using the first of the possible solutions described above. The examples so far in this part of the chapter have all involved financial arrangements which were issued at a discount and carried no interest. Consider now another bond: the bond has a face value of $10,000 and bears interest paid periodically, but the interest rate can vary over the term of the instrument. This is in fact a description of a retail savings bank account – it carries interest at the then current market rate. Or it might be a corporate bond which bears interest at the consumer price index rate plus 2 percentage points. Or it might be some Notes which carry interest at the bank bill swap rate plus 4 percentage points. The exact amount of interest on this bond is not entirely certain at the time the bond is purchased, but it is probably “sufficiently certain” once the simplifying assumptions are made. It might seem odd to force taxpayers to estimate gains and losses on a bond like this, given that the interest will be paid periodically – unlike the bond issued at discount, there is no deferral of the taxpayer’s profit until the end of the arrangement. Nevertheless, the TOFA rules apply and will require taxpayers to predict the likely interest, to accrue some amount, and then to adjust for reality. Section 230-175 creates a running balance adjustment regime which reconciles amounts projected with amounts received. This provision differs from s 230-185 and s 230-190, both of which are invoked only where there is a “material change”, although the boundary between s 230-175 and s 230-190 seems more than a little vague. Section 230-175 would operate if the taxpayer projected that it would receive $2,000 on 1 August when the next interest payment would fall due, and reported an amount of income in the year ended 30 June based on that prediction. An adjustment can be made if the amount actually received differs. The section applies if “a provision of this Subdivision has applied on the basis that you were sufficiently 656

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certain … to receive … a particular amount … and … the amount you receive [is different]”. Subsections (1) and (2) deal with the two possibilities: • The amount received is less than the amount projected, so that the taxpayer has over-estimated its income. In this situation, the taxpayer is entitled to a deduction for a loss, and the amount is allocated to the year in which the payment was received: subs (1); • The amount received is more than the amount projected, so that the taxpayer has under-estimated its income. In this situation, the taxpayer is treated as having made an additional gain, and to have made it in the year in which the payment was received: subs (2). Sales and part sales. The rules in Subdiv 230-G create a balancing adjustment regime that is triggered when a financial arrangement is sold or part of an arrangement is sold, or if an arrangement ceases to be a financial arrangement: s 230-435. It is the final reconciliation of everything that has happened under the arrangement. Under Step 3 of the Method Statement in s 230-445(1) the taxpayer may make a further gain (assessable income) or a further loss (an allowable deduction) as a consequence of the balancing adjustment. To see how this works, consider again the first example above. Assume that on 1 February 2015 a taxpayer subscribes $10,000 for a bond that carries no interest but will pay $12,000 in two years time. Assume the holder holds the bond for 19 months and sells it in August 2016. The taxpayer will have had to report some of the $2,000 gain in the year ended 30 June 2015 (say $400) and another amount in its return for the year ended 30 June 2016 (say another $1,000). Now consider what happens if the security is sold in August 2016 for: • $11,300 – in this case, the taxpayer has realised a commercial loss because it bought the bond for $10,000 and has already been taxed on the assumption that it would enjoy another $1,400. In fact, it has only realised $1,300 (perhaps because market interest on other bonds has risen or this borrower is now considered less creditworthy) so it should be entitled to a special deduction of $100. This amount is calculated in these steps: Step 1: $11,300 (Item (a)) Step 2: $10,000 (Item (a)) + $1,400 (Item (b)) = $11,400. As Step 2 exceeds Step 1, Step 3 provides “an amount equal to the excess ($100) is taken, as a balancing adjustment, to be a loss that you make from the arrangement”. • $11,600 – in this case, the taxpayer has realised a commercial gain because it bought the bond for $10,000 and has been taxed on the assumption that it would enjoy another $1,400. In fact, it has enjoyed $1,600 and so it should report an additional $200 as assessable income. This amount is calculated in these steps: Step 1: $11,600 (Item (a)) Step 2: $10,000 (Item (a)) + $1400 (Item (b)) = $11,400. As Step 1 exceeds Step 2, Step 3 provides “an amount equal to the excess ($200) is taken, as a balancing adjustment, to be a gain that you make from the arrangement”. Issuers of financial arrangements. The discussion so far has focused just on the position of the lender under a very simple financial arrangement – a loan issued at a discount. But TOFA is also meant to prescribe the position of borrowers under these loans, and the position of parties with obligations under other kinds of financial arrangements. The operative provision in s 230-15(2) makes that clear from the outset by prescribing when losses made on financial arrangements are deductions, and the rules in Subdiv 230-B are all couched in terms of the financial benefits that you “are to receive or are to provide under the arrangement”. So the timing position of borrowers is also governed by these rules – the borrower deducts [12.510]

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amounts using an accrual method if the amount is “sufficiently certain”, or at the time of realisation if not certain. The rules about the effects of changed circumstances also apply to borrowers as do the rules about balancing adjustments, typically when the issuer has to redeem the arrangement.

(c) Elective Timing Rules [12.520] We have alluded to the fact that TOFA is a very extensive regime and its scope

extends far beyond loans issued at a discount. It is also intended to operate in the rarefied world of derivative instruments such as forwards, swaps and options. Indeed, enacting a statutory regime for these exotic instruments was one of the main reasons for TOFA. These kinds of financial arrangements do not sit well within the system in Subdiv 230-B because cash flows under them are not predictable, and so taxpayers are offered other options which typically will permit them to use for tax purposes the timing rules they already use in preparing their commercial accounts. The four optional regimes are: 1. 2. 3.

an optional regime which allows certain financial instruments to be taxed on a fair value (ie a market-to-market) basis: Subdiv 230-C; an optional regime which allows certain foreign currency denominated positions and “qualifying forex accounts” to be taxed on a retranslation basis: Subdiv 230-D; an optional hedging regime: Subdiv 230-E; and

4. an option to use the amounts recorded in an entity’s financial statements: Subdiv 230-F. The ability to substitute any of these options for the basic method in Subdiv 230-B is not simply a matter of choice – taxpayers must meet a number of requirements. In general terms, access to the options will usually require that the taxpayer prepares accounts in accordance with the Australian or foreign accounting standards, the accounts are audited, and the accounts classify and treat the instrument and amounts arising under it in a particular way. In other words, the relevant accounting standard must be invoked by the taxpayer and applied to the instrument in its financial accounts. The kinds of standards that the requirements are alluding to include AASB 132 – Financial Instruments: Disclosure and Presentation, AASB 139 – Financial Instruments: Recognition and Measurement, AASB 7 – Financial Instruments: Disclosures and AASB 121 – The Effects of Changes in Foreign Exchange Rates. We will consider two situations where these rules might be invoked by a taxpayer. The first is the shares and other securities held by banks in their trading portfolio. Banks will usually revalue these shares to their market value in reporting their financial position – that is, the bank will report as profit not only the dividends received on the share but also the fact that the market value of the share was higher at the end of the year than it was at the beginning. And if the reverse happens – the market value of the share was lower at the end of the year than it was at the beginning – the bank will report the decline in value as a loss. The banking industry wanted to do the same for tax purposes. All shares are defined to be financial arrangements (ss 230-50, 230-530(2)) and so they would be within the TOFA regime. However, Subdiv 230-B would not view movements in value as “sufficiently certain” – who can predict what the share market will do – and taxpayers do not have the choice under the rest of the tax legislation: (i) just to revalue their assets and claim an increase as income or a decline as a deduction; or (ii) to ignore the profit made on a real sale when it occurs on the basis that it was already accounted for in some prior year. (Notice that banks do not hold these shares as trading stock as described in Chapter 5.) Subdivision 230-C allows banks this option: 658

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• Section 230-210(2) states that the taxpayer can make a “fair value election” if the taxpayer prepares accounts in accordance with the Australian or foreign accounting standards and the accounts are audited. • If the taxpayer makes the election, s 230-220 says the scope of the election extends to all financial arrangements that are reported in the financial accounts (and are included in future accounts) as assets that are classified “as at fair value through profit and loss” – in other words, the taxpayer records the movements in the value of these assets as generating profit or loss for accounting purposes. • If the taxpayer makes the election, s 230-230 provides that the amount of gain arising under the financial arrangement for tax purposes is “the gain … that the [accounting] standards … require you to recognise in profit or loss for the income year from the asset …” The second example is a little more complicated. It deals with a hedge transaction. The taxpayer, an Australian company, negotiates a contract on 19 February to sell its main US office in Los Angeles to a US company, with completion expected to occur in six months, after certain renovations are complete. The price of US$15 m is payable on completion. At the time the contract is entered, the taxpayer would expect to receive A$23 m at current exchange rates of A$1 = US$0.65. If the building has a cost base of A$13 m, the taxpayer expects to make a taxable capital gain of A$10 m. It plans to use the US$15 m to buy another building in San Francisco. But the taxpayer may be concerned that the exchange rate will move against it over the next six months – that is, the Australian dollar may rise. The company decides to hedge the exchange rate exposure by entering a forward foreign currency contract – that is, it contracts with Bank Ltd to sell its US$15 m in six months for an agreed price of A$23 m. The effect is that it has locked in a fixed price for its sale regardless of movements in the exchange rate, up or down. When it receives the proceeds of selling the building (US$15 m) it has already sold the same amount to Bank Ltd for A$23 m. If the currency appreciates and the taxpayer receives less Australian dollars for its US$15 m, there will be an additional gain on the currency contract and this will compensate; or if the Australian dollar depreciates and the taxpayer receives more Australian dollars for its US$15 m, it will have to sell these US$15 m to Bank Ltd for a loss. (In fact, the currency sale to Bank Ltd will probably not occur, especially if the taxpayer will need US dollars to complete the purchase in San Francisco – Bank Ltd will probably just make up, or collect from the taxpayer, the difference between the amount that the taxpayer collects valued at the spot rate and the agreed price of $A23 m.) From a commercial point of view, the currency hedge is simply a mechanism for ensuring price stability – it has no independent commercial significance. But tax law will view the currency hedge and the underlying asset, as separate assets and each will have its own timing and character rules. This will matter if the times at which each is realised do not exactly match, or if their characters are different. Given that the gain or loss made on the building will probably be of a capital nature, and the foreign currency sale will be a financial arrangement, there is certainly a character mismatch. And given that the capital gains tax event for the land happens at the time of contract, while the foreign exchange transaction does not get settled until completion, there is a potential timing mismatch as well. The rules in Subdiv 230-E exist to allow the taxpayer to align the time of realising, and the tax character of, gains and losses made on the head office and the hedge.

[12.520]

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• Section 230-315 states that the taxpayer can make a “hedging financial arrangement election” if the taxpayer prepares accounts in accordance with the Australian or foreign accounting standards and the accounts are audited. • If the taxpayer makes the election, s 230-325 says the scope of the election extends to all current and future hedging financial arrangements that meet certain requirements. Section 320-355 creates a series of record-keeping obligations that map the particular risk that the taxpayer wants to hedge, the taxpayer’s strategy and the mechanism for hedging the risk. Section 230-365 also stipulates that the hedge must be “expected to be highly effective …” Most importantly, s 230-360 requires the taxpayer to determine and record just how gains and losses are to be allocated from the hedge so that they “fairly and reasonably correspond with the basis on which gains, losses … in relation to the *hedged item … are recognised … under this Act …”. • If the taxpayer makes the hedging election, s 230-300(3) provides that the amount of gain arising under the hedging financial arrangement is treated as arising in the year that was determined under the plan in s 230-360. • Further, if the taxpayer makes the hedging election, s 230-310 provides that the tax character of the gain arising under the hedging arrangement is given the same character as the hedged item. Returning to the example, the forward currency contract would qualify as a hedging financial arrangement because it hedges the taxpayer’s foreign currency risk. Assuming the taxpayer has met the documentation and effectiveness requirements, the taxpayer would be able to make the hedging election. By making the election, the taxpayer would hope to match the time at which the gain or loss from the currency hedge arises with the time at which any gain or loss from the sale of the building occurs, in accordance with its plan in s 230-360. So, for example, the gain or loss on the sale of the building will be recorded in the year in which the contract for sale of the building was entered because of s 104-10(3). But the gain or loss from the hedging financial arrangement would, under the ordinary rules in Subdiv 230-B and apart from Subdiv 230-E, arise six months later when the gain or loss on the forward sale is realised. Section 230-360 exists to allow the taxpayer to shift the gain or loss from the hedge to the same period as the gain or loss on the building. Further, the taxpayer would also hope to be able to match the character of the gain or loss from the hedge with that arising on the sale of the building. The rules in s 230-310 operate as an exception to the general rule that gains and losses arising under financial arrangements are taken to be on revenue account – they exist to confer capital character on the gain made under the foreign currency hedge if the hedged asset or liability is capital in nature. This occurs in Item 1 in the Table in subs (4) – because the gain or loss arising under the hedging financial arrangement is reasonably attributable to a gain or loss made on a CGT asset, then the gain or loss made under the arrangement “is treated as a capital gain [or loss] from a CGT event”. To complete the example, if, by the time of completion: • the Australian dollar has appreciated relative to the US dollar, to A$1 = taxpayer will still collect the US$15 m proceeds which is worth A$21.4 m. will make a capital gain on the sale of the building of only $8.4 m, not expected. But Bank Ltd will pay it a further A$1.6 m pursuant to the agreement, taking the total capital gain for the year back to $10 m. The 660

[12.520]

US$0.70, the The taxpayer the $10 m it forward sale gain that the

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taxpayer makes on settling the forward sale contract is treated as a capital gain (even though made under a financial arrangement) and made in the year in which the contract for sale of the building was entered; • the Australian dollar has depreciated relative to the US dollar, to A$1 = US$0.55, the taxpayer will still collect the US$15 m proceeds which is worth A$27.2 m on the spot market. Now the taxpayer will have made a capital gain of A$17.2 m, not the $10 m it was expecting. However, it will have to pay Bank Ltd A$4.2 m pursuant to the forward sale agreement. The loss that the taxpayer makes on settling that contract is treated as a capital loss made in the year in which the contract for sale of the building was entered. The taxpayer can offset the capital loss made on the forward sale agreement against the higher capital gain it made on the sale of the building. The discussion may leave readers dazed and confused. The rules are certainly not easy to grasp or to apply. But there is hope; the government shares your pain. In the May 2016 Budget, the government confessed that, “TOFA has not delivered the envisaged compliance cost savings and simplification benefits to … taxpayers.” Consequently it announced that the government, “will reform the taxation of financial arrangements rules to reduce the scope, decrease compliance costs and increase certainty through the redesign of the TOFA framework. The new simplified rules will apply to income years on or after 1 January 2018.”

6. PREPAID EXPENSES AND AVOIDANCE SCHEMES [12.530] This part of the chapter examines two sets of statutory rules that deal with the

timing of deductions. The rules operate either to defer deductions when there is acceleration or to deny them when there is a timing mismatch from a transaction with an associate. Unfortunately, due to the 20 years that separate their introduction, they do not mesh well within the Act, but they serve similar goals and so are examined together here. Where a specific deduction provision allows deductions over the shorter of the life of a benefit and a fixed time period, the provision is concessional only in the case of expenditures to acquire benefits that enjoy a longer life than the maximum write-off period. Where the provision stipulates a fixed amortisation period, with no option for faster write-off if the benefit expires in a shorter period, it could, in theory, be concessional for some taxpayers and onerous for others. We saw in Chapter 7 that most prepayments are a form of dual-purpose outgoing, with the amount ultimately incurred to achieve an income-generating objective but the timing based on a desire to achieve another objective, namely tax minimisation. As a result of the judicial interpretation that an expense may be “incurred” and hence deductible under s 8-1 even when it has not yet been paid, it is attractive for tax purposes to “incur” and claim deductions for expenses immediately and declare relevant income, or receive the benefits under a contract, at a later time. The prepayment rules remain in the ITAA 1936. Section 82KZMD provides that a taxpayer who would otherwise be able to deduct a prepayment under s 8-1 is required to allocate the expenditure evenly over the shorter of the period to which the prepayment relates and 10 years. The taxpayer must deduct the amount on a daily pro rata basis over that period. The allocation rule applies to individuals who carry on a business and entities that are not carrying on a business incurring: s 82KZMA. For small business taxpayers, as a result of s 82KZM, the ordinary pro rata rules which spread deductions over the benefit period will only apply if the benefit lasts for longer than [12.530]

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12 months from the time of payment. Prepayments made by qualifying small business taxpayers for expenses related to benefits lasting 12 months or less can therefore be deducted immediately (assuming they satisfy the positive limbs of s 8-1). Thus, for example, a small business taxpayer could prepay 12 months’ interest on 30 June and deduct the entire amount in respect of the fiscal year ended 30 June, even though only 1/365th of the payment related to the income year in which the expense was incurred. It is common for small business owners to prepay rent, or professional subscriptions, in this manner. The concessional prepayment rule for small businesses does not extend to prepayments related to “tax shelter” investments. Prepayments related to tax shelter investments are deductible over the life of the acquired benefit: s 82KZMF. These are defined (in s 82KZME) as arrangements where a third-party manager has day-to-day control over the activity in which the taxpayer has invested. Another provision that requires taxpayers to recognise over a period expenses that yield longer-term benefits, but which most likely would be characterised as immediately deductible revenue outgoings if not for the provision, is s 25-25 of the ITAA 1997, which applies to borrowing expenses (capped for the shorter of the benefit life or five years).

(a) Prepayment Rules [12.540] Consider the position of a taxpayer who pays a $20,000 premium on 1 March for

an insurance policy with a term of two years. How much of the $20,000 can be deducted in the current year? Reference has already been made in Chapter 11 to the fact that, apart from the decision in Coles Myer Finance, there is no common law principle for spreading the cost of an allowable deduction over the life of any benefit it acquires. Instead, the two questions are: has the expense been “incurred”; and was it capital in nature? When money has actually been outlaid, it is hard to dispute the fact that the payment has been “incurred” in Ilbery’s case [1981] FCA 188, the Court accepted that, “expenditure actually made is an outgoing incurred”. But the cases will sometimes treat the fact that a payment generates an enduring benefit as indicating that the outlay was of a capital nature, and so not deductible under s 8-1. But there are many payments which courts have been reluctant to view as “capital” in this sense (interest, rent, insurance premiums and so on) and so the conditions exist for taxpayers to accelerate their deduction by prepaying next year’s expenses. It has been suggested that a cost expiry or amortisation rule would be a valuable contribution to common law tax accounting, but it does not generally exist. Instead, a general statutory regime was introduced in 1988 in s 82KZM of the ITAA 1936, and this is what we will examine here. Before we examine this regime, the Act has for a long time contained a few specific provisions where expiry of a sort is mandated for outlays, both revenue and capital. For example, for expenditure on certain wasting capital assets, depreciation in Div 40 of the ITAA 1997 allows a deduction for a proportion of the capital cost of equipment spread over the life of the asset where it is used to produce assessable income. Another example is Div 43 of the ITAA 1997 which provides a cost amortisation regime for certain capital expenses associated with some types of construction projects. Other provisions apportion a revenue expense over its life by amortising a deduction until it expires. An example where the cost of a revenue expense is deferred over the period of consumption is s 25-25 of the ITAA 1997 applicable to borrowing expenses. That section allows as a deduction for expenditure incurred borrowing money and spreads the deduction over the life of the loan or five years, whichever is shorter. 662

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Division 16E of the ITAA 1936 was also an example of this procedure by spreading the cost of interest for the issuer of a debenture over the life of the debenture. It might be thought that a complete application of the earning principle adopted in Arthur Murray would require some deferral (although it may not be clear exactly for how long and in what manner the deferral should be made). In fact, most of the cases decided in Australia in which the potential creation of an expiry rule might have arisen have nothing to say on this question and, instead, such authority as there is, tells against this possibility. The statutory assault on claiming deductions for prepayments began in 1988 with the enactment of s 82KZM of the ITAA 1936. The provision was further strengthened in 1999 and again in 2000 as a result of the report of the Review of Business Taxation (RBT). The 1988 version of the prepayment rules enacted what was commonly referred to as the “13-month rule” for expenses over $1,000 – that is, a taxpayer could deduct a prepayment in the current year, but only if it was less than $1,000 or it procured a benefit that would last for less than 13 months. So for example, a payment of $25,000 in interest on 1 June would still be deductible in the current year even though the payment satisfied the entire interest obligation for the next tax year, but not to the extent that it satisfied the interest obligation of the year after that. If the benefit procured by the prepayment lasted for more than 13 months it was pro-rated on a simple time basis (up to a maximum period of 10 years). The section was only intended to change the timing of a deduction, so it was stipulated that the section only applied where the outlay would otherwise be deductible under s 8-1 of the ITAA 1997. The RBT (Recommendation 4.6) proposed strengthening this regime by turning the 13-month rule into an “end-of-the-tax-year” rule for all taxpayers except small business taxpayers and individuals. For them, the 13-month rule would become a 12-month rule. The recommendation was eventually enacted with some modifications in 1999 by amendments to s 82KZM. The section was further amended in 2000 as part of the government’s attack on the so-called “mass-marketed tax-effective schemes”. The second round of amendments formed a package with the enactment of Div 35 of the ITAA 1997, which produced the deferral and quarantining rules for non-commercial losses. The amendments buttressed the non-commercial loss rules by deferring the time at which some types of deductions could be claimed (making it less likely that taxpayers would actually have losses in early years to which the noncommercial loss rules would have to apply). The prepayments provisions now contain three regimes: • rules for small business taxpayers and individuals with non-business deductions: s 82KZM; • rules for other taxpayers (ie large businesses and other taxpayers with non-business deductions): ss 82KZMA – 82KZMD; and • rules for taxpayers involved in tax shelter arrangements: ss 82KZME and 82KZMF. (i) Prepayment rules for SBE taxpayers and individuals’ non-business deductions [12.550] Section 82KZM applies to: (a) an SBE taxpayer; and (b) an individual, provided the

expenditure is not incurred in carrying on a business. The kinds of expenditure in question must be deductible under ordinary rules, but are defined to preclude “excluded expenditure” – that is, payments of less than $1,000, payments required by law, and some payments for services. [12.550]

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The basic rule applies if the taxpayer incurs certain kinds of deductible expenditure, and if the deduction is located in time according to: (a) whether the payment generates something that will endure for more or less than 12 months; and (b) when the benefit starts and stops. • If the benefit will endure for 12 months or less, and that 12 months ends before the end of the next tax year, then the taxpayer can deduct the expenditure immediately (the language is difficult but this result emerges from s 82KZM(1)(ba)(ii)). So if an SBE taxpayer pays a $20,000 premium on 29 June for its insurance policy (12-month term, starting immediately), the entire amount is deductible in the current year. But if the taxpayer pays a $20,000 premium on 29 June 2015 for a 12-month insurance policy but the term of the policy runs from 15 July 2015 to 14 July 2016, the taxpayer cannot deduct any of the payment in the current year (because there is no eligible service period in the current tax year). • If the benefit will endure for more than 12 months, then instead of deducting the entire amount in the current year, the taxpayer must pro-rate the deduction on a daily basis and claim as a deduction only the percentage that relates to days in the current tax year. So an SBE taxpayer who pays a $20,000 premium on 1 June for its insurance policy (24-month term, starting immediately), must pro-rate the deduction: 30 days in tax Year 1, 365 days in tax Year 2, and 335 days in tax Year 3. In the summary above, we have referred to the benefits generated by a payment as shorthand for the idea which the Act seeks to express – the “eligible service period” in relation to an expenditure. This term is defined in s 82KZL to mean a period of time that starts when “a thing [is] to be done under an agreement in return for the amount of the expenditure” and to stop when “the thing to be done under the agreement in return for the amount of expenditure is required, or permitted, as the case may be, to cease being done; or … 10 years after the beginning of the period”. This rather inelegant phrase – the idea that the expenditure is outlaid in return for a “thing to be done” – is amplified in s 82KZL(2) in three ways: interest is taken to be paid in return for making the principal available during the period for which the interest accrues; rent is taken to be paid in return for making the premises available during the period for which the rent accrues; and an insurance premium is taken to be paid in return for indemnifying against risk during the period for which the premium accrues. But if a taxpayer buys a car with a 36-month warranty, does this rule apply? Or if a taxpayer buys an option to purchase shares, and the option has a term of three years, is this captured? (ii) Prepayment rules for non-SBE businesses and other taxpayers’ non-business deductions [12.560] The rules for these taxpayers begin at s 82KZMA of the ITAA 1936. They operate to

spread a taxpayer’s deductions for prepayments over the eligible service period on a daily basis (ss 82KZMB(3) and 82KZMD(2)) without any concession. So a large business taxpayer which pays a $20,000 premium on 1 March for its insurance policy (12-month term, starting immediately), must pro-rate the amount on a daily basis up to the end of the year. (iii) Prepayments in relation to managed investment schemes [12.570] The rules in ss 82KZME and 82KZMF are special rules to deal with taxpayers who

participate in some kinds of managed investment schemes. The scope of the provisions is described principally by reference to four characteristics (s 82KZME(2) and (3)): • there must be “expenditure … incurred … under an agreement”; 664

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• the allowable deductions arising from the agreement must exceed the assessable income; • the taxpayer does not have day-to-day control over the operation of the agreement; • there are other investors, or, if not, the promoter of the agreement is also its manager. An important exception is created in s 82KZME(5) designed to deal with negatively-geared managed investments in real estate or share portfolios. Another exception in s 82KZME(9) protects taxpayers who invested on their managed investment with the benefit of a Product Ruling that was current at 11 September 1999. Where the rule is triggered, s 82KZMF, like the other rules, pro-rates the taxpayer’s allowable deduction over the “eligible service period” on a daily basis.

(b) Avoidance-Based Timing Rules [12.580] The rules in s 82KZM post-date earlier timing-based rules designed to deal with

other forms of timing games. These measures, introduced in 1979 as Pt III Div 3 Subdiv D of the ITAA 1936, apply to losses or outgoings incurred after various dates in 1978 – in most cases 19 April 1978. The Subdivision contains four sections – ss 82KH to 82KL of the ITAA 1936 – which are intended to deal with several schemes. The one we focus on here is about the deferral of tax by the taxpayer who incurs an immediate deduction for an outgoing but the payee, who is an associate, is assessable only in a subsequent year. [12.590] Consider the situation of the parties to the AGC case – one taxpayer, the company, being on an accruals basis is entitled to a deduction for its accruing interest expense; but the other party to the transaction, the cash basis lender, will not disclose any income until the repayment (or perhaps sale) of the bond. Division 16E of the ITAA 1936 and the TOFA rules now rule out this kind of game. But what if the arrangement involved services? A company agrees to provide services to a related company over a period of time in exchange for an immediate payment. The payer claims a deduction at the time of payment (subject to s 82KZM), but the recipient applies Arthur Murray accounting and defers the recognition of the income until the services are performed. There is no general principle that parties to a transaction must disclose income and deductions in the same period, and the attractiveness of the scheme depends upon the timing difference. Section 82KK of the ITAA 1936 is relevant in this context. It reconciles payments between related taxpayers by manipulating the timing as a remedy to a tax avoidance practice. Again it will be observed that the section has a very limited field of operation deriving from its purpose primarily as an anti-avoidance section and has been supplemented by other more general rules such as Div 16E or s 82KZM. The section applies to a loss or outgoing incurred after 19 April 1978:

• to an associate of the taxpayer; • being an allowable deduction; • where tax (either by withholding or assessment) will not be imposed on the outgoing until a subsequent year of income; and • where the loss or outgoing was incurred as part of an agreement for securing that no amount would be included in the associate’s assessable income (or be taxed by withholding) until a subsequent year. If these conditions are met then where the outgoing is not for goods or services, a deduction is available in the current year and succeeding years only for “an amount actually paid” so that [12.590]

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the incurring and derivation will occur in the same year. Alternatively, where the outgoing is in respect of goods or services, the deduction is spread over the years of income in which the goods or services are provided. [12.595]

Questions

12.23 Assume that in Year 1 the subsidiary company is a tenant of the holding company and pays to the landlord (holding company) $2,400, being the total rent payable for the next two years. The landlord wishes to defer the recognition of $1,200 of the rent under Arthur Murray-type accounting. Does s 82KK of the ITAA 1936 prevent this? Would s 82KZM also apply? 12.24 Would the problem which s 82KK attempts to address be solved by a cost expiry principle applicable to the payer? 12.25 Would it also be desirable to adopt Arthur Murray accounting for the cash basis recipient? [12.600] Section 82KL of the ITAA 1936, like s 82KJ, denies rather than merely defers the

deductibility of the payment – in this case of “eligible relevant expenditure”. It denies deductibility where eligible relevant expenditure is incurred in circumstances where the taxpayer or an associate recoups the expenditure. The intention of the section is that if a taxpayer obtains a deduction and a side-benefit which in total effectively recoup the expense, then the taxpayer does not get the deduction. This provision has been suggested as the remedy for some of the mass-marketed tax-effective schemes which appeared during the 1990s. It clearly attempts to deal with taxpayers whose outlay is immediately recouped. The best way to understand s 82KL is to work through it. Consider this example taken from the Explanatory Memorandum to the Bill which introduced it. The taxpayer (for example, a doctor) purchases supplies (masks, tape, cotton wool, soap) from Finance Ltd for $30,000. These same supplies could usually be bought for $500. The terms of the sale provide the following: • The purchase price of $30,000 is to be payable in 45 years time interest-free. • The price is to be guaranteed by an associate of the doctor who deposits $2,200 with Finance Ltd as security ($2,200 compounded at 6% for 45 years would accumulate to $30,000). • The associate has the option to purchase from Finance Ltd the $30,000 debt for $2200. The associate tells Finance Ltd to apply the security deposit as the purchase price for the debt. The “real world” result of these machinations is that the taxpayer has paid Finance Ltd $2,200 for medical supplies worth $500. But the “tax world” result which the taxpayer is after is an immediate tax deduction of $30,000, worth almost $15,000 if the doctor is on the 49% tax rate, for a cost of $2,200. The medical supplies are thrown in as part of the deal. What can prevent this? Try to apply s 82KL of the ITAA 1936 to the facts described above by proceeding through these questions: (a)

What is “relevant expenditure”: see s 82KH(1)?

(b)

Identify the “eligible relevant expenditure”: see s 82KH(1F).

(c)

What is “the additional benefit in relation to an amount of eligible relevant expenditure”: see s 82KH(1) and (1B)? What is “the expected tax saving” in relation to the amount of “eligible relevant expenditure”: see s 82KH(1) and (1B)?

(d)

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In order to apply the definition of “expected tax saving” in s 82KH(1) it is necessary to define the tax saving amount (see s 82KH(1B) and (1D)) and then, before one can apply that definition, to define a tax benefit: see s 82KH(1AD). [12.605]

Question

12.26 The brave may wish to try another example: the taxpayer (another doctor) enters an afforestation scheme. Under the scheme the doctor (whom we will call L) leases 10 hectares of land from Paragon for 21 years at an annual rent of $640 for the first year and $240 thereafter. The next day, L enters a management agreement with NQ Ltd under which NQ agrees to plant, tend and harvest a pine plantation on the land for 21 years for $3,920 per hectare payable immediately. L borrows $35,300 (which is $39,200 minus $3,900) from Liberton (which is associated with NQ) and it is paid at L’s direction immediately to NQ. Liberton itself has no funds and borrows from NQ the money which it then lends to L and pays back to NQ. The terms of the loan from Liberton to L require L to pay interest at 2.4% payable quarterly but Liberton will accept instead the proceeds of the harvest in satisfaction of the principal and interest. L now claims to be entitled to a deduction of $40,020 (being the 21 years management fee of $39,200, plus the first year’s rent of $640 and stamp duty of $180) for an outlay of $4,720 (that is, the difference between $40,020 and the amount lent by Liberton $35,300). How does s 82KL of the ITAA 1936 apply? In particular, what is the “additional benefit” secured to the taxpayer? (See FCT v Lau (1984) 16 ATR 55.)

7. ACCOUNTING FOR CAPITAL GAINS AND LOSSES [12.610] The accounting adopted for capital gains resembles the accounting for trading stock:

the costs of acquisition are deferred until realisation, but once a disposal occurs, all of the proceeds of sale, both received and to be paid in the future, are recognised immediately. This treatment favours the revenue for credit sales and the time of cost recognition. But the benefits are not exclusively in favour of the ATO – the recognition of gain is deferred until realisation, rather than accrued over the period during which the asset is held, and presumably grows in value. The justification for waiting until the asset is sold was explained by the government in the Draft White Paper (AGPS, Canberra, 1985, paras 7.8 to 7.13). The typical justification for taxing capital gains in this way depends on administrative difficulties and hardship considerations of trying to tax unrealised increases in value on an annual basis. But taxing only realised gains leads to the problems traditionally associated with taxing capital gains – bunching of all the gain into a single year and the “lock-in” of taxpayers with unrealised (and untaxed) gains into less profitable investments.

Reform of the Australian Tax System, Draft White Paper AGPS, Canberra, 1985 [12.620] Accrual or realisation basis 7.8 Capital gains add to a taxpayer’s purchasing power as they accrue, not just at the date when the gains are realised. Ideally, therefore, a capital gains tax would be levied on the annual increase in the value of the taxpayer’s assets. This would require, however, the periodic

valuation of all assets, which could create major difficulties for both taxpayers and the taxation authorities. Taxation on an accrual basis could also create liquidity problems for taxpayers, possibly forcing them to borrow or to sell assets to pay the tax.

[12.620]

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Reform of the Australian Tax System, Draft White Paper AGPS, Canberra, 1985 cont. 7.9 Such practical considerations have led virtually all countries with capital gains taxes to adopt a realisation basis. With a realisation basis, capital gains tax would be imposed when the asset was sold. This would obviate potential liquidity difficulties and the need for periodic asset valuations. 7.10 Some undesirable consequences follow, however, from the adoption of a realisation basis. These relate basically to the deferral of tax on capital gains, the consequent bunching of such income for tax purposes, the “locking-in” of investors to existing assets, and complications regarding the treatment of losses. 7.11 Deferral of taxation until the capital gain is realised would reduce the effective tax rate since the government would be, in effect, providing an interest-free loan of the amount of tax payable on the accrued increase in the value of the taxpayer’s assets. In order to place at least some limits on the extent of deferral, it would be necessary that disposal of assets by gift or death be deemed as realisation. 7.12 The phenomenon of bunching – whereby gains which have accrued over a number of years are included in taxable income in the year of realisation – arises under any system which taxes income from capital gains on a realisation basis. Bunching may result in an inequity, however, only if income from capital gains is taxed under a progressive rate scale. In such circumstances, the taxpayer could pay a higher average rate of tax than under an accrual basis, although such

comparisons should also allow for the benefit of tax deferral on a realisation basis. Even under a progressive rate scale, bunching is only a problem if the incremental income from capital gains is sufficient to push the taxpayer into a higher tax bracket; bunching imposes no penalty for taxpayers already facing the top marginal rate in the absence of income from capital gains. 7.13 The deferral of tax liability is also responsible for “locking-in” asset-holders to their existing asset portfolios. In other words, deferral provides investors with an incentive to continue to hold assets when, tax considerations apart, it would be more profitable to sell the assets and reinvest in some other asset – for example, the owner of a factory might be discouraged from selling and moving to newer premises. It is sometimes proposed that rollovers be allowed in order to overcome this problem, that is, capital gains realised from the sale of an asset would be free of tax at the time of sale if reinvested in a similar asset of comparable value within a stipulated period. This kind of rule would allow a person to accumulate, free of tax, substantial gains from building up, say, a residential investment property and repeatedly disposing of it for another property. It would amount to accepting that those who save from voluntarily realised, but reinvested, capital gains should be free of immediate tax, but those who save from other income sources (or reinvest capital gains in dissimilar assets) should pay tax at the time gains are realised. In addition to the inequities this would create, major administrative difficulties would arise in determining whether “like” assets were being exchanged for “like”.

[12.630] Prior to September 1999, capital gains enjoyed two concessions designed to alleviate

these problems to some extent. First, capital costs were increased by an indexation factor to remove the portion of the capital gain that represented inflation. Second, gains could be averaged to approximate the result that would have happened if the gain had been earned evenly over a period, rather than entirely in a single year. The Review of Business Taxation recommended that indexation be stopped for the future and that averaging be withdrawn completely. Instead, it proposed that capital gains be reduced by 50% for individuals (and 33% for superannuation funds) if the appropriate taxpayer had held the asset for more than one year. This concession, called the CGT discount, substantially complicates the accounting for capital gains. 668

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Questions

12.27 Is it appropriate that cost should, in all cases, be deferred until final realisation? What about in the case of the part disposal of an asset? 12.28 How compelling do you find the arguments against accrual of capital gains and losses for all assets? Does it hold true for, say, shares in listed companies? What about commercial real estate? What about residential real estate such as holiday homes? What about collectables such as artworks or coin collections?

(a) Calculating Net Capital Gains and Losses [12.640] The taxation of capital gains arises through s 102-5(1) which includes in a

taxpayer’s assessable income a “net capital gain”. This presumably feeds into s 6-10 as a form of statutory income. The basic outline of the tax accounting for capital gains looks relatively simple. • A taxpayer must work out if he or she has a net capital gain for a year, or if there is a net capital loss instead. • If the taxpayer has a net capital gain for the year, it is included in assessable income under s 102-5. If there is a net capital loss, it cannot be deducted from the taxpayer’s assessable income (s 102-10) but is carried forward under s 102-15 to reduce the capital gains of succeeding years. These “net” numbers are the result of the sum of individual capital gains and losses made from the CGT events that occurred during the year: • For most CGT events there is an individual capital gain if the “capital proceeds” exceed the “cost base” of that asset for that event. Costs can be indexed for inflation up to September 1999 if the asset was held for more than 12 months and the relevant cost was incurred prior to September 1999, but indexing is optional and cannot be done if the taxpayer wants to take the 50% or 33% CGT discount: s 115-20. Companies are not entitled to any CGT discount and so always claim indexation of their costs if indexation remains available to them – ie the costs were incurred before September 1999. • On the other hand, there is usually a capital loss if the “capital proceeds” on disposal of the asset are less than the “reduced cost base” (although some CGT events cannot give rise to a capital loss). • There is neither capital gain nor loss in between – that is, where the “capital proceeds” are greater than the reduced cost base but less than the indexed cost base. This happens less frequently now that the indexation of costs has largely been removed from the equation. • Once individual capital gains and losses are calculated, s 102-5 of the ITAA 1997 (Step 1) requires that individual capital gains and losses are then netted. Any carry-forward net capital loss from the prior year is also deducted at this stage (Step 2). • Only at this stage, the taxpayer applies any CGT discount to which it is entitled (Step 3). This ensures that individual gains are reduced by losses before the 50% or 33% discount is taken. The result is the net capital gain included in assessable income. We will now look at each of these steps more closely. (i) Calculating capital proceeds arising on a CGT event [12.650] The first step in calculating a net capital gain is to calculate the amount of the

“capital proceeds” of the CGT event – in most cases, the sale price. Section 116-20 of the ITAA [12.650]

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1997 provides that the capital proceeds are the sum of any money the taxpayer receives or is entitled to receive in respect of the disposal, and the market value (at the date of the CGT event) of any property that the taxpayer is entitled to receive. Notice that the taxpayer is (initially) treated as receiving all of the capital proceeds immediately on making a credit sale – that is, the taxpayer must report both the amount it actually received and the amount it is “entitled to receive” albeit at some time in the future. There are interesting questions about the distinction between “money” and “property” in s 116-20 of the ITAA 1997. If the taxpayer sells an asset for a payment of $100, presumably the consideration received is “money”. If the taxpayer sells an asset in exchange for the purchaser’s promise “to pay $100 on 31 August”, that consideration is probably also “money” of $100, and the taxpayer records $100 rather than the market value of the promise. If the taxpayer sells the asset for the taxpayer’s promise to pay “$100 plus the amount by which the price of one share in BHP-Billiton on 31 December as quoted on the ASX exceeds $15”, is the consideration received by the taxpayer money or property? In Taxation Ruling TR 93/15 (which has now been withdrawn), the ATO expressed the view that where a taxpayer sells an asset for an amount of money and “a right to a contingent and unascertainable amount”, the taxpayer receives as consideration both money and property. In this case the taxpayer would have to recognise a consideration in respect of the disposal of its asset, an amount of $100 and the market value of the right to the variable amount discounted to reflect the uncertainty of its ever being paid. (Interestingly, the ATO views the buyer in such a deal as paying money only.) This Ruling was to be replaced in 2007, but the replacement – TR 2007/D10 – has yet to be finalised. It is now unlikely that the Ruling will be finalised because the Government has released Draft legislation to enact statutory rules to deal with this situation, which is commonly referred to as an “earn-out” arrangement. The “earn-out” rules will treat the transaction as involving a sale for money only, for both parties. If an asset is sold for no consideration, consideration which cannot be valued, or in a non-arm’s length transaction, s 116-30 deems the seller to receive the market value of the asset disposed of at the date of disposal. The provision exists in order to tax donors as if they collected in cash the value of assets they give away, and to allow the ATO to adjust the values for transactions between related parties. But, because of the way it is drafted, it is a dangerous provision which has to be rectified in a variety of circumstances. For example, when a lease expires at the end of its term, there should be no CGT consequences for either party (unless the lessee paid a premium to acquire the lease). Unfortunately, to get to this result requires quite some statutory dexterity. For example, • When a lease expires, CGT event C2 occurs: s 104-25. Section 116-30(1) would deem the lessee to receive the market value of the lease at that time. Section 116-30(3A) requires the taxpayer to value their leasehold interest as if the expiry “had not occurred and was never proposed to occur” which presumably means: assume this lease is a perpetual lease. Fortunately, s 116-30(3) provides that s 116-30(1) does not apply to “these examples of CGT event C2 (i) the expiry of a CGT asset”. • A similar rule exists for CGT event D1 – the creation of contractual rights. Section 11630(3)(b) provides that s 116-30(1) does not apply to the person who creates the rights. Section 116-40 permits apportionment of the capital proceeds where there is a composite sum including more than the disposal amount. Notice, however, that there is no corresponding provision permitting apportionment of acquisition cost. 670

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Another interesting omission occurs in respect of anticipated proceeds such as a credit sale. We have already observed that ss 103-10 and 116-20 of the ITAA 1997 require the seller to recognise all the anticipated consideration in respect of the disposal, and s 116-45 permits an adjustment if the promised consideration is never received. Section 116-50 also allows a reduction of the capital proceeds where the seller repays them to the buyer or pays compensation to the buyer. But there is no provision which increases the capital proceeds if the amount eventually received exceeds the amount recorded at the time of the CGT event. For example, how much would the father in Egerton-Warburton have recognised as the capital proceeds of the farm if he had successfully contended that the stream of promised payments was of a capital nature? What would have happened if he lived longer than his life expectancy? Or similarly in Cliffs International, how much would Howmet and Mt Enid have disclosed as the consideration for the disposal of their shares in Basic, had the periodic payments received by them been characterised as instalments of a capital sum? It is not clear whether or how the eventual earn-out legislation would deal with this transaction. Alternatively, where all else fails, perhaps the consideration simply cannot be valued and the sellers simply recognise the market value of the thing sold – the farm and the shares – as the consideration for the disposal. Finally, the position of the vendor of an asset also has to take into account amounts that the purchaser pays, but not to the vendor. For example, if the purchaser takes over the seller’s debts owed on the property, this amount is also part of the seller’s capital proceeds: s 116-55 of the ITAA 1997. So for example, a seller who buys land for $120,000 (using $40,000 of his own funds and $80,000 borrowed from a bank) is treated as making a capital gain of $30,000 if he sells the land for $150,000, with $70,000 payable in cash to the vendor and the buyer agreeing to take over the vendor’s debt to the bank. (ii) Calculating the cost base [12.660] For most CGT events, the other step in calculating an individual capital gain or loss

is to subtract the appropriate cost base. There are, in fact, two different amounts which s 100-40(2) advises the taxpayer they might subtract from the capital proceeds – either the cost base or the reduced cost base. (Division 100 is a Guide; the operative rules to this effect are contained in the rules for each CGT event.) And notice further that the cost base (but not the reduced cost base) can be indexed for inflation under Div 114 and Subdiv 960-M of the ITAA 1997 in some cases, provided the taxpayer does not wish, or is not eligible, to claim a discount: s 115-20(1). Not surprisingly, these three computations – subtract from capital proceeds the indexed cost base v unindexed cost base v reduced cost base – would disclose a different amount if each were applied indifferently, and so rules exist to dictate which cost base is used in each circumstance: • If the disposal occurs within 12 months of the acquisition of an asset, the taxpayer subtracts the cost base (without indexation) to calculate a capital gain: s 114-10. (As the disposal occurred within 12 months of acquisition, the taxpayer will not be able to claim a CGT discount.) • But if the disposal occurs more than 12 months after the acquisition of the asset, the taxpayer can subtract the cost base indexed for inflation: s 110-25. Notice that indexation is switched off from 1999 and so the taxpayer can index its costs for inflation only up to 30 September 1999: ss 114-1, 960-275(2). (If the taxpayer wishes to claim a CGT discount, it must subtract the unindexed cost base.) [12.660]

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• If the disposal consideration is less than the unindexed acquisition consideration (the asset has depreciated relative to its cost) then the taxpayer subtracts the reduced cost base: see for example ss 104-10(4) and 104-25(3). This leaves the situation where the asset has been held for more than 12 months, and the disposal consideration falls between the indexed cost base and the cost base. In this case there is no CGT consequence (either for this asset or to be set off against other capital gains or losses) and so no cost base needs to be subtracted. For most CGT events, the capital gain will be computed by subtracting one of the cost bases. But some provisions such as ss 104-35(3) and 104-155(3) of the ITAA 1997 abort this process by cutting straight to the chase and stipulating the amount of the capital gain. These provisions compute the gain by treating the asset as having a cost base of only the incidental costs of selling it and, therefore, effectively provide for the gross receipt to be included as capital gain. This operation is confirmed by the Table in s 110-10. Notice also that some CGT events such as event E4 and event G1 cannot generate a capital loss. But for most CGT events, the calculation of both the indexed cost base and the reduced cost base begins from the concept of the cost base defined in s 110-25. The cost base includes five elements: 1.

the price and the value of any property paid or to be paid “in respect of acquiring” the asset: s 110-25(2);

2.

incidental costs of acquisition and disposal: s 110-25(3). These are defined in s 110-35 to be non-deductible expenses for professional fees, transfer costs, stamp duty, advertising and valuations;

3.

so-called “non-capital costs of ownership” incurred after 20 August 1991: s 110-25(4). These are defined to include interest, repairs, insurance premiums, rates and taxes, but only where they are not otherwise deductible;

4.

capital expenditure incurred to increase or preserve the value of the asset or in relation to installing or moving it: s 110-25(5); and

5. costs of establishing or defending the taxpayer’s title to the asset: s 110-25(6). If we leave the individual items that form the cost base briefly and move on to the indexed cost base, Div 114 and Subdiv 960-M express the indexing provisions. As we mentioned earlier, indexing has been switched off from September 1999: it does not apply to assets acquired after 21 September 1999 (s 114-10) and for assets acquired before that date, they can only index costs up the end of the September 1999 quarter (s 960-275(2)). But indexation still has a bearing on all corporate taxpayers (who are not eligible for CGT discount) and for other taxpayers who held assets with large costs as at 30 September 1999. They face an interesting choice: they can enjoy either indexing of their costs up to the end of the September quarter 1999 or take a CGT discount if they are eligible – but not both. Where a taxpayer prefers to index its costs for pre-September 1999 inflation, the indexing provisions provide for adjusting items in the cost base, although there is some disagreement between ss 110-25 and 960-275(4) which say that non-capital costs of ownership cannot be indexed, and appear to contradict s 114-1 which requires a taxpayer to “index expenditure in each element”. Indexation can only be performed where an asset has been held for more than 12 months (s 114-10(1)), although special provisions can modify this requirement. Indexation for this purpose is computed by reference to inflation of consumer prices: s 960-280(1). 672

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The reduced cost base is defined in s 110-55 and is used in the CGT event provisions to determine the size of any capital loss. No items are indexed to adjust for inflation, so the size of any capital loss is smaller by the inflation rate than it would otherwise be: s 110-55(1). The section provides that the reduced cost base is: • four out of the five items in the cost base – the amount paid to acquire the asset, incidental costs of acquisition and disposal, capital expenditure incurred to enhance the value of the asset, and costs of establishing or defending title; • not “non-capital costs of ownership”; • increased by amounts included in income by virtue of a “balancing adjustment event”: s 110-55(3). Let us now return to the individual items included in cost base. Anticipated payments can cause problems in determining the amount of the cost base similar to those that were apparent in calculating the anticipated capital proceeds. Consider, for example, if a taxpayer promises to pay a series of recurrent payments as consideration in respect of the acquisition, such as were promised by the sons in Egerton-Warburton or by Cliffs in Cliffs International. Section 110-25(2) of the ITAA 1997 says that the consideration in respect of the acquisition is the amount that the taxpayer has paid or is required to pay, and s 103-15 includes money that the person is required to pay “at a later time” and “by instalments”. But s 110-25(2) also recognises that the payer can acquire an asset by giving property. Again the same issue about whether some obligation is “money” or “property” also arises for a promised payment, just as for an expected receipt. While the former Taxation Ruling TR 93/15 did not adopt a symmetrical position, the proposed legislation will ensure symmetrical treatment, treating both parties as dealing only in money. The next question is, what happens if a lesser or a greater sum is eventually paid by the buyer – it promised to pay a contingent amount which the buyer treated as amounting to $100, but by the time the buyer sells the asset it has met its obligation in full by paying only $85? There is no analogous provision to s 116-45 adjusting the cost base where the amount is never paid and so on. An important part of the computation of the cost base is to reduce both the cost base and reduced cost base of a CGT asset to recognise deductions allowed under other provisions of the Act, where deductible expenditure might also make its way into one of the five elements of the cost base. In other words, there are rules that try to prevent the double-counting of costs, once as allowable deductions and again as forming part of the cost base. There is a limited rule in s 110-40(2) that an amount is only part of the second or third element of the cost base of an asset if it is not also a deductible deduction. But as the title to that section makes clear, this was as far as the anti-double-counting rules went prior to the May 1997 – the date of the 1997 Budget. Hence double-counting of costs in other elements of an asset’s cost base acquired before that date remains possible. For assets acquired after that date, a more general rule now applies. Sections 110-45(1B) and (2) now provide that no amount can enter the cost base of an asset if the taxpayer has deducted it from income. But the taxpayer is entitled to include the amount in the cost base if the deduction has been reversed by an offsetting income inclusion. Perhaps the easiest way to grasp the reason for these rules is to ask, without them, what treatment would be given to expenses which are associated with CGT assets but which also give rise to allowable deductions for taxpayers? One example is the payments made by Cliffs for the shares – they were deductible to Cliffs, but might they also enter the cost base of the [12.660]

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shares as “money paid … in respect of acquiring” the shares? If so, the taxpayer would be able to subtract the same cost twice. Other examples would arise from various depreciation and capital allowance provisions – depreciation (Div 40 of the ITAA 1997), or deductions for the cost of capital works (Div 43 of the ITAA 1997). These regimes allow a taxpayer to recover acquisition and construction costs over a period as deductions from income. Obviously the cost of such an asset should be recognised in computing the taxpayer’s assessable income but only once, otherwise the taxpayer will be subtracting the same amount twice – once from income and once from capital gain. The new rules do this. To see how the rules work for building expenditure, assume the taxpayer (a company) has a contract to have a building constructed and pays $100,000 to the builder. Once the building is used to produce income, the taxpayer is entitled to a capital allowance at 2.5% per year under Div 43 and can therefore deduct $2,500 per year. If the taxpayer sells the building after a year for $200,000, the building will have a cost base of $97,500 and the taxpayer will make a capital gain of $102,500. The new owner will be entitled to a deduction under Div 43 of $2,500 because the Div 43 regime works from the construction cost, not the buyer’s cost. It was always an explicit design feature of the building allowance provisions when they were first written as Divs 10C and 10D of the ITAA 1936 that there was no balancing adjustment when an income-producing building was sold. So, if a building was purchased for $200,000, the ongoing deduction was not reset to the new price paid by the buyer. This feature remains in s 43-235 of the ITAA 1997 which entitles each successive user to their share of the “undeducted construction expenditure”. If the new owner sells the building for $225,000 after one year, it will have a cost in the building of $222,500 because the buyer was entitled to a building allowance based only on $100,000 of construction expenditure incurred by the seller, not the $200,000 price the buyer paid. [12.665]

Questions

12.29 So consider our example again. Assume a taxpayer who is an individual pays $100,000 for an income-producing building on 1 July. He or she is entitled to a capital allowance at 2.5% per year under Div 43 and deducts $2,500 per year from his or her income. The taxpayer sells the building on 30 June of the next year. What are the income tax and capital gains computations if the taxpayer sells the building for: (a) $90,000; (b) $104,000; or (c) $138,000? 12.30 What calculation is made if the asset is sold within 12 months? 12.31 A taxpayer will obviously wish to maximise the base upon which the inflation adjustment will be calculated. Consider a taxpayer who subscribed for 10,000 shares at par value of $1 each on 1 January 1988, paying only 10 cents on each share, and on 1 February 1990 sells the shares for $1.50 (the market value at that time of $2.40 less the amount owing on the shares of $0.90). What will be the amount upon which the taxpayer’s inflation adjustment is calculated? (See s 960-275.)

Personal-use assets and collectables [12.670] A special accounting regime applies to gains and losses derived from personal-use

assets, and a separate regime applies to collectables. Personal use assets. Section 108-20(2) and (3) of the ITAA 1997 defines a “personal-use asset” as an asset – other than land, a collectable or certain debts – that is owned by the 674

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taxpayer and which is used or kept primarily for the personal use and enjoyment of the taxpayer and/or associates of the taxpayer. The tax accounting treatment for personal-use assets has three special features. 1.

A capital loss arising from the disposal of a personal-use asset is ignored when computing a taxpayer’s net CGT position: s 108-20(1). Any capital gain on the disposal of a personal-use asset (of sufficient cost) will, however, be taxed in the ordinary way.

2.

No capital gain arises from a personal-use asset unless it costs at least $10,000. So if a taxpayer buys a personal use asset for $4,000 and sells it for $2 m, the entire gain will be exempt from tax: s 118-10(3).

3.

A special rule consolidates personal-use assets that form a set: s 108-25. This is to prevent a taxpayer from avoiding the monetary limit on the cost of individual items that form a set of personal use assets. Collectables. The regime for collectables deals with what used to be referred to as “listed personal use assets”. These are artworks, jewellery, coins, rare books, stamps and so on which are used or kept mainly for personal use or enjoyment: s 108-10(2). These are assets often not held for personal enjoyment, but rather for investment and will often appreciate in value. The tax accounting for these assets has three special features. 1.

A capital loss arising from the disposal of a collectable can only be used to reduce capital gains on other collectables: s 108-10(1). Where there are insufficient capital gains realised during the year, any unused capital loss is carried forward to reduce capital gains on collectables in future years: s 108-10(4).

2.

No capital gain or loss arises from a collectable unless it costs at least $500: s 118-10(1). A special rule consolidates collectables that form a set: s 108-15. This is to prevent a taxpayer from avoiding the monetary threshold for each collectable in a set.

3.

[12.675]

Question

12.32 You give your friend a $16,000 diamond ring. What CGT consequences follow? What happens if the ring costs only $8,000? What happens if the ring costs only $400? [12.680] Before we leave the consideration of CGT, it is important to observe that in addition

to the general rules just discussed there are special regimes for certain assets contained particularly in Divs 130, 132 and 134 of the CGT provisions. These questions will focus your attention on their general operation. [12.685]

Questions

12.33 In July the lessor grants a lease of a factory for 10 years at a premium of $10,000. The next year, the lessor pays the lessee $3,500 for consent to reduce the term to five years. What CGT consequences follow? What would be the consequences if instead the lessee pays the lessor $2,000 to be released from the lease, or to include an option to renew in the terms of the lease? What if after the lease has expired, the lessee pays the lessor $2,000 not to enforce for six months the lessor’s right to reclaim possession of the factory? 12.34 X purchases a factory and Y pays X $40,000 for an option to purchase the asset exercisable at any time over the next four months. What CGT consequences follow if Y exercises the option? What if Y allows the option to lapse? What differences follow if X is a company that is granting to Y for $40,000 an option to purchase shares in the company at par? [12.685]

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(iii) CGT discounts [12.690] We have already alluded to the CGT discount rules which arose from the

recommendations of the Review of Business Tax in 1999. These rules are intended to allow individuals to pay tax at 50% of their usual rate on their “long term” capital gains (ie gains made on assets they have held for more than one year) and to allow superannuation funds to pay tax at 66% of their usual rate on their long-term capital gains. (Companies are not eligible for CGT discount.) The rules to give effect to this policy are in Div 115 of the ITAA 1997 and in s 102-5 of the ITAA 1997, and apply to capital gains realised after 21 September 1999. (Further CGT discounts which accumulate with the Div 115 discounts are offered in Div 152 where a taxpayer conducts a small business – they are not examined here.) Two particular difficulties to watch out for in the following discussion are the ordering rules about how the Div 115 rules deal with discounted gains, non-discounted gains and a capital loss in a single year; and how the benefit of the discount passes through trusts for the benefit of beneficiaries who are individuals. In general terms, the entitlement to a CGT discount arises where two basic conditions are met: 1.

the taxpayer must be an individual, trust or a superannuation fund: s 115-10. This means that companies cannot claim a CGT discount; and 2. the CGT asset affected by the event must have been acquired more than 12 months before the relevant CGT event occurred: s 115-25. This is clear enough where the asset was purchased and is then sold (ie a CGT event A1), but what about if the asset is not sold but is leased for a long term in exchange for a premium, or if an option over it is granted? Hence the section is supplemented by s 115-25(3), which insists that some CGT events can never give rise to a CGT discount. The section is also supplemented by s 115-40(1) to insist that the CGT discount cannot arise under a contract made within 12 months of the date of acquisition, even if the CGT event happens later. The 12-month rule also has a “look-through” test in s 115-45 to deal with selling a long-term shareholding in a (private) company but the company has substantial short-term assets locked within it. There are other conditions – one deals with the transition to the discount rules (s 115-15) and the other makes it clear that, if the asset was held at 21 September 1999, the taxpayer has the choice either to index its costs and pay tax at ordinary rates, or else not to index its costs and instead to take the relevant CGT discount: s 115-20. Section 115-100 prescribes the discount percentage of 50% for individuals and trusts, and 33 1/3% for superannuation funds. When these conditions are met, the mechanism for giving effect to the CGT discount is in s 102-5. Section 102-5(1) includes in a taxpayer’s assessable income a net capital gain made during the year and sets out the process for calculating the taxpayer’s net capital gain including the impact of any discount. • Step 1 starts by implication with the sum of the taxpayer’s individual capital gains made for any CGT event that occurred during the year. • Step 1 then requires the taxpayer to subtract any individual capital losses arising from other CGT events in that year. • Step 2 then requires the taxpayer to subtract any carry-forward net capital loss from a prior year. • Step 3 then requires the taxpayer to apply any CGT discount to which it might be entitled to the amount calculated so far. 676

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The mechanism thus creates a series of ordering questions. Assume a taxpayer has the following transaction: Asset A

Date of acquisition 15 July 2016

Cost $100,000

Date of CGT event 1 October 2017

Capital proceeds $140,000

Capital gain $40,000

If the transaction with Asset A is all that has occurred, a taxpayer who was an individual would report a net capital gain of $20,000 and a superannuation fund would report $26,666. If the taxpayer has these transactions: Asset A

Date of acquisition 15 July 2016

Cost $100,000

B

15 July 2016

$100,000

Date of CGT event 1 October 2017 3 July 2017

Capital proceeds $140,000

Capital gain

$130,000

$30,000

$40,000

The gain made on Asset B is not intended to be a discount capital gain, but how is it to be disaggregated from the sum of the two capital gains that were added together (prior to) s 102-5, Step 1? The Method Statement in s 102-5 applies the discount factor to “each amount of a discount capital gain” remaining after the individual gains and losses have been aggregated. While the drafting is poor, the obvious intention is to require a taxpayer who was an individual to report a net capital gain of $50,000 – $20,000 from Asset A and $30,000 from Asset B. If the taxpayer has these transactions: Asset A

Date of acquisition 15 July 2016

Cost $100,000

B C

15 July 2016 15 July 2016

$100,000 $100,000

Date of CGT event 1 October 2017 3 July 2017 1 August 2017

Capital proceeds $140,000

Capital gain/loss $40,000

$130,000 $88,000

$30,000 ($12,000)

Now there is another ordering issue. The $12,000 capital loss is subtracted at Step 1 but from which capital gain? The Note to Step 1 says that a capital loss can be subtracted in whatever order the taxpayer chooses. Clearly the taxpayer will prefer to use the loss to reduce the non-discounted gain and instead to leave the discounted gain intact. Hence a taxpayer who was an individual will now report a net capital gain of $38,000, being the $20,000 discounted gain on Asset A plus $18,000 (being the $30,000 gain on Asset B less the $12,000 loss on Asset C). A further complicating circumstance for the application of CGT discount rules is where the gain is realised by the trustee of a trust. The trust rules try to pass the CGT discount benefit through to individuals and superannuation funds (but to only these beneficiaries). This is more than a little difficult to manage, and requires modifications to a variety of provisions: the rules for taxing income derived through trusts are in Div 6, ITAA 1936, and s 102-5, Div 115 and s 104-70, ITAA 1997. [12.690]

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(b) Reconciling Capital Gains and Income Gains [12.700] When CGT was constructed, it was decided to make a regime that deliberately

overlapped with ordinary income, rather than a discrete system. So under the basic system, the disposal of an asset that was, say, a revenue asset would give rise to both ordinary income and a capital gain. So the CGT provisions had to contain mechanisms for reconciling ordinary income and CGT in an attempt to ensure that the taxpayer is taxed only once on the gain. Probably because the indexation option and the former averaging system made it preferable for taxpayers to take gains in the form of capital rather than income, these mechanisms give precedence to the ordinary income provisions. In order to prevent double tax, it would have been possible simply to allocate some assets to the income tax and the remainder to CGT. This is done, for example, by s 118-25 of the ITAA 1997 which allocates gains or losses on the disposal of trading stock exclusively to the income tax provisions. It is also done by s 118-24 of the ITAA 1997 which allocates most gains or losses on the disposal of depreciating plant exclusively to the income tax provisions. But, for most other assets, the mechanism is subtraction rather than demarcation – that is, s 118-20 reduces the amount of the capital gain by any amount that will be included in a taxpayer’s assessable income of any year under the income tax provisions. Section 118-20(1) now also reduces the capital gain by any amount which is included in the taxpayer’s exempt income. Section 118-20(4) also reduces the capital gain if the amount in question is treated as being “neither assessable income nor exempt income”. Notice that this subtraction process occurs when each individual capital gain is being computed. This means that a capital gain, which also gives rise to ordinary income, is excluded before the taxpayer computes its net capital gain and prior to the application of losses or any CGT discount. The predecessor provision, s 160ZA(4) of the ITAA 1936, did not always achieve a complete or accurate reconciliation of the two regimes and was amended in 1989 to remove some of the qualifications that impeded its operation. For a discussion of some of the problems of the former provision see R W Parsons, “A Survey of the General Provisions of Part IIIA of the Income Tax Assessment Act” (1987) 4 Australian Tax Forum 357. One of the problems that Parsons alluded to was the requirement that, in order for the reduction mechanism to work, the taxpayer must have both a capital gain “from a CGT event” and some amount included in assessable or exempt income “because of the event”. There are many instances where there will be a disjunction between the circumstances which trigger the derivation of assessable income and the so-called “CGT events”. [12.705]

Questions

12.35 Consider this example from Parsons’ article. A valuable employee has a dispute with the management about the non-payment of benefits promised by the employer. The employee validly resigns and then sues the employer for breach of the terms of the employment contract. After some negotiation, the employee is induced to return to employment by the promise of a payment of $50,000 and in return the employee agrees to abandon the suit. Assume the employee is liable for tax on the $50,000 payment under s 15-3 of the ITAA 1997 as a return to work payment. What happens if the employee is also liable to CGT on the disposal of the asset being the right to enforce the contract? 12.36 What would happen in the circumstances just described if the payment were characterised as a fringe benefit? 678

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12.37 What would happen if the payment were excluded from being a fringe benefit because it was deemed to be salary or wages for para (k) of the definition of “fringe benefit” in s 136(1) of the FBTAA 1986, albeit paid in arrears? 12.38 B leaves the employment of B Co Ltd and receives a payment of $60,000 purporting to be for the grant of a restrictive covenant by B in favour of B Co. In the opinion of the ATO, $20,000 of this payment is unreasonable and hence not within the exclusion given by para (m) of the definition of “eligible termination payment” in s 27A(1) of the ITAA 1936. What CGT consequences follow?

8. ACCOUNTING FOR HIRE PURCHASE, EQUIPMENT LEASING, LUXURY CAR LEASING [12.710] The next set of statutory accounting provisions we will examine try to deal

specifically with the position of the parties to hire purchase agreements and instalment sales. They share a common design: to treat the users of equipment as if they were the owners (rather than just users) of the equipment, and to treat the owners of the equipment as if they had sold the equipment (rather than just leased it) to the users and lent them the money to buy it. These statutory fictions change the tax effects of the transaction in a number of ways: the depreciation deduction is shifted and the cash flows are notionally changed from rent into payments of principal and interest. They also create fictions which have to be managed. One set of provisions was announced as part of the 1996 Budget, and arose out of the litigation in ANZ Bank v FCT (1993) 25 ATR 369 and FCT v Citibank Ltd (1993) 26 ATR 423 discussed earlier. You will recall that in these cases, the taxpayer financier was attempting to use net profit accounting as the method for reporting its income from leasing motor vehicles. If permitted, this might have had the effect of avoiding the impact of the limit on the depreciation that can be claimed by the owner of a luxury motor vehicle. In fact, the ATO won the litigation and the limit remained intact. Nevertheless, Sch 2E to the ITAA 1936 was enacted to deal more explicitly with the tax consequences of leasing luxury motor vehicles. Not only does it change the accounting in these cases, it has effects for both the lessor and the lessee of vehicles. A second and more general regime for re-characterising the treatment of hire purchase or instalment purchase of goods as an immediate sale is in Div 240 of the ITAA 1997. [12.720] Division 240 provides for the hire purchase of any goods to be treated as notional

sale and loan transactions, rather than as bailments with an option to purchase. In order to bring about this outcome the provisions must: (a) deem a number of events to occur that do not occur at property law; then (b) deem the tax consequences of these deemed events to occur; and (c) reverse, and so remove the tax consequences of, the events that actually occur as a matter of property and contract law. The Division applies to the hire purchase of goods. Section 995-1 defines a “hire purchase” to arise from any contract for the hire of goods where the “hirer has the right or obligation to buy the goods” or from an agreement for the purchase of goods by instalment. This “right or obligation” must presumably be one that arises under the contract and is legally enforceable (rather than say, merely customary); hence, and rather curiously, it seems these provisions have no impact on a transaction which is typically referred to as a “finance lease” – that is, an arrangement under which there is no explicit right to buy the goods, but the parties (and the rest of the world) assume that if the user offers the residual value at the conclusion of the lease, the goods will be transferred to the user. [12.720]

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Allocating Income and Deductions to Periods – Timing

For the user of the goods, the main effects of the application of Div 240 are: • the goods are deemed to be sold to the user by the financier at the commencement of the lease, and the user is thereafter taken to be the owner of the goods: s 240-20; • the price of this deemed purchase is set at the financier’s cost in acquiring the goods if this is stated in the documents and the parties were dealing at arm’s length, or else a reconstructed market price: s 240-25(5); • the financier is taken to have lent the price to the user for the term of the lease for the “notional interest”: s 240-25. As a result of this deeming, the user is no longer entitled to deduct the lease payments as they are made: s 240-55. This is because the user is now deemed to be the owner. Instead, the user deducts the notional interest for the loan applicable to the relevant period: s 240-50. The “notional interest” is defined as the amount of the outstanding notional loan principal × the implicit interest rate: s 240-60 (that is, a constant interest rate is applied to a declining balance, giving more interest at the beginning of the lease and less at the end). The “implicit interest rate” is defined as the compound interest rate at which the present value of the rental payments and the residual payment equals the notional loan principal: s 240-60 Step 3. Finally, to complete the fiction that the user is the owner of the goods, the user is now entitled to any deductions for depreciation in accordance with the capital allowance rules in Div 40: s 40-40 Item 6 or perhaps Item 10. (How the entitlement to depreciation is determined after Div 240 has applied is analysed in Taxation Ruling TR 2005/20.) If the user later actually buys the goods at the end of the lease term, as is common, it is necessary to deal with the constructive sale deemed to have occurred already. The effect of the application of Div 240 upon expiry of the lease is that the user is taken to remain the owner of the goods and does not get a deduction for the payment of residual value to the lessor: s 240-85. For the financier, the main effects of the application of Div 240 are: • the goods are deemed to be sold by the financier at the commencement of the lease: s 240-20; • the price received on this deemed purchase is the financier’s cost in acquiring the goods if this is stated in the documents and the parties were dealing at arm’s length, or else a reconstructed market price (s 240-25(5)), and any profit is included in the financier’s assessable income: s 240-35(2); • the financier is taken to have lent the price to the user for the term of the lease for the “finance charge”: s 240-25. Again, it is then necessary to remove the tax effects of the transactions that actually happen. So, the lease payments received are excluded from the financier’s income (s 240-40) and instead, the financier includes in its assessable income a proportion of the finance charge for the notional loan – that is, the notional interest for each arrangement payment period: s 240-35(1). Because the financier is no longer the owner of the goods, it ceases to be entitled to a deduction for depreciation: s 40-40 Items 6 or 10. If the goods are eventually sold by the financier to the lessee at the end of the lease, the lessor does not include this amount in its income: s 240-85. [12.730] Division 242, which predated Div 240, looks remarkably similar to Div 240, which

is not surprising given that both sets of the rules are trying to accomplish the same thing. It provides for leases of luxury cars (notice that this is any lease, not just a hire purchase) to be 680

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treated as notional sale and loan transactions, rather than as leases. The regime contains very much the same operative provisions as Div 240.

9. ACCOUNTING FOR TRANSACTIONS IN FOREIGN CURRENCY [12.740] When transactions occur in Australian dollars, the tax questions can be hard

enough, but this part of the chapter asks: what happens when transactions are denominated in a foreign currency? The relevant rules are complicated in part because they depend on the operation of two other sets of rules, namely: • the ordinary timing rules about when an amount of income or expense is to be recognised for tax purposes; and • the rules about translating the amount of that income or expense when denominated in foreign currency into domestic currency. (There are many rates that might be used to convert currencies – the spot rate on a day or the average exchange rate over a month, for example.) Services income. This point may seem a trifle obscure so an example may assist. Assume an Australian resident taxpayer performs services for an overseas client and sends an invoice for NZ$10,000 once the work is complete. The client pays the invoice by direct credit to the taxpayer’s bank account in NZ with NZ Bank Inc. Some time later, the taxpayer organises for NZ$10,000 to be transferred from its NZ bank account to its Australian bank account. Assume the currencies have fluctuated over the period – that is, NZ$10,000 is worth: • A$7,000 at the time the invoice was rendered (ie spot rate NZ$1 = A$0.70); • A$8,000 at the time the invoice was paid (ie spot rate NZ$1 = A$0.80); • A$7,500 at the time the taxpayer repatriated the funds (ie spot rate NZ$1 = A$0.75). How much income in Australian dollars should the taxpayer report? There is also a subsidiary question – what type of income is it? The two questions arise because there are a number of ways that the transaction might be conceptualised from a tax perspective. At the end of these events, the taxpayer has collected A$7,500 and so this ought to be the amount which the tax system eventually records and taxes, but it is not self-evident just how (or whether) the system will reach this amount. The simplest approach would be to say that the taxpayer has made A$7,500 – being the amount of dollars eventually received in Australia – and the amount is entirely income from services. But there are at least two problems with this simple approach: • If the transaction had occurred entirely domestically, any other taxpayer would be viewed as deriving the income when they billed the client (accrual accounting), or when the invoice was paid (cash accounting), but not at a time after that. The ordinary timing rules would say income earned from Australian clients was derived at some earlier time than the option being considered for income from NZ clients. • Second, what happens if the funds are never converted back into Australian dollars? The taxpayer would presumably escape taxation and this couldn’t be right. Another approach might be to say there are multiple transactions here. Let’s assume the taxpayer is an accrual basis taxpayer and so should be viewed as deriving the income when the bill is rendered:

[12.740]

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• One transaction involves the performance of the work and payment for it. That transaction generated some amount of income – A$7,000 because the amount of income is derived at that date and is converted using the spot rate applying on the date upon which the amount of NZ dollars is required to be expressed as Australian dollars. • The second transaction is the gain on the collection of that debt – the taxpayer has taken a debt owed by the client denominated in NZ dollars, and has realised it for more Australian dollars than the amount the taxpayer “paid” (by performing services) to get it. The collection of that debt has generated a further gain of A$1,000. • A third transaction happens some time later when the taxpayer takes one of their assets (NZ$10,000) and exchanges it for A$7,500. Because the NZ dollars asset had a cost of A$8,000, the taxpayer made a loss at the time of the exchange of A$500. Under the “separate transactions” view of the world, the legs should complement and add to each other – that is, the taxpayer made some income from performing the work and another amount from collecting the debt. Up to that point, the system is indifferent whether or not amounts have been physically converted into Australian dollars – tax consequences cannot be avoided or delayed just by not converting currencies. But if the currency is converted, another amount is earned / suffered from selling the foreign currency asset. This rather long-winded introduction is, hopefully, a comprehensible introduction to some of the most obscure rules in the ITAA 1997 – the foreign exchange gain and loss rules in Div 775. Indeed, the May 2016 Budget announced that these rules will be reviewed to try to make them more straightforward to understand and apply. These rules adopt the “multi-step” analysis of transactions along the lines just indicated. In other words, the income from performing services has to be recorded at the time that the income is derived and an amount of Australian dollars reported as assessable income. If the taxpayer is an accrual basis taxpayer, this income is derived when an invoice is sent – the taxpayer records A$7,000 as income from performing services. If the Australian dollar has moved in value by the time that the invoice is paid, the rules in Div 775 will trigger a further amount of income – in this case, a further $1,000. This happens under s 775-45. This section describes a tax event which is specifically manufactured in order to generate tax consequences. In this section, the event is foreign exchange realisation event 2 (FRE 2) – ceasing to have the right to receive an amount of foreign currency where the right represents ordinary income of the taxpayer. While the language is more than a little obscure, the basic meaning is, collecting a debt where the receivable represents ordinary income or the proceeds of sale of some asset. The taxpayer makes a further gain because its cost base in the foreign currency receivable (see s 775-85) is less than the amount received, and s 775-15 adds all amounts from FREs as further amounts of statutory income. If the Australian dollar had devalued relative to the NZ dollar and the taxpayer collected only A$6,500 when the invoice was paid, FRE 2 would generate an allowable deduction of A$500. The rules in Div 775 will also treat the conversion of the bank deposit into Australian dollars as a further transaction. Purchase of equipment. Now consider a second example. Assume a resident taxpayer has costs (not income) denominated in a foreign currency. For example, assume the taxpayer orders a machine from an overseas supplier and the invoice price is NZ$10,000. The machine arrives and is successfully installed and tested by the seller. The taxpayer then pays the invoice by direct transfer to the seller’s bank account in NZ with NZ Bank Inc. Assume the currencies have fluctuated over the period – that is, NZ$10,000 is worth: • A$7,000 at the time the machine was ordered (ie spot rate NZ$1 = A$0.70); 682

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• A$8,000 at the time the machine was installed and commissioned (ie spot rate NZ$1 = A$0.80); • A$7,500 at the time the taxpayer paid the invoice (ie spot rate NZ$1 = A$0.75). The question for the Australian tax system is: what is the taxpayer’s cost (expressed in Australian dollars) in the machine when calculating its depreciation deduction? The taxpayer’s actual outgoing is A$7,500 but, just as with the previous example, is this reached by one tax entry or several? Again, the timing rules in the domestic tax system will require that the taxpayer calculate its depreciation deduction using amounts expressed in Australian dollars. If the depreciation deduction is based on the amount of Australian dollars spent, then the taxpayer’s cost will be A$7,500 and the system can work from that basis. But when the expense was incurred, the taxpayer’s liability was only A$7,000. Again, the tax law might say there are multiple transactions here: • One transaction involves the purchase of the machine. That transaction generated a cost of A$7,000 – the liability to pay this amount has to be converted using the spot rate applying on the date upon which the became liable to pay some NZ dollars is required to be paid, expressed as Australian dollars. • The second transaction is a redemption – the taxpayer has extinguished a debt (owed to the supplier) denominated in NZ dollars by the payment of Australian dollars. The extinguishment of that debt has realised a loss in Australian dollars – the taxpayer had a liability to pay A$7,000 when it ordered the machine but made a loss of A$500 when it needed to deliver A$7,500 upon the conversion into NZ dollars. The loss on that second leg of the transaction is different from the amount arising under the purchase contract. Under the “separate transactions” view of the world, the legs would accumulate to reach A$7,500 – that is, the taxpayer has an amount (A$7,000) which is its cost in the machine and another loss (A$500) from satisfying the debt. Again, the rules in Div 775 adopt this “multi-step” approach. In this situation, a different tax event is manufactured in order to trigger an additional amount of income or deduction. The relevant section is s 775-55 which creates foreign exchange realisation event 4 (FRE 4) – ceasing to have an obligation to pay an amount of foreign currency that is a deductible expense or outgoing, or the cost for requiring some asset: in other words, paying bills denominated in a foreign currency. The taxpayer makes a further loss because the proceeds of assuming the foreign currency obligation (see s 775-95) is less than the amount payable to extinguish that obligation. Section 775-30 makes that additional loss deductible. Notice, however, the rule in s 775-75 may also be triggered. This provision attempts to undo all the effort of creating two transactions out of the single transaction of buying a machine. It integrates the payment of the price and the effect of the currency movement where the taxpayer pays for the equipment within 12 months of acquiring it. Item 3 in the table will allow the taxpayer to increase its cost in the machine for depreciation purposes to $7,500 and to ignore the effect of the foreign exchange loss. Loans. These two examples were simple because the taxpayers actually converted their funds and there was an obvious transaction which had some tax significance – charging for performing services or buying a machine. Consider this example which is slightly more complex. Assume an Australian resident taxpayer borrows US$100,000 from US Bank at an interest rate of 5% and uses the funds to buy land in the USA. It rents the land to a US tenant who pays rent in US dollars. To keep [12.740]

683

Allocating Income and Deductions to Periods – Timing

things simple, assume the rent exactly matches the interest, repairs, taxes and other expenses so that the taxpayer makes no profit each year. Three years later the taxpayer sells the land for US$100,000 and uses the proceeds to repay the loan. What are the tax consequences of these transactions in Australia? On one view, there are none. The taxpayer has borrowed US$100,000 and repaid US$100,000; the taxpayer has earned rent in US dollars but spent an equal amount of US dollars on deductible expenses; the taxpayer has bought land for 100,000 and sold it for 100,000. Certainly, the US would say there are no tax consequences in the US from these transactions. However, in Australia, there may be issues just because the transactions were denominated in foreign currency, even though there was no physical conversion of funds into Australian dollars or back again. For example: • The taxpayer borrowed US$100,000 and repaid US$100,000. If the rules require the amount of the loan to be recorded at spot rates, the taxpayer may be viewed as having made a gain if the loan was borrowed at US$100,000 = A$111,000 but repaid at US$100,000 = A$105,000. • The taxpayer bought land for 100,000 and sold it for 100,000. If the rules require the cost of the land to be recorded at spot rates, the taxpayer may be viewed as having made a loss if the land was bought at US$100,000 = A$109,000 but sold at US$100,000 = A$106,000. • The taxpayer has earned rent in US dollars but spent an equal amount of US dollars on deductible expenses. There are a number of transactions here and the conversion rules may require some to be recorded at spot rates, but others to be recorded at average rates. Even if they were all recorded at spot rates, it is likely that the converted amounts will not turn out to be equal, just because they will be recorded at different times. This may seem unfair, but for a venture which lasts for more than one year, it is likely to occur because the tax system of the country of residence will not wait until the entire venture is over before working out whether income or loss has arisen, and it cannot wait until amounts are physically converted before working out tax consequences. The rules in Div 755 will in fact require these transactions to be recorded in Australian dollars at multiple times, and would invariably trigger amounts of income or deduction, even though no physical conversion of funds ever took place and even though no profit (expressed in the foreign currency) was actually derived.

10. ACCOUNTING FOR GST [12.750] One special accounting regime in the Act tries to generate the proper interaction

between the income tax and the GST. Getting this interaction to work properly actually requires adjustments to be made in many places in the Act. The GST can affect a taxpayer’s costs and proceeds; it affects transactions involving receipts and payments, and assets such as trading stock, depreciables, CGT-only transactions and so on. The GST has a different impact according to whether the (GST) taxpayer is a consumer, a financial institution or registered, and GST has different effects according to the nature of the goods or services being sold. The income tax needs to recognise these GST differences as well. GST is meant to be an indirect tax on domestic consumption, but like most consumption taxes, it is usually collected from the businesses which sell goods and services to consumers. They pay the tax, but should not bear it. So the tax collected by the seller from the customer when it sells taxable goods and services should not be regarded as forming part of the seller’s profit, because the seller will have to hand over the amounts collected to the revenue 684

[12.750]

Statutory Accounting Regimes

CHAPTER 12

authorities. This means that when a registered business sells GST taxable goods or services for $110, it should be treated for income tax purposes as receiving $100 on its own account and $10 as a collection agent for the government. GST is also meant to be shifted fully forward to the final consumer of taxable goods and services, rather than a tax which sticks on business inputs. When a GST-registered business buys goods and services on which it was charged GST by a registered seller, the GST system refunds the tax component to the buyer in order to prevent the cascading of tax on the inputs to its business. So if a GST-registered business pays $66 for goods or services for its business, it should be treated as paying $60 on its own account and the other $6 should not be regarded as forming one of its costs because the $6 will be refunded to a registered buyer by the government. The rules which give effect to these ideas are located in Divs 17 and 27 of the ITAA 1997 and in various other disparate sections in the Acts. We will look separately at the income tax effects of the GST on the provision of services, sales of trading stock, calculation of depreciation and the impact on CGT. Section 17-5 states the basic proposition that a taxpayer’s assessable income does not include “the GST payable on a taxable supply”. This means that a GST-registered seller who sells a GST taxable service for $110, reports as income only $100. If the seller is not registered for GST, or if the service is actually not one which attracts GST (for example, it is a consultation with a doctor) there is no “taxable supply” for GST, and the seller will include the entire $110 as its assessable income. We have referred to a GST-registered business because GST is only owed by GST-registered businesses. Hence, if an unregistered business sells the same service for $110, it gets to keep the entire $110 and reports the $110 as assessable income. In regard to expenses, s 27-5 states the corollary – that a taxpayer’s allowable deductions do not include “an amount relating to an input tax credit”. This means that a GST-registered buyer who purchases a GST-taxed service for $110 as an input to its own business reports as its allowable deduction only $100. If the buyer or the seller is not registered for GST, or if the service is actually not one which attracts GST (for example, many of the services provided by banks) there is no “input tax credit” for GST, and the buyer will deduct the entire $110 (assuming the expense is otherwise deductible). The position for purchases is made more complicated because some buyers (notably banks and insurance companies) can recover only part of their input tax credits because they make partly taxed and partly non-taxed sales. In this case, where a registered buyer pays $110 for a service which attracts GST, but is not allowed under the GST rules to recover its full “input tax credit” (say, it can only recover 40% of the tax credits for its business inputs) the buyer will deduct $106 as its cost, as it will recover $4 as input tax credit. Notice finally the position of employees. They are not registered for GST and so cannot recover any input tax credits for their purchases. Hence they are allowed to claim $110 as the allowable deduction for their GST-taxed employment-related expenses. Section 27-15 states the logical implication of these two provisions: that when the GSTregistered business sends the monthly or quarterly GST payment it owes to the government, this amount too is not a deduction. These rules for the sale and purchase of services also apply to calculate the income and deductions arising from the acquisition and sale of trading stock. Hence the purchase of $66 GST-taxed trading stock gives rise to an allowable deduction of $60, and the sale of trading stock for $110 in a GST-taxable sale produces assessable income of $100. The taxpayer is thus [12.750]

685

Allocating Income and Deductions to Periods – Timing

taxed on $40 as its taxable income (and sends the remaining $4 to the government as its net GST obligation). There is one further provision, s 70-45(1A), which deals with the income tax position of the GST for trading stock that is on hand at the end of a tax year. When the taxpayer has closing stock, it must add back an amount as the value of closing value of stock on hand under s 70-45(1). Subsection (1A) says the amount added back is lower by the amount of the full input tax credit to which the taxpayer would have been entitled assuming it had purchased the item at that time, and was entitled to a full input tax credit for the purchase (which may or may not be the case). This reference to the purchase at the time of valuation means that the amount excluded from the closing value of the trading stock is not the $6 actually claimed when the stock was bought, but rather 1/11th of the (GST-inclusive) market value of the goods at the end of the year – in other words, something more like 1/11th of their likely sale price. But there are other less obvious trading stock rules where GST issues can arise. For example, s 70-90 says that if a taxpayer sells trading stock outside the ordinary course of its business, it records as assessable income not the amount it received, but rather the market value of the item. Section 70-95 makes the same amount the buyer’s cost in the stock. Or consider s 70-105 which says that if a taxpayer dies owning trading stock, his or her assessable income includes the market value of the trading stock at the time of death. How does GST affect these rules? The answer is in the definition of “market value” in s 995-1. It mirrors s 70-45(1A) and says the market value of an asset is its market value reduced by the amount of the full input tax credit to which the taxpayer would have been entitled, assuming it had purchased the item then and was entitled to a full input tax credit for the purchase. So assume the taxpayer has bought inventory for $110 and has claimed $10 as an input tax credit. The assumption of s 995-1 is that the subsequent “market value” of the goods would be a GST-inclusive amount, and so if the goods could currently be purchased for $165, the market value as defined (that is, net of the GST-input tax credit) would be $150. In the case of depreciables, the same issues of cost and proceeds arise. The impact of GST on the taxpayer’s “cost” for depreciation purposes is left undefined in Div 40. Instead, special rules exist in Subdiv 27-B. Section 27-80 provides that the cost of a depreciable asset excludes the input tax credit to which the GST-registered taxpayer is entitled. This means that an employee or a residential landlord (neither of whom can claim input tax credits for their plant) can depreciate an asset from a GST-inclusive price, while a GST-registered taxpayer entitled to a full credit depreciates from a GST-exclusive price. If the taxpayer then sells the plant, again the GST component would be excluded from the termination value for a registered taxpayer, and this happens as a result of s 27-95. For assets which are subject only to the CGT regime, the taxpayer’s cost base is set by Divs 110 and 112 of the ITAA 1997. The principal rule which affects the calculation of the taxpayer’s cost base is s 110-45(3A) which excludes the taxpayer’s “input tax credit (if any)” from its cost. The capital proceeds from a CGT event are defined in Div 116 of the ITAA 1997. Section 116-20(5) provides that the capital proceeds of a CGT event exclude the amount of the taxpayer’s “net GST (if any) on the supply”. Ordinarily this will mean only the GST that has to be remitted by a GST-registered taxpayer (although if GST adjustments arise as a result of the supply, these give rise to the “net” amount). This means that an unregistered taxpayer who buys a CGT asset (say a new house) for $440,000, has a cost of $440,000, while a registered taxpayer who is entitled to a full input tax credit will have a cost of $400,000. If the asset is 686

[12.750]

Statutory Accounting Regimes

CHAPTER 12

sold for $660,000, a registered taxpayer’s capital proceeds are $600,000 while an unregistered taxpayer’s capital proceeds are the full $660,000. The last income tax issue arises from the operation of GST adjustments. GST has rules in Divs 129 and 132 of A New Tax System (Goods and Services Tax) Act 1999 which modify the amount of a taxpayer’s input tax credit if the taxpayer puts an asset to a different use or perhaps changes its character – for example, the taxpayer purchased a car thinking it would use the car 60% in its taxable business activities (say, managing its leased commercial real estate) and only 40% for its input taxed business activities (say, managing its leased residential real estate), and later discovers that the actual percentage is more like 50/50. In this case, the taxpayer has over-claimed its input tax credit when the car was purchased and so the taxpayer will have to pay additional GST by way of an increasing adjustment. In this situation, s 27-90 of the ITAA 1997 operates for depreciable plant, and it allows a taxpayer to increase the cost of the asset for depreciation purposes by the amount of the increasing adjustment. To see the point of this process, consider the situation if the taxpayer purchased the car for $44,000. The taxpayer would have claimed 60% of $4,000 as an input tax credit (ie $2,400) and would have started depreciating the car from a cost of $41,600. Then the taxpayer’s GST increasing adjustment occurs and a further $400 is paid as GST. The taxpayer’s cost for depreciation purposes now increases under s 27-90 because there is a higher amount of unrecovered GST implicit in the car (ie $2,000 has not been recovered, not just $1,600). For adjustments to other receipts or payments, the same logic applies and similar rules exist in s 17-10 and s 27-10.

[12.750]

687

INCOME DERIVED INTERMEDIARIES

THROUGH

14. Taxation of Companies and Shareholders .................................... 747 15. Special Topics in Company Tax ....................................................... 809 [Pt5.10] In this Part we consider the income tax issues that arise when income is derived through an intermediary. By intermediary we mean a legal construct which for various commercial and legal purposes is treated as separate from the owners of the intermediary. Common examples are partnerships, trusts and companies and these are the intermediaries that are considered in this book. We generally use the term “intermediary” rather than the more usual term “entity” to avoid confusion because entity is used in the ITAA 1997 to include individuals and legal constructs: see s 960-100. In turn, the term “you” refers to entities in this broader sense: s 4-5.

PART5

13. Partnerships, Trusts and Income Splitting ................................... 691

It is not necessary for a legal construct to be a legal person for it to be treated to some degree as separate from its owners for tax or other purposes. Trusts and partnerships generally are not separate legal persons. While companies limited by shares registered under the Corporations Act have legal personality, for income tax purposes, as we shall see, “company” is more broadly defined and includes unincorporated associations such as clubs. There are intermediaries which are treated as separate from the owners for commercial purposes but which for income tax purposes are disregarded more or less entirely, such as unincorporated joint ventures, which are commonly used in the mining industry. While there is a definition of “non-entity joint venture” in s 995-1(1) of the ITAA 1997 which refers to such intermediaries, its only purpose is to make clear that they are not treated as separate for income tax purposes: ss 960-100(1A) and 995-1(1) definition of “company”. The major issue that arises if an intermediary is treated to some degree as separate from its owners for income tax purposes is how to reconcile income tax at the level of the intermediary and at the level of the owners. In turn, this gives rise to three problems. First, if taxable income or its equivalent is calculated at the level of the intermediary, there is an issue of whether or not to tax the intermediary, and when the intermediary is taxed, how to relate this tax with tax on the owners. Thus, companies are taxpayers under the income tax and the imputation system is used to impute the tax paid by the company to shareholders when dividends are distributed by the company. On the other hand partnerships and trusts are generally not taxed on their “net income” but rather the income is attributed to the partners or beneficiaries and taxed to them, whether or not it is distributed. This is usually referred to as “transparent” or “look through” taxation. The intermediary is not ignored – income is calculated at the level of the intermediary – but the tax effects arise at the owners’ level. Second, are the owners’ interests in the intermediary to be treated as CGT assets 689

separate from the intermediary’s ownership of its assets? If this occurs there are effectively two cost bases in the same assets as economically the owners own the assets of the intermediary. In turn, the dual cost base creates the possibility of duplication of gains and losses for tax purposes with respect to the same economic gain or loss. Clearly for companies and shareholders there are dual cost bases (shareholders in their shares and companies in their assets). For partnerships and trusts the issue is more complex under the income tax and CGT and is elaborated in Chapter 13. Third, if tax losses are incurred, are they locked in the entity or passed through to the owners? Generally taxpayers would prefer losses to be passed through to the owners, but this is only possible for partnerships, not trusts or companies. In turn, the locking of losses in intermediaries gives rise to very complex rules to prevent trafficking in the losses. Two further issues are also addressed in this part of the book. If individuals are treated as separate taxpayers from other members of their families, there is potential for reduction of tax by splitting income which really belongs to one individual with other members of the family. Intermediaries provide one of the main means by which income splitting is achieved in practice. In addition, if an intermediary is taxed separately from its owners and its tax rate is lower than individual tax rates, tax savings can be achieved by diverting income to an intermediary from an individual. Companies are taxed at a 30 per cent rate which is considerably lower than the top individual rate including Medicare Levy of 46.5 per cent. Hence it is common for income to be diverted to companies. On the other hand, individuals are entitled to the 50 per cent discount on certain capital gains and companies are not. Hence it is generally better tax wise for individuals to ensure that capital gains end up in their hands and not in a company. Because of the close relationship of the taxation of intermediaries and income splitting and diversion, we take up these issues in Chapter 13. We have already considered the operation of Divs 85 – 87 of the ITAA 1997 on diversion of services income to intermediaries in Chapter 4. Further, when there are multiple intermediaries in a commonly owned group, dual cost bases can become multiple cost bases and give rise to various kinds of tax planning. Conversely, losses and other tax attributes can be locked in one intermediary in the group and not available to others in the group even though together they effectively constitute one business. After adopting piecemeal solutions to these issues over various years, in 2002 Australia swept most of them away and adopted a system of tax consolidation of 100 per cent commonly owned corporate groups. This system treats a consolidated group as in effect one company (intermediary). Most large companies in Australia are now part of such consolidated groups so they are considered in this Part also.

690

CHAPTER 13 Partnerships, Trusts and Income Splitting [13.10]

1. TAX POLICY IN RELATION TO INTERMEDIARIES ................. ....................... 693

[13.20]

Australia’s Future Tax System, Report to the Treasurer, Pt 2 sec B2 ................................ 694

[13.40]

2. TAXATION OF PARTNERSHIPS AND PARTNERS................... ........................ 696

[13.50] [13.60] [13.80] [13.90] [13.100]

(a) What is a Partnership for Tax Purposes? ............................................................... (i) Types of general law partnerships ......................................................................... (ii) Tax law partnerships ............................................................................................ FCT v McDonald ........................................................................................................ (iii) Characterising unusual intermediaries .................................................................

[13.110]

(b) Calculation and Attribution of Net Income and Partnership Loss .......................... 701

[13.120] [13.130] [13.150]

(c) Transactions Between Partnership and Partners .................................................... 702 Poole & Dight v FCT ................................................................................................... 703 FCT v Roberts & Smith ................................................................................................ 705

[13.160] [13.170] [13.180] [13.210] [13.230] [13.250]

(d) Creation of Partnerships, Change of Partners and Dissolution .............................. (i) Income tax ........................................................................................................... Rose v FCT ................................................................................................................. Peterson v FCT ........................................................................................................... Tikva Investments Pty Ltd v FCT .................................................................................. (ii) CGT .....................................................................................................................

[13.260]

(e) Limited Partnerships ............................................................................................ 714

697 697 699 699 701

707 708 708 709 710 712

[13.280] 3. TAXATION OF TRUSTS AND BENEFICIARIES .................... ........................... 715 [13.290] [13.290] [13.300] [13.310]

(a) Trustees and Trusts .............................................................................................. (i) What is a trust? ..................................................................................................... (ii) Trustee and trust in tax law .................................................................................. (iii) Common types of modern trust ..........................................................................

715 715 716 717

[13.320] [13.340] [13.370]

(b) Present Entitlement ............................................................................................. 717 Taylor v DFCT ............................................................................................................ 719 Trustees of Estate Mortgage Fighting Fund Trust v FCT .................................................. 721

[13.390]

(c) Calculation and Attribution of Net Income of a Trust ........................................... 723

[13.420]

(d) Capital Gains of Trustees ..................................................................................... 725

[13.430]

(e) Child Beneficiaries and Division 6AA .................................................................... 726

[13.440]

(f) Deceased Estates .................................................................................................. 727

[13.450]

(g) Trust Distributions ............................................................................................... 728

[13.460]

(h) Trust Anti-avoidance Measures ............................................................................ 729

[13.470]

(i) Trust Losses .......................................................................................................... 731

[13.480] [13.490] [13.500]

(j) Creation, Dissolution and Dealings in Trust Interests ............................................. 732 (i) Absolute entitlement ............................................................................................ 733 (ii) Creation and dissolution ...................................................................................... 734 691

Income Derived Through Intermediaries

[13.520] [13.530]

(iii) Dealings in trusts other than deceased estates and unit trusts ............................. 736 (iv) Dealings in unit trusts ......................................................................................... 736

[13.540]

(k) Trusts Taxed as Companies .................................................................................. 737

[13.545] [13.550] [13.555]

(l) Managed Investment Trusts .................................................................................. 738 (i) MITs, WMITS and AMITs ....................................................................................... 738 (ii) Package of measures for AMITs ............................................................................ 739

[13.560] 4. INCOME SPLITTING AND DIVERSION ........................ ............................... 741 [13.570] [13.580]

(a) Assignments of Income ........................................................................................ 741 Booth v Commissioner of Taxation ............................................................................... 742

[13.590]

(b) Splitting and Diversion of Income Through Intermediaries .................................. 744

Principal Sections ITAA 1936 s 6(1)

ITAA 1997 –

–

s 995-1

ss 90 – 92

–

ss 40-295(2), 40-340(3), 70-100

Div 5A

ss 108-5(2)(c), (d), 106-50, 118-20 –

–

Subdiv 960-E

ss 94, 102

–

ss 95, 95A, 96, 97, 98, 99, 99A, 101

–

Div 6E

Div 115, Subdiv 207-B

ss 98, 100, Div 6AA

–

s 99

Div 128

692

Effect This section provides the definition of “trustee”. This section provides a definition of “partnership” for tax. These sections require a calculation of partnership net income or partnership loss at the partnership level and attribution of the income or loss to partners. These sections deal with the capital allowance and trading stock consequences of changes in partnerships. These sections deal with the CGT effects of changes in partnerships. This Division deals with taxation of certain limited partnerships as companies. This Subdivision defines the notion of an “entity” for tax purposes and creates the notion of a “non-entity joint venture” These provisions seek to deal with income splitting through partnerships and trusts. These sections set out how the next income of a trust is calculated and taxed on the basis of present entitlement. These provisions ensure that the tax benefits arising from franked dividends or discount capital gains are allocated to the beneficiaries who are allocated the relevant dividends or capital gains. These provisions set out how the income of underage children derived through trusts is taxed. These provisions set out how deceased estates are taxed.

Partnerships, Trusts and Income Splitting

ITAA 1936 ss 99B, 99C s 100A, Div 6D

Sch 2F, Divs 265 – 272

ITAA 1997 ss 104-70, 104-71, 104-72 –

– s 106-50

Div 6C

ss 104-55 – 104-65, 104-75 – 104-100 – Divs 275, 276

Div 6A

–

CHAPTER 13

Effect These provisions set out how trust distributions are taxed. These provisions deal with tax avoidance through trust stripping and distributions through multiple levels of trusts. These provisions deal with the ability of trust to use losses. This section deals with trusts where a beneficiary is absolutely entitles to an asset of the trust as against the trustee. These provisions deal with creation of and dealings in trusts. This Division taxes certain trusts in a similar manner to companies. These provisions create a parallel regime for taxing income earned through managed investment trusts on the basis of amounts attributed to unitholders This Division deals with assignments of income.

1. TAX POLICY IN RELATION TO INTERMEDIARIES [13.10] One of the perennial problems of tax policy is how to treat the intermediary, and the

investors in it, when income and gains are earned via an intermediary. While it used to be common for countries to tax companies in their own right and then to tax the shareholders on distributions and capital gains on shares without regard to the tax paid by the company, that tax policy gives rise to various economic distortions – between debt and equity, and retention and distributions. If other intermediaries are taxed on a transparent basis it also means that tax considerations influence the choice of intermediary. It has been a goal of policymakers to remove the distortions between types of intermediary and the treatment of investors in them, but the design of regimes for taxing intermediaries is by no means easy, and outcomes can be idiosyncratic: Australia introduced the imputation system to try to approximate transparency for the distributed profits of companies; some countries (such as the US) have created systems under which companies can elect to be treated as transparent; on the other hand, Australia has rules which prevent some partnerships and trusts from having transparent status. The most recent extensive official consideration of how to tax income flowing through intermediaries occurred in the Henry Review. The policy issues are considered in the following extract (which generally uses the term “entity” rather than “intermediary”).

[13.10]

693

Income Derived Through Intermediaries

Australia’s Future Tax System, Report to the Treasurer, Pt 2 sec B2 B2–1 Approaches to taxing the income of business entities and their owners [13.20] The organisational forms or entities used for business activities depend on a country’s legal arrangements and commercial practices. In Australia, businesses operate through companies, general and limited partnerships, and different types of trusts, as well as directly by individuals as sole traders.

progressive rate scale. However, there are situations where separate entity treatment may be more practical – in particular, for large businesses where ownership rights are frequently traded. Also, where such businesses are conducted through a company owned by nonresidents, there are constraints on Australia’s ability to tax the profits of the company other than on a separate entity basis.

Each of these entity types has advantages and disadvantages. For example, the limited liability of companies and their governance arrangements may make them better suited to conducting risky activities. Trusts, which separate legal and beneficial ownership, offer the benefits of asset protection. Operating as a sole trader is simpler than operating through a separate entity, reducing legal and accounting costs.

Other features of the tax system may also affect how different entities should be taxed. For example, concerns over tax losses arising from mismeasurement of business income (which may occur where capital expenditures are immediately deducted) may justify imposing limits on loss flow through …

Income tax can apply to both the owners of a business and the business entity itself (except in the case of sole traders). This raises the prospect of double taxation, which may give rise to high effective rates of tax. However, in some cases, even where income tax is paid at the owner and business levels, the total income tax paid may be less than if the business was operated by a sole proprietor subject to personal income tax only. Where double taxation is seen to be undesirable, it can be dealt with in a number of ways, including by flow-through treatment (where the income of the entity is attributed annually to the owners), taxing the owners only on distributions received and on changes in the value of the business, and taxing both the owners and the business separately but in an integrated way. These approaches can also be combined; for example, a flow-through approach can be combined with entity taxation in certain circumstances. If tax outcomes were the same regardless of the choice of business entity, the tax system would allow businesses to adopt organisational forms that are commercially preferred. … Flow-through treatment has considerable advantages in achieving outcomes consistent with a personal income tax system based on a 694

[13.20]

Commercial practice and needs, along with the non-tax legal and regulatory environments, are also relevant in considering the appropriate tax arrangements for different entity types. For example, in Australia, unit trusts have been the entity type most commonly used for managed investment vehicles, whereas in other countries companies may also be used. The nature of managed investment vehicles, which invest the savings of investors with very different tax profiles into domestic and foreign assets, places a premium on certain tax features, such as a flow-through treatment and certainty in tax outcomes. Principles Income tax arrangements for different types of business entity and their owners should be broadly consistent to limit biases in choice of business structure, while taking account of diverse circumstances and requirements. … B2–2 Current entity arrangements have strengths and weaknesses A high level of tax integration between entities and their owners In Australia, companies are the most significant type of business entity in terms of net assets and net income. For the 2006–07 income year, there were 750,275 companies (of which 1% were

Partnerships, Trusts and Income Splitting

Australia’s Future Tax System, Report to the Treasurer, Pt 2 sec B2 cont. public companies); 355,345 partnerships and 272,535 trusts identified for income tax purposes. Just over one million individuals reported net business income in their tax returns, reflecting sole traders. Partnerships are generally taxed on a flowthrough basis, so that each partner is taxed similarly to a sole trader. Generally, the income and losses of a partnership flow through to the partners in proportion to their interests in the partnership. Where a partner leaves a partnership, they are taken to dispose of their share in the underlying partnership assets. This can create some complexity due to the interaction of the capital gains tax and partnership rules. Trusts can be used as an alternative structure for conducting business activities. Trusts are largely taxed on a flow-through basis, with the income of a trust allocated to its beneficiaries based on their “present entitlements”. However, losses do not flow through to beneficiaries. Where there is income of the trust to which no beneficiary is presently entitled, it is taxed in the hands of the trustee at the top personal income tax rate plus the Medicare levy.

CHAPTER 13

In contrast to the treatment of partnerships and trusts, companies are taxed separately from their shareholders. Under the dividend imputation system introduced in 1987, resident companies are able to attach (frank) imputation credits to dividends paid to shareholders. The imputation credits represent tax paid by the company on behalf of the shareholders. Resident shareholders receiving franked dividends are taxed on the dividend and the attached credit, but their liability is reduced by the amount of the credit. From 1 July 2000, excess imputation credits have been refundable for individuals, superannuation funds and charities. Some variation in tax outcomes according to type of entity While the tax treatment of the entity and its owners is highly or fully integrated for all types of entity, in practice there is some variation in: how business income is taxed (with a more favourable treatment of capital gains and foreign source income for unincorporated entities), access to losses, and potential tax deferral benefits from retaining income in a company (see Table B2–2). These variations can distort business choices, and encourage more complex structures than would otherwise be used.

Table B2–2: Tax treatment of income attributable to individual resident owner Sole trader, partnership Taxable Taxed at individual’s income personal rate. Tax-preferred Tax preference retained. income Capital gains of entity Foreign source income Losses

50% of gain is taxed at individual’s personal rate. Taxed at individual’s personal tax rate with a credit for foreign tax. Can be used against other income.(d)

Trust

Company

Taxed at individual’s personal rate.(a) Partial claw back as a capital gain (unless non-fixed trust). 50% of gain is taxed at individual’s personal rate. Taxed at individual’s personal tax rate with a credit for foreign tax. Quarantined in trust to be carried forward.

Taxed at individual’s personal rate.(b) Claw back occurs when taxed as an unfranked dividend. Taxed at individual’s personal rate.(c) After foreign tax income taxed at individual’s personal tax rate. Quarantined in company to be carried forward.

[13.20]

695

Income Derived Through Intermediaries

Australia’s Future Tax System, Report to the Treasurer, Pt 2 sec B2 cont. Sole trader, partnership

Trust

Company

a. If there is trust income to which no beneficiary is presently entitled, it is taxed to the trustee at the top personal tax rate plus the Medicare levy. b. Retained profits taxed at 30%, but taxed at individual’s personal tax rate when distributed, with credit for company income tax paid. c. A tax concession broadly equivalent to the capital gains tax discount is provided to investors in listed investment companies. d. Subject to non-commercial loss provisions being satisfied. Trust tax rules are complex, uncertain and result in inappropriate outcomes The general rules governing the taxation of trusts rely on a mix of trust law concepts (which mostly derive from case law) and tax law concepts (which derive from case law and statute). Differing views on key concepts, such as “present entitlement”, “income of the trust estate” and “share”, create uncertain tax outcomes for taxpayers, increasing compliance and administration costs. For example, there are differing views as to whether the income of the trust estate refers to net accounting profit, distributable or gross ordinary income, or whether it can vary according to the terms of the trust deed. In addition, the interaction between the income of the trust estate (which relates to present entitlement) and the net income of the trust (the basis for a beneficiary’s tax liability) can be problematic; for example, when it comes to the treatment of capital gains derived through a trust. Recent court cases have also given rise to uncertainty around whether income retains its character as it flows through a trust.

[13.30] In relation to the imputation system for company shareholder taxation considered in

Chapter 14, the Review recommended that it be retained for the time being, but that in the medium term consideration be given to adopting an alternative form of corporate taxation. In the immediate response to the release of the Report, the government did not address these issues directly. In December 2010 it announced that in accordance with the Review, the trust taxation rules would be rewritten and at the end of the Tax Forum in October 2011 it announced formation of a short-term business tax reform group, with the first priority the treatment of business losses, and the second the longer-term options for taxation of companies and shareholders. It seems those projects are probably defunct and the current rules are likely to survive for the foreseeable future.

2. TAXATION OF PARTNERSHIPS AND PARTNERS [13.40] The general tax rules for partnerships are relatively brief. The income tax rules are in

Pt III Div 5 of the ITAA 1936 and the CGT rules in ss 106-5 and 108-5(2) of the ITAA 1997. There are many special rules for partnerships scattered throughout the income tax legislation but we will refer to only a few of these. The first issue to address is: what constitutes a partnership for income tax purposes? Under s 2-15(3) of the ITAA 1997, “partnership” is one of those defined terms in the legislation which is not asterisked. As we shall see it is not automatically to be assumed outside Div 5 that the definition is applicable wherever the term appears. 696

[13.30]

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(a) What is a Partnership for Tax Purposes? [13.50] In 2004 the definitions in relation to partnerships were rewritten (and moved from

ITAA 1936 to ITAA 1997). At this point you should read the definitions of “partnership” and “limited partnership” in s 995-1(1). You should also contrast this with the notion of a “non-entity joint venture” in s 995-1(1). To understand the definitions it is necessary to consider the background partnership law. (i) Types of general law partnerships [13.60] Each Australian state and territory has a Partnership Act modelled on the original

English legislation. These define a partnership as “the relation which exists between persons carrying on a business in common with a view of profit” and then list various indicia as follows. In determining whether a partnership does or does not exist, regard shall be had to the following rules: (1)

(2)

Joint tenancy, tenancy in common, joint property, or part ownership does not of itself create a partnership as to anything so held or owned, whether the tenants or owners do or do not share any profits made by the use thereof. The sharing of gross returns does not of itself create a partnership, whether the persons sharing such returns have or have not a joint or common right or interest in any property from which or from the use of which the returns are derived.

(3)

The receipt by a person of a share of the profits of a business is prima facie evidence that the person is a partner in the business, but the receipt of such a share, or of a payment contingent on, or varying with the profits of a business does not of itself make the person a partner in the business; and in particular: (a) The receipt by a person of a debt or other liquidated demand by instalments or otherwise out of the accruing profits of a business does not of itself make the person a partner in the business or liable as such: (b) A contract for the remuneration of a servant or agent of a person engaged in a business by a share of the profits of the business does not of itself make the servant or agent a partner in the business or liable as such: (c) A person being the widow, widower or child of a deceased partner, and receiving by way of annuity a portion of the profits made in the business in which the deceased person was a partner, is not by reason only of such receipt a partner in the business or liable as such: (d) The advance of money by way of loan to a person engaged or about to engage in any business on a contract with that person, that the lender shall receive a rate of interest varying with the profits, or shall receive a share of the profits arising from carrying on the business, does not of itself make the lender a partner with the person or persons carrying on the business or liable as such: Provided that the contract is in writing and signed by or on behalf of all the parties thereto: (e) A person receiving by way of annuity or otherwise a portion of the profits of a business in consideration of the sale by the person of the goodwill of the business is not by reason only of such receipt a partner in the business or liable as such. The words in the tax definition “an association of persons … carrying on business as partners” are a reference to this partnership law definition. Accordingly it is necessary to have recourse [13.60]

697

Income Derived Through Intermediaries

to partnership law cases to determine whether a partnership exists for tax purposes under this part of the tax definition. There is a substantial amount of law considering this issue which is summarised in the Ruling TR 94/8 and considered in the McDonald case extracted below. The fact that the parties might label their situation as a partnership, or that the documents insist no partnership exists, is not determinative. The idea that multiple parties are carrying on business in common is one distinguishing feature of a partnership. Tax law now has a label for the situation where parties are co-operating but they are not carrying on business in common: the “non-entity joint venture”. The definition describes a situation where the parties co-operate to produce something of value, but then they take a share of what is produced and go their separate ways. Arrangements in the mining and resources sector are sometimes structured in this way. [13.65]

13.1

13.2

Questions

A, B and C are three companies that enter into a joint venture for the development of a shopping centre. A is the main company carrying out the venture. B is a finance company which lends substantial funds to the venture. C is an investor which contributes its own agreed share to the venture. The joint venture agreement provides for the sale of the shopping centre and division of the profits among the venturers. Is the venture a partnership? (See United Dominion Corporation Ltd v Brian Pty Ltd (1985) 157 CLR 1, GSTR 2004/2.) A husband and wife, on the advice of their tax agent, sign a partnership agreement in relation to a business that the wife has conducted for many years. The husband contributes neither services nor capital to the partnership. The agreement provides that the husband and wife are to share the profits of the partnership jointly. Is there a partnership? Would it make any difference if the husband contributed $10,000 to the partnership for working capital, or performed minor services such as answering the phone and preparing the accounts of the partnership? (See TR 94/8.)

[13.70] By the 1990s most Australian jurisdictions had also adopted in their Partnership Acts

variants on further English legislation dealing with limited partnerships. Under this legislation it is possible to register a partnership as a limited partnership which means that the liability of the limited partners is limited to the amount they have agreed to contribute, similar to shareholders in a company limited by shares. However, a limited partnership has to have a general partner with unlimited liability in the same way as partners’ liability in other partnerships. And the limited partnership was still not created as a distinct legal person. Limited partners are not permitted to take part in the management of the partnership, which is the role of the general partner. Paragraph (a) of the tax definition of “limited partnership” is a reference to this kind of partnership. Starting in 2003, Australian states substantially amended their partnership legislation to create a new form of partnership called an incorporated limited partnership. As its name suggests, this kind of partnership is a legal person and, similar to a company, owns its property in its own right and can sue and be sued in its own name. Such partnerships can only be used in venture capital activities. Paragraph (b) of the tax definition of “limited partnership” is intended to be a reference to this kind of partnership. At the same time, states also amended their rules on limited partnerships so that the general partner, for example, is no longer the agent of the limited partners. This can have significance for tax purposes in international transactions. Moreover, it is made clear that both limited partnerships and incorporated limited partnerships can themselves be partners in other partnerships. Ordinarily, the general view is that one partnership cannot be a partner in 698

[13.65]

Partnerships, Trusts and Income Splitting

CHAPTER 13

another partnership. Rather, the partners in the first partnership become partners in the second partnership. The significance of the limited partnership definitions is considered in the section on limited partnerships. (ii) Tax law partnerships [13.80] In addition to referring to the general law of partnerships, the tax partnership

definition also includes “an association of persons … in receipt of *ordinary income or *statutory income jointly”. Cases covered by this part of the definition are usually referred to as “tax law partnerships” to distinguish them from the general law partnerships we have just been examining. The effect of this part of the definition is, for example, that spouses who own their home jointly and rent it out, say, while they are working interstate, will become a partnership for tax purposes. In practice the ATO does not require them to file a partnership return and will allow them to include the rental income and relevant deductions in their individual tax returns. It is not clear why this extension to the definition is included – perhaps it was designed to obviate the need to decide whether there is a general law partnership in such cases, which is often a difficult legal question. There are situations where it does matter whether a case involves a general law partnership or a tax law partnership as shown in the case of FCT v McDonald (1987) 18 ATR 957. The question was whether the whole of a loss on a rental property was incurred by the taxpayer, or one-half of the loss was incurred by each of the taxpayer and his wife. The evidence was that the taxpayer and his wife had signed a record of discussion recording their desire to improve the wife’s income, and that they therefore intended to invest in income-producing property on terms including the following: (a) (b) (c)

the property would be held as joint tenants; any net profits would be divided as to 75% to the wife and as to 25% to the taxpayer; all losses would be borne by the taxpayer.

FCT v McDonald [13.90] FCT v McDonald (1987) 18 ATR 957 Beaumont J: It is true that, for the purposes of the Act, “persons in receipt of income jointly” as well as persons carrying on business as partners, are deemed to be “partners” (see the definition in s 6(1)). Thus, if co-owners, who might not be partners under the general law, receive income jointly, they are treated as “partners” for the purposes of the Act. In the present case, the respondent and his wife were joint tenants, legally and beneficially, of the subject premises. They were in receipt of income jointly from the lettings. By reason of the extended partnership definition, they were deemed to be “partners” for the purposes of the statute. This circumstance does not, however, advance the respondent’s case: “Taxation law recognises

the schizoid nature of the partnership as both a distinct firm or profit centre in accounting and economic theory and as a non-entity in general legal theory”; see Fletcher, The Law of Partnership in Australia and New Zealand, 5th ed p 307. As Professor Fletcher notes, the Act requires that the accounts of the business (or, in the case of co-owners, notional business) be prepared on the basis that the partnership is a distinct commercial operation; yet no tax is levied on the earnings of the partnership and its income is credited to partners in the appropriate shares and taxed in their hands as part of their income: ss 90, 91 and 92. In the same way, the Act, as it stood at material times, allowed a partner, or a notional “partner”, a deduction in respect of “his [13.90]

699

Income Derived Through Intermediaries

FCT v McDonald cont. individual interest in a partnership loss”: s 92(1). “Carrying on business in partnership or being a partner confers no special rights or entitlements for taxation purposes”: Fletcher, op cit. As I followed the argument, the respondent acknowledged this. He accepted that if no more appeared in the case than that he and his wife were joint tenants, that is to say, that for the purposes of the general law, they were merely co-owners and not partners carrying on a business in common with a view of profit (see Partnership Act 1892 (NSW) s (1)), then although their receipt of income jointly would deem them to be “partners” for taxation purposes, the respondent would, by virtue of s 92(1), be allowed a deduction of only one-half of the losses incurred. The respondent’s concession was, I think, rightly made. It is common ground that the respondent and his wife were beneficially entitled to the premises as joint tenants. As joint tenants, they were entitled in equal shares to the rents and profits … For taxation purposes, the Act takes the taxpayer’s income as it finds it, that is to say, subject to the general law in all its aspects. This will pick up the position at law and in equity modified by any relevant legislation, including the provisions of the Act itself … What is relied on by the respondent in claiming to be allowed a deduction for the whole of the losses is his assertion that he and his wife were also partners under the general law (ie they were “true” partners … and that it was a term of the partnership agreement that he be liable for the whole of the losses of the venture). Alternatively, the respondent says, even if a general law partnership did not subsist, it was a term of the agreement between the respondent and his wife that he be liable for all the losses and his contractual liability was itself sufficient to entitle him to deduct the total amount claimed. In my opinion, no partnership under the general law subsisted between the respondent and his wife. Their relationship was one of coownership, and even if they were deemed to be partners by reason of s 6(1) of the Act, this circumstance is immaterial for our purposes. As has been noted, their notional “partnership” will 700

[13.90]

carry with it the consequence that they are to be treated as a “partnership” for some purposes. It does not follow that the respondent can deduct the whole of the losses. He may only deduct his individual interest in the “partnership” loss. His “individual interest” is the interest to which a “partner” is solely entitled, as contrasted with his joint interest in the whole … It is necessary therefore to determine whether the respondent and Mrs McDonald were merely notional “partners” for the purposes of the Act (ie merely co-owners) or were “true” partners under the general law … It is true that the record of discussion referred to the relationship in terms of an “investment” rather than that of a partnership. This is inconclusive. It is well established that the parties’ description of their relationship as a partnership or as not a partnership does not determine the legal question to be addressed by the court … In the present case, a number of indications point to the conclusion that the parties were not carrying on a business, with the consequence that their relationship was that of co-ownership rather than partnership. Their investment involved little, if any, active participation from either party. This was inevitable because the respondent was apparently in full-time employment, and Mrs McDonald was fully committed at home. On the few occasions on which the owners needed to be involved, the respondent and not Mrs McDonald attended to the matter. This was not a case of the active joint participation by the parties in a business activity. Rather, it was a case of a renting out of premises without the provision of other services … In my view, there was here a mere investment in property rather than a partnership in the properties or their profits. This is not, of course, to say that it is not possible for husband and wife to enter into a partnership under the general law with respect to land dealings … Given the respondent’s minor participation in the affair and given Mrs McDonald’s apparent lack of commercial expertise and her passive role, it is, I think, more accurate to describe them as co-owners in investments rather than as partners in a business operation. This is not to say that the respondent and his wife were not each entitled to claim one-half of

Partnerships, Trusts and Income Splitting

FCT v McDonald cont. the losses under s 51(1) of the Act. That provision is not limited to deductions from income derived as being the proceeds of a business. It is “a general provision relating to deductions claimable in relation to expenses, losses or outgoings incurred in gaining or producing any income whatever and not merely in relation to income derived from a business” … As has been noted, the respondent put an alternative submission that, even if a partnership under the general law did not exist, he could deduct the whole of the losses by virtue of his agreement to indemnify his wife. But s 51 does not permit a deduction merely by virtue of that agreement. In truth, it was a term of the agreement that the respondent actually give income away to his wife. That involves none of the features required as a condition of deductibility under s 51(1). In fact, the

transaction, so far as concerned the respondent, involved two significant detriments. In the first place, he gave away one quarter of his income entitlement; secondly, he indemnified his wife against any loss from the investments. It can not be said, as the language of s 51 requires, that a payment made pursuant to such an indemnity is a loss incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing such income. Rather, the assumption of liability for the losses, voluntarily made by the respondent, was a purely domestic arrangement in which the respondent sought to advance his wife’s finances … In any event, there is expressly excluded from deductions allowable under s 51(1) losses of a private or domestic nature and the wife’s half share of the losses now claimed by the respondent may be so described: see Parsons, Income Tax in Australia, Principles of Income Tax, Deductibility and Tax Accounting p 452-3.

[13.95]

13.3

CHAPTER 13

Question

Why did Beaumont J hold that there was no general law partnership? Why did it follow that the agreement as to the sharing of income and losses was ineffective?

(iii) Characterising unusual intermediaries [13.100] You will notice that the idea of “company,” “partnership” and “non-entity joint

venture” are each defined in Australian tax law and are mutually exclusive. It is sometimes necessary to classify more exotic intermediaries which do not readily fit into the categories we have created. This most often occurs with foreign intermediaries but can also arise with intermediaries created by domestic law. The accepted method of characterising intermediaries for tax purposes is that the legal attributes of the intermediary are established by the law under which the intermediary is created and then those characteristics are compared with typical Australian companies and partnerships to see which they most closely resemble.

(b) Calculation and Attribution of Net Income and Partnership Loss [13.110] A partnership is required to prepare a tax return (subject to the comments on tax law

partnerships above) but is not required to pay tax (s 91 of the ITAA 1936). The “net income” or “partnership loss” is calculated “as if the partnership were a taxpayer who is a resident” under s 90 by comparing the deductions of the partnership (apart from prior year losses: see the reference to Div 36) and its assessable income. Under s 92 each partner includes in assessable income the “individual interest of the partner in the net income” and similarly for partnership loss, exempt income and non-assessable non-exempt income. These results occur regardless of whether the income of the partnership is distributed. There are no rules in the tax law dealing with partnership distributions and accordingly they are disregarded. In a typical [13.110]

701

Income Derived Through Intermediaries

partnership, partners will draw against their income on a regular basis and then reconcile drawings with their entitlements at year end, but the amount they must pay tax on the entitlement, not the drawings. When it comes to capital gains, however, the system works differently. Section 106-5 of the ITAA 1997 provides that, “any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets is made by the partners individually”. This creates a bifurcated system. If the shoe shop (which operates as a partnership) sells a pair of shoes, the amount is recorded in the partnership’s return and is part of the net income which the partner then reports and pays tax on. But if the partners sell the shop and make a capital gain, this amount is not part of the partnership’s net income; instead, the amount is reported directly in the partners’ returns. The way partnerships are dealt with under CGT is examined more fully below. [13.115]

Questions

13.4

Why are prior year losses disregarded in calculating net income or partnership loss?

13.5

What happens to net income if a partner is tax exempt on its income, for example, a charity covered by Div 50 of the ITAA 1997?

(c) Transactions Between Partnership and Partners [13.120] The operation of Div 5 is relatively straightforward in most cases when the

partnership is dealing with third parties. Complications most commonly arise when there are dealings which appear to be between the partnership and one or more of its partners. We say “appear to be …” because a partnership is not a separate legal person under partnership law and so can’t be a party to any transaction. Because a partnership is not a separate legal person, such transactions are effectively between that partner on one side and all the other partners on the other. Another complication can arise because it is sometimes necessary to draw a distinction between partnership property and the partners’ own private property. Not everything owned by a partner (their home, for example) is affected by arrangement between the partners. However, that same piece of property may be available to third party creditors who have claims against the partners. The one piece of property may not be partnership property so far as the other partners are concerned, yet it is effectively partnership property so far as creditors are concerned. The tax consequences of such situations are not always clear as the following cases show. In Poole & Dight v FCT (1970) 122 CLR 427, Mr and Mrs Poole held a Crown lease of land from the Queensland government which was used for carrying on a business in a grazing partnership, the Cooinda Pastoral Co, consisting of Mr and Mrs Poole and their two daughters with respective shares of 50%, 25%, 12.5% and 12.5% in income and capital of the partnership. The partnership agreement provided that while the business was conducted on the Crown lease of Mr and Mrs Poole, the partnership would be responsible for payment of rent, rates and taxes in respect of the lease. Under Queensland legislation it was provided that the rent was credited towards the purchase price of the land by Mr and Mrs Poole. The partnership claimed a deduction for the rent paid to the government but the ATO disallowed the deduction on the basis that it was capital (as the payments were credited towards the purchase price of the land) and adjusted the income of the partners accordingly. 702

[13.115]

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Poole & Dight v FCT [13.130] Poole & Dight v FCT (1970) 122 CLR 427 Walsh J: I am of opinion … that each annual payment is an outgoing of a capital nature, because the lessee is by means of that payment paying off part of a purchase price for the acquisition of the fee simple in the land and reducing the balance required to be paid to obtain that estate. But there is a further question which must be considered. It has been submitted that from the standpoint of Cooinda Pastoral Co the payment made by it was an outgoing on revenue account and was an item which could not be disregarded in computing the net income of the partnership. Accordingly, the respondent was in error in adjusting the net income of the partnership by disallowing the deduction of that item and in making corresponding adjustments in the individual interests of the appellants in that net income: see ss 90 and 92 of the Income Tax Assessment Act. It was argued, therefore, that the method adopted by the respondent in making the assessments under appeal was wrong and that, at least, in the case of the appellant Mrs Dight [a daughter who did not have an interest in the lease], if not in that of the appellant Poole, the appeal must succeed. In my opinion, it is clear that from the point of view of the partnership considered as a whole this was a revenue outgoing. It was paid for the use of the land. It could not be left out of account in computing the income of the partnership available for distribution amongst its members. In my opinion there would be no warrant for holding that, for the purpose of that computation, you should treat the amount of the payment as being notionally paid back into the partnership funds by the two lessees. They were entitled, under the partnership agreement, to have it paid out of the partnership funds … In my opinion it was not correct to treat the partnership income as stated in the partnership return as being understated by reason of the deduction of the amount paid out to the Crown. But in the appeal by Poole I do not think that by this means he is able to establish … that the assessment is excessive. The amount in question

was paid by the partnership as required by the partnership agreement. But it discharged an obligation which, between himself and the Crown, lay upon him as lessee. He obtained the benefit of a payment on his behalf of an outgoing which if paid by him would have been, according to the opinion I have already stated, an outgoing of a capital nature. In my opinion, that benefit formed part of his assessable income. If as a lessee of the land he had allowed a stranger to use it in return for a money payment, this would have been included in his assessable income. In my opinion it makes no difference that by an agreement to which he was a party, the partnership was allowed to use the land, in consideration of paying any amounts due in respect of it to the Crown. In my opinion an amount so paid must be treated as income “derived” by Poole: see s 19 of the Income Tax Assessment Act and compare Cooper v Federal Commissioner of Taxation (1957) 7 AITR 93, at p 95; 97 CLR 397, at p 399. If the amount of Poole’s individual interest in the net income shown in his return as being derived from the profits of the partnership as shown in the partnership return had been accepted as correct, but an addition had then been made to his income, as shown in his personal return, of one-half of the amount paid by the partnership to the Crown, the total of his taxable income would not have been different from the amount upon which the assessment was based. I am of opinion, that it is not established that the assessment of his tax was excessive. In my opinion, his appeal should be dismissed. In the case of the appellant Mrs Dight the position is quite different. She has no interest in the lease. The partnership of which she is a member has the right to use the land but has no other rights in respect of it. She will get no benefit if an estate in fee simple is acquired by payment of the purchasing price. Therefore, the payment made by the partnership was not related in any way to the acquisition by her of a capital asset. From her point of view it was simply a payment made in fulfilment of a condition which attached [13.130]

703

Income Derived Through Intermediaries

Poole & Dight v FCT cont. to the right of the partnership to use the land. The share to which she was entitled in the profits of the partnership was ascertainable on the basis that the payment was a deduction properly made in arriving at its net profits. Her taxable income should not have been increased by adding to the

[13.135]

amount of her interest in the partnership income any part of the amount so deducted in arriving at the income of the partnership as shown in the partnership return. In her case the appeal should be allowed and the assessment should be varied, on the basis that her taxable income is reduced by one-eighth of the sum of $2148 paid by Cooinda Pastoral Co in respect of the lease.

Questions

13.6

Why was the appeal of Mrs Dight allowed but not Mr Poole? How was the transaction that required the partnership to pay the rent on the lease characterised from the point of view of the partnership and of Mr and Mrs Poole?

13.7

Some partnerships have “equity” partners who have an interest in the capital of the partnership and its assets, particularly goodwill, and “salaried” partners who receive only income from the partnership often of an agreed amount and have no interest in the capital. It is generally accepted that, under employment law, such a salaried partner cannot be a true employee. What is the tax treatment of the “salary” of a salaried partner? What if the net income of a partnership consisting of equity partner A and salaried partner B in a particular year is $50,000 and B’s “salary” is $75,000? (See TR 2005/7)

13.8

A Ltd, which is a construction company, and B, who owns a block of land, enter into an agreement under which A Ltd will construct a block of home units on the land and A Ltd and B will share the proceeds of sale of the units equally. Is there a partnership? Does it make a difference if the units are rented out until they are sold? If there is a partnership, how are the construction expenses incurred by A Ltd treated? (See ARM Constructions v FCT (1987) 19 ATR 337, 87 ATC 4790, Grollo Nominees v FCT (1997) 36 ATR 424 at 482-483, 97 ATC 4585.)

[13.140] In Part 3 of this book on deductions, the treatment of interest payments was

discussed at various points. In terms of partnerships and other intermediaries, it is possible to borrow at the level of the intermediary or at the level of the owner of the intermediary and to invest the moneys borrowed as equity in the intermediary. At the level of the owner, the question will be whether interest on the borrowing is incurred in gaining or producing assessable income. At the level of the intermediary, it is possible for the borrowing to be made not only for investment in the business of the intermediary but also to make payments of profit or capital to the owners of the intermediary. In the latter case, at first glance, it appears that the interest will not be deductible as it was not incurred in gaining or producing the income of the intermediary. Appearances can be deceiving as the next case shows. In FCT v Roberts & Smith (1992) 37 FCR 246; 23 ATR 494; 92 ATC 4380, a partnership of solicitors borrowed from a bank and used the moneys to pay back capital contributed to the partnership by the five partners, including Smith. Subsequently Roberts became a partner while the loan was still on foot. The partnership claimed interest deductions on the loan, including during the period while Roberts was a partner. The ATO disallowed the interest deductions and increased the assessable income of the partners accordingly. 704

[13.135]

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FCT v Roberts & Smith [13.150] FCT v Roberts & Smith (1992) 37 FCR 246; 23 ATR 494; 92 ATC 4380 Hill J: The issue continues to be whether the interest outgoing was incurred in the income producing activity or, in a case falling to be tested under the second limb, in the business activity which is directed towards the gaining or producing of assessable income. As the cases … all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary or appropriate: cf Total Holdings (Aust) Pty Ltd v FCT (1979) 9 ATR 885; 79 ATC 4279 and the discussion of tracing in the context of s 51(1) in Parsons, Income Taxation in Australia, 1985 p 348ff. For example, let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him. That partner uses the moneys so received to purchase a house. A tracing approach, if carried beyond the payment to the partner, encourages the argument raised by the Commissioner in the present case that the funds were used for the private purpose of the partner who received them. But that fact will not preclude the deductibility of the outgoing. The funds to be withdrawn in such a case were employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income. In principle, such a case is no different from the borrowing from one bank to repay working capital originally borrowed from another; the character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense. Both these cases would equally satisfy the second limb of s 51(1). In no sense could the interest outgoing in either case be characterised as private or domestic. Similarly, where moneys are originally advanced by a partner to provide

working capital for the partnership, interest on a borrowing made to repay these advances will be deductible, irrespective of the use which the partner repaid makes of the funds … The question then arises whether the same result should follow in this case. What is said to have happened is that the partnership has repaid to the partners some of their partnership capital; or, as the judge below put it, each of the original partners received a “refund” of capital. The Commissioner, in his statement of findings on material questions of fact lodged with the tribunal, referred to the decision of the original partners as being to “reduce their capital input by $25,000 each”. A perusal of the partnership accounts tendered at the hearing make it clear that this is not necessarily true. The confusion arises from the use of the word “capital” in the context of a partnership. Lord Lindley’s definition of “partnership capital” as set out in the 16th edition of Lindley & Banks on Partnership, 1990 para 17-01, is in the following terms: “By the capital of a partnership is meant the aggregate of the sums contributed by its members for the purpose of commencing or carrying on the partnership business, and intended to be risked by them in that business. The capital of a partnership is not therefore the same as its property: the capital is a sum fixed by the agreement of the partners; whilst the actual assets of the firm vary from day to day, and include everything belonging to the firm and having money value … The amount of each partner’s capital ought … always to be accurately stated …” The partnership capital, in the sense used by Lord Lindley, is fixed and, at least without the agreement of all partners, cannot be reduced. A perusal of the interim accounts of the partnership in evidence shows, and the parties are in agreement, that the account to which the payment out to the partners was debited in the present case, although designated to be partnership capital, was an account which represented the net value of the partnership at the date accounts were taken, that is to say, the [13.150]

705

Income Derived Through Intermediaries

FCT v Roberts & Smith cont. difference between gross assets, tangible and intangible, and partnership liabilities. For this purpose the accounting convention of treating partnership capital in the sense used by Lord Lindley as a liability was not adopted. It appears that the goodwill of the practice, for example, has been revalued from time to time and as at the time of the transactions in 1984 stood at $231,000. As the firm probably generated its own goodwill, it would seem the initial valuation of goodwill and subsequent revaluations found their way into the account designated partners’ capital. That account is, however, but in truth a book calculation made annually. It may be inferred that it may include the partnership capital in the Lord Lindley sense, as well, perhaps, as undrawn distributions and profits of the year not yet distributed. It should be explained that none of the interim accounts are made up as at year end, so that the accounts reveal a fund which, if the partnership agreement so provided or the partners agreed, would be available for distribution as at that date. In the absence of agreement, accounts of the partnership would be required to be taken each year as at 30 June and a partner’s share of the partnership income would be derived by him as at that date: FCT v Galland (1986) 162 CLR 408; 18 ATR 33; 68 ALR 403. The partnership agreement also provided for asset revaluations, which were thus reflected in the capital account as well. The difficulty is that there have been no findings of fact by the tribunal with respect to these matters, the resolution of which are critical for the present appeal. The point can be illustrated by an example. Let it be assumed that the original partnership capital in the Lord Lindley sense was $10 and that the balance in the account designated as “the capital account” of the partnership was $125, 000, which included goodwill. That would mean that the equity of each partner in the partnership, assuming five partners, was $25,000. But it could not be said that each partner had invested funds totalling $25,000 as capital in the partnership. A cheque for $25,000 drawn on the partnership 706

[13.150]

bank account would not operate to repay the partner any funds invested. The partnership capital would remain as $10, and all that would happen is that there would be a borrowing which was used to pay the partner $25,000. That borrowing would reduce the partner’s equity in the partnership, but it could not represent a repayment of capital invested. The partnership assets would remain constant. The goodwill would still be worth $125,000; it would not have been distributed to the partners, nor could it be. On those facts, there could be no question of there being a refund of a pre-existing capital contribution. Rather, looking at the facts objectively, the only purpose of the borrowing would be the provision of funds to the partners to which they were not entitled during the currency of the partnership (save of course by agreement among themselves). The provision of funds to the partners in circumstances where that provision is not a repayment of funds invested in the business, lacks the essential connection with the income producing activities of the partnership or, in other words, the partnership business. Likewise, the interest incurred on the borrowing will not be incidental and relevant to the partnership business. It may well be that the parties will be able to agree on the composition of the capital account. If at least $125,000 of the amount in that account represents partnership capital in the Lord Lindley sense, undrawn profit distributions, advances by the partners or other funds which have actually been invested in the partnership and which the partners were entitled to withdraw in June 1984, then in my view the taxpayer is entitled to succeed. If, on the other hand, only a nominal amount in the capital account is so made up, then Mr Smith at least must fail. In between, a question may arise as to apportionment, failing agreement, the appeal of Mr Smith should be remitted to the tribunal for the purpose of making findings on these matters, with or without the hearing of further evidence as the tribunal sees fit … If the tribunal were to find that the amount paid to each of the five original partners was in truth a refund of moneys previously invested in the partnership business, either by previous partners or by those who were partners when the

Partnerships, Trusts and Income Splitting

FCT v Roberts & Smith cont. money was borrowed, then that finding will bring about the result that the interest will be deductible in each year in calculating the net income of the partnership. The consequence for Mrs Roberts is that her application would also be allowed. However, I think that there is another reason why Mrs Roberts’ case should be decided in her favour, even if it should turn out that the appeal in Mr Smith’s case is allowed. It will be recalled that each person admitted to the partnership agreed, as a condition of becoming a partner, to accept liability to the bank for the regular interest payments on the bank borrowing. Although the liability was both joint and several, the incoming partner was indemnified by the other partners for their aliquot share of interest.

[13.155]

13.9

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The making of the regular interest payments was part of the cost to the new partner of becoming a partner. It in no way differed in substance from interest that would need to be paid had the incoming partner borrowed from an external financier to finance the purchase from the other partners of the partnership share. Nor in substance did it differ from a case where the incoming partner was financed into the partnership by the other partners and was required to pay interest to them. Nor would the case have been different if the arrangement had been to indemnify the other partners in respect of a proportionate share of the principal and to assume the liability for interest attaching to that share. In each of these cases the interest liability incurred has the necessary connection with the assessable income of the new partner to be thereafter derived under s 92 of the Act. It is relevant and incidental to that end.

Questions

Why was it necessary to refer the case of Smith back to the AAT but not Roberts? When may a deduction be claimed by a partnership for interest on money borrowed to pay to the partners?

13.10 Is the basis on which the interest deduction was allowed in this case any different from the discussion of the deductibility of interest in Part 3 of this book? Can joint owners of rented land borrow on the security of the land and deduct the interest if they use the money to take a holiday? (See TR 95/25. Similar issues arise for companies and trusts. In IT 2582 interest on borrowing by a company to pay income tax is regarded as deductible, while in TR 2005/12 interest on borrowing to make a distribution to a beneficiary of a trust in respect of an unrealised gain on trust property is not.) 13.11 Partnership agreements may provide that if a partner’s drawings exceed the partner’s entitlement to profits, then interest will be payable by the partner until the excess is repaid; and conversely if a partner does not fully draw the partner’s profit share, interest is payable to the partner by the partnership. How are such amounts characterised so far as the partnership and partners are concerned? (See Beville v FCT (1953) 10 AITR 458, 10 ATD 170.)

(d) Creation of Partnerships, Change of Partners and Dissolution [13.160] The tax consequences that arise when a partnership is created or dissolved, or there

is a change of partners, have been much debated, especially in relation to the CGT. The views adopted often depend on underlying assumptions about the extent to which the partnership is regarded in some sense as separate from the partners, even though the partnership is not a legal person.

[13.160]

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Income Derived Through Intermediaries

(i) Income tax [13.170] In Rose v FCT (1951) 84 CLR 118 a father who owned a pastoralist business took his two sons on as equal partners (one-third each). The Commissioner assessed him under s 36 of the ITAA 1936 (s 70-90 of the ITAA 1997) which referred to the disposal of trading stock outside the ordinary course of business in relation to the livestock of the business and s 59 in relation to depreciable assets (now in s 40-295 of the ITAA 1997 with different wording) which dealt with cases where “any property of a taxpayer, in respect of which depreciation has been allowed … is disposed of”. It was held that the taxpayer was not assessable under these provisions.

Rose v FCT [13.180] Rose v FCT (1951) 84 CLR 118 The Commissioner’s case must therefore depend on making good the proposition that for the purpose of s. 36 a partnership is to be considered a separate entity distinct from the individuals who compose it, so that when the taxpayer vested what was his as an entirety in himself and his two sons as partners having co-ownership, he is to be considered for the purposes of s.36 as having “disposed of” the property as an entirety in the assets to a distinct legal entity. A partnership is not a distinct legal entity according to English law. In Scots law a firm is a legal person distinct from the partners of whom it is composed. But in our law it is far otherwise with partnerships. “The members of these do not form a collective whole, distinct from the individuals composing it; nor are they collectively endowed with any capacity of acquiring rights or incurring obligations”: Lindley on Partnership, 11th ed. (1950), vol. 1, ch. 1, s. 4. If, therefore, a partnership is to be

treated for the purpose of s.36 as a distinct legal entity, it must be because of an assumption which the Income Tax Assessment Act requires, not because of the general law. But an examination of that Act discloses no ground for construing it as requiring that such an assumption should be made. By s.6 the word “partnership” is defined to mean an association of persons carrying on business as partners or in the receipt of income jointly but not to include a company. Division 5 of Part III, which deals with partnerships, is based upon the view that the collective income earned by the partnership belongs according to their shares to the partners regardless of its liberation from the funds of the partnership, that is, its actual distribution. There appears to be no foundation for importing into s. 36 a conception of a partnership varying from that adopted by the general law.

[13.190] Following the case, the Act was amended by the insertion of ss 36A and 59AA which

have now become ss 70-100, 40-295(2) and 40-340(3) to (7) of the ITAA 1997. [13.195]

Questions

13.12 What would be the result in Rose’s case under these provisions? Would an election be available? Who makes the election? 13.13 Why is there a difference in the provisions as to the amount of continuity required? Why does s 70-100 require the carrying on of a business while the depreciation provisions do not? 13.14 Do the provisions apply to tax law partnerships? (In relation to depreciation note ss 40-35 and 40-40 Item 7, ATO ID 1009/135.) [13.200] A partnership is not an entity, it is a relationship, and it is a relationship that exists

between the identified people. The implication is that when there is a change in partners (and 708

[13.170]

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possibly simply a change in the relative interests of partners without a change in partners), the partnership has dissolved and a new partnership has been created. Such a view is administratively inconvenient, however, as it requires the obtaining of a new tax file number, ABN and GST registration. It might also mean that income or losses ought to be recognised. The Partnership Act tries to ameliorate this consequence, for example, in relation to death of a partner: it provides “Subject to any agreement between the partners, every partnership is dissolved as regards all the partners by the death or bankruptcy of any partner”. There are also other cases which treat the partnership more like a separate intermediary in the sense that the partnership is treated as continuing even though the people are different. In Peterson v FCT (1960) 106 CLR 395, Mrs Edkins was a partner in a pastoral partnership who died on 29 December 1954. The partnership deed provided that “in case of the death of any such partner before the termination of the partnership the surviving partner or partners may nevertheless if she or they so desires or desire carry on the partnership in accordance with the terms hereof for the benefit of the surviving partner or partners and the estate of the deceased partner”. The Commissioner required a return for the estate on the basis that partnership accounts had to be taken at the date of death and again at the following 30 June. As is usual with rural partnerships, expenses (of planting crops, buying stock, etc) were incurred earlier in each income year and income was earned later in the year. The result according to the Commissioner was that Mrs Edkins incurred a loss to the date of death which died with her, and then a higher amount of income was assessable to her estate for the period 30 December to 30 June. Not surprisingly Windeyer J in the High Court did not find this result palatable and held that the share of the partnership income of the whole income year belonged to the estate so that the loss to the time of death was effectively set off against the subsequent profit.

Peterson v FCT [13.210] Peterson v FCT (1960) 106 CLR 395 The partnership was not dissolved by death and the income derived by the trustee consisted of a share in the profits of a continuing business. In any continuing business, income is ascertained periodically over accounting periods, and the various items of expenditure in any accounting period that are directly connected with gaining the amounts received, or expected to be received, from the ordinary conduct of the business must be taken into account. It is only the “net balance ascertained according to the usual and recognized principles of accounting” that is income … If what had to be ascertained here was the income derived from carrying on the business of a sheep station for an annual accounting period ended on 30th June 1955, expenditure in the first half of that annual period would obviously have to be deducted in arriving at the assessable

income … In my view the same considerations apply here. If the trustee is to be regarded as carrying on in partnership with the surviving partners the business in which the deceased was a partner at her death, that is so. If, on the other hand, the trustee is regarded as simply entitled to a share in the profits of a business carried on by others the result is the same. The date at which the profits of a partnership business are to be taken to have accrued depends upon the date at which they were ascertained and declared, or ought according to the partnership agreement or course of business to have been ascertained … The business profit can only be ascertained after deducting from gross proceeds the expenses incurred in their production in the accounting period.

[13.210]

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Income Derived Through Intermediaries

[13.220] In Tikva Investments Pty Ltd v FCT (1972) 128 CLR 158 Stephen J adopts a

midway view. Here Mr Krasnostein was a member of a property syndicate which purchased land to resell at a profit. Subsequently, with the tacit agreement of the other members of the syndicate, Tikva, a company controlled by Krasnostein, was substituted as member for him. The ATO assessed Tikva on its share of the profit on the sale of the land based on the original cost of Krasnostein. The Court upheld the assessment. (One suspects that the reason Tikva was substituted was to found an argument that Tikva did not acquire its share of the land with a profit-making intent as it was a gift from Krasnostein: see NF Williams (1972) 127 CLR 226.)

Tikva Investments Pty Ltd v FCT [13.230] Tikva Investments Pty Ltd v FCT (1972) 128 CLR 158 Whether or not the members of the syndicate were partners at general law it is clear that they were, together, an association of persons in receipt of income jointly; apparently some small sums by way of rental were received by the syndicate throughout its life and in the year of income in question this source of income was vastly augmented by receipt of a part of the proceeds of sale of the property. All these amounts were received, if not as the income of a partnership at general law, then as income from property which the syndicate members owned as tenants in common. Accordingly the members of the syndicate were, for the purposes of the Act, a partnership. … If then the syndicate be regarded as a taxpayer for purposes of calculation of assessable income how is s. 26(a), which, rather than s. 25(1), I regard as appropriate, to be applied in the ascertainment of its net income? In particular, what is the effect of s. 90 and its introduction of a deemed taxpayer, the partnership, not only upon the application of s. 26(a) but also upon the calculation of the amount of the profit which s. 26(a) would operate to include in the assessable income of individual partners? When s. 92 refers to “the partnership” it necessarily refers to the “association of persons” described in the definition of “partnership” in s. 6(1); with every alteration in the identity of the persons associated together, whether because of the substitution of a new partner for an old or the

710

[13.220]

introduction of additional partners, a new association of persons comes into existence, the old association of persons being replaced by the new. Thus once Tikva was substituted for Mr. Krasnostein as a member of the syndicate it thereupon ceased to be the same association of persons as it had previously been because no longer were the same persons associated together. … I have already concluded that each of the ten original purchasers should be regarded individually as having entered into the syndicate and acquired the Mullaloo land both with the purpose referred to in s. 26(a) and also so as to carry out a profit-making scheme. The fact that for limited purposes of calculation of partnership net income a new legal entity arose upon Tikva becoming a member does not, I think, produce the consequence that the whole question of the applicability of s. 26(a) is to be reviewed in relation to that new legal entity, treating it as having in some way acquired the partnership property from its predecessor and searching for the purpose actuating that acquisition. On the contrary it is, I think, correct to regard s. 26(a) as still applicable, regardless of the consequences of Tikva being substituted for Mr. Krasnostein as a member. Section 90 is no more than a definition section and the deeming which it effects is to be limited to matters of calculation only. It is to be observed that when Tikva accepted the assignment to it of Mr. Krasnostein’s interest in

Partnerships, Trusts and Income Splitting

Tikva Investments Pty Ltd v FCT cont. the land and syndicate Mr. Krasnostein was its controlling mind and his purpose was no different from that of the other members of the syndicate, to whose joint wills, in any event, Tikva necessary subjected itself by its acceptance of a oneeighteenth share in the syndicate. The ten original purchasers had, as I find, the purpose referred to in s. 26(a) and were engaging in a profit making scheme and all but Tikva had remained throughout entitled to the same undivided fractional interest in the syndicate’s assets, including the Mullaloo land. Accordingly the net income of the syndicate for the relevant year of income will include that portion of the profit derived from the sale of Mullaloo and received in the relevant year of income, either because that property was acquired for the purpose of profit making by sale or because it arises from the carrying on or carrying out of a profit-making undertaking or scheme.

[13.235]

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It will follow that Tikva’s assessable income will include its individual interest in that amount of net income. This is the express effect of s. 92(1) and there appears to me to be no room for the making of any allowance, on the facts of this case, in favour of Tikva for the fact that, when it took an assignment from Mr. Krasnostein, as a retiring partner, of his interest in the partnership, it received that interest as a gift having a value in excess of its original cost to Mr. Krasnostein; this will be so despite the fact that the partnership assets included assets to the profit on the sale of which s. 26(a) would apply. Whatever may be the position when, on a charge in membership of a partnership, a new business is begun, with new current market values being assigned to assets of the new firm in a reconstituted set of accounts, that is not the case here and I therefore express no views as to the tax consequences, if any, which may flow from such a situation when those assets include property, any profit on the sale of which would attract s. 26(a).

Questions

13.15 Did Windeyer J in Peterson treat the death of Mrs Edkins as terminating the partnership? What would be the effect of ss 40-295(2), 40-340(2) and 70-90 on the facts? (The business would clearly have held stock and depreciable assets.) Is the approach in Peterson different from Rose? 13.16 Does the approach of Stephen J in Tikva differ from Peterson? What elements in the decision recognise the partnership as ongoing? 13.17 How is intention determined in a partnership setting when it is relevant for tax purposes (such as the characterisation of assets as revenue or capital assets)? If different partners have different intentions, how is the tax treatment at the partnership level determined? [13.240] One particular problem that arose on changes in professional and service

partnerships was the tax treatment of unbilled work in progress (WIP). The problem would arise when a departing partner has worked on a long project but the client has yet to be billed. The departing partner would be paid some amount for her contribution to the work. When the unbilled WIP was completed and billed, the full amount entered the calculation of the net income of the partnership, and was thus included in full in the assessable income of the remaining partners. The cases consistently held that the outgoing partner who received a payment in relation to unbilled work was assessable on the amount received, but the continuing or new partners paying the amount did not get a deduction for the payment, as it was on capital account. Following Crommelin v DCT (1998) 39 ATR 377, the legislation was eventually amended by the inclusion of ss 15-50 and 25-95 of the ITAA 1997. [13.240]

711

Income Derived Through Intermediaries

[13.245]

Question

13.18 What is now the result for both the outgoing partner and the continuing partners if an outgoing partner is paid an amount in respect of unbilled WIP? (ii) CGT [13.250] Under the original CGT legislation, the drafting did not give any clear direction on

how CGT applied to partnership assets. If capital gains and losses were recognised at the partnership level, then capital losses would be locked in the partnership and reduce future capital gains in the partnership, since they are not dealt with in ss 90 – 92, while revenue losses would flow through. Further, any net capital gains flowing through the partnership would arguably not be able to be offset by capital losses at the partner level, as capital losses are applied to capital gains, not net capital gains. Influenced by this problem and the way that the UK dealt with CGT and partnerships under similarly structured legislation, the Australian Taxation Office (ATO) ruled in IT 2540 on the original legislation: • capital gains and losses arose for tax purposes at the partner level, not the partnership level because a partnership was not a legal intermediary capable of owning assets in its own right; • the partner’s share in the partnership determined the fractional share in the assets and so in the capital gains and losses made on partnership property; and • when partners entered or left the partnership or there were changes in partnership shares, there were disposals/acquisitions of all or part of the fractional interests in the assets, and not always of the whole interest. The first point was arguable as it had never been questioned that depreciation was calculated at the partnership level even though depreciation under the ITAA 1936 was based on the taxpayer “owning” the asset. The second and third points conflict with the partnership case law which is quite clear that partners have a non-specific interest in each asset of the partnership, whereas the Ruling asserts that they hold specific fractions of each asset (Canny Gabriel Castle Jackson Advertising Pty Ltd v Volume Sales (Finance) Pty Ltd (1974) 131 CLR 321 at 327-28, FCT v Everett 80 ATC 4076 at 4079). Each partner who was in the partnership before and after the event was treated as disposing of part of the partner’s fractional share in the assets to the other partners whose interest went up to the extent that the interest went down or of acquiring part of the fractional interest of other partners whose interest went down to the extent that the partner’s interest went up. New partners were treated as acquiring part of the fractional interests from other partners whose interest went down, and departing partners as disposing of all of their fractions to the partners whose interests went up. Taxpayers were given some leeway to nominate whether the disposal related to pre- or post-CGT assets if the fractional interests in differing assets consisted of both. The legislation was amended to resolve the issue in s 106-5 of the ITAA 1997. The Ruling and the s 106-5 examples also make clear that it is entitlement to the capital of the partnership, not the income (when there is a difference), which determines the relevant interest in the assets. Because the CGT can overlap with the income tax in the case of revenue assets, the CGT treatment at the partner level gives rise to problems, as profits and losses can then arise which are accounted for both through the partnership and at the partner level. The legislation deals 712

[13.245]

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with this problem by reducing the capital gain at the partner level by any assessable income arising for the partner through the partnership including the profit in its net income: s 118-20; see paragraph (b) in the various subsections. As emphasised in the partnership cases, a partner’s specific interest is in the net amount realised after assets of the partnership are disposed of and liabilities discharged. If we accept the position set out above in relation to assets, it leaves out of account the treatment of liabilities. Particularly when partners are admitted to or leave a partnership, the partners usually deal with the position of partnership liabilities to the extent they can. The provisions in the CGT legislation in relation to liabilities do not work very well in this scenario. Under s 112-35 the cost base of an asset acquired subject to a liability includes the amount of the liability. Under s 116-55, capital proceeds are increased by the amount of a liability if another entity acquires the asset subject to the liability by way of security over the asset. The italicised words used to apply on both sides under the 1936 Act. Where a new partner assumes a share of the partnership’s overdraft on purchase of an interest in the partnership, it is difficult to say that the liability is by way of security over the asset, or indeed that the asset is subject to the liability. [13.255]

Questions

13.19 A partnership owns land that was acquired after 19 September 1985 with the intention of reselling it at a profit. How does the income tax operate when the land is sold by the partnership for a profit. What happens if the land is sold at a loss? 13.20 A and B formed a partnership in 1980 to sell insurance. The partnership immediately acquired land and a building for $50,000 as the office of the business, with A and B each contributing $25,000 to the capital of the partnership. In 2000 A and B admitted C as an equal partner when the land was worth $500,000 and the partnership had borrowed $200,000 by way of overdraft. C paid $200,000 in total to A and B for the interest in the partnership and took on a proportionate share of the overdraft. In 2011 the partnership sold its business including the land and building for $2 m from which the overdraft was discharged. The partnership was then dissolved and each partner received $600,000. What are the tax consequences of these transactions? 13.21 In large professional partnerships such as accounting and legal firms, it has been found very difficult to operate the CGT rules. Accordingly, all the assets of the partnership apart from goodwill are held by a separate service company or trust which provides services to the partnership. The partnership agreement provides that the partnership is a “no goodwill” partnership. Partners do not pay anything on admission as a partner and do not receive anything from the partnership when they retire. What is the tax effect of such arrangements so far as admission and exit of partners is concerned? 13.22 What is the purpose of s 108-5(2)(d)? Does s 106-5 apply to tax law partnerships? (Note s 108-7.) 13.23 Many foreign countries treat the interest of the partner in the partnership as a separate asset from the interest of the partnership in its assets, while still taxing the partnership on a flow-through basis. How would such a system treat income of the partnership that is taxed to the partners but not distributed to them? If the assets of the partnership consist entirely of trading stock and a partner sells its interest in the partnership to a third party, how should such a transaction be characterised? (See N Agoustinos, “Partnerships and CGT: An International Comparative Analysis” (1993) 1 Taxation in Australia (Red edition) 126.) [13.255]

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Income Derived Through Intermediaries

(e) Limited Partnerships [13.260] When a loss is made at the partnership level, the partners enjoy the benefit of the loss

immediately and directly, and can use it to reduce tax on their other income. This is in contrast to losses made by companies and trusts where the loss remains quarantined in the entity and can only be used in future years to reduce the company’s or trust’s future income. This difference makes partnerships attractive for projects where losses might arise in early years. Moreover, one unattractive feature of operating as a partnership – the unlimited exposure of each partner to all of the liabilities of the partnership – was solved when limited partnerships were created by state Partnership Acts. Not surprisingly, during the 1980s and early 1990s limited partnerships were used to market investments like films, often loss-making. The limited partner would invest some of their own funds (say $10,000) and borrow considerably more (say $90,000) from the promoter of the investment scheme to invest in the partnership. In turn the partnership would buy the copyright in a film also with funds borrowed from the promoter, often at an exaggerated price. Each of the loans would be non-recourse; that is, if the loans were not repaid, the lender could not sue the borrower but could only sell the relevant asset (the film or the interest in the partnership). The limited partners became entitled to significant tax deductions arising from partnership losses generated by generous tax incentives for films plus the interest on the non-recourse loans. The losses typically far exceeded the limited partner’s own investment but the partner was not liable beyond the amount contributed as a result of the limitation of liability in a limited partnership. In 1992 Div 5A, which taxes a limited partnership in the same way as a company, was inserted into the ITAA 1936. Specific modifications are made in it which seek to attract the company tax rules to limited partnerships. Generally, the result is achieved by enacting that references in the legislation to companies are taken to include references to limited partnerships and references to partnerships do not include limited partnerships (ss 94J and 94K). For this purpose the definition of “limited partnership” is now found by cross-reference in s 995-1(1) of the ITAA 1997. The provisions have been the source of never-ending problems for taxpayers, and at least one author has recommended their repeal (Stewart, “Towards flow through taxation of limited partnerships: It’s time to repeal Division 5A” (2003) 32 Australian Tax Review 171.) [13.265]

Questions

13.24 A limited partner in a limited partnership sells its interest in the partnership in 2011. The interest was acquired in 2007. As required by the partnership agreement the partner contributed $10,000 in 2007 and another $10,000 on 1 January 2011. Is the limited partner entitled to the CGT discount and if so, to what extent? (See s 94P.) 13.25 A limited partnership in 2011 sells land which it holds on capital account and acquired in 2007. How is this transaction to be characterised? Note that CGT event A1 assumes that the taxpayer has to dispose of the legal and/or beneficial interest in the asset. Who has such interests in the asset? [13.270] Rather than repealing the provisions, the government has tried to deal with the most

pressing problems in a piecemeal fashion. These have largely arisen in the international arena because nearly all of Australia’s major trading partners tax limited partnerships on a flow-through basis. Limited partnerships are the vehicle of choice for venture capital activities internationally. Accordingly, in order to encourage international investors to continue to invest in Australian venture capital partnerships, they have been made an exception to Div 5A: see 714

[13.260]

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s 94D(2), (3). To deal with the problem of limited partners gaining access to losses in excess of their investment, s 92(2AA) was inserted. In addition, changes have been made to the Partnership Acts in most states to create the incorporated limited partnership for this kind of investment and in turn this has led to changes in the definition of “limited partnership” for tax purposes: see the definition in s 995-1(1) of the ITAA 1997. Similarly, outbound investments for Australia have encountered problems if limited partnerships are used (which are very common for real estate and other investments in the UK and US). A further exception to Div 5A has been created for such cases (called foreign hybrids): see s 94D(4), (5). Division 830 of the ITAA 1997 defines foreign hybrids as well as limiting losses of limited partners to the amount invested: see ss 830-45 and 830-50. [13.275]

Questions

13.26 How do the provisions of s 92(2AA) operate? Are the provisions limiting losses for venture capital partnerships and foreign hybrids sufficient to deal with the problems of generation of losses through limited partnerships? (See Freudenberg, “Losing my Losses: Are the loss restriction rules applying to Australian’s tax transparent companies adequate?” (2008) 23 Australian Tax Forum 125.) 13.27 Should Australia adjust its rules on limited partnerships because other countries tax them on a flow-through basis? Are there more general reasons in terms of the extract at the beginning of the chapter for taxing partnerships on a flow-through basis or as separate intermediaries like companies?

3. TAXATION OF TRUSTS AND BENEFICIARIES [13.280] The model for taxing income and gains realised by a trustee is another complex

topic where the policy and design are in a state of flux. For small privately-held trusts, the government announced at the end of 2010 that the tax rules would be completely rewritten. Treasury released a discussion paper late in 2011 and some tinkering with the current rules happened in 2011 in light of the High Court decision in Bamford’s case (discussed below), but the wholesale reform which had been promised has not happened. On other hand, a new model for trusts used for collective investment purposes, stemming from work by the Board of Taxation which began in 2009, was finally enacted in 2016.

(a) Trustees and Trusts (i) What is a trust? [13.290] The trust is a flexible institution created by courts of equity over the centuries for a variety of purposes, including family settlements, charities, and remedies for breaches of duty (constructive trusts). Strictly, the trust is a legal relationship under which a person (the trustee) who holds property is subject to various duties and obligations in relation to the property. Usually there will be other identifiable persons who benefit under the trust who will also have interests in the property (beneficiaries). Hence it is usual to talk in the trust situation of the division of the legal and equitable/beneficial ownership/interest in the trust property, with the former held by the trustee and the latter held by the beneficiaries. It is not a requirement, however, that there be beneficiaries with equitable interests in the property. It is nonetheless commonplace to think of the trust as an intermediary similar to a partnership (not with separate legal personality like a company though the trustee will be a person, either natural or [13.290]

715

Income Derived Through Intermediaries

legal) and of the beneficiaries as the owners of the trust. These differing perspectives of the trust are reflected in non-tax legislation. In New South Wales the relevant statute is called in the Trustee Act 1925 and in Queensland the Trusts Act 1973. (ii) Trustee and trust in tax law [13.300] Tax law reflects the same ambivalence about whether the word “trust” is being used

to refer to a thing or a relationship between people. The original provisions in ITAA 1936 dealing with taxation in trust situations are clear that the tax liability resides with the trustee or the beneficiary (not the trust) and there is no general definition of trust, only of trustee in s 6(1). In more recent times the legislation has tried to deal with the issue more directly. For example, in the controlled foreign company definitions in s 318 of the ITAA 1936, there is a definition of “trust” which means an entity in the capacity of trustee or as the case requires a trust or trust estate. In s 960-100 of the ITAA 1997 on entities for the purpose of that Act, the entity listed is “a trust”. It is also provided that the trustee of the trust is taken to be the entity consisting of the person who is trustee of the trust; that a person is a separate entity in each different capacity it has; and that if a provision refers to an entity of a particular kind it refers to the entity in its capacity as that kind of entity. The definition of “trustee” in s 6(1) of the ITAA 1936 is very broad. As with partnerships, the fact that a person is called a trustee or not in a document is not determinative (which obviously must be true for constructive trusts and resulting trusts that arise by operation of law without anyone noticing). Similarly “trustee” is one of those definitions that does not require an asterisk for the purposes of ITAA 1997: see s 2-15. Despite the breadth of the definition, the provisions considered in this chapter generally apply to a trustee only in respect of income of a trust estate which requires that there be both trust property and income from that property for the provisions to apply. Thus, in Leighton v FCT [2011] FCAFC 96, the Full Federal Court held that a non-resident, Leighton, who acted as agent for share trading by non-residents and had a bank account in his name into which the proceeds of sale were paid on trust for the non-residents was not the trustee of income of a trust estate as a result with respect to the sale proceeds. The moneys paid into the account represented the income of the non-residents themselves, not of Leighton as trustee. If interest had been paid by the bank on the moneys in the account, then Leighton would have been trustee with respect to income of a trust estate in relation to the interest income. [13.305]

Questions

13.28 The official operating the Victorian statutory accident compensation scheme was given various duties under legislation dealing with investment of the funds that financed the scheme. One of the relevant provisions stated the official “shall not … be bound by any law relating to the administration of trust funds by trustees but shall act in good faith”. Is the official a trustee for tax purposes? (See Registrar of the Accident Compensation Tribunal v FCT (1993) 178 CLR 145; 26 ATR 353; 93 ATC 4835.) 13.29 Persons operating a pooling scheme for wheat producers were obliged to sell the wheat and after accounting for expenses and dealing with various contingency funds to account to the producers for the sale proceeds. They were described as trustees in a statute. Are the persons trustees for tax purposes? (See DFCT v Trustees of Wheat Pool of Western Australia (1932) 48 CLR 5.) 716

[13.300]

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(iii) Common types of modern trust [13.310] In modern Australia, trusts are widely used for a variety of family, business and

investment purposes, probably more than any other country in the world. Their popularity is due to their flexibility, the effective limited liability that can be achieved in most cases, the protection of the trust’s assets from creditors of the beneficiaries and their tax treatment. If we ignore trusts that arise by operation of law, the main kinds of trusts which are consciously created and encountered in practice are: (a)

Fixed trusts where particular beneficiaries have specified interests in income and in capital (whether concurrent such as two beneficiaries each with a one-half interest in income and capital, or successive such as a life interest in income and a remainder interest in capital). Such trusts are not as common as they once were but may arise under wills or family settlements to provide for family members who are under various kinds of legal disability such as children. Note that the term “fixed trust” has a specific meaning under the tax legislation which will often not be met by trusts that colloquially may be called fixed;

(b)

Deceased estates during the period of administration of the estate. Trusts arising after the administration of the estate is completed will fall into one of the other categories, usually fixed or discretionary; (c) Unit trusts (a species of fixed trust) where interests in the income and capital are divided into units, and the unit holders are often expressed not to have any specific interest in the assets of the trust. These are widely used for public and private collective investment (such as listed property trusts) and for running service trusts for businesses, especially large legal and accounting partnerships; (d) Discretionary trusts where the trustee is given a wide discretion as to the allocation of income and capital among named and general classes of beneficiaries (more correctly termed, objects of the trust). There will usually be default beneficiaries who receive the income of the trust if there is no allocation by the trustee and at least one of the potential beneficiaries will be a company. Discretionary beneficiaries usually do not have any interest in the assets of the trust, specified or unspecified. Their only right is the ability to insist the trustee to administer the trust in accordance with the trust deed. These trusts are widely used as family tax and asset protection vehicles. They may own a family business or hold family investments. In terms of numbers they are by far the most common type of trust. The other major form of trust in Australia is the superannuation fund. Taxation of superannuation is briefly discussed in Chapter 4. Although it is possible for individuals or companies to be trustees, and for trusts to have more than one trustee, the typical modern Australian trust will have a single corporate trustee. There are a number of well-known public companies which operate businesses of being professional trustees as well as the Public Trustees of the various states and territories.

(b) Present Entitlement [13.320] Given that a trust is a relationship and not a separate legal person, any tax on

income being earned via a trust in the current year will have to be imposed on one of the three people involved in it: either the person who set up the trust (the settlor), the person who currently holds legal title to the trust assets and collects the income (the trustee), or the person(s) who are entitled to receive the income from the trustee (the beneficiary). As we will see, the tax law can impose the tax liability on any one of these people depending on the [13.320]

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Income Derived Through Intermediaries

situation, but the starting presumption in ITAA 1936 is that the people who are entitled to enjoy the benefit of the income are the preferred choice to pay the tax (see s 96, ITAA 1936). The original taxing provisions for income derived through trusts in ITAA 1936 are still to be found more or less intact in Div 6, though they have been much modified in various ways, more so than for partnerships under Div 5. The taxing scheme turns on whether there are any beneficiaries “presently entitled” to trust income or not. This term is not a term of trust law; it was created just for tax purposes, and so a meaning has had to be created in tax law. In 1980, s 95A(2) was inserted which tries to link the term to trust law by saying that a beneficiary who has a “vested and indefeasible interest” (terms which are known to trust law) in the trust’s income is to be treated as presently entitled. As we will see from the cases below, the term “presently entitled” is intended to describe anyone who is entitled to ask the trustee to pay the income to them. In fixed trusts and unit trusts, the Trust Deed will often stipulate that the income earned that year will belong to the beneficiaries and in fixed portions, and so present entitlement will arise almost automatically. For typical discretionary trusts, however, the Trust Deed will give the trustee wide discretion to decide whether to distribute or retain income in any year, how much income to distribute, which objects will get a share, and so on. In this case, until the trustee gets around to making those decisions, it cannot be said any of the objects is entitled to anything; the most they can insist upon is that the trustee make those decisions in accordance with the trust deed. Sometimes the Trust Deed will try to guard against slow or inactive trustees by providing that in default of a decision by the trustee, listed default beneficiaries will be deemed to be presently entitled. This can create other problems as we will see below. The general scheme of Division 6 is: • adult beneficiaries who are “presently entitled” are taxed directly under s 97; • where an infant beneficiary is presently entitled, the income is taxed to the trustee on behalf of the beneficiary under s 98 and at the infant’s rate; • the same applies to a beneficiary with a vested and indefeasible interest in the income but who cannot (typically because of an accumulation clause in the Trust Deed) demand immediate payment – ie beneficiaries who are deemed to be presently entitled under s 95A(2). Their income is also taxed to the trustee at individual rates on behalf of the beneficiary under s 98; • where there is no-one who “owns” this year’s income (no-one is presently entitled), the income has to be taxed to the trustee. Where the trust is a deceased estate, the trustee is taxed under s 99 generally at individual rates. Where the trust is any other kind of trust (typically a discretionary trust), the trustee is taxed under s 99A at the top personal marginal rate tax plus Medicare levy. The tax rates are found in the Income Tax Rates Act 1986, s 12(1), (9) and Sch 10 Pt I. [13.330] In Taylor v DFCT (1970) 119 CLR 444, a settlor had established separate trusts for

his three children. The terms of each trust were that the trustee could apply the income for the benefit of the relevant child but otherwise would accumulate the income until the child reached the age of majority (then 21) at which time the accumulated income would be paid to the child. In the event that the child died before reaching 21 years, the accumulated income was to be paid to the estate of the child (that is, in one way or another the child or the child’s estate would get the income, but not necessarily this year). The ATO assessed the trustee on the income under s 99A. 718

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Taylor v DFCT [13.340] Taylor v DFCT (1970) 119 CLR 444 Kitto J: In my opinion, immediately upon the making of the settlement in the present case the son became absolutely entitled to the income arising during his minority, though his personal enjoyment of it was postponed. But is that enough to require the conclusion that the son was “presently entitled” to the income during the relevant year? He was not in fact entitled to receive any of it in that year, because he was not legally competent to break the trust for accumulation and demand immediate payment. If it is to be held that nevertheless he was “presently entitled” to the income, two propositions must be sustained: (1) that the quoted expression is to be so construed that a beneficiary is “presently entitled” if he either is entitled to require immediate payment of it to himself (s. 97) or would be entitled to do so were it not for a legal disability that he is under (s. 98), and (2) that in the present case the son’s disability (infancy) was all that in the relevant year stood between him and a right to require the trustees to pay the income to him. The appellants contend for the suggested interpretation of “presently entitled”, and they say that by reason of the rule in Saunders v. Vautier (1841) 4 Beav 115 (49 ER 282) (aff’d Cr & Ph 240 (41 ER 482)) the son, but for his disability from giving a discharge, could have required the trustees to disregard the trust for accumulation and pay the income in the relevant year to him. The rule was stated by the Master of the Rolls in these words: “Where a legacy is directed to accumulate for a certain period, or where the payment is postponed, the legatee, if he has an absolute indefeasible interest in the legacy, is not bound to wait until the expiration of that period, but may require payment the moment he is competent to give a valid discharge.” Accordingly, if an amendment of the law in the year we are concerned with had removed the disability of infants to give valid discharges for money, the trustees would have had no answer to a demand by the son that they pay the income to him.

The ATO, however, relies upon statements in the judgments delivered in this Court in the case of Federal Commissioners of Taxation v Whiting (1943) 68 CLR 199 that – “when the Act speaks of a beneficiary being presently entitled to a share of income, it refers to the right of a beneficiary to obtain immediate payment rather than to the fact that a beneficiary has a vested interest” (1943) 68 CLR, at p 215, and that – “a beneficiary is not … presently entitled to income unless it can be established that there is income which he is presently entitled to receive; that he is entitled to obtain immediate payment thereof from the trustee” (1943) 68 CLR, at p 219. The ATO says that in the relevant year the trust for accumulation was in fact in full force and binding upon the trustees, and that in consequence the son was not “presently entitled” to the income in the sense attributed to that expression in Whiting’s Case. The statements above quoted from Whiting’s Case need, I think, to be understood in the light of the problem the Court was there considering; but before turning to the case it is well to look again at the terms of s. 98 itself. The section plainly acknowledges that a beneficiary may be “presently entitled” to income notwithstanding that he is under a legal disability. A disability from what? Since the consequence which the section attaches to the disability is that the trustee is to be assessed instead of the beneficiary the inference is clearly that the disability is from obtaining from the trustee income to which the beneficiary is presently entitled. It is therefore impossible to suppose that the learned judges who decided Whiting’s Case meant that a person whose title to a specific amount of income is absolute but who is under a disability from obtaining payment of it is for that reason to be held not “presently entitled” to it. In Whiting’s Case the Full Court differed from the primary judge (Rich J) on a question as to the meaning and application of “presently entitled”, and it is important to see how the difference of opinion arose. The income in question was income derived by a deceased estate which [13.340]

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Taylor v DFCT cont. throughout the relevant year of income was in course of being administered by executors. The debts and liabilities of the estate had not all been paid nor had all the legacies, and an annuity had not yet fallen in, so that the residuary estate had not yet been ascertained. Nevertheless, the executors, regarding it as certain that there would be a residue, made entries in the estate books crediting certain amounts of income to the residuary beneficiaries in the proportions in which the will entitled them to the residuary estate. It was an amount so credited to a beneficiary that was in question in the case. Rich J thought that since, on the true construction of the will, the beneficiary had “a vested interest in possession in income” – that is to say in income generally as distinguished from any specific amount of income – he was “presently entitled” to the income that had been appropriated to him. His Honour did not fail to recognize that as the administration was incomplete the beneficiary could not require the executors to pay that amount over to him, but he took a view that was based upon the special language of the Income Tax Assessment Act. He said: “… if the estate has in fact earned net income which is not required to be accumulated for the benefit of persons interested in expectancy, and is not insolvent, the beneficiaries are presently entitled to that income notwithstanding that for the purposes of other language than that of the relevant sections it might be proper to describe it as income of the executors, and notwithstanding that in the proper administration of the estate the executors may be entitled to withhold payment and apply it to some other purpose, and that actual payment may be exigible only in the course of some later adjustment … It is, however, certainly not income of the executors for the purposes of the Commonwealth Act.” The members of the Full Court took a different view. Their Honours held that the provisions of the Act must be construed in the light of the general principles of law applicable to the administration of estates by executors and trustees, and that consequently the crucial question was at what moment of time, having 720

[13.340]

regard to those general principles and to the provisions of the trust instrument, could it be said that a beneficiary had become presently entitled to a share in the income of a trust estate. The answer given was that only when the debts and liabilities, the annuity and the legacies had all been paid or provided for in full would it be possible to say that there was any income to which the residuary beneficiaries would be presently entitled. The point of difference between Rich J and the Full Court was, therefore, that the former thought that a beneficiary is “presently entitled” to the income produced by the trust estate if under the trust instrument he is “presently entitled to income of the estate” whatever be the stage that administration has reached, while the Full Court considered that a beneficiary is not “presently entitled” to any income of the trust estate unless the administration has reached such a point that an amount of income has become identifiable as being the subject of a present interest in possession vested in him by the trust instrument. When their Honours spoke of the beneficiary having a right to obtain immediate payment, they could not have been referring to his legal capacity to give a discharge for the payment. Having regard to the point of difference from Rich J to which they were addressing themselves, I think it is clear that they were holding only that an admittedly vested interest in possession in the income of an estate does not make the beneficiary “presently entitled” to any income which is not yet distributable, and so is not yet specifically caught by the beneficiary’s interest. Notwithstanding a passage in the joint judgment of Latham CJ and Williams J (Federal Commissioner of Taxation v. Whiting at pp 214-215) which I must own I do not altogether understand in view of the recognition by s. 98 that a beneficiary may be “presently entitled” to income notwithstanding that by reason of a legal disability he has no right to obtain immediate payment, the tenor of the judgments is, I think, that “presently entitled” refers to an interest in possession in an amount of income that is legally ready for distribution so that the beneficiary would have a right to obtain payment of it if he were not under a disability.

Partnerships, Trusts and Income Splitting

Taylor v DFCT cont. In my opinion the correct conclusion in the present case is that the son was “presently entitled” to the relevant income because (1) it was legally available for distribution, (2) as to the whole of it he had an absolutely vested beneficial

CHAPTER 13

interest in possession, and (3) but for his legal disability from giving a discharge he would have succeeded in an action to recover it from the trustees. I am therefore of opinion that s. 98 was the proper section to be applied in these cases, and that consequently the assessments made under s. 99A were erroneous.

[13.350] Taylor’s case, and Whiting’s case as explained therein, established the fundamental

contours of Div 6 before the insertion of s 95A(2). Whiting’s case is still important to deceased estates as discussed below. [13.360] After the insertion of s 95A(2), the ATO ran a series of cases in the 1990s that tested

the limits of the definition of “trustee” and the meaning of “present entitlement”. These cases were very different from traditional trusts and involved situations where a person was holding funds and it was not clear who was entitled to them and the income they were currently generating. The funds were invested pending the determination of who was entitled to the funds and the ATO again sought to tax the income under s 99A. The last case in the series is Trustees of Estate Mortgage Fighting Fund Trust v FCT (2000) 45 ATR 7. The trust was created by investors in the Estate Mortgage Trusts which were investment trusts that lost most of the investors’ money. Many of the over 18,000 investors formed a new trust and contributed money to it so that it could fund legal action against those behind the loss of the investors’ money. The moneys raised by the new trust were invested and the capital and income was used over time to pay the legal and other bills arising from the attempt by the investors to recover compensation for their losses. The ATO sought to tax the income to the trustee under s 99A but was unsuccessful.

Trustees of Estate Mortgage Fighting Fund Trust v FCT [13.370] Trustees of Estate Mortgage Fighting Fund Trust v FCT (2000) 45 ATR 7 Hill J: The purpose of the introduction of s 95A(2) remains obscure. It may be the case that the section was introduced to overcome the decision in Whiting, so that a beneficiary otherwise with an absolute interest, in an unadministered estate might be treated as being presently entitled. If this be so there is nothing in any extrinsic material which makes it clear. The subsection has been considered by a full court of this court in FCT v Harmer, by myself in Dwight v FCT and by another full court in Walsh Bay. In summary these cases make clear that an interest in income will be vested where the holder has an immediate fixed right of present or future enjoyment. A contingent interest would not suffice. An interest will be indefeasible where it is not subject to any condition.

There is no doubt that the beneficiaries of the trust have an interest in both the capital and the income of the trust. That interest is pro rata to the contributions they have made to the trust. That there is an interest in income which is vested is recognised by cl 2.3 which refers back to the definition of the “trust fund” which includes both income and capital. It may be recognised also by cl 7.1 which treats the beneficiaries as consenting to the trustees’ actions (implicitly, the use of the income for the purposes of the fund) by force of their having executed a form of approval. The evidence does not demonstrate whether any approval signed did in fact relate to the trustees dealing with income. But whether any such approval was given, the terms of the trust deed themselves acknowledge that the trustees will [13.370]

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Income Derived Through Intermediaries

Trustees of Estate Mortgage Fighting Fund Trust v FCT cont. deal with income in accordance with the deed, that is to say, by subscribing to the trust beneficiaries can be taken to have accepted that the trustees would deal with income on the terms contemplated by the trust deed. One may be permitted to ask whose money the trustees expended when they used income which was available to them. The answer is, as was acknowledged by counsel for the ATO, that the income expended belonged to the beneficiaries in the shares determined by their

[13.375]

contributions. Clearly the expenditure was authorised by the beneficiaries, either impliedly or explicitly is not material. There is no condition attaching to the entitlement of the beneficiaries to the income. That they have authorised it to be spent by the trustees is not a condition of their entitlement, it is something which arises because of that entitlement. In my view the tribunal erred in law in holding that the interest of the beneficiaries in income was not vested and indefeasible and its decision should be set aside.

Questions

13.30 What is the reasoning behind the result in Taylor’s case? Would it have made any difference if instead of the accumulated moneys passing to the estate of a child if they died before age 21, it was returned to the settlor in that event? What is the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282? What is its relevance to present entitlement? (See further the discussion of absolute entitlement below). 13.31 A US corporation sues an Australian corporation for damages in an Australian court. Under rules of court the foreign company is required to provide security for costs of the defendant in the event that the action is lost. The money is paid out of court and invested in the names of the solicitors for both parties. If the action is lost, the money invested and its income will go to the defendant to the extent of costs awarded against the plaintiff, or the plaintiff can pay those costs directly to the defendant and recover its money that was invested and the income from it. Is the plaintiff presently entitled to the income from the moneys invested? (See Dwight v FCT (1992) 37 FCR 178; 23 ATR 236; 92 ATC 4192.) 13.32 A developer enters into a development agreement with the government in relation to harbourside land owned by the government. The developer is required to pay $75 m to a third party who is expressed to hold it on trust. If the development agreement is terminated for breach by the developer, the money and any income on it goes to the government. If the application for development approval is unsuccessful, the money and any income from it will be returned to the developer. Is the developer or the government presently entitled to the income from the $75 m? (See Walsh Bay Developments Pty Ltd v FCT (1995) 31 ATR 15; 95 ATC 4378.) 13.33 Trust A is set up, of which the beneficiary is the trustee of trust B in its capacity as trustee of that trust. The beneficiary of trust B is C. How do the present entitlement rules work in this situation? (See FCT v Totledge (1982) 12 ATR 8309.) 13.34 What is the effect of s 96? Does the section only apply if there is trust property producing income, or is it a general provision protecting trustees from tax in their personal capacity? (See Parsons, Income Taxation in Australia, 1985 reprinted 2011, [2.41]–[2.44], FCT v Everett (1980) 143 CLR 440 and Leighton v FCT [2011] FCAFC 96.) 722

[13.375]

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CHAPTER 13

[13.380] Section 101 of the ITAA 1936 deems present entitlement to exist when the trustee of

a discretionary trust exercises its discretion in favour of specified beneficiaries and s 95A(1) ensures that a payment does not prevent the present entitlement continuing (ie if the money has been spent by the trustee by 30 June, how can the beneficiary now demand that it be paid to her?). The general form of discretionary trusts has been noted above. The trust deed usually contains procedures and time limits for exercise of its discretion by the trustee. Because many of the trusts are run by families unfamiliar with the intricacies of trust law who rely on their advisers to deal with the trust’s tax affairs after the end of the income year, often the procedures are not properly followed (especially if something has to be done by 30 June). If there are default beneficiaries, a failure to exercise the trustee’s discretion to appoint income to particular beneficiaries means that the default beneficiaries may end up with an unexpected tax liability. In turn, these beneficiaries may seek to disclaim their interest and so divert the net income to other beneficiaries or back to the trustee. The ATO has recently litigated a number of cases of this kind, including FCT v Ramsden (2005) 58 ATR 485 in the Full Federal Court. The outcome is that trustees need to be very careful to observe the terms of the trust deed in creating present entitlements in discretionary beneficiaries, and beneficiaries need to be careful to properly disclaim the income if they do not wish to find themselves entitled to it and having to pay tax on it.

(c) Calculation and Attribution of Net Income of a Trust [13.390] For some reason, Div 6 does not use the standard term “taxable income” but instead

requires people to pay tax on a trust’s “net income” but the idea is the same as “taxable income”. There is a definition of “net income” in the trust context in s 95 of the ITAA 1936 which is similar to that for partnerships in s 90. It will be noted that there is no equivalent definition to partnership loss. If a beneficiary is presently entitled to some or all of the income of the trust, then s 97 or s 98 applies to tax the income to that extent. Although s 98(1) and (2) tax the trustee using the individual’s rate scale, this tax is effectively a form of withholding against the beneficiary. If the beneficiary is presently entitled under more than one trust or has other income, then s 100 provides that the income taxed under s 98 is also assessable to the beneficiary who is entitled to a credit for the tax paid by the trustee under s 98 against the beneficiary’s tax. As with partnerships, in the case of business income it seems that the present entitlement of the beneficiary only arises at the end of the income year when the trust income is calculated (like Peterson’s case). Hence if there is a change of beneficiaries midway through the year, it is the beneficiary at the end of the year who is entitled to the income for the whole year under trust law unless the trust deed or statute provides for the income to be calculated separately in such cases. States and territories have legislation deriving from the UK Apportionment Act which requires daily apportionment of passive income in the form of rents, annuities, dividends and other periodic payments in the nature of income (eg Conveyancing Act 1919 (NSW) s 144). When income is taxed under s 99 or s 99A the tax is not by way of withholding. The trustee pays the tax and the income is not taxed again when distributed to a beneficiary, nor does the beneficiary get any credit for the tax paid by the trustee if the trustee subsequently decides to pay it to a beneficiary. Similar issues arise for trusts as for partnerships, where there are dealings between the trust and the trustee or beneficiaries but the solutions are not always the same. In a number of cases, [13.390]

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Income Derived Through Intermediaries

there are specific CGT rules that may be applicable and these are considered below. So far as borrowings are concerned the question is whether the analysis in Roberts & Smith together with general principles applies. If a trust borrows to repay capital invested in the trust, normally a deduction would be available to the trust, but not if the repayment is of unrealised capital gains in the trust rather than original invested capital: see TR 2005/12. If a beneficiary borrows to invest in a trust (eg to purchase units in a listed property trust), the interest will be deductible in accordance with ordinary principles. Differences are likely to arise in the case of discretionary trusts. Borrowing to invest in such a trust is unlikely to give rise to an interest deduction, as the discretionary beneficiary has no entitlement to income unless the trustee exercises its discretion in the beneficiary’s favour. [13.395]

Questions

13.35 How are losses treated in the case of trusts if the deductions of the trust in an income year exceed its assessable income? (Note that the rules for carry-forward of trust losses are elaborated below.) 13.36 Why is there no reconciliation of tax on the beneficiary and trustee where the trustee is taxed under s 99 or s 99A? 13.37 Is interest deductible if a trustee borrows to pay a distribution of income rather than realising assets? (See TR 2005/12, Hayden v FC of T (1996) 33 ATR 352; 96 ATC 4797 at 360 (ATR), 4804 (ATC) and Roberts & Smith extracted above.) What happens if a taxpayer causes a family trust to buy a residential property with borrowed money and the trustee then rents the property to the taxpayer for market rental? The taxpayer and family then live in the property as their main residence. (See FCT v Janmor Nominees (1987) 19 ATR 254; 87 ATC 4813; TR 2002/18 and Subdiv 118-B of the ITAA 1997.) [13.400] A major issue that arises with trusts is what happens when the “net income”

calculated for tax purposes is different from the trust income calculated for trust law purposes? For example, the trust deed may say the income available for distribution amounts to $10,000, but the “net income” (ie the amount on which someone has to pay tax) is only $8,000 because the tax system offers a concession such as accelerated tax depreciation. And the reverse may happen: tax law may say the “net income” is $10,000 (because the trustee has paid amounts which are not allowable deductions) but the trust deed says the beneficiaries are only entitled to income of $8,000? In either case how much will the beneficiaries be taxed on? The High Court in FCT v Bamford (2010) 240 CLR 481 adopted what is called the proportionate view of the word “share” in s 97(1) of the ITAA 1936. Under this view, the beneficiary’s entitlement to trust income under trust law is first expressed as a proportion of the total income under trust law. That proportion is then applied to the “net income” of the trust to work out how much of that net income is assessed to the beneficiary. Thus in the example above, the beneficiary would be assessed on $8,000 in the first case and $10,000 in the second case. The High Court rejected the so-called quantum view under which in the second case the beneficiary would only be assessed on $8,000 of the net income with the balance assessed to the trustee under s 99A. The High Court also indicated that the trust law concept of income was not immutable and was subject to variation by the trust deed or actions of the trustee under the deed or general trust law (which is further discussed under the next heading). In response to this case the ATO released a Decision Impact Statement which took the view that under the proportionate approach it was not possible to stream particular kinds of income to particular beneficiaries or for such income to retain its character in the hands of 724

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such beneficiaries. For example, if the trust deed provided that interest income of the trust (say $100) was to go to one beneficiary and rental income (say $300) to another beneficiary, these amounts were used in working out the share of the trust income which was then applied to the net income of the trust indifferently. So if net income for tax purposes was the same amounts, this would give rise to net income of $400 of which the first beneficiary was entitled to $100 and the second beneficiary $300; but each beneficiary would receive for tax purposes a mixture of interest and rent (the first beneficiary would have $25 interest and $75 rent for tax purposes being a one quarter share of each type of income). There was nothing in the Bamford decision that explicitly required this result but it was a possible reading of the High Court judgment. [13.410] This view created particular problems for income which other parts of the

legislation assumed could be streamed through trusts in this way. For example, the imputation provisions for dividends flowing through trusts in Subdiv 207-B of the ITAA 1997 discussed in Chapter 14 seemed to assume in their pre-2011 form that if the trust deed allocates franked dividend income to a particular beneficiary then the gross up for the franking credit at the trust level and the franking tax offset both flowed to that beneficiary. Accordingly, the government as an interim measure pending the rewrite of the trust taxing rules (which we are still waiting to see) amended the legislation in 2011 to ensure that, in this case, the franked dividend and franking offset would be allocated for tax purposes to the beneficiary who was specifically entitled to the franked dividend. This result is achieved by excluding franked dividends from the operation of Div 6 of the ITAA 1936 and entirely dealing with them in Subdiv 207-B; see in particular Div 6E. Dividends to which a beneficiary is specifically entitled are assessed to that beneficiary along with the franking credit and offset. To the extent that franked dividends are not specifically allocated to a particular beneficiary, they are treated as flowing pro rata to beneficiaries of the trust in accordance with their share of trust income after excluding amounts giving rise to a specific entitlement to franked dividends and capital gains.

(d) Capital Gains of Trustees [13.420] The original CGT legislation assumed that capital gains would pass through trusts

and be attributed to beneficiaries in the same way as trust income. The assumption was flawed in various respects. First, in trust law capital gains will usually belong to the capital beneficiary of the trust if the trust has separate income and capital beneficiaries. But tax law operated to include net capital gains in the assessable income of the trust along with other income in calculating net income, and then ss 97 and 98 will pass the tax liability to the income beneficiary of the trust rather than the capital beneficiary. Second, even if we ignore this problem and treat this part of net income as attributable to the capital beneficiaries, those beneficiaries may not be presently entitled, for example, if the capital beneficiary only takes the corpus if she survives the income beneficiary. The problems are in fact even worse, as the trust law division between capital and income may not be the same as the tax distinction, so that any attempt to reconcile taxation of capital gains with income and capital rights of beneficiaries is bound to be complex. Although this problem was identified almost immediately in 1986 when the CGT was enacted, it remained largely unfixed until legislative amendments in 2011 occasioned by the High Court decision in Bamford discussed above. In one of the years in question in that case, the only amount of net income was referable to a capital gain made by the trust. The trustee, in accordance with a power in the deed, had treated that amount as trust law income and [13.420]

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Income Derived Through Intermediaries

allocated it to a beneficiary. The issue was whether this action was effective to make the beneficiary taxable on the capital gain and the High Court, accepting as noted above that trust law income could be affected by the trust deed, held the trustee’s action effective. The ATO reaction to the case threw doubt on whether income of any kind could be streamed to beneficiaries as noted above; and one of the principal situations affected was capital gains as Div 115 of the ITAA 1997 which deals with the CGT discount assumed that streaming was possible. Accordingly, the 2011 interim legislation (described above in relation to franked dividends) also applies to capital gains flowing through trusts. Capital gains are now dealt with exclusively in Div 115 and excluded from the operation of Div 6 in a way which retains the right to stream capital gains to one beneficiary if that is provided for by the trust deed or flows from the exercise of a trustee’s discretion. That legislation also deals with the problem where the capital gain belongs to a beneficiary who is not presently entitled to receive it, such as a capital beneficiary of a trust. In such cases, the trustee can elect to be taxed on the capital gain under s 99 or s 99A as appropriate, or s 115-230, rather than allow the tax to fall on an income beneficiary who does not receive the capital gain. With the introduction of the CGT discount in 1999, other problems in the treatment of capital gains of trusts were also addressed. Previously what emerged from the trust was a net capital gain and the tax law did not seem to permit setting off net capital gains against gross capital losses of beneficiaries, though the ATO had issued a Ruling to the contrary. In 1999 Subdiv 115-C was introduced to deal with this problem. Putting aside the small business 50% reduction under Div 152, Div 115 along with s 102-5 allows the discount to the trustee in the calculation of net income of the trust. It then includes for a presently entitled beneficiary an additional amount equal to twice the discounted capital gain in the beneficiary’s assessable income as capital gain (not net capital gain) while allowing a deduction effectively for the 50% discounted net capital gain included in assessable income via s 97. The beneficiary can offset his, her or its capital losses against this capital gain and then claim the discount. The CGT treatment of dealings between the trustee and beneficiaries is dealt with below. [13.425]

Questions

13.38 A trust acquired an asset in January 1987 for $100,000 and sold it in 2004 for $500,000. The other income of the trust is $100,000 and it has no expenses. The trust has a beneficiary A with a life interest in income and beneficiary B who takes income and capital on the death of A. Who is taxable on the capital gain? What happens if the trustee calculates the capital gain using the CGT discount? 13.39 What is the relationship of the rules in Div 6 with other taxing rules in the legislation? For example, assume that a trust provides for the payment of an annuity to a beneficiary of $10,000 a year with the rest of the trust income going to another named beneficiary and that if the amount of the annuity in any year exceeds trust income the balance is to be paid out of trust capital. What happens if the trust income is $8,000 or $12,000 and net income is $15,000? (See ATO ID 2011/58 for the ATO’s highly contestable view of the scope of Div 6.)

(e) Child Beneficiaries and Division 6AA [13.430] The individual rate scale generally applied under s 98 meant that it was possible in the past to achieve significant income splitting with children under the age of majority by setting up a trust the income of which was used to maintain the children by paying school fees, etc. In 1980 Div 6AA – Income of Certain Children was introduced to deal with various forms 726

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of income splitting with children, sometimes referred to as the “kiddies tax”. Apart from a zero bracket of $416, which is clawed back if income is higher, income subject to the Division is taxed at the top personal marginal rate plus Medicare levy: see Income Tax Rates Act 1986 ss 13, 14, Sch 11 Pt I. Under s 102AC, the Division applies to children under the age of majority other than excepted persons who are children suffering varying kinds of extreme disadvantage or “engaged in a full time occupation on the last day of the year of income” (with special rules to eliminate full-time students who happen to be working on that day). In the case of trusts, s 102AG has the effect that the Division applies to virtually all of the income flowing to children through s 98 (again eliminating children under severe disadvantage and also trusts created by wills, subject to various anti-avoidance provisions). Although trust income is the main case in practice that is captured by the Division, it also applies to income derived directly by minor children, for example, from property they hold, effectively on the irrebuttable presumption that it has been transferred to them to avoid tax on the previous owners who are likely to be their relatives: s 102AE. Children’s genuine income for rendering services as an employee or otherwise is not subject to tax under the Division. Special provisions in s 102AGA deal with income passing to minor children through trusts in the case of family breakdown, but so as to prevent income splitting in such cases.

(f) Deceased Estates [13.440] Deceased estates are subject to special rules. As noted previously, the income of a

deceased estate is generally subject to tax under s 99 at ordinary individual rates. This tax applies up to the point when the estate is fully administered: see Whiting’s case as explained in Taylor’s case extracted above. Over the years various morbid stratagems were used to move trust income from s 99A to s 99 (such as getting elderly people in nursing homes to set up multiple trusts in their wills with nominal capital for people they did not know in exchange for a small payment). As a result, the circumstances in which s 99 is available for deceased estates have been circumscribed to prevent abuse: see s 99A(2), (3). With the advent of the CGT, special rules were introduced to deal with assets as they passed from the deceased to the executor or administrator and then to the beneficiaries. The rules have significant concessional elements resulting from a political compromise as outlined in Chapter 3. Under Div 128, putting aside transitional situations, any capital gain or loss arising for the deceased on death is disregarded, and the executor or administrator to whom the asset passes takes the cost base of the deceased as the first element of the cost base. Acquisition occurs on the date of death. If the asset then passes to a beneficiary either under a specific bequest in the will, under an intestacy or under a settlement of any contest under the will, a similar result applies as between the executor or administrator and beneficiary. An exception applies if the asset passes to a tax-exempt beneficiary, in which case CGT event K3 may occur so that any capital gain or loss to death is brought to account for the deceased. Once again the CGT provisions are technically defective. They have been drafted with only the simplest deceased estate in mind and without regard to the fact that the CGT provisions generally see two CGT assets in the case of a trust – the interest of the trustee in the assets of the trust and the interest of the beneficiary in the trust. The special provisions in Subdiv 104-E discussed below, which seek to eliminate any CGT on the beneficiary when an asset passes from the trust to the beneficiary if the beneficiary did not acquire the interest from a third party or for consideration, do not apply in the case of a deceased estate: for example, see [13.440]

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s 104-75(1). The obvious intention is that there be no CGT on disposal or ending of the beneficiary’s interest in a deceased estate but it is very difficult to extract that result from the legislation. Again these problems are long-standing and unsolved. [13.445]

Questions

13.40 The deceased died on 30 June 2007. Her estate consisted of two large blocks of land with a house on each, one acquired before 20 September 1985 and one acquired after that date. She left the land to her son. Because of the deceased’s substantial debts, her executor subdivides each block of land and sells the part of each without the houses to pay the debts. The executor then transfers the remainder of the land with the houses to the son in 2009. What is the tax result of these transactions? (See Subdiv 108-D as well as Div 128.) 13.41 What if the deceased in the previous question left the land and houses to be held on trust by her executor with a life interest in her estate to her son and the remainder to her granddaughter on his death? The son lives in one of the houses as permitted under the will and the other is rented out. The son dies in 2011. What would be the difference if the deceased had lived in one of the houses? (See Subiv 118-B as well as Div 128, TR 2006/14 and TD 2004/3.)

(g) Trust Distributions [13.450] Apart from s 26(b) (repealed as redundant in 2006) and s 101 discussed above, the

ITAA 1936 originally had no specific provisions dealing with distributions from trusts. In a sense such rules were unnecessary – the income of domestic trusts was already fully taxed: either to the beneficiary or the trustee, in the year when it was earned, and regardless of whether it was paid to the beneficiary. There was no need for more tax if and when cash flowed. But in 1979 ss 99B to 99D were introduced dealing with distributions in a context where other amendments were made to Div 6 to make it operate properly in international situations. One can’t be sure the income of foreign trusts has ever been taxed in any country to the beneficiary (they may not have been presently entitled if the trust is a discretionary trust) or the trustee (the trustee may not be an Australian resident and may be exempt from tax offshore). In this case, cash flow might be the first time any tax has been paid. Although on a literal reading s 99B could apply to distributions of trust income in excess of the net income of the trust, Hill J explained in Traknew Holdings Pty Ltd v FCT (1991) 21 ATR 1478; 91 ATC 4272 that in view of its history, the provision was not intended to have this effect. And the enactment of CGT in 1985 added a new circumstance when distributions might be taxed. CGT event E4 in s 104-70 writes down the cost base of the beneficiary’s interest in a fixed trust if the amount distributed by the trustee exceeds the amount of “net income”. Various exceptions exist to prevent inappropriate write-downs under this event: see s 104-71. If the cost base is written down to zero by this process then any excess gives rise to a capital gain. The CGT discount further complicated the operation of the provision as the discount had the potential to be clawed back on distribution by the excess of the distribution of the full capital gain over the lesser amount of net income produced by discounting the capital gain. Amendments to ss 104-70 and 104-71 have attempted to deal with the problems but there is still debate as to whether the amendments achieve their purpose. CGT event E4 is particularly important in the property trust industry and for managed funds where distributions typically exceed the net income of the trust. 728

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Question

13.42 CGT event E4 refers to a payment “in respect of your unit or your interest in the trust”. Does it apply to distributions from discretionary trusts? (See TD 2003/28.)

(h) Trust Anti-avoidance Measures [13.460] Trusts have been used for various tax avoidance activities over the years and as a

result various rules have been inserted in the legislation to deal with some of the problems. Here we will look at some of the regimes dealing with such problems like trust stripping. Trust stripping refers to the situation where a beneficiary who is presently entitled confers a non-taxable benefit on someone associated with the trust in situations where it is not of concern to the beneficiary to be presently entitled. For example, assume that the controller of a trust enters into an arrangement with a grocer, that the grocer will supply the controller with groceries and be paid as a beneficiary of the trust by distributions from the trust. The grocer is not concerned that the amount is a trust distribution, as the sale price of the groceries is taxable in any event. The controller effectively avoids the tax on the trust distribution and so purchases the groceries out of pre-tax income. (This arrangement is similar to that used in one of the most famous UK cases on tax avoidance, IRC v Duke of Westminster [1936] AC 1 where the Duke paid a servant by a covenanted payment which reduced the Duke’s income and the employee no longer claimed his salary – the employee was not concerned as he was taxable on either payment.) Similar results can be achieved if the beneficiary gets a deduction for the amount reimbursed without the associate of the trust who receives the benefit being taxable on it. Under s 100A(1), if a beneficiary’s present entitlement to trust income arises out of, or in connection with, a reimbursement agreement, the beneficiary is deemed not to be presently entitled. The result is that the trustee will usually be assessed under s 99A. If the beneficiary is relying on obtaining a deduction for the benefit it provides under the reimbursement agreement, the deduction is disallowed: s 100A(6A). Various subsections give a very wide meaning to “reimbursement agreement” (s 100A(5), (7) to (12)) but it does not include an agreement entered into “in the course of ordinary family or commercial dealing”: s 100A(13). Taxpayers have argued that the section should be read down in various ways but so far the courts have rejected the arguments: see FCT v Prestige Motors Pty Ltd (1998) 38 ATR 568, Idlecroft Pty Ltd v FCT (2004) 56 ATR 699 and Raftland Pty Ltd v FCT (2008) 238 CLR 516. A similar device used prior to the introduction of the CGT was for a beneficiary of a trust to sell an interest in income in the trust to a tax exempt institution. The argument was that the amount received by the beneficiary was an untaxed capital gain, while the income when received by the institution was exempt. Part III Div 9C of the ITAA 1936 (ss 121F – 121L) was introduced to deal with schemes of this type. As usual with anti-avoidance legislation it is very widely drafted and can potentially apply to dealing between trustees or beneficiaries and tax-exempt institutions (like state bodies) in cases where no avoidance is involved. The Division has been overtaken by the CGT (see below on dealings in trust interests). It is also possible that the second strand of the Myer Emporium decision analysed in Chapter 5 could apply to such cases. It was noted earlier that s 95A(2) provides a special rule for when beneficiaries are presently entitled and that income falling within the provision is taxable to the trustee under s 98 on the individual rate scale. These rules were the source of considerable tax avoidance from the time of their introduction in 1980. As originally enacted, the income was taxable under s 98 even if [13.460]

729

Income Derived Through Intermediaries

the person who was deemed to be presently entitled was a trustee of another trust. Hence taxpayers would set up a trust with multiple trusts as beneficiaries and ensure that the beneficiary trusts were not presently entitled to the income of the trust under general principles but were deemed presently entitled under s 95A(2). The result was that the income was taxed in the head trust under s 98 using the individual rate scale. Because of the large number of trusts used (more than 100 in some cases), no tax was collected as the income to which each sub-trust was presently entitled under s 95A(2) was below the tax threshold. These schemes were dealt with by amendments made in 1982: see ss 95B, 97(2) and 98(2)(aa). A further scheme was later developed of making tax-exempt bodies deemed presently entitled under s 95A(2) but postponing distribution for long periods such as 80 years. It was possible to do this because the deemed present entitlement under s 95A(2), unlike present entitlement otherwise (see Taylor’s case extracted above), did not require that the beneficiary have an immediate right to sue the trustee for the income if it was not paid over. The income was not taxed because of the tax-exempt status of the beneficiary, but remained in the trust for use by the trustee. These schemes were dealt with by separate legislation, the Trust Recoupment Tax Assessment Act 1985: see IT 2329. More recently, taxpayers relied on chains of trusts, often with non-resident ultimate beneficiaries. The complexity of the structures made it hard for the ATO to trace the ultimate beneficiaries and the money may be gifted by the non-resident beneficiaries back to Australian residents who were the real controllers of the trust and its income. In 1999 as a stop-gap measure, Div 6D was introduced to deal with this problem, pending the introduction of the proposed regime to tax trusts like companies. This regime did not eventuate, and in 2007 changes were made to Div 6D in recognition of its continuing operation and to solve many difficulties to which it gave rise. The Division applies by s 102UG when a closely held (usually discretionary) trust has another trust as one of its beneficiaries. The trustee of the first trust is required to give a trustee beneficiary statement to the ATO which contains the names of the trustee beneficiaries, and either their tax file numbers if resident in Australia or their addresses if not resident in Australia: s 102UG. The statement is required to be given when the trustee is required to file the trust tax return for the income year: s 102UH. If the trustee does not give a correct statement or the income travels in a circle so that the trustee of the first trusts becomes presently entitled to income of another trust attributable to the original income, the trustee is subject to Trustee Beneficiary Non-disclosure Tax at the top personal marginal rate and the income is not included in the assessable income of the trustee beneficiary: ss 102UK and 102UM. There are also rules for present entitlements in respect of tax preferred amounts which are not subject to tax, such as trust capital or unrealised gains on trust property: s 102UT. These arrangements often involved non-resident trustee beneficiaries from whom it was difficult to collect tax, so in 2007 a related change was made to tax the first trustee at the top individual marginal rate on Australian source net income of trusts to which a non-resident trustee beneficiary is presently entitled (with the exception of income subject to final non-resident withholding taxes), s 98(4) and Income Tax Rates Act 1986 s 28(b). This is effectively a withholding tax and not a final tax, as the ultimate beneficiary can obtain a refund of tax as appropriate by filing a tax return and being assessed in the normal way on the income ultimately received from the first trust: ss 98A, 98B. When this tax is levied, there is no 730

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need to include such income in a trustee beneficiary statement or give a statement with respect to that non-resident trust if that is the only income to which the trustee beneficiary is presently entitled. A further tightening occurred in 2010 when trustees of closely held resident trusts became required to withhold at the top marginal tax plus Medicare levy on present entitlements to or distributions of trust income (whichever comes first) in respect of resident beneficiaries which are not exempt from tax and not under a legal disability unless the beneficiary provides the trustee with her tax file number: see Taxation Administration Act 1953 Sch 1 ss 12-175, 12-180. (Tax collected under other anti-avoidance rules above takes priority over this withholding.) This means that the ATO can then cross-check this information with the beneficiaries tax returns under computer income matching processes. The Bamford case referred to above highlighted another tactic used by taxpayers to exploit the differences between trust income and net income. By manipulation of trust income and net income across income years, it was possible to produce years where there was a small amount of trust income but a large amount of net income, and other years when there was a large amount of trust income and little net income. By allocation of the trust income in the former category to tax exempt bodies like charities, the large net income would be protected from tax, while in the latter category the trust income could be allocated to real beneficiaries yet bring little tax liability with it. Often one suspects that the tax exempt body would not be notified of the present entitlement and the income left in the trust. The amendments in 2011 following the Bamford decision included two anti-avoidance rules for this kind of case. The first in s 100AA requires the amount to be notified or paid to the tax exempt beneficiary within two months of income year end or otherwise the trustee is taxed under s 99A. The second effectively treats the excess of net income over trust income allocated to tax exempt beneficiaries as income assessable to the trustee under s 99A.

(i) Trust Losses [13.470] As we noted earlier, if a trust suffers a loss, that loss is quarantined in the trust (it is

not directly available to the beneficiaries) and can only be used to reduce tax if and when income arises in future years. If the trust is winding down or just unprofitable, the prospect of future income may be slim. Tax law has long contained rules to prevent trafficking in tax losses made by companies (ie the owners of the company sell the shares in the company and the new owners then seek to take advantage of the company’s carry-forward tax losses in various ways) but until the mid-1990s there were no similar rules in relation to losses quarantined inside trusts. Hence if a trust made a tax loss that the controllers of the trust did not expect they could utilise, various methods were adopted to “sell” the benefit of the loss to other parties – the trust would effectively be taken over. Although not enacted until 1998, rules were announced in the 1995 Budget to implement a similar regime for trusts and take effect generally from then. The rules are found in Sch 2F to the ITAA 1936 but use numbering similar to that in the ITAA 1997. Different rules are provided for different categories of trust. The main division is between fixed trusts and non-fixed trusts. The definition of “fixed trust” in s 272-65 requires that persons have fixed entitlement to all of the income and capital of the trust. “Fixed entitlement” is defined in s 272-5 in terms borrowed from s 95A(2) to mean that beneficiaries have vested and indefeasible interests in all of the income and the capital of the trust. The difference to s 95A(2) is that the trust loss rules extend to capital of the trust and then are also [13.470]

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Income Derived Through Intermediaries

elaborated by special rules. The intention is that public unit trusts should be fixed trusts. A non-fixed trust is any trust which is not a fixed trust: s 272-70. This is intended to cover primarily family discretionary trusts. Because of the way that the provisions of trust deeds of public unit trusts are drafted, on a strict reading of the definition it is doubtful if they are fixed trusts, which caused much angst in practice but has been solved at least for managed investment trusts (discussed below). We will proceed to consider losses of listed widely held trusts and discretionary trusts in what follows on the assumption that the former are fixed trusts and the latter non-fixed trusts. There are other categories of fixed trusts for which different rules apply: Div 266. In order to be able to utilise its losses, a listed widely held trust has to show that when abnormal trading occurs in its units (as defined in Subdiv 269-B) after incurring a loss, it satisfies the 50% stake test: s 266-125. This test requires that the trust show that the same individuals continue to own more than 50% of interests in income and capital of the trust from the time of the loss (including tracing through interposed companies, partnerships and trusts): s 269-55 along with the tracing rules in Div 272. Alternatively the trust has to pass the same business test: s 269-55 with this test in Subdiv 269-F. These are similar to the rules for companies, though there are many differences in the details. In the case of a discretionary trust, it is more difficult to define continuity of ownership and accordingly under Div 267, there are a number of potentially applicable tests to satisfy (s 267-20): the pattern of distributions test under Subdiv 269-D; the 50% stake test if there are more than 50% fixed interests in the trust; and the control test under Subdiv 269-E. The same business test is not available for non-fixed trusts. Because discretionary trusts will often have difficulty satisfying these tests, an alternative is provided – the trustee can in certain cases elect to be a family trust under s 272-80. If the election is made, the only test applicable is an anti-avoidance provision which deals with schemes to take advantage of the loss in Div 270 (which also applies to other trusts such as listed widely held trusts): see ss 267-20(1)(c) and 272-100. A family trust is one which is effectively owned by the family of a nominated individual and related intermediaries: Subdiv 272-D. If distributions are made or present entitlements conferred by the family trust outside the designated family group, the relevant income is taxed at the top personal marginal rate under Div 271 and the income is then not included in the assessable income of any person: s 271-105. Convoluted and difficult as these tests are, they are far exceeded in complexity and scope by the company loss rules discussed in the next chapter. The family trust election concept has been borrowed by other parts of the legislation in relation to the imputation system of company taxation and the carry-forward of company losses where a company is owned by a discretionary trust. The rules continue to be criticised by taxpayers and tax professionals. In 2005 the time for making family trust elections was effectively made limitless for elections starting in that or later years, so long as the same family controlled the trust throughout the period. In 2007 the rules were further liberalised by extending the definition of family and allowing variation or revocation of elections in limited circumstances.

(j) Creation, Dissolution and Dealings in Trust Interests [13.480] The advent of the CGT complicated the taxation of trusts even further through rules

needed to handle the creation and dissolution of trusts, and dealings in trust interests. 732

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(i) Absolute entitlement [13.490] We noted above that CGT includes a net capital in assessable income and therefore

in the calculation of trust’s “net income” for Div 6. However, s 106-50 of the ITAA 1997 provides that if a beneficiary is absolutely entitled to an asset of a trust as against the trustee (disregarding any legal disability), CGT applies on the basis that the beneficiary in effect owns the asset. Hence in such cases the CGT events happen directly to the beneficiary and the trust is ignored for CGT purposes. The rules in Div 6, however, still apply to such a trust and the income from trust property of such a trust. It is generally accepted that the notion of “absolutely entitled” applies to a so-called bare trust – a trust where the trustee simply holds the asset, has no active duties to perform and whose only responsibility is either to deliver the asset to the beneficiary or deal with the asset as the sole beneficiary directs (and deliver up any proceeds if the beneficiary says to sell). The Board of Taxation recommended in its 2009 report Tax Arrangements Applying to Managed Investment Trusts that the income of such bare trusts be excluded from Div 6 and taxed direct to beneficiaries, just like capital gains. The government deferred its decision on this recommendation when announcing its general response to the report in the 2010 Budget; the matter should be taken up if the rewrite of Div 6 ever happens. In the UK there are cases on a similar provision which link it to the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282. The UK cases suggest that more than one beneficiary can be absolutely entitled, including cases where beneficiaries hold fractional interests in the assets, for example, two beneficiaries each with a half interest in the trust; and cases where beneficiaries hold successive interests in the asset, for example, a trust with a life tenant and a remainderman. The ATO issued a draft ruling TR 2004/D25 in December 2004 which has not yet been finalised. The ATO takes the position in the ruling that the absolute entitlement concept is not applicable to unit trusts because the structure of the legislation is to treat interests in unit trusts as separate from interests in trust property. Further and contrary to UK case law, the ATO considers that if more than one person has an interest in an asset, absolute entitlement does not arise. Since that time, there has been some Australian case law relating to the issue. In CPT Custodian v Commissioner of State Revenue (2005) 224 CLR 98 the issue was whether the sole unit holder in a unit trust owned land at midnight on 31 December for the purposes of state land tax when the trust deed provided, as is common with unit trusts, that the unit holders did not have an interest in the specific assets of the trust. The High Court held it was not the owner. There were several reasons for this conclusion: (1) a unit holder under a trust deed framed as in this case did not have a beneficial interest in the land so as to be the owner of a freehold estate in possession as required by the land tax statute; (2) the “rule” in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282 did not override this conclusion even when all units were held by a single unit holder, given the terms of the trust deed; (3) in any event the “rule” does not apply when the trustee is entitled to be paid fees out of the trust, “The classic nineteenth century formulation by the English courts of the rule in Saunders v Vautier did not give consideration to the significance of the right of the trustee under the general law to reimbursement or exoneration for the discharge of liabilities incurred in administration of the trust”; and (4) moreover, the potential to apply the “rule” as at midnight on 31 December did not mean that the sole unit holder was the owner – the right had to be exercised for that to occur. While the third reason seems contrary to much of the case law on Saunders v Vautier [13.490]

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Income Derived Through Intermediaries

(1841) 4 Beav 115; 49 ER 282 and to the existing judicial analysis of present entitlement above, the issue for absolute entitlement under the CGT is to what extent the High Court views are relevant. In Kafataris v FCT (2008) 172 FCR 242; [2008] FCA 1454 where the Federal Court had to consider ss 104-55, 104-60 of the ITAA 1997 which required both absolute entitlement and a single beneficiary, Lindgren J referred to step 1 in the High Court reasoning above, but in relation to absolute entitlement follows a more traditional analysis of the rule in Saunders v Vautier (1841) 4 Beav 115; 49 ER 282, in particularly accepting that a group of beneficiaries could be absolutely entitled to an asset for CGT purposes and not considering the issue of the trustee’s entitlement to reimbursement or indemnification out of trust assets. In the event, it was held that there were a number of beneficiaries so that the sole beneficiary requirement of these particular provisions was failed, which automatically meant that one of the beneficiaries could not be absolutely entitled on her own under the “rule”. (The particular kind of tax planning in the case is now not important as the law has since been amended.) [13.495]

Question

13.43 Is it possible to reconcile the ATO views in TR 2004/D25 with these two recent cases? (ii) Creation and dissolution [13.500] When a trust is deliberately created, either (i) assets are transferred by the owner to a

trustee (generally referred to as a settlement, with the transferor called the settlor) to be held on particular trusts or (ii) the owner of an asset declares that the asset is held on particular trusts (generally referred to as a declaration of trust). Because of ITAA 1936 s 102 discussed below, it is common for closely held trusts to be created by a professional adviser with nominal capital (such as $10) and then for the real settlor to transfer substantial assets to the trust. Section 104-10 provides that CGT event A1 occurs if a change of ownership of a CGT asset occurs from you to another person, except in the case where you cease to be legal owner but continue to be beneficial owner. This event would seem to apply to a settlement or a transfer of an asset to an existing trust unless the settlor/transferor is the only beneficiary of the trust. There are more specific rules in CGT events E1 (creating a trust over a CGT asset) and E2 (transferring a CGT asset to a trust) dealing with these kinds of cases and, being more specific, these provisions will take precedence over s 104-10: see s 102-25. These provisions link into the absolute entitlement rule by providing that the events do not apply if you are the sole beneficiary of the trust and are absolutely entitled to the asset against the trustee (disregarding any legal disability). There is a tension evident in the law between setting up a new trust (which should trigger tax) and changing the trustee of an existing trust (which should not). A change of trustee will, in the normal case, involve a disposal by the transfer of legal title in the trust assets from the old trustee to the new trustee, but former rules provided that a mere change of trustee is excluded from the operation of CGT event A1 (former s 104-10(2) ITAA 1997). These rules gave rise to a practice sometimes referred to “trust cloning”. The idea is to create a new trust out of an existing trust by transferring assets to the trustee of the new trust, but without triggering any tax by insisting that only the trustee changed. Amendments were made to event A1, event E1 and event E2 and Div 126-G in 2010 to try to clarify the circumstances when creating a new trust would trigger tax and when a new trust could be created without triggering CGT. The new rules in effect trigger CGT on the transfer of an asset to any trustee (even a trustee holding on the assets on the same terms and for the same people as the old trust, 734

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a transaction which looks very much like a mere change of trustee). Div 126-G sets out conditions which must be met for this transaction to enjoy the benefit of a rollover. When a trust is dissolved, the assets of the trust will normally be transferred to beneficiaries which will result in a CGT event for the trustee. In recent years the ATO has taken the position that any significant change in the terms or control of a trust will result in the dissolution of one trust and the creation of another trust, even though the trustee does not change and even though the assets of the trust do not change: see Creation of a New Trust – Statement of Principles issued in 1999. For example, a family which runs a business through a discretionary trust may wish to “sell” the business. The “buyer” may effect the transaction by buying the shares in the corporate trustee for a nominal amount (the trustee of such a trust will normally be a company) and injecting capital into the trust which then distributes the capital to the “selling” family. Prior to the introduction of the trust loss rules, a loss trust might be “sold” in a similar way. If this type of transaction amounts to a dissolution of the original trust and the creation of a new trust as the ATO considers, then it will amount to a disposal of the business by the original trust to the new trust. Similarly, in the loss situation, the dissolution or termination of the original trust will mean that the losses cease to exist with the trust (as also occurs when an individual dies or a company is liquidated). The loss situation remains important for CGT even after the introduction of the trust loss rules as they do not apply to capital losses. The issue in a loss trust situation has been dealt with by the High Court of Australia in FCT v Commercial Nominees of Australia Ltd (2001) 47 ATR 220, [2001] HCA 33 and the Full Federal Court in FCT v Clark (2011) 190 FCR 206 (the High Court refusing special leave to appeal). In the latter case where there was a change of trustee, a complete change of beneficiaries and for a period a substantial excess of liabilities over assets of the trust, the majority Edmonds and Gordon JJ said at [87], “When the High Court in Commercial Nominees spoke of trust property and membership as providing two of the indicia for the continued existence of the eligible entity or trust estate, the Court was not suggesting that there had to be a strict or even partial identity of property for the first and objects for the second. It was speaking more generally: that there had to be a continuum of property and membership, which could be identified at any time, even if different from time to time; and without severance of one or both leading to the termination of the trust in question. In the present case, the ATO never contended, nor on the evidence could he, that there was a severance in the continuum of trust property and objects of the CU Trust. Their identity changed from time to time, but not their continuum.” [13.510] In August 2001 following the High Court decision, the ATO reissued Creation of a

New Trust – Statement of Principles essentially without change, taking the view that the Commercial Nominees decision is confined to superannuation funds and does not affect other trusts. On the other hand, many in the tax profession consider that so long as there is continuity within the trust deed (including amendments authorised by the deed) and assets continually held on the trusts of the trust deed (even though the assets change over time), there is no dissolution of the trust. The Clark case has confirmed this view and the ATO has indicated that it will now review the Statement of Principles. It is possible that the matter will be taken up in the rewrite of Div 6 to provide a legislative rule to deal with the termination of trusts. [13.510]

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Income Derived Through Intermediaries

(iii) Dealings in trusts other than deceased estates and unit trusts [13.520] CGT events E5 to E8 cover various kinds of trust transactions, excluding in each

case “a unit trust or a trust to which Division 128 applies” (recall that Div 128 deals with death). They seek to ensure that tax is levied either at the trustee or beneficiary level on dealings in trust interests and, to a certain extent, that there is no double taxation of capital gains. If transactions are not dealt with in these specific provisions then ordinary CGT principles apply. Thus, under CGT event E5 if a beneficiary becomes absolutely entitled to a CGT asset of a trust as against the trustee, a CGT event occurs for the trustee with the capital gain or loss determined by a comparison of the market value of the property and its cost base or reduced cost base. Similarly the beneficiary makes a capital gain or loss based on a comparison of the market value of the asset, and the cost base or reduced cost base of the beneficiary in the capital of the trust to the extent that it relates to the asset. The apparent double tax of the same gain will not, however, arise in most cases as there is an exception for the beneficiary if the beneficiary did not pay for the interest in the trust and did not acquire it by assignment from another entity. The following series of questions raise the operation of these CGT events and also the interaction with other parts of the CGT legislation. [13.525]

Questions

13.44 A is a discretionary beneficiary of a trust. The settlor of the trust does not wish for A to receive any distributions from the trust in future and pays A $10,000 in consideration for A disclaiming any interest in the trust. What are the consequences? (See TD 2001/26.) 13.45 Do CGT events E5 to E8 or Div 128 apply to will trusts (ie trusts created by a will that take effect after administration of the estate is completed)? (See PS LA 2003/12.) What is the difference between the two regimes so far as the interest of the beneficiary in the trust is concerned? (iv) Dealings in unit trusts [13.530] Unit trusts and units in them are handled by the CGT rules very much like

companies and shares in companies. While the analogy of the unit trust with the company is not supported by earlier case law (see Charles v FCT (1954) 90 CLR 598, Read v Commonwealth (1988) 176 CLR 57), it would be a brave judge who would hold that virtually the entire CGT miscarries for unit trusts because of a false analogy: see TD 2000/32. On the one hand, this means that many provisions dealing with shares are repeated for unit trusts (such as s 104-35(5)(d) on the issue of units in a unit trust, Subdiv 124-H on interposing a company between unit holders and a unit trust) or apply also to unit trusts (such as Subdiv 130-A on bonus equities). We will not go into these provisions in this chapter. When studying the treatment of companies and shareholders in the next chapter, you should note if the specific provisions apply also to unit trusts or have an analogous rule for unit trusts. The analogy to a company means that unit trusts are sometimes excluded from the operation of various CGT provisions on trusts. For example, the creation of a unit trust, transfer of assets to a unit trust or conversion of another form of trust to a unit trust will give rise to CGT event E1, E2 or E3 in respect of assets held immediately afterwards by the trustee of the unit trust. The exception in E1 and E2 for assets to which the sole beneficiary of the trust is absolutely entitled does not apply to unit trusts. Further as already noted, unit trusts are excluded from CGT events E5 to E8. 736

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By contrast there are some rules that apply to unit trusts, and some but not all other types of trusts. CGT event E4 discussed above in relation to distributions will have its most common application to unit trusts. It also applies where a beneficiary has an interest in a trust asset but not to discretionary beneficiaries of a discretionary trust. Similarly Subdiv 124-M on scrip for scrip and Div 125 on demerger rollovers apply to trusts other than discretionary trusts. It accordingly is necessary to read CGT rules on trusts very carefully to be sure to which kinds of trust they apply. While the CGT rules are clear about the interest of a unit holder in a unit trust being separate from the interest of the trustee in the trust assets, for other trusts as we have seen the legislation is not so clear. Moreover the extent to which that separation applies for all purposes of the CGT is open to question, see discussion of absolute entitlement above.

(k) Trusts Taxed as Companies [13.540] In most cases, the commercial similarity between trusts and companies is not

matched by their tax treatment. Companies are taxed in their own right whether or not their income is distributed, and they do not benefit from the CGT discount. Investors in trusts, however, receive a distribution that hasn’t been reduced by any tax at the trustee level. These differences led to the substitution of trusts for companies in a variety of commercial contexts. From the 1970s onwards, there was a very significant shift of closely held or private businesses out of private companies and into discretionary or unit trusts. During the 1980s a further trend emerged of substitution of public unit trusts for public companies. The trend started with moving passive assets out of public (listed) companies into public unit trusts, for example, supermarket companies transferring real property (stores) they owned to unit trusts owned by their shareholders and renting the properties back so that the rental income ended up in the trust and could be distributed without being subjected to corporate tax. The trend moved on to setting up widely held trading operations as trusts rather than companies, for example, the Queensland Coal Trust which was listed on the stock exchange in the mid-1980s and operated coal mines in Queensland. The trend, so far as it concerned widely held trusts, was countered by Divs 6B and 6C of the ITAA 1936 which tax certain unit trusts in a similar manner to companies (and were undoubtedly the model for Div 5A in relation to limited partnerships). Div 6B is applied if passive assets were moved out of companies into trusts owned by the shareholders. It has now been switched off but Div 6C will survive and we will concentrate on it. Company tax treatment applies if the unit trust is widely held (s 102P), resident in Australia (s 102Q) and is engaged in any business activities other than trading in securities or investing in land to hold and derive rent (ss 102M, 102N and 102R). Rather than simply equating the relevant trusts with companies as in Div 5A, the provisions spell out in more detail to what extent company tax concepts apply: ss 102L. Hence some differences between Div 6C trusts and companies still remain: CGT generally applies to unit trusts subject to Div 6C in the same way as other unit trusts, though there is an exception in respect of bonus units: see s 130-20(4); the trust loss rules and not the company loss rules apply to such trusts; and investors in these trusts are entitled to the CGT discount. More recently there has emerged a trend of widely owned businesses seeking to get the advantages of trust taxation to the maximum extent possible while not being subject to Div 6C. The most popular mechanism is a stapled unit trust and company under which the investor acquires a unit in a unit trust taxed under Div 6 linked with a share in a company which carries on the active business element that would otherwise trigger Div 6C. The linked [13.540]

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Income Derived Through Intermediaries

units and shares are traded together on the stock exchange (ie an investor cannot sell the unit without selling the share in the same transaction and vice versa). The best-known example is the restructure of the Westfield shopping centre group in 2004 (see CR 2004/51, CR 2004/56), but there are many others. In turn Div 6C has been amended to allow a broader range of permitted activities, particularly in the property industry, without falling within Div 6C, and to allow stapled trusts to restructure back into a unit trust though controlling a trading business in a company.

(l) Managed Investment Trusts [13.545] We have noted already that while the promised reform to the rules in Div 6 ITAA

1936 has not materialised, the project to reform the regime for taxing certain types of widely-held trusts has now been largely completed. In February 2008, the Treasurer commissioned the Board of Taxation to undertake a review of the tax regime applying to managed investment trusts (“MITs”) – ie trusts which are widely held, managed by professional fund managers, and undertake primarily passive investment activities. The project formed part of a larger government initiative at the time trying to make Australia a major regional centre for financial transactions in Asia. During the course of the next 8 years a number of measures were gradually introduced: • changes to the rate and method of taxing non-residents investing in Australian MITs, through the introduction of a final, flat-rate “MIT withholding tax” levied at 15% – Div 840-M of the ITAA 1997 and Div 12-H of the Tax Administration Act 1953, • mandating CGT treatment for gains and losses made by MITs on most of their assets, on the basis that most of their investors would have been making capital gains or losses had they owned the assets directly instead – Div 275-B of the ITAA 1997, • changes to allow restructuring of some trusts and new MIT structures to operate by amending to Div 6C – s 102NA of the ITAA 1936 and Div 124-Q of the ITAA 1997, • changes to the range of activities from which MITs are effectively excluded by the threat of being taxed as companies under Div 6C – s 102MA – 102MD, • switching off Div 6B, and • the creation of a new paradigm for taxing income earned through a MIT. Under this measure, which started for 2016, the tax liability of residents investing in some kinds of MITs is determined by a so-called “attribution regime”, instead of the notion of “present entitlement” expressed in the current rules in Div 6. (i) MITs, WMITS and AMITs [13.550] Division 275-A of the ITAA 1997 sets out the requirements for a trust to be classified as a “managed investment trust”. The rules basically require: the trustee is a resident (s 275-10(3)(a)), the trust is not undertaking active business operations, either directly or through a subsidiary that it owns (s 275-10(4)), the trust is a managed investment scheme as defined in the Corporations Act (s 275-10), units are widely-held based on tests that vary according to the circumstances of the trust (ss 275-15, 275-20 and 275-25), ownership of units is not concentrated (s 275-30) and the fund is managed by an entity that holds an appropriate financial industry licence (s 275-35). A trust which is wholly-owned by a MIT is also a MIT (s 275-10(1)(b)). First, a trust which meets the MIT definition is eligible to make the election to treat many of its assets as held on capital account (s 275-115). CGT treatment extends principally to 738

[13.545]

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transactions with shares, units in trusts and land, consistent with the limited range of activities that MITs can undertake before they trigger Div 6C (s 275-110). Gains and losses made on debt instruments are not affected and so will likely give rise to statutory income or loss under the rules governing traditional securities (ss 26BB and 70B) and the TOFA regime (Div 230). While CGT treatment is notionally elective, s 275-115 provides that gains on realising (non-land) assets will be deemed to be on revenue account if the election is not made. Secondly, every trust which is a MIT is also subject to a non-arm’s length income rule in Div 275-L. Where the Commissioner makes a determination that a MIT has made non arm’s length income in current year, the trustee must pay tax on the excessive amount at the rate of 30%. This is intended to serve as a further brake on the incentive to shift income out of (related) companies and into MITs where it will be taxed in the hands of unitholders, potentially at the 15% withholding tax rate. Non-resident investors in a trust which meet this definition, and one more condition, may also be liable to withholding tax (instead of income tax) on amounts distributed to them. Division 12-H of the Tax Administration Act 1953 which sets out the rules for collecting amounts toward MIT withholding tax requires both that the trust is a MIT and that, “a substantial proportion of the investment management activities carried out in relation to the trust in respect of all of the following assets of the trust are carried out in Australia throughout the income year” (Sch 1, s 12-383). Where this is the case, the foreign investors pay a final, flat rate tax of 15%, instead of income tax at marginal rates under Div 6. Section 276-10 then creates a further sub-species of MIT – the attribution MIT (“AMIT”). A trust which is a MIT can elect to be an AMIT provided that the membership interests in the trust have “clearly defined rights to income and capital”. This means that the rights of unitholders cannot be affected by the exercise of unconstrained discretions or powers which the trustee could use to differentiate between unitholders in a preferential manner. Rights don’t have to identical; they just have to be clearly defined, most likely in the trust’s constitution. Section 276-15(1) adds two safe harbours: members will have clearly defined rights if the trust is registered as a “managed investment scheme” under the Corporations Act, or if the rights to income and capital of all membership interests are the same. Summary If … Trust is a MIT

Trust is a MIT

Trust is a MIT

and … then sufficient management occurs non-resident investors are in Australia subject MITWT, not income tax trustee makes CGT election gains and losses on certain assets automatically receive CGT treatment the trust and its investors are interests are clearly defined subject to the package of and trustee makes AMIT measures in the AMIT regime election (and not Div 6)

(ii) Package of measures for AMITs [13.555] Where a trust that meets the conditions in Div 275 to be a MIT elects to be treated as

an AMIT, a package of measures is then enlivened, including: [13.555]

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Income Derived Through Intermediaries

• the trust is deemed to be a “fixed trust” which assist the trust in satisfying the trust loss provisions discussed above, and for the rules about enjoying the benefits of franking – Div 276-B • a formal system is available which simplifies how to correct errors that have been discovered in calculating the taxable income of prior years (referred to as “unders and overs”). Under this system, errors can be “fixed” by making adjustments to amounts in the year the error is discovered, rather than having to fix the amounts in the year when the error occurred – Div 276-F • cost base adjustment rules exist to increase the cost base of units for CGT purposes – CGT event E10. You will recall the discussion above about how the cost base of units can be decreased under CGT event E4 when cash distributions exceed the amount of net income on which tax was paid. Under these rules, the cost of units in AMITs can also be increased for retained amounts – ie where the cash distributions are less than the amount of net income on which tax was paid. But the main objective of these rules was to enact a new income attribution mechanism for unitholders in AMITs. Under these rules, an amount is included in the assessable income, exempt income and so on, of unitholders based on trustee’s decision about how much of the trust’s income etc to attribute to each beneficiary – Divs 276-C; 276-D; 276-E; 276-G; 276-H. The drafting in these provisions is quite impenetrable (even by the standards of tax laws!) but the operative rules such as s 276-80 (and there are several operative rules) refer to the “determined member component” of something and then provide that, “the member [is to be treated] as having derived, received or made the amount reflected in the determined member component in the member’s own right …” This is meant to convey the idea that the member must treat that amount as an amount of their own assessable income, exempt income, etc. The second part of s 276-80 then insists that we are to, “treat the member as having derived, received or made the amount reflected in the determined member component … in the same circumstances as the AMIT derived, received or made that amount, to the extent that those circumstances gave rise to the particular character of that component.” This formula is the drafter’s attempt at capturing the proposition that a trust is simply a conduit which does not affect the character of amounts earned through it, so if the trust earned an amount of foreign source interest then the unitholder is also deriving foreign source interest, in case that matters. This is the end of a longer administrative process described in huge detail in the legislation: the trustee must identify various components of its income and tax offsets (s 276-260(2)) and then record what it has discovered by making a written determination (s 276-255). A portion of each component on that piece of paper is then attributed to members (s 276-210(2)) by the trustee which then reports amount attributed to the member by sending an AMMA statement (Div 276-H). The amount shown on the AMMA statement is the determined member component (s 276-205), which is the end of the chase. The AMMA statement actually plays a critical part in the process because it effectively determines the amount on which unitholders are taxed. In this document the trustee must notify every entity who was a member at any time during the year of the amount and character of components allocated to the member by the trustee, and the amount of any adjustment to the member’s cost base in its units. The AMMA statement must be in writing and delivered within 3 months of the end of each income year. At various places in these rules the legislation recognises that these processes may not work correctly – estimates may prove to be wrong, new information may be discovered, calculation mistakes can happen, and so on. The 740

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legislation permits trustees to revisit the various determinations and re-issue AMMA statements. However, the legislation imposes a 4 year time horizon on fixing mistakes in this manner – a document issued after 4 years cannot be an AMMA statement. It is not obvious that this new formulation – replacing “presently entitled” with trust components that have been “attributed” – actually changes current law or practice in any meaningful way. Under Div 6 a unitholder would include in assessable income the share of the net income of the trust estate to which they are presently entitled; they really only know what that amount is and what is composed of because the trustee sends a periodic distribution statement along with the cheque. Under Div 276 a unitholder will include in assessable income the share of the trust component attributed to them; they will know what that amount is and what it comprises because the trustee will now send an AMMA statement along with the cheque. Perhaps the major change has nothing to do with “attribution” per se; the regime seems to make the AMMA statement conclusive of the unitholder’s liability. Section 276-205 says the “determined member component” (which is the thing that has tax consequences for unitholders under s 276-80) “is the amount … as reflected in the AMIT’s latest *AMMA statement …” This gives the new piece of paper an authority which distribution statements do not have. In most cases, the operative rule in s 276-80 will include amounts, and trigger their tax effects, in the hands of the unitholders but there are circumstances where the trustee can be taxed instead: • if the unitholder is a non-resident and the trust is not a WMIT. In this case s 276-105(2) imposes tax on the trustee in a manner similar to s 98; • where there has been a break-down in the mechanics of the attribution process such as, the trustee failed to allocate all of the component to members (s 276-415) or the amounts shown on the AMMA statements don’t add up to 100% of that component (ss 276-405, 276-410); and • the trustee must pay tax on the excessive portion of any non-arm’s length income (s 275-605). Notice that the general trust regime in Div 6 is switched off for a trust that is an AMIT (s 95AAD). It effectively makes these rules the tax system for investors in the large commercial trusts operating in the funds management sector and the property industry, and the trustees of those trusts.

4. INCOME SPLITTING AND DIVERSION [13.560] There have been two main forms of lowering tax within a family group – splitting

income among the members of the family to the maximum extent possible and diverting income from individuals taxed at maximum marginal tax rates to intermediaries (mainly companies but also superannuation funds) taxed at lower rates. So far as income splitting is concerned, assignments of income were used in the past but these have been more or less entirely superseded by the use of partnerships, trusts and companies. Income splitting with underage children has also disappeared because of Div 6AA considered above.

(a) Assignments of Income [13.570] Under the rules of property law and equity it is possible to shift income from one person to another by a transfer of the income stream. The easiest way to achieve such a [13.570]

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Income Derived Through Intermediaries

transfer is by assigning the property giving rise to the income stream. It is a common feature of human nature that property owners are unwilling to relinquish ultimate control of their property (and with it control of family members). Hence transferors tried to assign only the income to the transferee, retaining ownership of the underlying asset which generated the income. The general law on assignment of income not surprisingly came to be developed in Australia in tax cases, most notably Norman v FCT (1963) 109 CLR 9, Shepherd v FCT (1965) 113 CLR 385 and FCT v Everett (1980) 143 CLR 440. These cases demonstrated three different situations. First, there is an assignment of a right to future income from property (or an expectancy) which is only legally effective under the law of property and equity if made for consideration (Norman). Second, there is an assignment of a presently existing right to income from property which is effective under the law of equity and property even if made as a gift (Shepherd). Third, there is an assignment of the property itself and along with it the income from the property, likewise effective if made as a gift (Everett). It might be asked why tax consequences should turn on arcane features of the law of property and equity, but nowadays the question is unimportant, as a number of features of the tax law have rendered income assignments unattractive. In the first place, there is Div 6A introduced in 1964, the full force of which only came to be realised in the 1980s. These provisions reverse the tax operation of an assignment of a “right to receive income from property” that “will or may” terminate within a period of less than seven years from the first payment of income under the assignment (as opposed to an assignment of the underlying property). Second, the introduction of the CGT in 1985 meant that such assignments could amount to the disposal of (part of) a CGT asset so that a capital gain could arise depending on the cost base of the asset and the operation of the market value substitution rules (as many assignments were gifts). For situations such as Norman, where there is no existing property that can be disposed of, there is even a special CGT event E9 which purports to tax the assignor on the “market value the property would have had if it had existed when you made the agreement …” Third, the second strand of the reasoning in the Myer Emporium case (see Chapter 5), reinforced by s 102CA in Div 6A of the ITAA 1936 that was passed to achieve the same result, means that any consideration received for assignment of a right to receive income from underlying property which is not itself assigned will be assessable income. Finally, the enactment of Div 6AA in 1980 effectively limited the range of potential assignees to spouses and adult children. The operation of Div 6A was considered in Booth v Commissioner of Taxation (1987) 164 CLR 159. The taxpayer, who worked for the ATO, made a number of assignments for more than seven years of a percentage of the rent from a commercial property he owned. The assignments were to his spouse and to a family trust. During the period of the various assignments the property was let for three years with an option to renew for a further three years and on a weekly basis during renovations to the property. The ATO assessed the income subject to the assignments to the taxpayer under Div 6A. The High Court agreed with the ATO.

Booth v Commissioner of Taxation [13.580] Booth v Commissioner of Taxation (1987) 164 CLR 159 Mason CJ: It is possible to assign immediately a present right to future income, independently of

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the proprietary right which generates that income, before that income arises. Shepherd is an

Partnerships, Trusts and Income Splitting

Booth v Commissioner of Taxation cont. illustration of such an assignment. But, as Norman demonstrates, in some cases it may be impossible to identify a present right to future income divorced from the proprietary right which generates that future income. In such cases an attempted assignment deals with future property or an expectancy and operates to vest the future income in the assignee as and when that future income accrues due, but not before it accrues due. Accordingly, the assignment would not be effective to prevent the income being derived or being deemed to be derived by the assignor. When s. 102B(1) is examined … it is evident that the sub-section was directed to transfers (or assignments) of a right to receive income capable of transfer (or assignment), not to the owner’s abstract right to income from his property. The expression “right to receive income from property” naturally embraces a presently existing chose in action, such as the right to payment or royalties which was the subject of the assignment in Shepherd. Whether the expression also embraces a right not presently existing, to receive income from property, that is, an expectancy, is another question. It is perhaps possible that the definition of the expression in s. 102A(1), when it spoke of a “right to have income that will or may be derived from property paid to … the person owning the right”, was intended to comprehend an expectancy, such as the payment of future interest on a loan repayable at any time, which was the subject of the attempted assignment by way of gift in Norman. And s. 102A(2) provided that a reference to a transfer of a right to receive income from property should be read as a reference to any such transfer. However, s. 102B(1) was directed to transfers which would have effectively alienated income for tax purposes, but for the operation of the sub-section. It is expressed to apply to “income that, but for the transfer, would have been included in the assessable income of the transferor”. On the view which I have expressed an assignment of future income before it accrued to the assignor would not be effective for tax purposes to alienate that future income.

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But if the would-be present assignment for value of an expectancy is an assignment of a right to future income, for example, the right to rent under a lease to be entered into subsequently, there are strong reasons for thinking that the assignment falls within the purview of Div. 6A of Pt III. True it is that the language of the subsection naturally contemplates the transfer of a right to receive income which has an existence antecedent to the transfer. However, the equitable assignment of future property as and when it comes into existence answers the statutory description. Moreover, it conforms to the object of Div. 6A as an anti-tax avoidance measure to treat the provisions as having an application to equitable assignments of this kind. Otherwise, Div. 6A would be easily circumvented and fail in its purpose. 17. Section 102B(1) applies only in those cases in which the period for which the right to receive income is assigned, otherwise than by will or codicil, will or may, for any reason other than the death of any person or his becoming under a legal disability, terminate before the prescribed date. The words “that will, or may … terminate before the prescribed date” govern the period for which the transfer of the right to receive income is to subsist. They do not relate to the right which is the subject of the transfer. Does it follow that, so long as a right to receive income from property is transferred for a period which will not terminate before the prescribed date, the transfer is immune from the operation of s. 102B(1), even if the right to receive income itself will or may terminate before that date? If the language of the subsection could be construed as evincing an intention not to strike at transactions by which a transferor deprives himself of the right to receive income for the stipulated period, there might be a case for giving an affirmative answer to the question. But the sub-section applies to transfers, not transactions, and it is therefore not to the point that the taxpayer deprives himself by contract of the right to receive income for the stipulated period unless the contract operates as a transfer for that period. Moreover, there was simply no point in excluding a transfer for seven years or more which was not susceptible of earlier termination if the right to receive income thereby transferred [13.580]

743

Income Derived Through Intermediaries

Booth v Commissioner of Taxation cont.

income transferred for short periods to be included in assessable income of transferor.”

would terminate or was itself susceptible of termination within the stipulated period. That the object of Div. 6A was to strike at alienations of the right to receive income for less than the stipulated period appears not only from the terms of s. 102B(1) but also from the heading to the section. The heading is in these terms: “Certain

Once this is accepted, it is inescapable that the present assignments fall foul of s. 102B(1). At no time could it be said that a right to receive income was transferred for a period which would or might not terminate before the prescribed date.

[13.585]

Questions

13.47 Wife transfers to Husband for an eight-year period for consideration of $100 the right to interest on a $100,000 10-year loan made by Wife which may be repaid at any time by the borrower. Is the assignment effective at law? Is the assignment effective for tax purposes so that the interest is taxable to Husband? Is the $100 or some other amount assessable to Wife? If one payment of interest was due but not paid at the time of the assignment, who is taxable on that payment? (See Gair v FCT (1944) 71 CLR 388 per Latham CJ, Norman per Windeyer J, Div 6A of the ITAA 1936 and Divs 104, 108-A and 116 of the ITAA 1997.) 13.48 Husband assigns to Wife the gross rent on a 10-year lease which has eight years to run. In consideration, Wife agrees to meet the outgoings on the leased property. Is the assignment effective at law? Is the assignment effective for tax purposes so that the rent is taxable to Wife? If so is Wife entitled to deductions for the expenses? If not, what happens to the expenses? Is Husband assessable on any amount in relation to the transaction? Would it make any difference if the lease contained a provision that Husband could terminate the lease for non-payment of rent (an almost invariable provision of a lease)? Would it make any difference if Husband assigned the net rent? (See Norman, Shepherd, Booth, Div 6A of the ITAA 1936 and Divs 104, 108-A and 116 of the ITAA 1997.) 13.49 Employee assigns one-half of next year’s wages to Spouse for $100. Is the assignment effective at law? Is the assignment effective for tax purposes so that the wages are assessable to Spouse? Is the $100 or some other amount assessable to Employee? (See Parsons, Income Taxation in Australia [13.32]–[13.49].)

(b) Splitting and Diversion of Income Through Intermediaries [13.590] Although assignments of income have fallen out of favour, income splitting has not. It is still a common practice easily and directly achieved through intermediaries such as partnerships, trusts and companies. Family members (apart from underage children for whom Div 6AA of the ITAA 1936 remains a barrier) may in most cases become partners in a partnership, beneficiaries in a trust (unit or discretionary) or shareholders in a company without necessarily making any significant contribution in capital or labour to the intermediaries. Income can then be allocated to them either on a fixed or discretionary basis, either in that capacity or in some cases as employees of the intermediary. At first glance it may be thought that discretionary income entitlements are the preserve of the discretionary trust, but this is not the case; for example, the articles of association of a company can provide that the directors may pay such dividends on such shares as they wish or the board of management 744

[13.585]

Partnerships, Trusts and Income Splitting

CHAPTER 13

of a partnership may determine the income entitlements of the partners at their discretion. Through these mechanisms, the real controller of the intermediary can seek to split income while maintaining control of the underlying assets producing the income. When the tax capacity of family members apart from underage children has been utilised (ie income has been allocated to them to use up the lower rates of individual tax), the next step in the process is the diversion of further income to another intermediary which is taxed on its own right and whose members are only taxed on a distribution basis, rather than an attribution basis. The obvious candidate is a family company taxed on its taxable income at 30% (with future reductions promised) as a partner in a partnership or as a beneficiary in a trust. This device is commonly used in practice. So far as a business or investment is owned by the company, lower tax rates can be preserved simply by not distributing its income. If the shareholders need the cash in the company, attempts may be made to extract it in a tax-free form. Apart from Div 6AA, there are very few mechanisms that seek to control the initial splitting or diversion of the income, though there are more rigorous rules that seek to prevent the extraction of cash from private companies in tax-free form in Div 7A of the ITAA 1936 (considered in the next chapter). In relation to partnerships, some curb in the form of high tax rates is provided by s 94 of the ITAA 1936 which applies if “the partnership is so constituted or controlled, or its operations are so conducted that the partner has not the real and effective control and disposal” of net income included in the partner’s assessable income under s 92. While this was relatively easy to apply to underage partners, it is much more difficult to apply to adult partners unless the control is spelt out clearly, which is not the case in most family situations. With the introduction of Div 6AA, income of underage children was excluded from s 94 and the section does not apply to company partners: s 94(1)(a). The section has very complex provisions for trustee partners which were held in Trustees of the Lisa Marie Walsh Trust v FCT (1983) 14 ATR 399, 83 ATC 4415 to be defective in many cases. The section has largely been forgotten. The same applies to s 102 which is intended to deal with trusts set up to divert income to family members. It applies if the person who created the trust “has power to revoke or alter the trusts to acquire a beneficial interest in the income derived by the trustee … or the property producing that income” or “income is, under that trust … payable to or accumulated for, or applicable for the benefit of a child or children of that person who is under the age of 18 years”. If the section applies, the ATO may assess the trustee to pay tax on the trust income as if it were added to the income of the person who created the trust. The income is then not otherwise taxable to the beneficiary or the trustee. But two decisions of the High Court of Australia rendered the section largely redundant. In Hobbs v FCT (1957) 98 CLR 151; 6 AITR 490 it was effectively held that the section did not apply to an accumulation trust if the underage beneficiary was not presently entitled to the trust income, because the income was not applied for the benefit of the beneficiary and if the income would pass elsewhere if the child died before reaching a certain age. In other words, the trust was not like that in Taylor’s case (extracted at [13.340]) but was a typical accumulation trust. If the income could pass elsewhere it did not fit within the words of s 102. And in Truesdale v FCT (1970) 120 CLR 353, the accountant who acted for a father set up a trust for the benefit of the father’s underage son and provided a nominal amount of capital for the trust by way of settlement. The father then “fed” substantial property into the trust. The [13.590]

745

Income Derived Through Intermediaries

accountant was not reimbursed by the father for the nominal capital provided to the trust. Menzies J held, notwithstanding a New Zealand decision to the contrary, that the father had not “created” the trust within the terms of the section, rather the accountant had created it. To this day, most family trusts are set up in this way to avoid the application of s 102 (the adviser will also not have power to revoke the trust and get a beneficial interest under it so that s 102(1)(a) is also avoided). As with s 94 subsequent events, particularly the tax rates applied under Div 6AA, but also the 46.5% top personal rate under s 99A, have largely overtaken s 102 and it is not nowadays raised by the ATO. Apart from Divs 85 – 87 of the ITAA 1997 on alienation of personal services income considered in Chapter 4, there are no other real attempts to control diversion of income to companies to take advantage of the corporate tax rate or through other intermediaries to companies by specific provisions in the income tax legislation, apart from the provisions considered under this heading or earlier in the chapter. The ATO also tries to attack diversions of services income earned by non-employees under general deduction principles or under the general anti-avoidance rule. Starting in 2003 the ATO began to apply Phillips case (see Chapter 7) more rigorously to ensure that charges by service trusts and companies of professional firms were at market rates, and this campaign has had some success. TR 2006/2 sets out the ATO’s thinking about where the limits on this kind of income splitting lie. On the other hand, an attempt to apply Pt IVA of the ITAA 1936 to services income diverted from an individual to intermediaries failed, as there were good commercial reasons for the diversion in FCT v Mochkin (2003) 52 ATR 198, though the ATO has had success in the past under s 260 of the ITAA 1936: see FCT v Gulland, Watson, Pincus (1985) 160 CLR 55. These issues are considered further in Chapter 20 on tax avoidance. But the ATO has largely conceded in TD 95/4 that if a taxpayer wants to have all their investments owned by the family company where the income is taxed at the corporate rate, instead of owning the assets directly and paying personal income tax rates, this option is open and isn’t amenable to challenge under Part IVA.

746

[13.590]

CHAPTER 14 Taxation of Companies and Shareholders [14.10]

1. INTRODUCTION........................................ ................................................. 749

[14.20]

(a) A Company is a Separate Taxpayer ....................................................................... 750

[14.30]

(b) Company, Public Company, Private Company, Resident Company ...................... 751

[14.60]

(c) Introduction to the Dividend Imputation System ................................................. 752

[14.80]

2. SHARES AND SHAREHOLDERS .............................. ...................................... 753 FCT v Patcorp Investments Ltd .................................................................................... 753

[14.90]

[14.120] 3. DIVIDENDS, PROFIT AND CAPITAL........................... .................................. 754 [14.130]

(a) Dividends ............................................................................................................ 755

[14.140] [14.160]

(b) Returns of Share Capital ...................................................................................... 756 FCT v Consolidated Media Holdings Ltd ....................................................................... 756

[14.180] [14.200] [14.230] [14.270] [14.290]

(c) Out of Profits ....................................................................................................... FCT v Slater Holdings Ltd ............................................................................................ Ruling TR 2012/5 ...................................................................................................... Condell v FCT ............................................................................................................. FCT v Uther ...............................................................................................................

[14.310] [14.320] [14.340]

(d) When is a Dividend Paid? .................................................................................... 765 Bluebottle UK Ltd v DCT ............................................................................................. 766 Brookton Co-operative Society Ltd v FCT ...................................................................... 767

[14.350]

(e) Bonus Shares ....................................................................................................... 768

[14.360] [14.410]

(f) Deemed Dividends from Private Companies ......................................................... 769 DFC of T v Black ......................................................................................................... 771

757 757 759 762 763

[14.450] 4. THE DIVIDEND IMPUTATION SYSTEM ........................ ............................... 773 [14.450] [14.460] [14.480]

(a) Policy of Dividend Imputation ............................................................................. 773 Taxation Review Committee ........................................................................................ 774 A Tax System for Australia in the Global Economy ......................................................... 776

[14.500]

(b) The Basic Scheme: Franked Dividends Paid to a Resident Individual ..................... 778

[14.530]

(c) Frankable Distributions ........................................................................................ 779

[14.540]

(d) Franking Accounts and Franking Deficit Tax ......................................................... 779

[14.560] [14.570] [14.600] [14.610]

(e) Imputation through Interposed Entities ............................................................... 781 (i) Interposed company ............................................................................................. 781 (ii) Interposed partnership ........................................................................................ 782 (iii) Interposed trust .................................................................................................. 782

[14.620] [14.620] [14.640] [14.650] [14.660]

(g) The Limits of the Imputation System ................................................................... (i) Imputation does not apply to profit untaxed in Australia ...................................... (ii) Imputation does not apply to taxed foreign profit ............................................... (iii) Imputation is of limited benefit for non-resident shareholders ............................. (iv) Imputation and the debt/equity distinction ........................................................

783 783 783 784 786 747

Income Derived Through Intermediaries

[14.680] 5. DEBT AND EQUITY ...................................... ............................................... 787 [14.700] [14.710]

(a) Division 974 ........................................................................................................ 788 New Business Tax System (Debt and Equity) Bill 2001 .................................................. 788

[14.720]

(b) The Debt/Equity Rules in General ........................................................................ 789

[14.750]

(c) Debt Test ............................................................................................................. 792

[14.760]

(d) Equity Test ........................................................................................................... 793

[14.800] 6. INTEGRITY RULES ....................................... ................................................ 794 [14.800] [14.810] [14.830] [14.840]

(a) Distributions of Profit Disguised as Returns of Share Capital ................................. (i) Tainted share capital account rules ....................................................................... (ii) Distributions from capital deemed out of profits and not frankable ...................... (iii) Capital streaming rules .......................................................................................

794 795 795 795

[14.850] [14.860] [14.880] [14.900] [14.910] [14.920] [14.940] [14.970] [14.990]

(b) Streaming or Trading of Franking Credits ............................................................ (i) Benchmark rule .................................................................................................... (ii) Linked distributions ............................................................................................. (iii) General anti-streaming rule ................................................................................. (iv) Securities loans ................................................................................................... (v) 45 day/at risk rules .............................................................................................. (vi) General anti-avoidance rule for franking credits .................................................. Mills v FCT ................................................................................................................. (vii) Dividend stripping .............................................................................................

797 797 798 799 799 800 801 803 806

[14.1000] 7. COMPANY LIQUIDATIONS ................................ ......................................... 806 [14.1000] (a) In General ........................................................................................................... 806 [14.1010] FCT v Uther ............................................................................................................... 806 [14.1030] (b) The Archer Brothers Principle ............................................................................... 807 [14.1040] Archer Brothers Pty Ltd v FCT ...................................................................................... 807

Principal sections ITAA 1936 s 6(1)

s 6BA s 44

ITAA 1997 Subdivs 960-E, 960-F, 960-G, s 995-1 Subdiv 130-A –

ss 45, 45A, 45B – s 47 – s 103A

–

s 109, Div 7A of Pt III s 128B(3)(ga)

–

s 177E

–

748

–

Effect The definitions of “company”, “share”, “shareholder”, “dividend”, “entity”, “corporate tax entity”, “distribution”, “member”, “membership interest”. Dividend and capital treatment of bonus shares. Dividends paid out of profits included in the assessable income of a shareholder. Capital streaming anti-avoidance rules. Dividend and capital treatment of liquidation distributions. Definition of “private company” and “public company”. Deemed dividends where disguised profit distributions by private companies. Exemption from dividend withholding tax on franked dividends. Dividend stripping schemes.

Taxation of Companies and Shareholders

ITAA 1936 s 177EA

ITAA 1997 –

Div 1AA, Pt IIIA –

–

–

s 26-26

– – – – – – – –

s 59-40 Div 67 s 104-25 s 104-135 Div 197 Pt 3-6 Div 202 Div 203

–

Div 204

– –

Div 205 s 207-20

–

Subdiv 207-F

–

Div 208

– –

Div 974 ss 974-15, 974-20 ss 974-70, 974-75 s 974-130 s 974-135 s 975-300

– – – –

s 25-85

CHAPTER 14

Effect General anti-avoidance rule for franking credit trading and streaming. The “45 days/at risk” rules which define persons qualified for franking credits. Deductions allowed for dividends on non-equity shares. Deductions denied for interest on non-share equity and dividends on share equity. Exemption for issue of rights to acquire shares. Refunds of excess franking credit offsets. CGT event C2 on termination of shares. CGT event G1 on return of share capital. Tainted share capital accounts. Imputation system. Allocation of franking credits to a franked dividend. Benchmark rule to prevent streaming of franking credits. Additional anti-avoidance rules to prevent streaming of franking credits. Franking accounts of a company. Dividend grossed-up for franking credit and tax offset allowed for franking credit. Anti-avoidance rules for schemes to manipulate imputation system. Quarantining of franking credits of companies owned by non-residents and tax-exempts. Tests to identify “equity” and “debt” interests. “Debt test”. “Equity test”. Financing arrangement. Effectively non-contingent obligation. The definition of “share capital account”.

1. INTRODUCTION [14.10] This chapter examines the taxation of Australian resident companies and their

shareholders. Australian income tax applies to a company as a taxpayer separate and distinct from its shareholders. Currently, tax is levied on most companies at a rate of 30%. Effective 1 July 2015, small companies (with turnover of less than $2 m) have a tax rate of 28.5%. The Liberal-National Coalition Government introduced the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 which, if passed by the Parliament, will gradually reduce the company tax rate for all companies from 30% to 25% over 10 years by 2026-27. This reduction was recommended by the Henry Tax Review (2009). In Examples in this chapter, 30% is generally used as the company tax rate. When company profits are distributed to [14.10]

749

Income Derived Through Intermediaries

shareholders, income tax is levied on the distribution in the hands of the shareholders at their marginal tax rates. Australian resident shareholders may be entitled under the imputation system for a credit in respect of the company tax that has been paid. Company tax makes a significant contribution to Australia’s tax revenues. The 2016–17 budget papers estimated company tax revenues for 2015-16 of $64.7 b, out of total income tax collections of about $265 b. Australia’s company tax revenues are strongly affected by resource commodity prices and broader corporate profitability. Revenues are expected to decline because of the tax cut for small companies and more generous depreciation arrangements for small businesses (discussed in Chapter 10). Topics covered in this chapter are the definition of companies, shares and shareholders; distributions of profits and capital; debt and equity finance of companies; the operation of the dividend imputation system; and taxation of company liquidations. Australia’s corporateshareholder tax system needs to be understood in its international context because it draws fundamental distinctions between the treatment of Australian and foreign profits, and of resident and non-resident shareholders. Consequently, this chapter will also refer to the international tax treatment of companies and shareholders from time to time and reference should be made to the international tax chapters where relevant. Topics covered in Chapter 15 include the application of capital gains tax and other rules to bonus shares, share buybacks, options and value shifting; tax regimes for company takeovers, mergers and acquisitions including scrip for scrip and demerger rollovers; the rules that limit carry-forward and utilisation of company losses; and an introduction to the taxation of consolidated corporate groups. Australian company-shareholder taxation has historically used many of the same concepts as company law, derived from both statute and cases – such as “shares”, “dividends”, “profit” and “share capital”. The main statutory regime regulating companies in Australia today was radically reformed in 1998. It is now in the Corporations Act 2001 which has been further amended. The income tax law has not always kept pace with changes to company law, and this has caused uncertainty about some concepts. Some company tax concepts, such as dividend imputation, “debt interest” and “equity interest”, are specific to the tax law.

(a) A Company is a Separate Taxpayer [14.20] Under the Australian legal system a company has a separate legal personality which

makes it a useful vehicle for business and investment activity. A company can hold property, conduct business, enter contracts, sue and be sued, and continue to exist despite any change in its ownership. In Gas Lighting Improvement Co Ltd v IRC [1923] AC 723 at 740-1, Lord Sumner said: Between the investor, who participates as a shareholder, and the undertaking carried on, the law interposes another person, real though artificial, the company itself, and the business carried on is the business of the company, and the capital employed is its capital and not in either case the business or capital of the shareholders.

The income tax law follows the general law in treating the company as being, in its own right, a separate taxpayer (s 4-1 of the ITAA 1997). A company calculates a separate taxable income and pays tax on its own taxable income. Companies are not eligible for the CGT discount on disposals of their assets. Income tax is levied on the taxable income of a company, which files a tax return and pays tax in Pay as You Go (PAYG) instalments through the income 750

[14.20]

Taxation of Companies and Shareholders

CHAPTER 14

year. If a company has a tax loss, it can carry this forward to future years under s 36-17 of the ITAA 1997, subject to special restrictions requiring continuity of ownership and same business of the company (see [15.360] and [15.440]).

(b) “Company”, “Public Company”, “Private Company”, “Resident Company” [14.30] The term “company” is commonly used to refer to corporations formed as legal

entities under legislation such as the Corporations Act 2001 or equivalent laws in other countries. However, corporations can be formed under other laws, for example the Association Incorporation Acts of the various States, or statutes creating statutory corporations for specific purposes. For income tax purposes, “company” is broadly defined to include bodies corporate and also unincorporated associations of persons, which are not legal entities (s 995-1 of the ITAA 1997). Company taxation treatment is also extended to limited partnerships and public unit trusts (see definitions of “entity” and “corporate tax entity” in Subdiv 960-E and Subdiv 960F). A company acting as trustee is taxed in its capacity as trustee under the trust taxation rules discussed in Chapter 13. This chapter focuses primarily on incorporated companies with share capital and shareholders. The company taxation regime generally treats all companies in a similar fashion, be they multinational companies listed on the Australian Stock Exchange or family proprietary companies operating a small corner shop. In this respect Australian tax law is less flexible than jurisdictions such as the United States or New Zealand, where certain closely controlled companies can be established or elect to be taxed on a pass-through basis, like a partnership. [14.40] The term “private company” is defined, for most relevant purposes, in s 103A of the

ITAA 1936. The definition deems any ordinary limited liability company to be a private company unless it is a public company. A “public company” is defined, in general, to mean a company listed on a stock exchange, or a subsidiary of a public company. Complex anti-avoidance rules can deem a listed company to be a private company if 75% of its capital is controlled by 20 or fewer individuals. Integrity rules apply under Australian income tax law for a company which is a “private company” as compared to a “public company”. [14.50] Income tax law also draws a distinction between resident and non-resident companies.

A company will be a “resident” of Australia for income tax purposes if it is incorporated in Australia, or carries on business in Australia and has its central management and control in Australia or its voting power controlled by shareholders who are residents: see s 6(1) of the ITAA 1936 definition and [16.180]. [14.55]

14.1

Question

Which of the following is a company for income tax purposes? (1) an unincorporated non-profit netball association: see Case 86 11 CTBR; (2) a mining syndicate registered as a company under the Mining Partnership Act 1900 (NSW) which had a share capital, its shares were freely transferable and it had limited liability. However, it was not registered, nor was it required to register, as a company under the Companies Act 1936 (NSW) and it could not sue or be sued in its own name: see Case H73 (1957) 8 TBRD. [14.55]

751

Income Derived Through Intermediaries

(c) Introduction to the Dividend Imputation System [14.60] A tax system which levies income tax on profits of a company, and levies income tax

again when the taxed profits are distributed as dividends to shareholders, can be said to subject company profit to “double taxation”, on the assumption that shareholders bear company tax. Australia’s imputation system is intended to provide relief from such “double taxation”. The imputation system applies to the distribution of company profits by resident companies. A summary is provided here and we return to the detailed policy and imputation rules in Part 4 at [14.450] et seq. [14.70] Dividend imputation operates where a resident company pays Australian company

tax on its profit and distributes the profit to its shareholders. A resident individual shareholder, who receives a “franked dividend” that carries an imputation credit, paid by a resident company out of Australian source profits which have borne Australian company tax, is treated as receiving the pre-tax amount of distributed profit. The resident shareholder is permitted to apply the tax paid by the company as a “franking credit”, which is a tax offset against their income tax liability on their share of the pre-tax profit. So, for example, if a company derives taxable income of $100, and pays tax of $30, it can distribute a “franked dividend” of $70 to a resident individual shareholder. The shareholder is treated as having assessable income of $100 – calculated as the franked dividend of $70 plus an “imputation” credit of $30 for the company tax. If the shareholder has an individual tax rate of 47% (the top marginal rate plus the Medicare Levy), this rate is then applied to this “grossed up” dividend income of $100, but the imputation credit of $30 is applied against the personal tax liability of $47, leaving only $17 tax to be paid by the individual. If the individual had a lower tax rate, say, 15%, and was liable to pay tax of $15 on the “grossed up” dividend income of $100, he or she could apply $15 of the imputation credit to reduce the tax owed to nil, and claim a tax refund for the balance of $15. The end result for the resident individual shareholder is that the overall rate of tax on the distributed company profit equates to the shareholder’s individual marginal tax rate. It can be seen from this example that company tax functions under imputation as an advance payment of tax on behalf of resident shareholders on their share of the taxable Australian profit of resident companies. The company is, in effect, not taxed as a separate entity, but rather as the agent of the shareholders, earning income and paying tax on their behalf. [14.75] A non-resident shareholder who receives a franked dividend paid out of taxed profits

by an Australian resident company is taxed quite differently from a resident shareholder. Non-resident shareholders do not receive imputation credits. Instead, they are merely relieved from paying any further Australian income tax or dividend withholding tax on the franked dividend (they may, of course, still be subject to tax on the dividends in their home country). The dividend imputation system only offers relief from Australian “double taxation” on corporate profit. It does not provide relief where profit of resident companies from foreign sources bears foreign tax. A final important distinction in the company tax system is between debt and equity capital. The tax law presupposes a distinction between making an investment of capital in a company by way of holding shares in the share capital as a shareholder, and making an investment by way of advancing debt capital as lender or creditor to the company. Dividends are not deductible but subject to dividend imputation relief in the hands of the recipient. Interest is 752

[14.60]

Taxation of Companies and Shareholders

CHAPTER 14

deductible to the company (if incurred in deriving assessable income), and assessable to tax in the hands of the recipient. These limits in the dividend imputation system lead to various tax planning incentives and opportunities. We return to these below.

2. SHARES AND SHAREHOLDERS [14.80] The Corporations Act 2001 refers to “members” of a company, being persons entered

on the register of members of the company (s 231), rather than using the term “shareholder”. However, the income tax law still refers to “shares” and “shareholders”. A “share” is defined to mean a share in the capital of a company, and a “shareholder” includes a “member” of a company: s 6(1) of the ITAA 1936 and s 995-1 of the ITAA 1997. The shares of a shareholder are “membership interests” in the company as defined in Subdiv 960-G of the ITAA 1997. This general rule is subject to an important exception: if the shares constitute “debt interests” under the debt/equity rules in Div 974, although legally in the form of “shares”, they will not be treated as membership interests. The dividend imputation rules in Pt 3-6 of the ITAA 1997 apply to distributions on “membership interests” which satisfy the “equity test” under the debt/equity rules in Div 974: see [14.760]. This means that a distribution of a dividend on a share which is a “debt interest” is not able to carry an imputation credit. In FCT v Patcorp Investments Ltd (1976) 140 CLR 247 the High Court had to consider whether the term “shareholder” is limited to a person entered on the register of members of a company. The case involved a “dividend stripping operation” where the taxpayer companies acquired shares in a number of other companies at a purchase price based on their net assets, drew out large dividends which substantially depleted the net assets of the companies, then resold the shares at a lower price reflecting the reduction in net assets, and claimed a deduction for the loss on resale. The key to the dividend stripping operation was that, as the law then stood, the recipients of the dividends would be exempt from tax on the dividends so long as they were a “shareholder” in relation to the companies at the time they received the dividends. The opinion of the High Court is reflected in the extracts of the judgment of Gibbs J.

FCT v Patcorp Investments Ltd [14.90] FCT v Patcorp Investments Ltd (1976) 140 CLR 247 Gibbs J: I now turn to consider whether the appellant companies were shareholders in the stripped companies at the respective times when the dividends in those companies were declared and paid. By s. 6 (1) of the Act, “shareholder” is defined to include “member or stockholder”, but that definition provides no assistance in the present case, because in the case of a company limited by shares a member must be a shareholder. For present purposes, the terms “shareholder” and “member” are synonymous. Their meaning must be sought in the rules of company law. Section 16 of the Companies Act, 1961 (N.S.W.) … appear[s] to declare, in the

clearest possible way, that a person, other than a subscriber, does not become a member of a company until his name is entered on the register. [E]ntry on the register is necessary to constitute membership of a company, and the beneficial ownership of shares, without registration, does not make a person a share-holder. In my opinion it follows that none of the appellant companies was ever a shareholder in Austin. It is true that they became the beneficial owners of the shares in that company. However, no transfers of the shares were executed in favour of the appellant companies, no resolution was passed by Austin or its directors that the appellant companies be [14.90]

753

Income Derived Through Intermediaries

Patcorp Investments cont. registered and they never were registered. Since they were not shareholders they were not entitled to a rebate in respect of the sums which they received as a result of the declaration of dividends in that company. [One company,] Mining Traders, was clearly a shareholder in all the other stripped companies – it was duly registered as such – but registration was not effected until after the dividend had been declared. The registration, when effected, showed that Mining Traders had become a member on the date on which registration had been approved – a date which was before that on which the dividends were declared. The register correctly showed the date “at which” the name of Mining Traders was entered in the register (see s. 151 (1) (b) of the Companies Act), rather than the date on which its name was registered. According to

the register, therefore, Mining Traders was a shareholder in all the stripped companies (except Austin) when the dividends were declared. This is in my opinion sufficient for the purposes of ss. 44 and 46 of the Act. To depart from the register would lead to the practical inconvenience mentioned in Dalgety Downs Pastoral Co. Pty. Ltd. v. Federal Commissioner of Taxation (1952) 86 CLR 335. The present case of course is one in which the register does not need rectification – it is correct. If a person ought to have been on the register on a certain day and he is subsequently registered as from that day, speaking generally I consider that it should be held that he was a shareholder on that day. The registration, assuming it to be a proper registration, operates retrospectively from the date on which it was effected to the date at which the name of the shareholder was entered in the register.

[14.100] When a taxpayer beneficially owns shares in a company through an interposed trust

or partnership, they are not treated as a “shareholder” in the company for income tax purposes. However, the beneficial owners of dividends received through trusts and partnerships are eligible to receive franked dividends as if they were registered shareholders: Subdiv 207-B of the ITAA 1997 and see [14.600], [14.610]. [14.110] As a company is a separate legal person, a share in a company is a CGT asset of the

shareholder. Shareholders can choose to realise their interest in the profits accumulating in a company by disposing of their shares at a price which reflects those profits, rather than receive the profits as dividend distributions. Where shares are held as trading stock or as revenue assets of a shareholder, for example if the shareholder has a business of share dealing, gains on disposal of the shares will be ordinary income. Where shares are held on capital account, for example by ordinary investors, CGT is payable on the realisation of share gains by disposal of the shares. This reintroduces, to a limited extent, “double taxation” of corporate profit. However, for resident individuals who hold their shares for at least 12 months, the CGT discount will shelter half the capital gain from tax. Tax consequences of the disposal of shares and other transactions involving shares are discussed in Chapter 15.

3. DIVIDENDS, PROFIT AND CAPITAL [14.120] An implication of the principle that a company is a separate entity from its

shareholders is that when a company distributes its profits by way of a dividend to its shareholders, that dividend is assessable in the hands of the shareholders. The income tax law follows this principle. 754

[14.100]

Taxation of Companies and Shareholders

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(a) Dividends [14.130] A “dividend” is defined in s 6(1) of the ITAA 1936 to be any money or property

distributed to a shareholder, or any amount credited to a shareholder as shareholder, but excludes a distribution or amount debited to a share capital account of the company. In contrast, the term “dividend” is not defined in the Corporations Act 2001, which instead establishes rules that limit the circumstances in which a dividend can be paid by a company. The broad statutory definition of “dividend” for tax purposes means that a distribution may be a “dividend” even if it is unauthorised or illegal at company law (eg MacFarlane v FCT 86 ATC 4477). Some transactions between a company and a shareholder are deemed to be a “dividend” for tax purposes. A “distribution” in relation to a company is defined in s 960-120 of the ITAA 1997 to be “a dividend, or something that is taken to be a dividend, under this Act”. Section 44(1) provides that the assessable income of a shareholder in a company includes dividends paid out of profits of the company. Dividends are assessable under this provision and not as ordinary income under s 6-5 of the ITAA 1997. The concept of a “dividend” appears to require that the money or property is bestowed upon and received by the shareholder as their property, to be held unconditionally for their benefit. The concept also appears to require that the company be dealing with the shareholder in their capacity as a shareholder and not in some other capacity such as an employee or creditor or customer of the company (eg Summons (Kenneth A) Pty Ltd v FCT 86 ATC 4979; DFC of T v Black (1990) 90 ATC 4699; Campbell v CIR (NZ) (1967) 14 ATD 551, Lonsdale Sand and Metal Pty Ltd v FCT (1998) 38 ATR 384). The requirement that money or property be “distributed” to the shareholder seems to exclude the situation where a company creates new rights in a shareholder, for example by the issue of new shares to existing shareholders, or of options to subscribe for or sell back shares in the company. The case FCT v McNeil (2007) 229 CLR 656; [2007] HCA 5 concerned the issue of 272 “sell-back” rights (put options) to Mrs McNeil, an existing shareholder, in respect of her shares in St George Bank. The sell-back rights were issued to Mrs McNeil as part of a share buy-back scheme established by St George. They were tradable on the stock exchange and at the date of issue had a market value of $514. Both the taxpayer and the ATO agreed, and the High Court appeared to accept, that the issue of these rights was not a “dividend” (at para [42]). McNeil caused concern because it had generally been assumed that the issue of rights by a company to its existing shareholders, to buy or sell shares in the company, would not be taxable. The decision was reversed by statute for the issue to existing shareholders of call options (rights to acquire shares) but not for the issue of put options (rights to sell shares): s 59-40 of the ITAA 1997. In contrast to the issue of new shares or rights, the distribution of existing property owned by a company to its shareholders will be a “dividend” under the s 6(1) definition. For example, the in specie distribution by a company, Parent Co, of its shares in a subsidiary company, to the shareholders of Parent Co is a dividend: Condell v FCT (2007) 66 ATR 100; [2007] FCAFC 44. There is no specific rule as to the amount of an in specie dividend but s 21 of the ITAA 1936 appears to require that the market value of the property at the date of distribution is the amount of the dividend. This is the approach taken in Ruling TR 2003/8 [4] and it is implicitly accepted in the Condell case. [14.130]

755

Income Derived Through Intermediaries

[14.135]

14.2 14.3

Questions

Is a loan of money from a company to a shareholder, which the shareholder is legally obliged to repay, a distribution or crediting as required by the definition of “dividend”? A public company listed on the stock exchange is a toy retailer. Shareholders are permitted to purchase toys at a 10% discount at Christmas if they present their share certificate at the cashier. Is the discount a dividend assessable under s 6(1) and s 44(1)?

(b) Returns of Share Capital [14.140] When a company distributes money or property to a shareholder by way of a return

of amounts they have subscribed as share capital, those amounts are not generally assessable as a dividend to the shareholder, as they represent a return of the shareholder’s capital investment. The definition of “dividend” in s 6(1) of the ITAA 1936 excludes a distribution debited to a share capital account (in para (d)), and s 44(1) only includes in assessable income dividends paid “out of profits”. A “share capital account” is defined in s 975-300 of the ITAA 1997 (formerly s 6D of the ITAA 1936) to include an account which a company keeps of its share capital. If there is more than one such account, the definition deems them to be treated as a single share capital account for tax purposes. This deeming rule was introduced at the same time as various changes to company law and accounting. [14.150] The definition of share capital account was considered in a case concerning a share

buy-back by Crown Ltd (the Melbourne casino company) from the taxpayer (FCT v Consolidated Media Holdings Ltd [2012] HCA 55). It is important to identify the share capital account for purposes of the buy-back rules because a portion of a buy-back price may be treated as a dividend and a portion may be treated as a return of capital, depending on the account debited by the company in the buy-back. In Consolidated Media Holdings, Crown had a Shareholders Equity Account and had created a Share Buy-Back Reserve Account especially for the buy-back. The High Court upheld the interpretation of Emmett J at first instance that both the Equity Account and the Reserve Account were accounts “of share capital” and were to be treated as a single account. In so doing, the High Court overturned the narrower approach taken by the Full Court of the Federal Court. See further discussion on share buy-backs at [15.80].

FCT v Consolidated Media Holdings Ltd [14.160] FCT v Consolidated Media Holdings Ltd [2012] HCA 55 (Full High Court) The Court: An aspect of legislative history that is of greater utility … is the contemporaneous commencement on 1 July 1998 of Pt 2M.2 of Ch 2M of the Corporations Law. [The share capital account definition] must be read in light of that Part’s replacement of the previous notions of a company having “accounts” and “accounting records” with the broader and more functional notion of a company having “financial statements” and “financial records”. The reference in [former s 975-300] s 6D(1)(a) to “an 756

[14.135]

account which the company keeps of its share capital” (emphasis added) cannot in that light be confined, in the manner suggested by the Full Court, to the account “to which the paid up capital of the company was originally credited” or to “one in which a company ordinarily keeps its share capital on contribution” (emphasis added). Much less can it be confined … to an account which the company kept of its share capital on 1 July 1998.

Taxation of Companies and Shareholders

Consolidated Media Holdings cont. The word “account” in s 6D doubtless referred to a record of debits and credits relating to a designated topic. … In a context in which the relevant record-keeping obligation of a company under Pt 2M.2 of Ch 2M of the Corporations Law was to keep written financial records that correctly recorded and explained its transactions and financial position and performance and that

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would enable true and fair financial statements to be prepared and audited, it was sufficient for an account to answer the description in s 6D(1)(a) of “an account which the company keeps of its share capital” (emphasis added) that the account, whether debited or credited with one or more amounts, be either a record of a transaction into which the company had entered in relation to its share capital, or a record of the financial position of the company in relation to its share capital.

[14.170] A distribution debited to the share capital account that is not a dividend will be dealt

with under CGT event G1 or C2. If a capital return is carried out by paying an amount per share to shareholders, but without cancelling or redeeming the share, the relevant event is CGT event G1: s 104-135. The return of capital will reduce CGT cost base, but not give rise to a gain unless the amount returned exceeds the cost base; the CGT discount can apply to this event: Div 115. If a capital return is carried out by making a capital payment in redemption or cancellation of the share, CGT event C2 applies: s 104-25. The termination of the share interest is a taxable CGT event, and a capital gain emerges if the disposal proceeds exceed the cost base. The CGT discount can also apply to this event.

(c) Out of Profits [14.180] Section 44 of the ITAA 1936 provides that a dividend is only assessable to a

shareholder if it is paid “out of profits” derived by the company from any source. This notion is consistent with a long tradition in Australian cases, relevant to both company law and tax law requirements for a dividend. [14.190] In FCT v Slater Holdings Ltd [1984] HCA 78; (1984) 156 CLR 447 the High Court had to consider whether “profits” is limited to profits recognised as taxable income, or whether it had a broader meaning. The company was limited by guarantee and it made a distribution to a person who was a “member” rather than a holder of shares. Under s 254SA of the Corporations Act 2001, a company limited by guarantee may not, today, pay a dividend to its members. However, this does not affect the authority of this case on the concept of “profits”. The opinion of the Court is reflected in these extracts from the judgment of Gibbs CJ:

FCT v Slater Holdings Ltd [14.200] FCT v Slater Holdings Ltd [1984] HCA 78; (1984) 156 CLR 447 Gibbs CJ: There is no dispute as to the source of the moneys that went to make up the dividend. The amount of $12,330.32 represented one-third of net capital gains totalling $36,990.96 which had resulted mainly from the sale of a shopping centre built and later sold by Ogg Holdings Limited. The amount of $12,000 was one-third of

a gift of $36,000 made to Ogg Holdings Limited by Mr William Ogg, Senior, on or about 2 June 1960. The balance of $2,569.68 represented one-third of revenue profits made by the company … Before us, counsel for the taxpayer abandoned the argument that the word “profits” in s.44(1)(a) [14.200]

757

Income Derived Through Intermediaries

Slater Holdings cont. of the Act refers only to profits of a revenue or income nature. As at present advised I can see no reason to doubt that the word includes capital profits … [T]he evidence in the present case shows that the components of the payment were identified – the sources of the payment are revealed. So much of the payment as represented one-third of capital profits reserve and one-third of the divisible revenue profits was clearly made out of profits. The remainder of the sum, whose source was the gift to the company, was also, in my opinion, paid out of profits. It is not always easy to determine what are profits out of which dividends ought to be paid. Although profit, in its ordinary sense, often means the excess of returns over the outlay of capital, Farwell J. said in Bond v. Barrow Haematite Steel Company (1902) 1 Ch 353, at pp 365-366, that the question whether there are profits available for distribution “is to be answered according to the circumstances of each particular case, the nature of the company, and the evidence of competent witnesses.” In answering the question, a starting point is provided by the well known definition of Fletcher Moulton L.J. in In re Spanish Prospecting Company, Limited (1911) 1 Ch 92, at p 98: “Profits” implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at the two dates.

I agree with the statements in In re Income Tax Acts (No. 2) (1930) VLR 233, at pp 245 and 250, that this dictum of Fletcher Moulton L.J. is not of universal application, and that each case must depend on its own circumstances. However, if the definition of Fletcher Moulton L.J. is taken as a guide, the amount of the gift in the present case contributed to an increase in assets and represented a profit. The other evidence in the present case reinforces that view. The amount paid was declared to be a dividend and that implies that it was paid out of profits. Moreover, there was expert evidence that the amount was to be regarded as a profit. Mr Cameron, a chartered accountant, deposed as follows: In my opinion a gift received by a company increases the net tangible asset worth of the company, is not paid in capital and is therefore properly to be regarded as profit. It is not a gain of a revenue nature and is therefore a profit of a capital nature. He was not cross-examined on that statement and there was no expert evidence to the contrary. It was argued on behalf of the respondent that a gift is not ordinarily regarded as a profit … Although a gift may be regarded as a windfall, and not in itself income, it seems hardly open to doubt that a company which had received a gift of money could distribute the amount by way of dividend to its shareholders. For the reasons I have given I consider that the amount received by the taxpayer was, as it purported to be, a dividend; it was a distribution of money paid by the company to a member and was paid wholly out of profits derived by the company. It was accordingly assessable under s.44(1)(a) of the Act.

[14.210] The concept of “profits” is not limited to realised gains or income. However, it is

dependent on recognition in some way in company financial statements. For company law and tax law purposes, it has long been accepted that if a “comparison between the state of a business at two specific dates” reveals appreciated assets that represent unrealised gain of the company, this may support a dividend. In Evans v DCT (SA) (1936) 55 CLR 80 at 101, the High Court considered “profits” in a provision similar to s 44. They made reference to a company’s balance sheet to identify that property it owned “represented surplus assets, that is, assets not required to make good issued share capital. This appears from the last preceding balance-sheet. … The word ‘derived’ does not connote that the profit must be a realized profit. 758

[14.210]

Taxation of Companies and Shareholders

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It is enough at least if it is an ascertained profit, ascertained by a proper account”. This statement in Evans was approved by the High Court in FCT v Sun Alliance Investments Pty Ltd (in liq) (2005) 222 ALR 286 which concerned whether unrealised gains recorded in company accounts were “profits” for the purposes of applying certain CGT loss limitation rules. From 1 July 2010, the Corporations Act no longer refers explicitly to payment of a dividend from “profits”. Section 254T of the Corporations Act 2001 now contains a more flexible rule that provides that a company must not pay a dividend unless: (a)

the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and (b) the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and (c) the payment of the dividend does not materially prejudice the company’s ability to pay its creditors. Assets and liabilities are calculated in accordance with company accounting standards in force at the time. At the same time, recognising this flexibility, the income tax law was amended by introducing new s 44(1A) of the ITAA 1936, which states confusingly that “for the purposes of this Act, a dividend paid out of an amount other than profits is taken to be paid out of profits”. These company and tax legislative changes have created confusion about the circumstances in which a company may pay dividends and the requirement for those dividends to be assessable to a shareholder. A separate question that is of some importance is in what circumstances a dividend may carry an imputation credit, that is, be franked by the company. We return to that question in [14.530]. [14.220] ATO Ruling TR 2012/5 addresses the operation of s 254T and the dividend tax

rules. The ATO appears to accept the advice of counsel, appended to the ruling, that the revision of s 254T does not change the common law requirement that a company must pay a dividend out of profits and the consequence that such a dividend will be assessable to the shareholder under s 44. Below is an extract from the (non-binding) Explanation to the ruling.

Ruling TR 2012/5 [14.230] Effect of the new section 254T of the Corporations Act 31. The Corporations Act previously provided that “a dividend may only be paid out of profits of the company” (“the profits test”). The phrase “out of profits” in the previous section 254T of the Corporations Act was generally accepted as a reference to retained or ascertained accounting profits of a permanent character. … 34. Although profits are no longer referred to in section 254T of the Corporations Act, the concept of profits as the source of a dividend payment continues to be relevant to the payment

of a dividend in compliance with section 254T, and to the assessment and franking of dividends for taxation purposes. 35. The ordinary meaning of “dividend” is a share of profits allocated by a company to its shareholders. In Henry v Great Northern Ry Co (1857) 27 LJ Ch 1 it was stated that a dividend is an appropriation of a share of a company’s profits, being the right of a shareholder to receive his aliquot proportion of the profits of the enterprise. According to Lindley LJ in Verner v General & Commercial Investment Trust [1894] 2 Ch 239 at 266: “dividends presuppose profits of some sort”. In an Australian context it has been [14.230]

759

Income Derived Through Intermediaries

Ruling TR 2012/5 cont. stated: “A dividend is a share of profits, whether at a fixed rate or otherwise, allocated to the holders of shares in a company”, per Beach J in Churchill International Inc v BTR Nylex Ltd (1991) 4 ACSR 693 at 696. 36. The better view appears to be that for the purposes of the Corporations Act and company accounting, dividends can only be paid from profits and not from “amounts other than profits”. The new section 254T of the Corporations Act imposes three specified additional prohibitions on the circumstances in which a dividend can be paid, as inherently a dividend can only be paid out of profits, having regard to the ordinary and legal meaning of the word dividend. … 38. Subsection 44(1A) was inserted into the ITAA 1936 to ensure that any company distributions that were not paid out of profits but were paid as dividends in reliance on the new section 254T of the Corporations Act would continue to be included in shareholders’ assessable income as dividends under section 44 of the ITAA 1936, by deeming such dividends to be paid “out of profits” for taxation purposes. This is subject to the exclusion of amounts debited against an amount standing to the credit of the share capital account that are not dividends for taxation purposes under the definition of dividend in subsection 6(1) of the ITAA 1936. … 41. A payment that is a dividend paid or credited in compliance with new section 254T of the Corporations Act will be an assessable dividend for taxation law purposes as well, provided it is not debited against an amount standing to the credit of the share capital of the company. … Profits 44. Profits must be recognised in a company’s accounts and be available for distribution by way of dividend. Profits can be recognised in the company’s annual financial statements for the preceding year, or in properly prepared half

760

[14.230]

yearly or interim financial statements for the current financial year. The source of the profits from which a dividend will be paid would usually be expected to be recorded in the directors’ minutes of the resolution determining to pay a dividend, or in the documentation that accompanies or supports the resolution. 45. If profits are applied against prior year losses or losses of share capital or otherwise applied or appropriated they will cease to be available for distribution by way of dividend. 46. In relation to the profits from which a dividend can be paid, in QBE Insurance Group Ltd & Ors v ASIC & Anor, NRMA Insurance Ltd v ASIC (1992) 38 FCR 270 at 286-287, Lockhart J stated: Plainly profits of a company available for dividend may be trading profits derived during the relevant financial year. Also, it is well established that capital profits, in the sense of profits earned on the realisation of capital assets, may be available for dividend provided there has been an accretion to the paid up capital: see Australasian Oil Exploration Ltd v Lachberg (1958) 101 CLR 119 at 133 and the cases there cited and Marra Developments per Mahoney JA at 629. The position with respect to unrealised accretions to the value of assets has been considered, though to a limited extent, in certain of the authorities. It has been held that unrealised accretions to the value of a company’s capital assets may be available for dividend where it is clear (and, by inference, only where it is clear) that the accretion in value is of a permanent character: see Dimbula Valley (Ceylon) Tea Co Ltd v Laurie (supra) at 371-372; Marra Developments at 629 … However, the authorities attach the rider that capital profits of this kind cannot be utilised for payment of dividend unless its paid up capital is intact. There must upon a balance of account be an accretion to the paid-up capital: Lachberg (at 133) and Marra (at 630).

Taxation of Companies and Shareholders

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[14.240] If a company fails to keep proper financial statements, its records are fraudulent or

inaccurate, or the distribution is in breach of the Corporations Act, the Commissioner may examine all of the facts and circumstances, and the substance of the distribution to a shareholder (consistent with MacFarlane v FCT 86 ATC 4477). This may occur if there has been a misappropriation of company money or property or unauthorised payments or dispositions of property. The Commissioner may treat this as a dividend out of profits for tax purposes even if it is not a dividend at company law, based on the definition of “profit” summarised above. [14.245]

14.4

Question

Acme Pty Ltd holds a block of land at Whitford’s beach which was acquired to be used for private purposes for the shareholders of Acme, John and Betty Whitford. The block cost $100,000, using share capital contributed by John and Betty. It has now risen in value to $200,000. What would be the position if Acme borrowed $100,000 from a bank under a mortgage secured over the land, and paid a dividend of $100,000 representing the increased land value to John and Betty?

[14.250] The different tax treatment of dividends and capital distributions creates

opportunities to avoid or defer tax on corporate distributions of profit, as long as directors comply with company law and establish a proper basis for the distributions in the company financial statements. Australia’s income tax law does not require the distribution of profits to shareholders to be made before any other distributions, in contrast to, for example, US tax law. Rather, Australia’s income tax law gives flexibility to a company that keeps proper financial records to choose to make a profit or a capital distribution under what is sometimes called the Archer Brothers principle, from a case which concerned a distribution by a company liquidator: see below at [14. 1040]. Suppose that Acme Pty Ltd raises $100,000 share capital by issuing 100,000 shares for an issue price of $1 each, and then applies the $100,000 capital to purchase a rental property, which it leases out and on which it derives $10,000 rental income, which is offset by deductions of $10,000 for a prior year tax loss. This leaves the company with $10,000 cash, and a $10,000 current year profit which it could pay out as a dividend to its shareholders. As no tax has been paid by Acme, this dividend could not be franked and so would be fully taxable in the hands of the shareholders. Does Acme have a choice to apply the $10,000 cash as a $10,000 return of share capital to its shareholders instead of a taxable dividend? It appears that Acme may indeed do this, in compliance with company law, if it keeps a proper set of accounts which records the initial issue of 100,000 shares at $1 each as a credit of $100,000 to the share capital account; follows the necessary procedures set out in s 256B of the Corporations Act 2001 to make a return of share capital of $10,000 to shareholders in a fair manner that does not prejudice creditors; and then records the payment of $10,000 to the shareholders as a debit to the share capital account. If Acme takes these steps, this should be both necessary and sufficient to establish the distribution as a return of share capital for tax purposes also. [14.260] What if a company distributes a dividend that exceeds in value the amount (validly) recorded in its profit account? Neither s 6(1) nor s 44 explicitly permits the bifurcation of a [14.260]

761

Income Derived Through Intermediaries

distribution into two parts so as to treat it as out of share capital to the extent debited to share capital, and out of profits to the extent that profits exist. In Condell v FCT (2007) 66 ATR 100; [2007] FCAFC 44 the value of a property distribution to its shareholders by US computer company, Hewlett-Packard Co, greatly exceeded the amount that was debited from Hewlett-Packard’s retained earnings account in respect of the distribution. Hewlett-Packard organised a “spin-off” of shares in its subsidiary, Agilent Co, to Hewlett-Packard’s shareholders. Mr Condell, an Australian resident, owned 3,483 shares in Hewlett-Packard. The total market value of the Agilent shares distributed was US$29 b and Hewlett-Packard debited its “retained earnings” account with approximately US$4 b. On 7 April 2000, Mr Condell received a distribution of 1,327 Agilent shares as part of the “spin-off” (a ratio of 0.3814 Agilent shares for each Hewlett-Packard share). On that date, the Agilent shares were each worth US$77, so that the total market value of the Agilent shares received by Mr Condell was A$168,961 at the then-applicable exchange rate. All parties accepted that A$168,961 was the amount of the dividend received by Mr Condell. The more difficult issue was whether this entire dividend was “out of profits” so as to be assessable to Mr Condell under s 44. The Administrative Appeals Tribunal found that the dividend was not wholly out of profits and so was entirely a return of capital. On appeal, the primary judge reversed this decision and found it was in its entirety an assessable dividend. The case was appealed to the Full Court of the Federal Court. Kenny and Allsop JJ upheld the decision of the primary judge (Gyles J dissenting).

Condell v FCT [14.270] Condell v FCT (2007) 66 ATR 100; [2007] FCAFC 44 Kenny and Allsop JJ: … The primary judge concluded … that the relevant question was to understand the source of the distribution of shares, that is, how the company accounted for the making of the distribution. It did so by debiting one account only, the retained earnings account. That being so, the dividend was paid (that is the shares were distributed) out of (that is only out of) profits. We agree with this approach. There was no issue on appeal about the distribution of shares in specie being a dividend. “Dividend” is defined in s 6(1) of the ITAA 1936 to include any distribution made by a company to any of its shareholders whether in money or other property. There was no issue on appeal that the only account of Hewlett-Packard debited by reason of the distribution of the shares in Agilent to the Hewlett-Packard shareholders was an account representing profits. There was no suggestion that the Hewlett-Packard accounts in evidence were other than true and fair and completed according to proper United States 762

[14.270]

accounting principles and practice. This was not a case where there was an issue about the legitimacy of the accounts or about the need to rewrite or “look through” the accounts to ascertain the true source, from the company’s perspective, of the payment of the dividend, or, here, the distribution of the shares: cf MacFarlane v Federal Commissioner of Taxation (1986) 13 FCR 356. 6. Against that background, the relevant question is whether the shares (the dividend) were distributed (“paid” in s 44(1)(a) being defined in s 6(1) in relation to dividends as including distributed) out of profits derived by the company. The correct perspective to answer the above question is the identification of the source, from Hewlett-Packard’s point of view, from which the distribution of shares was made: Federal Commissioner of Taxation v Slater Holdings Ltd [1984] HCA 78; (1984) 156 CLR 447 at 457. It was accepted in argument that the dividend must be paid (that is here, the shares must be distributed) wholly out of profits: cf Slater Holdings

Taxation of Companies and Shareholders

Condell cont. 156 CLR at 459. The accounts of Hewlett-Packard reveal that the source, from its point of view, of the distribution of the shares was, and was only, the retained earnings account. That account was debited with somewhat over US$4 billion. The market value of the shares distributed on the day of distribution was somewhat over US$29 billion. It can be readily concluded, and it was the basis upon which the parties approached the appeal, that this discrepancy did not represent any inadequacy, error or lack of truth and fairness in the accounts. Rather, the shares in Agilent and the assets that were transferred to Agilent had been carried in Hewlett-Packard’s books and accounts at less than current market value. That wholly unremarkable state of affairs did not alter the fact that from the point of view of HewlettPackard the distribution of the shares in Agilent had its source in retained earnings. To use the words of Hewlett-Packard in the notes to the audited accounts filed with the United States Securities and Exchange Commission: “HP

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distributed substantially all of its remaining interest in Agilent Technologies through a stock dividend to HP stockholders on June 2, 2000, resulting in the elimination of the net assets of discontinued operations and a $4.2 billion reduction of retained earnings …” The shares were distributed out of a profit account. That was the complete explanation given by Hewlett-Packard for the distribution of shares. The difference between the market value of the shares and the extent of the adjustment in the accounts does not, in our view, require a further explanation of the source of that additional value to understand what, from the company’s perspective, is the source of the distribution of the shares. The terms of s 44(1)(a), applied here to the distribution in specie of shares, do not require that the source of the fund “liberated” or distributed in the hands of the shareholder be explained. Rather, one must ascertain, from the company’s perspective whether the shares were distributed out of profits. The accounts reveal the answer to that question – the retained earnings account.

[14.280] On the other hand, what if a company makes a return of capital to a shareholder

that exceeds in value the amount recorded in the share capital account of the company? Can the excess be taxed as a dividend out of profits under s 44? This was argued by the ATO in the case of FCT v Uther [1965] HCA 42; (1965) 112 CLR 630. In Uther, there was an “informal” liquidation of a company by a distribution to its shareholders of all of its assets, the value of which significantly exceeded the paid-up capital of shareholders, as a Court-sanctioned capital return. Section 47 concerning liquidation distributions, as it was worded at that time, did not apply because there was no formal liquidator. The judgments of Taylor and Menzies JJ expressed the majority view on s 6(1) and s 44 as drafted at that time (for more on liquidations, see [14.1010]).

FCT v Uther [14.290] FCT v Uther [1965] HCA 42; (1965) 112 CLR 630 Taylor J: [T]here remains a difficulty in the way of [the Commissioner] which I regard as insuperable. This difficulty springs initially from the provisions of s. 44 (1) of the Act which provides that the assessable income of a shareholder, in the case of a resident, includes dividends paid to him by the company out of profits derived by it from any source. ….

In the case of a dividend paid as such by a company in the ordinary course of the management of its affairs this latter requirement does not create any problem for such dividends may be paid only out of profits. But in the case of other authorized distributions of the property of a company there is no such limitation and merely to characterize such distributions as dividends for [14.290]

763

Income Derived Through Intermediaries

Uther cont. the purposes of income tax legislation does not operate to enable it to be said that in making the distribution the company was subject to any such limitation or, otherwise, to say that the distribution must have been paid out of profits derived by the company. … On the assumptions which I have made it is true that the respondent received from the company by way of dividend as defined the sum of 30,044 pounds but, in my view, it is impossible to say that this amount was paid out of profits derived by the company. It was, to adopt the

language of Dixon C.J. in Parke Davis & Co. v. Commissioner of Taxation (1959) 101 CLR 521, received in partial distribution of a mass of assets which, although in a colloquial sense they contained profits, was a distribution of capital. The point which Blakely’s Case (1951) 82 CLR 388 made was that, although in the case of distribution by a liquidator, s. 47 carried the matter as far as deeming such distributions to a limited extent to be dividends paid out of profits derived by the company, in the case of distributions of the character now under consideration, no provision of the Act takes this final and essential step.

Menzies J agreed, and stated at (1965) 112 CLR 630 at 643–644: A return of paid-up capital or a payment off of share capital – whichever form of words be used – is, of course, a distribution by a company to its shareholders but, whether or not what is distributed exceeds the nominal amount by which the capital is reduced, there is always but a single distribution and all that is distributed has the one character … When the capital of a company is divided into shares, the nominal value of a member’s shareholding measures, but does not state, his interest in the capital of the company so that, upon a return of capital, that member is entitled to receive his proportionate share of the capital being reduced and not merely a sum equivalent to the nominal value of the reduction being effected. It is in the light of the foregoing principles that I read the exempting words at the end of the definition of “dividend” in the Act as removing a distribution which is a return of capital from the scope of the definition. It neither calls for, nor warrants, the splitting up of a single distribution which exceeds the amount of the nominal reduction into two elements, one having the character of a return of capital and the other some different and unidentified character. The

764

[14.290]

concern of the Commissioner to treat “a return of paid-up capital” as meaning nothing beyond the amount by which the nominal capital is reduced stems, not unnaturally, from the advantage that has been taken of the now well-established principle of company law that, in the course of a reduction of capital, more can be paid in to shareholders than a nominal amount whereby the capital paid up upon their shares is reduced. … The Commissioner has attempted an apportionment as if, of the 499,663 pounds 10s. 0d., only the amount of the reduction in the nominal value of the shares - viz. 24,763 pounds were a return of paid-up capital and the balance were something else. That “something else”, so it was argued, is a dividend for tax purposes. … To deal with the same sort of problem as here confronts us when there is the liquidation of a company rather than a reduction of its capital, a special provision was found to be necessary, viz. s. 47. It seems to me that if there is to be any apportionment of what is, according to company law, a return of capital into a return of capital and dividend for taxation purposes, some like provision would be necessary.

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[14.300] Kitto J dissented in Uther, finding that only the amount actually reflected as a

reduction of capital in the company’s books was a “return of paid up capital” and the balance of the distribution was a dividend out of profits of the company. In his view at (1965) 112 CLR 630 at 637: the fact that the excess was not distributed separately from the share capital returned does not seem to me a ground for saying that there was not a distribution of the excess out of profits within the meaning of s 44.

The dissenting judgment of Kitto J, at least to the extent that it focuses on the character of the distribution being out of profits from the company’s point of view, appears to be preferred in subsequent court decisions including Slater Holdings (at [14.200]) and FCT v McNeil (2007) 229 CLR 656; [2007] HCA 5. The ATO state in Ruling TR 2003/8 that a distribution to shareholders in excess of the amount debited to the share capital account will be an assessable dividend to the extent paid out of profits even where it is an in specie dividend (such as the distribution of shares in Condell) as well as if it is paid in cash. Further, the ATO asserts that an in specie dividend will be paid out of profits derived by the company “if, immediately after the distribution of property, the market value of the assets of the company exceeds the total amount (as shown in the company’s books of account) of its liabilities and share capital” (TR 2003/8 paras [6]–[8]). However, Uther has never been expressly overruled. [14.305]

14.5

Questions

How would the CGT provisions apply to the facts in Uther?

(d) When is a Dividend “Paid”? [14.310] A dividend is included in assessable income only when it is “paid” to the

shareholder, defined in s 6(1) of the ITAA 1936 to include any amount credited, for the benefit of the shareholder. Section 960-120 of the ITAA 1997 provides that a company “makes a distribution in the form of a dividend on the day on which the dividend is paid, or taken to have been paid”. A question arises as to whether a dividend being “paid” for tax purposes depends on there being a payment, or at least a debt due, to the shareholder under company law. This was an issue in Bluebottle UK Ltd v DCT (2007) 232 CLR 598; [2007] HCA 54. The directors of the airline company, Virgin Blue, resolved to declare a final, fully franked dividend to the shareholders on 11 November 2005 and fixed the “record date” for the dividend as 28 November 2005. The dividend was paid on 15 December 2005. The ATO alleged that a shareholder of Virgin Blue, Cricket Pty Ltd, owed income tax on another transaction. Consequently, the ATO issued a notice to Virgin Blue under s 255 of the ITAA 1936 demanding that the company withhold an amount of tax from the dividend payable to Cricket. To avoid the notice, on 13 December 2005, Cricket assigned by deed its rights in respect of the dividend, amounting to more than $60 m, to Bluebottle. The case turned in part on the time at which the dividend became a debt due to Cricket and whether the assignment was valid. [14.310]

765

Income Derived Through Intermediaries

The High Court concluded that the dividend became a debt due on the “record date” of 28 November 2005. Consequently the assignment of the dividend to Bluebottle was legally valid. However, the Court further held that the assignment did not bind Virgin Blue, which was obliged only to pay the dividend to its registered shareholder, Cricket (which would then have held the dividend on trust for Bluebottle). Consequently, the s 255 notice was effective and Virgin Blue was liable to withhold an amount from that dividend, in respect of Cricket’s alleged tax liability, as demanded by the ATO. In reaching this conclusion, the High Court compared the situation before the 1998 company law reforms with the current situation. Before the 1998 reforms, company law drew a distinction between final and interim dividends declared or paid. A decision to pay an interim dividend, even if described as a “declaration”, was revocable until the dividend was paid (Brookton Cooperative Society Ltd v FCT (1981) 147 CLR 441 at 455). By contrast, the declaration of a final dividend gave rise to a debt payable by the company to the shareholder immediately or from the date stipulated for payment. Under the Corporations Act 2001, this distinction is no longer relevant, and the time of payment will depend on the terms of the company’s constitution and the relevant provision of the Act, as the High Court explains.

Bluebottle UK Ltd v DCT [14.320] Bluebottle UK Ltd v DCT (2007) 232 CLR 598; [2007] HCA 54 (Full High Court) Gleeson CJ, Gummow, Kirby, Hayne and Crennan JJ: Virgin Blue Holdings Limited (“Virgin Blue”), is a listed public company, limited by shares. Its constitution provides that the replaceable rules contained in the Corporations Act 2001 (Cth) do not apply to the company. Its constitution gives the directors power “from time to time [to] determine that a Dividend is payable”. … Section 254U [of the Corporations Act 2001] provides that: (1)

The directors may determine that a dividend is payable and fix: (a)

the amount; and

(b)

the time for payment; and

(c) the method of payment.The methods of payment may include the payment of cash, the issue of shares, the grant of options and the transfer of assets. Section 254V then deals with when the company incurs a debt in respect of dividends. It provides: (1)

766

A company does not incur a debt merely by fixing the amount or time for payment of a dividend. The debt arises only when the time fixed for payment arrives and the decision to pay the dividend may be revoked at any time before then.

[14.320]

(2)

However, if the company has a constitution and it provides for the declaration of dividends, the company incurs a debt when the dividend is declared. [Section 588G(1A)] now provides that a debt is incurred “when the dividend is paid or, if the company has a constitution that provides for the declaration of dividends, when the dividend is declared”. … If, as we would hold to be the better construction of Virgin Blue’s constitution, the board of that company was empowered to choose between declaring a dividend and determining that a dividend would be paid, fixing its amount and time for payment, the question of when did the company incur a debt will be decided by applying the relevant branch of s 254V. In this matter, on 11 November 2005, the board of Virgin Blue declared a dividend, and, by operation of s 254V(2), the company incurred a debt when the dividend was declared. … The debt was payable on 15 December 2005, the date stipulated for payment. But the liability to make the payment was complete when the shareholders to whom the liability was owed were identified. Those shareholders were identified on the record date, 28 November 2005.

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[14.330] The case of Brookton Co-operative Society Ltd v FCT [1981] HCA 28; (1981) 147

CLR 441, referred to in Bluebottle above, was decided under the old corporations law. In Brookton, an interim dividend had been declared, but then rescinded before payment. The ATO argued that the dividend had been credited to the shareholders in the books of account of the company, and hence was “paid” as required by s 44 of the ITAA 1936. As indicated in Bluebottle, the Court held that no debt was due to the shareholder in respect of the interim dividend, which was revocable until actually paid. Still of relevance today is the discussion by Mason J (whose judgment reflects the opinion of the Court), of the various ways in which payment of a dividend might be made.

Brookton Co-operative Society Ltd v FCT [14.340] Brookton Co-operative Society Ltd v FCT [1981] HCA 28; (1981) 147 CLR 441 (Full High Court) Mason J: The cross-appeal relates to the sum of $47,914.97 which was declared on 29 April 1973 by the directors of Tunwin as an interim dividend to be paid to the taxpayer. The declaration was in these terms: “Resolved - that an interim dividend of $47,914.97 be declared and credited to the accounts of Brookton Co-operative Society Limited and be available to that company on demand.” The Tunwin directors were also directors of the taxpayer. The minutes of the taxpayer’s directors’ meeting held on 15 May 1973 record that advice was given to the meeting that the Tunwin dividend “had been declared and (was) due to the Society”. The meeting resolved that “upon receipt of these dividends the money be invested on fixed deposit”. An appropriate journal entry was made in the books of Tunwin and credited to the taxpayer in Tunwin’s Sundry Creditors ledger. The amount of the dividend was reflected in the financial statements of both companies as at 30 June 1973. … At the time when the interim dividend was declared, Tunwin was under a contingent liability to make certain payments pursuant to a contract which had yielded the profit required to support the interim dividend. The Tunwin directors had not thought it necessary to make provision for the contingent liability before declaring the dividend. Subsequently, Tunwin was required to

meet the liability. Having done so, it had insufficient funds for remaining profits out of which to pay the dividend. On 10 December 1973 the Tunwin directors endeavoured to rescind the declaration of the dividend. … Payment of a dividend may occur in a variety of ways not involving payment in cash or by bill of exchange, as, for example, by an agreed set-off, account stated or an agreement which acknowledges that the amount of the dividend is to be lent by the shareholder to the company and is to be repaid to the shareholder in accordance with the terms of that agreement. It is, however, well settled that the making of a mere entry in the books of a company without the assent of the shareholder does not establish a payment to the shareholder (Manzi v. Smith (1975) 132 CLR 671, at p 674). The strongest point against the taxpayer is that Tunwin’s accounts for the 1973 year reflected a debt owing to the taxpayer and the taxpayer’s accounts for the same year reflected that debt as an asset of the taxpayer. But when we look beyond the accounts to the resolutions we see that there was no agreement of the kind suggested. It seems that the common directors thought, erroneously as it happens, that the declaration of an interim dividend created a debt, for the resolution passed by the directors of the taxpayer peaks of the dividend being “due”. In

[14.340]

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Income Derived Through Intermediaries

Brookton Co-operative Society cont. error they found salvation; no doubt it was due to this error that the accounts of the two companies took the form that they did. “Paid” is defined by s. 6 (1) in relation to dividends so as to include dividends “credited or distributed”. By virtue of s. 44 (1) (a) and the statutory definition, a dividend does not form part of the assessable income of a shareholder unless it is paid or credited, notwithstanding that the declaration of a final dividend by the company in general meeting creates a debt and an enforceable right on the part of the shareholder to the dividend. … The reference to “dividends”

[14.345]

in s. 44 (1) (a) must be read as a reference to dividends the payment of which is enforceable by the shareholder because they have been declared so as to create a debt, or to dividends which are no longer revocable because, as between company and shareholder, they have been satisfied by payment. When s. 44 (1) (a) is so read, the purpose of the extended definition becomes clear – it is to guard against the possibility, perhaps remote, that the word “paid” might be so narrowly construed that dividends credited or distributed to shareholders in circumstances where they can no longer be revoked or rescinded by the company would not constitute assessable income in the hands of shareholders.

Question

14.16 Acme Pty Ltd declares a dividend of $10 in favour of John, payable on 10 June. By written agreement with John, the dividend is not paid in cash, but the accounts of Acme are altered on 10 June to show that John is from that date a creditor of Acme for a loan of $10 to John, such loan to be paid to John on demand. Has the dividend been paid? Would your answer change if there was no written agreement, but John was a director of the company and the details of the loan were recorded in a resolution of directors? What if there was no written agreement, and the only evidence of the arrangement was the recording of a loan of $10 from John in Acme’s accounts?

(e) Bonus Shares [14.350] The question of how a bonus share should be treated for income tax purposes has

long been controversial. The famous US income tax decision of Mr Justice Pitney in Eisner v Macomber 252 US 189 (1920), so frequently cited for its metaphor that income is to capital, as the fruit is to the tree, concerned the question of whether a gain was realised when a shareholder received a bonus share – Justice Pitney thought the bonus share remained part of the tree, that is, was a capital transaction. However, the distinction between a distribution of profits and a return of capital is not easy to draw when dealing with a bonus share issue. Suppose that Acme Pty Ltd has two shareholders, John and Betty, who each hold one share. Acme wishes to issue 10 new shares to each of John and Betty, in such a way that they do not need to outlay any cash. Acme could declare a dividend of $10 per share payable out of profits in favour of John and Betty, and direct that the dividend due to each of them be satisfied by issuing to each of them 10 new shares at an issue price of $1.00 per new share. Alternatively, Acme could issue 10 new bonus shares for no consideration to each of John and Betty. A third alternative would be to subdivide each of the two existing shares into 11 shares. The view of Pitney J in Eisner v Macomber was approved in dicta by the High Court in FCT v McNeil (2007) 229 CLR 656, also citing the English case, IRC v Blott [1921] 2 AC 171. Gummow ACJ and Hayne, Heydon and Crennan JJ affirmed at 668 ([38]) that: “bonus shareholders do not receive a gain severed and detached from their existing shareholding. 768

[14.345]

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Rather, their proportional interest in the business of the company is re-expressed in the sense explained in IRC v Blott. In that case, Viscount Finlay, with reference to Eisner, said: ‘the bonus or so-called dividend was not severed from the capital; on the contrary, it was added to it. … What might have been paid as income went to increase the capital of the company. The shareholder got his proportionate share in the business of the company as increased by the additional capital.’” Bonus shares are deemed to be dividends in some circumstances by s 6BA of the ITAA 1936. Unfortunately, this provision is confusing. It appears to be intended that, as suggested by Eisner v Macomber and Blott, if bonus shares are simply issued as new shares for no consideration, in a manner which gives the shareholders no choice as to whether they receive them, the bonus shares will not be treated as a dividend. For CGT purposes, the cost base of the original shares will be spread between the bonus shares and the original shares: Subdiv 130-A of the ITAA 1997. However, where the shareholder has a choice whether to take a cash dividend or the bonus shares, the bonus share issue will be treated as a dividend by s 6BA, which will be out of profits and will be frankable. Note that if the first option is taken, but an amount was transferred from profits to the share capital account in respect of the bonus share issue, this would “taint” the share capital account and the bonus share would be treated as a dividend: see [14.580] on “tainting” share capital.

(f) Deemed Dividends from Private Companies [14.360] A reason often given in support of company tax is that, if income tax were levied

only as dividends were paid, shareholders could defer tax almost indefinitely by allowing profits to accumulate in the company rather than have them distributed to the owners. This argument reflects a view that the company tax represents an advance payment of income tax ultimately payable by the shareholders on their share of the company profit. The company tax rate is substantially below the top marginal rate of tax for individuals of 47% (including the Medicare Levy), so the advance payment of tax on corporate profit is not a full payment for high-income shareholders. As such, accumulation of profit in companies still offers tax deferral opportunities that will become even more attractive with a lower company tax rate. The disparity between the company tax rate and the top personal marginal rate also creates a significant incentive for those who use companies to find methods of extracting profit from a company in a non-dividend form. Since a company and its shareholders are separate legal persons, the benefit of money or property generated by the company’s profits can be passed to shareholders in a number of non-dividend forms. For example, the company can lend money to the shareholder, lease property at low or zero rent, buy or sell property on favourable terms, supply or receive services on favourable terms, or pay wages or salary at generous rates to the shareholder or associates, as employees of the company. Such transactions do not take the legal form of dividends. Nonetheless, they may have the same economic effect as a dividend if, in substance, they shift value referable to the profits from the company to the shareholder. [14.365]

Question

14.17 Acme Pty Ltd derives a $100 tax-free capital gain. Its sole shareholder is Mr Brown, a resident. Acme makes a 100-year interest free loan of $100 to Mr Brown, the loan document being prepared by a lawyer and executed by Mr Brown and the company. Should the income tax law, as a matter of policy, deem Mr Brown to derive dividend [14.365]

769

Income Derived Through Intermediaries

income as a result of this transaction? Would your answer change if the loan was for five years only? Would your answer change if the loan was for two years at a reasonable rate of interest? What if Acme instead paid Mr Brown a $100 director’s fee? Should the fee be a deductible expense of the company? [14.370] The income tax law recognises the potential for profit to be distributed under the

guise of such transactions. It is assumed that this conduct will be most likely among closely held companies, their shareholders and their associates, and not by public companies listed on a stock exchange. The main rules to address it are in Div 7A of the ITAA 1936, which applies to transactions between a “private company” (defined in s 103A) and its shareholders and other associates to be a dividend. The general scheme of Div 7A has three elements. First, any payment, transfer of property, loan or forgiveness of debt made by a private company to a shareholder or associate is deemed to be a dividend: see ss 109C, 109D and 109F. A payment by a third party at the direction of a private company of which the taxpayer was a shareholder can also constitute a deemed dividend for the purposes of s 109C: see FCT v Rozman [2010] FCA 324. A “payment” includes the payment of money or transfer of property, and also includes the provision of an asset for use by a shareholder or associate, such as a lease or licence of property or merely permission to use the asset: s 109CA. Loans repaid in full before the lodgment date for the tax return for the loan year are not deemed dividends, so long as the moneys are not then re-lent: s 109R. Division 7A will not operate where a transaction would otherwise constitute a dividend, for example under the s 6(1) definition of “dividend”, and is assessable under s 44(1): s 109L and s 109A. [14.380] The second element of Div 7A is that specified types of payment, transfer of

property, or loan are excluded from deemed dividend treatment. Broadly, exclusions apply to arm’s length commercial transactions which do not have the effect of shifting profit from the company to the shareholder because the shareholder pays full consideration for the benefit received. For example, s 109J provides an exception for payments under arm’s length obligations, and s 109M provides exceptions for loans made in the ordinary course of a money-lending business. An exclusion also applies to payments made to another company, because the profit will not have escaped the company tax net at this point: s 109K. This in turn requires complex anti-avoidance rules to ensure the deemed dividend rules are not circumvented by making loans or payments through interposed entities. Section 109L excludes amounts which are treated as income under other provisions. Section 109N is most important as it has an exception for certain permitted loans. For a loan to avoid deemed dividend treatment, if it is not repaid in full by the tax return lodgment date, (1) it must be made on terms which satisfy s 109N; and (2) it must be repaid with minimum repayments each year over a time schedule which satisfies s 109E. The failure to make the required minimum repayment each year leads to a deemed dividend under s 109E. To be a permitted loan under s 109N, a loan must be under a written agreement, have an interest rate not less than a prescribed minimum based on housing rates, and have a term of not more than seven years unless fully secured by a land mortgage (in which case the term may be up to 25 years). [14.390] The third element is that a deemed dividend will only be assessable under Div 7A if,

and to the extent that, the private company has at year end a “distributable surplus” within 770

[14.370]

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the meaning of s 109Y. The definition of “distributable surplus” limits the amount of any deemed dividends under Div 7A to the surplus (if any) of the company’s assets over its liabilities and share capital at year end. If a company has no distributable surplus, there can be no deemed dividend. The net assets over liabilities (which include provisions) of a company are ascertained by examining a company’s “accounting records”, which are defined to include “invoices, receipts, orders for the payment of money, bills of exchange, cheques, promissory notes, vouchers and other documents of prime entry and also includes such working papers and other documents as are necessary to explain the methods and calculations by which accounts are made up”: s 995-1 of the ITAA 1997. [14.400] In DFC of T v Black (1990) 25 FCR 274, a company “wrote off” a loan owed by a

shareholder by resolving to forego its right to demand repayment, and recording in its books of account that the debt was written-off. The Court found that s 108 (the forerunner to Div 7A) did not apply to deem a dividend because at that time s 108 did not cover forgiveness of loans. In the alternative, the ATO argued the loan forgiveness was a dividend as defined in s 6(1). This argument, too, was rejected by the Court.

DFC of T v Black [14.410] DFC of T v Black (1990) 25 FCR 274; 101 ALR 535 Sweeney J: The taxpayer, a gifted photographer, held 100 shares and his wife one share in a company (“Lens-co”) which carried on a photography business from 1 July 1978. With effect from 1 July 1984 the business of that company was acquired by another company (“Print-co”), in which the taxpayer and his wife held 50 shares each … At all material times Lens-co carried on business from premises owned by the taxpayer which it occupied rent free. A loan account was maintained between Lens-co and the taxpayer, the balance in which fluctuated from time to time. When it was opened it acknowledged the taxpayer as a creditor for $40,277 as the price of assets which he had transferred to Lens-co. With the passage of the years the taxpayer came to be recorded in that loan account as a debtor. The Tribunal also found that “towards 30 June 1984 decisions were taken which were to result in the transfer of the assets of the business of Lens-co to Print-co”, in Lens-co deciding to forego the indebtedness of it and in the placement of Lens-co in liquidation, as a company stripped of assets and liabilities … [The Tribunal found that] “Upon the evidence presented before me the resolution to ‘forego’ and the action taken on the part of Lens-co in writing up its books of account to give effect to

that resolution constituted nothing more than a unilateral act on the part of Lens-co whereby the company declared its intention to remit the debt due to it by” (the taxpayer) “and adopted accounts intended to reflect that decision. On the face of it, although that was done when Lens-co was substantially controlled by” (the taxpayer), “it was not done in such a way as to confer any right upon him against the company such as would have entitled him to resist a claim for payment of the debt. There is no basis in the evidence before me for” (the taxpayer) “to contend that he was released, whether by Deed under seal or by any agreement for which consideration was given, or that he so acted in consequence of the company’s representations as to be entitled to allege an estoppel. Once that is recognised, it follows that nothing has passed to” (the taxpayer). “His liability to the company remains as it was. He may cease to be liable to pay the company by force of law by reason of the effluxion of time, but he was not so released by reason of either the passage of resolution or the action taken by the company in writing up its books of account.” “The situation is therefore quite unlike the situation considered by the Supreme Court of New Zealand in Campbell v. Commissioner of Inland Revenue (N.Z.) ((1967) 14 ATD 551) where debts [14.410]

771

Income Derived Through Intermediaries

Black cont. of shareholders were forgiven by Deeds of Forgiveness. In those circumstances the execution and delivery of the Deeds conferred an immediate financial benefit upon the persons in whose favour the Deeds were executed. But no such advantage was conferred here... ” In the alternative, the Commissioner sought to rely upon s.6(1) of the Act, which read as follows: “‘dividend’ includes- (a) any distribution made by a company to any of its shareholders, whether in money or other property; (b) any amount credited by a company to any of its shareholders as shareholders”. So far as paragraph (a) is concerned, there simply was not a distribution made by Lens-co to

the taxpayer. The word “distribution” involves, at the least, a dealing out or bestowal. What Lens-co did here can amount, at best from the Commissioner’s point of view, not to a distribution but to an indication that it forewent the receipt of payment from the taxpayer. In my opinion, no amount was credited by Lens-co to the shareholder, as shareholder (emphasis added). The phrase “as shareholder” is to be read as “in the capacity of shareholder”. Removal of a debit standing against the taxpayer constituted, at best for the Commissioner, an amount credited to the taxpayer in his capacity as a debtor of Lens-co, not in his capacity as a shareholder.

[14.420]

Questions

14.8

Assuming that a private company has a distributable surplus, consider whether the following transactions are dividends under s 6(1) or deemed dividends under Div 7A: (1) a loan to a shareholder, or a forgiveness of a loan previously made to a shareholder; (2) giving a shareholder a right to use property of the company for free (or at concessional prices); (3) the provision of services for free to a shareholder; (4) the sale of an asset to a shareholder at less than true market value; (5) the purchase of an asset from a shareholder for more than true market value; (6) the payment of an excessive salary to a shareholder? (See also s 109.)

14.9

Acme owns a car and allows one of its shareholders to use the car to drive to work. Beta Pty Ltd owns a beach house which shareholders use at weekends. Does Div 7A apply?

14.10 How would Div 7A apply to the facts in Black? 14.11 If Acme Pty Ltd lends $100 to a shareholder on 1 July 2010, and on 30 June 2011 the shareholder borrows $100 from the bank to repay the loan, and on 1 July 2011 Acme Pty Ltd lends the shareholder a new loan of $100, which is used to repay the bank, has the shareholder repaid the first loan for Div 7A purposes? 14.12 Acme Pty Ltd makes a loan of $100,000 for eight years at the bank bill swap reference rate to Mr Smith, a shareholder, who uses the money to purchase a rental investment property. Mrs Smith, who owns the Smith family home, valued at $200,000, guarantees the loan, and secures the guarantee with a second mortgage over the home. There is already a first mortgage which secures a private loan of $100,000. Is this a permitted loan under s 109N? 14.13 Acme Pty Ltd has a balance sheet at 30 June 2011 which shows that its assets are $100,000, its liabilities are $20,000 before provision for income tax of $10,000 and annual and long service leave of $10,000 for the year, its share capital is $1,000 and it has made an interest-free loan of $5,000 made in a prior year to a director, of which no amount has been repaid. The market value of Acme’s assets is $200,000. What is the distributable surplus of Acme at 30 June? 772

[14.420]

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[14.430] In general, a deemed dividend under Div 7A is unfrankable: s 202-45(g) of the ITAA

1997. However, a distribution made because of a family law order is frankable (s 109RC) and the ATO has discretion to disregard Div 7A, or to allow a Div 7A dividend to be franked, where there is evidence that it was the result of a mistake or omission by the company (s 109RB). [14.435] It may be difficult to determine whether a payment or transfer of value from a

private company to an individual is a dividend or has some other character, where the recipient of a benefit is not just a shareholder, but also an employee of the company (which could include being a director). In this situation, the interaction of Div 7A with fringe benefits tax needs to be considered: see s 109ZB. The case of J & G Knowles v FCT (2000) 44 ATR 22, discussed at [4.420], raised a similar issue of characterisation of interest free loans from a trustee company, either in relation to the employment of the directors or in their capacity as the trust beneficiaries who were the ultimate owners of the business and assets. [14.440] Another provision, s 109 of the ITAA 1936, could also apply to deem remuneration

or retiring allowances paid by a private company to a shareholder, director or associate to be a dividend to the extent the ATO forms an opinion the payment is excessive. A company may choose to do this if the recipient may face a lower rate on the remuneration: see Ferris v FCT (1988) 19 ATR 1705. The company is also denied a deduction for the deemed dividend component of the excessive payment. The dividend is unfrankable.

4. THE DIVIDEND IMPUTATION SYSTEM (a) Policy of Dividend Imputation [14.450] Australia’s dividend imputation system was introduced in 1987. A basic summary of

the dividend imputation system is provided above at [14.60]. We first consider the policy reasons for introducing dividend imputation in Australia; the reasons for its longevity (it is now 30 years old); and whether it remains fit for purpose for Australia in future. We then examine the detailed rules for dividend imputation. In Part 5 (debt/equity) and Part 6 (integrity rules) we discuss the many integrity or anti-avoidance rules that accompany the dividend imputation system. The separate entity principle for company taxation results in corporate profit being taxed twice – once at the level of the company, and a second time at the level of the shareholder when paid out as a dividend. This is sometimes called the “classical system” of company taxation. If it was applied without any modification, then it could lead to multiple taxation of corporate profit, if the profit was distributed to the ultimate shareholder through a chain of companies. Historically, dividends passing through chains of companies were relieved of double taxation by an inter-company dividend rebate (former s 46 of the ITAA 1936). In 1987 the dividend imputation system was introduced to extend relief to company distributions to individuals, by offering a “franking credit” for tax paid by the company when its taxed profits were distributed by way of “franked dividend” to its shareholders. The imputation system is now contained in Pt 3-6 of the ITAA 1997 (commencing at Div 200). It applies to both companies and individuals receiving dividends directly or via trusts and partnerships (the s 46 rebate has been abolished). In 1975, the Asprey Committee considered whether company and shareholder “double taxation” should be relieved in some way. It considered whether company tax is a burden [14.450]

773

Income Derived Through Intermediaries

borne by the shareholders, or a burden which the company can “shift forward” to its customers by price increases in its products and services. The Asprey Committee also considered a range of methods to relieve “double tax” on company profits.

Taxation Review Committee [14.460] Taxation Review Committee, Full Report 1975 16.5. An initial question of a very fundamental kind is how companies should be regarded for tax purposes. One approach is to consider the company as a taxable entity in its own right, with an ability to pay quite distinct from that of the shareholders. Then, company tax problems would have to be seen largely in terms of securing equity between companies: the concept of fairness in the tax structure would have to be extended to define fair treatment of companies as well as of individuals. 16.6. Many people would argue, however, that it is in principle necessary to go behind the veil of separate legal personality which the company enjoys and translate the tax formally imposed on company income into a set of individual tax “burdens” – on shareholders, or on purchasers of the company’s product. The fairness of the tax is then related to the capacities to pay of the various individuals whose private disposable incomes are reduced by the tax. 16.7. This latter approach is basically the one adopted by the Committee. Hence some judgment has to be made about which set of individuals undergoes a reduction in private income. Is it the shareholders, or consumers of the company’s product, or both in some proportions? These questions are much debated by economists, with inconclusive results; but if anything, the balance of informed opinion has tended towards the view that the tax is unshifted. 16.8. In many cases, particularly for small family-owned companies, there is very little difference between a tax liability imposed under company income tax and one imposed under personal income tax on company profits as it accrues to the owners of the company. In such cases it seems difficult to justify making any assumptions about the incidence of company income tax that are not made in respect of personal income tax also. … 774

[14.460]

16.9. In terms of abstract analysis it is certainly possible to distinguish the kinds of current economic situations in which firms can or cannot treat all or some tax as a cost, and to work out the factors determining how long shifting could be sustained and what distortion to economic efficiency might ensue. But it seems clear that in the complex and changing circumstances of reality the actual extent and location of such forward-shifting must defy measurement and forbid any attempt to allow for it in the design of a company income tax. At least it permits a more logical planning of this tax to make the general assumption, somewhat simplistic as it may be, that shifting is not significant and that the tax is substantially paid by shareholders. 16.10. The case for taxing individual shareholders through company tax must then rest on the judgment that, in the absence of company tax, shareholders would be taxed inadequately: that elements of the shareholder’s capacity to pay would either not be brought to tax at all, or would be taxed too lightly, by the existing personal income tax. There are three distinct reasons why such a view might be taken: (a)

that those who own or operate business conducted under limited liability should pay extra tax for that privilege;

(b)

that, unless capital gains were taxed on an accruals basis (whatever allowance is made for inflation), company retentions would not be sufficiently taxed, and scope for tax avoidance would be provided for those accumulating savings behind the corporate veil;

(c)

that taxation of company income provides one of the few available means – from the revenue point of view certainly the most significant means – of levying tax on foreign residents deriving income from operations in Australia.

16.11. In the Committee’s view, the first of these reasons is far from convincing. The second and

Taxation of Companies and Shareholders

Taxation Review Committee cont. third reasons for company tax are, by contrast, judged to be extremely important, and the ensuing discussion reflects this judgment. Tax the Company and Exempt Dividends from Personal Income Tax 16.31. Taxing the company while exempting dividends from personal income tax is clearly unacceptable on equity grounds. If the company was not to be used as a tax shelter by highincome shareholders, the rate of company tax would have to be the maximum marginal rate of personal tax, in which case it would be absurdly high for the lower-income shareholder. Unless the present maximum marginal rate is substantially reduced, the rate of tax would be out of line with rates of company tax abroad. Foreign portfolio investors would be deterred from making investments in Australian companies and direct investors would seek by various devices or excess reliance on loan capital to ensure that a controlled Australian company had little or no profits.

CHAPTER 14

rates of tax: a positive rate on undistributed profits and a zero one on distributed profits. Initially, this was the way the Commonwealth company tax operated. Split-rate systems more often, however, impose a positive rate of company tax on distributed profits, though a rate lower than that on undistributed profits. 16.34. Alternatively, the shareholder may be permitted a credit against personal income tax on dividends received to allow for all or some of the tax paid by the company on the profits distributed. This is generally referred to as the imputation system. The system involves adding to the cash dividend received by the shareholder an amount representing tax paid by the company. The shareholder is taxed on the dividend so “grossed up” and is allowed credit of the amount representing the company tax against his personal income tax liability…

16.32. It is thus clear that income tax must continue to be imposed both on companies and on shareholders, above all for international reasons and to prevent the company from being a tax shelter for high-income shareholders. But the unfair incidence upon the individual shareholder of the existing system needs remedying. To this end consideration must be given to a system that makes some allowance at either the company level or the shareholder level for company tax on distributed profits.

16.35. The differences between split-rate and imputation systems are not significant at the domestic level: if a withholding tax on dividends paid to residents is added to a split-rate system, it will be virtually indistinguishable in its consequences from a corresponding imputation system. But the differences are by no means insignificant in the international field. Thus a split-rate system imposing a zero rate of tax on distributed profits would tax non-resident shareholders only to the amount of withholding tax on such profits – in other words, to a maximum levy of only 15% where the shareholder is resident in a country with which Australia has a double taxation agreement. This difficulty is shared by the split-rate system with all the one-tax systems at the shareholder level.

16.33. Where an allowance is made at company level, the system is generally referred to as split-rate. For example, if dividends paid are allowed as a deduction in computing profits subject to company tax, there are in effect two

16.36. It is therefore assumed in what follows that some form of imputation is needed and that this should allow, with as much precision as is administratively possible, for all or some of the company tax on distributed profits.

Split-Rate and Imputation Systems

[14.470] In 2009, Secretary of the Treasury Ken Henry, who chaired the Henry Tax Review

(see http://www.taxreview.treasury.gov.au), returned to the question of design of Australia’s company-shareholder tax system in an era of economic globalisation. Note that caution is required in considering economic modelling of this question. There is little empirical evidence as to the incidence of company tax. [14.470]

775

Income Derived Through Intermediaries

A Tax System for Australia in the Global Economy [14.480] A Tax System for Australia in the Global Economy, Speech, Ken Henry, 23 February 2009 For the Review Panel, understanding Australia’s place in the global economy is critical to our deliberations. For the most part, we are adopting an open economy perspective – one of a relatively small domestic economy with few restrictions on cross-border financial flows, in which capital is therefore highly elastic. The Draft White Paper [of 1985] endorsed Asprey’s criticisms of the classical company tax system, and, much to the astonishment of Australia’s business community, following the tax summit Treasurer Keating unveiled a full imputation system and the alignment of the company and top personal tax rates. … The Draft White Paper was written at a time in which we were only just beginning to come to terms with the economy opening up – as high levels of border protection and capital controls were being dismantled and labour market deregulation and macroeconomic reforms, such as the floating of the exchange rate, were beginning to take effect.

(such as company income tax) are shifted onto immobile factors such as workers and land via an outflow of capital which lifts its marginal product to the pre-tax return demanded by offshore investors. In contrast, and again assuming a perfectly elastic supply of capital from abroad, the taxation of domestic savings in equity (which occurs primarily through the taxation of dividends and capital gains at the personal level) does not affect the aggregate level of capital invested in Australia as any reduction in Australian-owned capital invested domestically is offset by an increase in imported capital.

One of the proposals implemented following the Draft White Paper was the alignment of the company and top personal tax rates at 49%, undertaken in concert with the introduction of full dividend imputation. The rate alignment involved a substantial cut in the top marginal tax rate from 60% and a small increase in the company tax rate from 46%. However, soon after the company tax rate was reduced to 39% for international competitiveness reasons. Since that time, company tax rates in Australia and abroad have continued to decline, for the most part only partially funded by company tax base broadening measures.

Thus, in a relatively small, globally integrated, capital-importing country like Australia, the company tax probably has the effect of lowering real wages. And it also has the effect of increasing pre-tax returns per unit of shareholder capital invested in Australian companies. If domestic shareholders have access to full company tax imputation, the company tax actually increases their dividend income – both in pre-tax and post-tax terms. Indeed, taken together, the company tax and full dividend imputation are, under certain simplifying assumptions, equivalent to a subsidy on domestic savings invested in domestic companies. It is not surprising then that Australian investors have a portfolio bias for franked dividends. Moreover, while a cut in the company tax rate would increase gross domestic product, it would also attract more foreign investment, increase real wages and reduce the rate of return to domestic shareholders, including superannuation funds, as share prices increase due to the improved returns for non-resident investors. …

Among policy advisers there has also been increasing recognition that the incidence of Australian company income tax most probably falls in the long run, on the immobile factors of production – in particular labour – rather than being fully borne by the owners of capital. Where capital is perfectly mobile, the supply of capital from abroad is perfectly elastic. In these circumstances, the burden of taxes on capital

Over the past ten years, there has been substantial progress in our understanding of how taxation impacts on the international competitiveness of Australian business. This recognition has resulted in our company income tax shifting, broadly, from a residence to a source basis. Today, most income of resident companies from direct investments overseas is exempt from tax.

The implications of being a small, open economy

776

[14.480]

Taxation of Companies and Shareholders

A Tax System Economy cont.

for Australia

in

the

Global

The income of resident savers is still largely taxed on a worldwide basis, with income from offshore equity investments being taxed as an unfranked dividend. From an open economy perspective, this represents a tax on domestic savings and does not distort the level of investment or affect the cost of capital for those Australian firms that have access to foreign capital. A related observation: in a closed economy, a full imputation system addresses tax neutrality between debt and equity – pretty much. But in an open economy model, where foreign shareholders are not entitled to imputation credits and interest income is largely taxed on a residence basis, there is a tax bias favouring debt. Factoring foreign tax systems into the equation muddies this result of course. So an open economy model affects the way one should think about our company tax arrangements, including dividend imputation. But I don’t want to be interpreted as arguing the case for doing away with imputation. Our system has some distinct advantages. For one thing as imputation credits are only provided for Australian tax paid, Australian multinationals have fewer incentives to shift profits offshore. If ending imputation means an increase in incentives to artificially shift profits offshore or otherwise avoid company tax, the reduction in the company tax base could have ongoing revenue consequences.

CHAPTER 14

There are also some limitations of the open economy framework that should be noted. Capital flows are not fully mobile between countries, with home biases still evident. … And even in very stable times, there are segments of the Australian economy for which the small, open economy framework is simply not appropriate. For example, small and medium enterprises in Australia do not generally have access to foreign equity. For these firms, the imputation system, which is accepted and well understood, probably does serve a role in attracting domestic savings. Moreover, for small businesses, the company income tax combined with the imputation system ensures that business owners face much the same tax consequences irrespective of the form in which they receive income from the company; whether it be as dividends, wages or interest. It should also not be assumed that governments of small, open economies should not impose any taxes on capital (including business taxes). This would be a misreading of the optimal tax literature. The absence of perfect capital mobility and the presence of location specific rents mean there is a case for taxing investment in Australia. That some countries, including the United States, provide a credit to their companies for tax paid in Australia may also be relevant. However, we may wish to rethink how we design capital income taxes; and, in particular, whether we build upon the existing income tax framework, or pursue more farreaching change. …

[14.490] The issue has been raised again in the Re:Think Discussion Paper released by the

Treasury in February 2015 (see http://www.bettertax.gov.au/publications/discussion-paper). However, there remains relatively little appetite to repeal the dividend imputation system in Australia, because of its strengths in ensuring company tax is paid by foreign investors and providing a backstop for the personal income tax, which mean it is successful in raising revenue. If the company tax rate is lowered, this reduces the value of imputation credits to shareholders. ATO Taxation Statistics 2014 (for the 2011-12 year) show that the value of imputation credits claimed by individuals, superannuation funds and charities is around $19 b, and by Australian companies around $10 b, per year. This means that half of Australia’s company tax collections (approximately $65 b) are recouped by taxpayers in franking credits, and about one third of those essentially reduce personal income tax collection. The remainder of the difference between company tax paid and imputation credits claimed is attributable to [14.490]

777

Income Derived Through Intermediaries

earnings retained by companies and an estimated $12 b of imputation credits paid to non-resident shareholders who cannot utilise them to offset Australian company tax.

(b) The Basic Scheme: Franked Dividends Paid to a Resident Individual [14.500] The basic scheme of dividend imputation is directed at the case where the company’s

shareholder is a resident individual. The steps in the analysis are as follows: • If a resident company derives a taxable profit of $100 and pays tax of $30, it obtains a “franking credit” of $30 representing the tax paid on the profit. The company records this by making a credit of $30 to a special tax account called a “franking account” (s 205-15 of the ITAA 1997). • If the company pays a cash dividend of $70 out of the after-tax profit to a shareholder, the company can declare this to be a “franked” dividend and allocate or “impute” the $30 franking credit to the dividend. The company records this by making a debit of $30 to its franking account (s 205-30) and by issuing a “distribution statement” to the shareholder stating that the franking credit has been allocated (under Subdiv 202-E). • If the shareholder is a resident individual, they will return the cash dividend of $70 as income, under s 44 of the ITAA 1936, and will also return the amount of the franking credit of $30 as an extra item of income, under s 207-20(1) of the ITAA 1997. Thus a total amount of $100, equal to the pre-tax profit represented by the dividend, is included in the shareholder’s income. • The resident individual shareholder will then be entitled to a tax offset equal to the franking credit of $30 under s 207-20(2) of the ITAA 1997. This tax offset can be applied against the total income tax liability of the resident in respect of their total taxable income. If the resident has a total income tax liability which is less than the franking credit, they can obtain a cash rebate or refund for the difference under Div 67 of the ITAA 1997. For example: i. If the taxpayer’s tax rate on the grossed-up dividend income of $100 was 47% (the highest marginal rate including the Medicare Levy), the franking credit would in effect provide a credit of $30 against tax payable of $47 on the dividend, leaving the shareholder liable to only pay another $17. ii.

If the taxpayer’s tax rate on the grossed-up dividend income of $100 was 19% (the lowest marginal rate), the franking credit would in effect provide a credit of $30 against tax payable of $19 on the dividend, leaving the shareholder with $11 of unused tax offset which could be applied against tax due on other income, or, if no other tax was due, could give rise to a tax refund of $11. The resident individual shareholder is put in the same position as if they had directly earned the $100 pre-tax profit from which the dividend was paid. The company tax, under imputation, can be seen to represent an advance payment of the income tax ultimately payable by the shareholders on their share of the company profit. The rationale for imputation can likewise be seen to rest on the proposition that a company can be regarded as earning its income and paying its company tax as economic agent of the shareholder. [14.510] The payment of a franked dividend by a resident company requires that certain

mechanical procedures be followed, including the issue of a distribution statement to the shareholder, which specifies the amount of the franking credit (s 202-80 of the ITAA 1997). The mechanics are addressed in the Questions below at [14.555]. 778

[14.500]

Taxation of Companies and Shareholders

CHAPTER 14

[14.520] The principle that the company, under imputation, is making an advance payment

of tax on behalf of the ultimate shareholder is straightforward where the shareholder who receives a franked dividend is a taxable person. If the individual taxpayer is on a low tax rate, or has tax losses, they are eligible for a refund of the company tax. Refundability of franking credits was not part of the original design of the dividend imputation system. Under subdiv 207-E, some tax-exempt shareholders may obtain a refund of franking credits, including eligible charities or public benevolent institutions (ss 207-110, 207-125, 207-130 and 207-135), and some superannuation and insurance funds (s 207-120).

(c) Frankable Distributions [14.530] The object of Subdiv 202-C is to ensure that only distributions of realised taxed

profits can be franked (s 202-35). However, s 202-40 takes a confusingly different approach, declaring that a distribution is a “frankable distribution” to the extent it is not unfrankable under s 202-45, which provides a list of dividends and other distributions which are not frankable. There seems nothing to prevent a franking credit being attached to a distribution of a realised untaxed profit in this provision. Tax Ruling TR 2012/5, extracted at [14.230], confirms that dividends paid in compliance with s 254T of the Corporations Act out of profits are frankable, even if the company’s net assets are of a value less than its share capital or the company has prior year losses. However, under s 202-45(e), distributions “sourced, directly or indirectly, from a company’s share capital account” are unfrankable. There is unfortunately little guidance on what is meant by “sourced” from share capital for the application of s 202-45(e). [14.535]

Question

14.14 Which of the following are unfrankable under s 202-45: (1) A dividend paid out of taxed trading profits of a company? (2) A dividend paid out of exempt foreign trading profits? (3) A dividend paid out of taxed realised capital gains of a company? (4) A dividend paid out of untaxed realised capital gains of a company? (5) A dividend paid out of an asset revaluation reserve of a company? (6) A dividend paid out of a tainted share capital account of a company? (7) A return of capital by a company? (8) A dividend on a share which is an equity interest under the debt/equity rules in Div 974? (9) A payment of interest on a debt which is a non-share equity interest under the debt/equity rules in Div 974? (10) A distribution on a share which is non-equity share under the debt/equity rules in Div 974? (11) A payment of interest on a loan which is a debt interest under the debt/equity rules in Div 974? (12) A loan to a shareholder by a private company which is deemed to be a dividend under Div 7A of the ITAA 1936? (13) A capital distribution which is deemed to be a dividend under the capital streaming rules in ss 45 – 45C? (15) A redemption of a preference share out of profits (s 6(1) of the ITAA 1936 definition of “dividend”)?

(d) Franking Accounts and Franking Deficit Tax [14.540] The dividend imputation rules seek to ensure that a company limits its allocation of

franking credits to its distributions of realised profits on which company tax has been paid. The rules do this through the requirement that a company track its tax paid in a “franking account” and pay franking deficit tax (FDT) if its franking account is in deficit at year end. Every company must have a franking account: s 205-10. Division 214 provides the rules for audit of franking accounts by way of franking returns, and collection of FDT. A franking account is in surplus at year end when franking credits exceed the franking debits to that time, [14.540]

779

Income Derived Through Intermediaries

and is in deficit when franking debits exceed the franking credits to that time: s 202-40. A company will obtain credits for its franking account, broadly, from tax paid by a company on its taxed profits, or from the receipt of distributions of other company’s taxed profits (as discussed below – where one company pays a franked dividend to another company, the franking credit passes to the second company and is a credit to its franking account). There will be debits to a company’s franking account where it allocates franking credits to its own franked dividends, and also where it receives a tax refund. [14.550] An entity is liable to pay an amount equal to the deficit by way of FDT if its franking

account is in deficit at year end: s 205-45(2). The liability to FDT creates an offsetting credit in the franking account: s 205-15 Item 5. The FDT is due one month after the end of the tax year: s 214-150. The FDT thus aims to ensure that the franking credits allocated to distributions made by a company in a year match the franking credits it obtains in a year from tax payments (net of refunds) and receipt of franked dividends. The FDT is not a penalty as such because it can be offset against future company tax payments of the company: s 205-70. However, if the deficit exceeds 10% of the total amount of franking credits arising in the year, a penalty is imposed by reducing the tax offset by 30%. The FDT mechanism might raise the question as to whether a company can manipulate its franking account by, say, overpaying its tax in one year, and then seeking tax refunds in the next year. Anti-avoidance rules aim to prevent this: s 205-20 provides that a company cannot obtain franking credits by voluntary tax payments; s 205-50 provides for FDT to apply if a company receives a tax refund within a short period after year end which would have put it in a franking deficit if received before year end. [14.555]

Questions

14.15 Is any particular method prescribed for attaching franking credits to a dividend? (See s 202-5(c).) 14.16 What is a distribution statement and does it need to meet any particular form? (See s 202-80.) 14.17 Can a non-resident company pay a franked dividend where it has paid Australian tax on its profits and has resident shareholders? (See ss 202-5(a) and 202-20.) 14.18 Can entities other than companies pay franked dividends? (See s 202-5(a) and Subdiv 202-B.) 14.19 When must a public company determine the franking credit it wishes to attach to a dividend? When must it give the shareholders the distribution statement declaring the franking credit attached? (See ss 202-5(c) and 202-75(2).) 14.20 When must a private company determine the franking credit it wishes to attach to a dividend? When must it give the shareholders the distribution statement declaring the franking credit attached? (See ss 202-5(c) and 202-75(3).) Can a private company “backdate” the franking of dividends? 14.21 What is the maximum franking credit which a company distribution statement can attach to a cash dividend of: (a) $70; (b) $140; (c) $100? (See s 202-60(2).) 14.22 What is the franking percentage of a cash dividend of $70 if the franking credit attached to it is: (a) $30; (b) $15; (c) $0? (See s 203-35.) 14.23 What happens if the distribution statement for a cash dividend of $70 states that a franking credit of $70 is attached to the dividend? (See s 202-65.) 14.24 Can a distribution statement be amended after it is given to shareholders? (See s 202-85.) 780

[14.550]

Taxation of Companies and Shareholders

CHAPTER 14

14.25 How does the imputation system interact with the PAYG and income tax payment regime in producing surpluses and deficits in the franking account? If Ausco has a franking deficit of $300,000 on 30 June 2005, and makes a PAYG payment of $300,000 for the final quarter of the year ending 30 June 2005, 21 days after that quarter ends, does that credit count in determining the franking deficit for the year ending 30 June 2005? (See s 205-15 Item 1.) 14.26 How does the FDT interact with tax refunds? Assume that Beta has a franking account with a surplus of $9 m and pays a $30 m dividend with $9 m franking credits on 21 June 2004. Its advisers then settle a tax audit from 1999 and receive a $12 m tax refund on 30 June 2004. Is there an exposure to FDT? Would the FDT offset penalty apply? (See s 205-70.)

(e) Imputation through Interposed Entities [14.560] If a resident individual receives a franked dividend through an interposed company,

trust or partnership, the rules enable the individual to benefit from the franking credit on the dividend. (i) Interposed company [14.570] The imputation rules prevent cascading layers of taxation as a dividend passes

through interposed up the chain to the ultimate individual shareholder. Assume that a resident individual (RI) contributes share capital to InterCo, a resident company, which in turn contributes share capital to Ausco, which in turn invests the capital in Australia and derives an annual profit of $100 subject to 30% company tax. If Ausco pays a $70 franked dividend with a $30 franking credit to InterCo, which in turn pays a $70 franked dividend to RI, the imputation rules operate as follows: • Ausco franks the $70 dividend paid to Interco; • InterCo returns a $70 dividend as assessable income under s 44; • under s 207-20, Interco (1) includes the franking credit of $30 in assessable income (s 207-20(1)) and obtains a tax offset of $30 (s 207-20(2)), so the dividend is tax-free in effect. However, note companies are not entitled to a Div 67 refund for excess tax offsets; • a franking credit of $30 arises in the franking account of InterCo: s 205-15 Item 3; • InterCo can now pay RI a franked $70 dividend, with a $30 franking credit, which is treated as at (b) above. [14.580] For consolidated corporate groups that are wholly owned by a single parent (head)

company, a similar result is achieved by ignoring all of the interposed subsidiary companies and treating the group as having only one franking account, in the head company. The ultimate individual shareholders of the group therefore receive franked dividends directly from that head company. See further Chapter 15. [14.590] A company with prior year or current year losses has a choice as to whether or not to

apply the losses against franked dividends it receives: see s 36-17 and Subdiv 36-C of the ITAA 1997. Without this rule, a company would potentially “waste” a loss, because the franking credit on the franked dividend effectively frees the dividend from tax in any event. [14.595]

Questions

14.27 What would be the position if InterCo had a franked dividend of $70 and deductible expenses of $50? Could it pass the same share of the franking credit through to RI? [14.595]

781

Income Derived Through Intermediaries

What would be the position if InterCo had a franked dividend of $70 and deductible expenses of $300 – could it pass any franking credit through to RI? 14.28 What would be the position under s 36-17 of the ITAA 1997 if InterCo had received a franked dividend of $70 to which a $30 credit is attached, had interest income of $100 and had a prior year tax loss of $300? 14.29 Can a non-resident company receive franking credits to its franking account on receipt of a franked dividend? (See ss 205-25, 205-15 and 205-30.) (ii) Interposed partnership [14.600] Recall that a partnership is treated as a flow-through entity for tax purposes.

Assume that a resident individual (RI) contributes equity capital for a half interest in InterPart, a partnership, which in turn contributes share capital to Ausco, which in turn invests the capital in Australia and derives an annual profit of $100 subject to 30% company tax. If Ausco pays a $70 franked dividend with a $30 franking credit to InterPart, which in turn distributes one half of the partnership income to RI, the imputation rules operate as follows (Subdiv 207-B): • the partnership includes the $70 dividend and $30 franking credit in its net income under Pt III Div 5 of the ITAA 1936, giving it net income of $100 (s 207-35(1) and (2)); • RI as partner includes a half share of the $100 net income, including half of the franking credit, in their assessable income – ie $50 (ss 207-35(3), 207-50(2), 207-55(3) Item 1 and 207-57); • the partner gets a tax offset for the half share of the franking credit – ie $35 (s 207-45). [14.605]

Question

14.30 What would be the position if the partnership had the franked dividend of $70 and deductible expenses of $50 – would the same share of the franking credit pass through to the partner? What would be the position if the partnership had the franked dividend of $70 and deductible expenses of $300 – would a share of the franking credit pass through (see s 207-50(2)(b))? What would be the position if the partnership had the franked dividend of $70 as well as interest income of $100 and deductible expenses of $150? (iii) Interposed trust [14.610] Recall that a trust is generally treated for tax purposes as a flow-through entity for

“net income” flowed to its presently entitled beneficiaries. However, it is the trustee who holds legal title to the shares and who is the registered shareholder entitled to the dividend (under the rule in Patcorp). Assume that a resident individual (RI) contributes equity capital to InterTrust, a resident trust, which in turn contributes $1,000 share capital to Ausco, which in turn invests the capital in Australia and derives an annual profit of $100 subject to 30% company tax. If Ausco pays a $70 franked dividend with a $30 franking credit to InterTrust, which in turn gives RI a present entitlement to one half of the trust’s net income to RI, the imputation rules operate as follows (Subdiv 207-B): • the trust includes the $70 dividend and the $30 franking credit in its net income under Pt III Div 6 of the ITAA 1936, giving it net income of $100 (s 207-35(1) and (2)); 782

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• the beneficiary, RI, includes a half share of the $100 net income, including half of the franking credit, in their assessable income – ie $50 (ss 207-35(3), 207-50(3), 207-55(3) Item 3 and 207-57); • The beneficiary gets a tax offset for the half share of the franking credit – ie $35 (s 207-45). The interposed trust imputation rules permit “streaming” of franked dividends to one beneficiary, subject to limitations in the trust taxation rules in Div 6 and Div 6E of the ITAA 1936. So, in the above example, if RI were entitled to the entire franked dividend under the terms of the trust deed, RI would receive the benefit of the entire franking credit on the dividend. See the example in s 207-35(4). Imputation credits are denied on trust and partnership distributions of franked income which are made under arrangements which give the distributions the character of interest on a loan: ss 207-150(1)(e), 207-160, 207-165 and 207-170. [14.615]

Question

14.31 What would be the position if the trust had the franked dividend of $70 and deductible expenses of $50 – would the same share of the franking credit pass through to the beneficiary? What would be the position if the trust had the franked dividend of $70 and deductible expenses of $300 – would a share of the franking credit pass through (see ss 207-50(3)(b) and 207-55(3) Item 3)? What would be the position if the trust had the franked dividend of $70 as well as interest income of $100 and deductible expenses of $150?

(g) The Limits of the Imputation System (i) Imputation does not apply to profit untaxed in Australia [14.620] The imputation system stops short of giving full recognition to the principle that a

company earns its income as agent of the shareholders, in relation to untaxed or tax-sheltered income of a company. A company may have a tax-free gain from pre-CGT assets; or untaxed current year profits protected from tax by prior year losses; or income sheltered from tax by concessions such as the research and development deduction; or profits which are not subject to income tax, such as unrealised gains on assets recorded in asset revaluation reserves or unrealised foreign exchange gains and losses; or windfall gains such as a gift or loan forgiveness. If the agency principle were applied to such untaxed profit of a company, the profit should remain untaxed when passed through to the shareholder as a dividend. This is not, however, the position under s 44 of the ITAA 1936. A shareholder includes in assessable income a dividend paid out of any profit, taxable or untaxable, of the company. Thus, dividends paid out of profit which is untaxed at the corporate level will become subject to full income tax at the shareholder level: if the shareholder is a resident, then at the marginal tax rate; if a non-resident, then at the dividend withholding tax rate. Thus, the treatment of the company as a separate entity re-emerges. The company must distribute any untaxed profits as an unfranked dividend and full tax will be paid on it by the shareholder. (ii) Imputation does not apply to taxed foreign profit [14.640] The imputation system stops short of giving full recognition to the principle that a

company earns its income as agent of the shareholders in respect of foreign profit. If a resident individual were to earn taxed foreign income directly, they would obtain a foreign tax offset for the foreign tax paid: see [17.140]. If the agency principle were applied to taxed foreign [14.640]

783

Income Derived Through Intermediaries

profit of a company, credit for the foreign tax paid by the company should be passed through to the shareholder when that profit is paid out as a dividend. However, franking credits arise only for payments of Australian tax, not foreign tax. To the extent that foreign profit of an Australian resident company bears foreign company tax, it is generally exempt from Australian tax for the company (see the chapters on international tax). If foreign taxed profit is distributed as a dividend by the Australian company to resident shareholders, it is unfranked and so it is taxable at the shareholder’s individual marginal rate without any credit for the foreign tax. The corporate profit is “double taxed” in this case. So, for example, if a company derives $100 of foreign profit and pays $30 foreign tax, it will normally pay no Australian tax: see [16.30], [16.220]. However, when it pays the after-tax amount of $70 to its shareholders, this will be an unfranked dividend in their hands. If the shareholder is a resident individual whose tax rate on the dividend income was 46.5%, they would pay tax at 46.5% on that $70 dividend without any credit for the foreign tax. The Review of Business Taxation (1999) and the Review of International Taxation Arrangements (2002) recommended that partial imputation relief be extended to taxed foreign profits of companies. The government has so far resisted this. A significant concern is that, because imputation credits are able to be generally offset against taxable income, and are refundable, the end result would be that the Australian government would be giving tax refunds for foreign tax. However, non-resident shareholders who receive unfranked dividends paid out of foreign taxed profits are treated differently from resident shareholders. If a non-resident shareholder receives a dividend paid by an Australian company out of foreign taxed profit, they may benefit from the “conduit foreign income” rules in Subdiv 802-A of the ITAA 1997. Under these rules, such a dividend will not be subject to dividend withholding tax: see s 44(1)(b), s 128B(3)(ga). This reflects the principle that a non-resident deriving the foreign-sourced income directly would not be subject to Australian income tax. The object of the “conduit foreign income” rules is to encourage the establishment in Australia of regional holding companies for foreign multinationals and to improve Australia’s attractiveness as a continuing base for its own multinationals. The different treatment of Australian-taxed and foreign-taxed profit under the imputation system is of fundamental importance. It means that, for Australian resident shareholders in Australian companies, the after-tax return on $100 of corporate profit taxed in Australia and paid out as a dividend will be higher than the after-tax return on $100 of corporate profit taxed overseas and paid out as a dividend. This means that, all things being equal, Australian investors may prefer to invest domestically and Australian companies will be discouraged from investing outside Australia unless the pre-tax return is substantially higher than available alternative investments in Australia. (iii) Imputation is of limited benefit for non-resident shareholders [14.650] A substantial part of corporate ownership rests with overseas shareholders.

Australia has tax treaties with many countries which limit the rate of income tax which can be imposed on dividends to 15%, or, in the case of the recent UK and amended US treaties, as low as 5% to 0%. Abolition of company tax in favour of taxing only dividends would substantially affect income tax collections. The dividend imputation system reflects this fiscal constraint. It does not extend the agency principle to the full logical extent of that principle, 784

[14.650]

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but subjects it to significant limitations in the case of non-resident shareholders. A non-resident shareholder who receives a franked dividend from an Australian resident company is taxed quite differently from a resident shareholder. The non-resident shareholder does not receive an imputation credit but instead is merely relieved from paying any further Australian income tax or dividend withholding tax on the franked dividend (they may, of course, still be subject to tax on the dividends in their home country). Recall the case where the company derives a taxable profit of $100, pays tax of $30, and obtains a “franking credit” of $30 representing the tax paid on the profit. • If the company pays a cash dividend of $70 out of the after-tax profit to a non-resident shareholder, the company can declare this to be a “franked” dividend and allocate or “impute” the $30 franking credit to the dividend. The company records this by making a debit of $30 to its franking account (under Div 205) and by issuing a “distribution statement” to the shareholder stating that the franking credit has been allocated (under Subdiv 202-E). • However, the non-resident is not entitled to a tax offset for the franking credit in the same way as a resident. Instead, the franking credit provides a more limited form of relief: i. Absent dividend imputation, a dividend paid to a non-resident would ordinarily be subject to dividend withholding tax at a rate of up to 30%, although if the shareholder is from a country with which Australia has a tax treaty, the rate would normally be reduced to 15%, and in some cases to 5% or 0% (see the international tax chapters). ii. Under dividend imputation, if the non-resident receives a cash dividend of $70 to which a franking credit of $30 is attached, then the cash dividend is exempt from withholding tax (and any other income tax) under ss 128B(3)(ga) and 128D of the ITAA 1936. iii. However, the non-resident is not entitled to any tax offset or tax refund under s 207-20(2) of the ITAA 1997 for the franking credit. The company tax functions under the imputation system as a final payment of tax on the non-resident share of the taxable Australian profit of resident companies. This is a departure from the agency principle of imputation; again, the separate entity principle re-emerges. In the above example, the $30 franking credit will usually have a cash value of $30 to a resident individual shareholder. However, its cash value will be less than that to a non-resident shareholder, if they are from a country with which Australia has a tax treaty which operates to reduce the dividend withholding tax rate to below 30%. Moreover, it will often be the case that, in the home country of the non-resident shareholder, any Australian dividend withholding tax would be allowed as a foreign tax credit against income tax payable by the non-resident in the home country on the dividend, so the benefit of relief from withholding tax is reversed by higher tax in the home country. For completeness, reference should be made to two other rules. First, the “exempting company” rules in Div 208 of the ITAA 1997 are designed to limit the use of franking credits of Australian companies which are owned as to 95% or more by non-residents. Essentially, the franking credits are “quarantined” so that they can only ever be used by the non-resident owners to relieve dividends from withholding tax, and cannot be transferred in some way to resident shareholders for whom they would be more valuable. Second, ss 46FA and 46FB of the ITAA 1936 allow a deduction for a dividend in some circumstances, when paid by a resident subsidiary company wholly owned by a non-resident parent company. If a resident subsidiary receives an unfranked dividend on a non-portfolio [14.650]

785

Income Derived Through Intermediaries

shareholding (at least 10%) and pays it on to the non-resident owner, it can claim a deduction for the dividend: this effectively puts the tax rate at the withholding tax rate on the dividend. (iv) Imputation and the debt/equity distinction [14.660] The debt/equity rules are discussed in Part 5 below. In general, tax law presupposes

a distinction between making an investment of capital in a company by way of holding shares in the share capital as a shareholder, and making an investment by way of advancing debt capital as lender or creditor to the company. Dividends are presumed to be non-deductible to the company, but subject to dividend imputation relief in the hands of the recipient. Interest paid on debt is presumed to be deductible to the company (if incurred in deriving assessable income), and assessable income subject to tax in the hands of the recipient. A key argument in support of the dividend imputation system is neutral between debt and equity in company financing. That is, one of the rationales for imputation is said to be that it reduces the differential between the overall tax rate on earnings on debt capital and the overall tax rate on earnings on equity capital. Imputation eliminates this bias for residents. If a resident had to choose between investing $10,000 as debt and receiving $1,000 interest, versus investing equity which has pre-tax profit of $1,000 and pays a franked dividend of $700 with franking credit of $300, the after-tax return should be equivalent. However, this is not the case for non-residents. Interest on debt capital will generally be taxed in the hands of the non-resident at not more than 10% under the interest withholding tax rules, and may in some cases be exempt from tax under tax treaties or interest withholding tax exemptions: see the international tax chapters. Since the company will obtain a deduction for the interest, this reduces the overall tax rate on the distributed income to 10%. By contrast, if the non-resident contributes equity capital, and the company pays tax at 30% on profit, and then pays out a franked dividend which is exempt from dividend withholding tax, the overall tax rate on the distributed income will be 30%. [14.670] In summary, the company tax regime in Australia operates to impose different tax

rates on resident and non-resident shareholders, and on their respective shares of the Australian and foreign-taxed corporate profit of an Australian resident company, and on debt and equity investment. This generates tax planning incentives for shareholders and companies. A shareholder may seek to withdraw profit from a resident company by mechanisms such as a return of share capital or a long-term loan instead of a dividend, so as to avoid tax on the dividend, especially where no franking credit is available, or the shareholder cannot benefit from the franking credit. To prevent this, anti-avoidance rules aim to stop the use of non-dividend transactions to extract value from companies. The dividend imputation system also creates an incentive for companies to distribute Australian taxed profits disproportionately to Australian resident shareholders who will benefit from the franking credit and foreign profits disproportionately to non-resident shareholders. If resident shareholders were able to enter arrangements to obtain a disproportionate share of the taxed Australian profit, and non-resident shareholders were able to enter arrangements to obtain a disproportionate share of the foreign profit, the overall rate of tax on corporate profit would fall. The imputation system contains extensive antiavoidance rules designed to prevent such behaviour at both company and shareholder levels. 786

[14.660]

Taxation of Companies and Shareholders

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The dividend imputation system eliminates the “bias” between domestic debt and equity investment but a bias remains between residents and non-residents. It remains, in general, more attractive for non-resident investors to utilise debt than equity to invest in Australian companies.

5. DEBT AND EQUITY [14.680] Different tax treatment applies to returns on debt (essentially, interest) and returns

on equity (essentially, dividends), for both the recipient and the company. Dividends paid on equity capital are non-deductible to the company (affirmed in s 26-26 of the ITAA 1997). As noted by Hill J in Macquarie Finance Ltd v FCT (2004) 57 ATR 115; [2004] FCA 1170: It is accepted without question in the Australian income tax system and indeed in most other systems that a deduction is not available for dividends paid by a taxpayer company on its share capital. It may not be possible to give a clear logical answer as to the reasons (cf Upfold “When might Dividends be Deductible” (2001) 30 Australian Tax Review 5). One answer might be that dividends are a distribution or division of profit after that profit has been ascertained, which means that they could not be seen to be part of the cost of earning or deriving that profit: Commissioner of Taxation (WA) v Boulder Perseverance Ltd (1937) 58 CLR 223. Such an explanation would require it to be said that the declaration of a dividend is not part of the actual business activity but subsequent to it. Another possible explanation might be that a dividend is part of the cost of the fixed capital of the business, thereby related to the business entity or structure rather than the process by which the business operates.

In contrast, interest paid on debt instruments is usually deductible for the company if funds are used to gain assessable income, although the cases reveal that the characterisation of an instrument as debt does not always mean that payments under the instrument are deductible, but may sometimes be capital in nature: Macquarie Finance Ltd v FCT (2005) 146 FCR 77; 61 ATR 1; [2005] FCAFC 205 and St George Bank Ltd v FCT [2009] FCAFC 62. For the recipient, in general both dividends and interest will be assessable income, but different tax rates may apply. If we ignore cross-border investment, then the effect of the company-shareholder imputation system is, generally speaking, to levy the same overall tax rate on returns to debt and equity (taking into account tax at the company level and the shareholder level). However, this symmetry disappears when we take into account crossborder investment. Interest on debt paid by Australian resident companies to non-residents is subject to interest withholding tax at a maximum rate of 10% (see Chapter 18). Since such interest is deductible to the Australian company if used in earning Australian profit, it follows that where profit is distributed as deductible interest rather than non-deductible dividends to a non-resident, the overall tax rate for non-resident investors falls from 30% to 10%. This creates an incentive for non-residents to convert their investments in resident companies from investments in the legal form of shares to investments in the legal form of debt. Australian tax law seeks to prevent this in two ways. As discussed in Chapter 18, “thin capitalisation” rules limit the ratio of debt to equity permitted for companies controlled by non-residents. The debt/equity rules in Div 974 may also apply to re-characterise the investment. [14.690] The income tax law traditionally distinguished debt and equity instruments by

reference to whether or not the instrument had the legal form of a share or of a debt: see FCT v Midland Railway Company of Western Australia Ltd (1952) 85 CLR 306; Emu Bay Railway Co Ltd v FCT (1944) 71 CLR 596. Since 2001, the Act has contained a comprehensive [14.690]

787

Income Derived Through Intermediaries

statutory regime to distinguish between debt and equity for company tax purposes, in Div 974 of the ITAA 1997. The goal of these rules is to characterise investments as “debt” or “equity” on the basis of their economic substance, not legal form.

(a) Division 974 [14.700] The debt/equity rules in Div 974 of the ITAA 1997 are applicable to interests issued

on or after 1 July 2001. The background is explained in the Explanatory Memorandum to the Bill introducing the provisions.

New Business Tax System (Debt and Equity) Bill 2001 [14.710] New Business Tax System (Debt and Equity) Bill 2001, Explanatory Memorandum 1.4 The income tax law provides a tax treatment of returns to the shareholders of a company which differs from the tax treatment of returns to its creditors (debt holders). 1.5 Shareholders of a company receive dividends – which may be franked (i.e. they may carry imputation credits representing underlying company tax which may be used to reduce the shareholders’ tax) but which are not deductible to the company making the dividend. By paying franked dividends a company can ensure that, for the most part, its profits are ultimately taxed at its shareholders’ marginal tax rates. Creditors, on the other hand, receive returns which cannot be franked but which are usually deductible to the company. 1.6 This differential tax treatment is fundamental to the tax law. It recognises the fundamental difference between the equity holders of a company, who take on the risks associated with investing in the activities of the entity, and its creditors, who, as far as possible, avoid exposure to that risk. In recognising this fundamental difference, it is essential that the tax law draws the borderline separating the 2 (the debt/equity border) in such a way that the legal form of an interest cannot be used to result in a characterisation at odds with its economic substance. 1.7 A mischaracterisation of a debt interest as an equity interest can result in the inappropriate franking of debt-like returns (see Example 2.2), or companies circumventing the thin capitalisation measures. On the other hand, mischaracterising an equity interest as debt could allow inappropriate tax deductions for the issuer 788

[14.700]

through so-called deductible equity (see Example 2.3). In other words, mischaracterisation could result in frankable returns being made to creditors of an entity and deductible returns to its equity holders. This would undermine the wellestablished distinction between the 2 types of returns and would expose the revenue to a significant risk of erosion. … 1.9 Under the new law, the test for distinguishing debt interests from equity interests focuses on a single organising principle – the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested. This test seeks to minimise uncertainty and provide a more coherent, substance-based test which is less reliant on the legal form of a particular arrangement. It provides greater certainty, coherence and simplicity than is attainable under the current law. ... 2.2 The new rules classify an interest in a company as equity or debt according to the economic substance of the rights and obligations of an arrangement rather than its mere legal form in a more comprehensive way than the current law. Relevant to the classification is the pricing, terms and conditions of the arrangement under which the interest is issued. This limits the ability of taxpayers to have returns on an interest artificially categorised as frankable or deductible to best suit the tax profiles of the issuer and the holder so as to create undesirable tax arbitrage. 2.3 … If taxpayers could choose the categorisation – by structuring the instrument’s legal form and without regard to the substance or

Taxation of Companies and Shareholders

New Business Tax System (Debt and Equity) Bill 2001 cont. nature of the arrangement – it would be at the expense of the revenue, as Examples 2.1, 2.2 and 2.3 illustrate. Example 2.1: The different tax results of debt and equity The practical effect of the difference in tax treatment between distributions made by a company to its equity holders and other returns paid by a company (e.g. interest paid to a creditor) can be illustrated by a consideration of the different tax results that arise when $100 of assessable income is derived by a company and then paid either as a frankable distribution or as interest on a loan. The company tax rate is assumed to be 30%. If paid as a frankable distribution, the company pays $30 tax and pays a fully franked dividend of $70 (the after-tax amount); the $30 tax paid by the company may be imputed to the recipient of the dividend. If paid as interest, the company could distribute the full $100 without paying tax (the $100 assessable income being offset by a $100 deduction); the recipient of the interest would then be liable to tax on the full amount. If the recipient is a taxable resident, the $100 derived by the company is effectively taxed at the recipient’s marginal tax rate in both cases (in the franked dividend case, the tax already paid by the company is imputed to the recipient). However, if the recipient is a non-resident or a tax exempt unable to benefit from refundable imputation credits, the $100 is taxed at the

CHAPTER 14

company tax rate if it is distributed as a franked dividend. On the other hand, it is usually tax exempt if it is paid as interest to such recipients, and interest withholding tax may not be payable (because of an exemption granted under section 128F of the ITAA 1936, for example). Even if interest withholding tax is payable, it is subject to a lower rate of tax than equity. Example 2.2: Artificial categorisation of debt as equity A tax loss company (for whom an interest deduction is of no immediate value) with surplus franking credits, or a company with surplus franking credits seeking to lower its cost of capital or strengthen its shareholders’ equity base or gearing ratios, might seek to issue an equity interest that is debt-like. The purpose of this would be to compensate the investor with franked (and therefore rebatable) payments, notwithstanding that the payments are in substance interest. This would minimise the wastage of franking credits in the company’s franking account that would occur as a result of the company’s normal dividend policy, where the wastage would otherwise reduce the revenue cost of the imputation system. Example 2.3: Artificial categorisation of equity as debt A company might seek to stream a limited supply of franking credits to taxpayers best able to use them by issuing franked dividend-paying shares to Australian residents and other financial instruments to non-residents which provide economically equivalent, but non-dividend and unfranked returns, that are deductible in the company’s hands.

(b) The Debt/Equity Rules in General [14.720] The debt/equity rules contain a primary “debt test” in s 974-20 and a primary

“equity test” in s 974-75. The rules require you to determine whether a “scheme” (s 974-150) that involve either a “financing arrangement” (s 974-130) (an arrangement to raise finance) or a share, will give rise to a debt interest or an equity interest. The debt/equity rules are designed to counter, in a systematic fashion, two broad categories of financial arrangements: • Where a company seeks to raise finance by instruments which are intended to have the economic substance of debt, but which are given the legal form of shares, with the intention that they should attract dividend imputation treatment for distributions on the instruments. [14.720]

789

Income Derived Through Intermediaries

• Where a company seeks to raise finance by instruments which are intended to have the economic substance of equity, but which are given the legal form of a loan, with the intention that distributions on the instruments should not attract dividend imputation treatment, but instead give rise to deductible outgoings for the company (and interest withholding tax treatment for the recipient if a non-resident). The result which Div 974 is intended to achieve is that: • If a financial arrangement has the legal form of shares, but the economic substance of an ordinary loan or debt, the arrangement will be treated as a “debt interest” (ss 974-15, 974-20 and 974-65 of the ITAA 1997) and the shares will be deemed to be “non-equity shares”. This has five main consequences in the context of imputation: i. Dividends on non-equity shares cannot be paid as franked dividends (s 202-45(d) of ITAA 1997). ii.

However, dividends on non-equity shares may qualify for a deduction as if they were an interest expense, under s 25-85 and s 25-90 of the ITAA 1997, subject to certain limitations. These limitations, broadly, seek to limit the deduction for the dividend to an amount equating to a reasonable rate of interest on the instrument if it is viewed as debt, having regard to the terms of the instrument and the creditworthiness of the company.

iii.

Dividends on non-equity shares paid to non-residents attract interest withholding tax (WHT) rather than dividend WHT (s 128A(1) of the ITAA 1936, definition of “dividend” and s 128A(1AB), definition of “interest”).

iv.

However, dividends on the non-equity shares paid to residents still remain “dividends” (albeit unfrankable) and are still assessable to resident shareholders as dividends under s 44.

v.

The company must credit the capital amount subscribed in respect of the shares to a share capital account in the normal way, and repayments of the share capital must be debited to the share capital account, or they may be treated as a dividend assessable under s 44. The definition of “share capital account” in s 975-300 of the ITAA 1997 deems an account to be a share capital account even where a share arrangement is a “debt interest” under Div 974 or is shown as debt in the company’s accounts under the accounting rules. • If a financial arrangement has the legal form of a loan or debt, but the economic substance of an ordinary share, the arrangement will be treated as an “equity interest” (ss 974-70, 974-75 and 974-80 of the ITAA 1997) and the loan or debt will be deemed to be “non-share equity”. This has five main consequences in the context of imputation: i. Payment of the interest or other financial returns on the arrangement is not deductible (s 26-26). ii. iii.

iv.

790

However, payment of the interest or other financial return will be treated as a “non-share dividend” (Subdiv 974-E) assessable to the recipient under s 44. A non-share dividend is a frankable distribution (s 202-30 and Div 215); ie the company can allocate franking credits to the payments and resident recipients can claim the benefits of the franking credits in the same way as for normal franked dividends on shares. Payment of a non-share dividend to a non-resident will be treated as a dividend (and not interest) for WHT purposes (s 128A(1) definition of “dividend” and s 128A(1AB) definition of “interest”). [14.720]

Taxation of Companies and Shareholders

v.

CHAPTER 14

The company must credit the principal or capital received under the arrangement to a “non-share capital account”, which is intended to operate in the same manner as a share capital account for ordinary shares (Div 164). Repayments of the principal which are debited to non-share capital account will be treated as a “non-share capital return”. Returns of principal must be debited to the non-share capital account, or they will be treated as a non-share dividend assessable under s 44 (Subdiv 974-E).

[14.730] If an interest satisfies the debt test, it is deemed to be a “debt interest” (s 974-15). If

an interest satisfies the equity test it is deemed to be an “equity interest” (s 974-70). Where an interest satisfies both tests, the debt test prevails (ss 974-70(1)(b) and 974-5(4)) and the interest is deemed to be a debt interest. If an interest satisfies neither test, it is neither a debt nor an equity interest. The provisions allow “related schemes” (s 974-155) to be combined or single schemes to be disaggregated, and can involve more than two parties: see ss 974-15, 974-70, 974-105, 974-150 and 974-155. The debt and equity tests are applied having regard to the circumstances at the time the scheme commences. [14.740] The debt and equity tests are each subject to exclusions. For example, the debt test is

subject to a “short term” trade credit exception (s 974-25); and the equity test is subject to an exception for “at call loans” between connected entities (s 974-75(4)). As is shown by the examples in the Explanatory Memorandum extracted at [14. 710], the debt/equity rules are, essentially, integrity or anti-avoidance measures. Where a company issues ordinary shares on normal terms to parties acting at arm’s length (with no special side-arrangements), it is intended that these shares should still be treated as equity interests eligible for dividend imputation treatment. Likewise, if a company issues ordinary debt instruments on normal terms to parties acting at arm’s length (with no special sidearrangements), it is intended that these should still be treated as debt interests eligible for deductions for the interest payments. Even within these integrity measures, further anti-avoidance rules apply. The ATO has discretion to apply an “alternative” debt test in s 974-65, which permits the ATO to have regard to the value of contingent payment obligations in addition to the value of effectively non-contingent payment obligations on certain conditions. For example, this may apply where a debt note was issued by a profitable company for $1 and had a non-contingent redemption value of 99 cents and a contingent profit right of 10 cents. If the ATO invokes this alternative debt test, the interest is deemed to be a debt interest. There is also an alternative equity test in s 974-80 which applies to arrangements where a debt interest is issued by entity A to entity B to fund payments on an equity-type interest issued by entity B. If this applies, the interest is deemed to be an equity interest (even if the arrangement would otherwise include a debt interest). [14.745]

Questions

14.32 Acme Ltd has many employees. In the ordinary course of its business, it employs Mr Smith as chief accountant on a two-year contract, and agrees to pay him a fixed annual salary at normal rates for the industry, plus an annual bonus equal to 1% of Acme’s net profit for the year payable at the discretion of the Board (which is also normal industry practice). Can the debt/equity rules apply? 14.33 A Co Ltd enters into a lease of an item of plant, worth $10 m and with an effective life of five years, from Financier Pty Ltd. The term of the lease is two years, the annual rent is $2.2 m, there are no options or other arrangements for A Co Ltd to acquire the plant [14.745]

791

Income Derived Through Intermediaries

at the end of the lease, and none of s 128AC of the ITAA 1936, Div 240, Div 242 or Div 250 of the ITAA 1997 apply. Can the debt/equity rules apply? 14.34 A Co Ltd sells a truck to a customer for $50,000. Assume the market value of the truck is $49,000. The customer has to pay $10,000 on delivery of the truck, and $40,000 within 60 days after delivery of the truck. The customer pays the $10,000 on delivery and pays the balance of $40,000 60 days after delivery. Does s 974-25 apply? 14.35 Acme Ltd made a loan of $100 to Delta Ltd. Acme and Delta were connected entities and Delta had an annual turnover of $6 m. The loan was interest free. The loan had no fixed repayment date, but was repayable in full at any time on demand by Acme. ls the loan treated as a debt or equity interest? See s 974-75(4) and (6).

(c) Debt Test [14.750] The fundamental concept behind the debt test is that, where a person invests capital

with a company, the terms of the investment should impose upon the company an “effectively non-contingent obligation” to return to the investor over the period of the investment an amount at least equal in value to the original capital invested. The concept of an “effectively non-contingent obligation” is defined in s 974-135. The debt interest is constituted by the effectively non-contingent obligations: see ss 974-55, 974-60 and 974-105. The debt test requires you to identify and value the payment obligations under the arrangement. In this respect, a number of important rules apply: • The test may be satisfied by an effectively non-contingent obligation to make repayment of the capital itself (eg repay loan principal), or an effectively non-contingent obligation to make payments of returns on the capital (eg pay loan interest), or a combination of both. Hence, you must identify and value both obligations to pay the capital back, plus the obligations to pay interest or other returns on the capital. • However, in determining if the debt test is satisfied, you only have regard to the value of the “effectively non-contingent” obligations to make payments of capital or returns on the capital (s 974-20(4)) – you disregard the value of any contingent payment obligations even if they are likely to occur. So, for example, if a loan instrument carried an effectively non-contingent obligation to fixed interest at 10% per annum, plus a contingent right to bonus interest at rates declared by the directors at their discretion, you would disregard the value of the bonus interest. • The debt test looks at the value of the effectively non-contingent payment obligations of the company. The debt test will only be satisfied if the effectively non-contingent obligations have a value at least equal to the value of the capital which was originally invested in the company by the investor. Special valuation rules apply to determine the value of the obligations (see ss 974-35, 974-40, 974-45, 974-50, 974-140 and 974-145): i. If there is an effectively non-contingent obligation to terminate the interest within 10 years of the interest being issued, the payment obligations are valued at their nominal value; if not, the payment obligations are valued at their present value under the formula in s 974-50. Note this formula uses a special low discount rate. ii.

792

Where the interest has options by which it may be terminated early, or converted into shares during its term, special rules apply to determine how this affects the value of payment obligations during the term (see ss 974-40 and 974-45).

[14.750]

Taxation of Companies and Shareholders

CHAPTER 14

Redeemable preference shares are subject to a particular rule in s 974-135(5), which provides that an obligation to redeem a preference share is not contingent merely because there is a requirement under the corporations law that the redemption amount be met out of profits or the proceeds of a fresh issue of shares. [14.755]

Questions

14.36 A Co Ltd subscribes $10 m for 10 million redeemable preference shares in C Co Pty Ltd. Both companies are resident, and are not connected entities. The terms of the shares set a fixed redemption date for the shares, being a date in five years’ time. The shares carry a right to a cumulative dividend of 8% per annum (if profits are sufficient) payable in priority to the ordinary shares, and have no voting rights. The amount payable on redemption is $10 m plus an amount equal to any unpaid annual dividend entitlement. Does this satisfy the debt test? 14.37 Big Bank lends Acme Ltd $500,000 at 5% interest per annum on 6 June 2004 under a loan secured by a mortgage over all of Acme’s business assets. Acme has an unconditional obligation to repay the principal amount of $500,000 in a single payment due on 6 June 2006. Six months later Acme suffers a huge financial loss due to an explosion at one of its factories, and announces that it will be going into voluntary liquidation, and that the value of its business assets after the explosion is now $245,000. Does the loan fail the debt test because Acme will not be able to repay it in full? 14.38 Boulder Perseverance Ltd issues a $10,000 debenture to an investor. Boulder has an unconditional obligation to repay the principal amount of the debenture in full in nine years’ time. The debenture confers on the investor an unconditional right to an interest coupon of 5% per annum, plus a right to a further amount of interest equal to 10% of the annual profit (before interest and tax) of Boulder. Does this satisfy the debt test? Would your answer change if the repayment obligation was in 20 years time? You may assume that the present value of any payment to be made at a future date is 75% of its nominal value. (See also Boulder Perseverance Ltd v Taxation, Commissioner of (WA) (1937) 4 ATD 389 for the position under the old law.)

(d) Equity Test [14.760] The equity test lists various kinds of equity interests: s 974-95. The fundamental

concept behind the equity test is that, where a person invests capital with a company, the terms of the investment mean that, in substance or effect, the return of the capital invested, or the payment of returns on the capital invested, will either be “contingent on the economic performance” of the company, or “at the discretion” of the company: s 974-90. The concept of “contingent on the economic performance” of a company (or connected entities) is limited in s 974-85, which provides that a return is not contingent on the economic performance of an entity or its activities merely because it is contingent on “(a) the ability or willingness of an entity to meet the obligation to satisfy the right to the return; or (b) the receipts or turnover of the entity or the turnover generated by those activities”. [14.770] The equity test also refers to interests which give a right to be issued with an equity

interest or be converted to an equity interest: s 974-165. An interest may commence as a debt interest and later convert to an equity interest, and vice versa: s 974-100. For example, a convertible note may satisfy the debt test as well as the equity test at the date of issue, in which [14.770]

793

Income Derived Through Intermediaries

case it will be treated as a debt test at that date. It will only become an equity interest if and when it is converted to shares. Some difficult issues arise concerning valuation, dealt with in ss 974-35, 974-40 and 974-45. [14.775]

Questions

14.39 Midland Railway Ltd issues a $10,000 debenture to an investor. Midland has an unconditional obligation to repay the debenture in full in 20 years’ time. The debenture provides that the investor has an unconditional right to receive interest of 10% per annum on the debenture. Assume that the present value of any payment to be made at a future date is 75% of its nominal value. Is this a debt interest or an equity interest? Would your answer change if the investor were only entitled to receive the interest of 10% per annum, if Midland could pay the interest and still have a net profit for the year? 14.40 Hedge Fund Ltd issues a $10,000 perpetual debenture to an investor. The debenture has no fixed repayment date. Hedge Fund Ltd has an unconditional obligation to pay interest on the debenture at the rate of 15% per annum during the first 20 years of its term, and zero interest after that date. Assume that the present value of any payment to be made at a future date is 75% of its nominal value. Is this a debt interest or an equity interest? 14.41 Investor Ltd subscribes $10 m for 10 million credit notes issued to it by Bank Ltd. The terms of each note are: (1) the note cannot be redeemed for at least five years, and has no fixed final redemption date; (2) for the first five years the note is on issue, the holder of the note has an unconditional right to receive interest at 10% per annum; (3) the note holder has no right to redeem the note; (4) Bank Ltd is entitled (but not obliged) to redeem the note for $1.00 (ie at face value) on the date the note has been on issue for five years – such redemption option is to be exercised by delivery of a redemption notice and cheque for $1.00 to the note holder two business days before the expiry of the five years; (5) if the note is not redeemed after the first five years, the note holder will have an unconditional right to receive, for each further year that the note remains on issue, interest at the rate of 100% per annum. Assume that the present value of any payment to be made at a future date is 75% of its nominal value. Is this a debt interest or an equity interest?

6. INTEGRITY RULES (a) Distributions of Profit Disguised as Returns of Share Capital [14.800] Recall that the tax law treatment of a distribution can be given a capital character by

debiting the distribution to a share capital account Recall also that the dividend imputation rules treat non-residents, and some other non-taxable shareholders, less favourably than residents in respect of distributions. This creates an incentive for companies to distribute capital to those shareholders who value capital, and frankable profits to the shareholders who value taxed profits. As the Act contains no “profits first” distribution rule and companies have flexibility in choosing to distribute from a profit or capital account, it would seem relatively easy to disguise profit distributions as capital returns. Historically, this form of manipulation was difficult to achieve outside the context of liquidations, because restrictions in the company law required the maintenance of share capital for the protection of creditors and there was a strict prohibition against amounts being distributed from these accounts except with the approval of a court. The procedures were time-consuming and costly. 794

[14.775]

Taxation of Companies and Shareholders

CHAPTER 14

Since 1998, there has been a significant relaxation of the restrictions on distributions of capital by companies, which can now generally be approved by directors as long as they do not prejudice the interests of creditors. Companies are permitted under s 254S of the Corporations Act 2001 to capitalise profits without having to issue shares by simply transferring amounts from profit and loss account to share capital account. Leaving a company with a relatively unfettered ability to choose between distributing cash by way of either dividend or a return of share capital was seen to pose an unacceptable threat to the revenue. A series of anti-avoidance measures were enacted to protect against this perceived threat. These are briefly summarised here. (i) Tainted share capital account rules [14.810] For tax purposes, the benefit of capitalising profits is largely reversed by a tax

anti-avoidance rule which deems to be “tainted” a share capital account to which profits are transferred: Div 197 and s 975-300 of the ITAA 1997. Among various draconian penalties, the main feature of a tainted share capital account is that it is deemed not to be a share capital account for the purposes of the definition of “dividend”. Amounts distributed from such an account are therefore deemed to be dividends out of profits. The rules thus effectively prevent a company transferring amounts from profit and loss account to share capital account and then distributing them as share capital. [14.820] An older “anti-tainting” rule is in s 6(4) of the ITAA 1936 and applies to

arrangements where A subscribes share capital to a company, and under the arrangement the company makes a distribution to B which is debited to a share capital account. In such a case, the exclusion in paragraph (d) of the definition of “dividend” for distributions debited to share capital account does not apply. Hence the distribution to B will be treated as a dividend. (ii) Distributions from capital deemed out of profits and not frankable [14.830] A distribution debited to share capital that is deemed by some provision to be a

dividend, is also deemed to be out of profits for the purposes of s 44 under s 44(1B). This provision is needed to ensure the deemed dividend is assessable. A distribution out of share capital is also deemed to be unfrankable: s 202-45(e). (iii) Capital streaming rules [14.840] The capital streaming rules in sections 45, 45A, 45B and 45C of ITAA 1936 are designed to counter arrangements to provide shareholders with capital benefits in lieu of assessable (and frankable) dividends. The general principle is that shareholders are more likely to prefer a capital benefit to a dividend in cases where the company is unable to provide a fully franked dividend to its shareholders. However, it is also recognised that shareholders may prefer a capital benefit to a dividend in other circumstances, for example, shareholders who hold pre-CGT shares, hold post-CGT shares with a high cost base, or have capital losses; or shareholders who are not able to realise the full value of the franking credits on a franked dividend, in particular non-residents. Section 45 applies to bonus shares to deem them to be dividends when issued in lieu of dividends franked to less than 10%. It is supported by s 6BA, which broadly deems bonus shares to be dividends when shareholders are offered a choice between lowly franked dividends or bonus shares. [14.840]

795

Income Derived Through Intermediaries

Section 45A broadly applies if a company streams capital benefits to shareholders who derive a greater benefit from capital benefits than other shareholders, and the other shareholders receive dividends. The “capital benefits” may include shares, a return of capital, or increasing the value of existing shares. A person may be regarded as deriving a greater advantage from a capital benefit if they hold pre-CGT shares, are a non-resident, have a cost base for shares at least equal to the capital benefit, have capital losses, would not obtain a rebate on an unfranked dividend, or have tax losses. If s 45A applies, the ATO is empowered under s 45C to deem the capital benefit to be an unfranked dividend. Under s 202-45(h) it is an unfrankable dividend. However, if the arrangement involves the provision of shares (eg bonus shares) and the other shareholders receive fully franked dividends, s 45A will not apply: s 45A(5). Section 45B applies to schemes to provide capital benefits in substitution for dividends. It operates where three requirements are met: 1.

A company provides a capital benefit to a person: “capital benefits” may include shares, a return of capital, or increasing the value of existing shares.

2.

A taxpayer (whether the recipient of the benefit or another person) obtains a tax benefit: a “tax benefit” is deemed to arise if they will pay less tax, or will pay tax at a later time, than would have been the case if they had instead received a dividend: s 45B(9). 3. A person who carried out any part of the scheme had a non-incidental purpose of enabling a taxpayer to obtain such a tax benefit. If s 45B applies, the ATO is empowered under s 45C to deem the capital benefit to be an unfranked dividend. Under s 202-45(h) it is an unfrankable dividend. In addition, if a non-incidental purpose of the arrangement was to conserve franking credits, the ATO can impose franking debits on the company: s 45C(3). The most difficult aspect of s 45B is to determine when a shareholder will have a purpose (other than an incidental purpose) of obtaining a tax benefit when they have entered an arrangement which involves the receipt of capital rather than dividends. Partly to address this, s 45B(8) contains a non-exhaustive list of matters to which regard might be had in determining if the purpose is present. The list might be said to reveal three general indicators of an arrangement to which s 45B could apply: first, the capital return having its actual source in profits; second, the recipient being a person for whom capital returns have specially favoured tax treatment (eg persons with capital losses, persons with pre-CGT shares and non-residents); third, the capital return not involving any substantial diminution of the shareholder’s equity interest in the company. [14.845]

Questions

14.42 Consider the example discussed at [14.250] where Acme Pty Ltd leases out a rental property and derives $10,000 rental income, which is offset by deductions of $10,000 for a prior year tax loss. This leaves the company with $10,000 tax-free cash, and a $10,000 current year profit which it could pay out as an unfranked dividend to its shareholders. If Acme were to instead apply the $10,000 cash representing the profit to making a $10,000 return of share capital to its shareholders, would s 45A or s 45B apply? What if half the shareholders were resident individuals and half were non-resident individuals? What if Acme paid $5,000 as an unfranked dividend to the non-residents (who paid 15% dividend withholding tax) and $5,000 as a capital return to the residents? 796

[14.845]

Taxation of Companies and Shareholders

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14.43 Beta Ltd has operated a gold mining business (representing 75% of gross assets) and a uranium mining business (representing 25% of gross assets) for many years. It sells the uranium business and finds that it has substantial surplus cash. It decides to return the cash to shareholders by making a share capital reduction where it will cancel one out of every four shares held for a market value consideration of $3.00 per share. Will s 45B apply?

(b) Streaming or Trading of Franking Credits [14.850] You should now have a good understanding of two features of Australia’s dividend

imputation system. First, franking credits are a valuable tax attribute: a person entitled to a franking credit can reduce their tax payments, generating a real economic benefit. Second, the imputation system has clearly defined limits which create certain systemic biases. Resident shareholders will usually derive greater value from franking credits than non-resident shareholders. There is an incentive for companies to channel, or “stream”, franking credits to the shareholders who can make best use of them (and to stream capital distributions to other shareholders). There is also an incentive for taxpayers who cannot obtain the full benefit of franking credits to enter into transactions with other taxpayers who could do so, at a price. The income tax law contains several integrity rules designed to prevent companies streaming franking credits to those shareholders for whom franking credits have greater value than other shareholders. It also contains rules designed to prevent companies and shareholders engaging in trading of franking credits. The main rules are briefly outlined here. (i) Benchmark rule [14.860] The benchmark rule in Div 203 requires that all frankable distributions in a franking

period must have the same franking percentage as the first frankable distribution in the period: ss 203-25 and 203-30. It operates differently for private and public companies. The benchmark rule does not apply where distributions are in different franking periods. The franking period for a listed public company is six months – ie the income year is divided into two franking periods: s 203-40. However, a listed company may not be subject to the rules if it has a single class of shares and its constitution prevents it from differentially franking dividends: s 203-20. The franking period for a private company is the income year (s 203-45), so all frankable distributions in a year have to be franked equally at the franking percentage set by the percentage for the first distribution in the period (s 203-25). Breaches of the rule are penalised. The disclosure rule in Subdiv 204-E requires a company subject to the benchmark to notify the ATO if the benchmark franking percentage varies between periods by 20 percentage points or more: s 204-75.A company cannot depart from the benchmark franking percentage for a dividend except with the permission of the ATO, which can be granted only in exceptional circumstances: s 203-55. [14.870] Under the benchmark rule, if Ausco Pty Ltd, as a private company, were to pay a

franked dividend of $1.00 a share with a franking percentage of 100% on all shares held in the name of shareholders with addresses in Australia on 29 June, and an unfranked dividend of $1.00 a share on all shares held in the name of shareholders with addresses outside Australia on 30 June, it would suffer a franking debit for “under-franking” on the second dividend: ss 203-30, 203-50(1)(b), 203-50(2), 203-50(3), 203-50(4) and 205-30 Item 3. If Ausco instead paid the unfranked dividend to non-residents on 29 June and the franked dividends to [14.870]

797

Income Derived Through Intermediaries

residents on 30 June, it would be required to pay “over-franking tax” by way of penalty on the second dividend: ss 203-30, 203-50(1)(a) and 203-50(2). [14.875]

Questions

14.44 What would be the position under the benchmark rule if Ausco paid to all shareholders in January a total franked dividend of $700,000 which had a franking percentage of 100%, the franking account of Ausco having a surplus of $300,000 at that time, and then wanted to pay another dividend to all shareholders of $700,000 on 30 June, when the franking account had a nil balance? 14.45 What would be the position if Ausco Pty Ltd, as a private company, were to pay on 29 June a franked dividend of $1.00 a share, with a franking percentage of 100%, on all shares held in the name of shareholders with addresses in Australia, and an unfranked dividend of $1.00 a share on all shares held in the name of shareholders with addresses outside Australia on 2 July? (ii) Linked distributions [14.880] Subdivision 204-B applies to “linked distributions” where a shareholder who would

receive a franked dividend from a company can elect to receive in substitution an unfranked dividend (linked dividend) from a different entity, or vice versa. Suppose Ausco Pty Ltd had resident and non-resident shareholders, an Australian subsidiary, Aussub, and a US subsidiary, US Sub Inc. Ausco might cause US Sub to issue a redeemable preference share to each Ausco shareholder, and announce that under the new Ausco dividend selection plan, any non-resident shareholder who delivered a written notice to Ausco electing to forego dividends on Ausco ordinary shares would receive a dividend in US dollars from US Sub on the preference share equal to the foregone dividend on the ordinary share. The non-residents might all enter the plan and receive dividends from US Sub (the linked dividends) in lieu of dividends from Ausco. To prevent this being used as a strategy to direct the franking credits of Ausco to the Australian shareholders, Subdiv 204-B would impose a franking debit on Ausco equal to the debit it would have suffered had it continued to pay franked dividends to the non-residents. [14.890] Subdivision 204-B also applies if a shareholder who would receive a franked

dividend from a company can elect to receive in substitution a tax-exempt bonus share (see [15.40]). To prevent this being used as a strategy to direct the franking credits of the company to the Australian shareholders, Subdiv 204-C imposes a franking debit on the company equal to the debit it would have suffered had it continued to pay franked dividends to those who in fact took the bonus shares. One limitation in Subdiv 204-B is that it requires the relevant scheme to offer a choice to substitute one kind of dividend for another. [14.895]

Question

14.46 Would Subdiv 204-B apply if US Sub issued ordinary shares to non-residents, and Aussub issued ordinary shares to residents, and Ausco announced a compulsory dividend plan under which all non-residents would have to receive dividends from US Sub, and all residents would have to receive franked dividends from Aussub (of an amount equal to the US Sub dividends), and no shareholders would receive a dividend from Ausco? 798

[14.875]

Taxation of Companies and Shareholders

CHAPTER 14

(iii) General anti-streaming rule [14.900] Subdivision 204-D of the ITAA 1997 contains the most powerful anti-streaming

rule. It applies where a company pays franked dividends to the shareholders (favoured members) who derive a greater advantage from franking credits than the other shareholders (disadvantaged shareholders), and the other shareholders receive lesser or nil franking credits. Importantly, unlike the position under Subdiv 204-B, there is no requirement that shareholders have a choice to select one kind of dividend over another, and no requirement that a dividend of one kind be paid in substitution for a dividend of another kind. If the section applies, the ATO can do one or both of (s 204-30(3)): • impose a franking debit on the company (ss 204-30(3)(a), 204-35, 204-40 and 205-30 Item 7); • cancel the franking credit benefits of the favoured members on the franked dividends (ss 204-30(3)(c), 204-45, 207-145(1)(b) and 207-145(2)(b)). [14.905]

Questions

14.47 Suppose Ausco Pty Ltd had resident and non-resident shareholders, an Australian subsidiary Aussub, and a US subsidiary, US Sub Inc. Would s 204-30 apply if US Sub issued ordinary shares to non-residents, and Ausco announced a compulsory dividend plan under which all non-residents would have to receive dividends from US Sub (and no dividends on their ordinary shares in Ausco), and all residents would have to receive franked dividends from Ausco? 14.48 Would s 204-30 apply if US Sub issued ordinary shares to non-residents, and Aussub issued ordinary shares to residents, and Ausco announced a compulsory dividend plan under which all non-residents would have to receive dividends from US Sub, all residents would have to receive franked dividends from Aussub (of an equal amount to the US dividends), and Ausco would cease paying dividends? 14.49 Would s 204-30 apply to a resident private company, Beta Pty Ltd, if the shareholders in Beta were a group of resident individuals, and the company paid franked dividends to the individuals on high marginal tax rates and unfranked dividends to individuals on low marginal tax rates? (iv) Securities loans [14.910] The principle that the company is making an advance payment of tax on behalf of

the ultimate shareholder appears straightforward where the shareholder receives a dividend out of profits which have accrued while they were a shareholder. But who should obtain the franking credits in the case where a person purchases shares just before a dividend is paid? Or in the case where a person acquires a share under a securities loan or under a legal mortgage of shares? The general rule is that the franking credits pass to (or through, in the case of a trust or partnership) the person or entity who has legal title to the share at the relevant time for the dividend – that is, the registered shareholder to whom the dividend is paid or payable by the company as a matter of company law. The same logic would suggest that other persons who hold shares as registered holder, even though not a beneficial owner, would receive dividends as shareholder in terms of the Act. Examples of this would be vendors of shares under sale and purchase contracts where settlement of the sale has occurred but registration of the transfer of title has not been made, or persons in whose name shares are registered under a legal mortgage of the shares. [14.910]

799

Income Derived Through Intermediaries

The imputation regime recognises this in Div 216. It has rules which apply deemed shareholder status to a purchaser of shares under a cum-dividend sale and purchase contract on a stock exchange, where the purchaser is entitled to the dividend, but the company pays the dividend to the seller because they are still entered on the register on the books closing date. A similar rule applies when a share is loaned under a securities loan, and the company pays the dividend to the borrower where the lender is entitled to the dividend. Where a situation is not covered by these specific situations, it may be that the rules by which imputation credits pass through a trust can be applied. For example, suppose shares are sold ex-dividend, and the company pays the dividend to the purchaser because they are entered on the register on the books closing date: the purchaser would arguably receive the dividend on trust for the seller. (v) 45 day/at risk rules [14.920] The general rule that franking credits pass to the registered shareholder at the books

closing time for the dividend can facilitate the “trading” of franking credits. For example, a shareholder might enter into a short-term arrangement to transfer legal title to shares to another person shortly before the books closing date for the dividend, and then have legal title to the shares transferred back shortly after payment of the dividend. The government allowed these short-term trading arrangements for a considerable time, perhaps on the theory that they aided the liquidity of the market in Australian company shares. However, they were ultimately seen to be adverse to the revenue, and the so-called “45 day/at risk” rules were introduced in Pt IIIAA Div 1A of the ITAA 1936, in detail. Broadly, the complex 45 day/at risk rules seek to deny franking credits to the holder of legal title to shares, unless that person is exposed to at least 30% of the economic risks and benefits of ownership of the shares for a minimum holding period of 45 days for ordinary shares (for preference shares the period is 90 days). The rules use the financial concept known as “delta” to measure the risks of loss and opportunities for gain on the shares: s 160APHM. Delta measures the rate at which an option over a share will change in value as the price of the underlying share changes. For example, if a call option to purchase a share at a particular price increases by 25 cents if the share price increases by a dollar, the option has a delta of 0.25; or if a put option to sell a share at a particular price falls by 25 cents if the share price increases by a dollar, the option has a delta of –0.25. To be regarded as holding shares “at risk” the delta of the “net position” of the taxpayer must not be less than 0.3. A holder who satisfies these tests is a “qualified person” eligible to receive franking credits. Sections 207-145(1)(a) and 207-150(1)(a) of the ITAA 1997 provide that franking credit benefits are denied where a recipient of a franked distribution is not a “qualified person”. An exclusion applies to individual small investors. It allows such investors to claim up to $5,000 in franking tax offsets in respect of franked dividends received each year without having to determine if they are a “qualified person” under these rules: s 160APHT. One example will illustrate the general effect of the 45 day/at risk rules. Assume that a non-resident (NR) has ordinary shares in BHP and wishes to trade in franking credits on the shares. NR (as the lender) chooses to enter into a securities lending arrangement with B (the borrower), a resident. Under the arrangement, B is “loaned shares in BHP” by having them transferred to B in time to become registered shareholder, just before the books closing date 800

[14.920]

Taxation of Companies and Shareholders

CHAPTER 14

for the payment of a franked dividend on the shares. B receives the dividend, keeps it, and then transfers the shares back to NR. B would pay NR a lending fee based in part on the value of the dividend and the franking credits. The “45 day/at risk” rules prevent this transaction because they prevent B claiming the franking credits on the franked dividend. The rules would require B to actually hold the shares “at risk” for an initial holding period of at least 45 days. This initial rule applies to the period commencing the day after the date of acquisition of the shares, and ending on the 45th day after the day the shares became ex-dividend: s 160APHD. The ex-dividend day is the day after the last day you could acquire the shares and become entitled to the dividend: s 160APHE. In this example, B will not have held the shares “at risk” for the initial holding period of 45 days. The “at risk” concept behind the rules refers to both upside and downside risk associated with holding shares – upside risk being the prospect that the shares will increase in value and downside risk being the prospect that the shares will reduce in value. Under a securities loan, B as borrower is exposed to nil downside or upside risk, since the shares are simply transferred to B and then transferred back with no price adjustment: all the exposure to price risk associated with the shares remains with NR, the lender. [14.930] Where taxpayers receive dividends on shares held through trusts or partnerships, the

“at risk” rules operate at two levels. The trustee or partnership itself must be a qualified person in relation to the shares it holds (ie hold the shares at risk for the requisite period): s 160APHU. In addition, the taxpayer must be a qualified person in relation to their trust or partnership interest in the shares (ie also hold the interest at risk for the requisite period). In addition, where the trust is a discretionary trust, the taxpayer’s interest in the trust is deemed to have a delta of zero unless a family trust election is made under the trust loss rules in Sch 2F of the ITAA 1936: see the rules in s 160APHL. The beneficiary of a discretionary trust is not regarded as holding their trust interest at risk, since they are mere objects of the trustee’s discretionary powers – their interest in theory is not exposed to upside or downside price risk. However, in a closely controlled family trust, it may be assumed the family members are in fact exposed to price risk on the underlying assets of the trust as a matter of economic substance. Fund managers and some other taxpayers may elect to ignore the “at risk” rules and instead accept a ceiling on franking credits claimed in an income year, calculated based on a hypothetical portfolio exposure to residence companies in the ASX All Ordinaries Index: s 160APHR. The 45 day/at risk rules apply to non-share equity interests in the same way as they apply to normal shares. (vi) General anti-avoidance rule for franking credits [14.940] Part IVA of the ITAA 1936 contains s 177EA, which is a general anti-avoidance provision which applies to any scheme involving a dealing in shares which has a purpose (other than an incidental purpose) of securing franking credit benefits for a taxpayer. It is designed to apply to any franking credit arrangement which might escape the operation of the other anti-avoidance rules mentioned above. A scheme must satisfy three critical requirements for s 177EA to apply to a franked dividend on a share (s 177EA(3)): (i)

the scheme must involve a disposition of an interest in shares (note the broad meaning of “interest” in s 177EA(13) and “disposition” in s 177EA(14)); [14.940]

801

Income Derived Through Intermediaries

(ii)

a person must obtain a franking credit benefit from a franked dividend on the shares the subject of the disposition;

(iii)

it must be concluded that any person who carried out any part of the scheme did so for a purpose, which need not be a dominant purpose, but must not be a non-incidental purpose, of enabling that franking credit benefit to be obtained. If the section applies, the ATO may either (s 177EA(5)): • impose a franking debit on the company (if it is party to the scheme); • cancel the franking credit benefits in the hands of the shareholder receiving the franked dividend. Section 177EB has been introduced to deal with similar arrangements involving consolidated groups. The most difficult aspect of s 177EA is to determine when a shareholder will have a purpose, other than an incidental purpose, of obtaining franking credit benefits when they have entered an arrangement which involves the receipt of franked dividends. Given the franking credit on a dividend has a major effect on the after-tax value of any investment in shares in a company which pays franked dividends, it might be said that s 177EA will have a very wide potential operation. Partly to address this, s 177EA(4) provides that a person is not to be taken to have a non-incidental purpose of obtaining franking credit benefits merely because the person has acquired shares in a company. This suggests that the circumstances of the shareholding need to reveal some “unusual” feature which points to a purpose of obtaining franking credit benefits other than as an ordinary incident of ownership of shares in the company concerned. Section 177EA(17) contains a non-exhaustive list of matters to which regard might be had in determining if the “unusual” features are relevant. The list suggests two general indicators of an arrangement to which s 177EA should apply: first, the presence of contractual arrangements which point to the holder of the shares holding them solely to receive franking credits, and taking steps to pass to other persons all, or nearly all, the economic exposure to the other aspects of ordinary share ownership – such as the risks and benefits of changes in the market price of the shares; second, the person who is the holder of the shares being someone – such as a resident – for whom the franking credits have a greater value than the other persons to whom the economic exposure is otherwise passed – such as non-residents. [14.950] Section 177EA was successfully applied by the ATO in Electricity Supply Industry

Superannuation (Qld) Ltd v DFCT (2003) 53 ATR 120; [2003] FCAFC 138. In this case, s 177EA was applied to an arrangement in which the trustee of an investment fund directed franked dividends in disproportionate shares to beneficiaries who could claim the franking credits. [14.960] In Mills v FCT [2012] HCA 51 a hybrid security issued by the Commonwealth Bank

was found to be frankable and s 177EA did not apply. Mills was a test case. Mr Mills, then a senior director of specialist tax firm Greenwoods & Freehills, was an investor in the securities, along with 30,000 other Australian shareholders and was the test litigator for the Bank. All banks are required by Australian law (and by global regulation in the Basel Accords) to maintain minimum ratios of “Tier 1 capital”. These capital requirements are intended to prevent the problems that occurred in the Global Financial Crisis. In 2009, to meet a need for more “Tier 1 Capital”, the Commonwealth Bank issued its PERLS V securities. This was the fifth issue of this kind by the Bank and it was very successful, raising over $2 b in capital. The 802

[14.950]

Taxation of Companies and Shareholders

CHAPTER 14

PERLS V issue differed from previous PERLS issues because it involved both the Australian Bank and its New Zealand branch. Each PERLS V security comprised a preference share issued by the Commonwealth Bank of Australia stapled to a note issued by the New Zealand branch. An investor who purchased a PERLS V security was entitled to quarterly distributions of interest on the note, paid by the New Zealand branch, plus a franking credit on the preference share, reflecting company tax paid by the Bank as an Australian taxpayer. It was accepted by the Commissioner that a PERLS V security, considered as a whole, was a non-share equity interest under Div 974 of the ITAA 1997. The distributions on the security, although called “interest”, were treated as dividends and so could carry a franking credit. In contrast, under New Zealand tax law, the note that formed part of the PERLS securities was analysed separately from the preference share and it was treated as debt, so the Commonwealth Bank obtained a deduction in New Zealand for the distributions of interest. In Mills, it was accepted that there was a “scheme” to which s 177EA could apply, that there was an imputation benefit being the franking credits delivered to investors and that there was an issue of membership interests, which were the stapled security including the preference shares. The ATO won at first instance and by majority in the Full Court of the Federal Court but the taxpayer succeed in the High Court. Justice Gageler (with whom all the other judges agreed) concluded that s 177EA did not apply.

Mills v FCT [14.970] Mills v FCT [2012] HCA 51 (Full High Court) Gagler J: The Explanatory Memorandum for s 177EA as originally inserted into the ITAA 1936 in 1998 explained the section as “a general anti-avoidance rule … to curb the unintended usage of franking credits through dividend streaming and franking credit trading schemes”. It went on to explain “dividend streaming” as “the distribution of franking credits to select shareholders” and “franking credit trading schemes” as schemes that “allow franking credits to be inappropriately transferred by, for example, allowing the full value of franking credits to be accessed without bearing the economic risk of holding the shares”. A Supplementary Explanatory Memorandum described the section as a “catch-all” provision, the object of which was to protect Pt 3-6 of the ITAA 1997 from “abuse of the imputation system through schemes which circumvent the basic rules for the franking of dividends … not otherwise prevented by those basic rules”. … [It] went on to explain that … a reference to a “purpose” of a scheme “is usually understood to include any main or substantial purpose” of the scheme. It added: “[a] purpose will be an incidental purpose when it occurs

fortuitously or in subordinate conjunction with one of the main or substantial purposes of the scheme, or merely follows that purpose as its natural incident.” The issue was – as the issue remains in this appeal – wholly as to whether, within the meaning of s 177EA(3)(e) of the ITAA 1936, having regard to the “relevant circumstances” of the arrangements for the issue of PERLS V, it would be concluded from the perspective of a reasonable person that the Bank entered into and carried out those arrangements “for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling [a taxpayer who is a holder of PERLS V] to obtain an imputation benefit” by reason of the allocation of a franking credit to the payment of interest on a note. For the purposes of addressing that issue, the primary judge separately analysed each of the “relevant circumstances” in s 177EA(17) of the ITAA 1936. He took the view that: the circumstances referred to in ss 177EA(17)(a), 177EA(17)(c) and 177EA(17)(d) were each neutral in that they pointed neither towards nor [14.970]

803

Income Derived Through Intermediaries

Mills cont. away from the Bank having a purpose of enabling a holder to obtain an imputation benefit; the circumstances referred to in ss 177EA(17)(b), 177EA(17)(f), 177EA(17)(ga) and 177EA(17)(h) each pointed towards the Bank having a purpose of enabling a holder to obtain an imputation benefit which was not merely incidental; and the circumstances in ss 177EA(17)(g) and 177EA(17)(i) each pointed away from the Bank having such a purpose. Of the circumstances referred to in ss 177D(b)(i) to 177D(b)(viii), as incorporated by s 177EA(17)(j), he took the view that many had no application beyond the circumstances he had already taken into account but that those referred to in ss 177D(b)(ii) and 177D(b)(iv) pointed towards the purpose. … He also regarded the fact that the interest payments were frankable in Australia yet deductible against assessable income in New Zealand as part of the ″form and substance″ of the scheme within s 177D(b)(ii). … Having earlier described the franking credit attaching to the payment of interest on a note as “integral to the return on the [n]ote” and as “the very thing that makes an investment in [PERLS V] commercially acceptable”, the primary judge expressed his conclusion as follows: Having regard to all the relevant matters and circumstances, some of which do not point towards the relevant purpose, I consider, on balance, that overall they point towards the purpose of enabling holders of [PERLS V], such as the [t]axpayer, to obtain an imputation benefit. That is a basic and fundamentally important aspect of the terms of the [n]otes. The characteristics of [PERLS V] are much more like those of debt than of equity. By issuing [PERLS V] in New Zealand, the Bank was able to achieve the result that it obtained a deduction in New Zealand in respect of the [d]istributions on the [PERLS V], but had the advantage, in terms of cost, of offering Australian residents the imputation benefit. As to whether the primary judge was correct in treating as relevant the deductibility for New Zealand income tax purposes of the interest 804

[14.970]

payments on the notes, members of the Full Court took different views. To Jessup J, the deductibility in New Zealand of distributions frankable in Australia was “an exemplar of what the legislature had in mind when it posited a distinction between ‘form’ and ‘substance’ in [s 177D(b)(ii)]”. To Edmonds J, it was wholly irrelevant. Where I disagree with Jessup J in relation to the construction of s 177EA(3)(e) is in two respects. First, a purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose. Indeed, the centrality of a purpose to the design of a scheme directed to the achievement of another purpose may be the very thing that gives it a quality of subsidiarity and therefore incidentality. That is not impermissibly to confine the scope of s 177EA(3)(e) to a dominant purpose: the categories of ″dominant″ and “incidental” are not exhaustive. The parenthesised words in s 177EA(3)(e) make clear that a dominant purpose of enabling a holder to obtain a franking credit is sufficient but not necessary for the requisite jurisdictional fact to exist, but it does not follow that a purpose which does no more than further or follow from some dominant purpose is incidental. Second, counterfactual analysis is not antithetical to the statutory inquiry mandated by s 177EA(3)(e). Purpose is a matter for inference and incidentality is a matter of degree. Consideration of possible alternatives may well assist the drawing of a conclusion in a particular case that a purpose of enabling a holder to obtain a franking credit does or does not exist and, if such a purpose exists, that the purpose is or is not incidental to some other purpose. On that construction of s 177EA(3)(e), there is in the case of a capital raising where the issuer intends to frank distributions on the equity interests disposed of a “purpose … of enabling” the holders of those equity interests to obtain franking credits. Any such capital raising is therefore potentially within the scope of s 177EA(3)(e). If, however, the intended franking of distributions serves no purpose other than to facilitate the capital raising then the purpose is an incidental purpose: s 177EA(3)(e) is not engaged and s 177EA does not apply. That is to be contrasted with franking credit trading and

Taxation of Companies and Shareholders

Mills cont. franking credit streaming where it is the issue of equity interests that is incidental to the provision of the franking credits. No doubt, there are other scenarios within the “catch-all” operation of s 177EA where the circumstances are more nuanced. The present case does not involve one of them. … It has been observed in the context of the more familiar operation of s 177D within Pt IVA that having regard to the eight matters listed in s 177D(b) does not require that they each be analysed individually; provided they are taken into account, a ″global assessment of purpose″ is permissible and often it is appropriate (FCT v Consolidated Press Holdings Ltd (2001) 207 CLR 235 at 26). The same is true of the eighteen circumstances listed in s 177EA(17) read with s 177D(b)(i)-(viii). For the purposes of the present case, the question posed by s 177EA(3)(e), and to be answered from the perspective of a reasonable person, can be broken down into two subquestions. In issuing PERLS V, did the Bank have a purpose of enabling holders to obtain franking credits? If so, was that purpose subordinate to or in subsidiary conjunction with some other purpose? The answer to both those sub-questions is “yes”. The Bank obviously issued PERLS V with the intention of holders obtaining franking credits:

CHAPTER 14

the proposed franking of distributions was not only disclosed in the prospectus, it was integral to the calculation of the distribution on the notes (s 177EA(17)(f)), integral to the calculation of yield to investors (ss 177D(b)(ii) and 177D(b)(iv)) and integral to the calculation by the Bank of its after tax cost of capital (ss 177D(b)(ii), 177D(b)(iv) and 177D(b)(vi)). The Bank equally obviously issued PERLS V because the Bank needed to raise Tier 1 capital in circumstances where all the means available to the Bank to raise Tier 1 capital would have involved the Bank franking distributions to the same extent and where PERLS V represented the most commercially attractive of those available means (s 177D(b)(ii)). The circumstances that Tier 1 capital raised by the Bank from the issue of PERLS V was to be used by the Bank to generate income in New Zealand not taxable in Australia, and that distributions on the notes were deductible against assessable income in New Zealand, are required to be taken into account as relevant circumstances (ss 177EA(17)(ga), 177D(b)(ii) and 177D(b)(vi)). However, their probative value for the purpose of answering the question ultimately posed by s 177EA(3)(e) is elusive. They do not make it more or less likely that the Bank had a purpose of enabling the holders of PERLS V to obtain franking credits and they do nothing to alter the relationship between that purpose and its purpose of raising Tier 1 capital.

[14.980] In Mills, the Commissioner argued that the Commonwealth Bank had got “the best

of both worlds”. The PERLS V securities enabled the Commonwealth Bank to raise Tier 1 capital at a cheap price, estimated by the Bank, after tax and after taking account of the franking credits that had to be paid out, as 5.86%. This compared to the economic cost of an ordinary issue of shares being 14.2%. The PERLS V securities enabled the Bank to distribute some excess franking credits that it had not been able to use because of the various limits on the dividend imputation system, to Australian investors who can use them. On $2 billion of capital, the Bank saved about $170 million in tax. Even if the Commissioner had won the case, the Commonwealth Bank estimated the cost of capital as rising only to 7.8%, still much cheaper than ordinary shares. The main reason is the deduction that the Bank obtained for the interest paid out of the New Zealand branch. Should Australian taxpayers care about this tax deduction in New Zealand? Today, capital is commonly raised and invested across borders. International tax arbitrage by multinationals – [14.980]

805

Income Derived Through Intermediaries

for example, by using hybrid securities that have different tax treatment in different countries – is one way in which the global tax burden of multinational enterprises is lowered. (vii) Dividend stripping [14.990] Sections 207-145(1)(c) and 207-145(2)(c) provide that imputation credit benefits

will be denied to a person who receives a franked distribution where the distribution is received as part of a dividend stripping operation. This term is defined in s 207-155, but in a way which leaves the central concept of “dividend stripping” undefined. Given the breadth of operation of s 177EA (discussed above) it is, perhaps, difficult to conceive of dividend stripping schemes which would involve franking credits and not attract s 177EA. Dividend stripping is discussed further in [15.100] ff.

7. COMPANY LIQUIDATIONS (a) In General [14.1000] The distinction drawn by the income tax law between a dividend as a distribution

of profits generated by the assets of the company, and a return of the capital invested in the company, is also to be seen in the treatment of a distribution of all the assets of the company on a winding up or liquidation. The case of Uther, also extracted at [14.290], confirmed earlier authority that a distribution on liquidation of a company was treated as a distribution of capital, even if the company had retained earnings. Section 47 of the ITAA 1936 was drafted to deal with this situation. Taylor J in Uther explained its operation:

FCT v Uther [14.1010] FCT v Uther [1965] HCA 42; (1965) 112 CLR 630 Taylor J: Burrell’s Case (1924) 2 KB 52, which has been followed consistently in this Court and which was referred to by Fullagar J. in Blakely’s Case (1951) 82 CLR 388, established quite clearly that a distribution by a liquidator in the course of a winding-up does not constitute, either in whole or in part, a distribution of the company’s profits … Speaking for the Court in Parke Davis and Co. v. Commissioner of Taxation (1959) 101 CLR 521 Dixon C.J. said of [s 47]: “Its purpose is obvious enough. The section was first enacted in an earlier form to meet the situation, made clear enough by Inland Revenue Commissioners v. Burrell

(1924) 2 KB 52 which decided in effect that a distribution of a mass of assets, although in a colloquial sense they represented or contained profits, was a distribution of capital” (1959) 101 CLR 521, at p 530. Section 47 … in effect, deems distributions to shareholders by the liquidator of a company in the course of winding up, “to the extent to which they represent income derived by the company”, to be dividends paid to the shareholders and then it deems such dividends to have been paid to the shareholders by the company out of profits derived by it.

[14.1020] This statement, and the existence of s 47 itself, may imply that a liquidation

distribution would not naturally come within the conception of a dividend paid out of profits under s 44. However, a different view is expressed by Williams ACJ, Kitto and Taylor JJ in Archer Brothers Pty Ltd v FCT (1953) 90 CLR 140, who suggest that s 47 merely clarifies the 806

[14.990]

Taxation of Companies and Shareholders

CHAPTER 14

treatment of liquidation distributions. In s 47, “income” is given an extended meaning to encompass statutory income and gross assessable capital gains, as well as ordinary income. To the extent that a liquidating distribution is deemed to be a dividend, it may be frankable A final liquidation distribution is also subject to CGT as disposal proceeds for a redemption or cancellation of the shares in the company, and so it is covered by CGT event C2. Under CGT event C2, the final distribution is treated as the capital proceeds of disposal, but any capital gain is reduced to the extent the distribution is a s 47 deemed dividend (s 118-20). An interim liquidation distribution may be treated as a payment under CGT event G1, unless made within 18 months of the company’s dissolution: s 104-135(6) of the ITAA 1997. Further, provision exists for liquidators and administrators of insolvent companies to declare shares and financial instruments worthless so that losses can be realised (CGT event G3 in s 104-145 of ITAA 1997). This special rule reflects the fact that shares in a company will otherwise not be taken to be disposed of until the company ceases to exist by deregistration: for an insolvent company this may take many years to occur.

(b) The Archer Brothers Principle [14.1030] The power of the liquidator to identify whether distributions should be taken to be

out of profits or a return of paid-up share capital was confirmed in Archer Brothers Pty Ltd v FCT [1953] HCA 23; (1953) 90 CLR 140. The liquidator made a distribution out of moneys which had come to a private company as income, but the distribution was accounted for by the liquidator as a return of income which had been applied to replace a loss of paid-up capital. Under s 47, such amounts are not deemed to be dividends. Under previously applicable tax law (now repealed), it would have been of tax advantage if the distribution were treated as a distribution representing income for the purposes of s 47, because the distribution would then be deemed to be a dividend and so the company would not have been liable to undistributed profits tax, while the shareholders could have obtained a rebate on the dividend. The High Court approach in Archer Brothers emphasised the significance of the company accounts, and gave the liquidator considerable flexibility to decide how to make distributions to the shareholders, and out of what accounts, in determining the tax treatment of the distribution:

Archer Brothers Pty Ltd v FCT [14.1040] Archer Brothers Pty Ltd v FCT [1953] HCA 23; (1953) 90 CLR 140 Williams ACJ, Kitto and Taylor JJ: In the present case the respondent wrote the following letter to the appellant on 3rd May 1950: “With reference to your income tax affairs for the year ended 30th June 1949, please be good enough to advise: – (1) The amount of distribution made to shareholders during the above-mentioned year and the extent to which this distribution represents a return of capital. (2) The amount of dividend, if any, paid from the profits of the year ended 30th June, 1949, before the 31st December, 1949”.

On 19th May 1950, the liquidator replied: “In reply to your letter of 3rd May we set out below details of distributions made to shareholders during the year ended 30th June, 1949: – 12th January, 1949, One shilling (1/-d.) per share. 30th May, 1949: Ten shillings (10/-d.) per share. The total distribution of 11/– per share set out above represents a return of capital. No dividends have been paid out of profits for the year ended 30th June, 1949. A distribution of three shillings (3/-d.) per share, being a further return of capital, was made on 20th December, 1949”. [14.1040]

807

Income Derived Through Intermediaries

Archer Brothers cont. These distributions were in fact made out of funds in the hands of the liquidator constituted in part by profits or income of the year of income ending on 30th June 1949, and in part by the proceeds arising from the sale and conversion of the appellant’s assets in that year. When the liquidator said that no dividends had been paid out of profits for the year ended 30th June 1949, he meant presumably that they should not be regarded as dividends paid out of profits because the distributions were all replacements of paid-up capital. As these distributions were all applied to replace a loss of paid-up capital, although they included some profits forming part of the taxable income of the appellant for the year of income ending 30th June 1949, they would not, by virtue of s. 47, form part of the assessable income of the shareholders. If there had been sufficient surplus

808

[14.1040]

assets, other than the income included in this taxable income, to distribute as a replacement of paid-up capital, the liquidator could have made a sufficient distribution of this taxable income to the shareholders [to prevent application of undistributed profits tax]. On the other hand he could have paid additional tax and then distributed the balance of the fund to the shareholders. These distributions would it seems be dividends within the meaning of the definition of dividend in s. 6 of the Act and would certainly be deemed to be dividends paid to the shareholders out of profits or income derived by the company within the meaning of s. 47. By a proper system of book-keeping the liquidator, in the same way as the accountant of a private company which is a going concern, could so keep his accounts that these distributions could be made wholly and exclusively out of those particular profits or income [so that the shareholders would become entitled to a rebate].

CHAPTER 15 Special Topics in Company Tax [15.10]

1. TRANSACTIONS INVOLVING SHARES......................... ................................ 812

[15.10]

(a) Sale and Purchase of Shares ................................................................................. 812

[15.40]

(b) Issue of Shares and Options ................................................................................. 813

[15.60]

(c) Redeemable Preference Shares ............................................................................. 815

[15.70]

(d) Share Buy-Backs .................................................................................................. 815

[15.100] [15.110] [15.150] [15.160] [15.180]

(e) Dividend Stripping .............................................................................................. (i) The position of the dividend stripper .................................................................... (ii) The position of the vendor shareholder – s 177E .................................................. Slutzkin v FCT ............................................................................................................ FCT v Consolidated Press Holdings Ltd .........................................................................

[15.200]

(f) Pre-CGT Companies ............................................................................................. 822

[15.210] [15.220] [15.230]

(g) Value Shifting ...................................................................................................... 823 (i) Division 725: share value shifting .......................................................................... 823 (ii) Division 727: value shifting between entities ........................................................ 824

817 817 818 819 820

[15.240] 2. ROLLOVERS FOR TRANSACTIONS WITH SHARES ................ ...................... 824 [15.250]

(a) Contribution of Assets to a Wholly-Owned Company .......................................... 824

[15.280] [15.290]

(b) Scrip for Scrip Rollover for Takeovers and Mergers ............................................... 825 Review of Business Taxation Final Report (1999) A Tax System Redesigned, Recommendation 19.3 ............................................................................................... 826

[15.320]

(c) Demerger Relief for Company Spin-offs ............................................................... 827

[15.340]

(d) Rollovers Within a Corporate Group .................................................................... 829

[15.350] 3. COMPANY LOSSES ...................................... ............................................... 829 [15.365]

Business Tax Working Group on Company Losses, Report 2012 ..................................... 830

[15.370] [15.380] [15.400] [15.410] [15.420]

(a) Continuity of Ownership Test .............................................................................. Taxation Review Committee ........................................................................................ (i) Ultimate individual owners or controllers .............................................................. (ii) Same share rule ................................................................................................... (iii) Listed public companies ......................................................................................

[15.440] [15.460] [15.500]

(b) Same Business Test .............................................................................................. 836 Avondale Motors (Parts) Pty Ltd v FCT ......................................................................... 837 Lilyvale Hotel Pty Ltd v FCT ......................................................................................... 839

[15.530]

(c) Unrealised Losses ................................................................................................. 841

832 832 833 834 835

[15.550] 4. TAXATION OF CONSOLIDATED GROUPS ...................... ............................. 842 [15.550]

(a) Policy and History of the Consolidation Regime ................................................... 842

[15.650]

(b) What is the Consolidated Group? ........................................................................ 845

[15.680]

(c) The Single Entity Rule .......................................................................................... 846 809

Income Derived Through Intermediaries

[15.710]

Ruling TR 2004/11 ..................................................................................................... 848

[15.720] [15.730] [15.740] [15.770]

(d) Asset-Based Model of Consolidation .................................................................... 851 (i) Why Reset the Tax Cost of Assets? ......................................................................... 852 (ii) How is the Tax Cost of Assets Set? ........................................................................ 852 (iii) Formation of an existing group and combining groups ....................................... 854

[15.780]

(e) Group Tax Liabilities and Franking Credits ........................................................... 854

[15.800] [15.810] [15.820] [15.830] [15.840]

(f) Losses in a consolidated group ............................................................................. (i) Utilisation of losses in pre-consolidation tax return ............................................... (ii) Rules restricting transfer of losses to head company of consolidated group .......... (iii) Rules restricting usage of transferred losses by head company ............................ (iv) No duplication of losses in a consolidated group ................................................

[15.850] [15.860] [15.870]

(g) Exit of a Subsidiary from a Consolidated Group ................................................... 857 (i) Set cost base of shares in line with underlying assets ............................................ 857 (ii) Exit history rule .................................................................................................... 859

855 856 856 856 857

Principal sections ITAA 1936 ITAA 1997 s 44(2)–(6) – Div 16K of Pt III Div 36, s 36-17, – Subdiv 36-C s 40-340 – Subdivs 122-A, – 122-B, s 40-340, Subdivs 126-B, 124-G, 124-N Subdiv 124-M – Div 125 – Subdivs 165-A, – 165-B, 165-D, 165-E, s 165-165, Div 166 Subdiv 165-CC – –

Subdiv 165-CD

– –

Div 170 Subdiv 170-D

–

Div 175

–

Div 245

810

Effect Demerger dividend exemption. Dividend and capital treatment of share buy-backs. Rules for application of carry-forward losses for companies. Rollover for depreciating assets. CGT rollovers on contributions of assets to wholly-owned companies.

CGT scrip-for-scrip rollover. CGT demerger rollover. Denial of losses if continuity of ownership or same business tests failed; same share rule; rules for widely held companies. Treatment of unrealised losses on change of ownership/control of companies. Denial of loss duplication on shares and debt held in loss companies. Loss grouping and cost base adjustments. Deferral of losses on transfer of loss assets to associates. Schemes to inject income or gains into loss companies. Commercial debt forgiveness.

Special Topics in Company Tax

ITAA 1936 –

ITAA 1997 s 701-1

–

s 701-5

–

ss 701-10, 701-60, 705-25, 705-35, 705-40, 705-60

–

ss 701-15, 701-60, 711-10, 711-20

–

s 701-40

–

ss 703-5, 703-10, 703-15, 703-30, 703-50

–

Div 707

–

Subdiv 709-A

–

Div 721

–

Divs 725, 727

CHAPTER 15

Effect This section establishes the single entity rule for consolidated groups: subsidiary members are deemed to be part of the head company of a consolidated group rather than separate entities for the purpose of the group’s income tax calculations. The head company of a consolidated group inherits the tax history of subsidiary members under the “entry history rule”. The tax cost bases of a subsidiary member’s assets are reset in the hands of the head company on joining a consolidated group, to reflect the actual economic cost to the head company of acquiring the assets. The tax cost bases of the head company’s membership interests in a subsidiary member are reset in the hands of the head company on a subsidiary leaving the group, to align the tax cost base of the membership interests to the tax cost base of the subsidiary member’s underlying assets. The tax history of assets, liabilities and business of a subsidiary members is inherited by a subsidiary on leaving the group, under the “exit history rule”. A consolidated group is formed by an election by the top resident head company and all its wholly owned resident subsidiary companies, trusts and partnerships. Once formed, election cannot be revoked and membership is compulsory for all present and future wholly owned resident subsidiaries. This Division contains the rules limiting usage of pre-consolidation losses brought into a consolidated group by members of the group. The head company of the group operates a single franking account for imputation purposes. The head company is primarily liable to pay tax for the group, as all taxable income of the group is treated as derived by the head company alone, for income tax and PAYG purposes. However, all subsidiary members are prima facie jointly and severally liable for income tax liabilities of a consolidated group if the head company fails to pay them when due. Tax sharing agreements may be used to limit a subsidiary member’s liability to a reasonable share of group liability. Value shifting rules to prevent deferral of gains and generation of artificial losses by shifting value between shares or companies.

811

Income Derived Through Intermediaries

[15.00] This chapter deals with the tax rules for transactions involving shares, including the

sale and purchase of shares and cost base rules for shares and options; the rules for redeemable preference shares, share buybacks, value shifting and pre-CGT companies; tax rollovers for company takeovers, mergers and acquisitions including CGT scrip for scrip and demerger rollover; the rules that limit carry forward and utilisation of company losses; and an introduction to the taxation of consolidated corporate groups.

1. TRANSACTIONS INVOLVING SHARES (a) Sale and Purchase of Shares [15.10] An important implication of the principle that a company is a separate entity from its

shareholders is that, for tax purposes, the relevant assets which the shareholders are treated as owning are shares in the company, rather than interests in the underlying property and liabilities of the company (Hobart Bridge Co v FCT (1951) 82 CLR 372). It follows that gains or losses on the shares should be recorded as income or deductions of the shareholder in the same way as gains or losses on any other asset. Consistent with this, a share is a CGT asset of the shareholder: s 108-5 of the ITAA 1997. Shares held as an investment to earn dividends will prima facie be treated as assets held on capital account, and so gains and losses will be treated as capital gains or losses subject to CGT treatment. Shares can also be held as trading stock by share traders, in which case gains and losses are given ordinary income or deduction treatment: Investment and Merchant Finance Corporation Ltd v FCT (1971) 125 CLR 249. Gains or losses can also be subject to treatment as ordinary income or deductions where the shares are acquired in an operation of business for the purpose of resale at a profit, or where they are held as “revenue assets” of a business of investing in shares with a purpose of both deriving dividends and realising gains by the regular sale of shares which have appreciated in value: London Australia Investment Co Ltd v FCT (1977) 138 CLR 106. [15.15]

15.1

15.2

Questions

Is a variation of rights attached to a share treated as a disposal of the share for CGT purposes? (See TR 94/30). If consideration is paid for the rights variation, could another CGT event apply? Is a share split or share consolidation treated as a disposal for CGT purposes? Does it make a difference if shares are actually cancelled or redeemed? (See TD 2000/10).

[15.20] The proposition that the share is a separate and distinct item of property also means

that, when a taxpayer holds shares in a company with accumulated profits, a different fiscal outcome is produced according to whether they realise their interest in the profits by receiving a distribution by way of dividend, or instead by selling the shares. One method results in assessable income under s 44 of the ITAA 1936, and the other method results, for the ordinary investor, in a capital gain. While part of the sale price may reflect accumulated profits that could have been received as dividends, it has never been income tax law or practice to treat that part as a severable income component of the total sale price. Likewise, if a person purchases shares in a company with accumulated profits, and the company subsequently pays out those profits as dividends to the purchaser, it has never been income tax law or practice to treat any part of the purchase price as a severable deductible component referable to those dividends: IRC v Forrest (1924) 8 TC 704; IRC v Sir John Oakley (1925) 9 TC 582. One 812

[15.00]

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consequence of this different tax treatment is that, on sale of a business by selling the shares in a company that has retained earnings, it is common to pay out a dividend to the seller, prior to sale, at least to the extent that the earnings have been subject to company tax. If the shareholders of a company bear the burden of company tax (a contested assumption; see the discussion of company tax incidence in [14.450]-[14.480]), then the taxation of gain realised by a sale of shares can lead to “double taxation” of company profit. Suppose that an individual shareholder holds shares in a company that have increased in value since acquisition because the company has accumulated after-tax profits from its business operations. If, instead of a dividend being paid out, the shareholder sells those shares, the accumulated after-tax profits will be reflected in the sale price and taxed as a gain to the shareholder. No imputation credit is available to alleviate the double tax. Subsequently, if the purchaser of the shares has the accumulated after-tax profits distributed as a dividend, they will be taxed again, at the purchaser’s individual tax rate, with an imputation credit for the underlying company tax. In theory, the distribution of the profits should reduce the value of the shares acquired by the purchase. This would, eventually, allow the purchaser to realise an offsetting loss by disposing of the shares, after receiving the dividend, at a reduced price. However, realisation of this loss is necessarily deferred if the purchaser holds the shares as a long-term investment. For individuals, trusts and superannuation funds, a capital gain on the sale of shares will qualify for the CGT discount if held for at least 12 months: Div 115. This reduces the extent of double taxation. One of the arguments supporting the introduction of the CGT discount was to relieve the double tax applicable to the sale of shares, so as to encourage investors to sell their share investments and reduce “lock in” caused by the tax system. [15.30] A share sale may also realise a capital loss for the taxpayer. It is common for

taxpayers to plan realisation of capital losses on CGT assets, in the same fiscal year as capital gains, enabling offsetting of gains and losses. A “wash sale” of shares may be entered into in order to realise a tax benefit such as a loss or deduction, and then immediately afterwards reinstate the taxpayer’s shareholding using economically similar shares. For example, this may be done by entering into scheme that provides concurrent and contingent sell and buy contracts through a stockbroker over shares listed on the stock exchange. The Commissioner may seek to apply Part IVA to deny the capital loss or deduction on sale of the shares: Ruling TR 2008/1. The length of time between the sale of the shares (realising a loss) and subsequent repurchase of economically similar shares may indicate whether a sole or dominant purpose of obtaining a tax benefit is established.

(b) Issue of Shares and Options [15.40] The issue of a new share, or a right (or option) to acquire a new share, is a creation of

new rights and obligations between company and shareholder. This constitutes a potential CGT event for both parties. The issue of equity interests is deemed not to be a taxable CGT event: see the exclusions for CGT event D1 (s 104-35), CGT event D2 (s 104-40) or CGT event H2 (s 104-155). As a share is a CGT asset, it is necessary to establish its cost base. Normal rules apply when a shareholder acquires an existing share from another shareholder. However, special rules are needed for newly issued shares and options. The general rule is that the cost base of a newly issued share or right is the lower of the amount paid for the share or right, and its market value: ss 112-20(2) and 112-20(3). For a [15.40]

813

Income Derived Through Intermediaries

bonus share issue that is treated as a dividend (see [14.350]), the cost base will be the market value of the share and the bonus share is taken to be acquired at the date of issue. If a bonus share is not treated as a dividend, the cost base of the original shares of the recipient shareholder will be spread across the original and the bonus shares, which are taken to be acquired at the date of issue of the original shares: Subdiv 130-A of the ITAA 1997. Where a new share is issued partly-paid with a contingent obligation to pay the balance when called for at a future date, the future payments can only be included in the cost base when the future call is made (Dingwall v FCT (1995) 30 ATR 498). Indexation of cost base (where applicable for pre-September 1999 assets) is only allowed from that date: s 960-275(3). By contrast, where an existing share is purchased for a price on terms that payment will be made in instalments, as under a Telstra instalment receipt, it seems the full price can be treated as the cost base at the purchase date: Dolby v FCT 2002 ATC 2325. [15.50] In FCT v McNeil (2007) 229 CLR 656; [2007] HCA 5 (discussed at [14.130]), the

High Court held that the market value of a tradeable put option issued to the shareholders in a company was ordinary income of the shareholder under s 6-5. This decision cast doubt on the tax treatment of both call and put options. The government responded by enacting s 59-40 of the ITAA 1997. This provision ensures that call options (rights to acquire newly issued shares) issued by a company to existing shareholders are non-assessable non-exempt income for shareholders who hold their shares on capital account (not as trading stock or revenue assets) and satisfy some other conditions. However, it does not overturn the specific result in McNeil, which involved a put option. Amendments were also made to the CGT rules to ensure that, where an option is exempt in the hands of the shareholder, a disposal of the option will generate taxable capital gain. If the option is assessable to the shareholder, the cost base of the options will reflect the amount assessed: s 112-37. Where a company issues to a person, a right or option to acquire shares, the subsequent exercise of the right or option could also be taxable to that person as an exchange of the right or option for the share. Likewise, if a person has a convertible note which enables them to convert debt into shares, the subsequent exercise of the conversion right could prima facie be taxable as an exchange of the debt for the share: see TR 96/14; compare the contrary view in British South Africa Co v Varty [1965] 2 All ER 395. Special relief now applies in these cases – the exercise of rights to acquire the shares is generally not taxable, and the cost base of the new shares includes both the amounts (if any) paid for the rights, options or notes, plus any amounts paid for the shares on exercise: see ss 26BB(4) and 26BB(5), Subdivs 130-B, 130-C, 130-E, ss 104-40(5), 104-30(1)(c), 134-1(4) note 2, and Div 134. For the company that issues an option to acquire new shares for consideration, the issue of the option does not trigger a capital gain for the company: ss 104-30(5) and 104-40(6). If the option is exercised, then the company has no gain – the option consideration is assimilated to the receipt of capital for the issue of the shares: s 134-1(4). However, if the option lapses without exercise, that triggers a capital gain for the company (CGT event C3, s 104-30), and a capital loss for the option holder (CGT event C2, s 104-25). CGT rollover relief applies for capital reorganisations where shareholders exchange old rights or options for new rights or options, or old shares for new shares, of equivalent market value, in the same company: Subdivs 124-E and 124-F. What about employee shares or options, where an individual agrees to contribute labour to a company in exchange for shares or options? In this case, the market value of the shares (or 814

[15.50]

Special Topics in Company Tax

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any discount to market value allowed for the employee) will be assessable income under Div 83A of the ITAA 1997. The employee may be eligible for exemption or deferral concessions for employee share schemes. Special rules also apply to determine the cost base of shares issued in an employee share scheme (Subdiv 130-D). From the company’s perspective, although shares issued to employees form part of their remuneration, the ATO takes the view that no deduction is allowed under s 8-1 for issue of shares in exchange for services, as there is no “loss” or “outgoing” of the company: TR 2008/5.

(c) Redeemable Preference Shares [15.60] Company law has long permitted companies to issue preference shares that are

redeemable at a particular time or on a particular event taking place, at the option of either the company or the shareholder. However, company law has always stipulated that such shares may only be redeemed out of profits, or out of the proceeds of a fresh issue of shares made for the purposes of the redemption: see Corporations Act 2001 s 254A and s 254K. The definition of “dividend” in s 6(1) of the ITAA 1936 deems the redemption of preference shares to be a dividend, except to the extent that the redemption amount is debited to share capital account and is less than or equal to the “paid up” amount which has been subscribed as share capital for the shares. A special rule in s 975-300(1)(b) of the definition of “share capital account”is designed to cover the case where share capital for a redeemable preference share is credited to a loan account under financial accounting rules which treat it as debt rather than equity. A dividend arising from a preference share redemption is frankable under the ordinary rules. On redemption, preference shares are required to be cancelled. Consequently, a share redemption will also be covered by CGT event C2. Any capital gain of the shareholder is reduced to the extent of the dividend element in the redemption price. [15.65]

15.3

Question

John subscribes $100 for a redeemable preference share in Acme. Acme uses trading profit to redeem the share for $101. What is the tax treatment to John? Is this fair?

(d) Share Buy-Backs [15.70] Company law historically prohibited companies from purchasing their own shares;

this was to protect creditors by ensuring that a company preserved its share capital. The redemption of preference shares was the only permitted exception. However, the company law was gradually relaxed, and it is now relatively straightforward for a company to reduce its issued shares by entering into share buy-back arrangements with its shareholders. The income tax law contains special rules for share buy-backs in Pt III Div 16K of the ITAA 1936. The key issue is whether the price for a share buy-back should be treated just as consideration for shares, or whether it should be treated as a distribution from the company that buys back the shares, which may be a dividend if there are profits in the company. If the consideration is a dividend, a further question is whether it is able to be franked. A proposal to simplify the buy-back rules and rewrite them in the ITAA 1997, recommended by the Board of Taxation in 2008, has not yet come to fruition. In consequence, readers must navigate some of the most cumbersome section numbers remaining in the Act: the main operative buy-back provisions are s 159GZZZP (for off-market buy-backs) and s 159GZZZR (for on-market buy-backs). [15.70]

815

Income Derived Through Intermediaries

[15.80] In an “off-market share buy-back”, the company enters into a contract with a

shareholder to repurchase their shares at an agreed buy-back price, rather than in the ordinary course of trading on the stock exchange. The income tax law deems an off-market buy-back to give rise to a dividend paid out of profits, to the extent to which the company does not debit the buy-back price to a share capital account. In other words, the buy-back price is bifurcated into a capital return element, equal to the amount debited to share capital account, and a deemed dividend element, equal to the amount debited to profit accounts or not otherwise debited to share capital account. CGT event C2 applies to the capital return element, and s 44 applies to the dividend element. The deemed dividend in an off-market share buy-back is frankable. Off-market share buy-backs are commonly used by both listed and unlisted companies to pass franking credits from the company to shareholders. A legislative “safe harbour” applies to determine the split between capital and dividend elements, or a company may use another approved method. The integrity rules against trading and streaming of franking credits, discussed at [14.850] et seq. may apply to share buy-backs, unless the safe harbour method is applied. It is often the case that a company will obtain a Class Ruling confirming the extent of franked dividend treatment of CGT treatment, and the possible application of these integrity rules, to a buy-back for its shareholders. Examples include: CR 2015/27 (off-market buy-back by Rio Tinto Ltd) and CR 2014/90 (off-market buy-back by Telstra Corporation Ltd). The off-market buy-back rules were considered by the High Court in Commissioner of Taxation v Consolidated Media Holdings [2012] HCA 55 (see [14.160]). Consolidated Media Holdings Ltd (CMH) owned all of the ordinary shares in Crown Ltd (of Crown Casinos). In 2002, Crown implemented an off-market buy-back of about 840 million ordinary shares, for consideration of $1 billion, from CMH. Crown recorded a debt in a new account labelled “Share Buy-Back Reserve Account”, in addition to its “Shareholder Equity Account”. The High Court concluded that these two accounts, taken together, should be treated as a single share capital account. In consequence, the Court concluded that the whole of the consideration for the buy-back was debited to share capital. As a result, the taxpayer realised a capital gain on the disposal of its Crown shares back to the company. [15.90] The other form of buy-back is an “on-market” buy-back by a listed company in the

ordinary course of trading on the stock exchange. On-market buy-backs are effected by a stockbroker purchasing shares on behalf of the company in ordinary stock exchange sale and purchase transactions. A seller of shares on the day will not know if they have sold to the company, or to another shareholder. In this case, the income tax law deems the whole buy-back price to be sale proceeds to the selling shareholder, most often generating capital gains tax consequences: s 159GZZZR. [15.95]

15.4

15.5

816

Questions

Katherine receives a purchase price of $100 in respect of an off-market buy-back of shares by Company M, a listed company. Company M debits $70 against its share capital account. Assume that Katherine has a cost base of $90 in the shares. What proportion of the price is treated as a dividend for Katherine? Does Katherine have a capital gain or loss in respect of this transaction? (See s 159GZZZQ(1) – (4) of the ITAA 1936). Are the following unfrankable under s 202-45? (1) An off-market share buy-back where the buy-back price is taken to be a dividend? (2) An on-market buy-back by a listed company – does a franking debit arise (note s 205-30 Item 9)? [15.80]

Special Topics in Company Tax

CHAPTER 15

(e) Dividend Stripping [15.100] The practice of “dividend stripping” has a long history and emerged when

Australia’s company income tax had three particular features. First, there was an undistributed profits tax that applied to private companies that failed to distribute a prescribed proportion of their profits to individual shareholders within a prescribed time. The purpose of the undistributed profits tax was so that individual shareholders could not avoid tax on profits in private companies by simply allowing them to accumulate in the company. Second, if individuals sold the shares for a capital sum, the gain was tax-free, as there was no capital gains tax. Third, if individuals sold the shares to a public company, there was a general rebate of tax under s 46 of the ITAA 1936 on dividends received by the public company. This regime created an incentive for individual owners of private companies with substantial accumulated profits – the vendor shareholders – to sell the shares in their private companies to a public company – the dividend stripper – for a capital sum, rather than draw off the profits by way of dividend. The public company would pay the capital sum for the shares, draw off the profits by way of a large dividend freed from tax by the s 46 rebate, and then sell the shares (possibly back to the original owners) for a lower sum than the original capital sum paid over. It was the drawing off of the profits by way of the large dividend that was the “dividend stripping”. Typically, the individual owners of the private company would arrange matters so that the private company had little by way of assets except cash representing the accumulated profits (the business assets having been transferred out before the scheme). The large dividend would strip the company of most of its assets, and would substantially recoup the purchase price paid for the shares by the dividend stripper. The dividend would have substantially depleted the assets of the company, which in turn would have reduced the value of its shares by a corresponding amount. As a result, the dividend stripper was able to realise a large deductible loss on the shares if they held them as a share trader. Naturally, dividend strippers tended to be share traders. (i) The position of the dividend stripper [15.110] In Investment and Merchant Finance Corporation Ltd v FCT (1971) 125 CLR 249,

the taxpayer was a share trader and purchased shares in a private company (which had substantial accumulated profits) for £86,504, then drew off a dividend of £81,900 and sold the shares for £21, generating a large trading loss. The High Court held that the share trader could claim the s 46 rebate on the dividend (which meant it was tax-free), as well as a deduction for the £86,483 difference between the acquisition and resale price (because the High Court accepted that the shares were trading stock in the business of the share trader company). The value of that deduction meant that, after tax, the share trader made a significant cash gain from the transaction. The Commissioner sought to argue that the whole transaction should be treated as a single profit-making scheme, so that the dividend as well as the resale price should be aggregated to determine the net position (thus reducing the overall deductible loss). This argument was rejected. As a result of this case, and others, dividend stripping became a highly successful “industry” in the 1970s at the expense of the revenue. Menzies J expressed the general view of the courts at that time: It is, of course, true that it is because company dividends are rebatable under s. 46 that dividend-stripping is so attractive, and, if it be thought that this is a practice which should be checked, it is to that section that Parliament may choose to direct some of its attention. It is not [15.110]

817

Income Derived Through Intermediaries

for the courts, however, to depart from Parliament’s clear statement in s. 44 that assessable income of shareholders, including companies, shall include dividends, and to do so in order to bring the dividends into account as part of the profits of transactions of buying and selling outside the operation of s. 46 which makes certain dividends paid to companies rebatable. [15.120] The Patcorp case, extracted at [14.90], also concerned a dividend stripping scheme,

and whether the recipient shareholder was “registered” such that they could receive the dividend which would be exempt by virtue of the s 46 rebate. In response to these cases, Parliament introduced former ss 46A and 46B to counter such dividend stripping schemes. These rules reduced the s 46 dividend rebate and prevented some particular kinds of stripping transaction. They were repealed when the s 46 rebate for inter-corporate dividends was repealed. Some other rules in the Act aim to prevent a company purchaser of shares in another company from claiming a tax loss on a disposal of shares, where the company purchaser has not suffered an economic loss because the purchase price has previously been recouped by a franked dividend. The share buy-back rules prevent this and the CGT provisions also reduce capital losses where pre-acquisition profits have been extracted as franked dividends: s 110-55(7), (8) of ITAA 1997 and see Sun Alliance Investments Pty Ltd (in liq) v FCT (2005) 225 CLR 488; [2005] HCA 70. [15.130] Today, instead of an inter-corporate dividend rebate, the imputation system permits

resident companies to draw off franked dividends freed from tax by imputation credits (s 207-20 of the ITAA 1997). The Parliament has enacted an anti-avoidance rule in the imputation rules concerning dividend stripping. Sections 207-145(1)(c) and 207-145(2)(c) provide that imputation credit benefits will be denied to a person who receives a franked distribution where the distribution is received as part of a dividend stripping operation. This term is defined in s 207-155, but in a way that leaves the central concept of “dividend stripping” undefined. In this, it is similar to s 177E, discussed below. (ii) The position of the vendor shareholder – s 177E [15.150] The above provisions attack the position of the dividend stripper but they do not

address the position of the original owner of the shares – the “vendor shareholder” – who has received a capital sum rather than a dividend by disposing of their company shares to the dividend stripper. Historically, that capital sum was tax-free. With the introduction of dividend imputation and capital gains tax, the incentive for the “vendor shareholders” to engage in dividend stripping operations is reduced. However, the incentive remains where company profits are untaxed or taxed at low rate. The CGT discount may mean capital gains are to be preferred over dividends for individual and trustee shareholders. Moreover, the fact that the company tax rate at 30% is below the top marginal rate for individuals, means that even under imputation there is an incentive to extract the benefit of accumulated profits in non-dividend forms. The position of the vendor shareholder in a dividend stripping scheme was challenged by the Commissioner in Slutzkin v FCT (1977) 140 CLR 314. The Slutzkin family sold a private company with accumulated profits to Cadiz Corporation for a capital sum. It was a term of sale that the private company have all assets converted to cash and no liabilities at settlement date. After acquiring the company, Cadiz Corporation drew off the profits as part of a dividend stripping operation. The Commissioner sought to apply s 260, the former general anti-avoidance rule, to the scheme on the basis that the Slutzkins had entered it for the purpose 818

[15.120]

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of avoiding tax on a dividend. The Commissioner lost before the High Court, which held that s 260 did not apply, as the Slutzkins had merely exercised a “choice” to realise their investment by selling the shares cum dividend. The judgment of Barwick CJ reflects the views of Stephen and Aickin JJ.

Slutzkin v FCT [15.160] Slutzkin v FCT (1977) 140 CLR 314 Barwick CJ: On these facts I should have thought it was clear beyond argument that the receipt by the appellants of the proceeds of the sale of the shares formerly held by them in the company was not taxable. By no manner of torture of the language of the decided cases would the sale of the shares by the appellants, albeit in unison with the other shareholders in the company, fall within the operation of s. 260 of the Act. It was no more than a realization by them of the benefit of their shareholding in a way which would not attract tax. It may be granted that a purchaser of the shares could not have been found willing to pay the price in cash, which in fact was agreed to be paid, unless the company had made its assets liquid and itself free of debt; and that all shareholders were willing to sell their shares. It may also be granted that to obtain the benefit of

the shareholding by way of dividend or by liquidation would have rendered the shareholders liable to tax in respect of the money thus received. But the choice of the form of transaction by which a taxpayer obtains the benefit of his assets is a matter for him: he is quite entitled to choose that form of transaction which will not subject him to tax, or subject him only to less tax than some other form of transaction might do. Inland Revenue Commissioners v. Duke of Westminster (1936) AC 1, too easily forgotten, is still basic in this area of the law. There is no room in that area for any doctrine of economic equivalence. To the legal form and consequence of the taxpayer’s transaction, which in fact has taken place, effect must be given: see Inland Revenue Commissioner (N.Z.) v. Europa Oil (N.Z.) Ltd. (1971) AC 760.

[15.170] This notorious decision was a key reason for the repeal of s 260 and its replacement

with a new general anti-avoidance rule in Pt IVA of the ITAA 1936 in 1981, discussed further in Chapter 20. A specific rule was included in Pt IVA to attack the position of the vendor shareholder under a dividend stripping arrangement. Section 177E is intended to provide that, where profits have been drawn out of a company by way of a dividend stripping scheme, the vendor shareholders in relation to the scheme are taken to have obtained a tax benefit under Pt IVA, by way of avoidance of receipt of an assessable dividend. The Explanatory Memorandum discloses that a specific provision was thought necessary because it would otherwise be difficult to establish a tax benefit under s 177C. This is because it would be difficult to prove that, absent the dividend stripping scheme, a dividend would be paid in any particular tax year to the vendor shareholder. Section 177E has several requirements. First, it is necessary to identify who is the relevant vendor shareholder in relation to the scheme. Section 177E determines this by requiring that you identify who would have received an assessable dividend if a dividend had been paid by the company immediately before the scheme commenced. Hence, pinpointing the time when the scheme has commenced is critical. Second, the person identified as the “vendor shareholder” who would have received the dividend, must be a person who would include the dividend in assessable income. Hence, s 177E may not apply to a non-resident shareholder. [15.170]

819

Income Derived Through Intermediaries

A third matter is: What amounts to a scheme of dividend stripping? The central concept of dividend stripping is left undefined in s 177E, and this has given rise to the question of whether the section can apply to any transaction involving a dividend, or at least a large dividend, or whether the section is limited in scope to transactions such as the Investment and Merchant Finance and Slutzkin arrangements which had a predominant purpose of avoiding tax. These matters have been addressed by the High Court in C of T v Consolidated Press Holdings Ltd (2001) 207 CLR 235 (and see C of T v Consolidated Press Holdings Ltd (No. 1) (1999) 91 FCR 524); see also Ruling IT 2627. In Consolidated Press Holdings, an Australian company arranged to dispose of shares in two UK subsidiaries to two newly formed companies in a tax haven. The shares in the UK companies were sold at a capital gain, but before the sale the two UK companies declared dividends, and the shares were sold cum dividend so that the dividends were not received in Australia by the Australian company. The evidence showed that the reorganisation was undertaken not to avoid Australian tax on dividends paid from the profits of the UK companies but for other reasons, and that the Australian company had no requirement to bring the profits back to Australia. The High Court had to consider if this was a dividend stripping scheme.

FCT v Consolidated Press Holdings Ltd [15.180] FCT v Consolidated Press Holdings Ltd (2001) 207 CLR 235; [2001] HCA 32 Gleeson CJ, Gaudron, Gummow, Hayne and Callinan JJ: [Section 177E] is a provision which is to be understood in the context in which it appears, and in the light of the legislative purpose it serves, which cannot adequately be explained independently of that context. The expression “dividend stripping” is not a legal term of art, having a literal meaning which can be clearly defined apart from its context. It is not defined in Pt IVA, presumably because the legislature considered its meaning to be sufficiently clear in the context of schemes to reduce income tax. The primary question is whether there was a scheme by way of or in the nature of dividend stripping, or one having substantially the effect of such a scheme. Hill J and the Full Court accepted the submission of the taxpayers that there was no scheme by way of or in the nature of dividend stripping. Their reasoning on the point was similar. Hill J accepted that it was not essential to the character of a dividend stripping scheme that it produced advantages to the stripper, or that the stripper was unrelated, in a corporate sense, to the shareholders of the target company. He considered that what must be involved was a company, pregnant with accumulated profits out 820

[15.180]

of which a dividend had been or would be likely to be declared; the anticipated liability of the shareholders to pay tax on such dividends; the preparation of the company for sale; the sale or allotment of shares in the company to the stripper; and the payment of a dividend to the stripper. But, obviously, not all sales of shares cum dividend, involve dividend stripping. In order to explain why, Hill J reverted to a familiar notion. He asked what conclusion an objective observer would reach as to why the scheme had taken place. He said: [A] scheme will only be a dividend stripping scheme if it would be predicated of it that it would only have taken place to avoid the shareholders in the target company becoming liable to pay tax on dividends out of the accumulated profits of the target company. It is that matter which distinguishes a dividend stripping scheme from a mere reorganisation. In my view an objective examination of what took place here would not lead to the conclusion that there was a dividend stripping scheme, or for that matter a scheme in the nature of dividend stripping, if that is a

Special Topics in Company Tax

Consolidated Press Holdings cont. significantly different thing. At least one of the United Kingdom companies did have substantial accumulated profits that much is clear. Both also had substantial investments in overseas companies from which dividends could be derived. The United Kingdom companies had no need to distribute accumulated profits. Any accumulated profits could have sat there forever. The sale of shares and subsequent liquidations were brought about not to enable the shareholders to receive capital instead of dividend distributions, although that was one consequence of what happened, but as part of a reorganisation of the United Kingdom companies for reasons which had to do with United Kingdom and Australian tax other than in respect of dividends which might be derived from the accumulated profits by way of dividend. The Full Court commenced by referring to four decided cases as examples of dividend stripping: Bell, Newton, Hancock and Ellers Motor Sales. Those cases had the following common characteristics: a target company, with substantial undistributed profits creating a potential tax liability; the sale or allotment of shares to another party; the payment of a dividend to the purchaser or allottee; the purchaser escaping Australian tax on the dividends so declared; and the vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers. A further common characteristic of each case was that the scheme was carefully planned for the predominant if not sole purpose of the vendor shareholders avoiding tax on a distribution of dividends. The Full Court pointed out that there were two features of the present case which were difficult to reconcile with a dividend stripping scheme. The first was that the assets of the United Kingdom companies did not consist wholly or even primarily of accumulated or current year profits. The net assets of CPIL(UK) (US$550,102, 063) and CPIHL(UK) (US$186,356,205) substantially exceeded the amounts of such

CHAPTER 15

profits. The second was that the consideration received by each of the taxpayers for the sale of its shares in the United Kingdom companies (an allotment of shares in CPIL(B)) attracted capital gains tax in Australia. However, it was the purpose, or absence of purpose, which the Full Court regarded as decisive. Their Honours said: The widely understood connotation [of the expression “dividend stripping”] was explained in the pre-1981 case law to which we have referred. The so-called dividend stripping cases invariably had as their dominant, if not exclusive, purpose the avoidance of tax that otherwise would or might be payable by the vendor shareholders in respect of the profits of the target companies. The apparent exceptions … are readily explicable on the basis that the particular scheme, insofar as it involved vendor shareholders, was complete before the dividend stripper began its operations and thus could not itself be described as a dividend stripping operation. The case law preceding the 1981 Act strongly supports the view that Parliament framed s 177E(1)(a) on the basis that dividend stripping operations necessarily involve a predominant tax avoidance purpose. The Full Court agreed with Hill J that no purpose, let alone a dominant purpose, of avoiding tax on a distribution of dividends could be found in the present case. What was involved was a corporate reorganisation of which it could not be predicated that the purpose, or a purpose, was to convert an entitlement to dividends into a receipt of a capital sum. In one respect, immaterial on the facts of the present case, there may have been a difference between Hill J and the Full Court as to the operation of s 177E(1)(a)(i). Hill J considered that a scheme would only be a scheme by way of or in the nature of dividend stripping if it would be predicated of it that it would only have taken place to avoid the shareholders in the target company becoming liable to pay tax on dividends out of the accumulated profits of the target company. The Full Court considered that s 177E was intended to apply only to schemes which can be said to have the dominant purpose of tax [15.180]

821

Income Derived Through Intermediaries

Consolidated Press Holdings cont. avoidance; the required tax avoidance purpose ordinarily being that of enabling the vendor shareholders to receive profits of the target company in a substantially tax-free form, thereby avoiding tax that would or might be payable if the target company’s profits were distributed to shareholders by way of dividends. Hill J may not have intended anything different from what was said by the Full Court. If there is a difference, the formulation of the Full Court is to be preferred, being consistent with the scheme of Pt IVA, and s 177A(5) in particular. … Hill J and the Full Court found that there was no purpose of avoiding tax on distributions of

[15.185]

15.6 15.7

profits. For the reasons already given, it is dominant purpose which matters. There was a corporate reorganisation, entered into for reasons related to the United Kingdom tax treatment of future earnings, and a desire to avoid double taxation. The disposal of shares involved in the reorganisation attracted liability in Australia to capital gains tax. A number of the characteristics common to schemes that have been regarded as typical dividend stripping schemes were absent. Above all, there was an absence of the particular taxation purpose which is the hallmark of such a scheme, and which is the reason why such schemes were intended to be covered by Pt IVA of the Act. The conclusion of Hill J and the Full Court on this issue was correct.

Questions

How would s 177E apply to the facts in Slutzkin and Investment and Merchant Finance Corporation Ltd? Does a dividend stripping scheme need to have a dominant purpose of avoiding tax? If so, is it a dominant purpose of avoiding tax on a dividend, or will any tax avoidance purpose suffice? How is the purpose of the arrangement determined?

[15.190] A recent application of s 177E is found in Lawrence v FCT [2009] FCAFC 29, in

which the Full Court of the Federal Court found that a taxpayer whose private company had significant undistributed profits was engaged in a complex scheme “having substantially the effect of” dividend stripping. The arrangement was not “by way of or in the nature of” dividend stripping because there was no sale or allotment of shares to a purchaser or vendor shareholders, but Jessup J held that it had the effect of placing company profits in the hands of shareholders in a tax-free form, in substitution for taxable dividends and so was caught by the extended formulation in s 177E. The ATO takes the view that “dividend access share” arrangements, in particular involving discretionary trusts that have a private company beneficiary, will also fall foul of the dividend stripping rule: see TD 2014/1.

(f) Pre-CGT Companies [15.200] As capital gains tax only applies to assets acquired after 19 September 1985, the principle that a company is a separate entity of its shareholders meant that a share could be a pre-CGT asset of the shareholder even if the assets of the company were all, or substantially all, post-CGT assets. On the other hand, assets of a company could remain pre-CGT, even while the shares of shareholders became post-CGT assets. These positions were reversed by special rules. CGT event K6 applies where pre-CGT shares are held in a private company that owns property acquired post-CGT: s 104-230. It deems a taxable capital gain to arise on a disposal or other CGT event in respect of pre-CGT shares, if the gross market value of the post-CGT property inside the company equals or exceeds 75% of the net value of the company. The shareholder makes a taxable capital gain 822

[15.185]

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equal to the capital proceeds that are “reasonably attributable” to the post-CGT assets, less the sum of the cost bases of the post-CGT property. As explained in Ruling TR 2004/18, this provision applies only where there is post-CGT “property” owned by a company, and not the broader notion of “CGT assets”. However, the “net value” of the company is worked out by taking into account all assets and liabilities of the company, based on the ordinary meaning of the word “asset”. Division 149 applies where a company that owns pre-CGT assets has post-CGT shareholders. For example, a company may own land acquired before 20 September 1985, or it may have goodwill in relation to a business that commenced before that date (if the business does not change substantially, the ATO accepts that the goodwill remains pre-CGT in character, even if it increases in value as a result of business growth after 1985: see TR 1999/16). Section 149-30 deems the pre-CGT assets inside a private company to become post-CGT assets, if there is a change of majority underlying ownership of interests held by individuals in the company after 19 September 1985. The market value of the pre-CGT assets at the date they become post-CGT assets becomes their cost base. Section 149-70 has the same effect for public companies. Listed public companies were required to test for changes in ultimate underlying ownership of individuals, under various testing regimes which proved increasingly difficult to satisfy, and most would now be deemed to no longer hold pre-CGT assets. The ATO’s view of Div 149 is explained in Ruling TR 2004/7.

(g) Value Shifting [15.210] Shares have certain features which enable their value to be manipulated so as to

obtain favourable fiscal outcomes for the shareholders. The ITAA 1997 contains a complex and extensive general value shifting regime to counter such practices. It is beyond the scope of this chapter to explore this in detail. However, examples of application of the main rules in Divs 725 and 727 are provided below. (i) Division 725: share value shifting [15.220] Suppose that A and B are associates, who each hold one share in Company C, having

acquired the shares at a cost of $50 m per share in 2002 when Company C was worth $100 m. Suppose also that Company C now has a net worth of $200 m, and that the market value of the shares is now $200 m (ie $100 m per share). If A wanted to transfer all his shares to B, he would have a taxable disposal of the shares and realise a gain of $50 m under CGT event A1. However, if he were to instead allow B to subscribe $1,000 to Company C in exchange for $1,000 of new shares, there would be no CGT event A1, but B would have still been given effectively 100% control of the company, putting him in the same position as if A had transferred all his shares. Further, A could then transfer to B his one remaining share, which would now be valueless, and claim a capital loss of $50 m. Division 725 counters this practice by deeming there to be a new CGT event happening to A’s shares. The end result will be to tax A as if he had disposed of all his shares. In addition, the cost base of his one original share will be reduced from $50 m to nil, to reflect the fact that value has been shifted out of it, so as to prevent any capital loss being claimed. To ensure that the value shift is not taxed again if and when B disposes of his shares, the cost base of his shares will be adjusted upwards by reference to the amount of value shifted across to his shares. [15.220]

823

Income Derived Through Intermediaries

Division 725 is generally applicable only to value shifting operations carried out by controllers of a company and their associates, or by parties actively involved in orchestrating the value shift. It applies to all methods by which value might be shifted out of some shares in a company to other shares, such as new shares being issued at a discount to their market value, or existing share rights being varied. As the example shows, particular care must be taken in closely-controlled private companies to make sure that any new share subscriptions are carried out on arm’s length market value terms. (ii) Division 727: value shifting between entities [15.230] Suppose that Right Pty Ltd and Left Pty Ltd are both owned and controlled as to 80% by Ambidextrous Ltd, and that the cost base of Ambidextrous’ shares in Right is $80 m, this reflecting the fact that the sole asset of Right is a loan of $100 m it has made to Left. If some time later Right forgives the debt, the result will be to shift all the value out of Right and into Left. Ambidextrous Ltd could then realise a capital loss of $80 m by liquidating Right. Division 727 counters this practice by deeming there to be a cost base adjustment to Ambidextrous’ shares. The cost base will be reduced from $80 m to nil, to reflect the fact that value has been shifted out of the company and hence the shares, and so prevent any capital loss being claimed. To ensure that the value shift is not taxed again if and when Ambidextrous’ shares in Left are disposed of, their cost base may be adjusted upwards by reference to the amount of value shifted across to Left. Division 727 is generally applicable only to value shifting operations carried out between companies under common ownership. However, as well as debt forgiveness, it applies to all methods by which value might be shifted out of one company into another, such as: the sale of assets or the provision of services or the leasing of assets at an undervalue; or the purchase of assets or obtaining of services or hiring of assets at an overvalue.

2. ROLLOVERS FOR TRANSACTIONS WITH SHARES [15.240] The income tax law has long contained various company rollovers that allow relief

from capital gains tax for transactions involving contributions of assets to a company with no change in the underlying economic ownership of the assets. Usually, the untaxed appreciation in value is “rolled over” so that tax is deferred until the company disposes of the assets. More recently, company rollovers have been introduced for dealings in shares as a result of corporate takeovers and demergers. The rollover relief is available for CGT purposes, and in some cases for depreciating assets, but not for trading stock, financial securities and other revenue assets of the business. A similar pattern applies to CGT rollovers applicable to company transactions, as to other CGT rollovers: see [3.310]. In general, any capital gain on a disposal or other dealing in the asset or company share is disregarded or deferred, and the tax attributes of the transferred asset or share roll over to the new owner. The new owner of a share that is eligible for a rollover usually “inherits” the cost base of that share, sometimes calculated in a particular way; its time of acquisition; and, in some cases, its pre-CGT status.

(a) Contribution of Assets to a Wholly-Owned Company [15.250] It is possible to defer a capital gain on CGT assets transferred to a company in exchange for shares, where the transfer is from an individual to a company wholly-owned by 824

[15.230]

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Special Topics in Company Tax

the individual (Subdiv 122-A); from a trustee to a company wholly-owned by the trustee (Subdiv 122-A); or from a partnership to a company wholly-owned by the partners (Subdiv 122-B). The rollover is extended to Div 40 depreciating assets by s 40-340(1). [15.260] The main requirements for application of Subdiv 122-A are as follows:

• An individual or trustee elects to obtain a rollover if they dispose of a CGT asset, or all of the assets of a business, into a company of which that individual or trustee owns 100% of the shares. (A few other CGT events may also be relevant): ss 122-15, 122-25. • Collectable or personal-use assets, and assets that become trading stock of the company, are not eligible for the rollover. • The disposal of the CGT asset is in exchange solely for ordinary shares in the company, or for the company promising to discharge liabilities in respect of the asset or assets of the business. • The shares must have market value substantially the same as the value of the assets contributed to the company (disregarding any liabilities in respect of those assets): s 122-20. Special rules in ss 122-35, 122-37 apply to liabilities. [15.270] The “replacement asset” rollover in Subdiv 122-A has the effect that any capital

gain or loss made by the individual or trustee from the asset or each of the assets of a business is disregarded (ss 122-40, 122-45). If the individual contributes a pre-CGT asset to the company, the individual’s shares in the company are also taken to be pre-CGT. The cost base of the shares for the individual is, essentially, the “inherited” cost base of the contributed CGT asset (s 122-40); however, this will be adjusted if all of the assets of a business are contributed to take account of liabilities, trading stock and depreciating assets. [15.275]

15.6

Question

Nick is a small business owner who wants to incorporate his business. He disposes of all of his business assets into a shelf company, Nick Pty Ltd, and receives in exchange 10 issued shares in the company. Assume that all of Nick’s business assets were acquired after 20 September 1985. Nick contributes trading stock with a market value of $20,000; plant and equipment with a market value of $50,000 and office furniture with a market value of $10,000. He also contributes land and buildings that he owns, with a cost base of $120,000. Nick has a bank overdraft of $15,000 in respect of his business. How does the Subdiv 122-A rollover apply for Nick? What is his cost base for the 10 shares? (See Example in s 122-50 of the ITAA 1997).

(b) Scrip for Scrip Rollover for Takeovers and Mergers [15.280] The “scrip for scrip” rollover in Subdiv 124-M of the ITAA 1997 applies, for CGT

purposes only, where shareholders exchange shares in one company for shares in another company, as in a takeover bid. The policy of the scrip for scrip rollover was explained by the Review of Business Taxation.

[15.280]

825

Income Derived Through Intermediaries

Review of Business Taxation Final Report (1999) A Tax System Redesigned, Recommendation 19.3 [15.290] A number of submissions to the Review suggested that the current CGT arrangements are an impediment to corporate acquisition activity in Australia. It was argued that under the current CGT regime, entities may be forced to pay a premium when making an acquisition to induce equity holders with potential CGT liabilities to accept the offer. This may act as an impediment to transactions that would otherwise be economically viable. … This measure will encourage start-up and innovative enterprises to remain in Australia. Often entrepreneurs receive the reward for their investment when the venture reaches the initial public offer (IPO) stage. However, under the current CGT arrangements, if the IPO were to proceed as a scrip-for-scrip transaction the entrepreneur would face a CGT liability even though there may be no cash payment. This may act as an incentive for some embryonic businesses to relocate to other jurisdictions to Australia’s detriment. It may also impact on the availability

of funding for these activities domestically as there would be fewer local success stories to attract the interest of investors. This issue may become more significant as the trend continues towards the globalisation of economic activity and the growing importance of knowledge-based industries. With rollover relief, the membership interests of resident taxpayers will retain their original tax value and the resident member will not be required to pay tax on capital gains at the time of the takeover. Tax would be deferred until the ultimate disposal of these interests with the original tax value used to calculate the tax payable. In recognition of the efficiency gains involved, the Review considers it appropriate to allow rollover relief where at least one of the entities is widely held regardless of whether they are listed or unlisted. Rollover relief will also be applied in relation to fixed trusts (including unit trusts) – either as target or acquiring entities or both.

[15.300] The main condition that must be satisfied for the Subdiv 124-M rollover, in

s 124-780(1), is the “80% condition”. The exchange must be in consequence of a takeover bid, scheme of arrangement, or like single arrangement which results in the acquiring entity (or the group of which the acquiring entity is a wholly-owned member) becoming owner of 80% or more of the voting shares in the original entity: s 124-780(2). The acquisition can satisfy this condition by moving from 0% to 80% or more (TD 2000/51), or if the bidder commences with 80% or more and increases their ownership (TD 2000/50). However, if there is, say, a first takeover bid which moves to 60%, and then later a second bid which moves beyond 80%, those who sold in the first bid will likely not qualify for relief. The rollover is subject to a “like for like” rule, so that shares must also be exchanged for shares. It is possible to obtain relief on acquiring other types of security, but again the “like for like” rule applies: the bidder must offer options for options, rights for rights or other interests for similar interests – and relief still depends on the acquisition of 80% or more of the voting shares in the original entity. Rollover relief applies pro rata if the bidder offers a combination of shares and non-scrip consideration such as cash: s 124-790. The rollover only applies to shareholders, etc, holding a post-CGT original interest and only if they would otherwise make a capital gain on disposal of the original interest: s 124-780(3). It does not apply if the shareholder would make a loss. If shares (or other original interests) are pre-CGT, the rollover does not apply, but the cost base of the new shares is their market value: s 124-800. 826

[15.290]

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If the rollover applies, then any gain on disposal is disregarded (s 124-785), and the cost base of the original shares becomes the cost base of the replacement shares (s 124-785). For CGT discount purposes, the shareholder is treated as acquiring the replacement shares at the date they acquired the original shares (s 115-30(1) Item 2). The Subdiv 124-M rollover does not apply to shares held by a non-resident unless the replacement shares are issued by a resident company that owns significant interests in Australian land (so that the share is “taxable Australian property”): s 124-795(1). Otherwise, a gain on sale of shares by a non-resident in an Australian company will not be subject to CGT in any event: Div 768. No rollover applies if the shares are trading stock or revenue assets. Ruling IT 2483 confirms that where shares are held by insurance companies and banks as revenue assets, a scrip for scrip exchange will realise a revenue profit at the time of exchange. [15.310] The acquiring company (the bidder) in a Subdiv 124-M scrip for scrip transaction

(or an ordinary share purchase) will generally obtain a market value cost base for the original shares it acquires in the target company. This is consistent with the separate entity status of the target company, and reflects the general position that the bidder company has presumably “paid” market value for the target, by issuing shares of that value to the ultimate shareholders of the target in the “scrip for scrip” exchange. However, in some circumstances, the rules ensure that the bidder will inherit the cost base of the original shareholders in their target shares, or even the cost base of the assets owned by the target company. The bidder will inherit the cost base of the target shareholders where the bidder and target companies are closely controlled companies and there is a significant or common stakeholder in both companies (s 124-783). The bidder will inherit the cost base of the underlying assets owned by the target company (calculated according to special rules and net of liabilities), in a “reverse takeover” or “top-hat” arrangement, called a “restructure” in s 124-784A, where the target company will comprise 80% or more of the total value of the new, “restructured” group, under the bidder company. Both of these rules are integrity measures intended to prevent companies taking advantage of the deferral of gain for ultimate shareholders, combined with the step-up in cost base of shares. This could be particularly advantageous when combined with rules for tax cost setting of assets in a consolidated group. [15.315]

15.7

Question

Acme Ltd has 100 shares on issue, which have a total cost base of $50 and a total market value of $100. Beta Ltd has 50 shares on issue, which have a total cost base of $25 and a total market value of $50. The shareholders in Acme Ltd and Beta Ltd decide that Acme should merge with Beta. Acme makes a takeover bid for Beta by offering to acquire all the shares in Beta for a scrip consideration, being the issue of one new share in Acme in exchange for each share in Beta Ltd. What are the tax consequences for all parties? What is the rationale for allowing rollover relief to the shareholders in Beta?

(c) Demerger Relief for Company Spin-offs [15.320] Demerger relief is available where a parent company “spins off” or “demerges” a

subsidiary by disposing of its shares in the subsidiary to the parent company shareholders by way of a pro rata distribution. Absent rollover relief, the pro rata distribution of the shares in the subsidiary could be a dividend, or trigger CGT event G1 or CGT event C2, or both, to the [15.320]

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Income Derived Through Intermediaries

shareholders. It could also be a taxable disposal of the shares by the parent company. This rollover relief is in Div 125 of the ITAA 1997, and ss 6(1) (definition of “demerger dividend”), 44 and 45B of the ITAA 1936. The value of the distribution for dividend and other purposes will be the market value of the shares: TR 2003/8. The rules allow the demerger to be effected by selling the existing shares in the demerged entity to the shareholders, or by issuing them new shares in the demerged entity: see s 125-70(1)(2). [15.330] Under s 125-80, the shareholder does not recognise a gain or loss on the CGT event

affecting their shares. Where they originally hold post-CGT shares in the head entity, the cost base of those shares is allocated pro rata to market value between the original shares and the new shares in the demerged entity: ss 124-85 and 124-90. A shareholder cannot choose Div 125 rollover relief if they are a foreign resident and the company does not own significant Australian real property interests (that is, any new shares acquired by the shareholder in the company are not taxable Australian property): s 125-55(2). Dividend relief applies under s 44 of the ITAA 1936 to demerger dividends. The allocation of shares in a demerged entity by the head company to its shareholders may prima facie give rise to an assessable dividend under s 44. Section 44 allows a company to elect that such a “demerger dividend” shall be treated as a dividend not paid out of profits, and also be treated as being neither assessable income nor exempt income: s 44(2) – (4). Recall the transaction in Condell’s case, (see [14.510]), which took place before the Div 125 rollover was introduced. In essence, that was a demerger transaction that likely qualified for relief under US tax law. Would Mr Condell qualify for demerger relief for the in specie dividend he received from Hewlett-Packard, in the form of Agilent shares? To qualify for demerger dividend relief, at least 50% of the assets of the demerged entity by market value must be used by it in carrying on a business: s 44(5) and (6). Further, s 45B may apply to cancel the demerger dividend relief if the ATO considers the demerger rules are being used to avoid tax on disguised profit distributions. A CGT rollover also applies to the group demerging the subsidiary. No capital gain or loss arises on disposal of the shares: s 125-155. No CGT event J1 arises in respect of prior intra-group rollovers: s 125-160. However, the group cannot claim capital losses arising from group assets losing value because of the demerger: ss 125-165 and 125-170. To be eligible for rollover, there must be a group (demerger group, s 125-65) of companies that consists of a head entity and one or more “demerger subsidiaries”. For these purposes, a demerger subsidiary is a company in which the head entity directly or indirectly holds more than 20% of the rights to income and capital, or more than 20% of the voting rights: s 125-165. The group must dispose of 80% or more of their total membership interests in the demerged entity, and do so by allocating the shares to shareholders in the head entity of the demerger group on a pro rata basis (ie in the same proportions as they hold shares in the head entity): s 125-70(2). For each member of the head entity, the shares they hold after the demerger must represent the same proportion of the total market value of the head entity and the demerged entity, as the shares they held before the merger represented the total market value of the head entity: s 125-70(2). Exceptions to the pro rata market value requirement are made for certain employee shares and adjustable interests: s 124-75. 828

[15.330]

Special Topics in Company Tax

[15.335]

15.8

CHAPTER 15

Question

Acme Ltd has 100 shareholders who each hold one share in Acme. The shares have a market value of $1 each. Acme holds 100 shares in its wholly-owned subsidiary, B Pty Ltd and 100 shares in its wholly-owned subsidiary, C Pty Ltd. The market value of the shares in B Pty Ltd is 50 cents each, and the market value of the shares in C Pty Ltd is 50 cents each. Acme decides to distribute all the shares in C Pty Ltd pro rata to its shareholders, ie one share in C for each share held in Acme. What is the rationale for allowing the Acme shareholders to pay no tax in this case? Is it because the shareholders have not realised any gains, but merely reorganised the way they hold their interests in the same assets? What should happen to the cost base of the shares they hold in Acme and the cost base of the shares they now hold in C? Should Acme suffer a gain, or claim a loss, on the distribution?

(d) Rollovers Within a Corporate Group [15.340] Historically, the tax law contained a number of rollovers for transfers of assets

within a wholly-owned corporate group. These rollover rules “looked through” the separate parent and subsidiary companies, in recognition that, where a group is wholly-owned, economically it is equivalent to a single company, so it may be appropriate to disregard transfers of assets within the group. Since the introduction of the consolidated group tax regime, explained in Part 4 below, most group rollovers have been repealed. One CGT rollover remains important for assets transferred between resident and non-resident companies, or between two non-resident companies, which are members of a wholly-owned corporate group (Subdiv 126-B). The consolidation regime would not apply in this case. As for other rollovers, under Subdiv 126-B, a capital gain or loss on the transfer of the asset is disregarded and the acquiring company takes an inherited cost base in the asset. This rollover is extended to depreciating assets by s 40-340(1). CGT event J1 may apply to tax the deferred gain to the acquiring company, if there is a subsequent change of the group’s ultimate parent company: ss 104-175, 104-180 and 104-182. Rollover relief can also be claimed for certain business restructures, including interposing a new shelf company between an existing company and its shareholders (Subdiv 124-G), and for replacing a fixed trust with a company as the owner of business or investment assets (Subdiv 124-N).

3. COMPANY LOSSES [15.350] An important implication of the principle that a company is a separate entity from

its shareholders is that, when a company has a tax loss or capital loss for a year, that loss accrues to the company and not its shareholders. The income tax law follows this. Division 36 (s 36-17 and Subdiv 36-C) applies to net operating or “revenue” losses of companies and provide that losses of a company can be carried forward and applied against its taxable income of in future years. The losses are not passed through to the shareholders (contrast the treatment of a partnership net loss). A similar rule applies for the carry-forward of capital losses under ss 102-10 and 102-15 of ITAA 1997. However, the principle that the company is a separate entity as far as losses are concerned is not allowed its full logical operation under the tax Acts. It is subject to an extensive range of [15.350]

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anti-avoidance rules which reflect the theory that the company losses should be regarded as being made by the company as agent of the individuals who control the company. These anti-avoidance rules operate in two ways. First, the company is generally only permitted to carry forward its losses and apply them as a deduction against its income, so long as the individuals who beneficially owned the shares and controlled the company when it made the losses, continue to own those shares and control the company when it seeks a deduction for the losses. This is achieved by the “continuity of ownership” test. A limited exception applies if the company continues to carry on the same business. Secondly, where a company makes an economic loss, the general theory is that the only parties who should be entitled to recognise that loss as a deduction or capital loss in the income tax system are the company itself, and the individuals who ultimately control the company. Any companies interposed between the loss company and the ultimate individual controllers should not be able to duplicate tax recognition of the same economic loss by claiming deductions or capital losses on the interposed entities’ debt and equity interests in the loss company. The Act contains complex loss duplication integrity rules, as well as the consolidated corporate tax regime (see Part 4 below) to prevent this result. [15.360] As a result of these integrity rules, company profits and losses are treated

asymmetrically in the tax law. This asymmetric treatment limits exposure of the revenue (and taxpayers more broadly) to business risk, but may also place undue impediments on sensible risk taking and entrepreneurial activity by Australian businesses especially as they seek to adjust to new economic conditions. A Business Tax Working Group established by the Treasury in 2012 accepted that full refundability of company losses, which it considered the policy benchmark, would not be practical and would produce a significant cost to the revenue. Instead, it recommended company loss carry-back for a limited time of 2 years, subject to a cap of not less than $1 m. The Rudd-Swan government enacted a one-year loss carryback rule; however, this was reversed by the Abbott-Hockey government primarily for revenue reasons. Consequently, unlike some other countries, carryback of losses is not possible in Australia. The Business Tax Working Group report explains how tax losses arise and why they matter more for some companies than others, in their 2012 Report.

Business Tax Working Group on Company Losses, Report 2012 [15.365] Available from http:// www.treasury.gov.au/PublicationsAndMedia/ Publications/2012/Business-Tax-Working-GroupFinal-Report/Final-Report-on-the-Tax-Treatmentof-Losses/Chapter-2-The-tax-treatment-of-losses Companies may be in a tax loss position for many different reasons and the length of time they are in a tax loss position will vary depending on the different factors at play. For example: 1.

830

A start-up company with significant upfront expenditure but little to no

[15.360]

income in its early years of operation. The company faces the prospect of significant income in later years if the upfront investment proves successful but there is also a substantial risk of the investment failing. 2.

A viable company temporarily in loss because of a temporary shock (if the business’ position was viewed over a five year period it would not be in loss). This cameo is intended to represent a business in an industry that faces seasonal and cyclical fluctuations.

Special Topics in Company Tax

Business Tax Working Group on Company Losses, Report 2012 cont. 3.

A once profitable company facing a sustained change in its operating environment that needs to consider changing business strategies or shutting down.

4.

A company investing to upgrade its product line in order to attract more customers. This company makes losses due to reduced assessable income and increased deductions as a result of refurbishments and staff training.

5.

A terminal company that has never had positive taxable income. This is what may happen to the start-up company if its investment does not pay off.

6.

A consolidated group of companies that is able to spread income and deductions across the group.

The treatment of losses restricts business cash-flow in a downturn The current tax treatment of losses can be seen as the Government withholding its share of the cash flow impact of a loss, leaving businesses to bear the full impact of a loss in the year it is incurred. The current tax treatment of losses delays (and in the extreme case of zero future assessable income, denies) the cash flow benefit for businesses associated with accessing the tax value of a loss. This cash flow impact can be detrimental to a business’ future economic prospects, especially where the company requires short-term liquidity to meet day-to-day outgoings. It also reduces the ability of a business to make investments in new equipment, research and development, staff training and development and other activities that help to increase the viability of the business in the long-term and add to productivity. Poor cash flow can also limit its access to commercial funding through debt and equity markets. Improving loss recoupment would enhance the automatic stabiliser role of company tax to the extent that affected businesses are credit constrained, by providing a cash injection to allow expenditures that could not otherwise be made. As would be expected with an automatic stabiliser, the smoothing effect on business

CHAPTER 15

investment would be accompanied by greater volatility in government revenue as the impact of refunding amounts to those in a loss position would be more pronounced during a downturn in the economy. However, government revenues would improve more quickly as businesses recover. The bias against risk taking reduces the quantity and quality of investment An income year is an arbitrary time period, likely to be shorter than the life of an investment. Requiring businesses to bring to account their financial position at the end of an income year can result in a tax loss in that year, despite the business being profitable over the life of an investment. Businesses in this position face a higher effective tax burden as the use of that loss is restricted, notwithstanding the fact that the business may not have incurred a loss over a longer time frame or even over a different snapshot in time. In the … examples introduced earlier, the arbitrary income period is the cause of the losses in scenarios one, two, three, four and six. Where there is a probability of a business incurring a tax loss in an income year, the current tax treatment of losses can be viewed as either: increasing the effective tax rate on investment above the marginal tax rate that would otherwise apply; or lowering the expected after-tax return on investment. In this way, the current tax treatment of losses influences business decision making by creating a bias against riskier investments. A lack of uplift means that the full value of a carry forward loss is not used, and the risk that the loss may not be able to be used because of the operation of the current integrity tests, deters investments that may incur a tax loss. As a result, some investment that may be optimal or socially desirable given the prevailing tax rate may not be undertaken. When considering the deployment of scarce resources, businesses must assess whether a possible investment provides sufficient returns over time for the risk involved, compared to other potential investments. In doing so, businesses often assess expected future returns from a potential investment against a “hurdle” rate of return. This hurdle rate takes into consideration the project’s risk and the opportunity cost of [15.365]

831

Income Derived Through Intermediaries

Business Tax Working Group on Company Losses, Report 2012 cont. forgoing other projects. The tax treatment of losses influences the net present value of future cash flows and the effective rate of return compared to the hurdle rate of return. In this way the tax treatment of losses may influence business investment decisions. The current asymmetric tax treatment of profits and losses increases the necessary pre-tax return for more risky investments, with the difference between the necessary pre-tax and post-tax rate of return increasing with increasing risk. This tax wedge reduces the investment in more risky investment, relative to a tax system that treats profits and losses symmetrically.

The tax system’s bias against risky investments may divert capital to less risky, lower value investments. The bias against business risk taking is likely to be particularly detrimental to productivity in Australia’s current circumstances that require businesses to be flexible and innovative, and to be able to take advantage of new opportunities presenting themselves in the changing global environment. Reducing the tax system’s bias against risky investments could be expected to increase both the quantity and quality of investment, potentially improving the allocation of resources across the economy. This could have positive flow-on effects for productivity, which in turn can support growth in real wages and employment.

[15.368] To overcome the problem of losses being unable to be passed through to

shareholders and as a stimulus to mineral exploration, the Abbott-Hockey Government enacted an exploration development incentive to apply for 3 years from 2014 to 2017. The scheme in Div 418 of ITAA 1997 allows small mineral exploration companies to give up a portion of their tax losses so as to provide an immediate, refundable tax offset to their Australian resident shareholders for “greenfields” mineral exploration expenditure. The total exploration credits available are capped at $100 m over 3 years.

(a) Continuity of Ownership Test [15.370] In general, a company cannot “carry forward” and deduct a loss unless it can

demonstrate that the individuals who had majority ownership and control of the company at the start of the year in which the loss arises, have at all times maintained majority ownership and control until the end of the income year in which the loss is utilised. This test is generally referred to as the “continuity of ownership test” or “COT”. The COT is a legislative response to the risk that, by use of the corporate form, taxpayers may be able to trade or traffic in their tax losses by selling the company to others who have income or gains against which the losses can be deducted. Most tax jurisdictions comparable to Australia limit carry-forward of losses on the basis of a change in ownership. The rationale of the COT in Australia is discussed in the following extract from the Asprey Committee report.

Taxation Review Committee [15.380] Taxation Review Committee, Full Report 1975 16.137. Until 1944 no restrictions were imposed on the carry-forward of losses by companies. In that year provisions were inserted in the Act

832

[15.368]

denying the carry-forward of losses by a private company unless shares having not less than 25% of the voting power in the company were

Special Topics in Company Tax

Taxation Review Committee cont. beneficially held by the same persons in both the year of loss and the year in which it was sought to apply the loss. 16.139. … the provisions continued to be part of the law as a means of limiting the carryforward by private companies of losses of previous years. In this they were designed to control the practice of buying the shares in a company that has suffered losses in order to be able to take advantage of those losses by applying them against future profits of the company. But they proved quite ineffective. Schemes were devised by which they were easily avoided and they became no more than traps for the unwary. 16.140. The Ligertwood Committee … questioned whether the principle of limiting, for taxation purposes, the allowance of losses of previous years incurred by companies which have substantially changed their shareholders, is soundly based’. In recommending the repeal of the provisions inserted in 1944, the Ligertwood Committee referred to its view that a company, in fact as well as in law, is a legal entity separate from its shareholders and concluded that a

CHAPTER 15

company’s losses should be treated for fiscal purposes without regard to the identity of its shareholders. 16.143. The Committee agrees with the policy of these provisions limiting the carry-forward of company losses and is not persuaded by the reasoning of the Ligertwood Committee. In the taxation of companies it is necessary to go behind the veil of separate legal personality. An individual carrying on business as a sole proprietor or partner who suffers losses has no means open to him of obtaining their equivalent in tax relief except by subsequently making profits against which those losses will be deductible. Moreover, he is limited in thus taking advantage of the losses by the span of his life: losses suffered by an individual cannot be applied against profits made by his personal representative after his death. If there were no restrictions, by reference to continuity of ownership, on the carry-forward of losses by companies, an individual who conducts business through a company would have an unfair advantage: by selling his shares he would obtain immediately the tax equivalent of the losses suffered by the company; and the value of the losses could be turned to advantage after his death.

[15.390] The COT in Div 165 applies to realised losses on revenue and capital account. For

prior year tax losses, Subdiv 165-A applies. Under s 165-12, if a company incurs a loss in a prior year (“loss year”), and wishes to deduct it against income of a later year (“income year”), it must pass the COT for the entire period from the start of the loss year to the end of the income year. In some cases part of a tax loss for a year may be carried forward through s 165-20, if the tests would be satisfied for part of the year. For current year tax losses, Subdiv 165-B applies. If a company has a change of ownership or control during a year (“current year”) such that it fails the COT for that year then it must: (1) divide the current year into two periods – the period before the COT is failed and the period after it is failed; and (2) calculate a notional taxable income or notional net loss for each period as if each period were a tax year. If there is a net loss for one period, it cannot be deducted against taxable income of the other period. Similar rules apply to prior year net capital losses (Subdiv 165-CA), current year net capital losses (Subdiv 165-CB) and bad debts (Subdiv 165-C). (i) Ultimate individual owners or controllers [15.400] The tests for determining whether a company has maintained “majority ownership

and control” are set out in Subdiv 165-D. It is, in general, necessary to trace ownership and control back to the ultimate individual owners or controllers of a company. The primary test is [15.400]

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Income Derived Through Intermediaries

a “majority ownership test” which requires that the same individuals should have maintained, directly or indirectly, at all relevant times (generally from the start of the loss year to the end of the income year in the case of prior year losses) beneficial ownership of rights to more than 50% of the voting power, more than 50% of any dividends, and more than 50% of any capital distributions of the company (ss 165-150, 165-155 and 165-160). This primary test is supported by a second “control of voting power” test which can apply if the majority ownership test is passed, but someone has obtained voting control of the company for purposes of obtaining a tax advantage. The COT requires tracing through any interposed companies, trusts or partnerships, to ascertain the ultimate individual owners of the shares. This tracing exercise can be difficult, and is supplemented by various special rules. For example, a problem may arise if a share is held by a discretionary, or non-fixed, trust: see TD 2000/27 and Subdiv 165-F. In general, a company controlled by a family discretionary trust will not satisfy the COT unless the trust makes a “family trust election” which involves limiting trust distributions to members of a specified family grouping: see s 165-215. Where a company is in liquidation, s 165-208 provides that the COT will not be failed merely because a liquidator or administrator has been appointed. Where a company issues shares with preferred or variable rights with respect to voting, dividends or capital, it may be difficult to establish affirmatively that there has been continuity of majority interests in the sense required by the COT. Division 167, which was enacted in 2015 but given effect backdated to 2002, contains special rules for establishing ownership interests to address this problem. Anti-avoidance rules counter arrangements involving persons being issued with, or continuing to hold, shares for the purpose of formally satisfying the COT: see ss 165-80 to 165-200. (ii) Same share rule [15.410] The COT requires that it is established positively that the same individuals had the

same definitive majority rights in respect of voting, dividends and capital at all times from the start of the loss year to the end of the income year (s 165-165). This strict “same share rule” means that the COT can only be passed if the group of individuals who together had a majority interest in a loss company at the time it incurred the loss not only continue to hold a majority interest, but continue to hold it by holding shares in the same proportions as they held them at the time the loss was incurred. Under s 165-165, it is permissible to have regard only to shares held by each person in the later year to the extent they are the same shares they held in the loss year. For example, if John held 80 shares and Betty held 20 shares in a company in the year of the loss, and John held 20 shares and Betty held 80 shares in the year the company seeks to use the loss, the general intent is that the COT would be failed as the proportions of ownership have changed. In this example, the same share rule means that you have regard only to the 20 shares John still holds, and the 20 shares Betty originally held – as this accounts for only 40 out of 100 shares the COT is failed. The same share rule seems to be grounded in the theory that, when John sold 60 shares to Betty, he would have realised a capital loss on the disposal, and so as to the extent of that realisation of a tax benefit from the underlying loss of the company, it follows that the company should not, subsequent to the disposal, realise the same loss. Consistent with this theory, the company can obtain relief from the same share rule in cases where it can be shown 834

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that the duplication of loss will not occur because the loss will not be realised by the shareholder on the disposal: ss 165-12(7), 165-37(4), 165-115C(4) and 165-123(7). Examples of this might be where the share ownership changes because one of the shareholders subscribes for new shares, or all shareholders receive bonus shares, or where share capital is split or consolidated. (iii) Listed public companies [15.420] The requirement to trace the ultimate owners of shares can cause significant

problems for listed public or widely held companies. Concessional tracing rules apply to these entities and to companies where more than 50% of the voting, dividend or capital rights are held by a listed public company, a superannuation fund or a managed investment scheme: Div 166 of the ITAA 1997. Under Div 166, eligible companies may test for “substantial continuity of ownership” at the end of each income year and on certain “corporate change” events, such as a new share issue of 20% or more of share capital, or a takeover notified to the stock exchange (s 166-175). A company can elect out of the rules (s 166-15). The key elements of the rules are: • All registered shareholdings in the loss company of less than 10% are aggregated and treated as a notional single shareholder. • An indirect stake in the loss company (held through one or more interposed entities) of less than 10% is attributed to the top interposed entity which is deemed to hold that stake directly in the loss company. • Where a widely held company holds, directly or indirectly, between 10% and 50% of the loss company, this stake is attributed directly to the widely held company as the ultimate owner (s 166-240). • Complying superannuation funds, certain managed investment funds, family trusts, nominees and bearer shares are treated as notional owners so it is not necessary to trace through such entities to their underlying members. The “same share” rule does not apply to companies which are eligible for the Div 166 concessional tracing rules. However, a modified “same share, same interest” rule applies in some circumstances (s 166-272). [15.425]

15.9

Question

Acme Ltd is a resident private company. It had a tax loss of $100,000 in the year ending 30 June 2003. It has a trading loss of $75,000 for the six months to 31 December 2003. Assume that at 30 June 2002, Acme had an issued share capital of 100 ordinary shares, and that John held 60 and Betty held 40. What are the implications under the following alternative transactions for the realised and unrealised losses, assuming the transactions were to happen on 31 December 2003: (1) John sells 30 shares and Betty sells 20 shares to Doris, John’s sister; or (2) John sells 55 shares to Betty; or (3) John subscribes for 600 new shares and Betty subscribes for 400 new shares; or (4) Acme issues a redeemable preference share to Doris for an issue price of $100,000, which carries a preferred right to an annual dividend of $10,000, and is redeemable at $10,000 in nine years time.

[15.430] The COT addresses arrangements to transfer losses from one company to another. A

similar result could be achieved by transferring income or capital gains into a company that [15.430]

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Income Derived Through Intermediaries

has losses. Div 175 of the ITAA 1997 counters schemes where parties take steps to inject income or capital gains into loss companies, or to inject deductions into companies with income or capital gains. The rules concerning commercial debt forgiveness in Div 245 of the ITAA 1997 are also a form of loss integrity measure. Where debts owed by a company are forgiven, the amount of the debt forgiveness can be applied to reduce various tax attributes of the company, including its tax losses. The object of the debt forgiveness rules is to prevent the loss suffered by the company funded by the debt, being duplicated as a second loss in the hands of the lender on the realisation of the debt. It does this by reducing, not the loss of the lender, but the losses of the borrower company. Where the borrower has insufficient tax losses to account for the full debt forgiveness, the borrower must reduce other tax attributes such as undeducted tax expenditures and cost bases of assets.

(b) Same Business Test [15.440] As a result of the COT, in a genuine business transaction, if shareholders dispose of

the business by selling the shares in the company, they will also lose their interest in the accrued but unused tax losses. The COT does not contain any requirement that the shareholders have a tax avoidance purpose. The purchaser of the company will be prevented from using the losses and so will not place any value on the tax losses in the price it is prepared to pay for the shares. This may be regarded as unfair to the original owners: had they held the business directly rather than through a company, they would still remain able to use the losses against their own future income or gains after the sale of the business. The income tax law allows an exception to the COT where the company continues to carry on the same business under new ownership. This is known as the “Same Business Test” or “SBT”. Under the SBT, if the COT is failed, a company can still carry forward its losses if it can demonstrate that, from immediately before the time the COT is failed, the company has continued to carry on the same business, and has not entered into any new kinds of transactions or businesses, until after the end of the year in which the loss is realised. The SBT was introduced in 1965 (in former s 80E of the ITAA 1936) as a concession to alleviate the harsh consequences of the COT. The rationale for the SBT was particularly strong when there was no capital gains tax regime. However, it might be thought that, since the introduction of CGT, the case is somewhat weaker, as the original individuals who hold shares (directly or indirectly) in a company which has losses from its business operations, may now obtain a benefit from their interest in the losses by realising a capital loss when they dispose of their shares in the company. [15.450] The SBT is set out in s 165-210 (Subdiv 165-E). It has three aspects: (1) a “same

business test” which requires the company to continue to carry on the identical business if it is to pass the SBT; (2) a “new business test” which deems the SBT failed if the company derives income from a business it did not previously carry on; and (3) a “new transactions test” which deems the SBT to be failed if the company derives income from a transaction of a kind it had not previously entered. There are a number of cases on application of the SBT in Australia and in the United Kingdom, which has long had a similar rule. The leading Australian case is Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97 in which the taxpayer company, having incurred losses while conducting a business of a dealer in motor parts and accessories, effectively set about closing down its business, and disposing of assets and liabilities until it had no 836

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employees, no customers, no assets (other than stationery) and no liabilities. Then, at a later date all the shares in the company were purchased by another company group also engaged in the motor trade, and carrying on a business which included dealing in motor parts and accessories. The new owners effectively commenced using the loss company as the vehicle for that business. It was claimed that this satisfied the same business test because “same” should be read to mean “similar” or “of like kind” rather than “identical”. Gibbs J in the High Court construed the same business test (in former s 80E of the ITAA 1936) and rejected this argument of the taxpayer.

Avondale Motors (Parts) Pty Ltd v FCT [15.460] Avondale Motors (Parts) Pty Ltd v FCT (1971) 124 CLR 97 Gibbs J: Before 15th March 1968 [the date the company ownership changed] the taxpayer carried on the business of dealer in motor parts and accessories at three different premises in conjunction with a motor dealer having franchises for certain vehicles. After that date it carried on the same kind of business but under a different name, at different places, with different directors and employees, with different stock and plant and in conjunction with a motor dealer having different franchises. The question whether a company has commenced a new business or has continued an old business under different conditions is simply one of fact. In some circumstances a company may expand or contract its activities, it may close an old shop and open a new one, without starting a new business, but the only conclusion that can be drawn from all the circumstances of the present case is that the business of the taxpayer after 15th March 1968 was different from that which it carried on before that date. However, the taxpayer submits that s. 80E(1)(c) does not require that the business carried on during the year of income should be identical with that carried on immediately before the change referred to in that paragraph. It is submitted that the word “same” in that paragraph means “similar” or “analogous” and not “identical”, and that it is enough that the businesses are similar in their nature. … The meaning of the phrase “same as”, like that of any other ambiguous expression, depends on the context in which it appears. In my opinion in the context of the section the words “same as” import identity and not merely similarity and this is so even though the legislature might have

expressed the same meaning by a different form of words. It seems to me natural to read the section as referring to the same business, in the sense of the identical business, and this view is supported by a consideration of the purposes of the section. The relevant sections of the Act show an intention on the part of the legislature to impose, in the case of companies, a special restriction on the ordinary right of a taxpayer to treat losses incurred in previous years as a deduction from income. The company cannot take the losses into account if there has been a change in the beneficial ownership, of its shares or of the shares in the company of which it is a subsidiary, of the kind mentioned in s. 80A or s. 80C. This restriction is imposed to prevent persons from profiting by the acquisition of control of a company for the sole purpose of claiming its accrued losses as a tax deduction. However the restriction if imposed absolutely would lead to injustice in cases where a company, notwithstanding substantial changes in the ownership of its shares, continued to carry on the same business. No injustice would, in my opinion, result from a refusal to treat an accrued loss as a tax deduction where the company after the change carried on a different business, although one of a similar kind. In such a case, as a general rule, there would have been no business reason for the purchase of the shares, but only the wish to obtain the right to claim another’s losses as a deduction from one’s own income. To allow the accrued losses to be claimed as deductions in a case where shares in a company had been acquired, not for the purpose of carrying on any existing business of the company, but simply for the purpose of “buying” its accrued losses, would [15.460]

837

Income Derived Through Intermediaries

Avondale Motors cont. be to reward an obvious device for no intelligible reason. I conclude that s. 80E(1)(c) requires that

the business carried on at all times during the year of income should be the same business; mere similarity of kind is not enough.

[15.480] The ATO view on the SBT is set out at length in TR 1999/9. The ATO generally

administers the SBT as a concession with limited operation and even implies, in this ruling, that the SBT is akin to an “exactly the same business” test. The ruling allows little leeway for adding new business assets or changing existing business operations. Paragraph 13 of the Ruling states: In the same business test, the meaning of the word “same” in the phrase “same business as” imports identity and not merely similarity; the phrase “same business as” is to be read as referring to the same business, in the sense of the identical business. However, this does not mean identical in all respects: what is required is the continuation of the actual business carried on immediately before the change-over. Nevertheless, it is not sufficient that the business carried on after the change-over meets some industry wide definition of a business of the same kind; nor would it be sufficient for there to be mere continuance of business operations from immediately before the change-over into the period of recoupment, if the business had so changed that it could no longer be described as the same business. The analysis of whether the same business continues after the change-over may give rise to questions of degree and ultimately depends on the facts of the case. In making the analysis it needs to be acknowledged that a company may expand or contract its activities without necessarily ceasing to carry on the same business. The organic growth of a business through the adoption of new compatible operations will not ordinarily cause it to fail the same business test provided the business retains its identity; nor would discarding, in the ordinary way, portions of its old operations. But, if through a process of evolution a business changes its essential character, or there is a sudden and dramatic change in the business brought about by either the acquisition or the loss of activities on a considerable scale, a company may fail the test. [15.490] The existence of the “same business” is a question of fact and an appellate court will

not often overturn a first instance decision on the issue. However, in Lilyvale Hotel Pty Ltd v FCT [2009] FCAFC 21, the Full Court of the Federal Court accepted the primary judge’s findings of fact but drew a different inference from the facts about the business of the taxpayer. The taxpayer, Lilyvale, sought to deduct in the 2002–03 income year carried-forward losses of approximately $10 m from previous years. In August 2002, all the shares in Lilyvale were sold to a new owner. Prior to the share sale, Lilyvale owned a hotel in Sydney and ran it through an operating agreement with a hotel management company, Enterprises Australia Pty Ltd. After the share sale, the agreement with the management company was terminated and the hotel was operated directly by Lilyvale. The primary judge found that the SBT was failed as a result of this change. The Full Court overturned the decision; the decision of Edmonds and Graham JJ discusses the policy of the SBT and reflects the decision of the Court.

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Lilyvale Hotel Pty Ltd v FCT [15.500] Lilyvale Hotel Pty Ltd v FCT [2009] FCAFC 21 Edmonds and Graham JJ: The precursor to s 165210 was introduced as a “safety net” … This policy is acknowledged in the Treasurer’s Second Reading Speech to Income Tax Assessment Bill 1965: Under the legislation introduced last October, losses of a previous year are not, for 1965-66 and subsequent years, allowable as deductions against the income of a year of income of any company unless there is found to be, during both years, a beneficial ownership by the same shareholders of shares in the company that carry at least 40% of the voting and dividend rights and 40% of entitlements to distributions of capital in the event of the company being wound up. It is proposed to retain this basic principle but to modify its application in a number of ways. One amendment proposed will ensure that a major, or even a total, change in the shareholdings of a company will not operate to disturb a deduction for a prior year loss incurred by the company if, at all times in the year of income in which the deduction may be claimed, the company is carrying on the same business as it carried on immediately prior to the change in its shareholdings. For this purpose, a company is not to be treated as qualifying for the deduction if, after the change in its shareholdings occurred, it begins to carry on a business, or enters into transactions, of a kind that it did not carry on or enter into before the change occurred. The Government considers that this amendment will satisfactorily meet cases of mergers and takeovers of companies that are carried out for sound economic purposes and with which there is not associated any transfer of profitable business from one company to another so that income which would otherwise be taxed is derived free of tax. (Emphasis added) …

[T]he primary judge accepted the appellant’s evidence comparing the operation of the hotel after the sale (with that before the sale) and adopted the appellant’s summary in the following terms: (a)

the hotel business was conducted by the Applicant under the same name;

(b)

the same get-up and style, trademarks and presentation were used;

(c)

the management team (including in particular the general manager) continued unchanged;

(d)

the staff engaged in the conduct of the business continued unchanged except for normal turnover, which was lower in the Applicant’s case than was normal in the industry;

(e)

the contracts for the provision of services by external contractors continued unchanged;

(f)

the services and facilities provided by the Applicant in the conduct of the hotel business were unchanged;

(g)

the hotel was marketed in the same way, to the same markets and using the same agents and representatives;

(h)

the signature restaurant (Unkai) and other restaurants continued to operate in the same way;

(i)

the Applicant continued to derive the (assessable) income from the provision of the same hotel services and facilities;

(j)

the same manuals and procedures continued to be used under licence from the same (ANA) group;

(k)

the same computer management and reservation systems continued to be used, obtained from the same independent suppliers;

(l)

the same reports continued to be supplied to the ultimate shareholders in the Applicant (albeit that the identity of the shareholders changed);

(m)

the owner’s representative (whose identity changed from time to time) continued to perform the same role; [15.500]

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Income Derived Through Intermediaries

Lilyvale Hotel cont.

appellant’s business before the share sale. On the contrary, they must be taken into account. …

(n)

a “guest relationship manager” was retained to present a “Japanese face” to the hotel guests;

(o)

the management of the hotel was to the same extent (and with no greater degree of supervision) entrusted to the general manager and the executive committee; it “remained the same throughout the entire period.”

(p)

in the period from the test time in August 2002 to April 2003, the Applicant undertook and achieved a “seamless transition,” whereby it carried on its business in the same fashion as it had done before August 2002, such that no change resulting from the change in ownership was perceptible to its customers.

In our opinion, the leaned primary judge fell into error in concluding that in answering the “same business test” one had to have regard to the management of the business. In our opinion, the fact that at one stage the appellant conducted its hotel business without the intervention of a hotel management group and at another did so with the assistance of such a hotel management group is a distinction without a difference. In our opinion, the appellant correctly described the business which it carried on as that of “owning and operating …[a] hotel to derive revenue from its guests and profits from its operation”. The execution of the management of the hotel at different times in different ways had no bearing upon the identification of the business which the appellant carried on. …

[W]hat business the appellant carried on before the share sale is a question of fact, the answer to which depends on the characterisation of the activities in which the appellant was actually engaged – “the real nature of the taxpayer’s business”: per Sheppard J in J Hammond Investments Pty Ltd v Federal Commissioner of Taxation (1977) 31 FLR 349 at 357. But if the activities of Enterprises Australia in managing the hotel are carried out as agent for and on behalf of the appellant, we are unable to comprehend why these activities should be excluded from consideration in the characterisation of the

[15.510]

[T]he appellant did not move to a different location or locations to conduct its hotel business. It did not, so it would seem, introduce gaming machines or otherwise change the character of the hotel business. In Avondale Motors, the appellant was engaged in a motor vehicles spare parts business. The “before” and “after” nature of “the business” was, unlike the present case, quite different. This was a case where changes in the way in which the business was carried on did not render it a different business.

Question

15.10 A coal company sold its interest in a mining venture to another entity, but was engaged in various “winding up” activities in consequence of the business sale, such as assigning mining leases, in the relevant tax year. In view of Avondale Motors, can the company claim tax losses carried forward from prior years when carrying on the mining venture? Coal Developments (German Creek) Pty Ltd v FCT (2008) 71 ATR 96; [2008] FCAFC 27. [15.520] The Turnbull Government’s Innovation Statement of December 2015 included a

proposal to “relax” the operation of the SBT by replacing it with a “similar business test”, intended to increase access to company losses (see http://www.treasury.gov.au/Policy-Topics/ Taxation/NISA/Access-to-company-losses). The new rule is to apply for losses incurred from the year starting 1 July 2015. The reform is intended to introduce a more flexible “predominantly similar business test”, which it is hoped will assist start-ups and smaller 840

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companies, which may only have one income stream and have less capacity to offset losses. Factors to be taken into account in determining “similarity” include: (a)

the extent to which assets in current business (including goodwill) were also used in the former business; (b) the extent to which the sources of assessable income in the current business were also the sources of income in the former business; and (c) whether any changes to the former business are changes that would reasonably be expected to have been made to a similarly placed business. Additional integrity measures are also proposed.

(c) Unrealised Losses [15.530] The COT and SBT are extended, in Subdiv 165-CC, to apply to a company that

owns assets with unrealised losses, that is, assets that have declined in value during the period in which they were owned by the company. The COT and SBT will apply where there is a change of majority ownership or control of such a company: s 165-115A(1). For example, if Acme has a CGT asset with a cost base of $100 and market value of $50 at the time of a change of majority ownership or control, it should not be able to realise (and then deduct) the loss of $50 after the change in ownership, unless it passes the SBT up until the time it wishes to deduct the loss: see ss 165-115B(4) and 165-115BA(4). While the general principle is straightforward, the legislative implementation of the principle is complex. One complexity is: from what starting point do you measure the control and ownership of the company to determine whether there has been a relevant majority change? In general, the first starting point is from when the legislation commenced (11 November 1999). If there is a second majority change after that date, the time of that second majority change becomes the starting point for the next period of measurement, and so on: s 165-115A(2) and (3). A second complexity is that, to determine if there are unrealised losses, it becomes necessary to obtain a market valuation of all assets each time there is a change of majority ownership and control of a company, which can be the source of large compliance costs. The legislation accordingly operates by reference not to unrealised losses on individual assets, but rather by reference to whether the company has an overall “net unrealised loss” on all its assets: ss 165-115A(1)(b) and 165-115E. This means the rules only apply where the company would realise an overall net loss if it were to dispose of all its assets at market value. So, for example, a company can generally ignore the rules if the market value of all its assets in total exceeds the sum of their total cost bases: s 165-115E(2). Other exceptions designed to reduce compliance costs, particularly for smaller companies, also apply: eg if net assets are less than $6 m, the rules generally will not apply: s 165-115A(1). A third complexity is: how do you determine, when a loss on an asset is actually realised, how much of the realised loss is referable to the accrued unrealised loss at the change of majority ownership and control? The legislation deals with this in fairly blunt fashion. As noted, the subdivision only applies if the company has an overall “net unrealised loss” on all its assets at the change of majority ownership and control. If it does have a net unrealised loss, then this net amount is applied to reduce the amount of any loss subsequently realised on the disposal of any asset which the company owned at the time of change of majority ownership and control, unless the company can pass the SBT: ss 165-115A(1)(c), 165-115A(1A), 165-115B, 165-115BA. [15.530]

841

Income Derived Through Intermediaries

[15.540]

Question

15.11 Assume that Beta Ltd owns 70% of the shares in Sub Pty Ltd, and that the other 30% are held by Peter. The sole asset of Sub is a block of land in Sydney which the company purchased for $20 m and leases out as a rental property. The land now has a market value at 30 April 2004 of $10 m. On 1 May Beta Ltd sells all its shares to Bank Ltd for $7 m. If, after this change of majority ownership and control, Sub terminates the lease, obtains permits to subdivide the block of land and build 12 units, and then sells the block of land to Boris the Builder for $9 m, will Sub be able to realise all or part of the capital loss of $1.1 m?

4. TAXATION OF CONSOLIDATED GROUPS (a) Policy and History of the Consolidation Regime [15.550] In 2002, Australia enacted a comprehensive consolidated group tax regime for

wholly-owned Australian corporate groups, which treats a consolidated group as a single entity for tax purposes. The consolidation regime is in Part 3-90 of the ITAA 1997 (starting at Division 700). The consolidation regime provides for “consolidated groups” to be taxed as if the head company and all its wholly owned resident subsidiaries are a single entity rather than separate taxpayers. Although some other countries, notably the United States, provide tax rules for consolidated groups, Australia’s consolidation regime is unique. [15.560] Consider the following scenario: Acme Ltd is a single company which carries on two

businesses: an oil business which makes a profit of $100 for the year; and a gold business which makes a loss of $50 for the year. Acme will have a taxable income for the year of $50. Beta Ltd is a parent company which has two wholly owned subsidiaries: A Pty Ltd, which carries on an oil business which makes a profit of $100 for the year; and B Pty Ltd, which carries on a gold business which makes a loss of $50 for the year. Should the income tax system treat A Pty Ltd as having a taxable income of $100, and B Pty Ltd as having a loss of $50 to be carried forward to future years, or should it permit the Beta Ltd group to return a consolidated taxable income of $50? In the case of Beta Ltd and its two subsidiaries, it can be argued “that the true income of a single enterprise should be taxed even though the enterprise is carried on through more than one company” (Taxation Review Committee, Full Report, 31 January 1975, p 246). In other words, where a parent corporation owns all the shares in subsidiary corporations, the parent and its subsidiaries form a single economic enterprise which should be treated as one entity to achieve a correct reflex of the true net income of the enterprise. It is for similar reasons that accounting standards require groups of companies to prepare consolidated accounts in which the results of the group, considered as a single enterprise, are reported. Should not the tax law also require groups to file a single consolidated income tax return? [15.570] Consolidation of a head company and its subsidiaries implies that transactions

between members of the group should have no income tax consequence. Since a single enterprise cannot make a gain or a loss by dealings with itself, it follows that neither should members of the consolidated group be able to recognise gains or losses from intra-group dealings. Further, the shareholdings or debt interests of members of a consolidated corporate group should not generate tax consequences. A single economic enterprise has no “internal” shares or loans from which taxable gains or losses can be derived – any gains or losses will be limited 842

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to those arising from the actual business assets and liabilities of the enterprise. Likewise, where consolidated income tax treatment applies to a head company and its subsidiaries, the intra-group shares and debt should not be a source of taxable gains or losses – only gains or losses attributable to the underlying business assets and liabilities of the subsidiaries should be recognised. [15.580] The Asprey Committee accepted “in principle that a company and, at least, its

wholly-owned subsidiaries should be treated as one entity for income tax assessment purposes” (Taxation Review Committee, Full Report, 31 January 1975, p 247). However, the Asprey Committee saw that to implement this principle by permitting company groups to file a single consolidated tax return would involve “some major compliance and administrative difficulties” and that “procedures which would have the effect of permitting extensive offsetting of losses within all company groups could have significant revenue implications”. Consider the following scenario: Profit Ltd has a profitable business, which is expected to make a profit for the current year of $10 m. Halfway through the year it purchases all the shares in Loss Ltd, which is anticipated to make a loss of $10 m for the current year. Would it be fair to allow Profit Ltd and Loss Ltd to file a consolidated taxable income of $0 for the current year? What tax rule prevents this currently? Would practices of “trafficking in loss companies” emerge if the income tax law permitted this? [15.590] Before the consolidation regime was introduced, various concessional rules applied

to corporate losses and transfer of assets within wholly-owned corporate groups. The most significant form of group relief concerned losses. Like many other countries, Australia had rules that enabled companies that were members of wholly-owned corporate groups to transfer losses to other companies within the group. The effect of the rules was to ignore, to a limited extent, the separate entity status of the companies in the group and treat the group as a single economic enterprise (former Div 170 of the ITAA 1997). To inhibit loss trafficking this privilege was restricted to cases where both companies had been 100% members of the same group at all times from the start of the year the loss company made the loss, to the end of the year the loss was transferred to the other group member. Since the introduction of the consolidated group regime, these loss grouping rules are now phased out. However, the Act contains an integrity measure for companies in a “linked group”. Subdivision 170-D of the ITAA 1997 operates to defer losses on asset disposals by a company which is a member of a group of companies under common majority control. The rule prevents a company obtaining an immediate loss when it disposes of an asset at a loss to another member of the linked group, a connected entity, or an associate of a connected entity. Instead, the loss is deferred until the asset either: (1) ceases to exist; (2) is transferred on to an entity which is not a member of the linked group, or a connected entity or an associate; (3) the transferee ceases to be a member of the linked group, connected entity or an associate; or (4) the company which made the loss itself leaves the linked group. [15.600] A third form of group relief was the CGT rollover for transfers of assets between

wholly owned members of a company group, in Subdiv 126-B (discussed above in Part 2). Again, after amendments over many years to prevent abuse, the ultimate circumstances in which the rollover could be claimed were quite restricted, and supported by rules to recapture any deferred gain should the subsidiary to which an asset was “rolled over” subsequently [15.600]

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cease to be subject to 100% control of the ultimate corporate parent. Other integrity provisions include the complex value shifting rules in Div 727 were also enacted (see [15.220]). [15.610] As well as loss duplication, the operation of CGT for corporate groups was also

found to reveal cases of gain duplication. One of the most important examples occurred where a parent held shares in a subsidiary and the market value of the shares had appreciated as a result of an appreciation in market value of the underlying assets of the subsidiary. The parent could recognise a capital gain in respect of the appreciation in value by the sale of the shares in the subsidiary to a third party. However, if the subsidiary were to subsequently dispose of its underlying assets, it would also recognise a capital gain in respect of the same appreciation in value. Thus, two taxable gains would be recognised in relation to one economic value increase in the subsidiary’s assets. This outcome was seen to inhibit merger and acquisition activity, where typically a bidder, having acquired a target company at a price reflecting the appreciated market value of its underlying assets, would then want to dispose of some of the underlying assets as part of post-acquisition restructuring. [15.620] In 1998 the Review of Business Taxation was asked to consider again the question

of whether company groups should be taxed on a consolidated basis. In contrast to the view of the Asprey Committee, the Review saw the consolidation regime as offering “major advantages to entity groups” when compared to the existing law at that time, in terms of “reduced complexity and increased flexibility in commercial operations” (A Tax System Redesigned, July 1999, p 518). The Review considered that a consolidation regime was the only comprehensive solution to the problems of loss duplication and gain duplication which had emerged since the capital gains tax commenced. In its final report, the Review proposed in Recommendation 15.1: That consolidated income tax treatment for groups of entities (“consolidation”) be introduced, based on the following six principles: (i) consolidation is optional, but if a group decides to consolidate, all its wholly-owned Australian resident group entities must consolidate; (ii) consolidated groups of wholly-owned Australian entities with a single common head entity be treated as a single entity; (iii) repeal of the current grouping provisions; (iv) losses and franking account balances of entities entering a consolidated group generally be able to be brought into the consolidated group; (v) losses and franking balances remain with the consolidated group on an entity’s exit; and (vi) Consistent with Recommendation 15.5, the tax values of assets and liabilities on exit be established according to the asset-based model. [15.630] These basic recommendations were enacted in Part 3-90 of the ITAA 1997.

Section 700-1 explains the principle of the consolidated group regime as follows: This Part allows certain groups of entities to be treated as single entities for income tax purposes. Following a choice to consolidate, subsidiary members are treated as part of the head company rather than as separate income tax identities. The head company inherits their income tax history when they become subsidiary members of the group. On ceasing to be subsidiary members, they take with them an income tax history that recognises that they are different from when they became subsidiary members. 844

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[15.635] While the objective of achieving “single entity” treatment can be easily

comprehended, it is not so easy to express exactly how this outcome is best achieved. It is possible to conceive of several different methods of achieving single entity treatment. One might be to deem the formation of a consolidated group to constitute the creation of a new single taxpayer entity. A second might be to follow the same approach as adopted by financial accounting, which is to treat each entity as having a separate existence, but to then calculate for each of the separate members a net income which is adjusted to exclude the effect of transactions with other group members, and then aggregate these separate net incomes to produce a single group result. As revealed in s 700-1, the consolidation regime takes a third approach. It treats the resident head company as continuing to exist as a taxpayer, but deems all its wholly owned resident subsidiaries to no longer have a separate and distinct existence for income tax purposes. Instead, the subsidiaries are deemed to become “part” of the head company. In addition, the tax history of the subsidiaries is deemed to become part of the tax history of the parent company. Finally, the assets of all the subsidiary members are given a new tax cost in the hands of the parent company. [15.640] The “consolidated group” regime was effective from 2002. It required major

changes in tax compliance of corporate groups in Australia during a three-year transition period from 2002 to 2005. The legislation is lengthy and detailed and has required significant ongoing technical amendments and generated a number of cases about technical aspects, many of which concern entities joining or leaving a consolidated group. It has also required a major administrative and interpretive effort by the ATO through the issue of many tax determinations, tax rulings and the Consolidation Reference Manual. While the consolidation regime aimed to close, and has succeeded in closing, some opportunities for tax avoidance by corporate groups, while arguably providing some overall improvements in the tax regime for such groups, it has also opened up a number of hitherto unthought-of avoidance opportunities that may pose a significant threat to the revenue. As discussed by Professor Graeme Cooper, there are difficult choices for governments in seeking to enact tax rules for corporate groups which may be either partial and incomplete, or else comprehensive, complex and “highly engineered” like the Australian regime: “A few observations on taxing corporate groups: The Australian experience” (2011) 59 Canadian Tax Journal 265-294.

(b) What is the Consolidated Group? [15.650] A consolidated group must consist of a single Australian resident parent company

(the “head company”) and all of its resident wholly-owned subsidiaries (the “subsidiary members”): Div 703 of the ITAA 1997. The rule that confines consolidation to wholly-owned entities is one of administrative simplicity rather than principle. It leads to interesting questions as to what is meant by “wholly-owned”. After some debate, the legislation was enacted on the basis that it generally means 100% beneficial ownership of all the shares in a company which are treated as equity interests, rather than debt interests, under the “debt/equity” rules in Div 974: s 703-30 and Subdiv 960-G. Rights, options and certain employee shares are disregarded. A consolidated group may include wholly owned partnerships and trusts, as well as subsidiary companies. A head company has a choice as to whether it elects to form a consolidated group with its subsidiaries under s 703-50. If a choice is made to consolidate, all current and future resident [15.650]

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Income Derived Through Intermediaries

wholly-owned subsidiaries of the head company are automatically deemed to form part of the consolidated group: s 703-5(3). The choice to consolidate is irrevocable: s 703-50(2). [15.660] When the consolidation regime was first introduced, it was expected that most

corporate groups of a reasonable size would make the choice to consolidate. About 90% of large corporate groups have elected to consolidate. However, at the other end of the scale, it is not surprising that the majority of small groups (annual turnover under $2 m) choose not to consolidate. It is more surprising that a large proportion of small to medium enterprises (SMEs) in the $10 m to $100 m range have not consolidated; see discussion in the Board of Taxation Discussion Paper on Post-Implementation Review into Certain Aspects of the Consolidation Regime (2009).

Corporate groups in the mid-tier SME sector may choose not to consolidate for a range of reasons, including the complexity of their entity structures (which often include discretionary trusts), the existence of substantial pre-CGT assets and perceived difficulties with treatment of those assets in the consolidation regime, and high compliance costs of electing into the regime. However, by choosing not to consolidate, these SMEs miss out on the ability to transfer losses and obtain CGT rollovers in respect of assets within the group. This seems likely to be a disadvantage. The Board of Taxation in 2010 recommended the extension of transitional concessions to encourage more SME groups to consolidate. [15.670] The basic rule, that a group must be formed by a single resident head company, was

found to cause difficulties for multinational groups which hold a number of wholly-owned subsidiaries in Australia through “multiple entry points” – ie the subsidiaries are not held from offshore through a single Australian resident holding company. Such foreign-owned groups are permitted to form a special type of consolidated group called a multiple entry consolidated group (“MEC group”) under Div 719. A MEC group is, broadly, treated as a single entity in the same way as a normal consolidated group, subject to certain complications which are beyond the scope of this chapter.

(c) The Single Entity Rule [15.680] Section 701-1(1) sets out the “single entity rule” or SER: If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period. 846

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As the section indicates, the SER only operates for the limited purposes set out in subsections (2) and (3). These limited purposes are, in essence, the calculation of the income tax liabilities of the head company and the subsidiary for any year during or after the period of membership of the group. The SER does not apply to other federal taxes such as fringe benefits tax or withholding tax. The “single entity” status of the head company and its subsidiary members operates only for the purpose of the tax liabilities of the consolidated group. It does not apply to calculation of the income tax liabilities of third parties dealing with the head company or its subsidiary members. [15.690] The “entry history rule” ascribes to the head company certain elements of the tax

history of the subsidiaries whose separate existence is no longer recognised. For example, the depreciation method (prime cost or diminishing value) applied for depreciating assets brought into the group will be covered by this rule. Section 701-5 provides: For the head company core purposes in relation to the period after the entity becomes a subsidiary member of the group, everything that happened in relation to it before it became a subsidiary member is taken to have happened in relation to the head company. [15.700] In applying the SER, it must be remembered that the single entity model of

consolidation has application only for the purposes of the income tax law. At general law the head company and its subsidiary members will continue to retain their separate status and to create legal rights and obligations with each other, and with third parties, on the basis of this separate legal existence. This raises the question of how far the “single entity” fiction should be taken to override the legal reality of the subsidiary members’ continuing legal existence in determining the taxable income of the consolidated group. In considering this question there are, in principle, four different cases which can be distinguished. The first case is where a single subsidiary member has a dealing or transaction with an outside party, which does not involve the head company or any other group member. An example might be a subsidiary member entering into contracts with a third party to sell or purchase property, or to supply or acquire services, or to lend or borrow money. Where the members of the consolidated group engage in transactions which are wholly external to the group, it would appear reasonable to apply the SER on the basis that, for income tax purposes, the action by the subsidiary should be taken to be an action by the head company, since the subsidiary is taken to be part of the head company. The second case is where a subsidiary member has a dealing or transaction with the head company or another group member, which does not involve any outside party. An example might be a subsidiary paying a dividend to the head company, or one subsidiary selling goods, or leasing land, or paying management fees, or lending money, or subscribing share capital, to another subsidiary member. Where the members of the consolidated group engage in transactions which are wholly internal to the group, then it would appear relatively straightforward to hold that, for income tax purposes, these transactions should be disregarded by reason of the SER, since a single entity cannot have dealings with itself. The third case is where the head company or a subsidiary member enters into a dealing or transaction with an outside party, which also involves in some way another member of the group. One example might be a head company making a loan to a subsidiary member, and then assigning the right to interest on the loan for a lump sum to an outside party. Another example might be a head company selling shares in a subsidiary to an outside party. Where the members of the consolidated group engage in transactions which are partly internal and partly external to the group, then it is less clear how the SER should apply because the character of [15.700]

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Income Derived Through Intermediaries

the transaction with the third party will depend, at least in part, on the separate legal existence of the head company and its subsidiary members. The fourth case is where a subsidiary company enters into a dealing or transaction which occurs over a period, part of which period occurs while the subsidiary member is part of the consolidated group and part while it is not. One example might be where a subsidiary enters into a contract to dispose of a CGT asset while it is a subsidiary member of a group, but settles the contract after it leaves the group. For CGT purposes the disposal is taken to occur at the time of the contract, but is it the head company of the consolidated group or the subsidiary which is taken to make the disposal? Even regarding the tax treatment of the consolidated group companies, there may be exceptions. Section 701-85 has the effect that the operation of the SER is subject to any other provision of the Income Tax Assessment Act 1997 and the Income Tax Assessment Act 1936 (and certain related Acts) that so require, either expressly or impliedly. Some of these issues are addressed in Ruling TR 2004/11.

Ruling TR 2004/11 [15.710] Consequences of the SER 7. For income tax purposes the SER deems subsidiary members to be parts of the head company rather than separate entities during the period that they are members of the consolidated group. 8. As a consequence, the SER has the effect that: (a)

the actions and transactions of a subsidiary member are treated as having been undertaken by the head company;

(b)

the assets a subsidiary member of the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group;

(c)

assets where the rights and obligations are between members of a consolidated group (intra-group assets) are not recognised for income tax purposes during the period they are held within the group whether or not the asset, as a matter of law, was created before or during the period of consolidation (see also paragraph 11 and paragraphs 2628); and

(d)

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dealings that are solely between members of the same consolidated group (intragroup dealings) will not result in ordinary or statutory income or a deduction to the group’s head company. [15.710]

9. An example of an intra-group dealing is the transfer of a capital gains tax (CGT) asset from one group member to another. This transfer is not treated for income tax purposes as a disposal or acquisition in the hands of the head company. Although the legal transfer of the CGT asset between the subsidiary members occurs at general law, it has no income tax consequences as the group’s head company is taken to be the owner of the asset both before and after the transfer. 10. Another example is the payment of a dividend from one member of a consolidated group to another group member. For income tax purposes this transaction is treated as a movement of funds between two parts of the same entity (the head company), rather than the payment of a dividend. The members of the group paying and receiving the dividend are not seen as separate entities for income tax purposes. 11. Transactions where intra-group assets are transferred to a non-group entity are recognised as a transfer by the head company. For example, the disposal of an intra-group CGT asset will ordinarily result in CGT event A1 (section 104-10 of the ITAA 1997) happening to the head company. The cost base of the asset in such a case will only be incidental costs incurred by the group to non-group members in relation to the transfer. However, in the case of the transfer of an intra-group debt, because the transfer is in

Special Topics in Company Tax

Ruling TR 2004/11 cont. substance equivalent to borrowing money or obtaining credit from another entity, no CGT event happens (see Taxation Determination TD 2004/33). 12. The SER ensures that the members of a consolidated group are treated as a single entity for the purpose of applying income tax laws to that group. The SER does not affect the application of those laws to an entity outside of the consolidated group. The income tax position of entities outside of the group will not be affected by the SER when they deal or transact with a member of a consolidated group … Application of the SER principle 26. With the single entity rule Parliament, has expressed its intended policy outcome in broad and simple language, in this case by equating a consolidated group with a single entity. A necessary feature of this drafting approach is the omission of statutory mechanisms for effecting the policy for each provision of the income tax law (although in some cases they are provided). In construing a rule drawn this way, like in all cases of statutory interpretation, the fundamental object is to ascertain the legislative intent by reference to the language of the instrument as a whole: Cooper Brookes (Wollongong) v. FCT (1981) 35 ALR 151 at 169-170 per Mason and Wilson JJ. See also the legislated approach to statutory interpretation in the Acts Interpretation Act 1901 (Cth). 27. Accordingly, relying on these established approaches to statutory interpretation, (and notwithstanding the operation of section 701-85 – itself an interpretive directive), interactions with other provisions in the Income Tax Assessment Acts need to be taken into account in applying the SER. For example, a mechanical application of the SER should not defeat the policy underpinning the SER by producing results in relation to transactions that would not occur for a single company that operates by division. 28. Rather, when considering transactions or dealings the correct use of the rule is to indicate when, and for what purposes, transactions or parts of transactions are to be regarded or disregarded in determining the income tax

CHAPTER 15

position of the head company of the consolidated group. For this reason, the way the rule applies will depend on the purpose for which a transaction is being considered and the perspective of the relevant taxpayer (also see paragraphs 36 to 39). Consequences of the SER 29. The Guide to the consolidation regime at section 700-1 expresses the intention of the law to treat a consolidated group as a single entity. It provides “[f]ollowing a choice to consolidate, subsidiary members are treated as part of the head company of the group rather than as separate income tax identities”. 30. To the extent the SER applies to the consolidated group to treat the group as a single entity, with the head company as that entity, any consequences flowing from this deeming are to be treated as the actual state of affairs of the head company. Marshall (Inspector of Taxes) v. Kerr [1993] STC 360 at 366, which was subsequently approved in the appeal decision in the House of Lords, supports this position (per Gibson, J): … I further bear in mind that because one must treat as real that which is only deemed to be so, one must treat as real the consequences and incidents inevitably flowing from or accompanying that deemed state of affairs, unless prohibited from doing so. 31. A consequence flowing from the SER is that while an entity is a subsidiary member of a consolidated group, actions and transactions of that member are treated as having been undertaken by the head company. In addition, the assets owned by subsidiary members of the group are taken to be owned by the head company (other than assets where the rights and obligations are between members of the group) [see the EM, paragraphs 2.12, 2.20 and 2.26]. 32. A further consequence of the SER is that intra-group dealings are not recognised for income tax purposes. This is clearly the intent of the legislation as indicated in the EM. For example, paragraph 2.18 states that intra-group transactions are not recognised: Transactions between members of a consolidated group will be ignored for income tax purposes. For example, payment of management fees between [15.710]

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Ruling TR 2004/11 cont. group members will not be deductible or assessable for income tax purposes. In addition, intra-group dividends will not be assessable or subject to the franking regime. 33. The EM at paragraph 2.12 also concludes that an intra-group transfer of an asset could not have income tax consequences as an entity cannot transact with itself. 34. This is also the basis for paragraph 2.9 of the EM which provides that “when an entity becomes a subsidiary member of a consolidated group the membership interests in the entity held by the group are ignored”. As a result, the intra-group rights and obligations that are derived from the holding of membership interests within a group are no longer recognised. Dealings solely within the consolidated group in respect of these rights and obligations cannot trigger income tax consequences in respect of the head company. 35. In summary, the SER ensures that the income tax laws will apply to a consolidated group on the basis that the group is a single entity with all of the actions and transactions undertaken by the subsidiary members of the group being imputed to the head company. This allows for the proper administration of the income

[15.715]

tax laws to the consolidated group. The SER, broadly speaking, allows for parity between the income tax position of a consolidated group, treated as a single entity, and of a company carrying on business in divisions. Intra-group assets transferred to a nongroup entity 36. The transfer of intra-group assets to nongroup entities will have income tax implications for the head company. The SER gives effect to the legislative intention that the consolidated group (being the head company) should be treated in a similar way to a single company for income tax purposes. An analogy used is that the income tax outcomes of transactions within the group should be similar to the outcomes for a single company that operates through divisions. However, the intra-group assets of a consolidated group represent rights between members of the group. Such rights could not exist between divisions of a divisional company. Accordingly, the income tax law has regard to intra-group assets on being transferred to a non-group entity. 37. The tax cost of an intra-group asset, whilst recognised as an asset of the head company on its transfer, will be limited to the costs incurred by the group to non-group entities in relation to the transfer.

Questions

15.12 Consider the application of the SER (as explained above) to the facts drawn from two well-known cases: (a) FCT v The Myer Emporium Ltd (1987) 163 CLR 199: Myer loaned $80 m to Myer Finance, its wholly-owned subsidiary, for seven years at a rate of interest of 12.5% pa, meaning total interest over the term of the loan would be $72 m. Three days later Myer assigned to Citicorp Canberra Pty Ltd the right to interest on the loan in exchange for a lump sum of $45.37 m. Should the income tax system continue to recognise this transaction as producing a taxable profit of $45.37 m to Myer Emporium, with Myer Finance to claim interest deductions of $72 m over the term of the loan? Or should the consolidation regime mean this is now treated as a financing transaction where the Myer group raises $45.37 m and pays back $72 m? How does the single entity rule apply? (See also Taxation Determinations TD 2004/33, TD 2004/83, TD 2004/84 and TD 2004/85.)

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Special Topics in Company Tax

(b)

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Federal Coke Co Pty Ltd v FCT 77 ATC 4255: Bellambi Coal Co Ltd had a wholly-owned subsidiary, Federal Coke, which was in the business of producing coke. Bellambi purchased coke from its subsidiary and on-sold it to customers, including under a supply contract with an overseas customer, Le Nickel. Le Nickel wished to reduce its purchase obligations under the supply contract. The contract reduction would reduce Bellambi’s sales profits and also require Federal Coke to close its business. Bellambi agreed to the contract reduction in exchange for a payment of compensation by Le Nickel. After receiving advice that the payment would be of a revenue nature if paid to Bellambi as compensation for variation of the supply contract, but a windfall gain of a capital nature if paid to Federal Coke as compensation for having to close down its business, it was decided to have it paid to Federal Coke. The Full Federal Court held that the payment must be assessed as received by Federal Coke, and not as if received by its parent, and so was of a capital nature. Should the income tax system continue to treat this as a capital payment? How does the single entity rule apply?

15.13 Prior to consolidation it was a fact that different taxable gains could emerge on the disposal of a business of a subsidiary according to whether the disposal was effected by selling the assets of the subsidiary or selling the shares in the subsidiary. Consider, for example, the following scenario: Hobart Bridge Co v FCT (1951) 82 CLR 372: Parent subscribed capital to its wholly-owned subsidiary H, intending that H be a long-term member of the group. H used the capital to purchase land to subdivide and sell at profit in a business of trading in land. A State government then commenced action to compulsorily acquire the land. Parent negotiated to instead sell the shares in H to the State government. The High Court held that, because the parent and subsidiary were legally separate entities, the sum received must be characterised as a capital sum received for the sale of shares in the subsidiary, which represented a capital asset of the parent, rather than as revenue sum received for disposal of the underlying land of the subsidiary which represented a revenue asset of the group. Should consolidation continue to recognise this as a sale of a capital asset (the shares) or a sale of trading stock (the underlying land)? How does Pt 3-90 treat this?

(d) Asset-Based Model of Consolidation [15.720] Australia’s consolidation model is unique globally, in being an “asset-based model”.

Essentially, the shares held by the head company in its subsidiary members cease to be recognised for income tax purposes, and instead, all the assets of the subsidiary members of the group should be taken to be held directly by the head company. Among the many questions which this model poses is whether the head company, having “acquired” all these assets, should simply inherit the tax cost which they had in the hands of the subsidiaries, or whether the head company should be taken to have “acquired” these assets at their actual economic cost to the head company. The Review of Business Taxation took the view that the latter approach should apply. That is, the head company should reset the tax cost of the subsidiary assets in its hands by reference to the effective cost to the head company of acquiring those assets. Thus, s 701-10 provides that, when an entity becomes a subsidiary member of a consolidated group, each asset of the subsidiary has its “tax cost” set at the asset’s “tax cost setting amount”, which by virtue of s 701-60 is determined pursuant to a formula in Div 705 [15.720]

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of the Act. The formula is designed to measure the actual economic cost to the parent of its acquisition of the subsidiary’s underlying assets. (i) Why Reset the Tax Cost of Assets? [15.730] Consider the following scenario: Parent Ltd carries on a business of land

development, and all the land it holds is treated as trading stock for income tax purposes. It acquires all the shares in Gentle Beach Pty Ltd for $100 from the Whitford family. Gentle Beach Pty Ltd was a private company formed by the Whitford family some years ago to purchase the family a private beach house at an original cost of $20. It has no liabilities and its sole asset is the private beach house, now worth $100. The Whitford family recognised a capital gain of $80 on the sale of the shares in Gentle Beach Pty Ltd for $100. Some time later, the value of the land has increased again, and Parent Ltd arranges for Gentle Beach Pty Ltd to sell the land to a Melbourne businessman for $120. Should the income tax system recognise a gain on the sale of the land of $100, or $20? An important objective of the consolidation regime is to prevent double taxation of the same economic gain: see s 700-10. Thus, to the extent the increase in value of the beach house from $20 to $100 was taxed when Parent Ltd acquired the shares in Gentle Beach Pty Ltd, that same gain should not be taxed again when the Parent Ltd group sells the land for $120 to the businessman. (ii) How is the Tax Cost of Assets Set? [15.740] The consolidation regime achieves the above objective by allowing Parent Ltd to

reset the tax cost of the land when it acquires Gentle Beach, pursuant to a formula in Div 705 which applies where a subsidiary member “joins” a consolidated group (Subdiv 705-A). In the simple scenario set out above, Parent Ltd would: • first, determine its “allocable cost amount” (ACA) for Gentle Beach Pty Ltd in accordance with the Table in s 705-60. On the simple facts here, only Item 1 of the table would be relevant, namely the cost base to Parent Ltd of the shares in Gentle Beach – this would equate here to the price paid for the shares, ie $100; • second, the ACA of $100 would be apportioned across the assets of the subsidiary in accordance with ss 705-25 and 705-35. Here, the land being the only asset, its tax cost would be set at $100. Thus, on the sale of the land by Gentle Beach for $120, the single entity rule would deem Parent Ltd to sell the land, and the tax cost setting rule would deem the land to have a cost of $100 to Parent, meaning the taxable gain would be $20. This would leave the question of whether that gain would be a revenue or capital gain. Does the entry history rule mean that the land of Gentle Beach, previously a private capital gains tax asset, would keep that character in the hands of Parent Ltd? Or would the land be taken to become part of the trading stock of Parent Ltd since all other land of Parent is actually held as trading stock? The provisions of Pt 3-90 are silent on this issue. [15.750] In the above scenario, the price paid for the shares in Gentle Beach Pty Ltd (ie $100)

could be seen to be equal to the price paid for the underlying land, as the target company had no other assets or liabilities. In real commercial transactions, the position will be more complex and so will be the operation of the tax cost setting formula in Div 705. A glimpse of these complexities may be obtained if we consider a scenario where the acquired subsidiary 852

[15.730]

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also has liabilities. Assume that Parent Ltd purchases all the shares in New Sub Pty Ltd for $215 m. Assume that Parent Ltd did not previously hold any shares in New Sub and that at the time of purchase the assets and liabilities of New Sub Pty Ltd are: Assets

Historical cost ($m) 50 50 50 50 0 200

Existing tax value ($m) 50 50 40 50 0 190

Market value ($m) 50 60 45 60 100 315

Cash Trading stock Depreciating plant Land Goodwill Total assets Liabilities Bank loan (100) (100) (100) Net assets 100 90 215 Tax attributes Tax losses: nil; Franking credits: nil On a consolidated basis, Parent has effectively paid $315 m for all the assets of New Sub, as Parent paid $215 m in cash and took on a bank loan liability of $100 m in acquiring New Sub. Thus, we would expect that the tax cost of the assets should be reset at their market values (totalling $315 m) under Div 705. The formula in Div 705 essentially operates in this way, treating the assets acquired for the sum paid for the shares plus the sum of liabilities assumed. • First, Parent Ltd would determine its ACA for New Sub Pty Ltd in accordance with the Table in s 705-60. On the facts, here: – Item 1 of the Table would be relevant, namely the cost base to Parent Ltd of the shares in New Sub – this would equate here to the price paid for the shares, ie $215 m, – Item 2 of the Table would also be relevant, namely the liabilities of New Sub at the time of acquisition – this would equate here to the bank loan of $100 m (Note that where liabilities are deductible, or denominated in foreign currency, additional complexities arise in measuring the true value of the liability.), – No other items would apply, so the total ACA would be $315 m. • Second, this allocable cost amount of $315 m would then be apportioned across the assets of the subsidiary in accordance with ss 705-25 and 705-35. On the facts here: – Under s 705-25, the assets include cash of $50 m, which (assuming it is in Australian currency) is a retained cost base asset – it gets a tax cost equal to its face value, ie $50 m, – Under s 705-35, the remaining assets are “reset cost base assets” and the balance of the ACA ($265 m) is allocated across these assets in proportion to their market value – which on the facts here gives the assets a tax cost reset at their market value in the column above. There are anti-avoidance rules which preclude trading stock, depreciating assets or revenue assets from having their tax cost reset above market value (s 705-40), but these will not apply here. [15.760] The formula for setting the tax cost of assets is, in practice, likely to be more

complex, because of the other tax attributes of a joining subsidiary company. For example, what if the subsidiary member brings tax losses into the consolidated group? [15.760]

853

Income Derived Through Intermediaries

Consider the following scenario: Parent Ltd acquires all the shares in Hopeless Pty Ltd for $300. At the time its sole asset is land worth $270 and it also has an unused capital loss of $100 which Parent Ltd expects it can use and so values at $30. Should the tax cost setting rules allocate the $300 paid for the shares in Hopeless Pty Ltd between the land and the tax loss? This allocation is achieved in effect by the way the formula in Div 705 works in this case. The assumed after-tax value of the tax loss ($100 multiplied by the company tax rate of 30% = $30) is deducted from Parent Ltd’s ACA for the company, under Item 6 of the Table in s 705-60. This means that Parent Ltd will have an ACA of $270 – ie $300 paid for the shares, less $30 for the loss – and this ACA amount of $270 will be allocated to the land. What if Parent Ltd does not think it will be able to use the loss, and instead pays $270 only for all the shares in Hopeless Pty Ltd, having valued the loss at $0? In this case, the formula in s 705-60 will still reduce the ACA by the assumed after-tax value of the loss ($30) – ie from $270 to $240. It should be noted, however, that Parent Ltd could elect, under s 707-145, to instead cancel the loss, and so avoid the ACA reduction. (iii) Formation of an existing group and combining groups [15.770] The above examples address the most basic case where a single subsidiary member

“joins” an existing or new consolidated group. If the head company has held its shares in a subsidiary for some time before consolidation, additional rules are needed: Subdiv 705-B. In this scenario the effective cost to the head company of acquiring the assets of the subsidiary cannot simply be determined by adding the parent’s cost base for the shares to the sum of any liabilities of the subsidiary. The formula needs to take into account previous transactions within the group, including the use of taxed and untaxed retained earnings by the subsidiary to finance the acquisition of the assets; the fact that the head company may have previously recouped some of the cost of the shares by dividend distributions; and the fact that the CGT cost base of the shares may have been inflated above historical cost (for example, by being restated to market value under Div 149 in the case of pre-CGT shares being deemed to become post-CGT shares). Special rules also apply where one consolidated group is acquiring another consolidated group (Subdiv 705-C); or one consolidated group is acquiring an unconsolidated group (Subdiv 705-D). Assume that “joining” subsidiary member A Pty Ltd itself has a subsidiary company, B Pty Ltd. In this case, the tax cost setting is done on a “top down” basis. The tax cost of the assets of A are set first, including its shares in B. Subsequently, that is used as the first element of the ACA in setting the tax cost of the assets in B for the consolidated group.

(e) Group Tax Liabilities and Franking Credits [15.780] Under the single entity model, the head company alone is required to file a single tax return and pay income tax on a single taxable income calculated on the basis that all the taxable income of the group is earned by it. An implication of this is that only the head company should be able to frank dividends in the imputation system. Division 709 provides that the head company is the only entity in the group which can have an operating franking account (s 709-55) and that for imputation purposes all franked distributions by the group will be taken to be distributions by the head company. On joining a group, franking credits in a member company’s franking account are transferred to the head company’s franking account (s 709-60). 854

[15.770]

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[15.790] Where only the head company files a tax return, an issue arises as to the practical

matter of collecting the income tax payable on the consolidated taxable income of the group. The SER appears to have the effect that the entire liability would rest with the head company alone. This may not be of complete comfort to the revenue. Consider the following scenario: Parent Ltd has two wholly-owned subsidiaries, Stay Co Pty Ltd and Leave Co Pty Ltd. Assume that Parent has no assets except the shares in subsidiaries. Assume the market value of Stay Co’s net assets is $10 m and the market value of Leave Co’s net assets is $10 m. Six months into the current year Parent sells all the shares in Leave Co Pty Ltd for $10 m to Rupert Murdoch Inc. At the time of the sale, the trading operations of Stay Co had accrued a taxable net profit of $200 and the trading operations of Leave Co had accrued a taxable net profit of $100 to that point of the year. Stay Co subsequently has a taxable net profit of $300 for the year, giving Parent Ltd a consolidated taxable income of $400. The managing director of Parent Ltd absconds to Cuba with all the group’s funds, leaving it insolvent and unable to pay its tax liability. Should Leave Co be liable for any of Parent Ltd’s tax? If so, should it be liable for all or part? The position taken in Div 721 is that, if a head company defaults on group tax liabilities, each of its subsidiary members shall be jointly and severally liable for the total income tax liability for any year in which they were part of the group for all or part of the year: see s 721-15. Hence, on the facts here, Leave Co would be jointly and severally liable for the full tax on the consolidated taxable income of $400 (and given the insolvency of the other parties would be left to bear the full amount). To add insult to injury, it would obtain no franking credits for paying the tax bill. The commercial implications of this situation are considerable. To ameliorate the consequences, Div 721 recognises an instrument termed a “tax sharing agreement” which, if correctly drafted and executed, can provide for subsidiary members of a group to limit their liability in respect of the consolidated group’s income tax to a “reasonable allocation” of the total group liability: see ss 721-25 and 721-30. To be effective, the tax sharing agreement must be in place before the tax is due.

(f) Losses in a consolidated group [15.800] Where a consolidated group exists, losses and profits arising within the group are

treated as if they occur for a single entity. This simple rule means that losses are fully “grouped” and no loss grouping rules are required. It is not so simple to determine how to treat pre-existing tax losses of a joining entity that are brought into a consolidated group. This difficulty was foreshadowed by the Asprey Committee report. Consider the following scenario: Parent Ltd has a wholly-owned subsidiary, Old Co Pty Ltd. Halfway through the tax year Parent purchases all the shares in New Co Pty Ltd. At the time of purchase New Co has a tax loss of $100 from the previous year, but is anticipated to make a profit of $50 for the current year. Old Co makes a final profit of $100 for the current year and New Co, continuing to conduct the same business as before, makes a final profit of $50 for the current year. Should the income tax system levy tax of $15 on the group on the basis that the group has a consolidated taxable income of $50, being $150 of income for the current year offset by a prior year loss of $100 – ie is it fair that $50 of New Co’s prior year loss be applied without restriction against Old Co’s income? What practices might emerge if New Co’s loss could be used against Old Co’s income without restriction? [15.800]

855

Income Derived Through Intermediaries

In this case, the single entity rule gives an inappropriate result if the $100 loss could be deducted against the income of $150, as it would promote trafficking in loss companies. The consolidation legislation responds to this by a highly complex set of rules in Div 707 of the ITAA 1997. It is beyond the scope of this chapter to consider their full application, but their operation on the scenario above can be briefly discussed. (i) Utilisation of losses in pre-consolidation tax return [15.810] First, New Co calculates a taxable income for the half year ending at the time it is

acquired by Parent Ltd: see s 701-30. If we assume it earns its net profit of $50 evenly over the year, this means $25 would be earned before it joins the group and $25 after it joins. New Co would calculate a taxable income for the period up to joining of $25, from which it could deduct $25 of its prior year loss, leaving an unused loss of $75. Consistent with this, the Parent Ltd group would be treated as having a consolidated taxable income (before losses) for the year of $125, being Old Co’s $100 for the year and New Co’s $25 for the period post-acquisition. (ii) Rules restricting transfer of losses to head company of consolidated group [15.820] The next question is how much, if any, of New Co’s unused loss of $75 should be

taken to become a loss of the Parent Ltd group. Division 707 essentially deems that the loss will be transferred to the head company only if the loss would be eligible for use by the subsidiary under either the continuity of ownership test (taking into account any changes of ownership on joining the group) or the same business test, and Parent Ltd does not elect to cancel it under s 707-145: see Subdiv 707-A. It may be noted that if the means by which New Co has come into the group involved Parent Ltd acquiring 50% or more of the shares in New Co, the continuity of ownership test will ordinary be failed, and reliance will have to be placed on the same business test. The ATO explains its view as to how the same business test applies to consolidated groups in Tax Ruling TR 2007/2. (iii) Rules restricting usage of transferred losses by head company [15.830] Assuming the loss satisfies one of the tests, and is transferred to Parent Ltd, the next

question is how much of the unused loss can be used against the consolidated income of Parent Ltd group. This is covered in Subdiv 707-C. As explained in s 707-305, the policy decision was taken that, in principle, the loss of New Co should only be able to be applied against that proportion of the consolidated income which is attributable to New Co. In this case, that should mean that $25 of the unused loss of $75 could be applied against the $25 profit earned by New Co – leaving a consolidated taxable income of $100. However, the actual course of the legislation is much more complex. It actually provides that Parent Ltd can only use the loss against a fraction (called the “available fraction”) of the consolidated income. The fraction is, conceptually, intended to be the market value of New Co as a proportion of the total market value of the group at the time of acquisition, this fraction being seen as a reasonable proxy for the proportion of total group income New Co will be expected to contribute – ie it is assumed income is contributed in proportion to market value. Further, where a loss company joins a group part way through a year, the application of its loss against group income is proportionately reduced: see s 707-335. 856

[15.810]

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So, if we were to assume that Parent had no assets except the shares in Old Co and New Co, and that the market value of Old Co’s net assets was $10 m and the market value of New Co’s net assets was $10 m at acquisition, the available fraction for the New Co losses would be 0.50. This would prima facie allow the unused loss of $75 to be applied against 0.50 of the group’s consolidated income of $125. However, as New Co joined the group halfway through the year, this usage would be reduced by half. So, the end result would be that the unused loss could only be deducted against income of one-quarter of $125 (ie $31.25), giving a consolidated taxable income of $93.75. (iv) No duplication of losses in a consolidated group [15.840] An important purpose of the “asset-based” model adopted for the consolidation

regime is to “prevent a double tax benefit being obtained from an economic loss realised by a consolidated group”: s 700-10. To understand this objective, consider the following scenario: Parent Ltd subscribes $100 of share capital to a new wholly-owned subsidiary, F Pty Ltd, which uses the $100 to purchase a business with a market value of $100. The business subsequently declines in value to $50. F sells the business for $50, realising a capital loss of $50. Subsequently, the Parent liquidates F, receiving the $50 cash as the proceeds of final disposal of its shares in F, which cost $100, realising a capital loss of $50 on the shares. If the income tax system treats Parent and F as separate taxpayers, there will be recognition for tax purposes of two capital losses arising from the one economic loss. Is this appropriate? The single entity rule prevents the double loss being recognised, because the liquidation of F will be disregarded for income tax purposes. Since F is taken to be part of Parent, Parent is not recognised as holding shares in F and likewise not recognised as incurring a loss on the shares on liquidation. So also, for example, if Parent Ltd has two wholly-owned subsidiaries D Pty Ltd and E Pty Ltd, and E has a CGT asset which cost $100 to acquire and now has a market value of $50, no loss is recognised if E transfers the asset to Parent for $50.

(g) Exit of a Subsidiary from a Consolidated Group [15.850] Where a head company of a consolidated group sells a subsidiary company to a

person outside the group, the subsidiary will “exit” the consolidated group. The SER is not of itself sufficient to produce the correct recognition of economic losses and gains in this situation. Part 3-90 treats the exit of the subsidiary as a sale of shares and not of the underlying assets, and rules are necessary to work out the cost base of those shares to the head company. (i) Set cost base of shares in line with underlying assets [15.860] Consider the following scenario: Parent Ltd subscribes $100 share capital to Plant

Sub Pty Ltd. Plant Sub Pty Ltd uses the $100 to purchase an item of plant which is a depreciating asset under Div 40. The plant is depreciated for tax purposes at 10% per annum. After five years, the adjustable value of the plant is $50 and its market value is $60. Parent Ltd sells all the shares in Plant Sub to Acme Ltd for $60. What should Parent Ltd recognise for income tax purposes under consolidation in relation to this sale? Has it made a loss of $40? Has it made a gain of $10? An important objective of the “asset-based model” of consolidation is that the gain or loss recognised on the sale of shares in a subsidiary member of a consolidated group should align [15.860]

857

Income Derived Through Intermediaries

with the gain or loss which would be made if the underlying assets and liabilities were sold. Thus, the correct outcome under consolidation should be that Parent Ltd recognises a gain of $10, as this is the gain it would recognise if it sold the plant for $60 when its adjustable value was $50 under Div 40. Consolidation achieves this result pursuant to s 701-15, which provides that when a subsidiary member ceases to be a wholly-owned subsidiary of the head company, the tax cost of the head company’s shares in the subsidiary is reset just before the time it leaves the group. The tax cost resetting for the shares is, by virtue of s 701-60, effected pursuant to a formula in Div 711 which aligns the tax cost of the shares to the tax cost of the underlying assets. Thus, in the case of the scenario above where Parent Ltd sold Plant Sub Pty Ltd for $60 at a time when its sole asset was plant with an adjustable value of $50, Div 711 would operate to deem the tax cost of the shares in Plant Sub to be $50 for Parent Ltd, resulting in a gain of $10 on the sale of the shares. However, the consolidation regime does not go so far as to deem the sale of the shares to be taxable as if it were a sale of the underlying assets. It is still treated as a sale of shares and, assuming the shares are otherwise regarded as capital assets, the gain would be a capital gain. In the scenario just discussed, the alignment of the reset tax cost of the shares to the tax cost of the underlying assets was straightforward, as the subsidiary company had no other assets or liabilities. In real commercial transactions, the position will be more complex and so will be the operation of the exit tax cost setting formula in Div 711. Consider the following scenario where the subsidiary has liabilities: Parent Ltd subscribes $100 m for new shares in Sub Pty Ltd. Sub borrows $100 m from Which Bank. Sub uses the $200 m to purchase assets, including depreciating assets, with a cost of $200 m to commence a new business. Parent subsequently sells all the shares in Sub to a third party for $110 m. At this time the assets and liabilities of Sub are: Asset Cash Trading stock Depreciating plant Land Goodwill Total assets Liability (bank loan) Net assets

Historical cost ($m) 50 20 50 50 0 170 (70) 100

Existing tax value ($m) 50 20 40 50 0 160 (70) 90

Market value ($m) 50 20 50 50 10 180 (70) 110

Absent consolidation, there would be a capital gain of $10 m on the sale of the shares in Sub (Parent having acquired them for $100 m and sold them for $110 m). However, on a consolidated basis, a gain of $20 m should be recognised, as Parent has effectively been paid market value of $180 m for assets which had a tax cost of $160 m, given that Parent has been paid $110 m in cash and relieved of a bank loan liability of $70 m in disposing of Sub. Division 711 will achieve this result by giving the shares a tax cost of $90 m. Under s 711-15, it will: • First, determine the allocable cost amount for the shares in Sub Pty Ltd pursuant to the Table in s 711-20. In this case, the figure is $90 m derived from: 858

[15.860]

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– Item 1 of the table, being the total of the “terminating values” of the assets – which equates to their existing tax values of $160 m: see s 711-30). (Note that there is no tax value for the “internally generated goodwill” which has increased in value from nil to $10 m.) – Item 4 of the table, which requires that the sum of Sub’s liabilities be deducted – being the liability of $70 m, giving a net result of $90 m, • Second, this ACA amount of $90 m is allocated to the shares in Sub, giving them a tax cost of $90 m immediately before they are sold for $110 m. (ii) Exit history rule [15.870] It will be observed from the example above that one effect of consolidation is that

the cost base of equity in subsidiaries effectively depreciates in line with the depreciation of underlying depreciable assets. Here the original cost of the shares was $100 m, and is reset at $90 m, which equates to the depreciation of the plant from $50 m to $40 m. In addition, Sub, having ceased to be a member of the Parent Ltd consolidated group, will regain its separate tax entity status. At this point, s 701-40 has an “exit history rule” which gives the leaving subsidiary a new tax history for the assets, liabilities and business it takes with it, by deeming that: Everything that happened in relation to any eligible asset etc. while it was that of the head company, including because of any application of section 701-5 (the entry history rule) is taken to have happened in relation to it as if it had been an eligible asset etc of the entity.

One aspect of the exit history rule is that the tax cost of the assets in the hands of Parent Ltd will become their tax cost for Sub (unless it is acquired by another consolidated group, which will then reset their tax cost under Div 705). There are, however, limits on the exit history rule. One important limit is that the leaving subsidiary cannot take away any tax losses or franking credits – these remain with the old group: see Subdiv 707-D and Div 709.

[15.870]

859

INCOME DERIVED FROM INTERNATIONAL TRANSACTIONS 17. Taxation of Residents .................................................................... .. 909 18. Taxation of Non-Residents .............................................................. 921 [Pt6.10] In this Part we look at the international dimension of income taxation. Australia, like most countries, taxes income on a residence and source basis, with residents taxed on their worldwide income and non-residents taxed on their income sourced in Australia. Australia provides relief from the double taxation that inevitably arises on foreign income of its residents under such a system in various ways.

PART6

16. Principles for Taxing International Transactions ........................ 863

As a source country, Australia collects taxes from non-residents usually on a flat rate basis, sometimes by assessment and sometimes by withholding at source. Non-residents are subject to a number of special rules that do not apply to residents in order to prevent avoidance of Australian tax by foreigners. Australia is an active participant in the network of bilateral tax treaties that seek to reconcile conflicting tax claims of different countries and allow administrative cooperation. Its domestic rules on international taxation are to a large extent framed to fit with tax treaties. Underlying this system are a number of basic concepts such as residence and source, tax treaty obligations, transfer pricing and administrative cooperation which are relevant to residents and non-residents alike. We explore these common issues in Chapter 16 as well as introducing the overall policy and structure of the system. In Chapter 17 we look at the specific rules for the taxation of residents and in Chapter 18 the rules for non-residents.

861

CHAPTER 16 Principles for Taxing International Transactions [16.10]

1. POLICY AND STRUCTURE OF INTERNATIONAL TAXATION.......... .............. 864

[16.20]

(a) International Tax Policy and How it Affects Domestic Tax Rules ............................ 864

[16.20] [16.40] [16.50] [16.60]

(i) Individuals ............................................................................................................ (ii) Intermediaries (Companies and Trusts) ................................................................ (iii) International Tax Administration ......................................................................... (iv) Tax Havens and Disappearing Income .................................................................

866 868 869

[16.70] [16.80] [16.90] [16.100]

(b) Tax Treaties ......................................................................................................... (i) Enactment as Domestic Law ................................................................................. (ii) Structure of Tax Treaties ....................................................................................... (iii) Interpretation of Tax Treaties ...............................................................................

869 869 870 871

864

[16.120] 2. RESIDENCE............................................ ...................................................... 872 [16.120] [16.130] [16.140] [16.160] [16.180] [16.190] [16.210] [16.220]

(a) Domestic Law ...................................................................................................... (i) Individuals ............................................................................................................ Ruling TR 98/17 ........................................................................................................ FCT v Applegate ......................................................................................................... (ii) Companies .......................................................................................................... Malayan Shipping Co Ltd v FCT .................................................................................. Ruling TR 2004/15 .................................................................................................... (iii) Other Intermediaries ...........................................................................................

872 872 872 876 878 878 879 883

[16.230]

(b) Tax Treaties ......................................................................................................... 883

[16.240] 3. SOURCE.............................................. ........................................................ 884 [16.250] [16.270]

Thorpe Nominees Pty Ltd v FCT ................................................................................... 886 Spotless Services Ltd v FCT .......................................................................................... 887

[16.280] 4. TRANSFER PRICING...................................... ............................................... 888 [16.290]

(a) Domestic Law ...................................................................................................... 888

[16.300]

(b) Tax Treaties and Transfer Pricing Guidelines ......................................................... 889

[16.330] 5. INTERNATIONAL TAX COMPETITION AND COOPERATION ......... ............. 891 [16.340] [16.340] [16.350] [16.360] [16.380] [16.390]

(a) Base Erosion and Profit Shifting ............................................................................ 892 (i) Is Tax Competition Bad? ....................................................................................... 892 Australia’s Future Tax System, Report to the Treasurer, Pt 2 vol 1 pp 156-158 ................ 893 (ii) The BEPS Action Plan ........................................................................................... 894 (iii) Implementation of BEPS Project .......................................................................... 898 OECD/G20 Base Erosion and Profit Shifting Project, Explanatory Statement, pp 6, 8-9 ................................................................................................................... 899

[16.410] [16.420] [16.440]

(b) Transparency and Administrative Cooperation ..................................................... 902 (i) Exchange of Information and Transparency .......................................................... 902 (ii) Assistance in Collection ........................................................................................ 906 863

Income Derived From International Transactions

[16.450] [16.460]

(iii) Dispute Resolution .............................................................................................. 906 (iv) Other International Tax Cooperation ................................................................... 907

Principal Sections International Tax Agreements Act 1953 This Act gives effect to Australia’s bilateral tax treaties Provision Effect s4 This section provides for the Agreements Act to be read with ITAA 1936 and ITAA 1997 and provides that in the event of conflict, the Agreements Act prevails (with the exception of Pt IVA). s5 This section gives effect to Australia’s current tax treaties including its two most important with the UK and the US. Other relevant provisions Effect ITAA 1936 s 6(1) This section contains the definition of “residence” for individuals and companies. UK treaty article 4 This article deals with residence for treaty purposes including dual residents. ITAA 1997 ss 6-5, 6-10 These sections provide that residents of Australia are taxed on their worldwide income and that non-residents are taxed on their Australian-source income. Australia–Vietnam tax treaty article 22 This article is typical of Australia’s treaty sourcing rules. ITAA 1997 Div 815, UK treaty articles 7, 9 These provisions cover transfer pricing in international transactions. UK treaty articles 26, 27 These articles deal with international tax administrative cooperation and dispute resolution.

1. POLICY AND STRUCTURE OF INTERNATIONAL TAXATION [16.10] This section begins with a description of the basic policy and principles of

international taxation, and how (in brief) they are reflected in tax rules in practice. We then provide a brief discussion of the major international instruments used to deal with many international tax issues – bilateral tax treaties.

(a) International Tax Policy and How it Affects Domestic Tax Rules (i) Individuals [16.20] In the international context, the comprehensive income tax base reflected in the

extract from Simons in Chapter 1 implies that the total worldwide income of the individual should be taxed under the progressive rate scale applicable to individuals. In a world of many countries, it is necessary to choose a country which carries out this role. [16.30] The country with which the individual has the closest social and economic ties is the

appropriate country from a policy perspective because it is that country which can best achieve 864

[16.10]

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the equity objectives of the income tax system in relation to the individual (such as the appropriate tax rates for the individual’s income and taking account of the personal circumstances of the individual – like health and family relationships). This country is generally referred to as the residence country of the individual. While generally the residence of most individuals is clear, determination of residence can be problematic in both a policy and practical sense with expatriates; that is, people who are seconded to work in another country for a limited but reasonably long period of time (say two to four years) and who will return to their country of origin after the secondment. Which country should be regarded as the one with which they have the closest social and economic connections? Under most countries’ domestic tax law they will become residents of the country of secondment. They may qualify, for example, for free health care in that country which may suggest that they should be taxed there on a residence basis. On the other hand, they will usually retain very close links with their country of origin, such as being a member of a pension or superannuation plan there, which is taxed on a beneficial basis – and this may suggest for such longer-term issues they should be regarded as residents of the country of origin. For these kinds of reasons a number of countries, including Australia, now try to soften the hard line between the tax treatment of resident and non-resident individuals with special tax regimes for temporary residents. The comprehensive income tax base does not, however, dictate that all the tax on the individual’s income should be collected by the country of residence. The country where the income is generated (with which the income has the closest economic connection, commonly called the country of source) has a claim to tax on the basis that it has provided the infrastructure and the economic resources for generating the income (often referred to as the benefit theory of taxation). As the claim is not based on the other income or circumstances of the individual, a flat rate of source taxation is generally appropriate, as the use of infrastructure and economic resources can be reasonably assumed to be proportional to the amount of income. One of the important issues for international taxation is to effect a division of revenue between two countries where income sourced in one country is derived by a resident of the other country. This division has equity consequences as between nations. If investment and income flows are in balance between two countries, it is possible to achieve a fair division of tax revenue by giving greater emphasis to exclusive residence country taxation. If the flows are not in balance, it is necessary to agree to a balance between residence and source taxation to achieve a division of revenue that is acceptable (and fair) to both countries. While the comprehensive income tax base does not dictate which country should levy tax, it does imply that generally there will only be a total levy of tax on the income as calculated under the progressive rate scale of the residence country. If two countries are levying tax on the same income, one as the country of residence and the other as the country of source, it is necessary to provide an adjustment mechanism so that the combined levy does not exceed the appropriate tax rate for the individual as set by the residence country. One mechanism for achieving this goal is exclusive residence taxation. As just noted, however, this will not achieve fairness between countries where flows of income are not in balance. There is no international consensus for such a system. Another method is to reduce taxation at source so that it does not exceed the residence tax, and then for the residence country to relieve double taxation by collecting at a maximum the difference between the source tax levy and the residence tax rate. Tax treaties, reflecting the current international consensus, generally adopt this approach by limiting source taxing rights in various ways and ensuring that relief from double taxation is [16.30]

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provided by the residence country. One way of achieving such relief is by way of foreign tax credit for source country tax against residence country tax, up to the amount of residence tax on the income (since 2008 this mechanism is called a foreign income tax offset in Australia). It is often simpler from a compliance viewpoint to simply exempt the foreign-source income from residence tax in cases where it is likely that the source country tax is about equal to the residence country tax. This method is known as the exemption system; as noted in Chapter 17, other justifications for this method are also advanced which do not depend on the source tax being similar in amount to the residence tax. If a country is operating a progressive income tax scale for individuals, it is usually considered necessary to take the exempted foreign income into account in determining the amount of tax levied on other income (exemption with progression). Relief of double taxation is dealt with in Chapter 17. (ii) Intermediaries (Companies and Trusts) [16.40] The discussion above reflects the common starting point in tax policy of looking at

individuals, as at the end of the day all taxes end up being paid directly or indirectly by individuals. Most income flowing across borders in fact is derived through intermediaries. Hence, we are usually faced in international taxation with two issues: the taxation of income derived through intermediaries (see Part V above); and of income derived across borders. One option for income taxation is to ignore intermediaries and simply tax individuals on income which is derived by intermediaries in which they have some ownership interest. Even in the domestic context, as we have seen, this is not regarded as a practical option, largely for simplicity reasons. In the international context, separate taxation of intermediary income ensures that source country tax is conveniently collected where interests in that intermediary are held by residents of another country. As a result, intermediaries are subject in most countries to the same international construct as individuals; that is, taxed on worldwide income by the country of residence and taxed on a source basis if income is earned in other countries. It thus becomes necessary to determine the residence of intermediaries. The objective of taxing income derived through intermediaries similarly to income derived by individuals suggests that the residence of an intermediary should be determined by the residence of its individual owners. This is not a practical solution, as it requires tracing of ownership through tiers of intermediaries in many cases. In any event, if it turns out that the owners themselves are resident in different countries, tracing will not provide a single residence country for the intermediary. Even a majority ownership rule is becoming increasingly difficult to apply in a globalising world where the ownership of listed companies is becoming more widely dispersed across residents of different countries. Most countries therefore adopt residence rules for intermediaries based on the place where the intermediary is created, or where the intermediary is primarily managed: see Section 2 below. Both of these tests are subject to manipulation and hence it is possible for a resident taxpayer to set up an intermediary which is not classified as a resident of the same country and to derive foreign income through that intermediary which is not distributed to the owner (in the case of a company) or made the subject of a present entitlement (in the case of a trust). As the income is foreign-source income of a non-resident, it is not subject to tax in the residence country of the owner under normal international tax rules. To overcome this problem of residence rules for intermediaries, many countries have established controlled foreign company (CFC) regimes (and equivalents for trusts) to tax certain income of this type to the 866

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resident controllers of the foreign intermediary as it is earned by the intermediary. Because these rules are more targeted, it is possible to look through intermediaries to the ultimate owners, but even with this limited objective, the complexity of the laws and the compliance costs they generate are considerable. Similar problems do not arise for partnerships, to the extent they are taxed on a completely transparent basis: see Chapter 13. Source taxation is also becoming increasingly difficult to levy as a result of globalisation. As noted above, the basic concept of source is the country with which the income has the closest economic connection. Source rules are analysed in detail in Section 3 below and Chapter 18. In the case of active income such as from employment or a business, this concept has been applied by sourcing income at the place where the activity that produces it occurs (which is taken to be the place where the value added occurs). In the case of passive income, there is minimal activity of the taxpayer in earning the income. Accordingly, such income is generally sourced by the place where the asset producing the income is located in the case of tangible assets like land, or by the place where the activity of the person paying the income occurs in the case of intangible assets, for example, in the case of interest on a loan to a business where the business activity of the borrower occurs. The source rule for passive income has been under pressure for some time for a number of reasons. First, it is often dependent on the residence of the payer, and in the case of an intermediary as already noted, residence is to a degree a matter of choice. Further, in a world where capital and investment markets are increasingly globalised it is possible by simple portfolio choice to change the source of income; for example, withdrawing money from the local bank and depositing it in a foreign bank. The combined possibilities of choice of residence of an intermediary and choice of source of passive income create further problems for residence country taxation. Even where a resident taxpayer does not control a foreign intermediary, portfolio choice to invest in a non-resident intermediary deriving foreign-source income which is not distributed to the resident may defer residence taxation potentially forever. A specialised offshore fund market has developed to make this choice available to investors. A number of countries have responded with targeted rules that tax such income on an accrual basis to resident investors in foreign funds. We consider the CFC, transferor trust and foreign fund regimes in Chapter 17. The pressure on source rules is coming to be felt also in the active income area. The growth of multinational corporations means that a substantial part of cross-border trade occurs within multinational groups. It is thus possible by changing the pricing or form of transactions which are generally a matter of indifference within the group to move income from one country to another. Longstanding domestic transfer pricing rules and their equivalents in tax treaties are intended to deal with this type of activity, and could be efficacious in a simpler world where most cross-border trade was in raw materials and mass-produced finished products, and the financing of investment occurred in relatively simple forms. With the growth of services in international trade – especially knowledge-based industries, electronic commerce and financial innovation – it has become much more difficult to identify where value is added, how that value can be priced and how costs of financing are to be treated for tax purposes. These problems are also requiring increased cooperation between national tax administrations not only on the information front, but also in respect of audit and dispute resolution. Indeed the underlying idea that real investment was relatively fixed in location so that a place of activity test provided a robust source rule is now of doubtful validity. Product development, manufacture and marketing are often conducted on a global basis. Routine [16.40]

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Income Derived From International Transactions

component manufacturing and assembly operations are often contracted out and can be located almost anywhere. The knowledge-based part of the process which is usually the most value adding – such as research and development, management systems, know-how, advertising and sales campaigns – can be done by individuals located anywhere in the world at the choice of the multinational. Finally, as a result of electronic commerce, even sales and marketing do not require local outlets and can be done from anywhere. The system of taxation of intermediaries adopted by a country also can add to the pressure on international tax arrangements from both a source and residence country point of view. The Australian imputation system is domestically focused and generally operates if a resident shareholder receives a dividend from a resident company which has borne Australian company tax. The result internationally is that imputation is not operative, so that the company is taxed on its income in the country of source, and then shareholders are taxed on dividends or capital gains on their shares in their country of residence without reference to the company tax paid to another country (ie double taxation of dividends). Australian residents increasingly invest in foreign companies which may have foreign or domestic source income. Australian companies increasingly have foreign source income and foreign residents investing in them. The distortions arising from the domestic focus of the imputation system and the globalisation of business have become the cause of much debate and led to suggestions that the imputation system should be replaced. (iii) International Tax Administration [16.50] International taxation also puts considerable pressure on tax administration. Active

income is generally taxed at source on a net basis by assessment (that is, after allowing for costs of earning income) because the activity by the non-resident taxpayer to produce the income generally means that there is a sufficient presence in the source country to rely on filing and assessment of a tax return. The rate of tax for companies generally applies to such income. This rate is usually a flat rate, so that for active income the progressive tax rate scale of individuals does not apply – which is consistent with a benefit approach to source taxation. Passive income is taxed by withholding by the payer at source on a gross basis (that is, without allowing deductions). Generally there is no sufficient presence of the person deriving the income in the source jurisdiction to enforce payment after the income has left the country, and correspondingly there is no means of enforcing lodgment of returns or verifying deductions through a tax return process. The rates of tax on such income are generally flat rate and low, reflecting two related factors: first, an implicit allowance for some expenses, and secondly, a policy preference for very limited source taxation (apart from income from land) partly on the basis that the benefit obtained by the person deriving the income from the source jurisdiction is less than in the case of active income. At the enforcement level in the source and residence countries, there are significant problems for national tax administrations in obtaining information when dealing with foreign taxpayers or foreign-source income, particularly when derived through non-resident intermediaries. The general rule of private international law that one country will not enforce the revenue laws of another country places considerable barriers in the way of collecting taxes in international transactions. International cooperation is required if tax administration across borders is to be effective. Administrative issues are dealt with in Section 5 of this chapter and Chapter 18. 868

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(iv) Tax Havens and Disappearing Income [16.60] Countries can deliberately contribute to distortions in the international tax system.

For many years there has been a group of countries commonly called tax havens which were prepared more generally to give up taxing rights in order to attract portfolio capital from residents of other countries, and in some cases changes of residence by individuals from those countries. The traditional tax haven had little business activity other than a financial sector, levied low or zero rates of tax on income, and had strict bank secrecy laws to conceal the ownership of income and no exchange controls to facilitate inflows and outflows of capital. These conditions create an environment for tax avoidance and evasion of the residence- and source-based tax of other countries, creating both tax policy and tax administration difficulties. Typically, such tax havens operated outside the international tax consensus and had few or no tax treaties. Until relatively recently, tax havens were a minor irritant, as they did not have any marked effect on flows of direct real investment (being very small economies themselves); exchange controls generally prevented their use by portfolio investors and tax-motivated residence changes were confined to the very wealthy. The dismantling of exchange controls has led to a rapid increase in cross-border portfolio investment and the use of tax havens by portfolio investors. More recently a number of medium-sized countries, including Australia in its offshore banking unit regime, have seen advantages in establishing themselves in niches particularly for financial activities with a number of features of tax havens (though usually without the more obnoxious elements which encourage tax evasion). It is not necessary, however, to use a tax haven to make income disappear. Because of differences in countries’ tax rules a variety of strategies are available to produce double non-taxation, for example, one country may treat a payment as tax deductible interest while another country treats the same payment as a tax exempt dividend with the result that such a payment from the first country to the second country is subject to little or no taxation. The policy and administrative challenges posed by tax havens and tax planning which causes income to disappear are considered later in this chapter: see Section 5 below.

(b) Tax Treaties [16.70] In the rest of the income tax as expounded in this book, we have been looking only at

domestic law. One of the characteristics of international taxation is that domestic law is overlaid by bilateral tax treaties entered into by Australia with other countries around the world. Treaties are agreements between states governed by international law which increasingly deal with global legal issues. Treaties about income tax are described in various terms such as double tax agreements (DTAs) or double tax conventions (DTCs). The reference to “double tax” indicates that one of their important objectives is to avoid international double taxation. In this book we refer to them simply as tax treaties, as they have other important objectives, and the reference to “treaties” indicates their international law status more accurately. (i) Enactment as Domestic Law [16.80] These treaties, like other international treaties, are subject to the Vienna Convention

on the Law of Treaties [1974] ATS 2 to which Australia is a signatory. In international law, treaties operate as agreements between states and do not generally confer rights on third parties such as individual taxpayers. As tax treaties are intended to confer enforceable rights [16.80]

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on taxpayers as well as on states, they are enacted as part of domestic law by the International Tax Agreements Act 1953 (yet another ITAA but we shall refer to it as the Agreements Act). This Act contains provisions giving effect to tax treaties in domestic law. Until 2011, current treaties appeared as Schedules to the Act, except one with Chinese Taipei which is not strictly a treaty but have been removed from the Agreements Act and now have to be sourced elsewhere such as on the Australian Treasury Tax Treaties website or the Australian Treaty Series (ATS). We will focus on the 2003 Australia–UK treaty [2003] ATS 22 and the Australia–US treaty [1983] ATS 16 of 1982 as amended by the 2001 Protocol [2003] ATS 14. As well as being two of Australia’s most important tax treaties, the 2001 US Protocol and 2003 UK treaty represented a major shift in Australia’s treaty policy (which has further evolved since then). The implementation of tax treaties enacts in its most recent form that a provision of the treaties “has the force of law according to its tenor”. Section 4 of the Agreements Act provides that the ITAA 1936 and ITAA 1997 are to be read as one with the Agreements Act but, with the exception of the anti-avoidance rules in Pt IVA of the ITAA 1936, the Agreements Act has effect notwithstanding anything inconsistent with its provisions in the ITAAs. In other words, it prevails over the ITAAs. It does not, however, generally rewrite the rules in the ITAAs. Tax is assessed under the ITAAs, and the Agreements Act in the usual case simply limits tax that may otherwise be payable under domestic law: see GE Capital Finance v FCT (2007) 159 FCR 473; 66 ATR 447. There is one important exception in relation to the source of income noted later in this chapter. Further, in some places the ITAAs expressly adopt definitions out of treaties for the application of specific provisions, such as the definition of permanent establishment in s 23AH(15) of the ITAA 1936. (ii) Structure of Tax Treaties [16.90] Bilateral tax treaties have a great degree of similarity with each other. This arises

because they are based on a common model, the OECD Model Tax Convention on Income and on Capital which is regularly updated, including many hundreds of pages of official Commentaries. The last update was 2014 and the next is expected in 2017. The OECD did not invent the Model but rather inherited it from the League of Nations, which began work on the topic in 1920 and produced the first models in the late 1920s. Nor does the OECD have a monopoly on model tax treaties. The UN maintains its own Model Double Taxation Convention between Developed and Developing Countries last updated 2011, and various countries publish their own models, eg US but not Australia. These models are not legally binding – only tax treaties actually signed between countries are – but they are the means by which broad international consensus on tax treaties is achieved as spelt out in the discussion in (a) above. To recapitulate, income is taxed on a source and residence basis. The source country has more or less unlimited prior rights of taxation of income from real estate and active income – provided an appropriate threshold is passed – but limited prior rights of taxation over passive income. The residence country gives double tax relief for source country tax by way of a foreign tax credit or foreign income exemption. Because tax treaties govern much of international taxation, it is common for countries’ domestic law tax rules outside treaties dealing with international taxation to largely follow the pattern established by the models. Australia is no exception. The structure of tax treaties follows a typical pattern which also indicates their broader objectives (the numbering is based on the OECD Model which most actual tax treaties follow closely): 870

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• scope and definitions in articles 1 – 5, including limiting their operation to income and capital taxes of residents of the two countries and reconciling their residence definitions; • distributive rules which allocate taxing rights between the two countries on the basis of categories of income in articles 6 – 21 and implicitly provide for division of revenue between the countries and common source rules; • relief of double taxation in article 23; • prevention of tax discrimination against foreigners in article 24; • administrative cooperation including dispute resolution, exchange of information and assistance in collection in articles 25 – 27. It is important to understand the basic difference between the OECD and UN models. Tax treaties generally operate on a reciprocal basis, ie their rules apply equally to both parties. Hence when trade and investment flows between countries are in balance, there is no problem in giving up source taxing rights, as the effect is to increase residence taxing rights of both countries with little effect on their overall tax revenue. The OECD Model is premised on such a balance and hence has comparatively greater emphasis on residence taxation, which is generally easier to enforce than source taxation. If trade and investment flows are not in balance, then the country which is the net capital importer will wish to emphasise source taxation if it wishes to maximise its revenues. Hence the UN Model has a greater emphasis on source taxing rights to protect the revenue position of developing countries. In the past, Australia was a significant net capital importer and hence in many ways its treaty position was closer to the UN Model. In the last 20 years, Australia has become a significant capital exporter so that the imbalance is much less. From 2000, Australia has been moving its treaty policy closer to the OECD Model as reflected in the 2003 UK treaty. This issue is explored in more detail in Chapter 18. (iii) Interpretation of Tax Treaties [16.100] The dual operation of tax treaties as international and domestic law has raised

questions as to the approach to interpretation – do we apply interpretation rules from international law (Vienna Convention [1974] ATS 2 articles 31 – 33) or domestic law (ss 15AA and 15AB of the Acts Interpretation Act 1901)? In Thiel v FCT (1990) 171 CLR 338; 21 ATR 531, it was established that international interpretation rules apply and that the OECD Commentaries may be relied upon in interpreting Australia’s treaties; in FCT v Lamesa Holdings BV (1997) 36 ATR 589 that foreign court decisions (not just from common law countries) could be similarly relied on; and in Unisys Corporation v FCT (2002) 51 ATR 386 that domestic law provisions derived from the OECD Model also would be treated in this way. In the years since these decisions Australian courts have expressed varying views over whether international law interpretation rules are applied to tax treaties and the significance of the OECD Commentaries but the approach in the cases referred to is still the predominant position. Tax treaties have an important internal interpretation rule usually found in article 3(2) which provides in effect that undefined terms in the treaty take the meaning which they have under domestic law, unless the contrary intention appears: see UK treaty, article 3(3) and US treaty article 3(2). [16.105]

16.1

Questions

What are the arguments for and against using international interpretation rules in relation to tax treaties? Is this approach effectively reversed by the internal interpretation rule in the treaty? [16.105]

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16.2

16.3

The definition of “permanent establishment” in tax treaties refers to “carrying on” a business. Is the domestic tax concept of “carrying on” business relevant for this purpose? (See Thiel.) Assume that a country changes an internal tax definition after a treaty enters into force which is relevant to the application of the treaty. Does the original or the amended definition apply in interpreting the treaty? Are changes in the OECD Commentaries after a treaty comes into force relevant to interpretation of the treaty? (See Taxation Ruling TR 2001/13.)

[16.110] In the analysis that follows in this and succeeding chapters we usually begin with

rules about international taxation in domestic law and then discuss how they are affected by tax treaties. The greatest impact of tax treaties is in relation to non-residents, so most discussion will be found in Chapter 18.

2. RESIDENCE (a) Domestic Law [16.120] The major definition of “resident” is found in s 6(1) of the ITAA 1936. “Non-resident” is defined in the same section conversely as any person who is not a resident; the equivalent terms in the 1997 Act are “Australian resident” and “foreign resident”.

(i) Individuals [16.130] The definition of a resident individual in s 6(1) is inclusive. It takes the general law

meaning of resident and then adds some specific rules. Residence is a concept used in many areas of law undefined. The ATO’s view of how it works in the income tax is set out in a 1998 Ruling.

Ruling TR 98/17 [16.140] 12. If an individual resides in Australia according to the ordinary meaning of the word, the other tests in the definition do not require consideration … Ordinary meaning 13. As there is no definition of the word “reside” in Australian income tax law, the ordinary meaning of the word needs to be ascertained from a dictionary. 14. For example, The Macquarie Dictionary defines “reside” as “to dwell permanently or for a considerable time; have one’s abode for a time” and the Shorter Oxford English Dictionary defines it as “to dwell permanently or for a considerable time, to have one’s settled or usual abode, to live, in or at a particular place”.

872

[16.110]

15. The ordinary meaning of the word “reside” is wide enough to encompass an individual who comes to Australia permanently (e.g., a migrant) and an individual who is dwelling here for a considerable time. 16. A migrant who comes to Australia intending to reside here permanently is a resident from arrival. 17. When an individual arrives in Australia not intending to reside here permanently, all the facts about his or her presence must be considered in determining residency status. 18. The period of physical presence or length of time in Australia is not, by itself, decisive when determining whether an individual resides here. However, an individual’s behaviour over the time

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Ruling TR 98/17 cont.

their presence has an habitual and routine character during the entire period.

spent in Australia may reflect a degree of continuity, routine or habit that is consistent with residing here.

26. This may apply when an individual comes to Australia on a short-term employment contract for less than six months. This would not normally be sufficient time to demonstrate behaviour that is consistent with residing here. If the employment is extended past six months, the facts surrounding the entire stay in Australia must be considered, not merely the original intended length of stay. (See Examples 3 and 4 at paragraphs 76 to 83.)

Behaviour while in Australia 19. The quality and character of an individual’s behaviour while in Australia assist in determining whether the individual resides here. 20. All the facts and circumstances that describe an individual’s behaviour in Australia are relevant. In particular, the following factors are useful in describing the quality and character of an individual’s behaviour: • intention or purpose of presence; • family and business/employment ties; • maintenance and location of assets; and • social and living arrangements. 21. No single factor is necessarily decisive and many are interrelated. The weight given to each factor varies depending on individual circumstances. Period of physical presence in Australia 22. Whether a considerable time has elapsed to demonstrate that the individual’s behaviour has the required continuity, routine or habit is a question of fact; that is, it depends on the circumstances of each case. The Commissioner’s view of the law is that six months is a considerable time when deciding whether the individual’s behaviour is consistent with residing here. 23. When behaviour consistent with residing here is demonstrated over a considerable time, an individual is regarded as a resident from the time the behaviour commences. 24. As residency is a question of fact, individuals who are in Australia for less than six months may establish they reside here. (See Example 1 at paragraphs 68 to 72.) Conversely, individuals may establish that they do not reside here, even if they have been in Australia for a longer time. (See Example 2 at paragraphs 73 to 75.) 25. If individuals enter Australia intending to remain for less than six months but later events extend their stay beyond six months, they are regarded as residents from their arrival, as long as

27. On entering this country, individuals may demonstrate they do not intend to reside in Australia, e.g., they may be visitors on holiday. When a change in their behaviour indicates an intention to reside here, e.g., they decide to migrate here, they are regarded as residents from the time their behaviour that is consistent with residing here commences. Intention is to be determined objectively, having regard to all relevant facts and circumstances. (See Example 5 at paragraphs 84 to 89.) 28. On the other hand, an intention to leave Australia after a brief stay is of little significance if the individual does not, or is unable to, depart … Example 1 68. Bjorn Anderson, a promising half-back from Sweden, is offered an eighteen month contract to play soccer in Australia for a club in the National Soccer League. The club provides accommodation for Bjorn and his family. As Bjorn intends to remain in Australia for the full term of his contract, he leases his house in Sweden, sells his car and redirects the family mail to Australia. His children attend an Australian school and his wife and children become involved in sporting activities. 69. However, Bjorn is having trouble acclimatising to Australian conditions. After withdrawing from yet another torrid session, Bjorn is put on notice to perform “or else”. Bjorn’s form continues to slide to the point that management seek to terminate his contract on the ground of non-performance. 70. Bjorn’s contract is paid out for an agreed sum. Four months after arriving in Australia, Bjorn and his family return to Sweden. [16.140]

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Ruling TR 98/17 cont. 71. Bjorn explains to the Commissioner that despite only being in Australia for four months he was residing here during that time and he argues that he is entitled to be taxed as an Australian resident. Decision: resident 72. As Bjorn established that he intended to live in Australia for eighteen months with his family and his behaviour over the four months is consistent with the intention, Bjorn resided in Australia. Example 2 73. Michael Desmond is a South African diamond corporation executive. He takes the opportunity to participate in an intensive eight month advanced management development program at an Australian university. 74. Michael’s wife and children do not accompany him to Australia and while here he stays in basic accommodation on campus. He spends his time studying or writing reports for his company. He is in Australia solely to do the course and at the end of eight months he returns home. Decision: non-resident 75. Michael does not exhibit behaviour that is consistent with residing here. All of the facts lead to a conclusion that he is a non-resident. Example 3 76. Jane Cierpinski is single and is a Professor of Biology at the University of Warsaw. She comes to Australia to work on a research project. She is contracted to do the research in Australia for five months. 77. A six month lease of a small furnished unit near her work is such an attractive proposition that she enters into the lease despite intending to leave after five months. She also buys an old car. She relaxes at the end of her long days by going to the movies, occasionally attending dinner parties hosted by her colleagues, reading novels or writing letters to her friends and parents. 78. Jane intends to return to Warsaw at the end of the project that actually lasts for seven months. She negotiates an extra month on the lease of her unit. Apart from depositing her salary 874

[16.140]

into an Australian bank account to cover normal living expenses, Jane retains all assets and investments in Poland, her country of domicile. Decision: resident 79. Jane’s behaviour over the seven months in Australia is consistent with residing here. She is regarded as a resident from her arrival. Example 4 80. Michelle Latour is a viticulturist who comes to Australia to do some research for five months. She actually stays for seven months to complete the Australian phase of her project. 81. Michelle’s husband and children do not accompany her to Australia. They stay in their home in Bordeaux. From Australia, she assists her husband in running the family business. 82. While in Australia, Michelle stays in a hostel. She uses credit cards to meet day to day expenses. Her concentration on her research is often interrupted because she has to constantly fax and phone her husband about their emerging business problems. In fact, she needs to make a quick trip home for a week to sort out a major business dilemma. Decision: non-resident 83. Michelle was in Australia for a considerable time. However, all of the factors relating to her presence in Australia suggest that the quality and character of her stay reflect that of a visitor who is temporarily in Australia rather than establishing behaviour consistent with residing here. Example 5 84. Peta Chu is an accountant who works in Hong Kong. Her work does not involve travel. She is single and lives in Hong Kong with her parents. She accepts an offer from her employer to travel temporarily to Australia to provide business advice to large numbers of former Hong Kong residents setting up businesses in Melbourne, Sydney and Brisbane. 85. Peta enters Australia on 5 April 1998, intending to spend three months travelling between the three cities, staying in various motels. Her employer asks her towards the end of her three months to take up a position in Sydney for a further nine months. 86. In early July, she leases a serviced executive apartment for nine months near her work place in

Principles for Taxing International Transactions

Ruling TR 98/17 cont. Sydney. The apartment is her home base during her stay here. She freights more clothing and some personal effects to Australia. Her parents visit her on two occasions. 87. Although based in Sydney, her commitments require some limited travel. On average, Peta travels at least once a week to meet clients outside Sydney. Decision: non-resident for year ended 30 June 1998 resident during her stay in the 1999 income year

[16.145]

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88. While Peta is on a working trip, the duration and nature of her stay in temporary accommodation during the 1998 income year do not establish a pattern of habitual behaviour and she is regarded as a non-resident. 89. From early July, Peta’s behaviour alters. The lease of more permanent accommodation, as well as her position in Sydney, indicates a more settled purpose for being in Australia compared to her first three months in Australia. Peta is regarded as a resident from the time her behaviour changes.

Question

Do you think these examples present a consistent and easily applied test for the residence of individuals? Do the results in the examples fit with the Ruling part? Do you think that a court would decide the matter by reference to a dictionary or to decided cases in analogous areas? (The Explanation section in the Ruling which is not reproduced refers to a significant number of cases on residence. In recent years the ATO has successfully litigated many cases in the AAT, which are not referred to in the ruling, on the basis that Australians working and largely living overseas are nonetheless still Australian tax residents within the ordinary meaning.)

[16.150] The three statutory additions are based on domicile, a 183-day rule and a

Commonwealth public servant rule. The last is designed to ensure that the public servants remain residents of Australia for tax purposes when posted overseas on government business so that Australia retains taxing rights over their income (which is an internationally accepted norm as evidenced by the government service article of tax treaties). Similarly, the first rule is mainly relevant to Australian residents who move overseas to determine whether they have lost residence and has been considered in a number of cases. In FCT v Applegate (1979) 9 ATR 899; 79 ATC 4307, the taxpayer, a solicitor, was asked by his firm to go to Vila to establish a branch office there as manager. It was always intended that after an indefinite although substantial period of time the taxpayer would return to Australia to the Sydney office, once the Vila office had been established. The taxpayer gave up the lease on his Sydney home in November 1971. He lived in a motel in Vila initially and then leased a house, for 12 months on a renewal option. He was admitted to practise law in the New Hebrides, and also obtained a residence permit. Dissatisfaction with medical facilities available led to his wife returning to Australia in December 1971 for the birth of their child, and the taxpayer came back to Australia to accompany them back to Vila. Illness after the end of the tax year in question led to the taxpayer’s return to Australia for treatment and then his permanent return. The taxpayer was assessed to income tax by the ATO as a resident on the income derived from his employment in Vila. The Full Federal Court held for the taxpayer:

[16.150]

875

Income Derived From International Transactions

FCT v Applegate [16.160] FCT v Applegate (1979) 9 ATR 899; 79 ATC 4307 Franki J: In my opinion two fundamental matters must be borne in mind. The first is that liability to tax arises annually and the question of where the taxpayer’s permanent place of abode is, if relevant, must be determined annually, and secondly that the words “his permanent place of abode” are in a subsection which contains the word “domicile”. … [I]n my opinion, the phrase “permanent place of abode outside Australia” is to be read as something less than a permanent place of abode in which the taxpayer intends to live for the rest of his life. There is nothing in the subsection which requires the intent of the taxpayer to be the critical factor even though it is, of course, a relevant factor. Essentially the question is whether, as a matter of fact the taxpayer’s permanent place of abode was outside Australia at the relevant time. … I consider that the learned judge correctly posed the relevant test when he said that … “what is required is that there be a permanent place of abode outside Australia and that the enquiry as to whether there is or not is an objective one, notwithstanding the fact that the intention of the taxpayer in relation to the length of time that he will reside in a place outside Australia is a relevant factor to be taken into account”. … Northrop J: In the present case there can be no doubt that whatever meaning is given to the phrase, during the period in question the taxpayer’s “place of abode” was outside Australia. During that period he did not reside in Australia. He had no residence in Australia. He had no home in Australia. He did not carry on business or work in Australia. He received no income from sources within Australia. It follows, therefore, that the real issue is whether, during the period in question, the taxpayer’s place of abode outside Australia was permanent or not. … The word “permanent” as used in para. (a)(i) of the extended definition of “resident”, must be construed as having a shade of meaning applicable to the particular year of income under 876

[16.160]

consideration. In this context it is unreal to consider whether a taxpayer has formed the intention to live or reside or to have a place of abode outside of Australia indefinitely, without any definite intention of ever returning to Australia in the foreseeable future. The Act is not concerned with domicile except to the extent necessary to show whether a taxpayer has an Australian domicile. What is of importance is whether the taxpayer has abandoned any residence or place of abode he may have had in Australia. Each year of income must be looked at separately. If in that year a taxpayer does not reside in Australia in the sense in which that word has been interpreted, but has formed the intention to, and in fact has, resided outside Australia, then truly it can be said that his permanent place of abode is outside Australia during that year of income. This is to be contrasted with a temporary or transitory place of abode outside Australia. Fisher J: Great significance was attached by the Commissioner to the taxpayer’s state of mind, and in particular to his intentions in respect of returning to Australia. In his argument before the trial judge he submitted that because the taxpayer had the intention eventually to return to Australia, he could not qualify as a non-resident under the definition. This was, he said, because on its proper construction the particular subsection of the definition only applied where a taxpayer formed a firm intention to leave Australia forever but although he might live in another country, he had not formed the intention to make that other country his home. This submission was rejected, and in my view correctly rejected by the trial judge. Before us the Commissioner’s submission again placed great emphasis on the taxpayer’s intentions in respect of his return to Australia. No person who was domiciled in Australia, he said, could be a non-resident unless he intended to live outside Australia indefinitely, without any definite intention of ever returning to Australia in the foreseeable future except at some remote albeit specific point of time. It was only in these

Principles for Taxing International Transactions

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FCT v Applegate cont.

attention to the taxpayer’s state of mind in respect of that or any other place.

circumstances that a person could be said to have his permanent place of abode outside Australia.

It follows that it is in my view proper to pay greater regard to the nature and quality of the use which a taxpayer makes of a particular place of abode for the purpose of determining whether it qualifies as his permanent place of abode. His intention with respect to the duration of his residence is just one of the factors which has relevance. …It is to my mind perfectly consistent with the establishing of a home in a particular place that the taxpayer is aware that the duration of his enjoyment of the home, although indefinite in length, will be only for a limited period. The knowledge that eventually he will return to the country of his domicile does not in my opinion deny him a capacity to make his home outside of his country of domicile. Such a conclusion is particularly open in the present circumstances where the taxpayer was not a completely free agent in the choice of when to return, it being a matter for negotiation between him and his employers.

Both of these tests to my mind attach too much significance to the taxpayer’s subjective state of mind with reference to returning to Australia to be appropriate for present purposes. Moreover, such a degree of subtlety is hardly warranted in the present context, namely of seeking to determine a taxpayer’s residence, itself primarily a question of fact. It would be a different matter if the issue was to his domicile with its attendant consequences for the personal law and status of the taxpayer. To my mind the trial judge correctly found against the Commissioner. The taxpayer contended, and in that judge’s view and in my view correctly contended, that the inquiry was whether there was a permanent place of abode outside Australia. Such an inquiry was to be determined upon objective consideration of the facts, one of which was the expressed intention of the taxpayer as to the length of time he will be outside Australia. Of crucial significance were not only the facts concerning his acquisition of a house in Vila, but also that he was intending and intended by his firm to remain indefinitely, albeit for a limited time. … To my mind it is significant that the word “permanent” is used to qualify the expression “place of abode”, that is, the physical surroundings in which a person lives, and to describe that place. It does not necessarily direct

To my mind the proper construction to place upon the phrase “permanent place of abode” is that it is the taxpayer’s fixed and habitual place of abode. It is his home, but not his permanent home. It connotes a more enduring relationship with the particular place of abode than that of a person who is ordinarily resident there or who has there his usual place of abode. Material factors for consideration will be the continuity or otherwise of the taxpayer’s presence, the duration of his presence and the durability of his association with the particular place.

[16.170] The second statutory test – actual presence for at least half of the income year (the

“183 day” test) – merely creates a presumption that the taxpayer is a resident and is rebuttable by the ATO being satisfied that the taxpayer’s “usual place of abode” is outside Australia and that the taxpayer does not intend to take up residence in Australia. The Full Federal Court in FCT v Subrahmanyam (2001) 116 FCR 180; 49 ATR 29 interpreted this test to mean that if the taxpayer cannot point to any other country being their usual home they will be deemed to be an Australian resident, even, it seems, if they have no intention of residing here. Australia introduced special rules for temporary residents in 2006 which are explained in Chapter 17. A temporary resident as defined in s 995-1 of the ITAA 1997 is a person who holds a temporary visa under immigration rules and who, or whose spouse, is not a resident for the purposes of Australia’s social security rules. Essentially these references to other areas [16.170]

877

Income Derived From International Transactions

of law are intended to be a definition of an expatriate. There is, however, no time limit for which this status may be held so long as the taxpayer obtains a renewal of the temporary visa, which does not fit with the general understanding of who is an expatriate. [16.175]

16.5

16.6 16.7

16.8

Questions

Where the posting overseas is for a fixed period, rather than indefinitely, does that make a difference? (See FCT v Jenkins (1982) 12 ATR 745; 82 ATC 4098.) An accountant who was born and has lived all her life in Australia and is working with an Australian firm is posted to an overseas office of her employer for one year. Will she be a resident of Australia for tax purposes? Can an individual be a resident of Australia for part of the year of income and a non-resident for part of the year? (See s 18 of the Income Tax Rates Act 1986.) An employee of a multinational company headquartered in the United States is posted to Australia from 1 January 2017 to 31 December 2017. Is the person a resident of Australia for tax purposes? What is the difference between a permanent place of abode and a usual place of abode? (See paras (a)(i) and (a)(ii) of the definition of “resident” in s 6(1).)

(ii) Companies [16.180] By contrast, the definition of residence of companies is exclusive. It has three parts,

with the second and third part having a two-pronged test which includes carrying on business in Australia, a test that seems to be more relevant to source than residence. The second test involving central management and control is the one that causes most issues in practice. This test originated in case law in the UK where, however, there was no similar requirement that the company carry on business in the UK. In Malayan Shipping Co Ltd v FCT (1946) 71 CLR 546, the taxpayer company was incorporated in Singapore by S who lived and carried on business in Melbourne. He appointed the other directors of the company, was managing director and under the constitution no action could be taken by the company without his agreement. The only business which the company did in the relevant years was to charter a Norwegian tanker under two time charters and to sub-charter this ship to S on 10 voyage charters. S organised everything to do with the charters.

Malayan Shipping Co Ltd v FCT [16.190] Malayan Shipping Co Ltd v FCT (1946) 71 CLR 546 Williams J: In these circumstances [counsel] could not but admit that the central management and control of the company was concentrated in [S] and its voting power controlled by him and therefore by a shareholder resident in Australia. But [counsel] contended that since the definition required that the company should be carrying on business in Australia and also that the central management and control should be in Australia or the voting power of the company should be controlled by shareholders resident in Australia, 878

[16.175]

the carrying-on of business could not refer to the control of the operations of business from which the profits arose but only to the actual operations themselves. … I am not prepared to accept [counsel’s] construction of the definition. In Mitchell Egyptian Hotels Ltd Lord Parker of Waddington said: “Where the brain which controls the operations from which the profits and gains arise is in this country the trade or business is, at any rate partly, carried on in this country.” The purpose of requiring that,

Principles for Taxing International Transactions

Malayan Shipping Co Ltd v FCT cont. in addition to carrying on business in Australia, the central management and control of the business or the controlling shareholders must be situate or resident in Australia is, in my opinion, to make it clear that the mere trading in Australia by a company not incorporated in Australia will not of itself be sufficient to cause the company to become a resident of Australia. But if the business of the company carried on in Australia consists of or includes its central management and control, then the company is carrying on business in Australia and its central management and control is in Australia. If, on the other hand, a company incorporated elsewhere is merely trading in Australia and its central management and control is abroad, it does not become a resident of Australia unless its voting power is controlled by shareholders who are residents of Australia … It appears to me, therefore, that, even if [counsel] is right in contending that the sub-charters were of the essence of the trading operations and were made in Singapore, the company was

CHAPTER 16

nevertheless a resident within the meaning of the definition. But I cannot attach this importance to the acceptance of the sub-charters in Singapore. The question where business is carried on is in every case one of fact. … In the present case all the terms and conditions of the charterparties were prepared and the complete decision to sub-charter the tanker from the company was made by [S] in Melbourne. Under the articles of association he was entitled to contract with the company and to vote as a director to enter into such a contract. He, and he alone, could decide whether the company would accept his offer or not. A resolution of the directors to accept the charters and sub-charters could only be effective if he concurred, and the seal of the company could only be affixed thereto with his consent. He had the company in a vice. In these circumstances the forwarding of the charters and sub-charters to Singapore for acceptance by the company was a mere formality. The essence of the business was his decision in Melbourne to charter and subcharter the tanker. It was this decision which in every substantial sense gave rise to the profits which the company made out of the sub-charters.

[16.200] In Taxation Ruling TR 2004/15 the ATO explained what it considered was decided

in the case, and how the central management and control test applied in the modern world. Unlike the case of individuals, the ATO has not been active recently in litigating the residence of companies, confining its attention to two cases where it considered that there was aggressive tax planning. One of the cases, Bywater Investments Ltd v FCT [2016] HCA 45 was recently decided by the High Court of Australia.

Ruling TR 2004/15 [16.210] Two requirements 5. For a company to be a resident under the second statutory test two separate requirements must be met. The first is that the company must carry on business in Australia, and the second is that the company’s central management and control (CM&C) must be located in Australia. 6. If no business is carried on in Australia, the company cannot meet the requirements of the second statutory test and, in these circumstances, it is not a resident of Australia under the second statutory test. In these situations there is no need

to determine the location of the company’s CM&C, separate from its consideration of whether the company carries on business in Australia. If the company carries on business in Australia it also has to have its CM&C in Australia to meet the second statutory test. 7. However, there are situations where the nature of the business or the level of control over the business requires the exercise of CM&C at the place where the business is carried on. Where a company’s business is management of its investment assets and it undertakes only minor [16.210]

879

Income Derived From International Transactions

Ruling TR 2004/15 cont. operational activities, the factors determining where a company is carrying on a business may be similar to those determining where it is exercising CM&C. In these situations the location of CM&C is indicative of where the company carries on business and vice versa. 8. The fact that a company, not incorporated in Australia, is carrying on a business in Australia does not, of itself, necessarily mean that the company has its CM&C in Australia. Carries on business in Australia 9. The question of where business is carried on is one of fact. It requires a consideration of where the activities of the company are carried on and is dependent on the facts and circumstances of a case. However, the Commissioner’s approach to this factual determination is to draw a distinction between a company with operational activities (for example trading, service provision, manufacturing or mining activities) and a company which is more passive in its dealings. It is appreciated that there will be some overlap in any particular situation. 10. For the purposes of the second statutory test, a company that has major operational activities relative to the whole of its business carries on business wherever those activities take place and not necessarily where its CM&C is likely to be located. Operational activities include major trading, service provision, manufacturing or mining activities. For example, the place of business of a large industrial concern is wherever its offices, factories or mines are situated. 11. On the other hand, a company whose income earning outcomes are largely dependent on the investment decisions made in respect of its assets, carries on its business where these decisions are made. This is often where its CM&C is located. 12. It is considered that for the purposes of paragraph 6(1)(b), the concept of carrying on a business may be wider than its ordinary meaning and extends to undertakings of a business or a commercial character. For example, for the purposes of the second statutory test, a company 880

[16.210]

may be carrying on business even if its only activity is the management of its investment assets. Central management and control 13. The second statutory test focuses on management and control decisions that guide and control the company’s business activities. This level of management and control involves the high level decision making processes, including activities involving high level company matters such as general policies and strategic directions, major agreements and significant financial matters. It also includes activities such as the monitoring of the company’s overall corporate performance and the review of strategic recommendations made in the light of the company’s performance. 14. Possession of the mere legal right to exercise central management and control of a company is not, of itself, sufficient to constitute CM&C of the company. Someone who has the “mere legal right to CM&C” is a person with the legal right to make these decisions involving CM&C but who for one reason or another does not exercise this right. However, a person with the legal right to CM&C may participate in the CM&C of the company even if they delegate all or part of that power to another, provided that they at least review or consider the actions of the delegated decision maker before deciding whether any further or different action is required. Location of central management and control 15. The location of the company’s CM&C is a question of fact to be determined in light of all the relevant facts and circumstances. In order to reduce uncertainty, the Commissioner as a matter of practical compliance will accept for those companies whose CM&C is exercised by a board of directors at board meetings that the CM&C is in Australia if the majority of the board meetings are held in Australia. The exception to this is cases where the circumstances indicate an artificial or contrived CM&C outcome. For example, where there is no business reason for the location of the meeting or where the decisions are made by someone other than the Board. 16. For the purposes of paragraph 15, a board meeting is treated as being held in Australia when

Principles for Taxing International Transactions

Ruling TR 2004/15 cont. the majority of directors of the company meet in Australia. If the location of the directors at board meetings is evenly split within and outside Australia, then the location of any directors with special powers may be decisive. This is also subject to the exception for cases where the circumstances indicate an artificial or contrived CM&C outcome. 17. On the other hand for the purposes of paragraph 15, if a majority of board meetings are held in a particular jurisdiction outside Australia, the company’s CM&C will not be located in Australia. This would apply regardless of whether the directors are Australian residents. Again, this is subject to the exception for cases where the circumstances indicate an artificial or contrived CM&C outcome. 18. As long as the high level decisions of the company are made at specific board meetings, the fact that less pressing business of the board is often conducted by circulating resolutions will not impact on the location of CM&C. 19. A parent company that does not involve itself in the CM&C of a subsidiary but ultimately has the power to remove the board in a manner consistent with the constitution of the company does not, for this reason alone, exercise the CM&C of the subsidiary for the purpose of the residence test. This approach is consistent with the framework of Australia’s tax treaties which treat parents and subsidiaries as separate entities and accept that parents and subsidiaries are often resident in different countries (see the Associated Enterprises article in tax treaties). 20. Where a parent company in Australia exercises CM&C in relation to a subsidiary (but does not conduct the day-to-day activities of the business in the way that the managing director did in Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156; (1946) 8 ATD 75; (1946) 3 AITR 256, the subsidiary would need to also be carrying on business in Australia for it to be a resident under the second statutory test. Location of central management and control in more than one country 21. It is possible for CM&C to exist in more than one country. Therefore the company can

CHAPTER 16

have CM&C in Australia notwithstanding that it also has its CM&C in another country. CM&C can be located where there is some part of the superior or directing authority by means of which the relevant affairs of the company are controlled. However, it is necessary that the exercise of that power and authority is to some substantial degree found in a place for the CM&C to be located there (and elsewhere). … Example 1 – Mere trading in Australia without CM&C in Australia Example 1(a) 65. Cup Co is incorporated in Singapore, where its directors and the majority of its shareholders are resident. Some of Cup Co’s business activities are conducted in Australia, other business activities take place outside Australia. All meetings of the board of directors take place in Singapore. At these meetings, decisions on the major contracts entered into by Cup Co, its finance, major policies and strategic directions are made. The members of the board also undertake their other directorial duties in Singapore. 66. Cup Co is not a resident of Australia under the second statutory test. Although Cup Co is carrying on business in Australia, its CM&C is located in Singapore and not in Australia. The mere fact that Cup Co carries on a business in Australia is not enough, in the absence of the exercise of CM&C in Australia, to satisfy the second statutory test. Example 1(b) 67. The facts are the same as Example 1(a), but one out of every four Board meetings is held in Australia. It is considered that high level decision making is not exercised to a “substantial degree” by the board of Cup Co in Australia. Thus, holding a minority of board meetings in Australia would not by itself constitute CM&C in Australia and Cup Co would not be a resident of Australia under the second statutory test. Example 1(c) 68. The facts are the same as Example 1(a), but two of Cup Co’s ten directors are resident in Australia. Cup Co would not be a resident of Australia under the second statutory test, as [16.210]

881

Income Derived From International Transactions

Ruling TR 2004/15 cont. having a minority of board members resident in Australia would not by itself constitute CM&C in Australia. Example 1(d) 69. The facts are the same as for Example 1(c), but the two Australian directors participate in the Board meetings held in Singapore from Australia by video-conference. As with Example 1(b), high level decision making is not exercised to a “substantial degree” by the board of Cup Co in Australia. The fact that a minority of board members located in Australia participate by videoconferencing in a Board meeting held by a majority of members in Singapore will not be sufficient to constitute CM&C and Cup Co would not be a resident of Australia under the second statutory test. Example 1(e)

concurs with them. The directors carry on all operational activities such as collecting rent, paying commission, finding tenants, making minor repairs and maintaining the buildings. 79. The residence status of Boom Co under the second statutory test will differ depending on the types of decisions and activities that Ben undertakes. 80. Possibility 1 – The level of control that Ben exercises is so minor that he is not making high level management decisions and his activities are so insubstantial that he is not participating in the business of the company. Such activities might include contacting the directors irregularly for an update on the business without interfering in their decisions or checking property prices and rents in the area without giving directions to the company. Boom Co is not a resident of Australia as it is not carrying on business in Australia nor is its CM&C in Australia.

Example 5 – Investment company – possible Australian controller

81. Possibility 2 – Both the directors and Ben exercise a sufficient degree of control over the high level decisions of the company that CM&C is exercised in both places. Such high level decisions might include directions that the company only concentrate on commercial leases, the rents be increased by 20% across the board or that major refurbishments take place. The activities that constitute the business of the company, such as the actual investment decisions, the execution of leases, finding tenants, collection of rent, paying commission, making minor repairs and maintaining the buildings are only carried out offshore. Boom Co is not a resident of Australia as it is not carrying on business in Australia, but its CM&C is located in both Australia and Hong Kong.

78. Boom Co was set up by Ben, an Australian resident. It is incorporated in Hong Kong and has two directors who are resident in Hong Kong and who hold board meetings in Hong Kong. Each director has two shares in Boom Co which they hold on trust for Ben. Boom Co owns real property all of which is outside Australia and makes its profits from commercial property leases on a large scale. Ben does not attend the board meetings in Hong Kong, however, the constitution of Boom Co provides that the decisions of the directors are only effective if Ben

82. Possibility 3 – Ben solely exercises the power to make high level decisions regarding the company’s leases, funding, leasing policies, strategies etc, but not participating in the management of the company, such as the actual investment decisions, the execution of leases, finding tenants, the collection of rents, paying commission, making minor repairs and maintaining the buildings. Boom Co is not a resident of Australia as it is not carrying on business in Australia, but its CM&C is solely located in Australia.

70. The facts are the same as for Example 1(d), but one out of every four Board meetings (Example 1(b)) is also held in Australia. Having only one in every four Board meetings in Australia, and two (out of ten) Australian directors participate in Singapore meetings by videoconference would not mean that high level decision making is exercised to a “substantial degree” by the board of Cup Co in Australia. Thus, Cup Co would not have its CM&C in Australia and would not be a resident of Australia under the second statutory test. However, if a majority of board meetings were to be held in Australia, the position is likely to be different. …

882

[16.210]

Principles for Taxing International Transactions

Ruling TR 2004/15 cont. 83. Possibility 4 – Ben makes all high level decisions regarding the company’s leases, funding, leasing policies, strategies and investment decisions, as well as managing Boom Co’s day to day activities. Ben makes the key investment decisions in Australia and the associated activities are conducted in Australia (for example, the payment of all expenditure,

[16.215]

CHAPTER 16

vetting of all tenants and the detailed monitoring of rental payments via the internet). The directors step aside from making any decisions in respect of the company. In this regard, the facts are similar to those in Malayan Shipping in that all high level and operational decisions in respect of Boom Co are made in Australia. Boom Co is a resident of Australia as it is carrying on business in Australia and its CM&C is located in Australia.

Questions

16.9

What is the relationship between the CM&C test and the carrying on business element of the definition? Is the Ruling consistent with the case? If not, why would the ATO seek to limit or contradict the case? Does the Ruling provide sufficient guidance in a world of electronic commerce and virtual meetings? How would you advise a company to proceed to ensure that its residence is certain under the CM&C test? 16.10 An Australian parent company has several foreign subsidiaries which have boards of directors composed of local accountants. The parent prepares scripts for directors’ meetings of the subsidiaries which are duly followed. The local directors would not do anything, however, which they considered in breach of local company law. Is the CM&C of the company in Australia? Is it an Australian resident? (See Esquire Nominees v FCT (1973) 129 CLR 177 per Gibbs J, Bywater Investments Ltd v FCT [2016] HCA 45.) 16.11 All the shares in a company incorporated in Hong Kong are held by A in capacity of trustee. A is a non-resident of Australia and the sole director of the company. All the beneficiaries of the trust are resident in Australia. The company owns several residential properties in Australia which it rents out. Is the company resident in Australia under any of the tests of company residence? (iii) Other Intermediaries [16.220] Although paragraph (a) of the definition of “resident” in s 6(1) of the ITAA 1936 is

expressed to apply to persons other than companies, it is clearly limited to natural persons. Other kinds of intermediaries besides companies which may or may not be persons under the legislation also are provided with residence definitions, often for limited purposes: see ITAA 1936 s 95(2) “resident trust estate”; and ITAA 1997 s 995-1(1) “resident trust for CGT purposes”. Some of the provisions of the ITAA 1997 do not use the term “resident” even if providing a residence definition in effect: see s 295-95 “Australian superannuation fund”.

(b) Tax Treaties [16.230] Tax treaties adopt the domestic definition of residence as a starting point. If a

taxpayer is a resident of both countries, this gives rise to potential double taxation on the basis of double residence. Tax treaties usually deal with this problem by providing a tie-breaker for the purposes of the treaty. The effect of the tie-breaker then usually prevents double residence taxation. For example, assume that an individual who is in receipt of a pension is a resident of [16.230]

883

Income Derived From International Transactions

Australia under s 6 of the ITAA 1936 and is also a resident of the UK under its domestic law. If the person is assigned an Australian treaty residence by the tie-breaker in article 4(3) because the person has a permanent home in Australia but not the UK, then only Australia can tax the pension under article 17 of the UK treaty. For companies and other entities, the usual tie-breaker is the place of effective management, which appears in the 2014 OECD Model and the majority of Australia’s tax treaties, including the UK treaty article 4(4). The US treaty does not have a tie-breaker for dual-resident companies, and the way in which the treaty is structured means that such companies do not get the benefits of the treaty. The OECD is in the process of changing the OECD Model tiebreaker as discussed in Section 5 of this chapter. Most treaties make little reference to other kinds of entities. The US treaty and UK treaty have rules dealing with partnerships in article 4 while the also latter deals with trusts in that article. [16.235]

Questions

16.12 A company registered in Australia has a branch in the UK through which its activities are largely carried out. The head office in Melbourne has no activities beyond being one home of the wife and husband owners of the company, which they use mainly when on holidays for three months a year. The owners are citizens of Australia and have most of their family here. They stay for nine months a year working in the UK where they have a permanent home also and manage the branch. Assume that under the laws of Australia and the UK, the company and the owners are both resident in each country. For the purpose of the treaty, where are the company and its owners resident? 16.13 What is the effect of the concluding sentence of article 4(1) of the UK treaty? What is the effect of article 4(2)? 16.14 Do you think that the place of effective management is a suitable tie-breaker in the current environment having regard to e-commerce? What alternatives can you suggest?

3. SOURCE [16.240] Australia’s source rules at the moment are an uncoordinated mixture of varying

vintage. For residents, source rules may be relevant in determining the exemption of foreign income under s 23AH of the ITAA 1936 but they are no longer directly relevant to the granting of foreign tax credits (foreign income tax offsets hereafter referred to as FITOs): see s 775-10 of the ITAA 1997. The original rules were generally made by the judges but as they are said to be questions of fact, it is not possible to state the rules with any precision. Sometimes they seem to follow a concept of the economic connection of the income and in other cases mechanical matters like the place of contract. For non-residents the rules are extremely varied. The judge-made rules sometimes apply: see ss 6-5(3), 6-10(5) of the ITAA 1997. At other times the judge-made rules are replaced by statutory source rules (for example, in relation to dividends and natural resource payments under ITAA 1936 ss 44(1) and 6CA respectively). In yet other cases, source rules by that name are simply irrelevant, and different rules performing a similar function are substituted, such as for withholding taxes on dividends, interest and royalties under Div 11A of the ITAA 1936, and capital gains under Div 855 of the ITAA 1997. On top of this for both residents and non-residents, the tax law may provide further modifications of the source rules, see the discussion of transfer pricing in Section 4 of this 884

[16.235]

Principles for Taxing International Transactions

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chapter. Finally, virtually all of Australia’s tax treaties contain a special source article which replaces the judge made and statutory source rules in favour of treaty rules as between Australia and the other country: see UK treaty article 21, US treaty article 27, or for a more typical provision, Vietnam treaty article 22 which reads: 1.

Income, profits or gains derived by a resident of a Contracting State which, under any one or more of Articles 6 – 8, 10 – 19 and 21, may be taxed in the other Contracting State shall for the purposes of the law of that other Contracting State relating to its tax be deemed to be income from sources in that other Contracting State. 2. Income, profits or gains derived by a resident of a Contracting State which, under any one or more of Articles 6 – 8, 10 – 19 and 21, may be taxed in the other Contracting State shall for the purposes of Article 23 and of the law of the firstmentioned Contracting State relating to its tax be deemed to be income from sources in the other Contracting State. In some cases the treaty does not deal fully with sourcing issues, and then additional rules are inserted in the Agreements Act such as in relation to the tax treaty with China: see s 11S(2). It is important to note that these rules apply for the purposes of the treaty and domestic law. Hence the treaty supplies the source rules for taxation of non-residents under ss 6-5 and 6-10 of the ITAA 1997, and for relief from double taxation under s 23AH of the ITAA 1936, see Tech Mahindra v FCT [2015] FCA 1082 para 36. Oddly, under the UK treaty there is no equivalent sourcing rule in the treaty or the Agreements Act for relief under domestic law, so that the judge made rules may apply for the purposes of s 23AH for income derived from the UK. Clearly there is scope for rationalisation of the current rules. The rules could be all stated as source rules, only one set of rules would be applicable in a given case and probably the rules for residents and non-residents could be unified. One approach would be to adopt the common treaty pattern and extend it to non-treaty cases (a number, but not all, of the statutory source rules reflect treaty positions). This would mean that virtually the same source rules would apply in all cases in Australia. Though these treaty rules generally reflect the underlying policy of sourcing income, in certain respects they can be manipulated (though this is probably true for all source and entity residence rules nowadays whatever their form). It may be considered that more robust rules should be applied in non-treaty cases which would be relevant to tax havens (Australia not having any comprehensive tax treaties with traditional tax havens). In this section we examine two cases to see how the courts approach their task of sourcing income. In Chapter 18 we examine which rules apply in which situations. In Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834 the taxpayer was an Australian incorporated company which was trustee of a discretionary trust. By an agreement entered into in New South Wales, it was granted options to acquire land in New South Wales at an undervalue by an Australian incorporated company. The taxpayer then entered into agreements in Switzerland nominating another Australian incorporated company to exercise the option (as it was entitled to do under the original option agreement). The price of these contracts was at the value of the land so that the taxpayer made a profit which it claimed was sourced in Switzerland and not taxable in Australia under the law as it stood at that time (trustees only being taxable on Australian source income as a result of an earlier High Court decision). The Full Federal Court disagreed with the taxpayer.

[16.240]

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Thorpe Nominees Pty Ltd v FCT [16.250] Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834 Lockhart J: The phrase “practical, hard matter of fact” appears in many of the reported cases where the meaning of the word “source” was discussed including cases earlier than Nathan’s Case. The use of the word “hard” renders the meaning of the phrase a little opaque … It must now be taken as accepted that the phrase “practical, hard matter of fact” embodies the notion that the question must be decided “in accordance with the practical realities of the situation without giving undue weight to matters of form, and not by the application of absolute rules of law”: per Gibbs J. in Esquire Nominees … Each of these formulations, though expressed in different language, is consistent with the other and should be applied in the present case. It is important to analyse each of the steps taken in this matter from the date of incorporation of Thorpe Nominees to the exercise of the option in June 1974 and the subsequent receipt of the moneys in question in June 1974 and June 1976; but it is unreal to sever the relevant events into occurrences in Australia on the one hand and those in Switzerland on the other. The relevant events must be looked at as a whole to determine the practical question of the source from which Thorpe Nominees derived the income in question in this case. There was a plan or scheme, call it what you like, devised in Australia for the purpose of avoiding income tax and to a lesser degree of saving New South Wales stamp duty. The Duncan Trust was established in Australia. All companies and natural persons relevantly connected with the plan were Australian residents, the companies being Thorpe Nominees, Collaroy Holdings, Vaucraft and Nawor; and the natural persons being Mr. and Mrs. Thorpe, the solicitor, the accountant, Mr. Thorpe’s accountant, senior and junior counsel and other directors of Vaucraft. The

land subjected to all the fine tuning was situated in New South Wales and was ultimately sold to persons in New South Wales. Collaroy Holdings granted the options to Thorpe Nominees in Australia. Although the steps to which I have referred earlier were taken in Switzerland in particular on 19 April, they were taken on advice from Australian lawyers and were plainly taken pursuant to a plan pre-arranged in Australia. Certain of the relevant contracts were signed in Switzerland, but payments to be made thereunder were made in Australia. It appears that there were no funds in Switzerland and that approval had not been obtained from the Reserve Bank to remit funds from Australia to Switzerland other than the costs of the Swiss attorneys. The agreements for the sale of the nomination rights between Vaucraft and Nawor were executed in Switzerland; but Nawor exercised the options in Sydney on 13 and 14 June 1974 and Vaucraft received the purchase price in Australia. Viewed as a matter of substance rather than form it is plain, in my opinion, that the source of the income in question is Australia not Switzerland. The activities in Switzerland were obviously part of a pre-arranged plan, which if not pre-arranged in every detail was at least pre-arranged in all important respects with only a few loose ends to be determined. Switzerland was selected as a place outside Australia, there being no particular reason for Switzerland as opposed to some other place outside Australia other than the favourable income tax rates offered by the Canton of Glarus. … It would give undue weight to matters of form to regard Switzerland as the source of the income in question. Having regard to the practical realities of the situation and the substance of the matter, the real source of the income in question was Australia.

[16.260] In Spotless Services Ltd v FCT (1993) 25 ATR 334 at first instance, the Federal

Court had to consider the source of interest under an elaborate scheme where the taxpayers deposited money with a Cook Islands bank (EPBCL), the deposit being secured by a letter of 886

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credit from the Midland Bank, Singapore branch. Eventually the case went to the High Court of Australia and was decided on Pt IVA (see Chapter 20). The judge at first instance was confirmed on the source issue by the Full Federal Court. The ATO did not pursue the issue in the High Court.

Spotless Services Ltd v FCT [16.270] Spotless Services Ltd v FCT (1993) 25 ATR 334 Lockhart J: What emerges from the authorities is plainly enough that the test to be applied in determining the source of income for the purposes of the Act is to search for “the real source” and to judge the question in a practical way … The cases demonstrate that there is no universal or absolute rule which can be applied to determine the source of income. It is a matter of judgment and relative weight in each case to determine the various factors to be taken into account in reaching the conclusion as to source of income. … In Cliffs International Inc v Federal Commissioner of Taxation Kennedy J observed that the place where the relevant contract was made from which the income was derived was held to be of no particular significance in Commissioner of Taxation (NSW) v Meeks but in Premier Automatic Ticket Issuers Limited v Federal Commissioner of Taxation and in Tariff Reinsurances Ltd v Commissioner of Taxes (Vic) the place where the relevant contract was made was held to be of considerable significance. Similarly with respect to the place where the income is received: see Tariff Reinsurances per Dixon J. The researches of counsel and my own researches have not revealed any case directly in point to the present appeals. In my opinion where the source of interest payable under a contract of loan lies at the heart of the judicial inquiry, the place or places where the contract was made and the money lent are of considerable importance; but it goes too far to say that the

source of the interest in the present case is necessarily determined solely by reference to the place where the contract of loan was made and the money in fact lent. … The event which concluded the contract and bound the parties was the delivery of the cheque in the Cook Islands on behalf of the Spotless companies to EPBCL and the receipt of the certificate of deposit by them through their agent, Mr Levy. … There are other facts and circumstances that in my view point strongly in the direction of the conclusions that the interest was derived by the taxpayers in the Cook Islands. The borrower, EPBCL, was incorporated in the Cook Islands and carried on business there. It did not carry on business in Australia. The deposit was repaid, together with interest, less withholding tax, from the Cook Islands. It is impossible to ignore the legal effect of the arrangements entered into by the parties with respect to the lending of the money. Until the cheque for $40m was handed over on 11 December in the Cook Islands and the certificate of deposit received in return there was no contract between the lender (the taxpayers) and the borrower (EPBCL). If EPBCL failed to honour the certificate of deposit on the due date the taxpayers could have sued on the certificate and there would have been no answer in law to their right to judgment. The source of the interest derived by the taxpayers from the making of the loan was the Cook Islands.

[16.270]

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[16.275]

Question

16.15 Note that the same judge is involved in both cases. Do you consider the reasoning in both cases is consistent? What is the role of economic substance and legal form in determining the source of income under judicial rules? Does it matter what the nature of the income is or that land is involved in one of the cases?

4. TRANSFER PRICING [16.280] As noted at the beginning of the chapter, transfer pricing refers to the pricing of

transactions between usually related companies which is designed to shift income between countries. For example, income can be located in or out of Australia by the price that a foreign parent charges a local subsidiary for goods sold to the subsidiary. If the price is above market value, income is moved out of Australia and vice versa if it is below market value.

(a) Domestic Law [16.290] Transfer pricing adjustments from 2013 are made under Divs 815-B – 815-D of the

ITAA 1997 which were enacted in 2013. Division 815-B is entitled “Arm’s Length Principle for Cross-Border Conditions between Entities” and substitutes the “arm’s length conditions” when an entity gets a “transfer pricing benefit from conditions that operate between the entity and another entity in connection with the commercial and financial relations”, s 815-115. The definition of transfer pricing benefit in s 815-120 performs two main functions. First, it is designed only to operate when there is a detriment to the Australian revenue; in terms of the example given in the previous paragraph it would only operate when the foreign parent charges a price that is above the arm’s length price – arm’s length conditions being defined in s 815-125 as “the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances.” Secondly, it ensures that there is an international element in the relevant transaction through the incorporation of terms relating to residence and an overseas or Australian permanent establishment (commonly referred to as a PE) in the cross border test in s 815-120(3). Residence is defined by a combination of definitions in domestic law and any tax treaty applicable to the transaction while PE is defined in domestic law but in a way which borrows from tax treaties and is most commonly fulfilled if a company has a branch office in another country (ie part of the same company as compared to a subsidiary – see Chapter 18). In determining the arm’s length conditions, the legislation looks to the economic substance of the transactions between entities where this is different to the legal form, see s 815-130. Division 815-B operates automatically, unlike the 1982 provisions it replaced which required the ATO to make a determination before issuing an assessment (as still occurs for Australia’s general anti-avoidance rule in ITAA 1936 Pt IVA). Under s 815-145, the ATO can make compensating adjustments for other taxpayers but this adjustment still requires a formal determination procedure. For example, assume an Australian subsidiary has paid an excessive royalty to a UK parent company and has withheld tax of 5% applying article 12 of the UK treaty (being tax payable on the royalty by the parent in Australia). The ATO can first adjust the royalty downwards and reduce the deduction for the subsidiary. Then, under s 815-145 a 888

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compensating adjustment can be made in effect to refund the withholding tax on the excessive portion of the royalty. Australia is better off overall, as it collects 25% tax on the excessive part of the royalty (30% corporate tax for denying the deduction less 5% withholding tax effectively refunded). When a resident of one country operates in another country through a PE, the taxation of the PE is dealt with by Div 815-C. It does not work by changing the price of the transaction between head office and branch, as there is no actual transaction between different parts of the same entity. Rather, it operates by allocating income and deductions of the entity based on an arm’s length profit for a notional transaction between the two and sourcing the income so determined in the country where the PE is situated: see ss 815-215 – 815-230. An example will make this method clearer. Assume that X Co in Australia has invented a new method of ventilation which keeps out noise. It sets up a branch (PE) in Hong Kong to market the invention there and in China. It manufactures the ventilator for $5 each in Australia and sells them to customers in Hong Kong and China for $10. Costs of shipping and selling paid by the Hong Kong branch are $1. Because of the intellectual property incorporated in the product its value when it leaves Australia is $8. If, in its books and tax return, X Co treated the product as if it were sold to the Hong Kong PE for $6, it would report $1 taxable in Australia and $3 taxable in Hong Kong, and not taxable in Australia under s 23AH of the ITAA 1936 (discussed in the next chapter). Under s 815-215 only $2 of the sale price of $10 is sourced in Hong Kong leaving a taxable profit of $3 for each product in Australia. On this basis, $2 of the sale price would be sourced in Hong Kong according to Australian law and not assessable as a result of s 23AH. As the $1 expense in Hong Kong relates to income that is not assessable, it would not be deductible.

(b) Tax Treaties and Transfer Pricing Guidelines [16.300] The structure of Div 815 mirrors closely that found in tax treaties – article 7(2) for

business profits of PEs (branches) corresponding to Div 815-C and article 9 for associated enterprises corresponding to Div 815-B. One difference is that the tax treaty rules apply in both countries whereas Div 815 applies only for Australia. Thus, if in the royalty example given in (a) above the UK agreed that the Australian adjustment of the royalty was correct it would make an adjustment to decrease the profits of the UK parent by excluding the excessive part of the royalty: see UK treaty article 9(3). Agreements Act s 24 authorises such adjustments in Australia in a converse case. Tax treaties do not provide for secondary adjustments and this is left to domestic law. Division 815 likewise does not provide for such adjustments so they generally do not occur in Australia. A secondary adjustment may also be illustrated by the example above. Although Australia and the UK will have adjusted the price of the royalty downwards, the Australian subsidiary will in fact have paid the excessive part to the UK parent. How is that payment to be accounted for? A secondary adjustment might treat it as a disguised dividend or a return of capital by the Australian subsidiary to the UK parent. The US does make such adjustments. These treaty provisions resulted from a study undertaken by the League of Nations in the 1930s which settled the international norm for allocating profits among related companies or the PEs of the same company as the so-called separate enterprise arm’s length principle (even though the term arm’s length does not nowadays appear in treaties). It was not until 1979 that they were elaborated in detail and then revised from 1995 on in the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators which run to over 300 pages [16.300]

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after 2010 revisions and further substantial revisions are in process, see Section 5 below. While it is simple enough to state the principle, it is another matter to apply it. The Guidelines are designed to provide methodologies for carrying out the exercise. They start with a so-called “functional analysis” of the business of the related parties to specify accurately what functions each performs in the light of assets used and risks assumed. Then comparables are sought using various methodologies that form the heart of the guidelines: • comparable uncontrolled prices or CUPs (if they can be found which is only common for standard commodities like oil); • cost plus, which takes the costs of the enterprise which are paid to unrelated parties and then marks them up by an appropriate profit percentage based on the mark up when comparable items are sold to unrelated parties; • resale price, which can be used, if the enterprise purchases from related parties but sells to unrelated parties, by subtracting an appropriate mark up from the sale price; • profit split, which takes the profit of the related parties from sales to unrelated enterprises and then splits the profit between them using some appropriate key (such as relative salary costs in a service industry); or • transactional net margin method, which compares net profit margins of comparable enterprises (as contrasted to gross profit margins used for cost plus or resale price methods). The first three are traditional transactional methods, while the last two were added in 1995 and differ in being profit-based methods. The Guidelines recognise that pricing is as much an art as a science and that there will often be a continuum or range of possible prices/profits. If taxpayers fall within the central part of the range, pricing adjustments will not be made. They also recognise that it will often be appropriate to aggregate transactions in similar areas rather than dealing with them individually. Various forms of administrative and compliance guidance are provided. Australia has complemented the Guidelines with a series of Rulings on transfer pricing which run to several hundred pages: the major ones are TR 94/14 (general principles), TR 97/20 (methodologies), TR 98/11 (documentation), TR 98/16 (penalties), TR 1999/1 (services), TR 2000/16 (compensating adjustments), TR 2001/11 (permanent establishments) and TR 2004/1 (cost contribution arrangements). These rulings are based on the pre-2013 transfer pricing law in Australia but have not yet been updated to reflect the new law, though there is an important ruling on the substance over form rule found in s 815-130, see TR 2014/6. Although the ATO has always generally accepted OECD guidance in these rulings, a Full Federal Court decision in SNF Australia [2011] FCAFC 74 left the relevance of OECD guidance in Australia in doubt. Moreover, the judge at first instance in that case doubted whether profit methods were permitted under the previous law. This decision was one of the reasons for revision of the transfer pricing rules in 2012-2013 which overcome the potential problems in the old law by closely modelling their language on article 9 of tax treaties and the Guidelines and by expressly adopting the OECD 2010 Guidelines as guidance in interpretation of Div 815-B, see ss 815-125, 815-135. The principles applied to PEs (branches) have, for many years, not automatically followed the approach for separate enterprises even though the language of articles 7(2) and 9 is very similar. Thus it has been accepted wisdom for many years that, with the exception of financial institutions, a branch cannot deduct interest or royalties on notional payments to head office unless the company as a whole has incurred interest or royalties to a third party. By contrast, a subsidiary can deduct interest or royalties on payments to their parent regardless of whether 890

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the parent has incurred similar payments to unrelated third parties. In 2008 the OECD published its final report on the issue which brings about almost total assimilation of the treatment of branches to separate enterprises. Because this approach is quite different from the previous OECD guidance for branches (eg in relation to royalties), the OECD in 2010 rewrote article 7 dealing with allocation of business profits to PEs under tax treaties. If adopted in Australian treaties (which has not occurred to date), this new drafting and approach will likely lead to further changes to domestic transfer pricing legislation which for branches even after the 2012-2013 changes does not construct separate transactions but rather allocates income and expense to achieve a similar result, as noted above. For this reason Div 815-C does not adopt the 2010 version of the OECD Commentary on article 7, but rather the version applicable to the OECD Model as it stood immediately before the 2010 change, ie the 2008 Commentary on article 7, see s 815-215 (the reference to “before 22 July 2010”). As a result of all this OECD activity, a new profession has emerged of transfer pricing specialists, including economists as well as accountants and lawyers. Major multinational companies spend large sums of money developing and documenting their transfer pricing practices to minimise the risk of audit adjustments. Sometimes the taxpayer becomes simply the person in the middle as tax administrations argue over the correct allocation of profits between them. The US is regarded as particularly active in making adjustments and Australia is not far behind. Nonetheless defects exposed in the transfer pricing rules in recent years which allow multinational companies to avoid tax in Australia and other countries, especially in the digital economy, has led to concerted international efforts to repair the international tax rules as discussed in Section 5 below. Despite all this activity and many disputes between the ATO and taxpayers, only three substantive cases on transfer pricing have found their way before Australian tribunals or courts since the last case in 1963, Roche Products v FCT (2008) 70 ATR 703, SNF Australia and Chevron Australia v FCT [2015] FCA 1092 (currently on appeal). [16.305]

Questions

16.16 An Australian company licenses its copyright in a film to its UK subsidiary, which distributes the film in the UK. The royalty charged is below that which would apply between arm’s length parties. Is the cross border test under Div 815-B satisfied and, if so, under which part of the test? May an adjustment of the price be made under Div 815-B? What compensating adjustment, if any, can be made under s 815-B? What impact will the UK treaty have on adjustments in Australia and the UK? Will the Australian adjustments be made under article 9 of the treaty, Div 815-B or both? 16.17 An Australian company sells land and an electricity generator on the land in Australia to an unrelated UK company at below market price. At the same time the UK company sells a similar facility in the UK to the Australian company for below market price. Can adjustments be made under Div 815-B? What about ss 40-180(2) Item 8, 40-300(2) Item 7, 112-20, or 116-30 of the ITAA 1997? What is the order of application of Div 815-B and specific market value rules in domestic law? What is the impact of article 9 of the UK treaty on any adjustments under domestic law?

5. INTERNATIONAL TAX COMPETITION AND COOPERATION [16.330] The difficulties of providing robust rules for the residence of intermediaries, of

sourcing income, of tax havens or other countries seeking to use the tax system to attract activities and of disappearing income have already been referred to. In the 1990s these issues [16.330]

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Income Derived From International Transactions

were addressed by the OECD in a project initially called “harmful tax competition” but subsequently referred to as “harmful tax practices.” The project had a substantive tax policy and law dimension (identifying the criteria for and then reducing the use of harmful tax regimes) and an administrative dimension of increasing tax transparency and improving international tax cooperation. After an initial flurry (see eg OECD, Harmful Tax Competition: An Emerging Global Issue (1998) through to The OECD Project on Harmful Tax Practices: The 2004 Progress Report), this exercise was fading away when the world was hit by the global financial crisis which among other things imposed very large costs on many countries’ governments in rescuing failed banks and created a dire need for tax revenue. As a result the G20, which was the central global body in the response to the crisis, became involved in taxation for the first time and moved tax from being largely a technical bureaucratic exercise conducted by the OECD to a central political issue with the OECD co-opted to provide and coordinate the knowhow required. Initially the G20/OECD focus was on transparency and exchange of information (essentially a tax evasion issue involving hiding money in tax havens with strict secrecy laws) and it turned this issue from a relative failure into a relative success, see (b) below. While this work was occurring investigative journalists and then academic studies began to look at the tax planning of multinational companies and found that many companies (largely from the US and operating in the digital economy initially) were paying little or no tax on their substantial offshore earnings through a variety of tax avoidance strategies. Apart from offering another pot of gold to revenue-starved countries, these strategies raised important fairness and voluntary compliance issues: If individuals were being pursued for hiding money offshore why should multinational companies be allowed to avoid tax and why should individuals bear the burden of fixing the problems of the global financial crisis which had been created by another group of multinational companies, the banks. In late 2012 the G20 requested the OECD to begin another project to deal with Base Erosion and Profit Shifting (BEPS) which combined substantive tax law and policy and transparency – in other words Harmful Tax Practices Mark 2. The basic work on that project was completed very quickly by the end of 2015 and it is now moving into the implementation phase but we will not see many results on the ground until 2017 and later years. In (a) below we look first at whether tax competition is good or bad, and then at the substantive elements of the BEPS Action Plan and the current implementation project. Then we move on in (b) to the ongoing international tax transparency and administrative cooperation project, which is partly within the BEPS project and partly outside it.

(a) Base Erosion and Profit Shifting (i) Is Tax Competition Bad? [16.340] As direct real investment has come to share some of the attributes of portfolio investment and direct investment in the finance sector (such as being highly mobile), source countries have responded by bidding down tax rates, viewing the non-tax benefits from direct investment such as employment, and knowledge transfers, as more than offsetting any tax revenue given up. Indeed, if the direct investment would not have been located in the country in the absence of the tax incentive, no tax revenue is given up. OECD member countries responded to this competition by agreeing in 1998 to a package including strengthening of 892

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residence country tax systems and limits on incentive regimes. The US under President GW Bush rejected this policy (all competition including tax competition is good). The 2009 Henry Review in Australia explored the issue in the following terms.

Australia’s Future Tax System, Report to the Treasurer, Pt 2 vol 1 pp 156-158 [16.350] Targeted responses international tax competition

to

The previous section suggested that there is a case for taxing different types of investments at different rates depending on their international mobility. Many countries tax investments according to their mobility. For example, resources, which generate location-specific rents, are typically taxed at higher rates, while more mobile investments such as research and development are often concessionally taxed. In Ireland, the manufacturing and traded services sectors are subject to a preferential corporate profit tax rate, while developing countries often use tax holidays to attract international investment, and many countries have adopted tonnage taxes for international shipping. The most effective tax instrument for attracting investments generating economic rents that are also highly mobile is a reduction in the tax rate. This would reduce the amount of tax applying to the firm-specific economic rent that the investment generates. However, reducing income tax rates for particular investments would also reduce tax on the normal return to those investments relative to other investments, potentially distorting investment allocation. An alternative approach is to allow eligible investments to be written-off at an accelerated rate. This reduces the tax on the normal return to the investment as opposed to the firm-specific rent, and so is likely to have greater downside costs due to inefficient allocation of investment and the potential for also distorting production decisions within a sector. Another problem with targeted tax concessions is the difficulty of determining which sectors or investments they should apply to, particularly in terms of identifying activities or sectors with significant firm-specific rents. Where tax concessions are inappropriately targeted they

will further adversely distort resource allocation. As such, the use of targeted provisions needs to be based on strong supporting evidence and must be balanced against the distortions they create to investment allocation and the additional compliance and administration costs. … International tax coordination Early efforts at international tax coordination centred on eliminating the double taxation of cross-border investments. Bilateral tax treaties became the primary means of reducing the risk of double taxation, and of reducing other tax barriers to cross-border investment such as tax discrimination and compliance costs. The focus of international tax coordination has now changed. Concerns now centre on the potential impacts of international tax competition and a “race to the bottom” in company and capital income tax rates, in the face of a worldwide decline in company income tax rates in recent decades and the potential for international tax evasion. Competing reductions in source-based capital taxes may arise because the supply of capital to an individual country is more responsive to taxation than the global supply of capital. From a global perspective, however, the consequence of individual countries’ decisions to reduce capital income taxes may be an inefficiently low level of capital taxation that limits their ability to finance public services and undertake redistribution. This characterisation of the effects of international tax competition is not, however, universally accepted. International tax competition is one of the many brakes on increasing taxes, and some argue that this limits the over-expansion of government. There may also be countervailing factors that limit company income tax rate reductions. For example, as economies become more open and the proportion of domestic companies owned by non-residents increases, governments may have [16.350]

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Australia’s Future Tax System, Report to the Treasurer, Pt 2 vol 1 pp 156-158 cont. an incentive to raise company income taxes on the basis that this exports, or at least appears to, part of the tax burden to foreign investors. A radical form of international tax coordination would see countries relinquishing source taxation altogether and only imposing residence-based taxes. However, the constraints on national sovereignty implied by such an approach make it highly unrealistic. An alternative approach would be to permit countries to retain source-based taxation but on a harmonised basis. Tax harmonisation of company income taxes has been discussed within the European Union for a number of years, although with little apparent progress to date. Estimating the potential benefits or costs from international tax coordination is challenging. … Attempts have been made to estimate the impacts of tax harmonisation within a region, in particular Europe. Harmonisation within Europe has been estimated to lead to a modest increase in total welfare, with an increase in GDP of around 0.1 to 0.4%. However, these benefits are estimated to be unevenly distributed between individual countries … The likely divergence in

[16.355]

outcomes, and the fact that the winners are typically those countries that achieve harmonisation by reducing tax rates and revenues (making compensating transfers problematic), suggest the potential for tax harmonisation is limited on a worldwide basis. Harmonising worldwide investment tax bases and rates may therefore be an unrealistic goal, even if it is of potential benefit to Australia (which is unclear). But given the potential costs of a worldwide trend to very low company income tax rates, Australia should not aim to radically cut its company income tax rate ahead of other countries. Furthermore, as discussed previously, the lower the existing company income tax rate and closer it is to that of other countries, the lower the likely benefit from additional reductions. Reflecting the difficulties and uncertain benefits of deeper forms of tax coordination, recent global developments have largely had more limited objectives. These have included shoring up countries’ abilities to impose residence taxation by improving the exchange of information between tax administrations. This more limited approach permits countries to craft their individual tax systems to reflect differences in factor endowments and productivities, and national preferences towards redistribution. …

Questions

16.18 How would you characterise the view of tax competition in the extract – good, bad or both? 16.19 What policies does the extract imply in relation to Australians investing overseas and non-residents investing in Australia? For example, should Australia increase or decrease its tax on Australian companies investing overseas or foreign companies investing in Australia? In its 2016 Budget, the government announced a reduction of the company tax rate to the 25% recommended by the Henry Review, but over a ten year horizon; this was not the first promised rate reduction since 2009 and whether it finally materialises only time will tell. (ii) The BEPS Action Plan [16.360] The G20/OECD was able to largely bypass these policy issues on the grounds of the

need for urgent action in the face of public outcry against tax avoidance. The concerns were partly caused by a number of national enquiries around the world where the heads of prominent companies were questioned at length over their tax planning. In Australia, the local version was the Senate Inquiry into Corporate Tax Avoidance which began in late 2014 and 894

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has to date issued two interim reports; the inquiry was reinstated following the July 2016 federal election and is due to be completed in the second half of 2017. In early 2013 the OECD published a report, Addressing Base Erosion and Profit Shifting describing the nature of the tax avoidance concerns including thinly disguised descriptions of well-known company structures, followed in the middle of the year by OECD, Action Plan on Base Erosion and Profit Shifting which contained 15 action items as follows: 1

Address the tax challenges of the digital economy;

2

Neutralise the effects of hybrid mismatch arrangements;

3

Strengthen CFC rules;

4 5

Limit base erosion via interest deductions and other financial payments; Counter harmful tax practices more effectively, taking into account transparency and substance;

6

Prevent treaty abuse;

7

Prevent the artificial avoidance of PE status;

8

Assure that transfer pricing outcomes are in line with value creation: intangibles;

9 10

Assure that transfer pricing outcomes are in line with value creation: risks and capital; Assure that transfer pricing outcomes are in line with value creation: other high risk transactions; Establish methodologies to collect and analyse data on BEPS and the actions to address it;

11 12

Require taxpayers to disclose their aggressive tax planning arrangements;

13

Re-examine transfer pricing documentation;

14 Make dispute resolution mechanisms more effective; and 15 Develop a multilateral instrument. Apart from the first and last, these action items were grouped into three categories: (i) Establishing international coherence of corporate income taxation (2–5); (ii) Restoring the full effects and benefits of international standards (6–10); and (iii) Ensuring transparency while promoting increased certainty and predictability (11–14). The underlying policy of the second group was essentially a reinforcement of the source taxation principle: that income should be taxed where value is added or created, which has a fairly obvious intuitive policy appeal. The first group wrestled with the more difficult policy problem where income disappeared and often could not be made to reappear on the basis of the value creation principle; the conclusion was that income slipping through structural gaps in the international tax system should be taxed somewhere. The third group was based on the already well established principles of transparency and certainty which are applicable alike to virtually all areas of taxation but pose particular difficulties in international taxation. Action 1 on the digital economy was the fundamental new concern that gave rise to the BEPS project but the final report concluded that the problems could in the first instance be dealt with by changes to existing rules and did not require fundamental restucturing of the international tax architecture. Action 15 concerns the means of implementation of those actions which require changes to tax treaties – a multilateral treaty will enable rapid rollout of treaty changes which otherwise may take decades to negotiate on a bilateral basis. The BEPS project has already generated many thousands of pages of discussion papers, submissions and reports with the reports coming in two tranches in 2014 and 2015. [16.360]

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Income Derived From International Transactions

Nominally the project is now in the implementation phase though there is still much work on substantive tax issues in progress generating more rounds of discussion papers and submissions in 2016. In the remainder of this heading we will discuss the actions which concern issues already canvassed in this chapter; in (b) we will consider the actions on transparency and certainty; and other actions will be considered where appropriate in Chapters 17 and 18. In doing so we will briefly describe the current state of play in Australia (at the end of 2016) on the BEPS Actions though it is an area of rapid development. Dual resident companies: We noted above that the current tax treaty tiebreaker for dual resident companies in the OECD Model Tax Convention is the place of effective management. On the basis that dual residence of companies is usually deliberately created by taxpayers as a tax planning tool, the OECD as part of Action 6 on treaty abuse is removing the tie-breaker for companies from its Model. Instead in future, the Model provision will leave the tax administrations of the states which are parties to a bilateral treaty to agree on the treaty residence, and failing such agreement, the company will not be entitled to benefits under the treaty. In the 2015 treaty concluded by Australia with Germany after the BEPS final reports were published, which generally follows BEPS recommended treaty changes, there is only partial acceptance of this recommendation. Place of effective management is still used as the tiebreaker in the treaty and the need for agreement between tax administrations only arises if that place cannot be determined or is in a third state. Transfer pricing: One of the major BEPS concerns was the failure of transfer pricing rules to locate income where value adding activities occur, with income being shifted by transfers of high value intangibles to low function fatly capitalised entities in tax havens, or by interest payments to such entities. These practices have been sought to be overcome in the final report on BEPS Actions 8–10 by three strategies: giving more emphasis to the economic substance of where value adding activity occurs rather than the legal form of transactions between related companies, allowing at the most a risk-free rate of return to a low function entity, and by allocating income from intangibles based on people functions rather than ownership or financing of the development of intangibles. These changes are to be given effect by a new version of the OECD transfer pricing Guidelines due to be published in early 2017. Australia already has underway the process of incorporating this new version into the domestic law on transfer pricing in ITAA 1997 Div 815-B. Whether the BEPS changes to transfer pricing are only a cosmetic moving of the deck chairs or will produce real effects is being hotly debated in international tax circles. Harmful tax practices: The main concerns here are the regimes introduced by many countries in Europe (including the UK) which grant a low rate of tax to income from intangibles as a way of (allegedly) encouraging research and development (R&D) activity – so called “patent boxes” named after the box on the (Dutch) tax return where such income is recorded. The problem with the regimes is that they do not generally require that R&D activity be undertaken in a country for a taxpayer to benefit from its regime and they are seen by many as a way of encouraging the shift of the tax base from other countries without much shift in activities. Partly the changes in transfer pricing described in the previous paragraph are intended to deal with this problem, but transfer pricing changes were not seen to be enough. Hence as part of Action 5 a nexus test has been adopted for patent box regimes – a country can offer a low tax rate on income from certain intangibles but only if the income has a real nexus with the country measured in a way that is highly detailed in the Action 5 final report. It is intended that over time the nexus test will be rolled out to other tax regimes which are 896

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designed to attract highly mobile income by a low tax rate. Countries in Europe are already moving to modify their patent box regimes. Australia is unaffected by these changes as its R&D tax incentive already has substantial nexus requirements. [16.370] Disappearing income: Tax planning involving transfer pricing depends on different

countries taxing income in different ways, typically at different tax rates. The objective is to move income to a lower tax jurisdiction and deductible expense to a higher tax jurisdiction. The exploitation of differences in tax systems to reduce tax is part of a broader form of tax planning often referred to as tax arbitrage, though the term “arbitrage” in this context may not be an accurate usage. For example, one country may give depreciation deductions to the lessor under a finance lease (which usually occurs in Australia subject to anti-avoidance rules) while another country may give depreciation deductions to the lessee on the basis that the lessee is the economic owner, thus characterising the lease as a sale and loan transaction (the US). If the lessor of the equipment is in the first type of country and the lessee is in the second type of country, then the two taxpayers obtain depreciation deductions against two different income streams which will be advantageous from a tax point of view if each country has accelerated depreciation as an incentive to make investment in equipment. Australia still has accelerated depreciation for certain types of assets such as aircraft, as do many other countries. This type of transaction is commonly referred to as double dipping. Another example arises from entity classification. If an Australian limited partnership with UK limited partners borrows to finance its activities, Australia usually treats the limited partnership as a company under Pt III Div 5A of the ITAA 1936, while the UK treats it as tax transparent and taxes the partners, not the partnership. Hence if the interest deductions exceed income in the early years as is common with new investments, the limited partnership will carry the losses forward for offset against its future income in Australia while the UK partners will immediately under UK law deduct the partnership loss against their other income. Hence the same deductions are again taken against different streams of income. Similar tax planning can occur with different characterisations of debt and equity in different countries. In fact, the range of possible tax planning is only limited by the differences in tax systems between countries. In the case of transfer pricing, it is often clear that a particular country is disadvantaged by the tax planning, and hence it is possible to get international agreement on a solution. For arbitrage more generally, it is not as clear in many cases which country is the loser. For example, in double dip leases each country gives up revenue, which is done deliberately to encourage investment. Could it be argued that the double dip is therefore to be encouraged as it further increases the tax incentive? Certainly the ATO has not seen it as Australia’s function to protect other countries against double dipping as exemplified in Ruling TR 98/21 involving aircraft leases between Australia and the US designed to lower the cost of Boeing aircraft to Australian airlines. Indeed one of the benefits of the double dip arose from a US law designed to indirectly subsidise exports so that US aircraft manufacturers could compete with Airbus. This US measure has since been held to be an illegal export subsidy under trade law and was withdrawn by the US in 2004 to be replaced by other subsidies designed to keep domestic industries in the US. The OECD dealt in passing with arbitrage in the changes to the Commentaries on the Model Tax Convention articles 1 and 23 dealing with partnerships in 2000, and increasingly countries are adopting measures to deal with the practice such as the UK before the BEPS [16.370]

897

Income Derived From International Transactions

project. The BEPS Action 2 final report on hybrid mismatch arrangements represents the most thorough attempt to deal with these kinds of problem to date. Even though it does not cover the field, it is highly complex and essentially works in three stages. First, it encourages countries to change rules which facilitate mismatches. Thus if a country has an exemption for dividends received by resident companies from non-resident subsidiaries (as Australia does in ITAA 1997 Div 768-A) the rule is proposed to be changed so that the exemption is limited to payments which are not deductible in the country of the payer. If a mismatch between countries’ rules remains, then generally the country of the payer is allowed to deny the deduction because of the mismatch. If that does not occur then the country of the recipient denies the exemption, which seems to bring us back to the beginning. The convoluted nature and hierarchy of these rules arise for a number of reasons. As noted above it is difficult to know in the case of disappearing income which country is the loser, and the BEPS response is that one country needs to deal with the problem whether or not it is the loser. The hierarchy tries to bring some order to that process so that the income is not taxed more than once without any double tax relief and also recognises that the US which is a major generator of hybrid mismatch arrangements is unlikely to be willing to change its system so that other countries can then take action (and the tax revenue). Finally the potential for mismatches is almost endless between tax systems so that the resulting law will inevitably be complex. The description here glosses over all of the many difficulties which produced a report of 450 pages, including over 250 pages of examples. In Australia, the government referred the issue to the Board of Taxation which reported before the 2016 Budget in Implementation of the OECD Hybrid Mismatch Rules. The government announced in the budget that it would proceed with legislation to give effect to the OECD recommendations subject to the Board’s qualifications and referred further work back to the Board. It will be some time before the ultimate outcome of this process is known in Australia and in other countries as this is the most complex part of all the BEPS recommendations. In 2016 the OECD is doing yet further work to deal with other mismatches involving PEs. In addition a change to tax treaties has been recommended by the OECD to ensure that the outcomes of its 2000 work on partnerships are accepted by all countries and extended to other hybrid entities besides partnerships such as trusts. The Australia-Germany 2015 tax treaty includes this BEPS recommended provision in article 1(2). Questions [16.375] 16.20 Would articles 3(2) and 24 of the UK treaty deal with the tax planning involving entity

classification of a limited partnership described above? 16.21 Do you consider that hybrid mismatches should be prevented by the international tax system? (iii) Implementation of BEPS Project [16.380] The implementation of the BEPS Action Plan is complex and like the plan itself

represents a significant change in the way international tax norms are implemented in several ways. It has already been noticed that the final report for BEPS Action 2 contemplates that some countries (notably the US) may not implement it. Why can the US ignore BEPS Action 2 and what worth is an Action Plan without political commitment? The answer to the question 898

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highlights one of the new features of BEPS. Although it is a package of measures, BEPS involves different levels of agreed political commitment by countries which is spelt out in the Explanatory Statement released in 2015 along with the final reports.

OECD/G20 Base Erosion and Profit Shifting Project, Explanatory Statement, pp 6, 8-9 [16.390] 11. A comprehensive package of measures has been agreed upon. Countries are committed to this comprehensive package and to its consistent implementation. These measures range from new minimum standards to revision of existing standards, common approaches which will facilitate the convergence of national practices and guidance drawing on best practices. Minimum standards were agreed in particular to tackle issues in cases where no action by some countries would have created negative spill overs (including adverse impacts of competitiveness) on other countries. Recognising the need to level the playing field, all OECD and G20 countries commit to consistent implementation in the areas of preventing treaty shopping, Country-byCountry Reporting, fighting harmful tax practices and improving dispute resolution. Existing standards have been updated and will be implemented, noting however that not all BEPS participants have endorsed the underlying standards on tax treaties or transfer pricing. In other areas, such as recommendations on hybrid mismatch arrangements and best practices on interest deductibility, countries have agreed a general tax policy direction. In these areas, they are expected to converge over time through the implementation of the agreed common approaches, thus enabling further consideration of whether such measures should become minimum standards in the future. Guidance based on best practices will also support countries intending to act in the areas of mandatory disclosure initiatives or controlled foreign company (CFC) legislation. There is agreement for countries to be subject to targeted monitoring, in particular for the implementation of the minimum standards. Moreover, it is expected that countries beyond the OECD and G20 will join them to protect their own tax bases and level the playing field. …

19. The past decade has seen the rapid expansion of the digital economy, and today it is increasingly the economy itself; therefore a ringfenced solution to the tax challenges it poses is not appropriate. BEPS risks are however exacerbated by the digital economy, and the measures developed in the course of the BEPS Project are expected to substantially address these risks. The key features of the digital economy have in fact been taken into account across the BEPS Project, in particular the changes to the permanent establishment definition, the update of the Transfer Pricing Guidelines and the guidance on CFC rules. … The work also considered several options to address the broader tax challenges raised by the digital economy, including a new nexus in the form of a significant economic presence. None of these options were recommended at this stage. This is because, among other reasons, it is expected that the measures developed in the BEPS Project will have a substantial impact on BEPS issues previously identified in the digital economy, that certain BEPS measures will mitigate some aspects of the broader tax challenges, and that consumption taxes will be levied effectively in the market country. Countries could, however, introduce any of these options in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties. OECD and G20 countries have agreed to monitor developments and analyse data that will become available over time. On the basis of the future monitoring work, a determination will also be made as to whether further work on the options discussed and analysed should be carried out. This determination should be based on a broad look at the ability of existing international tax standards to deal with the tax challenges raised by developments in the digital economy.

[16.390]

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Income Derived From International Transactions

[16.400] There is a fourfold level of political commitment in para 11. All countries are fully

committed to four new standards relating to parts of Actions 5, 6, 13 and 14. While existing standards (represented by Actions 7–10 on the OECD Model PE definition and the transfer pricing Guidelines) have been updated it is made clear that not every country has committed to the changes. Note that the dissentients are not named as such but the more prominent are often well known from other BEPS related sources: at least the US in the case of the PE definition and Brazil in the case of transfer pricing. The third level of commitment, here on Actions 2 and 4, is where there is convergence, meaning most countries are willing but not enough to make a standard – yet. No country is politically committed in these cases but most will nonetheless adopt the OECD recommendations. As Action 2 is not a standard the fact that the US is unlikely to adopt it does not matter in a political sense, but as we have already seen Action 2 is designed in such a way that inaction is likely to come at a revenue cost to the US. Finally there is recommended best practice which involves no level of political commitment or expectation: Actions 3 and 12 on CFC regimes and transparency measures to deal with aggressive tax planning are in this category. Nonetheless it is already evident that several countries including Australia are likely to adopt Action 12. Just as importantly as how the political commitments are structured is para 19 which permits countries to take action in the digital economy area on measures which were considered but not at this stage recommended by the BEPS project. India has already acted with a tax paid by Indian advertisers on international websites and it seems likely that the permission granted to act unilaterally was at the request of India. In addition domestic law anti-avoidance measures being taken in Australia and the UK may also be justified on the basis of this statement: see Chapter 18. The final twist in the level of political commitment which is not obvious from the extract but is everywhere evident in the details of the final reports themselves is the significant degree of optionality, flexibility and alternatives provided at all levels of commitment in implementing BEPS, which is designed to allow countries to get to the same objective by different routes. The mechanisms for implementation are (relatively) new in two directions: first, many of the recommendations require substantive changes to domestic tax law; and secondly, many of the treaty changes will be effected by a multilateral treaty rather than bilateral treaties. Both of these approaches have been seen recently in the G20/OECD work on transparency, see (b) below, but this is the first time there is political commitment to changes in the area of substantive tax and treaty law on a significant scale. Countries including Australia are already working on the domestic law side and the multilateral treaty (usually referred to as the multilateral instrument or MLI) was released in November 2016 with a large signing ceremony to be held in June 2017. Signature will require commitment to certain provisions on treaty abuse and there are several other optional treaty provisions for countries to adopt if they wish. How the MLI will interact with existing bilateral tax treaties and when optional commitments will be binding between particular pairs of countries are complex issues. Australia’s initial position appears in a December 2016 Treasury consultation paper and proposes adoption of most of the MLI provisions.

900

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Because implementation is a very large project and involves significant domestic law changes, a peer review process along the lines already used for transparency is indicated at the end of para 11 in the extract. The results of this process will start becoming public in 2017. The success of BEPS, like transparency more generally, is premised on widespread adoption by countries, not just the 44 countries represented by the OECD and G20. To this end already in 2015 an additional 17 developing countries had seats at the BEPS table and in 2016 the OECD has launched the “inclusive framework” which permits countries willing to commit to BEPS to be involved in the ongoing work. Over 100 countries have become involved in BEPS with the number rising regularly. Apart from the other new ground being broken, BEPS is taking the OECD tax work global and is a recognition of the ongoing geo-political realignment that is demonstrated in the following graph, Australian Treasury, Implications of the Modern Global Economy for the Taxation of Multinational Enterprises: Issues Paper (Canberra 2013), p 10:

Question [16.405] 16.22 There are widely divergent views on whether the BEPS project represents a significant change to international taxation and whether it is likely to solve the problems of tax avoidance which are its targets. Does BEPS represent a revolution or evolution of the international tax framework?

[16.405]

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Income Derived From International Transactions

(b) Transparency and Administrative Cooperation [16.410] As noted at the start of the chapter, tax administration across borders is inherently

more difficult than administration within a country. To some extent, countries can seek to bolster domestic rules to deal with international situations. For example, Australia has a procedure in s 264A of the ITAA 1936 copied from the US for offshore information notices. Under this provision, the ATO can give a taxpayer notice seeking the production of information held offshore with which the taxpayer has 90 days to comply. If the taxpayer does not comply, then the information cannot be produced by the taxpayer in any subsequent dispute concerning an assessment on the taxpayer, whether or not the information is protected by a foreign secrecy law. One important function of tax treaties (indeed, the most important function from the perspective of the tax administration) is to permit tax administrations to cooperate across borders and to provide for a method of dispute resolution between tax administrations and taxpayers which involves the affected countries. (i) Exchange of Information and Transparency [16.420] All of Australia’s tax treaties contain provisions allowing Australia to exchange

information about taxpayers with the treaty partner. Without this provision, exchange would be a breach of the provisions on secrecy of taxpayer information in Taxation Administration Act 1953 Sch 1 Div 355. Although the treaty article is relatively brief and has some safeguards, it can be extremely potent in operation. Australia for some years has routinely exchanged bulk information using information technology under an OECD standard format with a number of treaty partners concerning such things as dividends, interest and salaries paid to persons who are apparently residents of the other state. In addition, under the power to exchange information, Australia has entered into a number of administrative agreements with other treaty partners (such as New Zealand and the US) which permit joint audits of taxpayers or groups of related taxpayers including the attendance of Australian tax officials at the examination of taxpayers of interest to them by tax officials in the other country. Two major problems have existed with the traditional exchange mechanisms. First, identifying the person in the other state can be difficult, as there will be no taxpayer identification number which is common in both countries – just name and address information. The OECD has been working for some years to overcome the problems of identification through unique taxpayer numbering systems. Secondly, traditionally there have been no treaties and hence no exchange of information with tax havens so that by routing transactions through tax havens, taxpayers can break the information chain. One of the major outcomes of the OECD harmful tax competition/practices project has been commitments by all the major tax havens around the world to enter into exchange of information agreements with OECD members and to give up bank secrecy as part of such agreements. The OECD created a model tax information exchange agreement (TIEA) for this purpose in 2002 and Australia and other countries started negotiating these agreements. In addition, the OECD updated the OECD Model Tax Convention and Commentaries in 2004 as part of a broader exercise to improve information exchange among OECD members. These changes established an international standard for exchange of information containing the following elements: • Exchange of information on request where it is “foreseeably relevant” to the administration and enforcement of the domestic laws of the treaty partner; 902

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• No restrictions on exchange caused by bank secrecy or domestic tax interest requirements; • Availability of reliable information and powers to obtain it; • Respect for taxpayers’ rights; and • Strict confidentiality of information exchanged. Initially, progress on negotiating TIEAs with tax havens was slow, but as noted above, the global financial crisis led to the G20’s first major involvement in taxation dealing with international tax evasion. It adopted the standard and the OECD indicated that 12 information exchange agreements meeting the standard (in the form of TIEAs or the 2004 changes to the OECD Model) were necessary for a country to be regarded as complying with the international standard. This led to a mad scramble on the part of tax havens and some OECD countries to negotiate agreements meeting the standard with the result that the number of agreements rocketed as indicated in the following chart.

Source: OECD, The Global Forum on Transparency and Exchange of Information for Tax Purposes: Information Brief (14 September, 2011).© OECD. Australia currently has 36 TIEAs and 43 comprehensive bilateral tax treaties with exchange of information rules, which have been updated where necessary to bring them into line with the international standard. Unlike comprehensive bilateral treaties, TIEAs are not individually implemented by legislation; instead there is a general authorisation to the ATO to exchange information under such agreements in Agreements Act s 23. It is one thing to enter such agreements and another for them to work effectively in terms of domestic laws and administrative mechanisms. The Global Forum on Transparency and Exchange of Information for Tax Purposes was created (staffed by an OECD-based Secretariat) to monitor and review implementation of the standard by a peer review process. This led to a much fuller formulation of the international standard for exchange of information in the form of a handbook and each country is now ranked against the standard on the basis of its domestic law and administration and treaty instruments for exchange on [16.420]

903

Income Derived From International Transactions

information. The peer review by the Global Forum of Australia in 2010 concluded that Australia complied in all respects with the international standard and practice for information exchange. The country reviews are publicly released and the OECD also releases an overall ranking of all countries involved in the process with over 100 countries receiving ranking in four groups from compliant to non-compliant. Although peer pressure to date is the only enforcement mechanism that has been publicly applied, it appears to be effective as demonstrated in 2016 when the public leaking of the Panama papers detailing the activities of a law firm facilitating tax evasion and the resultant public reaction forced Panama to renew its commitment to the process. As with BEPS, investigative journalists have played an important part in keeping the pressure on countries to comply with the international standard. [16.430] The next stages in the development of transparency coincided with the BEPS project

(2013 to date) and occurred both inside and outside that project. The systemic addition to exchange of information between countries has been a new international standard on automatic exchange of particular kinds of information as compared to exchange of information on request discussed above. The major changes not necessarily involving exchange of information with other countries have been an increase in information provided to the local tax administration and the public release of tax information about large taxpayers, particularly multinational companies. At the same time there has been a shift in the international treaty structure on which exchange of information is based. Rather than exchange of information provisions within general bilateral tax treaties and bilateral TIEAs, the main instrument now is the multilateral Convention on Mutual Administrative Assistance in Tax Matters. This treaty is a product of the OECD and the Council of Europe and was opened for signature in 1988. It took until 1995 for the requisite five signatures to be obtained before the treaty came into force and in the ensuing 15 years there was only a handful of additional signatures. In 2010 the treaty was revised to meet the latest OECD standard and in 2011 the G20 members committed to the treaty (with Australia signing at this time). Now there are over 100 signatories. This treaty effectively supersedes the bilateral treaties even though they remain in force. Within BEPS, Actions 5 and 13 include elements on automatic exchange of information. Under Action 5 tax administrations are now required to exchange private rulings on international tax matters they have given to taxpayers with other countries affected by the rulings. This element was agreed at the G20 Leaders meeting in Australia in 2014 and is now in operation. It was partly driven by the Lux Leaks, which involved the public leaking of favourable transfer pricing rulings that a major accounting firm had obtained for taxpayer from Luxembourg in relation to the kinds of tax avoidance structures targeted by the BEPS project. Subsequently, the Netherlands and Ireland were also implicated and the European Commission is now attacking these rulings under EU state aid rules, which may lead to large payments of tax for past years. Forcing countries to exchange private rulings with other countries means they are much less likely in future to use favourable private rulings as a means of tax competition. BEPS Action 13 concerns transfer pricing documentation which large multinational groups have to provide to tax administrations to assist them in assessing the risk of inappropriate transfer pricing by a group; it consists of three elements, the master file outlining the global operations, the local file describing in much more detail local operations in the relevant country and the Country-by-Country (CbC) report detailing critical financial information on a 904

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CbC basis. The last is filed only in the home country of the multinational group and then is exchanged automatically under strict confidentiality conditions with other countries which have signed a multilateral mutual agreement to that effect (approaching 50 countries by end-2016). Australia introduced ITAA 1997 Div 815-E in 2015 to facilitate its participation in this process. The other and most important automatic exchange of information concerning financial account data originates with the US. As a result of a whistle-blower providing information to US authorities about the marketing of tax evasion schemes in the US by Swiss bank UBS, the US enacted the Foreign Account Tax Compliance Act in 2010, commonly known as FATCA, requiring foreign banks and other financial institutions to disclose to the US Internal Revenue Service (IRS) details of accounts and investments held through them by US citizens and residents, with significant consequences for not complying. Many other countries regarded this measure as extra-territorial and in many cases it would force banks etc to breach local laws where they operated. Hence the US and a group of European countries worked out an alternative process of having banks etc first provide the information to the local tax administration (which already occurs as a matter of course in many countries) and then an automatic exchange of that information between the local tax administration and the IRS. Two model agreements called Inter-Governmental Agreements (IGAs) were developed, one with a two way exchange (to and from the IRS) and one with a one way exchange (to the IRS only). The US has signed many IGAs (now covering well over 100 countries) and the system started in 2014. Australia signed a two way IGA in 2014. As most countries were signing two way IGAs, it was a natural step to extend this process to automatic exchanges between other countries (ie not involving the US on one side of the exchange). The OECD announced and the G20 adopted this process in 2013 and what is known as the Common Reporting Standard (CRS) involving two way automatic exchanges among the countries involved was developed, generally under the multilateral treaty referred to above. CRS commences operating in 2017 in Australia and over 90 other countries are committed to CRS. Building the systems to operate the IGAs and the CRS is an extremely complex and expensive process for tax administrations and reporting entities alike. Taxation Administration Act 1953 Sch 1 Div 396 facilitates the operation. The rules seem, however, already to have an impact with several countries, including Australia, running amnesties to encourage taxpayers to disclose offshore accounts before the new systems uncover them. In terms of disclosure of information to local tax administrations, the IGA and CRS systems in many cases involve the collection of much more information than occurred in the past that can be relevant to local taxes as well as foreign taxes. The main impact of BEPS in this regard is Action 12 on aggressive tax planning. On 3 May 2016, the Australian government announced that it will consult on the framing of mandatory disclosure rules on aggressive tax planning in the Australian context as recommended by Action 12 and a Treasury Discussion Paper, OECD Proposals for Mandatory Disclosure of Tax Information, was released. No further action has occurred at the time of writing this book. There has, however, been much more action in relation to publication of tax information about multinational and other companies, partly inspired by the BEPS project but not directly part of it. As noted above the CbC report is subject to strict confidentiality. There has been strong pressure, especially from NGOs, to publish this information but the OECD did not give in, largely to ensure the cooperation of the US in the process. That confidentiality does not prevent individual countries publishing information obtained by other means and in some [16.430]

905

Income Derived From International Transactions

countries tax returns are already public information. Australia is one of the countries that has moved in this direction. In 2013, s 3C of the Taxation Administration Act 1953 was enacted requiring the ATO to publish details drawn from Australian tax returns of total income, taxable income and tax payable by entities with total income of $100 million or more ($200 million or more in the case of resident private companies as a result of subsequent amendments). The first data was released in December 2015 for the 2013-2014 income year with regular releases for later years to occur in due course. Further, Australia has adopted a Voluntary Tax Transparency Code under which companies voluntarily agree to publish tax information (though with a threat from the government to make it compulsory if there is not a significant take-up). The Board of Taxation maintains a list of companies that have agreed to participate and the companies themselves publish the information. To facilitate collection of the information in one place, the companies report the information to the ATO which publishes it on data.gov.au. There was already a similar voluntary system operating in the resources sector, the Extractive Industries Transparency Initiative, which continues in operation. (ii) Assistance in Collection [16.440] In 2003 the OECD introduced a new article 27 into the Model Tax Convention

dealing with assistance in collection of foreign taxes (which overrules the private international law rules generally prohibiting this). Under this article, one tax administration actually collects tax debts owing to the other tax administration. Australia entered into its first such agreement with New Zealand in 2005 and it is now part of Australia’s tax treaty policy, supported by domestic legislation in Taxation Administration Act 1953 Sch 1 Div 263. Assistance in collection is also covered by the multilateral Convention on Mutual Administrative Assistance in Tax Matters but it is an optional part of that treaty and most countries reserve on the application of the collection provisions under article 30. Australia did not make such a reservation with the result that assistance may be provided by Australia to another country or by another country to Australia under the treaty only if that other country also did not reserve on the collection provisions. As the US reserved on collection and the UK did not, the result is that collection is available with respect to the UK but not to the US under the multilateral treaty, though there is a very limited form of collection assistance in article 25(5) of the US Treaty which is supported by s 20 of the Agreements Act. The multilateral treaty does not achieve a great deal more than the OECD Model assistance in collection provision, although it is more detailed in many respects. (iii) Dispute Resolution [16.450] The OECD Model Tax Convention contains the mutual agreement procedure in

article 25 commonly referred to as MAP, which provides a procedure for taxpayers to request the tax administrations of two countries to consult and seek to reach agreement if the taxpayer claims to be taxed not in accordance with the treaty. The tax administrations are obliged to consult but not to agree under the provision so that it is often seen as ineffective by taxpayers (as well as very time consuming). It is an increasing feature of international economic law that binding dispute resolution procedures are being put in place, and tax finally followed suit when the OECD adopted an arbitration provision as an addition to MAP in its Model treaty in 2008 and suggested a procedure for countries to achieve a similar result under existing tax treaties. 906

[16.440]

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Since 1995 there has been an Arbitration Convention within the EU for resolving transfer pricing disputes, and the first arbitrations have taken place. It is not necessary that there be a large number of arbitrations to prove the success of providing for arbitration – the idea is that the mere existence of the procedure will often pressure tax administrations to agree under the MAP rather than becoming involved in a costly arbitration. Australia concluded its first tax treaty covering arbitration with New Zealand in 2009 (followed by Switzerland in 2013 and Germany in 2015) but has not yet been involved in any arbitrations. The final report on BEPS Action 14 deals with dispute resolution and has established a new standard in the area designed to make MAP more effective with countries agreeing to: • join the MAP forum established by the Forum on Tax Administration, which gathers together the heads of the tax administrations of 46 countries, • report MAP statistics to it and agree to have their MAP performance monitored by peer review; • sign treaties based on the OECD Model (apart from arbitration and with some slight variations permitted), giving taxpayers access to MAP, in particular for transfer pricing and not declining MAP on the grounds of tax avoidance; • resolve MAP cases on a timely basis (an average of 24 months); • set up appropriate processes with sufficient staffing and public guidance, and avoiding performance indicators for MAP staff based on revenue collections, along with a number of other detailed, and measurable, rules. In addition 20 OECD countries (including Australia) agreed to sign up to mandatory arbitration, which has now been included as an option in the MLI releaed in November 2016. Despite the criticisms of MAP which should be addressed by the adoption of the BEPS minimum standard and binding arbitration, MAP has many advantages because of its informality and flexibility. Nowhere is this better seen than in relation to Advance Pricing Arrangements or Agreements (APAs). These are agreements in advance (similar in some ways to private rulings) between taxpayers and the tax administration sanctioning a particular transfer pricing methodology in detail and thus protecting the taxpayer from subsequent adjustment, so long as the agreement is complied with. Using exchange of information powers and MAP, it is possible to have the tax administrations of two or indeed several countries sign onto the same APA for all companies concerned. The first such bilateral APA was between Australia and the US in relation to Apple, and since then they have become common in highly integrated activities like global trading by financial institutions. They have largely remained the preserve of large companies because of the expense they involve. In future, they may become the major instrument for dealing with transfer pricing problems. (iv) Other International Tax Cooperation [16.460] Parallel with these OECD exercises has been more cross-country tax cooperation

and a concerted attack on tax evasion through tax havens. The multi-agency Project Wickenby in Australia, the purchase by Germany of bank information from a disgruntled employee of a Liechtenstein bank which has found its way to Australia among other countries, and the US led attack on Swiss banking practices are some of the more public manifestations of this new approach, as well as the disclosures of tax planning by multinational companies related to the BEPS projects. One upshot not covered above is the OECD Oslo Dialogue on Tax and Crime, which focuses on a whole of government approach to fighting tax crimes and illicit financial flows. The third tax related area where the G20 has joined with the OECD is another [16.460]

907

Income Derived From International Transactions

transparency measure to require the disclosure of the ultimate owner/controllers of all legal entities, which covers money laundering and corruption as well as tax issues. In addition, many tax administrations are working together to deal with tax avoidance more generally. In May 2004 the ATO announced the Joint International Tax Shelter Information Centre (JITSIC) Memorandum of Understanding which was expanded in 2007. During this period JITSIC was based in Washington DC and London and involved Australia, Canada, Japan, the UK and the US. From 2014 through the Forum on Tax Administration, JITSIC has expanded to 36 countries, been renamed the Joint International Taskforce on Shared Intelligence and Collaboration and moved into the OECD and Paris-based Secretariat of the Forum. It was largely responsible for coordinating the international response to the leaking of the Panama Papers in 2016.. [16.465]

Questions

16.23 Under the UK treaty article 27, can Australia collect information for the UK using a procedure for which there is no equivalent under UK law? What is the purpose of article 27(2)? Can Australia collect information that is relevant to both income tax and GST, and send it to the UK for use in income tax and VAT enforcement? 16.24 What is the difference between articles 26(1) and 26(3) of the UK treaty? What is the purpose of article 26(4)? 16.25 Do you think that tax havens will cease to be a problem now that once they have committed to exchange of information on request and automatically? Will they still give rise to harmful tax practices? 16.26 Has the relentless focus on a wide variety of tax avoidance and evasion issues by the G20 and OECD in recent years gone too far and undermined a fair balance between taxpayers’ rights and obligations?

908

[16.465]

CHAPTER 17 Taxation of Residents [17.10]

1. OVERVIEW OF THE INTERNATIONAL TAX RULES FOR RESIDENTS ..... ......... 910

[17.20]

2. TEMPORARY RESIDENTS .................................. ........................................... 911

[17.30]

3. THE EXEMPTION REGIMES ................................ ........................................ 912

[17.40]

(a) Income Derived Through Foreign Permanent Establishments of Australian Companies ............................................................................................................... 912

[17.50]

(b) Dividends and Non-Share Dividends from Foreign Companies ............................ 912

[17.60]

(c) Capital Gains on Shares in Foreign Companies .................................................... 913

[17.80]

4. THE FOREIGN INCOME TAX OFFSET REGIME ................... ......................... 913

[17.100] 5. THE DEDUCTION REGIME................................. ......................................... 915 [17.110]

6. THE ATTRIBUTION REGIMES ............................... ....................................... 916

[17.120]

(a) The CFC Regime .................................................................................................. 916

[17.140]

(b) The Transferor Trust Regime ................................................................................ 918

[17.170] 7. DEDUCTIONS AND THIN CAPITALISATION..................... ........................... 919

Principal Sections ITAA 1936 s 23AH

ITAA 1997 –

s 23AI

–

s 768-5

–

Div 768-G

–

Div 770

Pt X Div 6AAA

– –

Effect This section excludes active income from a foreign permanent establishment of an Australian resident company from the assessable income of the company. This section excludes income that was previously attributed to a resident taxpayer under the CFC attribution regime. This section excludes participation dividends and non-share dividends on equity interests from assessable income of resident companies. This subdivision excludes capital gains of an Australian resident company on share participations in foreign companies from CGT to the extent of their active assets. This division provides a foreign income tax offset for foreign income tax imposed on assessable income. This Part contains the CFC attribution rules. This Division contains the transferor trust attribution rules

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Income Derived From International Transactions

1. OVERVIEW OF THE INTERNATIONAL TAX RULES FOR RESIDENTS [17.10] Like many countries, Australia imposes tax on income derived by residents from

sources both in the country and abroad (worldwide taxation), while non-residents are only subject to tax on their income from sources within the country. The overlap of resident and source-basis taxation means that there will inevitably be a risk of double taxation whenever there is a cross-border investment or international business activity. The residence country will claim a right to tax the income by virtue of the taxpayer’s residence and the source country will claim a right to tax the income by virtue of its income source taxing rights. There are three policies used to guide the design of a country’s international tax rules in response to the problem of double taxation. The first is the “capital export neutrality” principle. This principle suggests the highest global welfare will be achieved if the tax system is completely neutral as between domestic and overseas investment by residents – the same level of tax will be levied wherever income is earned and resident taxpayers will decide between alternative investments solely on the basis of commercial criteria, namely risk and return. Capital export neutrality is achieved if foreign-source income of Australian residents is taxed similarly to domestic-source income, but a foreign income tax offset (FITO) is given for foreign taxes so the total tax generally will not exceed Australian tax. Capital export neutrality can only be fully achieved through a FITO mechanism if foreign taxes are equal to or lower than Australian taxes. If the foreign tax rate is higher than the Australian tax rate, true capital export neutrality would require the Australian government to refund foreign taxes in excess of the Australian tax. No country adopts such a policy, however. To do so would only invite foreign jurisdictions to levy excessive taxes on investors from abroad. The second policy is the “capital import neutrality” or “capital ownership neutrality” principle which suggests Australian residents should be subject to no higher taxes on income from a foreign jurisdiction than anyone else investing in the jurisdiction. Under this model, Australia would exempt foreign-source income from tax so Australians would be on an even footing with all other investors in that jurisdiction, including locals. At first glance this system looks like levying tax only on a source basis (ie giving up worldwide taxation of residents) but there are a number of differences between the two. First, exemption systems often only operate if the income is actually subject to tax in the foreign country. If such a test requires that the foreign tax be similar in level to Australian tax, the system is effectively a simplified FITO system, rather than a true exemption system as noted in Chapter 16. Secondly, to preserve the progressivity of the individual tax system, a system of exemption with progression is often applied to individuals. Under this system, tax is first calculated on worldwide income, the average rate of tax on that income is derived from this calculation and then that average rate is applied to the income which is not exempt from tax under the exemption system. This has the effect of raising the tax rate on domestic income above what it would be if the foreign income were simply exempt, and in effect prevents income splitting (see Chapter 13) being produced by arranging to derive income partly from Australia and partly from overseas. A third policy is “national neutrality.” This principle presumes that taxes paid to foreign governments yield no direct benefits to Australia, and Australian welfare will be maximised if no offset is provided for any foreign taxes levied on foreign-source income derived by Australians. Instead, foreign taxes should simply be treated as another cost of doing business and if Australians wish to invest overseas instead of in Australia, they should seek a higher rate of return abroad than they could obtain here to compensate for the fact that the foreign income will be subject to foreign tax which produces no welfare benefit for Australia. Under a 910

[17.10]

Taxation of Residents

CHAPTER 17

national neutrality model, foreign-source income of residents would be taxable in Australia and any foreign taxes or any other expenses incurred to derive the income would be allowed as deductions. No single policy guides the design of the Australian rules to relieve double taxation. In some cases, foreign income is assessed but taxpayers can claim FITOs for foreign tax levied on the income. In some cases, foreign income is exempt from Australian taxation. In some cases, foreign income net of foreign tax is assessable – the equivalent of allowing a deduction for foreign income tax. Until 1930 Australia taxed on a source-only basis. In that year worldwide taxation of residents was adopted but with a broad exemption system for foreign income subject to tax in a foreign country. In 1987 Australia moved to a FITO system but retained an exemption with progression system for foreign employment income. In 1990 Australia substantially moved back to an exemption system for active foreign business income that was subject to tax levels comparable to Australian tax in foreign countries (essentially a simplified FITO system). In 2004 Australia moved to a full exemption system for active foreign business income by removing the subject to equivalent tax requirement. Thus, at least for active business income, Australia’s policy can broadly be classified as capital import/ownership neutrality from 1930–1987 and since 2004, and capital export neutrality in the period 1987–2004. Nonetheless, for income derived through companies, at least since 1987, there has been effectively a national neutrality system with respect to foreign income as explained below.

2. TEMPORARY RESIDENTS [17.20] It was explained in Chapter 16 that special rules apply to a category of resident

known as “temporary residents”. These are persons with relatively temporary ties to Australia – primarily expatriate employees or contractors seconded to positions in Australia for a limited period – but who would satisfy the definition of resident for income tax purposes. The redistributive rationale for imposing a progressive income tax on the world-wide income of these persons whose real “homes” lie elsewhere is weak, and administrative and compliance problems are created for the expatriate and their employers. Accordingly, a special set of rules, found in ss 768-905 to 768-980 of the ITAA 1997, has been devised for this category of residents, with the broad intention of treating temporary residents similarly to non-residents for tax purposes. In effect, most types of their non-Australian income are exempt from Australian tax. A person’s status as a temporary resident is determined in the first place by the person’s visa status, with supplementary tests looking at their social security status. Surprisingly, there is no time limit on duration of a temporary residence status for tax purposes. Thus, provided the appropriate visa is renewed regularly, a “temporary” resident can be present in Australia for an indefinite period. Not all foreign-source income derived by qualifying temporary residents is exempt from Australian income tax. Foreign-source employment and services income remains taxable, just as it would be for ordinary residents. This rule is intended to deny temporary residents a competitive advantage when performing employment duties or service contracts abroad. Temporary residents are treated similarly to non-residents for capital gains tax purposes, including the loss of the CGT discount: see Chapter 18. As a result, generally only capital gains realised on the sale of land or land-rich companies (where the majority of the value of the company is attributable to the company’s direct or indirect interest in Australian land) will be [17.20]

911

Income Derived From International Transactions

assessable to temporary residents. Further, as many temporary residents will retain ownership of their home in their country of origin and that home will be subject to a mortgage to a bank in that country, the interest paid by the temporary resident to the bank is relieved of the interest withholding tax that would otherwise apply: see Chapter 18.

3. THE EXEMPTION REGIMES [17.30] The most important regimes in terms of the amount of income concerned are the

exemption systems which apply to active foreign business income. Accordingly we consider them first at (a)–(c) below. Together these three exemptions for Australian companies are often referred to as the participation exemption because they effectively exempt the three main ways an Australian company with foreign direct investment can realise income from their investment.

(a) Income Derived Through Foreign Permanent Establishments of Australian Companies [17.40] From 1990 to 2004 Australia provided an exemption more or less equivalent to a

FITO for income derived through foreign permanent establishments (PEs) of Australian resident companies. The equivalence arose because the income was in effect required to be subject to an equivalent tax to that in Australia on the income. In 2004 following from the Board of Taxation, International Taxation: A Report to the Treasurer (2003) Vol 1, Australia moved from a capital export neutrality policy basis to a capital import/ownership neutrality basis for active business income of Australian resident companies. As a result, under s 23AH of the ITAA 1936, income of an Australian company derived through a PE in another country is exempt from tax whether or not it is taxable there, with the exception of low-taxed passive income (technically it is non-assessable, non-exempt income but the effect is generally the same). In determining what is passive income for this purpose, the controlled foreign company (CFC) rules are in effect incorporated in the provision on the assumption that the foreign PE were a CFC (see [17.120]). For capital gains, the exemption applies if the asset in question was used wholly or mainly in the PE. Similar results apply for income derived by Australian companies through PEs of trusts and partnership in foreign countries. [17.45]

17.1

Question

As discussed in Chapter 18, income of Australian resident shipping and airline companies such as Qantas derived from foreign sources is exempt from foreign tax under tax treaties. How does s 23AH of the ITAA 1936 deal with such income if derived through a PE in the foreign country? Why?

(b) Dividends and Non-Share Dividends from Foreign Companies [17.50] The exemption for comparably taxed income of foreign PEs of Australian companies

was approximately matched under s 23AJ of the ITAA 1936 in the 1990–2004 period by an exemption for dividends paid from comparably taxed income of foreign subsidiaries of Australian companies (defined in terms of holding 10% of the voting power in the subsidiary). In 2004 following the Board of Taxation report, this exemption was equally widened to include income of foreign subsidiaries whether or not it was taxed in the foreign country, with the effective exception of low-taxed passive income caught by the CFC regime (again 912

[17.30]

Taxation of Residents

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technically it is non-assessable, non-exempt income). In 2014, the exemption was moved to ITAA 1997 s 768-5 and changed in three significant ways. First, it now adopts the debt equity rules (see Section 3 of Chapter 14) and so does not apply to dividends on shares which are debt interests but does apply to non-share dividends on non-share equity. Secondly, the 10% test now includes dividend or voting rights whichever is higher, rather than just voting rights. Thirdly, it is made clear that the exemption applies where the resident company holds its interest in the foreign company through interposed partnerships or trusts. As a result of the BEPS project (see Chapter 16 Section 5), the exemption is to be narrowed so that it does not apply when the dividend or non-share dividend is deductible in the country of the payer company: see Board of Taxation, Implementation of the OECD Hybrid Mismatch Rules (2016) pp 28–29 which was accepted by the government in the 2016 Budget. [17.55]

17.2

Question

An Australian bank which does not have a PE offshore is considering making a loan to a company in the UK. It is suggested that the Australian bank should form a subsidiary in a tax haven with share capital equal to the loan. The subsidiary would then make the loan to the UK company and pay any interest received as a dividend to the Australian bank which would claim an exemption under s 768-5 of the ITAA 1997. Is such an arrangement effective? (See TD 2011/22 in relation to the predecessor of s 768-5.)

(c) Capital Gains on Shares in Foreign Companies [17.60] Prior to 2004 there was no equivalent exemption for capital gains on shares in foreign

subsidiaries of Australian companies. Hence there was a strong incentive for Australian companies to extract income from foreign subsidiaries via dividends rather than capital gains. In turn the ATO sought to apply the general anti-avoidance rule to cases where it considered that a capital gain should have been realised, although the Full Federal Court rejected its application in the only case to reach court on the matter: RCI v FCT [2011] FCAFC 104. Following the Board of Taxation 2003 report on international taxation which led to significant changes to ss 23AH and 23AJ of the ITAA 1936 outlined above, capital gains on shares in foreign subsidiaries are treated similarly to remove the bias in favour of dividends. This treatment applies to capital gains realised on the disposal of shares from a non-portfolio holding (using the 10% voting test) in a foreign subsidiary. Subdivision 768-G reduces the capital gain otherwise realised by a percentage that reflects the degree to which the assets of the foreign company are used in an active business. The ATO considers that this reduction does not apply for shares held through partnerships and trusts, TD 2008/23. When s 23AJ was replaced with significant changes in 2014, no equivalent changes were made to Div 768-G.

4. THE FOREIGN INCOME TAX OFFSET REGIME [17.80] The FITO regime generally applies to relieve double taxation arising from foreign

income tax if one of the exemptions outlined above is not applicable, and thus is important to many taxpayers – particularly individuals as the exemptions apply only to Australian resident companies. The FITO is provided through Div 770 of the ITAA 1997 operative from 2008. The main operative provision is s 770-10 which grants a tax offset for foreign income tax imposed on assessable income. The credit is non-refundable, non-transferable and cannot be carried forward to a later year if it exceeds tax payable in the year: see s 63-10(1) of the ITAA 1997 Table Item 20 – the Table also sets out the order in which offsets are used to reduce [17.80]

913

Income Derived From International Transactions

income tax otherwise payable on taxable income. Foreign income tax is defined in s 775-15 and includes any taxes covered by a tax treaty. If foreign income tax is paid and then refunded directly or indirectly, it does not qualify for a FITO: s 770-140. There is no requirement that the tax be levied by a particular foreign country, just that it not be levied under an Australian law. This allows supra-national income taxes to qualify (some examples exist in the EU). It is not required that the income be foreign source under Australian concepts of source, or that the taxpayer be resident in Australia. Foreign income tax is only excluded if it is levied by a foreign country on a residence basis on income which Australian source rules regard as sourced outside that foreign country. The general effect is that the source rules of the foreign country are determinative as to whether Australia will accept the tax claim for the FITO, except where it is taxing the taxpayer because it regards the taxpayer as resident there. Australia will sometimes levy income tax on non-residents which is subject to tax in a foreign country, eg an Australian branch of a foreign bank may have made loans to a company resident in Fiji which levies income tax on the interest paid to the bank on the loan. Australia would also generally tax the interest as attributable to the branch and so a FITO would be necessary to prevent double taxation. The FITO is subject to a limit under s 770-75 of the greater of $1,000 or the amount calculated under the section which, in effect, determines the amount of Australian tax on the income apart from the FITO. The $1,000 is a de minimis amount and removes the need to calculate the limit where the amount of foreign tax is small. If the limit needs to be calculated, the foreign income is effectively treated as the top slice of income in determining the amount of Australian tax on the income. An amount of assessable income which is foreign source under Australia’s source rules but not subject to foreign income tax is also used in the calculation which effectively also increases the limit. The issue of timing differences between Australia and the foreign country as to when an amount is included in income is dealt with by giving the FITO for a particular amount of foreign tax not in the year the tax is paid to the foreign country but the year in which the income is assessed in Australia. [17.85]

17.3

Question

In the income year ending 30 June 2017, an Australian resident taxpayer receives dividends of $34,000, consisting of $14,000 fully franked dividends from Australian companies and $20,000 dividends from US companies on which the US has levied tax of $3,000. She also makes capital gains on the sale of shares in US-listed companies of $5,000 after the CGT discount. There is no US tax on the capital gains. This is her only income and her taxable income is $45,000 (including imputation gross up of $6,000 on the franked dividends; she has no tax deductions). What is the limit on the FITO she can claim? What is her tax payable after offsets? Is she entitled to a refund of imputation tax offsets and if so how much? If you need further information to answer this question, make assumptions about the information.

[17.90] Often foreign tax is actually paid by another person rather than the taxpayer claiming

the FITO. Most countries levy tax on passive income paid to non-residents by a withholding tax remitted by the payer of the income: see Chapter 18. In many cases the legal liability for the tax rests on the recipient not the payer, but in some countries and cases the legal liability for the tax may be on the payer rather than the recipient. Moreover, countries may disagree on who is the taxpayer with respect to the income. We note in Chapter 13 that income derived through trusts is sometimes taxed to the beneficiary and sometimes taxed to the trustee. In a particular case, a foreign country may regard the foreign trustee as subject to tax whereas 914

[17.85]

Taxation of Residents

CHAPTER 17

Australia taxes the beneficiary. Or the two countries may regard a legal intermediary deriving the income differently – Australia may regard the intermediary as a transparent partnership whereas the foreign country regards it as a company. The FITO in s 770-130 of the ITAA 1997 covers these kinds of cases where Australia taxes the income in the hands of one taxpayer while a foreign country taxes another person and ensures that the Australian taxpayer receives a FITO. There are many variations on this kind of theme, some of which are dealt with by the ATO in TR 2009/6.

5. THE DEDUCTION REGIME [17.100] It was noted earlier that the third policy for designing international tax rules,

“national neutrality”, would treat foreign taxes as another cost of doing business that would be recognised as a deduction from income. While Australia does not have an explicit deduction regime for foreign-source income (unlike the case with its explicit exemption and FITO rules), it does have an implicit deduction regime created through the imputation system. The imputation system provides shareholders with franking credits where dividends are paid from profits that have been subject to Australian income tax at the company level: see Chapter 14. This avoids the double taxation of profits derived through a company. Dividends paid from profits that had not been subject to tax at the company level are “unfranked” – included in assessable income under s 44 of the ITAA 1936 and carry no franking credits. Credits to the franking account are only available to resident companies for Australian tax they have paid. If an Australian-resident company derives profits abroad that are exempt from Australian tax under s 23AH (branch profits) or s 768-5 (participation dividends), no Australian tax is payable on that income and the profits will effectively generate unfranked dividends. From the shareholder’s perspective, the exemption or offset provided at the company level translates to a deduction at the shareholder level. Consider, for example, a company deriving $100 rental income from a country where the company tax rate, like Australia’s, is 30%. Whether the profits are derived through a branch or a subsidiary, only $70 will be repatriated to the head office or parent (the amount derived as a dividend may be slightly lower if it is subject to a dividend withholding tax in addition to the underlying company tax). When distributed as dividends to resident shareholders, the $70 will be assessable and taxed at the shareholder’s marginal rates without any imputation credits as the dividends will be unfranked (assuming no franking credits being available from other taxable income). This is equivalent to taxing the shareholders on the original $100 derived abroad and providing a deduction for the foreign taxes. A similar result follows if the foreign income is subject to tax and carries a FITO at the company level. To the extent Australian tax is not paid as a result of the FITO, the profits will effectively be distributed as unfranked dividends. The effect of the imputation system, therefore, is to claw back the benefit of exemptions or FITOs at the company level and convert these to deductions for foreign taxes at the shareholder level. Many Australian multinational firms have advocated extension of the FITO system by allowing taxpayers to treat foreign tax as Australian tax for the purpose of credits to a company’s franking account (or for other approaches which produce similar results). These calls have been particularly strong in the case of trans-Tasman investments, where it is argued Australia and New Zealand could enter into a reciprocal agreement to recognise each other’s taxes for franking purposes. So far, however, the government has resisted the calls, though it [17.100]

915

Income Derived From International Transactions

has accepted that imputation credits for Australian tax can pass through New Zealand companies to Australian shareholders: see Div 220 of the ITAA 1997. It will be recalled that the participation exemption regime is based on a policy of capital import/ownership neutrality. The interaction of the international double tax relief system with the imputation system means that active business income derived through Australian companies is subject to capital import neutrality/ownership neutrality at the corporate level and national neutrality at the shareholder level. Foreign income derived directly by Australian individuals is subject to a policy of capital export neutrality through the operation of the FITO. Not surprisingly this creates some tension in the system and in particular may lead to a preference for foreign income to be derived through a transparent tax intermediary (from an Australian point of view) rather than through a company, or through a company if it is not necessary to distribute the income and the shareholder can realise it through a capital gain by sale of shares in the company which attracts the CGT discount. Much international tax planning occurs around these kinds of tensions in Australia and elsewhere.

6. THE ATTRIBUTION REGIMES [17.110] We discussed in Chapter 16 the issues occasioned by the residence definitions for

intermediaries that make it possible for Australian residents to set up foreign intermediaries such as companies and trusts which derive but do not distribute foreign income. In the absence of special regimes, such income would not be taxable in Australia even though it is ultimately owned by Australian residents – it is only taxed on distribution or sale of the resident’s interest in the intermediary. The benefits of such deferral can be significant – compounded foreign income taxed at low or zero tax rates can significantly lower the effective tax rate on the income. The ITAA 1936 contains two regimes to prevent deferral in this manner: • the controlled foreign company (CFC) regime in Pt X of the ITAA 1936; and • the transferor trust regime in Div 6AAA of Pt III of the ITAA 1936 Although the Board of Taxation recommended significant changes to the CFC regime in 2008 which were accepted by the government, the changes were not enacted and with the advent of the BEPS project (see Chapter 16 Section 5) the changes have been abandoned. The BEPS final report on Action 3 made best practice recommendations for CFC regimes which are generally reflected in Australia’s existing regime so it seems that the current regime will remain as it is. Australia previously also had a foreign investment fund (FIF) regime in ITAA 1936 Pt XI to prevent deferral through portfolio investment in foreign funds deriving passive income but it was repealed in 2010. A replacement was proposed but apparently is not proceeding. Since the global financial crisis the volatility of foreign exchange rates and the historically low interest rates, especially outside Australia, mean that investing in foreign entities holding passive investments to defer Australian tax is much less likely than in the past as the investment is likely to provide lower returns at higher risk than equivalent investments in Australia.

(a) The CFC Regime [17.120] The CFC rules attribute income of “controlled foreign companies” to some Australian-resident shareholders. 916

[17.110]

Taxation of Residents

CHAPTER 17

The central charging provision is s 456 of the ITAA 1936, which includes in the assessable income of an “attributable taxpayer” a percentage of the “attributable income” of a CFC. Most of the remaining provisions of Pt X define and refine these concepts. A CFC is defined in s 340 as a foreign company in which five or fewer Australian residents have directly or indirectly at least a 50% interest in votes, rights to profits or rights to capital in the company, or otherwise control the company; or one Australian resident has at least a 40% such interest in the company. It will normally lie within the power of such a group to distribute profits as they are earned, and if they do not then there is potential for deferral of Australian tax. On the other hand, if the company is not controlled by Australians, the Australian investors are not in a position to require distributions and the Australian investors cannot be said to be deliberately engaging in deferral. The CFC regime is not designed to prevent all deferral of tax on income earned through foreign companies. Rather, it is aimed at instances where it is presumed that a foreign company was used for the purpose of deferring tax. Thus, the provisions that define a CFC’s attributable income make a distinction between “active” income such as income from business and “passive” income such as interest, rent, royalties or dividends earned through a CFC (with a range of exclusions from the definition – importantly interest and similar income derived by foreign subsidiaries of Australian resident banks is generally not treated as passive: see Divs 7 and 8 of Pt X). There may be sound commercial reasons to operate an overseas business through a locally incorporated company. However, if the purpose of the company is merely to hold assets through a foreign vehicle when the assets could be held directly by resident shareholders in the overseas company, it is assumed the insertion of the company between investors and the income is tax motivated. Thus, attributable income includes passive income but generally not active income, unless the income is viewed as “tainted” services or sales income, meaning generally it was derived in a transaction with an Australian resident associated person. The main purpose of the latter rules is to obviate the need to apply transfer pricing rules (see Chapter 16 Section 4) to the dealings of Australian multinational companies with their foreign subsidiaries (any income transferred out of Australia by transfer pricing is automatically attributed back to Australia by the CFC rules). Passive and tainted sales and services income is referred to together as tainted income. A further distinction made in the CFC legislation is between CFCs located in comparable tax jurisdictions and other jurisdictions. Listed countries are set out in the Regulations and comprise countries whose tax systems are considered “closely comparable” to Australia’s system. Tainted income derived by CFCs resident in listed countries is therefore generally excluded from attributable income, though there are some minor exceptions for particular types of income subject to particular identified concessions. There are currently seven listed countries – Canada, France, Germany, Japan, New Zealand, UK and US. The anti-avoidance focus of the CFC rules can be seen from the fact that the large proportion of Australia’s foreign direct investment is into listed countries. The large bulk of CFC income is thus excluded from the attribution regime by the listing approach. Tainted income from unlisted countries is generally attributable, though there is a further exclusion from attribution applicable to both listed and unlisted countries (most relevant to unlisted countries) in the form of a de minimis threshold exemption: tainted income will be excluded from attribution if it does not exceed 5% of gross turnover. Section 456 includes in the assessable income of an “attributable taxpayer” a percentage of the attributable income of a CFC. Not all shareholders in a CFC are attributable taxpayers. An [17.120]

917

Income Derived From International Transactions

attributable taxpayer is a shareholder who, along with associates, has a 10% or greater controlling interest in the CFC or, if five or fewer Australian entities control the CFC and the shareholder is one of those five shareholders whose interests together comprise a controlling interest, a 1% control interest in the CFC: see s 361. To prevent double taxation of income that is attributed to an Australian resident when derived by a CFC, s 23AI provides that the income is non-assessable, non-exempt income of the resident to whom the income is distributed as a dividend with an equivalent disregard of capital gains on disposal of shares in the CFC, s 461. Foreign tax paid by a CFC is generally deductible (in line with the implicit deduction regime for income derived through companies discussed above) but if the attributable taxpayer is an Australian company with a more than 10% interest in the CFC as will be common, this deduction is added back and a FITO is provided for the attributable income: s 770-135 of the ITAA 1997. As noted above, the outcome of the combination of the CFC rules and the double tax relief rules is that active foreign income of Australian companies is not subject to Australian tax, but their low-taxed tainted income is subject to Australian tax.

(b) The Transferor Trust Regime [17.140] In 1990 a trust attribution system known as the “transferor trust” regime, Pt III

Div 6AAA of the ITAA 1936, was introduced to complement the CFC rules adopted in the same year to deal with similar cases involving trusts – passive low-taxed foreign income being retained in a foreign (generally discretionary) trust to attract the benefit of deferral. Such income is not subject to current tax under the rules described in Chapter 13 for trusts, and is attributed to the transferor (the person who directly or indirectly established the trust). The essential feature of a discretionary trust is that the beneficiaries are usually not known before a discretion is exercised. In theory, it could turn out that the transferor to whom trust income is attributed will never actually receive any of the income on which he or she has been taxed. The rationale for the approach used in the legislation is simple – while the transferor in theory may not enjoy the income accumulating abroad, the legislation assumes that in practice no one would transfer funds abroad to set up a discretionary trust with no hope that they would never enjoy the benefit of the trust. It is assumed that the transferor makes the transfer on the assumption that the income will eventually be applied to the benefit of the transferor or as the transferor would wish. The impost is easily overcome – instead of transferring to a foreign discretionary trust, the transferor could transfer to a domestic trust and never be taxed on the trust income, except to the extent the transferor became presently entitled to income of the trust. In that case either the trust or the presently entitled beneficiaries will be subject to tax on current income as discussed in Chapter 13. The charging provision for Div 6AAA, s 102AAZD, includes in the assessable income of an “attributable taxpayer” in relation to a trust the “notional attributable income” of the trust. The notional attributable income is a reference to attributable income of the trust adjusted for the possibly different start and stop times for the trust’s income year and the transferor’s income year. An attributable taxpayer in respect of a trust is defined in s 102AAT in terms of a person who has transferred property or services to a discretionary trust. The attributable income of the trust is set out in s 102AAU. On its face, the attribution rule in s 102AAZD applies in respect of both resident and non-resident discretionary trusts, and the definition of attributable taxpayer covers transfers to both resident and non-resident trusts. However, the attributable 918

[17.140]

Taxation of Residents

CHAPTER 17

income of a resident trust is deemed to be zero (s 102AAU(2)), so in practice the regime only applies to transfers to non-resident discretionary trusts. A number of the concepts of the CFC regime are used in working out the attributable income (such as listed countries). Similarly the CFC regime adopts a number of concepts out of Div 6AAA, particularly for cases where a transferor trust holds a controlling interest in a foreign company. [17.145]

17.4

17.5

Questions

The taxpayer is an accountant who provides services to a non-resident discretionary trust located in a tax haven. The accountant invoices the trust for the services, calculating the charge using her normal hourly rate. Is the taxpayer an attributable taxpayer in respect of the trust? (See s 102AAT(a)(i)(C) and (D).) The taxpayer’s will provided for a settlement on a non-resident discretionary trust. Will the trustee of the testamentary estate be an attributable taxpayer in respect of the transfer? (See s 102AAL.)

[17.150] There are a number of exclusions and exemptions in Div 6AAA, such as transfers

made prior to the start of the regime or the transferor becoming a resident and certain transfers to “non-resident family trusts”, being a limited class of trusts established as part of a marriage dissolution or established for close relatives who are in necessitous circumstances: see the definition of “attributable taxpayer” in ss 102AAT and 102AAH. Distributions to resident beneficiaries from income derived by these trusts are assessable to the beneficiaries upon receipt under s 99B. [17.155]

17.6

Question

How does s 102AAM seek to overcome the deferral advantage where income escapes the Div 6AAA attribution rules and is assessable only on receipt under s 99B?

7. DEDUCTIONS AND THIN CAPITALISATION [17.170] The discussion of the regimes for relieving international double taxation above has

generally left out of account the treatment of deductions. Where relief is by way of exemption, then under s 8-1 of the ITAA 1997, the general approach is that related deductions are denied as they do not produce assessable income. Similarly in calculating the FITO limit under s 770-75 of the ITAA 1997, deductions are allocated generally between domestic and foreign source income to ensure the limit is not inflated by allowing deductions for earning foreign income to be claimed against domestic income. The approach in such cases is to allocate to foreign income deductions which relate directly to such income and a reasonable proportion of deductions that relate to income generally. There are two special cases to consider, where deductions relating to foreign income exceed that income and interest deductions. In relation to the first case, as a general rule the Australian income tax legislation operates on a global basis, meaning all expenses and all assessable income are considered together. This means that expenses incurred to derive one type of income may be deducted from another type of income. The most significant exception to this general rule is for capital losses, which are quarantined to be deductible only against capital gains. Tax losses arising from the excess of general or specific deductions over assessable income may be carried forward and deducted from taxable income in future years under Div 36 of the ITAA 1997. Hence to the extent that deductions relating to assessable income which is foreign income or subject to foreign income tax exceed that income, they may in effect be deducted against domestic assessable income. The same result applies for capital gains and capital losses. In the [17.170]

919

Income Derived From International Transactions

case of income exempt under s 23AH of the ITAA 1936 and s 768-5 of the ITAA 1997, excess deductions giving rise to losses (apart from interest deductions in the latter case) cannot be used against domestic income, and similarly for capital losses arising in a foreign PE of an Australian company which would be exempt if instead they were capital gains. Complex loss rules apply to CFCs. Interest and other debt deductions under the debt-equity rules are dealt with by a special regime in the “thin capitalisation” rules of Div 820 of the ITAA 1997. Although generally framed as a single regime for both inbound and outbound investment, the rules perform two distinct purposes. One purpose is to allocate interest and other debt deductions as between certain foreign income and other income for outbound investment. Interest on loans by Australian parent companies to foreign subsidiaries are allocated under the thin capitalisation rules, and may give rise to deductions even though dividends from the subsidiaries are exempt under s 768-5: see ss 25-90, 230-15(3) of the ITAA 1997. [17.180] The other purpose is in effect to supplement the debt-equity rules in relation to

inbound investment to prevent taxpayers from deducting interest expenses where investors have funded a subsidiary with little equity and a great deal of debt (hence the name thin capitalisation). This technique would otherwise allow foreign investors to extract profits from Australian investments such as an Australian subsidiary as tax-deductible interest instead of as non-deductible dividends: the foreign investor may be subject to tax on the interest but at a much lower rate of 10% compared to the company tax rate: see Chapter 18. In both cases the rules work by effectively isolating the Australian assets of the taxpayer and allowing those assets to be financed by debt up to a safe harbour limit (there are several safe harbours available depending on the circumstances). Above the limit, interest deductions are denied. The safe harbour that most taxpayers rely on effectively is 60% of the value of their Australian assets. In the inbound case this means that a foreign parent can finance an Australian subsidiary by loans up to 60% of the value of the subsidiary’s assets (whether the loans come from the parent or other foreign members of the group, or from external sources such as a bank). Conversely, an Australian parent can finance a CFC that it acquires by loans up to the value of 60% of its Australian assets, less loans that are already allocated against those assets. In many cases this means that the CFC can effectively be fully financed by loans, the interest on which is deductible, even though the capital gains and dividends received on shares in the CFC are exempt and no attribution of income occurs under the CFC regime because the income of the subsidiary is active business income. The operation of these rules is very complex and the subject of tax planning. Not surprisingly they have attracted a number of rulings from the ATO, and disputes between the ATO and taxpayers. Tax planning using interest deductions to reduce taxable income on inbound investment is a form of tax planning that has been considered by the BEPS project through Action 4. The BEPS final report in 2015 proposes a limit for interest and similar deductions of 10–30% (after netting off interest income against interest deductions) of EBITDA – earnings before interest, tax, depreciation and amortisation. While this is a very different system to Australia’s, the final report contains options that effectively allow Australia to retain its current regime and be in conformity with the BEPS recommendations. Australia in 2014 lowered its main safe harbour for thin capitalisation from 75% of assets to 60% and referenced the BEPS project in doing so.

920

[17.180]

CHAPTER 18 Taxation of Non-residents [18.20]

1. INCOME FROM REAL ESTATE............................... ....................................... 923

[18.30] [18.50]

2. BUSINESS INCOME...................................... ............................................... 923 FCT v Thiel ................................................................................................................. 924

[18.70]

3. CAPITAL GAINS......................................... .................................................. 928

[18.70]

(a) Domestic Law ...................................................................................................... 928

[18.80]

(b) Treaties ............................................................................................................... 928

[18.90]

(c) Change of Residence ........................................................................................... 929

[18.100] 4. DIVIDENDS, INTEREST AND ROYALTIES ....................... .............................. 929 [18.110]

(a) Withholding Tax Regime ...................................................................................... 929

[18.120]

(b) Dividends ............................................................................................................ 930

[18.140]

(c) Interest ................................................................................................................ 932

[18.160] [18.170] [18.180] [18.190]

(d) Royalties .............................................................................................................. (i) Intellectual property ............................................................................................. OECD Commentaries on the Model Tax Convention Article 12 (2014) ........................... (ii) Equipment leasing ...............................................................................................

932 932 933 936

[18.200] 5. EMPLOYMENT AND PERSONAL SERVICES...................... ............................ 937 [18.210]

(a) Employees ........................................................................................................... 937

[18.230]

(b) Professional and Consultancy Services ................................................................. 938

[18.240]

(c) Entertainers and Sports Stars ................................................................................ 939

[18.260]

(d) Other Personal Services Income ........................................................................... 941

[18.270] 6. OTHER INCOME........................................ ................................................. 941 [18.280] 7. TREATY SHOPPING AND ANTI-AVOIDANCE .................... ........................... 941 [18.320] 8. NON-DISCRIMINATION .................................. ........................................... 944

Principal Sections This chapter examines articles 6 – 21 and 25 of the UK treaty as well as equivalent provisions in the US and other treaties. ITAA 1936 ITAA 1997 Effect ss 6-5(3), 6-10(5) – These sections tax non-residents on income sourced in Australia. Div 855 – These provisions deal with the taxation of non-residents under the CGT. s 104-160 – This section deals with change of residence under the CGT.

921

Income Derived From International Transactions

This chapter examines articles 6 – 21 and 25 of the UK treaty as well as equivalent provisions in the US and other treaties. ITAA 1936 ITAA 1997 Effect Div 11A Subdiv 840–M These Divisions deal with withholding tax on dividends, interest, royalties and managed investment trust distributions paid to non-residents. ss 177DA, 177H These international anti-avoidance rules have recently been added to Pt IVA, partly prompted by the BEPS project. [18.10] Income derived by non-residents is dealt with by categories in the distributive rules of

tax treaties, and similarly in domestic law there is a significant schedular nature to the tax regime with many different approaches for various kinds of income. Accordingly we will deal with taxation of non-residents by type of income, generally following the order that the categories appear in tax treaties. We will also discuss relevant special administrative rules or procedures for collection of tax applicable to certain types of income as we proceed. The general issues of tax collection problems in the international setting and cooperation between tax administrations of different countries are dealt with in Chapter 16. Despite this approach, you should not lose sight of the fact that the default position under domestic law is that income of non-residents with a source in Australia is included in assessable income under ss 6-5(3) and 6-10(5) of the ITAA 1997 and then assessed in the normal way under the self-assessment regime after allowing for deductions and tax offsets. It is only where a separate or special regime is substituted – for example, the withholding tax on dividends, interest and royalties under Div 11A of the ITAA 1936 – that this method of taxation does not apply or is significantly modified. You should also recall the sourcing rule in tax treaties referred to in Chapter 16 which has the effect in most cases that if Australia can tax the income of a non-resident under a tax treaty, the income is deemed to be sourced in Australia for the purposes of the tax treaty and also for the purposes of domestic law, with the result that s 6-5 or 6-10 of the ITAA 1997 is automatically applicable in the absence of other taxing rules. As tax treaties override domestic law, other source rules are generally relevant to non-residents only from countries with which Australia does not have a tax treaty. One administrative provision of general application to non-residents should be noted at this stage. Under s 255 of the ITAA 1936 the ATO may collect tax owing by a non-resident from persons in Australia who have control of funds belonging to the non-resident. Generally the ATO gives a notice to the person concerned, who then accounts for the tax to the ATO. In practice this power is only used in a limited number of situations. Its potential breadth and limits were explored by the High Court in Bluebottle UK Ltd v DCT (2007) 232 CLR 598. Finally it should be recalled that one of the major parts of the BEPS project is to align the source of income with where the value adding or creating activity occurs, and hence to enhance taxing rights of the real source country. Most of the recommendations in the BEPS final reports, however, will affect the payer of the income by denying deductions rather than taxation of the payee (especially royalties and interest payments under Actions 8–10 but also Actions 2 and 4). 922

[18.10]

Taxation of Non-residents

CHAPTER 18

1. INCOME FROM REAL ESTATE [18.20] It is generally accepted that income from real estate is sourced in the country where

the real estate is situated. Perhaps because it is regarded as self-evident, there is not much case support for this proposition, though Thorpe Nominees (considered in Chapter 16) may be explained on this basis. Australia taxes non-residents who derive income from Australian real estate on an assessment basis (ie after allowing deductions); there is no withholding tax on rent derived by non-residents as such. The most common situation in which non-residents derive rent from Australia, however, is by investing in Australian-listed property trusts like Westfield or Stockland. In this case there is a final gross withholding tax on distributions of net income from such trusts of either 30 % or 15 % if Australia has a treaty with full information exchange with the country of residence of the investor: see Income Tax (Managed Investment Fund Withholding Tax) Act 2008 s 4. By “final” we mean that the tax is not followed up by the filing of a return and the issuing of the assessment to the investor – a result which is achieved by making the income non-assessable non-exempt under s 840-815 of the ITAA 1997. By “gross” we mean that the tax is levied without allowance of deductions against the income for the investor, again because it is non-assessable non-exempt. It should be noted that Div 840, which creates the liability for managed investment trust withholding tax, is not explicitly limited to rent but rent is the major type of income that it will cover. The administrative rules for this withholding are found in Sch 1 Subdiv 12-H of the Taxation Administration Act 1953. A special source rule is found in s 6CA of the ITAA 1936 for what is called “natural resource income”, defined as income derived by a non-resident calculated in whole or part by reference to the value or quantity of natural resources produced and/or recovered in Australia. There is a special withholding regime for natural resource income under Sch 1 ss 12-325, 12-330 and 12-335 of the Taxation Administration Act 1953. Treaties adopt the rule that income from real property is taxable in the state where the property is situated in the income from immovable/real property article (usually article 6).

2. BUSINESS INCOME [18.30] There are many old cases in Australia and other countries dealing with the source of

business income. These often concerned situations where income was taxed by the relevant government only on a source basis and not on a residence basis, so that the residence of the taxpayer was irrelevant in the decisions. Some of these cases gave importance to the place of contract (especially where the business consisted mainly of contracts such as purchase and sale of goods or insurance). In cases where the taxpayer manufactured or produced goods in one place and sold them in another, the source of the total income was usually split between the two places. [18.40] Tax treaties use a quite different method of dealing with business profits. They

contain a definition of “permanent establishment” (PE) and a country may only tax a taxpayer resident in the other country on business profits attributable to the PE: see UK treaty articles 5 and 7. Such profits are then given a source in Australia by the treaty-sourcing rule regardless of the effect of the judicial rules above, and hence are taxable. Although these treaty concepts are not adopted for taxing residents of non-treaty countries in domestic law, they are used in a variety of other contexts in domestic law (eg s 23AH of the ITAA 1936) and also in relation to [18.40]

923

Income Derived From International Transactions

dividends, interest and royalties discussed below. For these purposes domestic law has a PE definition in s 6(1) of the ITAA 1936 which is similar in effect to the treaty definition. The treaty PE definition starts with a fixed place of business through which the business of the enterprise is carried on and then provides a list of examples which, however, are to be read subject to the basic concept of fixed place. A special time limit is provided for construction sites to constitute a PE, and certain preparatory and auxiliary activities are excluded from being a PE. A number of deemed PE rules are found in Australia’s treaties, including agents (other than independent agents), processing activities and use of substantial equipment. Only the first of these additions is found in the OECD Model provision which reflects Australia’s view of itself in the past as being a significant capital importer. A resident subsidiary is not a PE of a foreign parent company simply by reason of the parent–subsidiary relationship. The BEPS project is (slightly) expanding the PE definition by (a) limiting the preparatory and auxiliary exception; and (b) expanding the agency PE rule to capture more cases. In Australia, however, these changes will be of less importance because of an expansion of the general anti-avoidance rule in Pt IVA of the ITAA 1936 to achieve a similar result, see Section 7 below. If there is a PE not all Australian-source profits are taxable, only those attributable to the PE. The allocation of income and deductions in this process has been discussed in Chapter 16 in relation to transfer pricing. Following the UN Model the usual rule is modified in some of Australia’s treaties, for example, with Indonesia, to include profits not connected to the PE which are similar in character to those earned by the PE. In most Australian treaties no profits are attributed to a PE in respect of its purchasing activities for other parts of the enterprise (a rule designed to encourage the purchase by non-residents of Australian products). In FCT v Thiel (1990) 171 CLR 338; 21 ATR 531, the question arose of how these rules applied where a non-resident was involved in an isolated activity in Australia which gave rise to income (as a profit-making deal or adventure in the nature of trade – see Chapter 5) in the absence of a PE. The taxpayer was a Swiss resident individual who invested in a technology trust in Australia which converted into a company and listed on the stock exchange. The taxpayer made significant profits by selling shares in the listed company and the ATO sought to tax the profits. The taxpayer argued that he was protected from taxation by the business profits article of the Swiss tax treaty as he did not have a PE in Australia and the High Court agreed.

FCT v Thiel [18.50] FCT v Thiel (1990) 171 CLR 338 McHugh J: Article 7 of the Agreement provides: Business Profits (1) The profits of an enterprise of one of the Contracting States shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them as is attributable to that permanent establishment. 924

[18.50]

Article 3(1)(f) defines the term “enterprise of one of the Contracting States” to mean, unless the context otherwise requires, “an enterprise carried on by a resident of Australia or an enterprise carried on by a resident of Switzerland, as the context requires” … The Agreement is a treaty and is to be interpreted in accordance with the rules of interpretation recognised by international lawyers … Those rules have now been codified by the Vienna Convention on the Law of Treaties to which Australia, but not Switzerland, is a party.

Taxation of Non-residents

FCT v Thiel cont. Nevertheless, because the interpretation provisions of the Vienna Convention reflect the customary rules for the interpretation of treaties, it is proper to have regard to the terms of the Convention in interpreting the Agreement, even though Switzerland is not a party to that Convention … Article 31 of the Convention requires a treaty to be interpreted in accordance with the ordinary meaning to be given to its terms “in their context and in the light of its object and purpose”. The context includes the preamble and annexes to the treaty: Art 31(2). Recourse may also be had to “supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion” to confirm the meaning resulting from the application of Art 31 or to determine the meaning of the treaty when interpretation according to Art 31 leaves its meaning obscure or ambiguous or leads to a result which is manifestly absurd or unreasonable: Art 32. The Agreement is one “for the avoidance of double taxation with respect to taxes on income”. Accordingly, it is necessary to interpret the words of the Agreement with that particular purpose in mind. Moreover, the term “enterprise” in Arts 3 and 7 of the Agreement is ambiguous because, on the one hand, it can mean a project or activity undertaken and, on the other hand, it can mean a framework for making and carrying out decisions in respect of activities and projects. Consequently, it is proper to have regard to any “supplementary means of interpretation” in interpreting the Agreement. In this case, the “supplementary means of interpretation” are the 1977 OECD Model Convention for the Avoidance of Double Taxation with respect to Taxes on Income and on Capital, which was the model for the Agreement, and a Commentary issued by the OECD in relation to that Model Convention … The “supplementary means of interpretation” are of assistance in interpreting the meaning of the expression “an enterprise carried on”. The Model Convention does not seek to attempt to define that expression, but the Commentary on Art 3 states:

CHAPTER 18

4. The question whether an activity is performed within the framework of an enterprise or is deemed to constitute in itself an enterprise has always been interpreted according to the provisions of the domestic laws of the Contracting States … Thus, the Commentary recognises that an isolated activity may be an “enterprise” for the purpose of the Agreement … If, as the Commentary acknowledges, an activity may constitute an “enterprise” for the purpose of the Agreement, ex hypothesi, the words “carried on by” cannot require the term “enterprise” to be read as always requiring a repetition of activity. Consequently, the expression “enterprise carried on by” in Art 3(1)(f) does not have any connotation requiring the existence of the enterprise before or after the profit has been earned. Nor does it require that the enterprise exist independently of the activity or activities which earns or earn the profit. The words “carried on by” are used in Art 3(1)(f) to signify the nature of the connection which must exist between the “enterprise” and a resident of one of the Contracting States. As counsel for the appellant pointed out, it would make no difference to the meaning of Art 3(1)(f) if the words “undertaken by” were substituted for the words “carried on by”. Moreover, as the term “enterprise” has no technical meaning in Australian law, there is no domestic reason for holding that an activity cannot constitute an “enterprise carried on” within the meaning of Art 3(1)(f). Consequently, the words “enterprise carried on by” in Art 3(1)(f) should be construed as including both an isolated activity and a framework for making and carrying out decisions in relation to activities and projects since that is the construction of that Article which will avoid double taxation to a greater extent than the competing construction which was favoured in the Federal Court … It follows from the foregoing discussion that the Art 3(1)(f) definition of “enterprise of one of the Contracting States” covers an isolated activity as well as a framework for making and carrying out decisions in relation to projects and activities. The definition in Art 3(1)(f) applies, however, only when the context does not otherwise require. Do [18.50]

925

Income Derived From International Transactions

FCT v Thiel cont. the words “the enterprise carries on business” which appear twice in Art 7(1) provide a context sufficient to reject the application of the Art 3(1)(f) definition to the words “profits of an enterprise of one of the Contracting States” which appear in the first line of Art 7(1)? The concept of carrying on of a business requires repetition of activity. Hence, in the expression “the enterprise carries on business”, the term “enterprise” must refer to a framework for making and carrying out decisions in relation to activities and projects rather than an isolated activity, and the Art 3(1)(f) definition is inapplicable. If the expression “profits of an enterprise” in the first line of Art 7(1) includes the profits of an isolated activity, then the term “enterprise” appears to have two different meanings in that Article. Nevertheless, I do not think that the context requires the rejection of the application of the Art 3(1)(f) definition to the phrase “enterprise of one of the Contracting States” in the first line of Art 7(1). If the definition in Art 3(1)(f) is applied to the first limb of Art 7(1), Art 7(1) exempts the profits of an isolated activity as well as the profits of a framework for making and carrying out decisions in relation to activities and projects from taxation in Australia unless the enterprise carries on business in Australia through a permanent establishment based in this country. To interpret the words “the enterprise” in the “unless” clause and the succeeding sentence of Art 7(1) as meaning a framework for making and carrying out decisions in relation to activities and

projects and not an activity does not, however, contradict the Art 3(1)(f) meaning of the term “an enterprise” in the first limb of Art 7(1). It simply means that the definition does not apply to the term “the enterprise” in Art 7(1) because, in its context, that term refers only to “an enterprise” which has derived its profits by using a framework for making and carrying out decisions in relation to activities or projects. Accordingly, profits derived from an isolated activity may constitute the profits of “an enterprise” within the meaning of Art 7. Indeed, it would be surprising if this was not the case. It is difficult to see any revenue or commercial reason for distinguishing between a Swiss resident who earns profits by constructing a number of buildings while he is in Australia for a few months and a Swiss resident who earns profits by constructing a single building while he is in Australia for a few months. To come within Art 7, however, it is not enough that the carrying on of an enterprise has produced “profits”. The heading to Art 7 must be taken into consideration in determining the meaning of that term. Although it is not necessary that the profits referred to in that Article be those of a business, the heading “Business Profits” indicates that, to come within Art 7, the profits of the enterprise must be profits from an adventure in the nature of trade … [T]he profits which the appellant earned were profits from an adventure in the nature of trade and were the profits of an enterprise carried on by a resident of Switzerland.

[18.55]

Questions

18.1

What approach does the judge take to interpretation of treaties? What is the relevance of the Vienna Convention on the Law of Treaties and the OECD Commentaries?

18.2

Do you agree with the analysis of article 7 of the treaty in Thiel?

18.3

Two major companies from the UK and US which manufacture batteries internationally invest in an Australian company to produce batteries for the Australian market. They proceed by a joint venture company as the Australian market is too small for each of them to set up their own factory. Each of the foreign companies orders manufacture of batteries as required from the Australian company with their own special branding. The Australian company sells to the foreign companies at cost (commonly called a cost toll arrangement). The foreign companies then sell to Australian sales subsidiaries they each

926

[18.55]

Taxation of Non-residents

CHAPTER 18

own at cost plus 50% and the subsidiaries sell into the Australian market making a profit generally of 5% on their costs. Are the foreign companies taxable in Australia under tax treaties? How can the ATO deal with any transfer pricing that may be occurring in these contracts? (See Case 110 (1955) 5 CTBR (NS) 656, articles 7 and 9 of the UK and US treaties and Chapter 16 on transfer pricing.) 18.4

A UK company owns a circus that tours Australia for two months every three years. Does the company have a PE in Australia? What if the company made only one tour lasting eight months? (See TR 2002/5.)

18.5

Alf is a New Zealand born stockbroker who lives in Australia and works for Bigbroker Ltd, an Australian stockbroking company. Although Bigbroker generally only acts for corporate clients, it allows Alf to act for a number of wealthy New Zealand residents whom he used to advise on investments when working in New Zealand. Do the NZ residents have a PE in Australia? (See Case 8775 (1993) 26 ATR 1056. Is it correct?)

18.6

Are profits of a UK resident company from mining activities in Australia taxable under article 6 or article 7 of the UK treaty?

[18.60] Business income attributable to a PE which Australia has power to tax under a treaty

is taxed through filing a tax return in the normal way (ie assessable income less deductions). In order to improve compliance among foreign taxpayers with PEs in Australia, PEs with revenue of at least $2 m are required to keep accounts (balance sheet and profit and loss) of their operations in Australia: s 820-960 of the ITAA 1997. Further, the Taxation Administration Act 1953 allows the making of regulations specifying payments made to non-residents to be subject to withholding, and the rate of tax applicable. This is not final withholding but is credited against the tax payable under an assessment of a return filed by the taxpayer: see Sch 1 s 12-315. Among the categories of payment specified in the regulations are construction site PEs and a 5% withholding rate on the payment applies: reg 44C Taxation Administration Regulations 1976. There are some other categories of business conducted by non-residents for which special rules are provided by domestic law and treaties, such as insurance, shipping and air transport. The shipping and air transport article of treaties adopts an exclusive taxing right for the country of residence of the shipping company or airline except for journeys between two places in the other country: UK treaty article 8. This approach is regarded as necessary, as it would be too difficult to allocate the profits of such companies amongst the many countries where they operate, and for airlines at least, international agreements ensure that the number of trips by airlines between the countries are equally shared by the airlines of each country. Australia’s treaties extend beyond transport to cover other activities such as “the use of a ship or aircraft for haulage, survey, or dredging activities, or for exploration or extraction activities in relation to natural resources, where such activities are undertaken” in one of the treaty countries: see UK treaty article 8(5)(b). Treaties also contain special rules to similar effect dealing with gains on disposal of ships and aircraft and employees of such enterprises: see UK treaty articles 13(3) and 14(3). Business profits which are dealt with in other articles of the treaty are not subject to the business profits article: see article 7(7) of the UK treaty. Hence business profits which are shipping profits subject to article 8 or income from real property within article 6 are not dealt with by article 7. [18.60]

927

Income Derived From International Transactions

[18.65]

18.7

Question

How do the UK treaty and the US treaty deal with income from the following activities in Australia of UK or US residents: (a) oil exploration activities by ships; (b) farming; or (c) operation of a hotel they own?

3. CAPITAL GAINS (a) Domestic Law [18.70] The taxation of capital gains is dealt with in Div 855 of the ITAA 1997. Non-residents are taxable on capital gains on land in Australia, assets of a PE that they have or had in Australia and options over such assets. They are also taxable on 10% or greater interests in companies or trusts (whether resident or non-resident) if the assets of the company or trust directly or indirectly include more than 50% by value of Australian land. Capital gains of non-residents are not taxed on the basis of source but rather depending on whether the relevant asset is characterised as taxable Australian property: Subdiv 855-A. This is reflected by the terminology in ss 6-5(3) and 6-10(5) referring to inclusion in assessable income “on some basis other than having an Australian source”. In the PE case the taxable gain is reduced for any period the asset was not used in carrying on a business through the PE during the time it was held: s 855-35. Capital gains are taxed to non-residents by assessment in the normal way, ie the taxpayer must file a tax return and pay the tax under self-assessment. Not surprisingly, enforcement of the CGT liability can be difficult once the proceeds of sale are outside Australia and so for contracts entered into on or after 1 July 2016 a buyer is required to collect non-final withholding tax of 10% of the purchase price in respect of land and shares in land-rich companies purchased from a non-resident: see Taxation Administration Act 1953 Sch 1 Div 12-D.

(b) Treaties [18.80] Under Australia’s treaties, the relevant article is titled “Alienation of Property” rather

than “Capital Gains” as in the OECD Model and refers to income, profits and gains, or some similar variation. Hence it is clear that the article extends beyond capital gains. The modern form of the article contains provisions permitting taxation of gains on the alienation of real estate in Australia (including interests in companies and trusts holding land in Australia) and property of a PE in Australia other than real estate. Australian treaties until 2006 usually preserved domestic rules in other cases: see UK treaty article 13(6). Since that time Australian treaties have come into line with domestic law changes in 2006 and adopted exactly the opposite treaty position for other assets which are taxable only in the country of residence: see Finland 2006 treaty article 13(5). [18.85]

18.8

928

Question

A US resident share trader buys and sells shares on the Australian Securities Exchange. Some of the shares are in mining companies whose assets consist of more than 50% by value of land in Australia. Is the share trader taxable in Australia on the gains on the shares? [18.65]

Taxation of Non-residents

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(c) Change of Residence [18.90] Because non-residents are only taxed on Australian-sourced income or in relation to

taxable Australian property under the CGT, a resident may be tempted to change residence shortly before deriving a large lumpy item of income which is not sourced in Australia or taxable Australian property. The problem is dealt with in relation to CGT by special rules on changes of residence. CGT event I1 occurs immediately before a taxpayer ceases to be a resident with respect to CGT assets that are not taxable Australian property. As a result the gain in market value up to the time of change in residence is captured on assets that thereafter will be outside the Australian tax net. It is possible for an individual to elect to defer the levy but the consequence is that the full gain on the asset is taxable when it is sold even though the taxpayer is then a non-resident: see s 104-165(2), (3) of the ITAA 1997. Conversely, when a taxpayer becomes a resident of Australia, she is treated as having acquired assets that are not taxable Australian property at that time for their market value: see Subdiv 855-B. Not all countries have similar rules and they may deal with the problem in different ways, for example, until recently the US taxed former citizens and residents for up to 10 years after losing residence on their full gains on certain types of assets. As a result it was possible to get double tax problems arising in cases of change of residence under the CGT. The US treaty seeks to deal with the problem fully. If an individual taxpayer who ceases to be a resident of Australia and becomes a resident of the US elects not to be taxed at that time, then Australia’s taxing right is denied and the US taxes the full gain on the later disposal. Alternatively if the tax is levied on change of residence, then the US gives a market value cost at that time for the purposes of calculating any subsequent US CGT: see US treaty as amended by the 2001 Protocol, article 13(5), (6). The UK treaty only has the former provision, article 13(5).

4. DIVIDENDS, INTEREST AND ROYALTIES [18.100] For passive income the judicial source rules also use a mix of factors. In relation to

dividends it has been held that the source is where investment decisions are taken (Esquire Nominees v FCT (1973) 129 CLR 177); for interest a mix of place of contract, where money is advanced and where the debtor resides (see Spotless Services case extracted in Chapter 16); and for know-how the place where the know-how is provided (United Aircraft Corporation v FCT (1943) 68 CLR 525). For non-residents there are also some special statutory source rules in the ITAA 1936, eg s 44(1) for dividends (see Parke Davis & Co v FCT (1959) 101 CLR 521). For both residents and non-residents in situations involving tax treaties, the treaty sourcing rules discussed below will generally be relevant and will override domestic law.

(a) Withholding Tax Regime [18.110] Source rules as such are generally irrelevant to the taxation of non-residents on

dividends, interest and royalties as there is a statutory regime for taxation. This regime simply specifies the circumstances in which the tax is payable (which are the effective source rules) but does not depend on source by that name. Under Div 11A of the ITAA 1936, a final gross withholding tax is levied on non-residents in receipt of these types of income. The tax rates are: dividends and royalties 30% (usually reduced by tax treaties), and interest 10% (Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974). The tax is called withholding tax because it is not collected from the non-resident but rather by withholding by the payer under Sch 1 Subdiv 12-F of the Taxation Administration Act [18.110]

929

Income Derived From International Transactions

1953. It is not easy for the payer to determine whether the recipient is a non-resident or entitled to treaty benefits so the collection rules use an address system, ie a person is treated effectively as a non-resident if they have an address outside Australia or if the payment is made at a place outside Australia. Treaty benefits are extended if the address or place of payment is in a treaty country, Taxation Administration Regulations 1976 regs 39 – 42. If the payment is made to another person in Australia, for example, a trustee residing in Australia, who then on-distributes it to a person outside Australia, that intermediary has the obligation to withhold. Some other countries use a certificate system to get treaty benefits under which the non-resident is required to obtain a certificate of residence from their country’s tax administration and to present the certificate to the payer, but this is a complex and slow system. If a person who is obliged to withhold tax on interest or royalties fails to do so they are denied deductions for the payments until the tax is paid: see s 26-25 of the ITAA 1997. Tax treaties contain a number of rules with which this withholding system interacts. These rules are discussed below. There is one common treaty rule for dividends, interest and royalties. If the property in respect of which the income is paid is effectively connected with a PE that the non-resident has in the country, then the income is taken out of the dividends, interest or royalties article and taxed under the business profits article: see UK treaty articles 10(5), 11(6) and 12(4). Domestic law follows this rule by excluding the operation of the withholding tax (ss 128B(3E), 128B(3)(h)(ii) of the ITAA 1936 for dividends and interest, and Agreements Act s 17A(4) for royalties).

(b) Dividends [18.120] Section 128B levies withholding tax on dividends received by a non-resident when

the dividend is paid by a resident company to the non-resident, ie the dividend is effectively sourced by the residence of the payer. The same rule is applied in tax treaties: see UK treaty article 10(1), (2). Under s 44(1) tax may also be levied by assessment on a non-resident shareholder who receives a dividend from a non-resident company paid out of its Australiansource profits, but this tax levy is eliminated by tax treaties: see UK treaty article 10(6). Treaties usually reduce the Australian withholding tax rate on dividends to a maximum of 15%: UK treaty article 10(2)(b). The Taxation Administration Regulations 1976 then apply the treaty rate to the person who has to withhold the tax on the dividend: reg 40(1)(b). [18.125]

18.9

Question

Under the UK treaty is the residence of the company paying the dividend determined under the treaty residence rules or under the domestic residence rules? Why?

[18.130] It was noted in Chapter 16 that the Australian imputation system is domestically

focused – it only applies to resident companies paying dividends on which Australian tax has been paid to Australian resident shareholders: see ss 202-5(a), 202-20, 205-25, 207-70 and 207-75(1) of the ITAA 1997. In other cases shareholders do not get the benefits of the imputation system directly. However, some indirect benefit is provided to non-residents by making the franked part of dividends free of withholding tax: s 128B(3)(ga) of the ITAA 1936. If the dividend is received by a non-resident through a PE in Australia, withholding tax does not apply as noted above so that the dividend is assessable in the normal way under s 44(1) of the ITAA 1936 and in this case the non-resident is entitled to a non-refundable imputation tax credit: see ss 67-25(1DA), 207-75(2) of the ITAA 1997. Australia has also entered into a special arrangement with New Zealand so that Australian resident shareholders in a New 930

[18.120]

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Zealand resident parent company with an Australian resident subsidiary can get the benefit of imputation for Australian tax paid by the Australian subsidiary and vice versa for New Zealand resident shareholders under the New Zealand imputation system: see Div 220 of the ITAA 1997. On the other hand a number of the streaming and anti-avoidance rules in the tax system are designed to prevent attempts to stream franked dividends to Australian resident shareholders and to give other benefits to non-resident shareholders: ss 45A, 45B and 177EA of the ITAA 1936, Div 204 of the ITAA 1997. Australia’s most recent treaties also reduce tax rates on direct investment to 5% if the shareholder is a company with 10% of the voting interests in the company (which is close to the OECD Model position) or to zero if the shareholder is a company that has 80% of the voting interests in the company and meets some other tests: UK treaty article 10(2)(a), (3). The purpose of these reductions is to reduce the double taxation of dividends that can arise when a parent company in one country has a subsidiary in another country. The provisions are also part of Australia’s attempts to ensure that its tax system encourages foreign multinationals to set up regional headquarters in Australia: see also ss 82C – 82CE of the ITAA 1936. As in this case the foreign income earned by subsidiaries in the region outside Australia belongs ultimately to the foreign multinational parent, it is considered that Australia has no real claim to tax the income as it passes through the headquarter company in Australia (which are often referred to as conduit situations). The participation exemption in s 768-5 of the ITAA 1997 for non-portfolio dividends received by resident companies from foreign companies ensures that there is no tax on the dividends coming to Australia (see Chapter 17). However, when this income is paid out to the foreign parent, it will be an unfranked dividend as no Australian tax will have been paid on the dividends. The UK and US treaties will usually eliminate the withholding tax on the outgoing dividends but even if there is no treaty, Australia allows the on-payment of dividends to a foreign parent company without withholding tax, and also for dividends paid out of other forms of income received from offshore: Subdiv 802-A of the ITAA 1997. If dividends are relieved of tax in these cases, then it is sensible that the same regime should apply to CGT on shares in the companies, as profits can be realised by payment of dividends or sale of the shares. As noted in Chapter 17, Australia has a participation exemption for capital gains on shares in foreign subsidiaries derived by Australian resident companies. The CGT rules for non-residents described above ensure that non-residents are not taxable on sale of shares in Australian companies apart from companies that are land-rich. Hence if a foreign resident parent company sells its shares in an Australian resident subsidiary which is not land-rich, no CGT is payable on the sale. This means that if foreign income of the subsidiary is effectively realised by the parent company by selling its shares in the subsidiary, no Australian tax is paid, an equivalent result for dividends. The CGT treatment, however, goes further as it also means that no CGT is paid on sale of shares in a subsidiary on gains attributable to Australian source profits retained in the subsidiary. Australia’s policy is that the company tax on resident subsidiaries or Australian PEs of foreign resident parent companies is effectively the source tax Australia collects on Australian sourced profits of the company. The BEPS final report on Action 6 proposes to provide 12 month holding periods for dividends taxed at the 5% and capital gains on shares and similar interests to prevent abuse of tax treaties by short term holdings and a provision to that effect is contained in the proposed multilateral treaty for implementing BEPS measures affecting tax treaties. [18.130]

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Income Derived From International Transactions

(c) Interest [18.140] Withholding tax applies to interest paid to a non-resident by an Australian resident

(other than in respect of borrowings to support activities of foreign PEs of the resident) or by a non-resident in respect of borrowings to support activities of a PE of the non-resident in Australia: s 128B(2), (5), (6) – (9) of the ITAA 1936. This PE gloss on the residence of the payer rule is reflected in the sourcing rules for interest in tax treaties: see UK treaty article 11(7), Exchange of Notes para 6(b). The rate of tax is set under domestic law and in most tax treaties at 10%, compared to the higher domestic rate on dividends and royalties. This lower rate reflects the fact that the lender will often have significant costs which could be deducted from the interest if it were assessable. Even with the lower rate the gross interest withholding tax paid is often too high, for example, a bank will borrow most of the funds it on-lends, and the spread between its borrowing and lending interest rates will be less than 10% of the interest payments that it receives so that the tax is more than its profits. In this event the lender will include a clause in the loan agreement that the interest rate is effectively increased to cover any withholding tax so that the tax ends up being borne by the Australian borrower. In recognition of this problem, ss 128F and 128FA of the ITAA 1936 remove withholding tax on interest paid on loans raised in international debt markets by companies and trusts for use in Australia. In addition recent treaties also have an exemption for borrowings from financial institutions: see UK treaty article 11(3)(b), (4), Exchange of Notes para 6(a), US treaty article 11(3)(b), (4). [18.145]

Question

18.10 If a UK or US bank lends to its Australian subsidiary, is the interest on the loan exempt from withholding tax under the treaty? [18.150] Just as Australia has been seeking to attract headquarter companies to its shores, so

it is seeking to encourage financial institutions to make Sydney a regional financial centre. As part of this effort, interest withholding tax is not levied on offshore banking units (OBUs) to the extent they deal with non-residents: ss 128AE and 128GB of the ITAA 1936. Their income is also subject to a special tax regime: Div 9A.

(d) Royalties [18.160] The withholding tax rules for royalties closely follow those for interest except that

the basic rate of tax is 30%: see s 128B(2B), (5A) and (9A) – (9C). Similarly, the treaty article on royalties is similar to that for interest, except that in recent times Australia has reduced the treaty limit on royalty withholding tax from 10% to 5%: see UK treaty article 12(2). The main issue in the royalties context is the definition of what items are caught by the withholding tax and the treaty provision. (i) Intellectual property [18.170] The “royalty” definition in s 6(1) of the ITAA 1936 has two quite different elements,

one relating to intellectual property and the other relating to equipment leasing. We deal with the two elements separately. In relation to intellectual property the ITAA definition like the OECD Model covers three main kinds of payments – in relation to copyright, patents and the like, and know-how (paras (a), (b) and (c) of the ITAA definition, paras (d) and (f) being ancillary to the other parts). The ITAA additions to the OECD Model definition are paras (da) 932

[18.140]

Taxation of Non-residents

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and (db) dealing with public satellite and cable transmission of TV or radio, para (dc) dealing with mobile telephone spectrum and para (e) with use of films and tapes in relation to cinema, TV or radio. Modern Australian treaties tend to reproduce all of the ITAA definition except that paras (da), (db), (e) are merged and para (dc) may not be included: see UK treaty article 12(3). In the case of mobile spectrum it is a requirement of Australian law that any successful bidder for spectrum must have a PE in Australia to hold the spectrum licence so that the income derived is taxed as business profits under article 7: see Agreements Acts 3(11A), UK treaty Exchange of Notes para 7(a). Three major issues arise under these provisions: what is a payment for use as opposed to sale; what kind of use is relevant; and what is the dividing line between know-how and services. Copyrights and patents are highly divisible kinds of property – it is possible to sell part of them for periods of time and for particular places, and such transactions in economic substance are little different from an exclusive licence of the copyright or patent for the same period and area, which complicates the first issue. The advent of software raised the second issue. In relation to the third issue, note that para (c) dealing with know-how applies to payments “for” information as opposed to “for use or the right to use”, unlike paras (a) and (e). In legal terms the provision of know-how is a service (FCT v Sherritt Gordon Mines Ltd (1977) 137 CLR 612), but in commercial terms it is effectively the confidential communication of intellectual property from one party to another. These three issues are addressed by the OECD in relation to software in the extract below, though the OECD has extrapolated the principles expressed there to intellectual property more generally (such as digital downloads, broadcasting etc). The ATO addresses similar issues though with different nuances in Ruling IT 2660 on the border between knowhow and services, Ruling TR 93/12 on payments for software and Ruling TR 2008/7 on assignments of copyright. Recent Australian cases on the meaning of royalties have made passing references to the OECD Commentaries in coming to similar conclusions though with a more literal approach to the definition (see questions following extract).

OECD Commentaries on the Model Tax Convention Article 12 (2014) [18.180] 12. Whether payments received as consideration for computer software may be classified as royalties poses difficult problems but is a matter of considerable importance in view of the rapid development of computer technology in recent years and the extent of transfers of such technology across national borders. … 12.1 Software may be described as a program, or series of programs, containing instructions for a computer required either for the operational processes of the computer itself (operational software) or for the accomplishment of other tasks (application software). It can be transferred through a variety of media, for example in writing or electronically, on a magnetic tape or disk, or on a laser disk or CD-ROM. It may be

standardised with a wide range of applications or be tailor-made for single users. It can be transferred as an integral part of computer hardware or in an independent form available for use on a variety of hardware. 12.2 The character of payments received in transactions involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. The rights in computer programs are a form of intellectual property. Research into the practices of OECD member countries has established that all but one protect rights in computer programs either explicitly or implicitly under copyright law. Although the term [18.180]

933

Income Derived From International Transactions

OECD Commentaries on the Model Tax Convention Article 12 (2014) cont. “computer software” is commonly used to describe both the program – in which the intellectual property rights (copyright) subsist – and the medium on which it is embodied, the copyright law of most OECD member countries recognises a distinction between the copyright in the program and software which incorporates a copy of the copyrighted program. Transfers of rights in relation to software occur in many different ways ranging from the alienation of the entire rights in the copyright in a program to the sale of a product which is subject to restrictions on the use to which it is put. The consideration paid can also take numerous forms. These factors may make it difficult to determine where the boundary lies between software payments that are properly to be regarded as royalties and other types of payment. The difficulty of determination is compounded by the ease of reproduction of computer software, and by the fact that acquisition of software frequently entails the making of a copy by the acquirer in order to make possible the operation of the software. 13. The transferee’s rights will in most cases consist of partial rights or complete rights in the underlying copyright (see paragraphs 13.1 and 15 below), or they may be (or be equivalent to) partial or complete rights in a copy of the program (the “program copy”), whether or not such copy is embodied in a material medium or provided electronically (see paragraphs 14 to 14.2 below). In unusual cases, the transaction may represent a transfer of “know-how” or secret formula (paragraph 14.3). 13.1 Payments made for the acquisition of partial rights in the copyright (without the transferor fully alienating the copyright rights) will represent a royalty where the consideration is for granting of rights to use the program in a manner that would, without such license, constitute an infringement of copyright. Examples of such arrangements include licenses to reproduce and distribute to the public software incorporating the copyrighted program, or to modify and publicly display the program. In these circumstances, the payments are for the right to use the copyright in the program (i.e. to exploit 934

[18.180]

the rights that would otherwise be the sole prerogative of the copyright holder). … 14. In other types of transactions, the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the program, for example, where the transferee is granted limited rights to reproduce the program. This would be the common situation in transactions for the acquisition of a program copy. The rights transferred in these cases are specific to the nature of computer programs. They allow the user to copy the program, for example onto the user’s computer hard drive or for archival purposes. In this context, it is important to note that the protection afforded in relation to computer programs under copyright law may differ from country to country. In some countries the act of copying the program onto the hard drive or random access memory of a computer would, without a license, constitute a breach of copyright. However, the copyright laws of many countries automatically grant this right to the owner of software which incorporates a computer program. Regardless of whether this right is granted under law or under a license agreement with the copyright holder, copying the program onto the computer’s hard drive or random access memory or making an archival copy is an essential step in utilising the program. Therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the program by the user, should be disregarded in analysing the character of the transaction for tax purposes. Payments in these types of transactions would be dealt with as commercial income in accordance with Article 7. 14.1 The method of transferring the computer program to the transferee is not relevant. For example, it does not matter whether the transferee acquires a computer disk containing a copy of the program or directly receives a copy on the hard disk of her computer via a modem connection. It is also of no relevance that there may be restrictions on the use to which the transferee can put the software. 14.2 The ease of reproducing computer programs has resulted in distribution arrangements in which the transferee obtains rights to make multiple copies of the program for operation only within its own business. Such

Taxation of Non-residents

OECD Commentaries on the Model Tax Convention Article 12 (2014) cont. arrangements are commonly referred to as “site licences”, “enterprise licenses”, or “network licences”. Although these arrangements permit the making of multiple copies of the program, such rights are generally limited to those necessary for the purpose of enabling the operation of the program on the licensee’s computers or network, and reproduction for any other purpose is not permitted under the license. Payments under such arrangements will in most cases be dealt with as business profits in accordance with Article 7. 14.3 Another type of transaction involving the transfer of computer software is the more unusual case where a software house or computer programmer agrees to supply information about the ideas and principles underlying the program, such as logic, algorithms or programming languages or techniques. In these cases, the payments may be characterised as royalties to the extent that they represent consideration for the use of, or the right to use, secret formulas or for information concerning industrial, commercial or scientific experience which cannot be separately copyrighted. This contrasts with the ordinary case in which a program copy is acquired for operation by the end user. 14.4 Arrangements between a software copyright holder and a distribution intermediary frequently will grant to the distribution intermediary the right to distribute copies of the program without the right to reproduce that program. In these transactions, the rights acquired in relation to the copyright are limited to those necessary for the commercial intermediary to distribute copies of the software program. In such transactions, distributors are paying only for the acquisition of the software copies and not to exploit any right in the software copyrights. Thus, in a transaction where a distributor makes payments to acquire and distribute software copies (without the right to reproduce the software), the rights in relation to these acts of distribution should be disregarded in analysing the character of the transaction for tax purposes. Payments in these types of transactions would be dealt with as business

CHAPTER 18

profits in accordance with Article 7. This would be the case regardless of whether the copies being distributed are delivered on tangible media or are distributed electronically (without the distributor having the right to reproduce the software), or whether the software is subject to minor customisation for the purposes of its installation. 15. Where consideration is paid for the transfer of the full ownership of the rights in the copyright, the payment cannot represent a royalty and the provisions of the Article are not applicable. Difficulties can arise where there is a transfer of rights involving: – exclusive right of use of the copyright during a specific period or in a limited geographical area; – additional consideration related to usage; – consideration in the form of a substantial lump sum payment. 16. Each case will depend on its particular facts but in general if the payment is in consideration for the transfer of rights that constitute a distinct and specific property (which is more likely in the case of geographically-limited than time limited rights), such payments are likely to be business profits within Article 7 or a capital gain within Article 13 rather than royalties within Article 12. That follows from the fact that where the ownership of rights has been alienated, the consideration cannot be for the use of the rights. The essential character of the transaction as an alienation cannot be altered by the form of the consideration, the payment of the consideration in instalments or, in the view of most countries, by the fact that the payments are related to a contingency. 17. Software payments may be made under mixed contracts. Examples of such contracts include sales of computer hardware with built-in software and concessions of the right to use software combined with the provision of services. The methods set out in paragraph 11 above for dealing with similar problems in relation to patent royalties and know-how are equally applicable to computer software. Where necessary the total amount of the consideration payable under a contract should be broken down on the basis of the information contained in the contract or by means of a reasonable apportionment with the appropriate tax treatment being applied to each apportioned part. [18.180]

935

Income Derived From International Transactions

[18.185]

Questions

18.11 What is the meaning given to “use” in the context of the royalties definition? An Australian State government acquires a site licence for 500 users at $500 per user of medical specialist software from Bigsoft Co, a UK resident company with no PE in Australia. The software is delivered over the Internet to the IT section of the government which then installs it on 500 computers in public hospitals throughout the State. Is the payment by the State to Bigsoft subject to royalty withholding tax? Would it make a difference if Bigsoft appointed Local Pty Ltd as its software distributor in Australia in exchange for similar payments? (See International Business Machines v FCT [2011] FCA 335, Task Technology v FCT [2014] FCAFC 113.) 18.12 Bigstudio Co, a UK film maker with no PE in Australia, sells Aussie Filmhouse Ltd, a local film distributor, copyright in its latest film for one year for the Australasian region in return for $5 m. One year later it enters into a similar agreement with Aussie Filmhouse in exchange for $3 m. The first agreement corresponds with the cinema release of the film and the second agreement with the availability of the film on various digital subscription services. Are the payments subject to royalty withholding tax, income tax or CGT in Australia? Would the result be different under the US treaty if Bigstudio were a US resident? (See Div 855 of the ITAA 1997, UK treaty articles 7, 12, 13, US treaty articles 7, 12, 13, and Ruling TR 2008/7.) 18.13 Fix Inc, a US television network with no PE in Australia, provides its sports program by satellite to private consumers in Australia on a pay-per-view basis. Are the payments subject to royalty withholding tax? Would it make a difference if Fix Inc provided a satellite feed to AussieTV Ltd, a cable channel, for $15,000 per event and AussieTV then marketed the programs to Australian viewers via a cable network? What if AussieTV had the broadcast rights to the 2016 Olympic Games and paid the International Olympic Committee (resident in Switzerland) for a direct digital feed of the vision and sound created by the host broadcaster, a Brazilian company? (See FCT v Seven Network [2016] FCAFC 70) 18.14 Taxplanning Co, a UK company with no PE in Australia, sells to Australian high wealth individuals on a private basis various standard tax schemes that it has devised for a price equal to 10% of the tax saving achieved. Are the payments to Taxplanning by the Australian individuals subject to royalty withholding tax?

(ii) Equipment leasing [18.190] The “royalty” definition in s 6(1) also includes payments for the use of or the right

to use industrial, commercial or scientific equipment. This part of the definition was also included in the treaty definition until recently (it is not in the UK, US or most subsequent treaties). Treaties contain a number of other provisions that are potentially relevant to cross-border equipment leasing. One of the common provisions of the PE definition in Australian treaties deems a PE to exist where “substantial equipment is being used in that … State by, for or under contract with the enterprise” (see Australia–Singapore treaty article 4(3)(b)). The shipping and air transport article often contains provisions about the leasing and operation of ships and aircraft. Hence issues often arise of which provision applies. 936

[18.185]

Taxation of Non-residents

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In McDermott Industries (Aust) Pty Ltd v FCT (2005) 59 ATR 358 the Full Federal Court held that a Singapore resident lessor of barges to an Australian lessee which used them in Australia gave rise to a PE under this treaty provision for the lessor, with the result that the operation of the royalties article (and royalty withholding tax) was displaced in favour of the business profits article and the profits of the lessor were taxable on a net basis rather than a gross final withholding basis. In treaties from 2006 on Australia has changed the substantial equipment PE provision to refer to the “operation” of the equipment which will prevent the creation of a PE of a passive lessor. As treaties since 2001 also generally do not include equipment leasing in the royalties definition, the effect is that equipment lessors under such treaties are generally not taxable in Australia when the equipment is used in Australia. [18.195]

Questions

18.15 A US or UK resident lessor leases barges to an Australian resident for use in Australia in similar circumstances to the McDermott case. Is the lessor taxable in Australia and how? (See UK treaty articles 5(3)(a), 8, 12(3) and US treaty articles 5(4)(b), 8, 12(4), and Rulings TR 2007/10 and TR 2008/8.) 18.16 Does the royalty withholding tax apply to hire purchase transactions which are legally the hire of equipment with an option to purchase but economically a sale and loan? (See s 128AC of the ITAA 1936 and Ruling TR 98/21.)

5. EMPLOYMENT AND PERSONAL SERVICES [18.200] Domestic law has very few special provisions dealing with the taxation of personal

services income of non-residents, unlike the previous categories. The case law on source suggests that income from personal services is generally sourced where the services are rendered, though the place of contract and payment can also be relevant: see French v FCT (1958) 98 CLR 398, FCT v Efstathakis (1979) 9 ATR 867. There is certainly no fixed rule that the place of rendering personal services is the source of the income: FCT v Mitchum (1965) 113 CLR 401. Treaties follow generally, but not exclusively, the place of rendering personal services in their sourcing rules. Collection of tax on personal services income of non-residents is generally under ordinary rules, for example, the salaries of non-resident employees working in Australia are generally subject to the PAYG withholding system. The progressive rate scale for individuals who are non-resident is modified when they are taxed by assessment – they are denied the benefit of the zero bracket and lower rates. They are taxed at 29 % for taxable income up to $37,000, and normal individual rates for income in excess of this amount: Income Tax Rates Act 1986 Sch 7 Pt II; note the modifications for “working holiday makers” (backpackers) whether residents or non-residents in Income Tax Rates Act 1986 Sch 7 Pt III.

(a) Employees [18.210] Tax treaties treat employment income of non-residents as taxable in Australia if the

services are performed here subject to an exception where the employee is not present in Australia for more than 183 days in a 12-month period; is an employee of a non-resident employer; and is not working for a PE of the employer while here. The purpose of the exception is to remove taxing rights when the employee and employment have only a limited connection with a country in order to protect the employee from being exposed to two, or even several, tax systems if moving between countries regularly in doing work. [18.210]

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Income Derived From International Transactions

The exception, however, has been subject to tax planning, commonly referred to as hiring out of labour. Suppose an Australian company requires a highly skilled employee for a short period to perform some task. Rather than the person being employed by the Australian company, he or she can arrange to be employed by a foreign company without a PE in Australia which in turn provides the services of the person to the Australian company. [18.215]

Questions

18.17 Can the problem of hiring out of labour be solved by treaty interpretation? (See TR 2013/1 and the discussion of tax treaties and tax avoidance below.) 18.18 How do the employment and business profits articles of tax treaties interact with the Australian rules on alienation of personal services income in Divs 84 – 87 of the ITAA 1997? (See Chapter 4 for these rules, Russell v FCT (2009) 74 ATR 446, (2011) 79 ATR 315.) 18.19 A is an employee of a US company without a PE in Australia who arrives in Australia on 2 January 2012 to work and leaves on 29 December 2012. Is A taxable in Australia under the US treaty? Would it make a difference if A were a resident of the UK? What if A had intended to leave on 28 June 2012 but fell very ill and was only fit to travel six months later? (See UK treaty article 14 and US treaty article 15.) [18.220] One of the major problems with the employment article in tax treaties is dealing

with fringe benefits. In Australia this problem is made more problematic by most fringe benefits being taxed to the employer under the FBT, see Chapter 4. Although share options are not taxable under the FBT they cause significant problems as they accrue over periods of time and countries’ taxing regimes for them vary significantly. In the UK treaty both these problems have been tackled. [18.225]

Questions

18.20 A UK resident employee of a UK employer without a PE in Australia works in Australia for four months during which time she is provided with a car by her employer. Is FBT payable on the provision of the car? Would it make a difference if the employee worked for a PE of her employer in Australia? What would be the position in equivalent situations under the US treaty if she were a US resident? (See UK treaty articles 2, 14, 15 and US treaty articles 2, 15.) 18.21 A UK resident employee is granted employee share options by his employer in 2014. The options are only exercisable in three years’ time and if the employee is still with the company at that time. The exercise price is the market price of the shares on the day they are granted. The employee comes to Australia to work for all of 2016 but does not become a resident here under the treaty. In 2017 the employee returns to the UK, exercises the options and sells the shares for a $50,000 profit. The UK taxes the employee on the profit made on the sale of the shares. Will Australia tax the employee under domestic law, and if so on how much? How will the treaty operate in this case? (See Div 83A of the ITAA 1997 discussed in Chapter 4, UK treaty articles 14, 22, Exchange of Notes para 8.)

(b) Professional and Consultancy Services [18.230] Tax treaties have traditionally contained an article titled “independent personal

services” that has applied to individuals rendering professional services to clients other than as employees (accountants, lawyers, etc). Although the terminology used is different (fixed base) the article parallels in much shorter terms the rules on PEs and business profits. Other articles 938

[18.215]

Taxation of Non-residents

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of tax treaties that cross-refer to PEs also cross-refer to this article if it is included in the treaty: see, for example, US treaty articles 10(5), 11(6), 12(3). In 2000 the OECD omitted this article from the Model Tax Convention and since then many countries have followed suit, including Australia in the UK treaty and subsequently: see article 3(1)(m), Exchange of Notes para 2. Under the UK treaty such income is now dealt with under articles 5 and 7. The UN Model contains a special provision that deems a PE to exist if services are rendered in a country by a person for six months in a 12-month period on the same or a connected project, with the result that the profits from the services become taxable there under the business profits article. By their nature services do not always require a fixed place of business in the same way as an office, factory or shop. The provision is designed to produce a PE even if the services are rendered at various locations so that there is no fixed place of business of the service provider in the country. In 2008 the OECD included in its Commentary a variant on the UN provision as a possible treaty provision but also included several arguments why such a provision should not be included in treaties. The next version of the UN Model will also include a fees for technical services article which will effectively assimilate such fees to royalties (knowhow) and allow a gross basis withholding tax on such fees. A variant on this article is considered in Tech Mahindra v FCT [2015] FCA 1082 which analyses various kinds of IT services provided by an Indian company to Australian clients and holds that some came within the provision (anything involving alteration of source code in software) and some not (general IT services such as software maintenance and supervision of software applications). To the extent that the fees are effectively connected with a PE or fixed base in the country of the payer, the business profits or independent services articles will apply rather than the fees for technical services article. In Tech Mahindra most of the services were provided by a PE in Australia, but in peak times additional services were provided by employees working in India. The court held that the IT services provided by Australian based employees were effectively connected with the PE but the services provided by the Indian based employees were not so connected; an appeal by the taxpayer from this aspect of the decision was dismissed [2016] FCAFC 130. [18.235]

Questions

18.22 A US partnership of lawyers establishes an office in Sydney to provide legal services to US and Australian clients. One of the partners in the firm moves to Australia and works in the Sydney office along with employed lawyers and other staff. Who is taxable on the net income of the partnership generated by the Australian office? (See Div 5 of the ITAA 1936 and US treaty article 14.) 18.23 Should the provision of services in a country for a reasonably long period of time give rise to a PE and source taxation if no fixed place of business is involved? Is a technical fees article a sensible extension of source taxation of services income?

(c) Entertainers and Sports Stars [18.240] Tax treaties which generally include the OECD Model Tax Convention article 17

have no time or other threshold for taxation of income earned by entertainers and sports stars from performances in a country in view of the substantial income that can be earned in a short period. In turn these types of taxpayers have sought to circumvent tax in the country of performance by using star companies they own which contract with the promoter of the event and then pay relatively modest fees to the entertainers or sports stars. Most tax treaties now [18.240]

939

Income Derived From International Transactions

contain special provisions to deal with star companies and expose them to tax in the country of performance as well: see UK treaty article 16(2) and US treaty article 17(2). An early case involving a star company is FCT v Mitchum (1965) 113 CLR 401. Robert Mitchum, a US resident, came to Australia to star in the film The Sundowners. A Swiss company (which may or may not have been owned by Mitchum) contracted his services to Warner Bros. His contract with the Swiss company required him to “advise in the connexion of the selection and suitability of principal members of the cast and to assist the producer in the selection, training and coaching of other members of the cast, and to consult with the producer in connexion with the revision and/or changes of the screenplay, and also to act, play, perform, and take part in two motion picture photoplays and in rehearsals etc. for and as directed by that company at such studios and places and on such locations as that company might from time to time designate”. He received US$50,000 for his work on the film which involved 11 weeks’ work in Australia. At the time Australia had a treaty with the US but not Switzerland. The ATO assessed the taxpayer on most of the remuneration received from the Swiss company. The Board of Review on appeal held that none of the income was sourced in Australia. The ATO appealed to the High Court. To be able to appeal, the ATO needed to show that the case involved a question of law. The ATO argued that there was a rule of law that income from services was sourced where the services were performed. The High Court held there was no such rule. Thus it seems that the income went untaxed in the light of the finding of the Board of Review and there was no need to consider the then US treaty which did not contain a specific article on entertainers. [18.245]

Question

18.24 How would the case be decided under the US treaty article 17 now? Would the result be different under the UK treaty if Mitchum were a UK resident? Would the star company be taxable in Australia on the income it received from Warner Bros, and which treaty would apply to determine this question? (See Swiss treaty articles 7, 17, US treaty articles 7, 17 and UK treaty articles 7, 16.) [18.250] Until 2004 tax collection in these cases was carried out under s 255 of the ITAA

1936. Now most of these cases are covered by Sch 1 Subdiv 12-FB of the Taxation Administration Act 1953 providing for withholding on payments to foreign residents under categories established by regulations and reg 44B of the Taxation Administration Regulations 1976 includes entertainment and sports activities of both the star or athlete and their entourage. The covered payments go far beyond those dealt with by treaty provisions on entertainers and sports stars. Often the amounts will not be assessable income as those treaty provisions do not cover payments other than relating to appearance, for example, fees for giving a public speech, and do not apply to the non-resident entourage of the entertainer or sports star who will usually exempt under the employee, independent personal services or business profits articles of treaties as appropriate. In such cases it is necessary to file a tax return and claim a refund of tax which is a significant administrative burden or to obtain an exemption in advance from the ATO.

940

[18.245]

Taxation of Non-residents

CHAPTER 18

(d) Other Personal Services Income [18.260] Several other kinds of personal services income are covered by treaties including:

directors’ fees (usually a separate article 16, but compare UK treaty article 14); government service (usually article 19, UK treaty article 18); diplomats (near the end of the treaty); and pensions (usually article 18, UK treaty article 17). Of more interest to users of this book will be the articles on students (usually article 20, UK treaty article 19). [18.265]

Question

18.25 Does the variety of treaty rules for the taxation of services make sense? How should cross-border services of individuals and companies be taxed? (See Arnold, “The Taxation of Income from Services under Tax Treaties: Cleaning Up the Mess” (2010) 65 Bulletin for International Taxation59.)

6. OTHER INCOME [18.270] Most of Australia’s tax treaties since 1980 have an “other income” or similarly

titled article: see UK treaty article 20. In the OECD Model this article gives exclusive taxing rights to the residence country but Australia follows the UN Model and preserves source taxing rights in respect of income sourced in Australia. One function of this article is to cover income not dealt with in the preceding distributive articles (such as gambling winnings if taxable outside a business context, as is the case in the US, or possibly alimony and maintenance depending on the treaty). A more important function is to deal with income sourced in third countries and to prevent double taxation arising from different countries regarding the income as sourced in that country. Under the OECD Model the other income article achieves this goal by the residence only taxation rule. It is more doubtful if Australia’s treaties achieve this result.

7. TREATY SHOPPING AND ANTI-AVOIDANCE [18.280] Australia does not have tax treaties with many countries (for a long-time OECD

member its total number of comprehensive tax treaties is very low), and some of its treaties are more generous than others. Hence foreign taxpayers will be tempted to set up companies or other intermediaries in a country with which Australia has a favourable tax treaty and to route transactions through that country to get treaty benefits that would not be available if the transactions occurred directly from the residence country of the taxpayers. This practice is referred to as treaty shopping. Treaties themselves contain some provisions dealing with the issue. One example is the requirement in the dividends, interest and royalties articles that the treaty benefit is only available if the taxpayer is the beneficial owner or beneficially entitled to the income but this has not had much impact on treaty shopping. The US is the country which has been the most concerned about treaty shopping in general and it will not enter into a treaty unless it includes a limitation of benefits (LOB) article. The relevant provision in its treaty with Australia is article 16 as amended by the 2001 Protocol. The UK by contrast has long considered that the area of passive income (dividends, interest, royalties and other income) is most prone to treaty shopping and has therefore included a test of “a main purpose” to obtain a benefit in its treaties to prevent abuse of those articles: see UK treaty articles 10(7), 11(9), 12(7) and 20(5). [18.280]

941

Income Derived From International Transactions

Australia by contrast has preferred to rely on its general anti-avoidance rule in Pt IVA (see Chapter 20) to deal with treaty shopping and specifically provides that Pt IVA is an exception to the general rule that tax treaties override domestic law: see Agreements Act s 4(2). Until 2003, the OECD Commentary on article 1 provided that tax treaties overrode domestic anti-abuse rules and included a number of possible treaty anti-abuse rules for inclusion in treaties which had been added in 1992. In 2003, this general position on the interaction of domestic anti-abuse rules and treaties was reversed but in addition many more general and specific treaty anti-abuse rules were added to the Commentary for countries to consider including in their treaties. This was not only a mixed message but also awkward for countries like Australia whose courts have generally taken the view that it is the Commentary at the time a treaty is signed which is applicable to that treaty and not later Commentary: see FCT v Thiel (1990) 171 CLR 338, Lamesa Holdings v FCT [1997] FCA 134 and Task Technology v FCT [2014] FCAFC 113, compare ATO ruling TR 2001/13. Hence simple reliance on the Commentary for the proposition of the superiority of Pt IVA over treaties is likely to apply only to Australian treaties signed from 2003 (10 of Australia’s 43 comprehensive tax treaties), and to what extent the 2003 Commentary would be readily accepted by courts is unclear as it represents a U-turn from the previous position without any change in the OECD Model treaty text. Australia can argue as a matter of international law that domestic law made Australia’s position clear when Pt IVA was enacted in 1981 and that position has been communicated to its treaty partners when negotiating treaties since then and hence has been accepted in those treaties. The ATO indicated in TD 2010/20 that it considers that Pt IVA applies to the Netherlands treaty which dates from 1976. The validity of these views in international law (as opposed to domestic law) can only be regarded as unclear, given the rule in the Vienna Convention on the Law of Treaties article 27 that a country cannot invoke its domestic law as justification for its failure to perform a treaty. Perhaps for this reason, Australia in several of its tax treaties since 2003 has either made clear by express provisions that its domestic anti-abuse rules override the treaty, or included a general anti-abuse rule in the treaty, or both: see eg UK treaty Exchange of Notes para 1, 2013 Switzerland treaty Protocol para 1 and 2015 German treaty article 23 respectively. And for good measure Australia has included many specific anti-abuse treaty provisions in these and the rest of its post-2003 treaties. It is very likely that these arguments will be rendered largely moot by the BEPS project which is described generally in Chapter 16. The final report on Action 6 on treaty abuse has adopted a minimum standard which has been accepted by all countries. It requires a preamble to tax treaties to indicate that they are not generally intended to facilitate double non-taxation and the inclusion of general treaty anti-abuse rules consisting of (a) an LOB treaty article plus an anti-conduit rule in either the treaty or domestic law; (b) a principal purpose test (PPT) anti-abuse rule modelled on the UK specific main purpose rules but generalised to the whole of the treaty; or (c) both LOB and PPT rules. This standard is included in the proposed BEPS multilateral treaty and will be a largely non-optional provision in signing that treaty though there will be a choice among (a), (b) and (c). Australia proposes to adopt option (b) when it signs the treaty; it has already included the PPT rule in its two most recent treaties and it seems that most other countries which sign the treaty will act similarly. Notwithstanding the adoption of this standard, the Action 6 final report will further bolster the Commentary on article 1 to the effect that domestic anti-abuse rules override tax treaties. 942

[18.280]

Taxation of Non-residents

CHAPTER 18

Hence it is likely that the future debate will turn to the meaning of the PPT rule. Article 7(1) of the proposed multilateral treaty reads: Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.

As it is an open-ended purpose test, its content will remain uncertain until court cases start to give it content. The reason the US has insisted on an LOB option is precisely because of the uncertainty of the PPT. In addition to generally accepting the BEPS recommendations, Australia has gone further by amending its general anti-avoidance rule in Pt IVA of the ITAA 1936 by the so-called MAAL (multinational anti-avoidance law) in 2015: see s 177DA. It also proposed a Diverted Profits Tax (DPT) in the 2016 Budget and released an exposure draft in November 2016. The MAAL deals with structures used by non-residents to avoid a PE in Australia or attribution of profits to an existing PE, with the result that no or lesser profits are taxed to the non-resident and interest or royalty payments by the non-resident avoid withholding tax. This amendment particularly affects companies operating in the digital economy and commenced on 1 January 2016. Australia’s DPT will impose a penalty tax rate of 40% from 1 July 2017 on profits transferred offshore through related party transactions with insufficient economic substance that reduce the tax paid on the profits generated in Australia by more than one-fifth and is modelled by a similar law introduced in the UK in 2015. Both these laws have been subject to international criticism. As noted in Chapter 16, the BEPS final report on Action 1 permits countries to adopt some measures to address BEPS even though they were not recommended by the OECD. It is debatable whether these laws are what the OECD had in mind. [18.315]

Questions

18.26 Bad Ltd is a former listed company resident in Australia which is now in liquidation; the liquidator has sold its business assets in Australia and subsequently sold the business assets of Badsub Inc, a 100% subsidiary of Bad resident in the US which is also in liquidation. After the sale of its assets Badsub’s funds are paid out to Bad by way of a liquidation distribution which is treated as a dividend in the US. Can Bad obtain treaty benefits for the dividend in the US having regard to US treaty article 16? Would the result be different under the BEPS proposed PPT rule? 18.27 Car plc is listed and resident in the UK and wishes to lend $100m to its subsidiary Carsub Pty Ltd which is resident in Australia; a loan direct by Car to Carsub would attract withholding tax of 10% in Australia. Car accordingly places $100m on deposit with Bank Inc resident in the US and Bank Inc lends $100m to Carsub at an interest rate which earns 0.1% profit for Bank after paying interest on Car’s deposit. Under the tax treaty between the US and the UK there is no withholding tax on interest permitted. Will the interest paid by Carsub to Bank be eligible for the zero tax rate under the US treaty article 11(7)? Would the LOB in article 16 of that treaty apply to deny that benefit if it were otherwise available? Would a PPT rule be applicable if the US treaty included such a rule? Would the Australian MAAL or DPT apply in such a case? (Note that the UK corporate tax rate is more than one fifth below the Australian corporate tax rate). [18.315]

943

Income Derived From International Transactions

8. NON-DISCRIMINATION [18.320] Tax treaties commonly contain non-discrimination articles that prevent a source

country discriminating against taxpayers resident in, or nationals of, the other country. It can be regarded as the complement of the residence country’s obligation to relieve double taxation. For example, if the residence country relieves double taxation by a foreign tax credit, it would be inappropriate for the source country to increase its tax on residents of that country (compared to other taxpayers) to use up the credit available in the residence country. This article was not included in Australia’s treaties for many years. As the US will not enter into a treaty without such an article, the 1983 US treaty contained a watered-down provision in article 23. The first full non-discrimination article agreed to by Australia appears in the UK treaty article 25. This article confers direct rights on taxpayers and can be relied on in the courts. The text of the UK article is largely in standard OECD form but it contains a number of additions not found in the OECD Model which reflect Australia’s desire to ensure that certain parts of domestic tax law are not overridden by the article. Paragraph 1 prevents discrimination on the basis of nationality, but this will have limited application in practice. Most countries do not base the operation of their tax law on nationality. Paragraph 2 prevents discrimination against PEs compared to resident taxpayers. Paragraph 3 prevents disallowance of deductions on the basis of the payment being made to a non-resident, except in relation to transfer pricing adjustments made in accordance with the arm’s length principle. Paragraph 4 prevents tax discrimination on the basis of foreign ownership of a resident company. Paragraph 5 ensures that Australia is not required by the article to extend personal allowances, reliefs and reductions to UK resident individuals. The express qualifications to this basic standard are several in the UK treaty, but have been decreasing since that treaty. In the 2015 treaty with Germany they have been reduced to one case concerning consolidation (Protocol para 8) but this is partly explained by the further provisions that the treaty does not affect general or specific domestic anti-abuse rules, article 23(3). Whether such non-discrimination articles will have any dramatic effect on Australian tax law remains to be seen. A study conducted some decades ago concluded that among Australia, Canada, NZ, UK and US, Australia discriminated the least against foreigners: Arnold, Tax Discrimination Against Aliens, Non-Residents, and Foreign Activities: Canada, Australia, New Zealand, the United Kingdom, and the United States (Canadian Tax Foundation, 1991). Moreover, tax treaty non-discrimination rules are quite limited compared to nondiscrimination in international trade and investment treaties. The tax rules generally only apply to the source country and to specific cases because of the very precise way in which they are drafted. In the EU in particular, the very broad non-discrimination rules in the EU treaty have been applied to taxation, with the result that many of the international rules in EU countries affecting both source and residence taxation have been ruled contrary to the EU rules by the European Court of Justice such as CFC, transfer pricing, imputation and thin capitalisation regimes. Partly in response to EU developments, the OECD has recently revised its Commentary on the non-discrimination article to ensure that the same outcome does not arise with the tax treaty rules. Moreover the BEPS final report on Action 6 has recommended that countries adopt a US-style saving clause in their treaties to the effect that the treaty does not limit a country in the way it taxes its residents except in some obvious respects such as the treaty 944

[18.320]

Taxation of Non-residents

CHAPTER 18

obligation for the residence country to relieve double taxation: see US treaty article 1(3), (4). These provisions ensure that domestic CFC and transfer pricing regimes among others are not affected by tax treaties. [18.325]

Question

18.28 Does the non-discrimination article in the UK treaty have any impact on the CFC, transfer pricing, imputation, consolidation and thin capitalisation regimes discussed in Chapters 14, 15, 16 and 17, apart from the exceptions for these regimes? Will other treaty provisions affect such regimes? Will the saving clause recommended by the BEPS project overcome any such problems?

[18.325]

945

TAX ADMINISTRATION 19. Administering the Tax Regime ....................................................... 949

[Pt7.10] The last portion of the book looks at the rules that set out how the tax system is meant to work. Any highly complex system – and income tax is certainly that – needs rules to govern the behaviour of the various participants involved in it. So, the following chapters look at the rules which dictate what steps are meant to be taken, in what order, and by whom, and then what can be done when some part of the process is not followed or breaks down. A glance at the law reports of decided cases will demonstrate that taxpayers pay a lot of attention to these technical details and try to win their battles with the Commissioner by showing some defect or failing in his actions. So the rules we are examining in Chapters 19 and 20 are aimed both at the Commissioner – authorising him to do various things – and at taxpayers – requiring them to do certain things by certain times and in particular ways.

PART7

20. Containing Tax Avoidance and Evasion .................................... .. 1011

Chapter 19 describes the principal elements of the tax system: when do taxpayers have to start paying money to the government; how and by whom is their tax liability eventually determined; what can they do if they disagree with that determination; what can the Commissioner do to enforce payment by the unwilling; and how can he check whether what he is being told is correct? All of these questions are governed by rules. And, like all legal regimes, the rules both authorise certain things, and imply their own limitations. Chapter 20 is devoted entirely to one special regime – the general anti-avoidance rule. As its name suggests, this rule is designed to give the Commissioner a general power to counter tax avoidance. It has been described as the “jewel in the Crown” in the Commissioner’s armoury because, when its terms are met, the rule allows him to impose the tax that might have been payable had a person undertaken a transaction in a different way. Taxing someone on what they might have done but didn’t do is obviously going to raise a number of difficulties. And again, because this is a written rule, the general anti-avoidance rule both authorises certain things, and implies its own limitations. We examine the power and the limits in the last chapter.

947

CHAPTER 19 Administering the Tax Regime [19.10]

1. ADMINISTERING THE INCOME TAX SYSTEM ................... ......................... 951

[19.20]

(a)The Commissioner and the ATO ............................................................................ 953

[19.30]

(b) Supporting Voluntary Compliance ....................................................................... 954

[19.35]

(c) Self-assessment .................................................................................................... 955

[19.40] [19.50] [19.60] [19.70] [19.80]

(d) Taxation Rulings and Determinations ................................................................... 957 (i) Public Rulings (Divs 357 – 358) ............................................................................ 958 (ii) Private Rulings (Div 359) ...................................................................................... 960 (iii) Oral Rulings (Div 360) ........................................................................................ 960 (iv) Other administrative sources ............................................................................... 961

[19.87]

(e) Statutory Remedial Power .................................................................................... 962

[19.90]

2. REGISTRATION SYSTEMS.................................. .......................................... 963

[19.95]

3. PAYING (AND PREPAYING) TAX ............................. ..................................... 963

[19.100]

(a) Collecting Tax from Payments to Employees ........................................................ 964

[19.120]

(b) Investors, Self-funded Retirees and Employees’ Investment Income ..................... 966

[19.130]

(c) Unincorporated Businesses .................................................................................. 967

[19.140]

(d) Companies and Corporate Entities ...................................................................... 968

[19.150]

(e) Withholding Regimes for Resident Taxpayers ....................................................... 968

[19.160]

(f) Withholding on Payments to Non-residents .......................................................... 969

[19.170] 4. ASSESSING (AND SELF-ASSESSING) TAX DEBTS ................. ....................... 970 [19.180]

(a) Tax Returns .......................................................................................................... 970

[19.190]

(b) Annual Assessments ............................................................................................. 971

[19.200]

(c) Default Assessments ............................................................................................. 972

[19.220]

(d) Amending Assessments ........................................................................................ 972

[19.240] 5. CHALLENGING THE ATO’S DECISIONS........................ .............................. 974 [19.250] [19.260] [19.270] [19.285] [19.290] [19.300]

(a) Objections to Assessments and Private Rulings ..................................................... (i) Objecting that it is not a lawful assessment .......................................................... David Jones Finance and Investments Pty Ltd v FCT ...................................................... FCT v Donoghue ........................................................................................................ (ii) Objecting to the accuracy of the assessment ....................................................... FCT v Reynolds ...........................................................................................................

974 975 977 978 980 982

[19.320] [19.330] [19.335] [19.340] [19.350]

(b) Reviews and Appeals ........................................................................................... (i) Choice of forum ................................................................................................... Haritos v FCT ............................................................................................................. (ii) Issues justiciable on appeal .................................................................................. (iii) Onus of proof .....................................................................................................

983 983 984 985 985 949

Tax Administration

[19.360] [19.370] [19.380] [19.400] [19.410]

(c) Reviewing the Exercise of Administrative Discretions ............................................ (i) Judicial review of discretions in making assessments ............................................. Giris Pty Ltd v FCT ...................................................................................................... (ii) Administrative Decisions (Judicial Review) Act 1977 ............................................. (iii) Inspector-General of Taxation .............................................................................

986 986 986 988 989

[19.420]

(d) Collection of Tax ................................................................................................. 989

[19.430] 6. AUDIT AND INVESTIGATION ............................... ....................................... 991 [19.440]

(a) Formal Investigative Powers ................................................................................. 993

[19.450] [19.450] [19.460] [19.480] [19.497] [19.500]

(b) Claims of Privilege ............................................................................................... 996 (i) Legal professional privilege ................................................................................... 996 Baker v Campbell ....................................................................................................... 996 Citibank v FCT ........................................................................................................... 998 FCT v Donoghue ...................................................................................................... 1000 (ii) Privilege against self-incrimination ..................................................................... 1001

[19.510]

(c) Obtaining Information from the ATO ................................................................. 1002

[19.520] 7. ENFORCEMENT AND PENALTIES ........................... ................................... 1004 [19.530]

(a) Tax Offences and Penalties ................................................................................. 1005

[19.540]

(b) Hardship Relief .................................................................................................. 1008

Principal sections ITAA 1936 s 161 ss 162, 163 s 166 s 166A

ss 167, 168 s 170

TAA 1953 Pt IVC, Div 3 Pt IVC, Div 4 Pt IVC, Div 5 Sch 1, Div 12

950

Effect This section requires taxpayers to file an annual income tax return. These sections authorise the ATO to insist on additional returns. This section requires the ATO to issue an assessment of the amount of a taxpayer’s taxable income. This section deems the income tax return of (principally) companies and superannuation funds to be an assessment of their taxable income. These sections authorise the ATO to issue special assessments of a taxpayer’s taxable income. This section sets out the basis on which assessments may be amended. Effect This Division sets out the requirements for the taxpayer to make an effective objection to an assessment (or private Ruling). This Division sets out the requirements for seeking the review of an assessment by the AAT. This Division sets out the requirements for appealing to the Federal Court from an assessment or a decision of the AAT. This Division sets up the rules for the PAYG withholding system, the system for withholding amounts from employees’ incomes and others toward their eventual tax liability for a year.

Administering the Tax Regime

Sch 1, Div 45

Sch 1, Div 284

Sch 1, s 298-20 Sch 1, Div 340 Sch 1, ss 353-10, 353-15 (formerly ss 263, 264 of ITAA 1936) Sch 1, Divs 357, 358, 359 Sch 1, Div 360

CHAPTER 19

This Division sets up the rules for PAYG instalments – the system for collecting instalments from other taxpayers toward the eventual annual tax liability. This Division creates and computes administrative penalties based on the shortfall amount arising from various taxpayer errors and omissions. This section allows the ATO to remit administrative penalties. This section empowers the ATO to waive payment of tax on the ground of serious hardship. These sections give the ATO powers to enter premises, obtain information and require attendance for examination.

These Divisions authorise the ATO to issue public and private Rulings on the way that tax law applies to certain transactions or persons. This Division authorises the ATO to issue oral private Rulings to individuals on the way that tax law applies to certain transactions.

1. ADMINISTERING THE INCOME TAX SYSTEM [19.10] In this chapter we will examine some of the problems of administering as large an

undertaking as the income tax. There are many perspectives which can be taken on this topic and many different sorts of questions arise. Interesting insights can be gleaned from fields such as public administration, economics, organisational theory and sociology. Because of the nature of this volume, the materials concentrate upon legal problems of administration. But when examining the cases and extracts below you should look for some recognition of the broader problems and issues which arise in any context involving mass decision-making such as: • Allocating enforcement resources: which taxpayers and practices should the ATO target for enforcement and why? • Choice of enforcement mechanism: what are the relative costs and benefits of better education and support, dispute resolution by negotiation, generating adverse publicity, the imposition of an administrative penalty by way of additional tax, or resorting to formal criminal prosecution, imprisonment and fines? • Efficient deterrence of tax avoidance: allocating resources in such a way as to deter avoidance by setting appropriate penalty levels and probabilities of detection, but doing so at least cost to all participants in the system. • Maladministration: the problems of, on the one hand, abuse of powers by taxation officers and, on the other, abdication of responsibility in making decisions. In 1776, Adam Smith in An Enquiry into the Nature and Causes of the Wealth of Nations (1776) (Book V, sec. ii b) expressed the goals of an efficient and equitable tax administration in these terms: III. Every tax ought to be levied at the time, or in the manner in which it is most likely to be convenient for the contributor to pay it. A tax upon the rent of land or of houses, payable at the same term at which such rents are usually paid, is levied at the time when it is most likely to be convenient for the contributor to pay; or when he is most likely to have wherewithal to pay. [19.10]

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Taxes upon such consumable goods as are articles of luxury, are all finally paid by the consumer, and generally in a manner that is very convenient for him. He pays them by little and little, as he has occasion to buy the goods. As he is at liberty too, either to buy, or not to buy as he pleases, it must be his own fault if he ever suffers any considerable inconveniency from such taxes. IV. Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the publick treasury of the state. A tax may either take out or keep out of the pockets of the people a great deal more than it brings into the public treasury, in the four following ways. First, the levying of it may require a great number of officers, whose salaries may eat up the greater part of the produce of the tax, and whose perquisites may impose another additional tax upon the people. Secondly, it may obstruct the industry of the people, and discourage them from applying to certain branches of business which might give maintenance and employment to great multitudes. While it obliges the people to pay, it may thus diminish, or perhaps destroy some of the funds, which might enable them more easily to do so. Thirdly, by the forfeitures and other penalties which those unfortunate individuals incur who attempt unsuccessfully to evade the tax, it may frequently ruin them, and thereby put an end to the benefit which the community might have received from the employment of their capitals. An injudicious tax offers a great temptation to smuggling. But the penalties of smuggling must rise in proportion to the temptation. The law, contrary to all ordinary principles of justice, first creates the temptation, and then punishes those who yield to it; and it commonly enhances the punishment too in proportion to the very circumstance which ought certainly to alleviate it, the temptation to commit the crime. Fourthly, by subjecting the people to the frequent visits, and the odious examination of the tax-gatherers, it may expose them to much unnecessary trouble, vexation, and oppression; and though vexation is not, strictly speaking, expense, it is certainly equivalent to the expense at which every man would be willing to redeem himself from it. It is in some one or other of these four different ways that taxes are frequently so much more burdensome to the people than they are beneficial to the sovereign.

These views have been echoed in a number of reviews of the Australian tax system including the Preliminary Report of the Taxation Review Committee (Asprey Committee) in June 1974 at para 3.6, (which noted “that revenue-raising be by means that are not unduly complex and do not involve the public or the administration in undue difficulty, inconvenience or expense”) and the Review of Business Taxation, Commonwealth, A Tax System Redesigned (1999), pp 15–17. Essentially nothing has changed in terms of the goals of tax administration since then. The various specific elements of the law which constitutes tax administration are examined in the following seven sections: • The balance of Section 1 explores the size and scope of the administration of the income tax and will consider the problems of maintaining a system of the size of the income tax by inducing voluntary compliance with obligations; • Section 2 will briefly consider the registration systems that underpin tax administration; • Section 3 consider how tax is collected from taxpayers and applied toward their tax debt; • Section 4 will examine the procedures by which a person’s tax liability is determined – that is by gathering information from tax returns and other sources, and then making assessments; • Section 5 will explore the procedure for objecting to the decisions reached by the ATO and for the review of assessments and administrative decisions through the Administrative Appeals Tribunal or the courts; 952

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• Section 6 will consider the Commissioner’s audit and investigative processes, including an examination of the investigation powers given to the ATO to verify whether tax obligations are being met; and • Section 7 will consider the formal mechanisms within the income tax system for enforcing tax obligations when a taxpayer does not voluntarily pay their obligation.

(a)The Commissioner and the ATO [19.20] In Australia, the federal taxation system, including the income tax, is in the hands of

the Australian Taxation Office (ATO). The ATO is within the Treasury portfolio but is an Australian Government statutory agency under s 4A of the Taxation Administration Act 1953 (TAA 1953). It operates under the Public Service Act 1999 and the Public Governance, Performance and Accountability Act 2013. The TAA provides for a Commissioner of Taxation, who is responsible for the general administration of the tax laws (ss 3A and 4), and for three Second Commissioners who possess all the Commissioner’s powers except for the delegation power (ss 4, 6D and 8). The Commissioners are appointed for a period of seven years by the Governor-General (ss 4 and 5). The ATO has evolved into an organisation consisting of a National Office, branch offices, regional offices, and a staff as at 30 June 2016 of 20,659, with an operating budget over $3.6 b. The ATO is the Australian Government’s chief revenue-raising agency. It also administers the revenue collection side of a large number of spending programs (including fuel grants, superannuation benefits and higher education funding) and the Australian business number registration scheme. The Commissioner is independent, but is required to present an annual report to the Treasurer, who presents it to Parliament (s 3B). Given the size of the organisation it is not possible for the Commissioner to do everything. Therefore, a system of delegation and authorisation has evolved. The Commissioner’s delegation powers are dealt with under s 8. The Commissioner may delegate any power, by an instrument of delegation, to a Deputy Commissioner or any other person. However, it is not practical for the Commissioner to delegate these powers to every officer needing them. Also, the Deputy Commissioners are stopped from sub-delegating their powers by the maxim delegatus non potest delegare (ie he who himself is a delegate of a certain power cannot further delegate the exercise of that power to a sub-delegate). To overcome these problems and to ensure efficient administration, a procedure has been adopted, whereby a Deputy Commissioner authorises certain officers to exercise the powers on his behalf. The validity of this authorisation procedure was confirmed by the High Court in O’Reilly v Commissioners of the State Bank of Victoria (1982) 13 ATR 706; 153 CLR 1. The ATO subject to audit and assurance reviews by the Australian National Audit Office (ANAO), oversight by the Office of the Australian Information Commissioner and the Commonwealth Ombudsman (in relation to public disclosure, freedom of information and non-tax specific matters) and oversight by the Inspector-General of Taxation. The InspectorGeneral’s role was established in 2003 to advise the Government on tax administration and investigate systemic problems with the tax system. From 1 May 2015 Inspector-General has assumed responsibility for reviewing and assisting individual complaints about the ATO from the Commonwealth Ombudsman. There are also three Parliamentary committees that take an interest in the ATO’s operations (House Standing Committee on Tax and Revenue, Senate Standing Committee on Economics and the Joint Committee of Public Accountants and Audit [19.20]

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(JCPAA)). Internally, the ATO in 2014 established the role of an independent integrity advisor, who reviews the ATO’s performance in relation to integrity and provides advice on possible improvements. The affairs of individual taxpayers are subject to strict secrecy provisions (Division 355) although the ATO may pass tax information to Royal Commissions, and specified government agencies and investigative bodies. A Taxpayer’s Charter exists which sets out the parameters for what a taxpayer can expect from the ATO and what the ATO expects from taxpayers. The final version of the Taxpayer’s Charter was released on 4 July 1997 after much debate. The Charter has subsequently been reviewed by the ATO and the ANAO seven times between 2002 and 2010 and was last subjected to a Review commenced by the Inspector-General of Taxation in November 2015/16 (see Inspector-General of Taxation, Review into the Taxpayers’ Charter and taxpayers protections (13 December 2016), pp 15–16). These reviews did result in a restructure of the Taxpayers’ Charter in 2007, but little change has occurred subsequently, Community criticisms remain that the ATO has failed since 1997 to educate its staff about their obligations under the Charter. This may be due to the fact that unlike the United States’ Taxpayer Bill of Rights the Charter does not create new rights and does not carry legislative force. The Charter outlines: • a taxpayer’s rights under the law; • the service and other standards a taxpayer can expect from the Tax Office; • what a taxpayer can do if dissatisfied with the Tax Office’s decisions, actions or service, and where the taxpayer can complain; and • the taxation obligations imposed on a taxpayer. The terms of the charter have not received any detailed consideration by the courts. The size of the task involved in administering the income tax can be gleaned from the most recent Commissioner’s Annual report 2015–16. For the 2015–16 income year the ATO processed over 41.9 million returns, statements and forms. It collected $342.6 b in net tax for the government. Income tax collected from individuals was $187,101 m and with most of that in the form of income tax on their wages ($173,436 m). A further $69,482 m came mostly from collections of company tax and superannuation funds. The ATO collected excises (which are additional taxes on tobacco, alcohol and motor fuel) of $21.492 m, and GST on behalf of the States of $57.5 b. It also issued 9,400 private rulings, processed 26,700 objections and reviews, issued almost 43,000 interpretive guidance products, provided and conducted 3.8 million compliance audits, reviews and other checks resulting in $13.8 b in total liabilities raised and $9.6 b estimated cash collected.

(b) Supporting Voluntary Compliance [19.30] The former Commissioner Michael D’ Ascenzo in an address (entitled “Consultation, collaboration and co-design: The way forward for the Tax Office”) in September 2006 noted that: The Tax Office is not, and never will be, resourced to chase every last dollar payable under the law, or to review every last transaction that may have tax consequences. We are funded to operate on a risk management basis and we make intelligent, risk based assessments about the allocation of our resources to optimise compliance with the tax laws.

Therefore it is evident that income tax system depends upon the honesty and voluntary compliance of taxpayers. There is a similar dependence upon the cooperation and compliance 954

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of tax practitioners to ensure the functioning of the system. There are, of course, obligations imposed by the Act, but without voluntary compliance by taxpayers the laws could not be enforced. Yet, at the same time, some people take advantage of the fact that few infractions of tax laws will be detected. Their activities give rise to the so-called “black” economy. The ATO has adopted a number of programs over the last three decades aimed at building and supporting voluntary compliance through its administration of the tax system. In March 2015, the Commissioner released its latest strategy entitled “Reinventing the ATO Blueprint”, which focusses on designing and administrating the tax and superannuation systems for the majority of taxpayers who do the right thing rather than for the few who do not. The Compliance Model used is aimed at tailoring the ATO response in a manner that recognises that taxpayers are not homogenous and that their needs and circumstances can change over time.

(c) Self-assessment [19.35] The system for tax collection administered by the Commissioner is a so-called “a

self-assessment” income tax system. Self-assessment was introduced in Australia on a piecemeal basis, initially, with a minimalist self-assessment system commencing on 1 July 1986. Unlike the traditional assessment system it replaced (where the returns lodged were supposed to be reviewed and examined by the ATO before tax was calculated and an assessment issued) under self-assessment, taxpayers’ returns are lodged (either in a paper form or electronically) and the lodging of a return is deemed to be an assessment. The taxpayer has the responsibility for calculating the amount of tax due and payable and is required to calculate the tax and make payment with the return if tax is payable. A notice may be issued by the Commissioner confirming the amount paid (or a refund is issued where appropriate). The ATO in theory does not review the returns on lodgment but can do so by post assessment compliance activity. Thus, the introduction of the self-assessment system in 1986 fundamentally altered the balance of power and focus of responsibilities between taxpayers and the ATO. Where the onus was on the ATO under the traditional assessing model to determine the correctness of the return, under the self-assessment system taxpayers lost the certainty they had previously enjoyed (which arose from the receipt of notice of assessment of their tax liability). An assessment no longer finalised the tax process; instead, the taxpayer was still in jeopardy at any time during the next two to four years, or possibly longer. The 13 December 1990 consultative paper (A full self assessment system of taxation: A consultative document) sets out the principal advantages of self-assessment as: The key changes include the elimination of receipt, checking and handling of bulky paper returns. These changes will significantly reduce the recurring costs of returns processing which in 1989-90 amounted to $80 m. They also provide savings for taxpayers in that less information would need to be forwarded to the ATO for returns purposes. A further benefit for taxpayers is the reduction in returns processing errors within the ATO which cause taxpayers to make enquiries about their returns and/or refunds. In addition, decoupling the processing of taxpayer data from collections or payment of cash to taxpayers, activities that would no longer be required to be carried out simultaneously, would create opportunity for smoothing workflows for tax agents in calculating clients’ tax liabilities and would provide faster turnaround time for taxpayers. This would mean the faster issue of refunds. A shift in emphasis from processing work allows the ATO to devote its resources to more productive tasks by helping taxpayers to meet their obligations, for example, through enhanced [19.35]

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enquiry and advisory services, and more generally, by focussing more closely on taxpayer needs, or by taking enforcement action against those who don’t comply.

This explanation did not address the balance of power shift issue. In fact, the introduction of self-assessment in the absence of a binding ruling system created concerns about uncertainty and about the resultant penalties and interest charges that could result from a taxpayer making a mistake. In the long term, the reduction in taxpayer compliance cost has not materialised. Although the changes initially marked a reduction in the information contained in annual tax returns, in more recent years there has been a marked growth in the information required and the information reporting requirements being imposed on third parties. For example, the size of the tax return for individuals grew from 6 pages in 1996 to 12 pages (before Schedules) in 2006 and continues to increase in size. The traditional way the Commissioner has compelled the creation of specific information is by requiring it to be lodged in a specific (approved) form as part of the income tax return. One example is the International Dealings Schedule (IDS). The prescribed format rules for income tax returns are located in ITAA 1936, s 161A and the words “approved form” has the meaning given by the TAA 1953, Sch 1, s 388-50. This approach of requiring information in a specific form is adopted to ensure the Commissioner gets the information in a consistent format. This does not occur in respect information gathered under the general compulsive powers to supply information (under TAA 1953, Sch 1, ss 353-10 and 353-15), which are limited to existing documents. Similarly, as the general compulsive powers to supply information are limited to existing documents, the law has provided for the provision from third parties of specific information. The information traditionally required to be supplied to the ATO consists of wage and salary data from employers, government welfare payments from Centrelink and other providers, interest income from financial institutions, dividend income from share registries and Medicare levy surcharge and private health insurance policy details from private health insurers. This information has been used by the ATO in its prefilling of individual’s income tax return data since 2007. Historically, these legislative obligations were spread throughout the tax legislation, but in more recent time have been centralised in Sch 1 of the TAA 1953 (eg Div 393 (which requires various investment bodies to provide quarterly reports about the quoting of investors’ tax file numbers and ABNs, and annual reports on Part VA investments), Subdiv 396-A (which contains the reporting requirements where financial institutions are subject to the United States’ FATCA rules), Subdiv 396-C (which contains the Common Reporting Standards reporting requirements) and Div 410 (which contains the structural framework for the taxable building and construction industry payments annual reports). Third party reporting obligations continue to grow in recent years to include, as noted above, FATCA and the OECD Common Reporting Standards reporting requirements. From 1 July 2016 additional third party reporting obligations are imposed under Subdiv 396-B of Sch 1, TAA 1953 for states and territories in relation to transfers of real property and Australian Securities and Investments Commission (ASIC) in respect market integrity data (ie reportable transactions that have taken place on certain financial markets). From 1 July 2017 further third party reporting obligations will be imposed on: • government related entities, other than local government bodies, to report on government grants; • government related entities, to report on consideration they provide for services; 956

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• trustees of trusts with an absolutely entitled beneficiary, to report on transactions relating to shares and units of unit trusts; • listed companies to report on transactions relating to their shares; • trustees of unit trusts to report on transactions relating to their trust units; and • administrators of payment systems to report on electronic business transactions where they are facilitated on behalf of an entity where it reasonably believes the transactions are for the purposes of a business carried on. In summary, self-assessment has provided major compliance costs savings for the ATO but taxpayers are burdened with a greater responsibility, and third parties with greater reporting obligations. In terms of voluntary compliance it is a more risky strategy for the ATO as presumably less early review could increase the risk of non-detection. Because the ATO does not look at tax returns promptly, taxpayer’s exposure to subsequent review has been extended over a longer period, with the risk of interest and higher penalties arising from any tax shortfalls being detected some years later. So taxpayers are asked to shoulder a greater responsibility, often without the necessary skills or knowledge they need to accurately apply Australia’s complex income tax laws to their specific circumstances.

(d) Taxation Rulings and Determinations [19.40] As indicated above, self-assessment has meant that taxpayers now have to deal with the uncertainty associated with what are often overly complex legislative provisions and the threat of significant penalties and the imposition of the General Interest Charge if their view of the law “is not as likely to be correct as incorrect”. It was recognised that in order to enable taxpayers to comply they needed a mechanism for taxpayers and their advisors to gauge the Commissioner’s view of a tax matter. They also need to be certain that if that transaction is undertaken in accordance with ATO advice, it is free from subsequent challenge by the ATO. However, historically there has been an absence of such information, and where available, it did not guarantee taxpayers safety from future ATO action where taxpayers relied on that information. The adoption of the Freedom of Information Act 1982 did lead to the ATO formally releasing its pronouncements on tax issues (Taxation Rulings) from December 1982, but these rulings were not binding. In fact the Commissioner has publicly argued against these old rulings in litigation when it deemed it necessary to do so. One example is in David Jones Finance & Investments Pty Ltd v FCT (1991) 21 ATR 1506 in which the ATO decided to resile from its previous practice of allowing taxpayers who were not themselves registered as shareholders to claim a benefit available to “shareholders”. This practice was inconsistent with the High Court’s decision in FCT v Patcorp Investments Ltd (1976) 140 CLR 247 but the practice had apparently been followed for 30 years. In its judgment, the Federal Court upheld the Commissioner’s decision to revert to the strict Patcorp position and apply it to David Jones Finance for the years 1985–1988. In 1992 further reforms led to the introduction of the binding rulings system. Since then it has grown into a multifaceted system with further changes occurring in 1994, 2001, and 2005 which have to various degrees dealt with both the availability and reliability issues. In this section we examine the design of the Rulings system as a mechanism aimed at assisting taxpayer compliance. The detailed provisions for Rulings are to be found in the TAA 1953, Sch 1, Divs 357 – 360. [19.40]

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(i) Public Rulings (Divs 357 – 358) [19.50] A Public Ruling is a “written binding advice, published by the Commissioner for the

information of entities generally, on the way in which, in the Commissioner’s opinion, a relevant provision applies or would apply to entities generally, or a class of entities. A public ruling will state that it is a public ruling” (see Taxation Ruling TR 2006/10: Public Rulings, para 4). Thus a Public Ruling explains to the world at large how the Commissioner proposes to exercise a particular discretion, or how the Commissioner interprets the Act in relation to a transaction, or the Commissioner’s understanding of the impact of certain court decisions. For that reason, many Rulings are extracted in the pages of this book. Today, the binding administrative documents issued by the Commissioner are the Taxation Rulings series (TR series); Taxation Determination series (TD series); Class Rulings series (CR series); Product Rulings series (PR series); Product Grants and Benefits Rulings series (PGBR series); Excise Rulings series (ER series); Fuel Tax Rulings series (FTR series); Fuel Tax Determination series (FTD series); Goods and Services Tax Rulings series (GSTR series); Goods and Services Tax Determination series (GSTD series); Miscellaneous Tax Rulings (MT series) that are labelled as “legally binding”; Wine Equalisation Tax Rulings series (WETR series); Wine Equalisation Tax Determination series (WETD series); Luxury Car Tax Determination series (LCTD series); and Law Companion Guidelines (LCG series). The five key groups of public Rulings are: • Rulings issued between 1982 and 1992. These are typically labelled with a number commencing IT. These Rulings are said to be “administratively binding on the ATO”, in that the ATO will usually choose to follow the Ruling. • Rulings issued after 1992. From June 1992 the Commissioner then issued Rulings under two titles: Taxation Rulings (which attempt to state exhaustively the ATO’s position on a topic) and Taxation Determinations (which provide a quick response on a precise question), called TRs and TDs. Both are usually released in draft for consultation prior to being released in a final form. They have a unique status which derives from provisions in the ITAA 1936 and TAA 1953 discussed below. The general effect of those provisions is that Rulings and Determinations can be relied upon by a taxpayer in challenging an assessment issued by the Commissioner, even if they are wrong as a matter of law. In other words, a taxpayer can pay either the tax imposed by law, or the tax due according to the public Ruling, whichever is less. • Product Ruling issued since October 1998. These are addressed to the entire world, in the sense that they apply to all the potential investors in an investment product. The first product Ruling was a proposed film version of Norman Lindsay’s The Magic Pudding: see PR 98/2. • Class Rulings issued since 2001. These public Rulings “enable the ATO to provide legally binding advice in response to a request from an entity seeking advice about the application of a tax law to a specific class of persons in relation to a particular arrangement. The purpose of a class Ruling is to provide certainty to participants in a financial dealing and obviate the need for individual participants to seek private rulings” (Paragraph 6 of CR 2001/1). Examples are Rulings on the tax consequences of a particular employer’s share scheme or a specific redundancy package. • Law Companion Guidelines (LCG) released since 29 November 2015. The scope and purpose of LCGs was only clarified by the Commissioner in LCG 2015/1: Law Companion Guidelines: purpose, nature and role in ATO’s public advice and guidance, which was first issued as a draft on 10 March 2016 (oddly after the release of 14 other LGCs in 2015 and a 958

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further Draft LGC in 2016), before being finalised on 3 June 2016. They are a public ruling, in whole or in part. Law Companion Guidelines LCG 2015/1 states that: 4. …Guideline expresses the Commissioner’s view on how recently enacted law applies to a class of taxpayers, or to taxpayers generally. Often, Guidelines will apply only to a particular class of persons, being taxpayers who rely on them in good faith (see Reliance from paragraph 28 of this Guideline)…. 8. The purpose of a Guideline is to provide an insight into the practical implications or detail of recently enacted law in ways that may go beyond mere questions of interpretation. Its content may be wide-ranging. 9. A public ruling may deal with any matter involved in the application of a relevant provision, including the Commissioner’s approach to discretions, risk management and safe harbours.[2] We expect that such material will routinely form part of a Guideline.

As indicated above, there has been rapid adoption by the Commissioner of LGCs as evidenced by the fact that within 8 months from their inception in November 2015 there were 19 finalised and drafts LGCs. It is clear that no Ruling is authoritative in the sense that it can supplant the statute and cases as the sources of law. Indeed, in the former Taxation Ruling IT 1, the ATO acknowledged in respect of the pre-1992 Taxation Rulings that “taxation rulings … cannot supplant the terms of the law. It is now well established that statements or declarations by the Commissioner of Taxation or his officers do not have the effect of an estoppel against the operation of the taxation law.” This remains true even after the 1992 amendments to the Act implementing the “binding” public and private systems and the subsequent reforms. Of course, in practice these limitations on the authority of rulings are more apparent than real. ATO staff must, according to an internal directive, apply public tax guidance even where there may the strong alternative views of the law (Practice Statement Law Administration PS LA 2003/3: Precedential ATO View). Further, few taxpayers will have either the inclination or the resources to challenge the ATO’s stated attitude even if advised that it is more likely than not to be wrong. As noted above, from 1992 the Commissioner has been given power to issue public Rulings and particular private Rulings, both of which would be “binding” on the ATO. It is clear that the intention of the system is to limit the ability of the ATO to change its mind once it had announced its position by a public Ruling, although the ATO would still be able to change its mind prospectively by issuing a new Ruling. Of course, residual leeway would remain in the ability of both the ATO and taxpayer to argue that the public Ruling did not apply to the taxpayer’s particular circumstances. But subject to this qualification, a taxpayer who entered a transaction relying upon a public Taxation Ruling issued after 1 July 1992 would be reasonably satisfied that he or she would be assessed on the basis stated in the Ruling. In addition to making Rulings binding, the second major change announced was the creation of a system for reviewing Rulings which a taxpayer believed to be incorrect. Since 1 July 1992, taxpayers have been able to challenge a public Ruling simply by applying for a private Ruling to the same effect as the public Ruling and then challenge the private Ruling in the manner described below. These changes give Rulings an interesting legal status. Under s 357-60, in Sch 1, TAA 1953 a taxpayer can rely on a public Ruling to prevent the ATO claiming the tax asserted, and this has now been used successfully against the ATO on several occasions. This system now adds a new ground for disputing a tax assessment: that the ATO erroneously applied (or distinguished) an inapplicable (or applicable) Ruling. The taxpayer [19.50]

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must establish, however, that the public Ruling in question covers the taxpayer’s individual case, a particularly difficult exercise where the facts are complicated: see Bellinz Pty Ltd v FCT 39 ATR 198. (ii) Private Rulings (Div 359) [19.60] In addition to these formal Rulings addressed to the world at large, the ATO has also

issued advance opinions to individual taxpayers who seek them for a specific planned or completed transaction. Again there has been a historical development to the legislative status of these documents. Prior to 1982, taxpayers sought informal advance opinions to indicate the way that the ATO would tax a particular transaction to be undertaken by the taxpayer. Many tax schemes were marketed with an opinion by a leading tax adviser about their tax consequences and some also had an advance opinion attached. They were also needed to market more mainstream ventures. For example, the prospectus advertising a mining joint venture project would probably contain an advance opinion from the ATO on the tax treatment of the participants. The status of private Rulings, like that of formal Rulings, had been a matter of some conjecture. Tax advisers argued that the issue of a private Ruling should bind the ATO not to tax a transaction in some other way after it was entered and the annual tax return filed. If the ATO wanted to change its mind on the consequences of a transaction after a private advance opinion had been issued, the ATO might do so but only on a prospective basis. They also argued that private Rulings should have more general application: the same client ought to be entitled to rely upon a Ruling obtained in respect of an earlier transaction if the later one was in all practical respects identical, and other taxpayers should be able to rely upon a Ruling obtained by someone else. The ATO stated in the former Taxation, Ruling IT 2500 that “advance rulings are subject to the necessary reservation that they are not binding on the Commissioner. … [even though] it is the administrative policy of the Australian Taxation Office to adhere to the advice supplied to a taxpayer in an advance opinion”. It also qualified the generality of advance opinions saying that: “an advance opinion applies only for the taxpayer for whom it is given and cannot be taken as a precedent for other cases. [Also the ruling] will have application only in relation to the fact situation presented by the taxpayer from whom the request was received and only in respect of the transaction specified in the advance ruling.” Again, events overtook the ATO’s position, and the changes announced with the 1991 Budget formalised by Taxation Laws Amendment (Self-Assessment) Act 1992 enacted a formal private Ruling system. Private Rulings became binding on the ATO so that it could not issue an assessment to a taxpayer who had obtained a private Ruling which was inconsistent with the Ruling: s 357-60 of Sch 1 of the TAA 1953. The Commissioner’s current approach to private Rulings is set out in Practice Statement Law Administration PS LA 2008/3: Provision of advice and guidance by the ATO. Private Rulings are also reviewable in the same way that assessments of tax may be challenged (ss 359-60 to 359-70), but again the taxpayer has to be sure the Ruling covers the details of the case: CTC Resources NL v FCT 27 ATR 403. (iii) Oral Rulings (Div 360) [19.70] The third stage in the development of private Rulings began in 2000. In the ANTS

Statement in August 1998, the Treasurer announced that there would be a system of oral 960

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Rulings for individuals. This system began in July 2000 and is now enacted as Div 360 of Sch 1 of the TAA 1953. These Rulings are a type of private Ruling in the sense that they benefit only the person to whom they are addressed. They bind the ATO but can only be given on a very few and relatively simple matters. (iv) Other administrative sources [19.80] In addition to the interpretive Rulings and advance Rulings, the ATO also generates

other sources of information which many tax advisers scrutinise very carefully. As well as public Rulings they include: • Law Administration Practice Statements (LAPS) issued to staff indicating how they should deal with various matters. These documents reveal some of the inner processes of the ATO and the formal ATO view on various important matters. (eg PS LA 2008/3 discussed above). They are not, however, public Rulings for the purposes of the Rulings system, but operate instead as inter-office instructions. Practice Statements come with the instruction to users that, “[they] must be followed by ATO officers unless doing so creates unintended consequences”. • A ″Register of Private Binding Rulings″, which was established in 2001 as a direct result of an internal review of the private ruling system by the ATO (Report of an Internal Review of the Systems and Procedures relating to Private Binding Rulings and Advance Opinions in the Australian Taxation Office (commonly known as the Sherman Report), issued on 7 August 2000). Edited private rulings are published in the Register only if they were applied for after 31 March 2001. For details of the Commissioner’s practice, see ATO’s Practice Statement Law Administration PS LA 2008/4: Publication of edited versions of written binding advice. • Compilations of the various private ruling requests, which are issued as ATO Interpretive Decisions (ATOIDs). The main purpose of the ATOIDs was to improve the accuracy and consistency of decision making in the ATO. Given their brevity the advice is general in nature and cannot cover all possibilities or individual circumstances. Thus, as with fact sheets ATOIDs are not binding. • The ATO also issues “Taxpayer Alerts” (TAs).. These documents represent a warning to taxpayers that the ATO has observed a practice, there are doubts about its effectiveness, and if others take it up, have dramatically increased their compliance risk. • The ATO also convenes various advisory and consultative Committees. The minutes of some of these Committees, particularly the National Taxation Liaison Group are published and often reveal the ATO’s attitude on particular topics. In conclusion, s 361-5 of Sch 1 of the TAA 1953 makes it clear that there will no imposition of a general interest charge or shortfall interest charge where a taxpayer relies in good faith on non-ruling advice (provided the advice, or the statement or publication, was not labelled as non-binding) or the Commissioner’s general administrative practice. [19.85]

Questions

19.1

Does the attitude of the ATO limiting private Rulings to particular taxpayers make for efficient administration?

19.2

Ought taxpayers who have relied upon a Ruling be entitled to be reassessed if they have submitted a tax return in accordance with an unfavourable position expressed by the ATO which is later rejected by a court? [19.85]

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(e) Statutory Remedial Power [19.87] It has been recognised by the government that in administering the tax law the

Commissioner is unable to remedy unintended consequences in the application of the law in some circumstances despite applying purposive principles to the interpreting the taxation laws. For example, this can occur when dealing with new scenarios which were not known or contemplated when the original provisions were drafted. A legislative solution is often required but given the low priority given to remedial measures this process can take many years. On 1 May 2015 in Media release no 021/2015, the then Assistant Treasurer announced the proposal aimed at remedying this problem that potentially has the effect of altering the Commissioner’s role as purely an administrator of the law. The Assistant Treasurer announced that the law would be amended to provide the Commissioner with a statutory remedial power to allow for a more timely resolution of certain unforeseen or unintended outcomes in taxation and superannuation law. It was argued that “this power provides a mechanism to deal with some aspects of complexity in the tax law, and provides more certainty and better outcomes for taxpayers.” This is a direct result of a concerted effort by business and tax advisory representative bodes since 2007 for the adoption of a United Kingdom styled “extra-statutory concession” whereby the tax regulator (in the UK Her Majesty’s Revenue and Customs) grants certain concessions to taxpayers to mitigate their tax liabilities even though the relevant allowances would not strictly be allowed under the terms of the tax legislation. There are similar legislative instrument making powers in Commonwealth law currently granted to the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC). However, the APRA and ASIC powers can be exercised for a particular entity and are generally limited in terms of the provisions of the law which can be modified. The Tax and Superannuation Laws Amendment (2016 Measures No 2) Bill 2016, reintroduced on 14 September 2016 after lapsing due to the 2016 Federal election, seeks to enact a new Div 370 in Sch 1, TAA 1953. Under the proposed s 370-5(1), the Commissioner will be allowed to make a disallowable legislative instrument that will have the effect of modifying the operation of tax and superannuation law to ensure the law can be administered to achieve its purpose or object. It will only be available where: • the modification is not inconsistent with the purpose or object of the provision; and • the Commissioner considers the modification to be reasonable, having regard to both the purpose or object of the relevant provision and whether the costs of complying with the provision are disproportionate to achieving the purpose or object; and • the Treasury or the Department of Finance advises the Commissioner that any impact on the Commonwealth budget would be negligible. To ensure particular entities are not adversely impacted by a modification, the proposed s 370-5(4) provides that the particular modification will have no effect for an entity if it would produce a less favourable result. If an entity self-assesses that a modification is less favourable it can treat the modification as not applying to itself and to any other entity. In such circumstances the Commissioner must also treat the modification as not affecting the entity. However, a modification which is less favourable to one or more entities can still be valid and 962

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apply to entities that do not have a less favourable outcome from the modification under this rule. The measure was intended have effect from the date of Royal Assent of the enabling legislation.

2. REGISTRATION SYSTEMS [19.90] Underlying tax administration are crucial registration systems used to identify

taxpayers and track their transactions. Simply if you do not know a taxpayer exists and/or cannot track their transactions is very hard to tax them. There are two key registration systems; the Tax File Number (TFN) and the Australian Business Number (ABN) systems. The TFN system (established in 1990 following the failure of the Australia Card proposal) and set out in Pt VA of the ITAA 1936) provides a personal tax identifier for taxpayers (including individuals, companies and superannuation funds), which enable the ATO to compare taxpayer information in returns with that supplied by third parties. These include other government agencies. The ability to link third party information to individual tax payers has enabled the ATO to pre-populate the tax returns of individual taxpayers with the third party information held. The importance the TFN system to the administration of the tax system is evidenced by the ATO practice to encourage children to apply for a TFN while in later years of high school. A TFN is acquired by an individual providing the request evidence of identity (so foreign residents can apply) (s 202B). It must be quoted by employees (s 202C) to superannuation funds, to investment holders (ss 202D to 202DM) and where government benefits are sought (s 202CB). Failure to quote a TFN can lead to withholding at source (see Subdiv 12-E of Sch 1, TAA 1953). Where the income amount is minor (s 12-140) or it is earned by a child under 16 years and below a prescribed income threshold (s 12-140), a TFN does not have to be quoted. The ABN system was introduced in 1999 by the A New Tax System (Australian Business Number) Act 1999 (ABN Act) to introduce a single identifier for business and making avoidance more difficult by requiring payers to deduct tax where an ABN is not quoted (s 7 of the ABN Act). Taxpayers who register for GST have the same number for their ABN and GST registration. The Commissioner is responsible for ABN registration process and maintaining the ABN register (s 28 of the ABN Act). To qualify for an ABN a taxpayer (entity) must be carrying on an enterprise (s 41). Commonwealth, State and Territory agencies (ss 5 and 38), companies registered under the Corporations Law (ss 8(2) and 41) and other entities required to be registered for GST require an ABN. An ABN must be quoted where an entity receives payment for supply of goods or services (s 12-190 of Sch 1, TAA 1953) or for voluntary agreements under PAYG system (s 55(1) of Sch 1, TAA 1953). Investors receiving payments will be subject to PAYG withholding unless TFN or ABN are quoted.

3. PAYING (AND PREPAYING) TAX [19.95] The administrative processes by which tax is collected operates in two parallel parts.

One part is the payments system – it collects money from people during the year as a prepayment of whatever tax debt they may end up owing. The other part is the assessment system – it calculates how much tax is actually owed for the year, and then reconciles the amount of the debt to the payments already collected. [19.95]

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It is important to note that in many respects, the two processes operate quite independently and converge only once every year. For example, instalments are withheld from the wages of employees each fortnight or month from July to June, but the final determination of whether they owe still more or are entitled to a refund occurs only when they file a tax return and receive an assessment, usually sometime after the next October. The same thing happens with businesses. They pay instalments quarterly or even monthly, but the final determination of whether they owe still more tax or are entitled to a refund occurs only when they file a tax return and receive, or are deemed to have received on lodgment, an assessment. A sense of this difference between prepayments and the final determination appears in s 3-5(1) and (2) of the ITAA 1997. These sections note that while “income tax is payable for each year by each individual and company, and by some other entities” in fact, “most entities have to pay instalments of income tax before the income tax they actually have to pay can be worked out”. Since 1 July 2000 a so-called “Pay-As-You-Go” system (PAYG) has operated for all taxpayers. It replaced the provisional tax system for collecting amounts from the selfemployed and retirees; the corporate tax instalment system for companies, superannuation funds and some other entities; the Reportable Payments System (RPS) and Prescribed Payments System (PPS) which applied to payments in various industries; and the Tax File Number (TFN) system which applied to various kinds of investment income. Under the PAYG system most taxpayers pay tax on an ongoing basis throughout the year of income, but under a single and more coordinated regime. To say that these former regimes were replaced is probably to believe too much of the political rhetoric that accompanies any tax change. In fact, most of the features of the former systems remain and were just re-enacted under another framework using a new label. The best evidence is that PAYG works differently for different types of taxpayer and for different types of income, those differences being the visible legacies of the former systems. There are two elements to PAYG. One is a withholding system: instalments toward the eventual tax debt are collected during the year by requiring a payer to withhold amounts from payments it makes to the taxpayer and remit those amounts to the ATO (PAYG withholding). The other is an instalment system: amounts are collected by requiring the taxpayer to report and pay tax on the income it has derived so far during the year (PAYG Instalments). Having two systems running in tandem means that the rules distinguish: between some taxpayers from other taxpayers; and some types of income from other types of income. The discussion below tries to isolate the rules that apply to the main permutations that emerge from these distinctions.

(a) Collecting Tax from Payments to Employees [19.100] For employed individuals, it is still the case that most of their tax is withheld from

their gross wages (and from other payments) by their employer and is remitted to the government by the employer on their behalf. It means that employees pay tax on their salary income in the current year, at the same time as they earn the income. This was called the Pay-As-You-Earn (PAYE) system under the former law prior to 30 June 2000, and is now PAYG withholding. The rules which impose the obligation to withhold amounts from payments to employees and to remit those amounts to the ATO start in Div 12 of Sch 1, TAA 1953. The principal rules for payments to employees are in: 964

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• s 12-35, which requires a person to withhold amounts from salary, wages and similar payments to employees; • ss 12-80 – 12-90, which require a person to withhold from termination payments and unused leave payments; • ss 15-10 and 15-25, which permit the ATO to prescribe Tables giving the formulae to calculate the amount to be withheld; • s 16-5, which requires the employer to withhold when it makes the payment to the employee (and ss 16-25 and 16-30 create a criminal offence and a civil penalty for not doing so); and • s 16-70, which sets out the time by which the employer must remit the amount withheld to the ATO. Section 12-35, the principal section for employees, says simply that “an entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee”. It raises three questions: • Who is an “employee” for PAYG purposes? • Is the payment within the group of payments from which tax must be withheld? • How is the amount to be withheld calculated? Whether the recipient is an employee, as opposed to an independent contractor, depends on the ordinary meaning of the word “employee” – that is, does the person meet the “control” and “integration” tests drawn from labour law. This is discussed in Taxation Ruling TR 2005/16. [19.110] The next step is to determine whether the payment is one from which the payer must

withhold. There are a number of express exclusions in the Act and s 15-15 of Sch 1,TAA 1953, provides a general power for the ATO to vary the amount that must be withheld from certain classes of payments. The express exclusions allow employers not to have to withhold from: • Payments that are exempt income of the recipient (s 12-1(1)); • Various cash payments that are fringe benefits (s 12-1(2), (3)); • Non-cash fringe benefits, including exempt fringe benefits (s 14-5(3)). The ATO has also issued general guidance which modifies the withholding obligation for payments of certain kinds of allowances paid to employees. The purpose of the guidance is to allow employers to pay certain kinds of allowances free from withholding because the allowance in question is one for which the employee would be entitled to an allowable deduction when he or she spent it. The kinds of allowances in question are travel allowances and similar allowances, but not the kind of allowances which are just additional salary – that is, the kind of “allowances” often specified under industrial awards for workers who perform higher duties or have higher skills (see Superannuation Guarantee Ruling SGR 2009/2: meaning of the terms “ordinary time earnings” and “salary or wages”). The importance of these rules is illustrated by the following example. Where an employee is required to travel interstate on business for five nights, the employee will need to have a plane fare, stay in a hotel, use taxis, buy meals, and so on. The employer might pay for the plane ticket directly, but provide an allowance of, say, $200 per day to the employee to cover the balance of the employee’s expected expenses. If the allowance were liable to PAYG withholding, the employer could only deliver a lesser sum, say $120 after withholding tax of $80, and so the employee would have to find the additional $80 to meet the expected expenses of $200. The employee would then report $200 as income, claim deductions for the $200 [19.110]

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spent, and because no tax is due, would get back the $80 withheld as tax, but would get back the $80 only after the tax return was processed. Allowing the employer to pay $200 free of tax where the employee is probably going to spend $200, and would get a deduction for $200, avoids collecting tax which is just going to be refunded. This process is constrained by rules in a Taxation Determination issued every year which sets out the amounts which the ATO considers reasonable for that year in various circumstances. For example, the reasonable travel and overtime meal allowance expense amounts for the 2015–16 income year are contained in Taxation Determination TD 2015/14. This process complements another part of the tax system for employees – the substantiation rules. In Taxation Ruling TR 2004/6 (reinstated on 28 April 2016) the ATO has indicated, 12.

Unless the following exception applies, all allowances must be shown as assessable income in the employee’s tax return. However where: • the allowance is not shown on the employee’s payment summary; • the allowance received is a bona fide overtime meal allowance or a bona fide travel allowance; • the allowance received does not exceed the reasonable amount; and

• the allowance has been fully expended on deductible expenses the allowance received is not required to be shown as assessable income in the employee’s tax return. Where the allowance is not required to be shown as assessable income in the employee’s tax return, and is not shown, a deduction for the expense cannot be claimed in the tax return… So, an allowance that meets the ATO’s rules and is actually spent by the employee can be paid free of PAYG, is not reported as income in the employee’s tax return, the employee does not claim deductions for its outlays, and is not required to substantiate the amount of the outlay. If we return to payments from which the payer must withhold, the last step is to determine how much the payer must withhold from the payment, be it wages, taxable allowances or whatever. Sections 15-10 and 15-25 of Sch 1, TAA 1953 set up the process for Commissioner to issue schedules which set out the amounts to be withheld. In practice, the ATO sends employers a table which employers simply apply.

(b) Investors, Self-funded Retirees and Employees’ Investment Income [19.120] A separate process exists for individuals with investment income, for self-funded

retirees living off the income from their savings and investments, and for employees with some income from their savings. These taxpayers report their position to the ATO on an Instalment Activity Statement (IAS). The separate regime exists because investment income is rarely subject to PAYG withholding. These investors are not in business so they cannot be expected to comply with the rules for businesses, and they do not have income that is taxed at source by withholding (ie banks or listed companies do not, as a matter of course, withhold tax from payments of interest or dividends). Investment income in the form of unfranked dividends, unit trust distributions and interest can be subject to withholding under s 12-140 or s 12-155 of Sch 1, TAA 1953 where the investor does not quote either a Tax File Number or an Australian Business Number to the payer, but the investor will usually ensure that the number is quoted, and so no withholding will usually occur. Investment income in the form of rent from real estate is also not subject to withholding. 966

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Instead, the PAYG instalment system operates for these people. Once the ATO has issued a notice to the taxpayer advising them of an instalment rate (s 45-50), these taxpayers then have to voluntarily report their investment income earned so far during the year and pay an instalment based on that. These rules are in Div 45 of Sch 1 of the TAA 1953 and contain two important elements: the rules determining how many instalments have to be paid; and the rules determining the amount of each instalment. The number of instalments that a person has to pay is determined under Subdiv 45-B. Section 45-50 that everyone will have to pay four quarterly instalments – one instalment after the end of each quarter during the tax year. But s 45-140 allows some taxpayers to choose to pay a single instalment instead during the year if certain conditions are met, most importantly, that: (a) the taxpayer is not registered for GST (because GST is paid at least quarterly); and (b) the taxpayer’s “notional tax” is likely to be less than $8,000. “Notional tax” is defined in s 42-325 through a complex series of adjustments, but means mostly the tax on the income of the taxpayer that is not subject to PAYG withholding. Self-funded retirees, small companies and others with little investment income, who do not carry on a business activity that requires them to be registered for GST and with an expected tax liability under $8,000 per annum, will usually elect to pay a single annual instalment toward their eventual tax liability for the year. In fact, because the date for the annual instalment is usually going to be 21 October of the next tax year (see s 45-70(1)), and if the taxpayer is an individual, their personal tax return for the year is due by 31 October, the ATO has adopted the practice of waiving the collection of the annual instalment for some individuals. The amount of each PAYG instalment is determined under Subdiv 45-C. Taxpayers are required to pay instalments calculated by applying the instalment rate notified to them by the ATO to their actual instalment income for the relevant period. The calculation method is generally adopted by business taxpayers and large companies. However, retirees, small investors, etc, who have the option to pay a single annual instalment under s 45-140, will likely choose to pay an instalment notified to them by the ATO under s 45-170. If their income has declined during the year, they do have the option of doing a full calculation instead and paying that (lower) instalment. The amount of the instalment is calculated by the ATO based on applying a GDP-based inflator to last year’s tax. Wealthier individuals, companies and others with investment income and an expected tax liability over $8,000 per annum do not have the annual instalment option under s 45-140 and so will have to pay four quarterly instalments toward their eventual tax liability for the year. These instalments can be based either on their gross revenue actually earned during the quarter (s 45-110), or individuals can elect to pay based on last year’s tax increased by a GDP adjustment factor (s 45-125).

(c) Unincorporated Businesses [19.130] Self-employed individuals (such as dentists, barristers, unincorporated plumbers,

electricians and so on), also operate under the PAYG instalment system. Withholding amounts from income before it gets to them is not a practical alternative because often the payers to these people will be private citizens – it is not realistic to expect patients to withhold tax before they pay their dentist. However, these unincorporated businesses can be subject to withholding on their gross business receipts if they do not quote an Australian Business Number to persons (also carrying on a business) who will be paying them: s 12-190 of Sch 1, TAA 1953. [19.130]

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Mostly, however, these taxpayers will have to pay instalments during the year toward their eventual tax liability. The number of instalments will usually be four because these business taxpayers will invariably have to be registered for GST. The amount of each instalment can be calculated either as a percentage of their gross revenue derived during the last quarter (s 45-110) or based on last year’s tax increased by a GDP adjustment factor (s 45-125). These amounts are reported to the ATO on the much-maligned Business Activity Statement (BAS).

(d) Companies and Corporate Entities [19.140] Large business taxpayers will invariably have to be registered for GST, and have a

tax debt exceeding $8,000. They will therefore have to pay four quarterly PAYG instalments calculated as a percentage of their gross revenue derived during the prior quarter. For these taxpayers, the amount of each instalment will have to be fully calculated – no rule-of-thumb based on last year’s tax is allowed. The mechanism for calculating the amount of the instalments begins s 45-110 of Sch 1, TAA 1953. It states that the amount of each quarterly instalment is the taxpayer’s “instalment income” multiplied by the taxpayer’s “instalment rate”. The taxpayer’s instalment rate is notified to them by the ATO (under s 45-15), and is in general terms the amount of last year’s tax expressed as a percentage of the taxpayer’s total revenue. So a corporate taxpayer with income of $1,000,000 and expenses of $800,000 would have paid $60,000 in tax (ignoring any tax credits), giving an instalment rate of 6 per cent. So, if in the next quarter the taxpayer derived instalment income of $200,000 it would be liable to pay an instalment of $12,000. The fact that it had also incurred expenses during that quarter of $100,000 (and so was more profitable than last year’s results suggest) or even $220,000 (and so had operated at a loss during that quarter) would have no bearing on the amount of the instalment due, unless the taxpayer chooses to vary its instalment rate under the procedure in s 45-205. The instalment rate is applied to the taxpayer’s instalment income. This too is the subject of a computation starting at s 45-120. For most taxpayers, the computation begins with the taxpayer’s ordinary income – that is, any statutory income such as a capital gain, a franking credit or a balancing charge for depreciation is excluded at this point. Also excluded is income subject to withholding: s 45-120(3)). The amount of the quarterly instalment is reported to the ATO on the BAS.

(e) Withholding Regimes for Resident Taxpayers [19.150] As mentioned briefly above, there are two important withholding regimes associated with the registration systems used to identify taxpayers and track their transactions which are applied to certain payments made to resident taxpayers. The first domestic regime applies to payments made by “investment bodies” (s 12-140 of Sch 1, TAA 1953) where the recipient has not provided to the payer either a Tax File Number (TFN) or an Australian Business Number (ABN). As noted above under the TFN system, taxpayers are in effect obliged to quote their TFN when entering employment, opening accounts with financial institutions and purchasing shares or debentures. There is no formal penalty attached to failure to quote a tax file number but, if the taxpayer chooses not to do so, tax must be withheld by any institution which pays salary, interest or dividends to the taxpayer at the maximum marginal rate plus Medicare levy. This is probably a sufficient incentive for most people to quote their tax file number. Any tax collected is then credited as a 968

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prepayment of the tax to be assessed on that income. This regime applies to payments of unfranked dividends paid by resident companies, interest and trust distributions. The second domestic regime is the so-called “no-ABN withholding”. This is provided in s 12-190. This section requires a person paying an amount of money for a “supply” which is a term drawn from GST law, to withhold unless the recipient has quoted their ABN in writing. The section is very widely drawn but is subject to a number of modifications which constrain the scope of the section to something more realistic. After all, the law couldn’t reasonably expect everyone to withhold tax from every payment made to someone else. Obvious limitations have to be imposed: • First, the section only applies to payments made to someone who carries on an enterprise, most usually being in business (s 12-190(1)(a)). • Second, the person receiving the money must be carrying on that enterprise in Australia (s 12-190(1)(a)). • Third, the person making the payment must themselves be carrying on business (s 12-190(4)(a)). • Fourth, there is a monetary threshold (s 12-190(4)(b)). No withholding is required if the payment is under $55 (including GST).

(f) Withholding on Payments to Non-residents [19.160] The last set of withholding rules we will examine applies to cross-border payments.

They are contained in Subdivs 12-F (Dividend, interest and royalty payments) to 12-FC (Seasonal labour mobility payments) and 12-H (Distributions of managed investment trust) of Sch 1 of the TAA 1953. Subdivision 12-F requires Australian resident payers to withhold tax from payments of dividends, interest and royalties to non-residents. These rules are formally tied to the withholding tax rules in Div 11A of the ITAA 1936 so that withholding is required only where the payment is liable to withholding tax under the Assessment Act: s 12-300. Questions

[19.165]

19.3

Which, if any, of the PAYG prepayment systems would be expected to apply to these payments: a fee of $100,000 paid to a concert pianist by a concert promoter – think about (a) both the promoter and the pianist; (b)

a payment of wages by the manager of the orchestra to each member of the orchestra;

(c)

a payment made under a disability insurance policy taken out by an employee;

(d)

a lump sum payment made by an employer as compensation for the loss of a limb in an industrial accident;

(e)

a lump sum payment for a restrictive covenant;

(f) (g) 19.4 19.5

a scholarship received from a university; a dividend paid by the employer on shares acquired by the employee under an employee share scheme. Is an employer obliged to withhold PAYG on the value of fringe benefits paid to the employee? What PAYG obligations arise for payments from third parties such as a tip paid by a customer? [19.165]

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4. ASSESSING (AND SELF-ASSESSING) TAX DEBTS [19.170] The processes described so far are designed to collect amounts of money from

taxpayers as a prepayment of their eventual tax debt. But they are just that – prepayments based on estimates of the tax that the taxpayer will end up owing for the year. The determination of how much tax the person really owes happens under another step in the system, referred to as the making of an assessment.

(a) Tax Returns [19.180] The making of an assessment usually emerges from processes that start with the

preparation and lodgment of a tax return, either by the taxpayer or a professional adviser. The return provides some of the information that indicates just how the taxpayer calculated its tax liability. The obligation to file an income tax return is imposed by s 161 of the ITAA 1936. This section requires every person referred to in the notice published annually by the ATO in the Commonwealth Government Gazette to file a return by the date specified in the notice. The notice generally requires that returns be filed by all entities (companies, partnerships, trusts, superannuation funds, etc) and individuals with a taxable income above the relevant threshold. People below the threshold will generally not be obliged to file returns but they will often do so in order to claim a refund of the PAYG instalments already collected from their income. Section 161A states that the return must be in the approved form (ie has the information required by the ATO). Full self-assessment taxpayers are also required supply some additional information (s 161AA of the ITAA 1936). Section 161A(2) allows electronic lodgment of returns. Almost all returns lodged by tax agents and a growing percentage of those lodged by individuals are done so electronically. The Commissioner may defer the time for lodgment (s 388-55 of Sch 1, TAA 1953). In addition to the annual returns regularly required by the ATO, it has further powers under ss 162 and 163 of the ITAA 1936 to require taxpayers to prepare additional returns with more information in special circumstances. One consequence of a system which requires the filing of annual returns is the cost to the taxpayer to collect, record and transmit the required information. These compliance costs can be substantial and are one source of economic inefficiency for an income tax. While these costs may be passed on to other groups, such as consumers, their effect can be reduced by tying the income tax to other information processing activities that the taxpayer would already do, even if the tax were not imposed. The cost of complying with the income tax has been subject to some serious research in Australia. Many studies have been undertaken attempting to estimate the costs to taxpayers of complying with their income tax obligations with researchers estimating taxpayer costs to be between 8 per cent and 11 per cent of tax revenue collected (J Pope, R Fayle and M Duncanson, The Compliance Costs of Personal Income Taxation in Australia (Sydney, ATRF, 1990)) and the costs for public companies ranged between 11 per cent and 23 per cent of tax revenue collected (J Pope, R Fayle and D L Chen, The Compliance Costs of Public Companies’ Income Taxation in Australia 1986-1987 (Sydney, ATRF, 1991)). In light of these high compliance cost estimates it is not surprising that the need to reduce tax compliance costs on the community has been a common thread in the most of the major inquiries and other more limited reviews of the Australian tax system, the major tax reform reviews conducted in other jurisdictions, and the independently commissioned studies over the last 230 years (from Adam Smith in 1776 to the 2010 Australia’s Future Tax System Review 970

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(the Henry Review)). Unfortunately, as Michael J Graetz in Taxing international income: Inadequate principles, outdated concepts, and unsatisfactory policies (2001) 26 Brooklyn Journal of International Law 1357 at 1410 notes “[s]implicity always seems to be the forgotten stepchild of income tax policy. Routinely lip service is offered to the idea that tax law ought to be as simple to comply with and administer as possible; then, after a nod and a wink, vaulting complexity overleaps itself.” In addition to the costs to taxpayers, there are of course the government’s costs. The Commissioner’s Annual Report 2014-15 gives an indication of the government’s costs of administering the income tax system. In 2014–15, the ATO claims that its compliance cost was 66 cents for every gross $100 collected in revenue including GST. One consequence of the move to full self-assessment is undoubtedly the shift from the administration to the taxpayer of many of the costs of compliance, as taxpayers must assume more responsibility for their returns and the ATO assumes less responsibility for verification.

(b) Annual Assessments [19.190] The next step in the process is usually the making of an assessment. This is the formal step by which the ATO determines just how much tax a person owes for the year and notifies the person of the amount. It is an integral step in the process because under the income tax system, many important consequences are made to depend on the making of an assessment by the ATO. Among the most important consequences, the assessment:

• fixes the amount of tax payable by the taxpayer for that year and makes it a debt owed to the Commonwealth (s 255-5 of Sch 1, TAA 1953); • determines the date by which the tax is payable (s 5-5 of the ITAA 1997); • determines the date from which shortfall interest charge is payable (s 5-10 of the ITAA 1997); • starts the period within which the taxpayer can object that its tax liability has been incorrectly determined (s 14ZW of the TAA 1953); • determines the statute of limitations that applies to preclude the ATO from reassessing the taxpayer in respect of that year’s income (s 170 of the ITAA 1936). Under an assessment system, the assessment is issued by the revenue authority after receiving and examining the return. Section 166 of the ITAA 1936 requires the ATO to assess the taxpayer from the return or from any other information in her or his possession. This provision operates primarily for individuals who still file returns and await the official making of an assessment. Under the self-assessment system, an event called the making of an assessment is still necessary to trigger the consequences listed above. For other taxpayers, most notably companies and superannuation funds, s 166A has deemed their own tax return to be an assessment made by the ATO (generally) on the day that the taxpayer files its return for the year. In other words, one step in the process by which the ATO accepts the return and then sends out a piece of paper repeating the taxpayer’s own figures to it has been eliminated for companies and superannuation funds. The same procedure also operates in s 72 of the Fringe Benefits Tax Assessment Act 1986 which deems the employer’s FBT return to be an assessment served on the taxpayer on the date on which the return is furnished by the employer. [19.190]

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(c) Default Assessments [19.200] The Commissioner is not limited to making an assessment based on the information

provided in a taxpayer’s return. The Commissioner can supplement or ignore inaccurate information there is reason to doubt it, and an assessment can be issued without a return. It should not be possible for a person to prevent a tax debt arising by just forgetting to file a tax return. The Commissioner is given powers in ss 167 and 168 of the ITAA 1936 to issue assessments based upon the Commissioner’s judgment of the amount of tax payable. Section 167 is obviously necessary for the recalcitrant taxpayer who either refuses to enter the tax system at all by failing to furnish returns or, more commonly, who files returns which are upon later investigation found to be incomplete. There is obviously the further problem in either case if the information which the ATO would need to reconstruct accurate accounts is not available. Section 167 can overcome this problem even though any reconstruction in such circumstances must necessarily be inaccurate, perhaps even more inaccurate than the taxpayer’s original return. That, however, is not viewed as a great problem. In Trautwein v FCT (1936) 56 CLR 63 Latham CJ said of similar provisions in the Income Tax Assessment Act 1922: Obviously the facts in relation to his [the taxpayer’s] income are facts peculiarly within the knowledge of the taxpayer. In the absence of some record in the mind or in the books of the taxpayer, it would often be quite impossible to make a correct assessment. The assessment would necessarily be a guess to some extent, and almost certainly inaccurate in fact. There is every reason to assume that the legislature did not intend to confer upon a potential taxpayer the valuable privilege of disqualifying himself in that capacity by the simple and relatively unskilled method of losing either his memory or his books.

This mechanism is most often used where no return at all is filed but it is also often used against taxpayers who have not yet had to file a return (eg Brent v FCT (1971) 125 CLR 418 (discussed in Chapter 4)). [19.210] The s 167 power is most commonly exercised where there is an the absence of

information or the taxpayer’s records do not explain the apparent wealth and lifestyle of the taxpayer. The ATO attempts to construct the taxpayer’s taxable income by reference, at least initially, to changes in the taxpayer’s assets over the tax year. But such a process, undertaken without access to the real information, must be at best an approximation. Is that fact enough to render it invalid? The evidentiary reliability of such estimates of income was discussed in L’Estrange v FCT (1978) 9 ATR 410; 78 ATC 4744. McGarvie J noted: Bearing in mind the evidence as to the reliability of the assets betterment statement and as to the conduct of the taxpayer, my assessment of the reliability of the taxpayer’s evidence, the absence of documentary evidence to cast doubt on the correctness of the taxable income shown by the assets betterment statement, and the probabilities of the case, I find that the taxpayer during the first period derived from unidentified sources a taxable income not included in his returns, which was approximately equal to the unidentified omissions shown on [the assets betterment statement].

(d) Amending Assessments [19.220] Often a taxpayer, after receiving an assessment, may discover they have omitted to

claim a deduction or have erroneously claimed something that they were not entitled to claim. Similarly, in the self-assessment environment the ATO may also discover an error by a taxpayer after the assessment has issued. In both cases s 170 of the ITAA 1936 provides that “the Commissioner may … at any time amend any assessment”. The ability to amend must be 972

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in accordance with times specified in the table in s 170, subject to specific qualifications. Further limitations on this general power are prescribed in s 170(2) – (4). Under the former manual assessment system, the ATO’s powers to amend prior assessments were made to depend upon the taxpayer failing to make “full and true disclosure” of all material facts. But under the self-assessment system, where any investigation of the veracity of a taxpayer’s return will only occur long after an assessment has been issued, such an impediment on the ATO’s power to amend an assessment, makes little sense. So, the current version of s 170 permits the ATO to amend any prior assessment for any reason but within a period of two or four years after the date that an assessment was made. So, the current text of s 170(1) allows the ATO to amend an assessment to increase the taxpayer’s liability: • at any time, where there has been fraud or evasion (s 170(1) Item 5); • within four years after the making of the assessment (or deemed assessment) for companies and other self-assessing taxpayers (s 170(1) Item 4); • within two years after the making of the assessment for individuals and others with simple tax affairs (s 170(1) Items 1, 2, 3). Section 170 lists a large number of exceptions allowing amendments outside these limits. Prior to 2004 the courts had decided that a nil assessment (no tax payable for the year) was not an assessment for the purposes of the Act (FCT v Batagol (1963) 109 CLR 243; FCT v Ryan (2000) 201 CLR 109; [2000] HCA 4) but this inconvenient rule was overcome by an amendment in 2004 to the definition of “assessment” in s 6 of the ITAA 1936 to include such situations. The Commissioner has power to amend an assessment at any time where there has been an avoidance of tax and The Commissioner “is of the opinion that the avoidance is due to fraud or evasion” (s 170(1) Item 5). The meaning of “fraud or evasion” has never been authoritatively determined by an Australian court. One of the few discussions of the meaning of the term occurs in the judgment of Dixon J in Denver Chemical Manufacturing Co v FCT (1949) 79 CLR 296, discussing the former Income Tax (Management) Act 1941 (NSW): I think it is unwise to attempt to define the word “evasion”. The context of s. 210(2) shows that it means more than avoid and also more than a mere withholding of information or the mere furnishing of misleading information. It is probably safe to say that some blameworthy act or omission on the part of the taxpayer or those for whom he is responsible is contemplated. An intention to withhold information lest the Commissioner should consider the taxpayer liable to a greater extent than the taxpayer is prepared to concede, is conduct which if the result is to avoid tax would justify finding evasion. In the present case the Board concluded that the appellant intentionally omitted the income from the return and that there was no credible explanation before them why he did so. They thought that the conduct of the taxpayer answered the description of an avoidance of tax by evasion. …

Much of the apparent force of s 170 and its limitation on the power of the ATO to reassess taxpayers has also been diminished through the recent practice of creating special exclusions from s 170. These exemptions, many of which are contained in s 170(9D) – (11) permit the ATO to amend an assessment already issued pursuant to the various sections enumerated there. Further exceptions to s 170 are scattered throughout the legislation: for example, s 177G permits the ATO to amend previous assessments to cancel tax benefits and make [19.220]

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compensating adjustments where the ATO applies Pt IVA of the ITAA 1936 to a scheme. Section 170A indicates that these miscellaneous provisions usurping s 170 are intended to operate cumulatively. Governments will commonly announce changes to the tax law which operate from a specified date. However, the final legislation may differ from that announced. Section 170B restricts the Commissioner’s powers to amend in such circumstances where a taxpayer in preparing their return has reasonably and in good faith relied upon a governmental announcement of a change, listed within the section. An example is the “look-through earnout right” rules (introduced by Tax and Superannuation Laws Amendment (2015 Measures No 6) Act 2016, Schedule 1, paragraphs 38 and 39). Under s 170B the tax position of a taxpayer who relied on an approach contained in a Treasury discussion paper, released some six years earlier on 12 May 2010 (Treasury, Proposal Paper: Capital gains tax treatment of earnout arrangements) is preserved. This occurs despite the fact that a different tax outcome would have arisen if the approach actually adopted under the legislation was applied. [19.225]

19.6

19.7 19.8

19.9

Questions

What variations would need to be made to the calculations suggested in L’Estrange in the light of the introduction of: (a) capital gains tax; (b) fringe benefits tax? How would the entries for certain capital receipts made in L’Estrange need to be varied after capital gains tax? Would the ATO be able to amend an assessment after 10 years where the taxpayer fraudulently omitted to disclose a dividend of $1,000 but had made an error overstating the taxpayer’s business income by $1,000? If the ATO did attempt to amend the assessment, would the taxpayer be able to have the other error rectified at the same time?

5. CHALLENGING THE ATO’S DECISIONS [19.240] The ATO’s determination of the taxpayer’s tax liability is open to challenge by a

dissatisfied taxpayer. So too are many of the decisions made by ATO staff exercising the multitude of administrative discretions in the Act. Review and appeal procedures are contained in a variety of provisions in the legislation as well as via informal administrative practices. Reviews may be dealt with entirely within the ATO’s office or may, in certain circumstances, lead ultimately to the High Court. Most taxpayer dissatisfaction is, however, dealt with long before the litigious stage. This occurs in part because of internal administrative review procedures to catch errors and internal appeals systems to remove contentious matters to uninvolved specialists for review. Tax administration would collapse if most disputes had to be resolved by litigation.

(a) Objections to Assessments and Private Rulings [19.250] A taxpayer who is dissatisfied with an assessment can object to the assessment.

Section 175A of the ITAA 1936 provides that a taxpayer “who is dissatisfied with an assessment may object against it in the manner set out in Pt IVC of the” TAA 1953 . For taxpayers still under the assessment system, this objection process still makes sense – the taxpayer is reacting to an assessment decision made by the ATO which is alleged to be 974

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wrong. For taxpayers already under full self-assessment (most notably companies) the objection process is curious. In fact, the taxpayer is objecting to its own income tax return, as the taxpayer’s return is deemed by s 166A also to be the ATO’s assessment. In other words, the taxpayer has to lodge two documents simultaneously – one which is its tax return prepared as the ATO’s practices dictate, and the other being the taxpayer’s statement of reasons why its own tax return is incorrect. In addition to objections against assessments, s 14ZL of the TAA 1953 offers taxpayers dissatisfied with a determination, notice or decision, or with a failure to make a private ruling, opportunity to object against it in the manner set out in Part IVC. This section permits taxpayers to challenge private Rulings as if they were assessments since, as was noted above, the Ruling effectively anticipates the manner in which the assessment must be prepared. Public Rulings, although binding on the ATO and having important consequences for taxpayers, cannot be objected to per se. Instead, a taxpayer dissatisfied with a public Ruling can apply for a private Ruling which will usually be given in the same manner as the public Ruling, and then object to the private Ruling. If the taxpayer has objected (unsuccessfully) to a private Ruling, the taxpayer cannot re-litigate the same ground by objecting to the subsequent assessment: s 14ZVA of the TAA 1953. In other words, the taxpayer should fully pursue any objection to the original Ruling once it has applied for the private Ruling. The machinery provisions determining how an objection must be prepared, when it must be lodged, and what happens to an unsuccessful objection are contained in Pt IVC of the TAA 1953. Section 14ZU of the TAA 1953 provides that a person making a “taxation objection” must: • make the objection in writing; • set out the grounds relied upon fully and in detail; and • lodge the objection within the period set out in s 14ZW. Where the taxpayer is objecting to an assessment, s 14ZW(1) permits the objection to be lodged up to four years after the taxpayer received notice of the decision objected to. Where the taxpayer is objecting to a private Ruling, s 14ZW(1A) permits the objection to be lodged up to four years after the last day for lodging the return for the year of income to which the Ruling relates. (i) Objecting that it is not a lawful assessment [19.260] The manner and form of conditions contained in s 175A of the ITAA 1936 and

s 14ZU of the TAA 1953 are reasonably stringent and will be discussed below. But before proceeding to them, it is instructive to consider the controversy whether these sections amount to a code, excluding any other manner of seeking the review of an assessment or other decision. The object of trying to challenge assessments by means other than lodging an objection is usually to avoid the problems caused by failing to meet the formalities prescribed in ss 175A and 14ZU, most commonly by failing to object within time, or where the taxpayer faces the problem that the ATO would win on the merits, and so the taxpayer tries to win on technicalities. The question we are considering is whether there is a distinction to be drawn between challenging the accuracy of an assessment (which can probably only be done through ss 175A and 14ZU) and disputing that the document which has been produced amounts to a lawful assessment (which might be done in other ways). Central to this discussion is s 175 of the ITAA 1936 and s 350-10 of Sch 1 of the TAA 1953 which purport to make an “assessment” liable to defeat only under the stated process in the TAA 1953, and to render it immune from challenge on other grounds and in other ways. [19.260]

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Some taxpayers have tried to take this other route and challenge the accuracy of assessments by arguing that the document is not a lawful assessment. They have usually proceeded without success, with courts reminding litigants that assessments can only be challenged through ss 175A and 14ZU. This conclusion is usually attributed as the consequence of s 350-10 (formerly s 177 of the ITAA 1936). For example, in F J Bloemen Pty Ltd v FCT (1981) 147 CLR 360 the High Court observed that the process outlined in ss 175A and 14ZU is the only way that an assessment can be challenged. The taxpayer in Bloemen tried to argue that the document which purported to be an assessment could be challenged as being instead merely tentative. The High Court held that the taxpayer was precluded by ss 175, 177 and the former 185 (s 175A and s 14ZU) from making this assertion: Once the Commissioner takes advantage of s. 177(1) by producing an appropriate document, the taxpayer is precluded from contesting that the Commissioner has made an assessment or that in making the assessment he has complied with the statutory formalities. The taxpayer is entitled to dispute his substantive liability to tax in proceedings under Part V [now Pt IVC of TAA 1953]. Section 177(1) specifically operates by compelling a court, for example the Supreme Court, in the exercise of its jurisdiction to treat a notice of assessment on its production as conclusive evidence that the assessment has been duly made and thereby foreclosing that issue. The rights of review given to the taxpayer by Part V [Pt IVC] are comprehensive. Quite evidently it was contemplated that the Commissioner would in every case take advantage of s. 177(1) and foreclose the exercise of jurisdiction to decide whether an assessment has been duly made. The general tenor of the statutory provisions suggests that a taxpayer wishing to challenge a notice of assessment served upon him will be effectively confined to the Part V procedures. Section 177(1)’s effect is to put the making of an assessment beyond challenge. Section 175A proceeds on this assumption and on the footing that, once a notice of assessment is served, no question will arise as to the making of the assessment by reason of the Commissioner’s reliance on s. 177(1)

But the strictness of the position in Bloemen and the effect of the former s 177 (s 350-10) was circumscribed by the decision of the Full Federal Court in David Jones Finance and Investments Pty Ltd v FCT (1991) 91 ATC 4315. The taxpayer was entitled to dividends on shares held by nominee companies on its behalf. Departing from his long-standing practice, the ATO had denied the taxpayer a rebate on the dividends under s 46 when making its assessment. The reason for not following prior practice was that the ATO claimed that the taxpayer was engaged in tax avoidance. The taxpayers sought orders from the Federal Court, declaring that the notices of assessment that had been issued were invalid because they were made for an improper purpose – punishing the taxpayer for being engaged in tax avoidance. The taxpayer claimed that the Court had the power to make these orders, notwithstanding s 177. The High Court is granted jurisdiction to review administrative action by officers of the Commonwealth under s 75 of the Constitution and, the taxpayer argued, a similar power is conferred on the Federal Court by s 39B of the Judiciary Act 1903. Morling and French JJ in the Full Federal Court first had to conclude that the powers of the High Court did also exist in the Federal Court and then whether the terms of s 177 (now s 350-10) purported to remove the power of the Court to examine the process leading to the making of an assessment and to question the bona fides of the assessment. They distinguished Bloemen and found for the taxpayer: 976

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David Jones Finance and Investments Pty Ltd v FCT [19.270] David Jones Finance and Investments Pty Ltd v FCT (1991) 21 ATR 1506; 91 ATC 4315 Paragraph 75(v) of the Constitution confers a jurisdiction upon the High Court which cannot be limited or qualified by any statute. That jurisdiction authorises the court to control excesses of power or failure of duty by officers of the Commonwealth … [and] it is apparent from the language of s. 39B, its identity with that of para. 75(v) and the Second Reading Speech, that the intention of the legislature was to confer on the Federal Court the full amplitude of the original jurisdiction of the High Court under para. 75(v). Consistently with that intention, and the case law, the jurisdiction so conferred will not be displaced, qualified or limited by privative provisions in statutes pre-dating the amendment. And for statutes which post-date it, there will be a powerful presumption, in the absence of clear words to the contrary, that no such displacement, qualification or limitation is intended. Statutory erosion of the jurisdiction will effectively return it, contrary to the legislative intention, to the exclusive province of the High Court. The interaction of s. 39B with s. 177 of the Income Tax Assessment Act must therefore be considered on the same footing as the interaction of para. 75(v) of the Constitution with that provision. For the High Court, invested by para. 75(v) of the Constitution with a jurisdiction not able to be impeached by legislative action, the question whether administrative conduct is within or beyond power or whether a statutory duty has been discharged is always open to enquiry. The enquiry is complicated when it involves a privative

provision only to the extent that the privative provision may have to be taken into account in defining the boundaries of the power or duty the exercise of which is under review. The conditional nature of the operation of s. 177 distinguishes it from the privative provisions considered in [other] cases … and leads to the conclusion that it is intended to operate and does operate to deny to the courts authority to enquire into the due making of the assessments and, except in Part V proceedings, whether the amount and all the particulars of the assessment are correct. On that characterisation its effect is purely jurisdictional and cannot displace the jurisdiction conferred on this court by s. 39B. In this court and in the proper exercise of that jurisdiction the “due making” of the assessment and the amount and all particulars thereof is open to enquiry. The first limb of s. 177(1), if it is to be regarded as an empowering provision, does not authorise conduct of the assessment process in bad faith. And to some extent that must mean that it will not authorise the conduct of the process for improper purposes. On the pleadings in the present case, it is alleged that the assessments in question were made in the exercise of an abuse of power and for improper purposes which are tantamount to an allegation of bad faith on the part of the Commissioner. And to that extent the enquiry raised by those allegations would not be affected by the operation of the first limb of s. 177(1).

[19.280] The ATO sought to challenge this decision but the High Court refused leave to

appeal. Unless and until it is overruled, David Jones Finance shows that it is possible for a taxpayer to argue on administrative law grounds that the process claimed to be an assessment was invalid, and hence did not amount to an assessment at law. This strategy offers many advantages to the usual form of challenge: the taxpayer does not have to conform to the manner and form of conditions for objections; and, if the argument succeeds, the accuracy of the assessment becomes irrelevant. In fact it may be easier (or it may be the only feasible alternative) for the taxpayer to show that the document was not a valid assessment than to show that it was erroneous, because the onus of proof in tax matters is on the taxpayer or, as in David Jones Finance, because of the state of the authorities – the taxpayer in David Jones [19.280]

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Finance would have had to convince the High Court to distinguish or overrule its earlier judgment in FCT v Patcorp Investments Ltd (1976) 140 CLR 247. Of course, such a strategy does not win a final victory if the ATO has sufficient time within which to issue a valid assessment of the year’s income. In FCT v Futuris Corporation Ltd (2008) 69 ATR 41; [2008] HCA 32 the High Court left open the possibility that s 39B of the Judiciary Act 1903 would be available if the ATO had acted in bad faith in issuing the assessment. Gummow, Hayne, Heydon and Crennan JJ noted: 25. But what are the limits beyond which s 175 does not reach? The section operates only where there has been what answers the statutory description of an assessment. Reference is made later in these reasons to so-called tentative or provisional assessments which for that reason do not answer the statutory description in s 175 and which may attract a remedy for jurisdictional error. Further, conscious maladministration of the assessment process may be said also not to produce an “assessment” to which s 175 applies. Whether this be so is an important issue for the present appeal. … 55. The issue here is whether, upon its proper construction, s 175 of the Act brings within the jurisdiction of the Commissioner when making assessments a deliberate failure to comply with the provisions of the Act. A public officer who knowingly acts in excess of that officer’s power may commit the tort of misfeasance in public office in accordance with the principles outlined earlier in these reasons. Members of the Australian Public Service are enjoined by the Public Service Act (s 13) to act with care and diligence and to behave with honesty and integrity. This is indicative of what throughout the whole period of the public administration of the laws of the Commonwealth has been the ethos of an apolitical public service which is skilled and efficient in serving the national interest. These considerations point decisively against a construction of s 175 which would encompass deliberate failures to administer the law according to its terms.

This issue was further explored by the Full Federal Court in FCT v Donoghue [2015] FCAFC 183. The case involved an auditor using documents supplied by a disgruntled former law clerk employed by the taxpayer’s solicitors, that the auditor (Mr Main) was aware were possibly the subject of a claim for legal professional privilege. The documents were used to support the issuance of notices of assessment. The judge at first instance in Donoghue v FCT [2015] FCA 235, applying the Futuris decision, found that the auditor had not acted in bad faith but had acted with reckless disregard for taxpayer’s right to claim privilege over the documents and consequently this was sufficient to constitute conscious maladministration. As a result of this conscious maladministration the assessment notices were invalid. The Full Court upheld the Commissioner’s appeal finding that the assessments were valid.

FCT v Donoghue [19.285] FCT v Donoghue [2015] FCAFC 183 Justices Kenny and Perram noted: 42. The effect of [ss 175 and 177(1)] was explained in Futuris … as not applying to assessments which have been produced as a result of conscious maladministration. Elsewhere in the judgment it is clear that the underlying concept which will take an assessment beyond the protection afforded by ss 175 and 177 is, in essence, a want of good faith in the process of 978

[19.285]

assessment. The Full Court in Denlay observed (at 433 [76]) in relation to Futuris at 165-166 [60]: Those observations highlight that their Honours were concerned, in their reference to conscious maladministration, with bad faith in the exercise of the decision-making power under challenge and the need for proof

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FCT v Donoghue cont. of an allegation of bad faith against the Commissioner or his officers. Their Honours were concerned with actual bad faith, not with some form of “constructive” bad faith established by unwitting involvement in an offence. In that circumstance, conscious maladministration is an instance of the absence of good faith. There may well be others. This is not to say that a taxpayer may not dispute a notice of assessment on other grounds (besides want of good faith or that the supposed assessment was provisional or tentative only) but rather that any such review must take its course

through the ordinary channels provided for review under the provisions of Pt IVC of the Taxation Administration Act 1953 (Cth) and will not go to validity. The Judicial Review Proceeding was brought under s 39B of the Judiciary Act 1903 (Cth), which would have ordinarily permitted this Court to review a decision of the Commissioner on the full range of judicial review grounds. The effect of s 175 and the High Court’s decision in Futuris, however, is that the only ground of review available to challenge a notice of assessment in a case such as the present is a want of good faith such as conscious maladministration. The correctness of these observations was not in dispute before the trial judge or in this Court.

On the issue of maladministration and the validity of the assessment Kenny and Perram JJ concluded: 58. It follows that the act of maladministration identified by the trial judge – breach of the common law of legal professional privilege – cannot, with respect, be correct. At best the law of privilege afforded Mr Donoghue an immunity against being compulsorily required to disclose communications with his attorneys. Where the Commissioner did not use any such power to obtain the documents in question, whether they were privileged was of no moment. 59. Of course, the authorities do not mean that a person in Mr Donoghue’s position is without remedy. In this case, Mr Donoghue could

have brought a suit against Simeon Moore immediately after he sought to blackmail him in order to restrain him from carrying out his threat. Even after the documents were delivered to the ATO it may perhaps have been possible, at least before the information in them became assimilated via the assessment process, to have sued the Commissioner under the principle in Lord Ashburton v Pape for the return of the material … However, all of these claims would have been in equity to enforce a claim for confidentiality …

On the issues of “good faith” and “reckless indifference” Kenny and Perram JJ noted: 94. The trial judge found that Mr Main had acted honestly and not in bad faith, but that he had been reckless as to Mr Donoghue’s right to claim legal professional privilege. Nevertheless, he concluded that he had engaged in conscious maladministration because he had acted in a recklessly indifferent fashion … 95. … All of the trial judge’s conclusions about the absence of bad faith, Mr Main’s honesty and his attitude of reckless indifference were premised upon an assumption that what was being assessed was Mr Main’s mental state in relation to an

obligation not to use privileged material … however, that assumption about the operation of the law of privilege was incorrect … the trial judge’s conclusion that Mr Main had acted with reckless indifference to Mr Donoghue’s right to make a claim for legal professional privilege miscarried because no such right existed and s 166 required the opposite conclusion… 96. The fact remains, however, that it is clear from s 166 what the correct position was in relation to the way Mr Donoghue’s case was conducted. … we have detected nothing [19.285]

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FCT v Donoghue cont. improper in Mr Main’s conduct of the audit process or in his dealings with the documents provided by Simeon Moore. He acted precisely as s 166 required him to do. There were no defaults in his conduct as a public servant. There was no

maladministration, still less conscious maladministration. That he was persuaded into making concessions during his cross-examination about what he should have done in relation to privileged documents signifies nothing when it is realised the cross-examination was conducted on a legally erroneous assumption.

Justice Davies, in agreeing with the judgement of Kenny and Perram JJ notes: 114. However, it cannot be an improper purpose or maladministration of the assessment power, let alone conscious maladministration, for the Commissioner to use information in his possession for the purpose of raising an assessment against a taxpayer where the Commissioner has formed the view that the statute imposes a liability on the taxpayer upon the facts as they are known to the Commissioner. Where the information in the Commissioner’s possession discloses that a taxpayer has a taxable income, the Commissioner’s duty in the exercise of his assessment power is to determine and fix the amount of liability that the law operates to impose on the taxpayer: s 166 of the 1936 Act; Macquarie Bank Ltd v Commissioner of Taxation [2013] FCAFC 119. 115. In the present case, the Commissioner (through his officers) applied the law to the taxable facts known to him concerning the

taxpayer’s affairs and raised assessments of the amount of tax payable based upon those taxable facts. The evidence did not show that the Commissioner’s officers acted with an absence of bona fides in the exercise of their statutory duty to make the assessments or that the use of the material was not for a legitimate purpose under the tax laws… On those findings, the application under s 39B of the Judiciary Act should have been dismissed. The circumstances under which the information on which the assessments were based came into the possession of the Commissioner could not, and did not, alter the liability to tax which the law imposed on the taxpayer on the facts known to the Commissioner and the Commissioner’s reliance on that information to raise the assessments could not, and did not, constitute the exercise of power in bad faith nor a deliberate disregard of his duty to assess in accordance with the law.

(ii) Objecting to the accuracy of the assessment [19.290] The more usual route is to follow the procedure laid down in Pt IVC of TAA 1953 and allege that the assessment is based on an incorrect interpretation of the law and so overstates the taxpayer’s liability. The two most important requirements for a valid objection are that it is lodged within the specified time – either two or four years, or such other time as the ATO may allow under s 14ZW(2) and (3) – and that the objection states fully and in detail the grounds on which the taxpayer relies in order to dispute the assessment. This latter requirement as to content has major ramifications for taxpayers – if the taxpayer fails to include in the objection a possible argument that the ATO might raise, the taxpayer cannot argue it at a hearing before either the AAT or the Federal Court. This is provided in s 14ZZK for AAT proceedings and s 14ZZO for Federal Court hearings, although in either case, the Tribunal or Court hearing an appeal has a discretion to allow taxpayers to amend the grounds of objections. The principal requirement for a valid objection is that it must specify in sufficiently explicit terms the particular respect in which the taxpayer asserts that the ATO’s assessment is wrong 980

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and the taxpayer’s reasons for that argument. No particular form of words is required – it needs only to be sufficient to communicate the grounds of objection. In Lancey Shipping Co Pty Ltd v FCT (1951) 9 ATD 267 Williams J said: The grounds of objection need not be stated in legal form, they can be expressed in ordinary language, but they should be sufficiently exclusive to direct the attention of the [Commissioner] to the particular respects in which the taxpayer contends that the assessment is erroneous and his reasons for this contention. In each case the sufficiency of the grounds is a matter for the court. Vague grounds such as that the assessment is excessive are not, in my opinion, a compliance with the Act.

The limits of this informality were reached in Case Z28 (1992) 92 ATC 264 where the taxpayer simply sent a letter to the ATO stating, “we are in possession of your assessment … and hereby wish to object to your assessment in full”. But the existence of the rules limiting taxpayers to their stated grounds, combined with the fact that taxpayers have the burden of proving the ATO wrong (ss 14ZZK and 14ZZO of the TAA 1953), has probably led to a result exactly the opposite from that which his Honour was hoping would be achieved. Limiting the taxpayer to only the grounds stated in the objection means that taxpayers draft “omnibus” objections asserting every conceivable argument against the assessment – a very simple process in the age of word processors – and this undoubtedly served only to confuse the real matters in issue. We mentioned above that the AAT and the Federal Court have discretion to permit the taxpayer to add grounds. This discretion has been exercised on occasions although it has been argued that the power conferred was limited to elaborating grounds already stated in the objection, rather than adding new grounds to the objection, a proposition which was rejected by the Full Federal Court in Lighthouse Philatelics Pty Ltd v FCT (1991) 22 ATR 707; 91 ATC 4942. While the effect of the restrictions in ss 14ZZK and 14ZZO is prima facie to limit the taxpayer to the grounds stated in the objection, the ATO has never been similarly limited by any equivalent provision. The unfairness of this position was considered in Danmark Pty Ltd v FCT (1944) 7 ATD 333 by Latham CJ who said: If an assessment is made by the Commissioner under one section and the taxpayer lodges objections in relation to the assessment as so made, and if he is limited upon a review or on an appeal to the ground stated in his objections, it would be manifestly unfair to allow the Commissioner to support the assessment upon the basis of the provisions other than those which the Commissioner has stated to be the basis of the assessment. If the objections lodged by the taxpayer are effective in relation to the assessment as actually made, in my opinion, as at present advised, it would be wrong for the court to allow the Commissioner to support the assessment by reference to provisions in relation to which the taxpayer has had no opportunity of raising any objections.

This position was, however, doubted in FCT v Reynolds (1981) 11 ATR 629; 81 ATC 4131. The ATO attempted to assess the taxpayer on the profit on the sale of a leased motor vehicle. The ATO issued an adjustment sheet which accompanied the assessment, stating that the amount was assessable under the former s 26AAA of the ITAA 1936. The taxpayer lodged an objection stating that the profit was not assessable under ss 26AAA, 25(1), 26(a) of the ITAA 1936 or any other provision of the Act. In the Supreme Court of Tasmania, Neasey J decided that the ATO could rely upon sections other than s 26AAA. The case also shows one of the dangers of drafting “omnibus” objections: [19.290]

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FCT v Reynolds [19.300] FCT v Reynolds (1981) 11 ATR 629; 81 ATC 4131 The first issue is whether the Commissioner is to be regarded as, in effect, estopped from arguing that his assessment was correct on any basis other than that which he stated in the adjustment sheet, namely, reliance on s. 26AAA. … The Danmark case does not assist the respondent. The … judgment of Latham C.J. indicates that there may be circumstances in which the court will not allow the Commissioner to take unfair advantage of the procedural provisions of the Act relating to appeals from assessments; for example, if a taxpayer objects to an assessment made under one section, and is bound by the grounds stated in his objection, and then the Commissioner supports his assessment under another section. There was no such unfair advantage to the Commissioner in that case because the taxpayer was not misled. Nor was the respondent here. His agents were careful to draft the notice of objection so as to take into account a number of sections of the Act

under which it might be claimed that the receipt was assessable, including s. 25(1). … I am not able to see that in this case any injustice has been done to the respondent by the Commissioner’s incorrect statement in the adjustment sheet of the basis upon which he considered that the amount in question was assessable income. … The respondent has not been misled into acting to his detriment. … The appeal is against the decision of the Board reducing the assessment. Thus, the basic question before the court is whether the assessment was right or wrong. It seems to me that if the Commissioner wrongly purported to rely upon one self-operating section of the Act, whereas another applies, that does not affect the rightness or otherwise of his assessment, and in the absence of any injustice to the respondent arising out of aspects of the appellant’s procedural actions, I can see no proper basis for restraining the Commissioner from changing his ground.

[19.310] Section 14ZW(1) of the TAA 1953 requires that generally, objections be lodged

within 2 years or 4 years, depending on the type of taxpayer, after service of the notice of the assessment, although s 14ZW(2) permits the ATO to grant an extension of time for the lodging of the objection but it is a matter within the discretion of the ATO. The taxpayer obviously has to make a case for an extension of time – s 14ZW(3) requires the taxpayer “to state fully and in detail the circumstances”. The Commissioner has indicated in Law Administration Practice Statement PS LA 2003/7 that an extension of time will available where the taxpayer was too ill to lodge an objection, or was overseas and did not return until the time limit had expired or where there were problems with the mail service. The ATO will look less favourably at delays caused by the negligence of the adviser and will not be at all impressed by ignorance of the law. The exercise of the ATO’s discretion can be reviewed by the AAT if the taxpayer wishes to make an application under s 14ZX(4). Once the taxpayer lodges an objection, s 14ZY requires the ATO to consider the objection and either allow it or disallow it, wholly or in part. Until 1991, there was no stipulated time limit on the ATO to reach a conclusion on the objection although Murphy J in the High Court in Re O’Reilly; Ex parte Australena Investments Pty Ltd (1983) 15 ATR 162; 83 ATC 4807 had said: Where time limits have not been specified in other sections of the Act a reasonable time has been implied. … Without a time limit any duty would be illusory. I interpret s. 186 [s 14ZY TAA 1953] of the Act as requiring the Commissioner to allow or disallow an objection in whole or in part within a reasonable time. 982

[19.300]

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Now, there is a clear obligation on the ATO in s 14ZYA to provide a timely answer to an objection. Section 14ZYA(2) and (3) provide that if an answer to the objection has not been forthcoming the taxpayer may give a notice to the ATO requiring a response and, if no answer is provided within 60 days, the ATO is deemed to disallow the objection. This has the effect of permitting the taxpayer to proceed further by taking the issue to the Federal Court or to the AAT. A taxpayer can withdraw a notice under s 14ZYA(2): McGrouther v FCT [2015] FCAFC 34. After considering the objection, the ATO is obliged to serve the taxpayer with a written notice of its decision on the objection. If the taxpayer is still dissatisfied with the assessment, the taxpayer then has rights under s 14ZZ for review of the assessment by either the AAT or the Federal Court.

(b) Reviews and Appeals [19.320] If the taxpayer is not satisfied with the result of the ATO’s internal review, the taxpayer may, by notice in writing, request that the assessment be referred to either the AAT or the Federal Court (AAT s 14ZZ of the TAA 1953). In fact, the terms of s 14ZZ(1) are more specific as “reviewable objection decisions” may be considered by the AAT, while all other decisions can only be appealed to the Federal Court. Sections 14ZZC and 14ZZN require the taxpayer to apply to the AAT for a review or to appeal to the Federal Court within 60 days after service on the taxpayer of the notice of the ATO’s decision on the objection. If the taxpayer has not acted sufficiently quickly, he or she may request the forum to exercise various discretions (for example in s 29(7) of the Administrative Appeals Tribunal Act 1975 (AAT Act)) to permit applications to be lodged out of time. The possibility of a reference to either the Federal Court or Tribunal raises three general issues: the choice of venue; the issues which are arguable on the reference; and the onus of proof in any proceedings.

(i) Choice of forum [19.330] The fundamental difference between reviews by the AAT and appeals to the Federal

Court is that the former involves a reconsideration of the assessment while the second is strictly an appeal on the legal validity of the assessment. Thus, for the purpose of reviewing a tax decision, the Tribunal may exercise all the powers and discretions that the ATO has itself. In other words, it is said the Tribunal stands “in the shoes of the Commissioner” and is entitled to reconsider the assessment and the exercise of any discretionary decision afresh. The Tribunal can, therefore, vary any penalties or the exercise of a discretion to determine what is a reasonable amount, without the constraints imposed upon a court merely to review for illegality. By way of contrast, the Federal Court can review the ATO’s decision on the objection and make orders confirming or varying the decision but the Court does not have power to re-exercise any discretion. If the Court finds the assessment to be invalid, it will normally remit the assessment to the ATO for reassessment in accordance with its reasons. Section 170(7) of the ITAA 1936 permits the ATO to amend assessments to give effect to Court orders and s 14ZZQ of the TAA 1953 requires the ATO to amend assessments to implement decisions of the Court. Some factors will weigh heavily in favour of choosing one forum rather than the other. For example, if the dispute involves the way the ATO has exercised a discretion, the taxpayer [19.330]

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would normally prefer to go to the Tribunal because it can exercise all the powers and discretions of the ATO and can substitute its own decision for that of the ATO. A court, however, cannot interfere with a discretion exercised by the ATO unless it finds that the discretion was not exercised in accordance with law. A further difference between each forum is that proceedings before the Tribunal may, at the taxpayer’s request, be in private (s 14ZZE) and may be reported without identifying the taxpayer, while taxpayers are invariably identified in the reports of Court proceedings. Also, each party to the proceeding before the Tribunal bears their own legal costs, whereas proceedings before the Court will usually be at the cost of whichever party is unsuccessful. The nature of the proceedings may also influence the choice of forum. Where a decision on an objection is referred to the AAT, the proceedings will be heard generally by a single member of the Tribunal and governed by the rules of the AAT Act. The AAT is not bound by the rules of evidence and it is obliged under s 33 of the AAT Act to conduct its proceedings with as little formality and technicality as it can achieve. One consequence of this direction is that taxpayers often represent themselves before the Tribunal. Further appeals can be made from proceedings before either the Tribunal or the Federal Court. In the case of the Tribunal an appeal can be made to a single judge of the Federal Court on a question of law. The appeal is confined to that question of law and does not amount to a rehearing of the entire case. In the case of the Federal Court, an appeal lies to the Full Court of the Federal Court, again only on a question of law. In each case, an appeal may lie to the High Court but only if special leave is granted. A five-judge Full Federal Court in Haritos v FCT [2015] FCAFC 92 conducted an authoritative examination of the limitations upon appeals from the AAT to the Federal Court under s 44 of the AAT Act, including whether a question of law may include mixed question of fact and law, and whether, in exercising its appellate jurisdiction on an appeal from a judge of the court, the Full Court may deal with a question or questions of law not previously raised before the primary judge.

Haritos v FCT [19.335] Haritos v Commissioner of Taxation [2015] FCAFC 92 Full Federal Court They noted: 62. … (1) The subject-matter of the Court’s jurisdiction under s 44 of the AAT Act is confined to a question or questions of law. The ambit of the appeal is confined to a question or questions of law. (2) The statement of the question of law with sufficient precision is a matter of great importance to the efficient and effective hearing and determination of appeals from the Tribunal. (3) The Court has jurisdiction to decide whether or not an appeal from the Tribunal is on a question of law. It also has power to grant a party leave to amend a notice of appeal from the Tribunal under s 44. 984

[19.335]

(4) Any requirements of drafting precision concerning the form of the question of law do not go to the existence of the jurisdiction conferred on the Court by s 44(3) to hear and determine appeals instituted in the Court in accordance with s 44(1), but to the exercise of that jurisdiction. (5) In certain circumstances it may be preferable, as a matter of practice and procedure, to determine whether or not the appeal is on a question of law as part of the hearing of the appeal. (6) Whether or not the appeal is on a question of law is to be approached as a matter of substance rather than form.

Administering the Tax Regime

Haritos v FCT cont. (7) A question of law within s 44 is not confined to jurisdictional error but extends to a non-jurisdictional question of law. (8) The expression “may appeal to the Federal Court of Australia, on a question of law, from any decision of the Tribunal” in s 44 should not be read as if the words “pure” or “only” qualified “question of law”. Not all so-called “mixed questions of fact and law” stand outside an appeal on a question of law. (9) In certain circumstances, a new question of law may be raised on appeal to a Full Court. The exercise of the Court’s discretion will be affected not only by Coulton v Holcombe [1986] HCA 33; 162 CLR 1 considerations, but also by considerations specific to the limited nature of

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the appeal from the Tribunal on a question of law, for example the consideration referred to by Gummow J in Commissioner of Taxation v Raptis [1989] FCA 557; 89 ATC 4994 that there is difficulty in finding an “error of law” in the failure in the Tribunal to make a finding first urged in this Court. (10) Earlier decisions of this Court to the extent to which they hold contrary to these conclusions, especially to conclusions (3), (4), (6) and (8), should not be followed to that extent and are overruled. Those cases include Birdseye v Australian Securities and Investments Commission [2003] FCA 232; 76 ALD 321, Australian Securities and Investments Commission v Saxby Bridge Financial Planning Pty Ltd [2003] FCAFC 244, 133 FCR 290, Etheridge, HBF Health Funds and Hussain v Minister for Foreign Affairs [2008] FCAFC 128; 169 FCR 241.

(ii) Issues justiciable on appeal [19.340] The effect of ss 14ZZK and 14ZZO of the TAA 1953 is, as was discussed above, to

limit the taxpayer prima facie to the grounds stated in the notice of objection. There is no similar limit on the ATO’s powers to vary a position taken, subject to the views expressed in Reynolds mentioned above. This limit on the issues justiciable on appeal is itself subject to being varied by the Tribunal or Court. (iii) Onus of proof [19.350] Sections 14ZZK and 14ZZO of the TAA 1953 place the onus of proof in relation to

virtually all matters on a tax appeal on the taxpayer. The taxpayer must show that the assessment is “excessive” which means that, unless the taxpayer can establish affirmatively that the assessment is wrong, then the assessment will stand. In FCT v Dalco (1990) 20 ATR 1370; 90 ATC 4088, the High Court said that “excessive” means that the total amount of tax assessed is too great, effectively overruling an earlier view that “excessive” simply meant that one step in the assessment process lacked authority. Placing the burden of proof on the taxpayer puts the taxpayer at a substantial disadvantage. Some sense of the importance of the decision can be gleaned from the efforts of the taxpayers in Bloemen and David Jones Finance. One suspects the taxpayers felt that they would have a better chance of attacking the validity of the assessment than of disproving its accuracy. We have already seen an example of the effect of the predecessor to ss 14ZZK and 14ZZO (s 190(b)) in Donaldson (extracted in Chapter 4) where figures, which were admitted to be reasonably arbitrary, were sustained by the Court because the taxpayer was unable to produce a more convincing set of values for the interests involved. [19.350]

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(c) Reviewing the Exercise of Administrative Discretions [19.360] The assessment of the amount of income tax owed by a taxpayer can involve the

exercise by the ATO of many discretions which are contained in the legislation. Examples of the sorts of discretions with which the Acts abound can be found, for example, in ss 99A, 177F of the ITAA 1936, and so on. The reliance in our Acts upon discretions to generate tax liabilities is, in some senses, contrary to Adam Smith’s maxim that tax liabilities should be certain. Further, the exercise of any discretionary power by a government or administrator has always been regarded in common law systems as a necessary evil but one to be constantly kept under scrutiny. The circumstances under which the exercise of a discretionary power can be reviewed by a court or other independent body are the subject of the field of administrative law and raise issues far too extensive to be discussed fully here. Instead, this part of the chapter will consider briefly the three principal ways in which the exercise of a discretionary power in a tax matter by the ATO can be reviewed by a court, the AAT and the Inspector-General of Taxation. (i) Judicial review of discretions in making assessments [19.370] The first judicial initiatives subjecting the discretionary powers of the ATO to some

form of external review was through the development by the courts of a series of principles interpreting the Act in a way which reduced the scope for the discretion. An example of this approach is found in Giris Pty Ltd v FCT (1969) 119 CLR 365, where the High Court considered a variety of arguments against the discretionary power given in s 99A of the ITAA 1936 for the ATO to determine whether to subject the accumulating income of a trust estate to tax under s 99 or at the higher rate applicable under s 99A. Barwick CJ read s 99 and s 99A as creating a combination which could not be operated by the ATO with complete flexibility. He also repeated the more general principles to be found in administrative law which allow a court to review the exercise of an administrative discretion for reliance upon irrelevant considerations, the use of arbitrary processes, not reaching decisions bona fide and so on:

Giris Pty Ltd v FCT [19.380] Giris Pty Ltd v FCT (1969) 119 CLR 365 It will be observed as a matter of verbiage that s. 99A purports to bring to tax the trust income which falls within its prescriptions and to do so of its own force. Verbally the Commissioner is given by s. 99A an authority or discretion in the nature of a dispensing power if he thinks it unreasonable to apply the section to the particular taxpayer in respect to the particular year of income. If he does not think it unreasonable so to do, s. 99 does not apply to the income of the particular trust estate in respect of the particular year of tax because, in default of the Commissioner’s opinion in the appropriate sense, s. 99A applies. It is possible to treat s. 99A in isolation and, regarding 986

[19.360]

it literally, not place the Commissioner under any duty to decide pro or con as to the reasonableness of applying that section to the particular taxpayer in the particular year of tax. In the Commissioner’s silence, the section would apply. However, I am not prepared to treat the section in isolation from s. 99 and to give literal effect to what after all is not much more than a draftsman’s device in allowing the section to apply where the Commissioner has not thought it was unreasonable for it so to do. In my opinion, the two sections must be read together and so read they do exhibit a cohesive scheme on the part of the legislature. In my opinion, the

Administering the Tax Regime

Giris Pty Ltd v FCT cont. operation of each of the sections depends on the view of the Commissioner as to the unreasonableness of applying the one rather than the other to the particular taxpayer in respect of the year of income in question. So read, in my opinion, a duty is imposed on the Commissioner to decide in each case and in respect of each year of income whether it is unreasonable to apply s. 99A rather than s. 99. It would also follow from my interpretation of the section that the Commissioner is in substance able to choose whether the trust income will be assessed under one section rather than another. He is able to make the choice in exercise of what, for want of a more precise expression, I shall call a legislative discretion: he can apply one section rather than the other if he thinks it unreasonable to apply the latter of them. I have been unable to find any content for the word “unreasonable” in the context of the two sections except considerations of a kind upon which a legislature acts in deciding whether an enactment or its particular terms are or are not unreasonable having regard to the interests of the public generally, of the citizen to be affected, of the revenue and of the requirements of those policies, political, economic and fiscal which the Parliament is prepared to sanction. Some facts are specified for the Commissioner’s attention in arriving at his opinion as to the unreasonableness

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but he is given no hint of what bearing any or all of them ought to have or may have on his judgment. In addition, he is required to have regard to any facts which he thinks appropriate to be considered in relation to the formation of his opinion. This view of the discretion gives to the Commissioner a wide charter which it might have been thought he was ill-equipped to exercise. What he is required to decide, in my opinion, is in truth a function of the legislature, rarely delegated to an official. Its repose in the Commissioner means that the citizen cannot know when disposing of his affairs what the impact upon him or them the law regarding the taxation of income will make; and unless the Commissioner is required to disclose the factual basis of his opinion as to unreasonableness, the taxpayer will not know after he is assessed upon what factual basis he was required to pay the tax imposed. But the wisdom of creating this somewhat unusual situation and the dangers inherent therein are of no concern to the court, though they might well be to the Parliament, if the features to which I have called attention do not lead to invalidity. However, in my opinion, the Commissioner is under a duty in each case to form an opinion and the taxpayer is entitled to be informed of it, and upon the taxpayer’s request, the Commissioner should inform the taxpayer of the facts he has taken into account in reaching his conclusion.

[19.390] The procedure identified recognises that the general principles of administrative law

are appropriate in the context of income tax and that they can be applied to the exercise of discretions which lead to the making of an assessment, such as whether to apply s 99A or s 99. It is interesting to note that in the drafting of ITAA 1997 a conscious effort was made to eliminate the need for the Commissioner to exercise discretion except where needed to combat tax avoidance. For example, while s 31C of the ITAA 1936 gave the Commissioner a discretion to alter the deduction allowable for trading stock not purchased at an arm’s length price, the corresponding provision, s 70-20 of ITAA 1997, simply declares that the amount of the deduction is taken to be the market value of the trading stock, a fact susceptible to objective determination. Discretions, if they are to be exercised properly, require work to be done by tax officers: the more self-executing the law is, the less time will be spent on decision-making. In fact the decision here is now forced upon the taxpayer, who under self-assessment takes on the risk that his claim may be too high. [19.390]

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(ii) Administrative Decisions (Judicial Review) Act 1977 [19.400] Another way of seeking the review of any discretions involved in the administration

of the Act is through the procedures available under the Administrative Decisions (Judicial Review) Act 1977 (ADJR Act). The legislation came into operation on 1 October 1980. The major limitation of this procedure, however, is that it applies only to steps in the administrative process apart from those which lead to the making of an assessment. The judicial review of steps leading to the making of an assessment can only be obtained through common law principles. The exclusion of these steps from the ADJR Act occurs in Sch 1 to the Act which excludes: (e) decisions making, or forming part of the process of making, or leading up to the making of, assessments or calculations of tax, charge or duty or decisions disallowing objections to assessments or calculations of tax, charge or duty, or decisions amending or refusing to amend, assessments or calculations of tax, charge or duty, under any of the following Acts: … Fringe Benefits Tax Assessment Act 1986… Income Tax Assessment Act 1936 Income Tax Assessment Act 1997 … Taxation Administration Act 1953, but only so far as the decisions are made under Part 2-35, 3-10 or 4-1 in Schedule 1 to that Act … (ga) decisions under s. 14ZY of the Taxation Administration Act 1953 disallowing objections to assessments or calculations of tax, charge or duty; (gaa) decisions of the Commissioner of Taxation under Subdivision 268-B or section 268-35 in Schedule 1 to the Taxation Administration Act 1953;

So, if the decision in question is one which is amenable to challenge under the ADJR Act, s 5 of the Act provides that the person who is aggrieved by a decision of an administrative character made under a Commonwealth Act may request the Federal Court to review that decision. Section 5 then sets out a range of grounds upon which an existing decision may be reviewed. To some extent these stated grounds codify and to some extent they vary grounds upon which the decision would be reviewable under ordinary administrative law principles. The usual grounds under s 5 might include an allegation that the decision was not authorised by the Act under which it was purportedly made, that the making of the decision was an improper exercise of the power conferred by the Act, or that the decision was otherwise contrary to law. Sections 8 – 10 of the ADJR Act make it clear that the Federal Court is intended only to review the legality of the decision in question, not to question its merits. The legality will be determined by reference to the grounds stated in ss 5 and 6 and includes objections on the basis of: • • • • • • • •

a denial of natural justice; a failure to observe required procedures; a lack of jurisdiction or authority to make the decision; an exercise of the power for an improper purpose; the making of an error of law; a decision having been induced by fraud; a decision reached on insufficient evidence; a decision based upon irrelevant considerations.

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[19.400]

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Section 13 gives to a person entitled to seek the review of the decision a power to require the decision-maker to furnish a statement in writing, similar to a statement under s 37 of the AAT Act, giving the decision-maker’s findings on material questions of fact, the evidence and other materials on which those findings were based, and the reasons for the decisions. There are many reported examples of decisions which show the scope of the ADJR Act to apply to decision-making by the ATO. While the exclusion of steps leading up to the making of an assessment is a substantial limitation on the number and type of potential decisions subject to review, the cases have shown a large residual scope for its application including the review of: • a decision to issue notices to produce documents or to attend and give evidence under the former s 264 (Clarke and Kann v DFCT (1983) 83 ATC 4764); • a decision whether to allow a tax agent further time to lodge clients’ tax returns (Balnaves v DFCT (1985) 85 ATC 4429); and • the issue of an order forbidding the departure of a taxpayer from Australia (Briggs v DFCT (1985) 85 ATC 4569). Where a reviewable decision is found to be invalid on one of the listed grounds, the remedies available to the applicant, which are listed in s 16, permit the Federal Court to quash the decision, to remit the matter for a further decision or to make directions and declarations of the rights of the applicant. (iii) Inspector-General of Taxation [19.410] Recourse to the Inspector-General of taxation represents one final way in which a

taxpayer may seek to have the activities of the ATO reviewed by an external authority. As noted above at [19.20], the Inspector-General became responsible for investigating administrative actions of tax officials from 1 May 2015 with the Inspector-General authorised to exercise certain powers under the Ombudsman Act 1976. Where a taxpayer is dissatisfied with the administrative actions of the ATO (such as delays in issuing assessments or a refusal to allow time to pay assessed tax), he or she may make a complaint to the Inspector-General. The Inspector-General must not investigate taxation laws imposing or creating an obligation to pay an amount or dealing with the quantification of a tax liability. This is consistent with existing s 7(2) of the Inspector-General of Taxation Act 2003 (IGT Act). The InspectorGeneral may also investigate action that is not in respect of tax administration action when it is transferred to him or her by the Ombudsman upon deciding that that aspect of the complaint could be more appropriately or effectively dealt with by the Inspector-General. The Inspector-General has a discretion of whether to investigate certain complaints and a discretion not to investigate a complaint if the complainant has not yet raised the complaint with the Commissioner or the Tax Practitioners Board as the case may be (s 9 of the IGT Act). The Inspector-General may report on a complaint or actions affecting a particular taxpayer or tax practitioner subject to confidentially (ss 7(1), 15 and 18 of the IGT Act),

(d) Collection of Tax [19.420] Where a taxpayer has a tax debt arising from an assessment, s 255-5 of Sch 1, TAA

1953 makes tax that is due and payable a debt owed to the Commonwealth. The collection and management of these debts and other debts arising under tax laws administered by the Commissioner is a key focus of the ATO. The ATO has published its Receivables (collection) [19.420]

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Policy through a series of Law Administration Practice Statements (PS LAs), setting out the circumstances when it will sue to recover tax or, alternatively, come to an arrangement with the taxpayer. Research indicates that the older the debt the harder it is to collect. The ATO is therefore pro-active in pursuing debt. It focuses on early intervention and the use of technology such as the dialler (ringing persons at home, after hours, use of text messages), in order to limit the escalation of debt. Private debt collection agencies are used to recover small (less than $10,000) debts. The ATO may grant taxpayers an extension of time to pay when they have difficulty in meeting the full amount by the due date. To encourage the payment of debts and to compensate the revenue for the loss of revenue caused by the late payment, a General Interest Charge (GIC) is levied under Part IIA of the TAA 1953 on late payment of income tax, including penalty tax or underpayment of tax after an amendment of an assessment. A GIC is tax deductible under s 25-5 of ITAA 1997. Subsections 8AAG(1) and (2) of the TAA 1953 gives the Commissioner power to remit the GIC in specified circumstances (eg that the delay in making a timely payment was not caused by the taxpayer). The assessment of penalty tax is a separate assessment to the assessment of the primary tax: Bonnell v DCT (No 5) [2008] FCA 991. A Shortfall Interest Charge (SIC) is imposed where there is a tax shortfall because the ATO has relied on the taxpayer’s information when making an assessment and there was less tax paid than should have been. The SIC is imposed in addition to other administrative penalties in the TAA 1953. The SIC is similar to the GIC in that it is calculated on a daily compounding basis, but the rate is 4% lower than the GIC rate (ss 280-105(1) and (2)). Where a taxpayer owes money to the ATO and a third party owes money to the taxpayer, the Commissioner can issue a notice in writing under s 260-5 of Sch 1 of the TAA 1953, directing that third party to pay the money directly to the ATO to meet the taxpayer’s outstanding tax liability. This type of notice is also called a “garnishee” and is used in non-tax proceedings. Similarly, under s 255(1)(a) of ITAA 1936, the Commissioner can serve a notice on a person who has receipt, control or the disposal of money belonging to a foreign resident who is liable to pay Australian income tax, requiring that person to pay the tax which is due and payable under an Australian assessment. A court can prevent a party (in this case a taxpayer) either from moving assets out of the jurisdiction or from disposing of them to a third party by the issue of a “Mareva” order (an equitable remedy available to the Commissioner). These orders cannot prevent a person from dealing with assets in the ordinary course of business. When the Commissioner believes taxpayers intend to leave Australia without discharging their tax liability or without making arrangements to discharge it, he can issue a departure prohibition order (DPO) under s 14S(1) of the TAA 1953. In the context of a tax dispute ss 14ZZM and 14ZZR expressly preserve the ATO’s right to require payment of any tax assessed even though the taxpayer has applied to the Tribunal or lodged an appeal to the Federal Court from a decision by the ATO disallowing an objection. This right exits even when there is a current Pt IVC review of the assessment which gave rise to the liability: DCT v Broadbeach Properties [2008] HCA 41; (2008) 69 ATR 357. As an administrative concession, the Commissioner has indicated in Law Administration Practice Statement PS LA 2011/4 that where a taxpayer has a genuine dispute about the tax liability, at the objection stage the Commissioner will generally agree to allow 50 per cent of the amount of tax assessed which is in dispute can remain outstanding and defer the recovery 990

[19.420]

Administering the Tax Regime

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of the unpaid balance of the disputed debt and the unpaid balance of the related components (that is, any tax shortfall penalty, GIC and SIC) until 14 days after the Commissioner determines the objection, or the date the decision is handed down by the relevant appellate tribunal or court. The Commissioner will remit 50% of the GIC which would otherwise accrue in the event that the taxpayer’s dispute is unsuccessful. Conversely, if the taxpayer is successful on appeal, the ATO must pay (assessable) interest on overpayments in respect of certain types of tax pursuant to the Taxation (Interest on Overpayments and Early Payments) Act 1983. The Commissioner remains unable to pay interest in respect of any overpayment of tax shortfall penalties incurred under Div 284, however, for income tax cases, the Commissioner is able to pay interest on overpayment in respect to an overpayment of SIC incurred under Div 280. In addition to the power to pursue unpaid tax, the ATO also has a specific discretionary power under s 255-10of Sch 1 of the TAA 1953 to extend the time for payment of tax. It also has powers to remit either the penalty or interest on unpaid tax. The ATO’s power to require the payment of assessed tax when the liability is disputed, as well as the exercise of the ATO’s dispensatory powers, can be reviewed by the Tribunal – a taxpayer may be able to challenge the exercise of the ATO’s discretion whether to permit assessed tax to remain outstanding under s 5 of the ADJR Act. The ATO’s power to recover through court proceedings whatever tax is owing is also constrained by the discretion of a court to grant a stay of recovery proceedings in circumstances it considers appropriate. In Snow v DFCT (1987) 18 ATR 439; 87 ATC 4078, French J set out the kinds of criteria that a court will consider when deciding whether to stay recovery proceedings being pursued by the ATO.

6. AUDIT AND INVESTIGATION [19.430] Effective administration of the income tax depends upon the willingness of

taxpayers to report their income and disclose aspects of their financial affairs to government authorities. The experience in Australia is, not surprisingly, that while most taxpayers do so with little apparent ill-effect, a handful of people are most unwilling to divulge the information about their activities that is necessary for the revenue authorities to assess them, or that what they do reveal is often inaccurate. For those occasions when it is necessary, the Acts contain a series of provisions which give the ATO power to require the disclosure of information and which permit it to seek out information both from the taxpayer and from other sources. Although this part of the chapter focuses on the information-gathering powers of the ATO a brief discussion of the ATO’s approach to compliance is necessary to emphasise the importance of these powers in underpinning these activities. In the mid-1990s, the ATO restructured the audit areas by transferring audit staff into the business lines. This changed the focus of audit teams from “specialised” teams to “functional” groups able to deal with all issues likely to arise during an audit. The actual audit processes also changed. The ATO no longer conducts audits on a random basis. Along with these changes, the ATO has implemented a “compliance strategy” which is focused upon increasing voluntary compliance through information and coercion. This coercion strategy involves the use of warning letters, pre-assessment audits and other projects, all aimed at reminding taxpayers of their obligations. The ATO also uses computer programs and statistical computations which it applies to tax returns to detect variations in the taxpayer’s reported position from the taxpayer’s own history and from industry norms (eg [19.430]

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industry bench marking for small business and a “risk differentiation framework” (RDF) to assess tax risk for large businesses). These process are supported, as discussed above [19.35] by an increasing amount of third party information which comes to the ATO automatically. Although there is a well-established source of information flowing to the ATO through informers, often in the form of disgruntled ex-employees or unhappy family members, it is not always reliable. Information will often come to light in other forums. For example, in the case In the Marriage of P and P (1985) FLC 79,911 at 79,921 it was revealed in the course of proceedings for a dissolution of the marriage that the husband had been claiming a rebate for his wife as a dependant while she was earning up to $600 per week as a prostitute. The threat of disclosure of financial transactions in open court (and hence the ATO) is a recognised bargaining weapon in many family law actions. However, the principal way through which the ATO tries to check the information it is given is the audit. The shift to self-assessment was principally intended to free resources in the ATO to allow post-assessment audit as the means of ensuring compliance. Indeed, the entire self-assessment strategy depends upon the ATO being able to undertake post-assessment investigations, because there is very little pre-assessment scrutiny. The audit process is essentially the inquisition of a taxpayer selected after an assessment has been issued, sometimes several years after the assessment has been issued. The selection is driven by the compliance model and risk assessment strategies, however in more limited cases it may be based on specific information about that taxpayer. People who have challenged their selection for audit have generally been unable to defeat the process on the basis that it is somehow unfair or done for an improper purpose. For example in Industrial Equity Ltd v DFCT [1990] HCA 46 the ATO was conducting an audit into the affairs of IEL and associated entities for the income years 1984 to 1988. The taxpayer had already been assessed and paid tax in respect of those years. He argued that the ATO could only exercise its investigatory powers in pursuit of a proven or suspected defalcator. The ATO admitted that it had no specific reason for investigating IEL. Rather, it was simply acting in accordance with a policy of auditing all of the top 100 Australian companies. The High Court said, 21 … It is entirely consistent with the Act that the Commissioner should, at one time, decide to look more closely into the affairs of particular categories of taxpayers as well as of particular taxpayers, with a view to ascertaining their taxable income, and this whether an assessment or an amended assessment has issued. It may be the top 100 companies this time, primary producers another time, and property developers yet another time. I.E.L. did not argue that the selection of the top 100 companies as a category for inquiry was necessarily improper, rather, the complaint was of the selection of I.E.L. merely because it fell within that category. Inevitably, there will be a random aspect to those who are finally selected for closer examination; but the Commissioner will still be acting for the purposes of the Act so long as he is endeavouring to fulfil his function of ascertaining the taxable income of taxpayers.

Another case, Knuckey v FCT [1998] FCA 1143, involved a tax agent who sought to challenge the ATO’s audit program for work-related expenses. The program concentrated not on taxpayers who made large claims for work-related expenses, but rather on tax agents with more than 100 clients who claimed more than $300 each for work-related expenses. Mr Knuckey was identified as one of these tax agents and so he was required to provide more detailed documentation to support the claims of a sample of his clients. The returns of the sample were then compared with the returns of the same taxpayers in other years, and of other clients of the practice. Discrepancies were found and so the ATO told Mr Knuckey that he 992

[19.430]

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would remain on the program. Once this became public knowledge, his clients, understandably, fled to other agents – they had no wish to retain a tax agent whose clients were being more thoroughly scrutinised. The tax agent argued that the ATO was acting for an improper purpose – to control the behaviour of tax agents. Again, the Full Federal Court agreed that the ATO had the power to implement this program: The program and its implementation must be looked at in the context of the overall purpose to be achieved. The evidence establishes that the end or ultimate purpose is that proper assessments be made in respect of work-related expenses. This overall purpose will colour the intermediate result sought to be achieved; namely, to obtain more accurate returns. The evidence does not show that the desired change in the conduct of tax agents is an end in itself. That change is a step towards achievement of the overall purpose which is the assessment of taxable income.

(a) Formal Investigative Powers [19.440] The ATO’s information gathering powers, which underpin the ATO’s audit activity

are in Div 353 of Sch 1 of the TAA 1953, in particular for income tax purposes ss 353-10 and 353-15. These provisions replaced, from 1 July 2015, ss 263 and 264 of the ITAA 1936, ending the 99 year enactment of information gathering powers in Commonwealth Tax Assessment Acts. The purpose for the change was: 2.22 …to consolidate and centrally locate the rules around the Commissioner’s power to obtain information … so that the rules now cover all the taxation laws, not just a number of specified tax regimes with duplicated rules covering the other tax regimes … 2.26 The amendments to Schedule 1 to the TAA 1953 do not alter the intended operation of the provisions as they apply to the administration and operation of various taxation laws. The amended TAA 1953 provisions are merely a rewrite and consolidation of the provisions being repealed. (Explanatory Memorandum: Treasury Legislation Amendment (Repeal Day) Bill 2014)

However, it is clear that s 353-15 on its plain wording has both: expands the operation of the former access powers in s 263 (by removing the limitation that s 263 could only be used for the purposes of the Assessment Acts so that the access power can be used for “the purposes of a taxation law”) and constrains it (by limiting the time when access was permitted by only allowing access at “reasonable times”). The inclusion of the s 263 access powers also expands the scope of Commissioner’s access powers under s 353-15 for all the legislation administered by the Commissioner to include access to a “place”. That said in light of the expressed intention above, the following analysis will be, in the absence to contrary judicial determination or the areas of clear wording change discussed above, will be premised upon the assumption that the law has not altered as a result of this change. These powers complement the provisions of s 262A of the ITAA 1936 which require that every person carrying on a business must keep records in English of the income and expenditure of the business so that the person’s assessable income and allowable deductions may be ascertained. These records must be kept for at least five years after the completion of the activities to which they relate. Section 353-15(1) enables the Commissioner or authorised ATO officers to, at all reasonable times, enter and remain on any land, premises or place, to have full and free access at all reasonable times to any documents, goods or other property, and to inspect, examine, make copies of, or take extracts from, any documents. As s 353-15 authorises access for the purposes of a ″taxation law″ (ie any Act which the Commissioner has the general [19.440]

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administration, any legislative instruments made under such an Act and the Tax Agent Services Act 2009, it is clear, as it was under s 263, that the person whose premises are to be searched by the ATO need not be the person whose tax affairs are being investigated (Southwestern Indemnities Ltd v Bank of New South Wales and FCT [1973] HCA 52.). The extent of the Commissioner’s powers under the former s 263 has been discussed in many cases as taxpayers have challenged the access on the basis that limitations implied by law operate to prevent the notices having the effect claimed by the ATO (eg legal professional privilege), or technical deficiencies in the delegation of the ATO officers. These challenges have rarely succeeded. For example: • In Citibank v FCT [1989] FCA 126, the bank’s premises were “accessed” by 37 ATO officers (including computer experts and a locksmith) seeking evidence in the bank’s possession concerning a tax avoidance scheme in which some of the bank’s customers were allegedly engaged. Citibank argued that the authorities given to the raiding officers and the description of the documents they were looking for were defective. The Court found no defect in the process. • In Allen, Allen & Hemsley v DFCT [1989] FCA 125 a law firm sought orders restraining the ATO from requiring production of its trust account records, claiming that the power conferred in s 263 was constrained by a limit that the power be exercised reasonably and was subject to claims that its clients might have for legal professional privilege. The trust account records sought contained over 11,000 entries, and, since it was said some them might have been subject to privilege which rendered them immune from production, the making of a claim for access in these circumstances was alleged to be unreasonable because each client would have to be sought and their permission sought for access to be given. The ATO was successful in large part because the Court considered it unlikely that any information subject to legal professional privilege was contained in, or would be disclosed by, going through the firm’s accounts. Section 353-10 of Sch 1 of TAA 1953 (formerly s 264 of the ITAA 1936) provides that the Commissioner, for the purpose of the administration or operation of a taxation law, may by notice in writing require any person to give any information the Commissioner requires, to produce any documents in their custody or under their control, or to attend and give evidence (orally or written) before the Commissioner on oath or affirmation. This is an independent power to acquire information and permits the ATO’s officers to interrogate a taxpayer about her or his own affairs and those of any other individual. The rules governing the service of these notices are in reg 12F of the Taxation Administration Regulations 1976. Again there have been numerous cases where taxpayers have sought to challenge the exercise of the ATO’s power and the same kinds of issues arise – is the information requested too onerous or imprecise, and is the taxpayer entitled to claim legal professional privilege in relation to particular documents. Again, the ATO tends to win cases where his powers are challenged: • In Daihatsu Australia Ltd v FCT (2000) 46 ATR 129; [2000] FCA 1658, the taxpayer argued unsuccessfully that the s 264 notice was vague and drawn too widely. The taxpayer also argued that they were issued for an improper purpose, namely to harass the taxpayer. The Court upheld the notice. • In MacCormack v FCT [2001] FCA 1700 the ATO sought from a large accounting firm the names and addresses of all clients to whom three partners in the firm had given tax advice during a 12-month period. The Court upheld the ATO’s decision and required the production of the information. 994

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Tax investigations may often involve the Federal Police, as well as ATO officials and police powers of investigation under the Crimes Act 1914 can come into play. Sections 3E of the Commonwealth Crimes Act provides that an issuing officer (a magistrate or Justice of the Peace) is satisfied, by information on oath or affirmation, that there are reasonable grounds for suspecting that there is any evidential material at the premises, may issue a search warrant. The warrant must refer to the offence to which the warrant relates, provide a description of the premises to which the warrant relates or the name or description of the person to whom it relates, refer to the kinds of evidential material that are to be searched, the name of the constable who is to be responsible for executing the warrant, the time at which the warrant expires, and times when the warrant may be executed. However, as search warrants are issued to police only where there is suspected criminal activity, they are of limited use to Commissioner in obtaining information needed for day to day compliance activity. Section 353-15 (formerly s 263) will have limited operation where information is located offshore. The problem is that the general access power relies on the documents or person being located in Australia. Therefore, jurisdictional barriers exist where the materials or persons are located offshore. In Denlay v Commissioner of Taxation [2011] FCAFC 63, the Full Federal Court (Keane CJ, Dowsett and Reeves JJ) noted at paras 83 and 84 “… we think, something to be said for the taxpayers” argument that, if specific legal authority were necessary to make access to the information provided by Mr Kieber lawful in the overseas location where that occurred, then s 263 did not provide it. 84… It is difficult to attribute to the Parliament an intention by s 263 of the ITAA 1936 to command the obedience of residents of foreign countries in those countries.

Jurisdictional barriers also exist in serving and compelling those persons to submit to an oral examination under s 353-10(1)(b) and production of documents is similarly to those documents in the “custody and control” of a person served (s 353-10(1)(c)) and most importantly, documents that actually exist (Perron Investments v Deputy Commissioner of Taxation (WA) (1989) 20 ATR 1299). The custody and control issues have been addressed to a limited degree by introduction in 1991 of evidentiary exclusionary sanctions which apply when information which is held offshore is not provided when requested under an offshore information notice (s 264A of the ITAA 1936). Consistent with the “Government’s commitment to the care and maintenance of the taxation and superannuation systems” (ie a program focused on modernising, rewriting and reorganising legislation), on 21 January 2016 the government released exposure draft legislation that proposes to rewrite s 264A as Subdiv 353-B of Schedule 1 to the TAA 1953. The draft Explanatory Memorandum to the proposed Tax and Superannuation Laws Amendment (Measures for a later sitting) Bill: Miscellaneous amendments, at paras 1.6 and 1.7 notes that this is seen as: another step towards achieving a single taxation administration Act for Australia … by consolidating into a single set of provisions the taxation administration provisions contained in various taxation Acts relating to offshore information notices

and notes that: With one exception, the rewritten provisions make no policy changes. The only policy change is to extend the offshore information notice rules to apply to assessments for all tax-related liabilities rather than merely to income tax and Petroleum Resource Rent Tax. They also [19.440]

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include the drafting changes needed to conform to the legislative approach used in Schedule 1 to the TAA 1953, to simplify how the law is expressed, and to remove any ambiguity about the operation of the law.

(b) Claims of Privilege (i) Legal professional privilege [19.450] The ATO’s investigative powers are subject to qualification by the principle of legal

professional privilege – a doctrine which has been mentioned already in earlier extracts. This common law doctrine, now contained in the Uniform Evidence Acts, provides for immunity from disclosure of certain communications between a lawyer and a client. As a result, the ATO is not entitled to require disclosure of privileged documents under either ss 353-10 or 353-15 of Sch 1 of the TAA 1953, nor under s 3E of the Crimes Act 1914, although as the cases suggest, there may be circumstances in which it can require production of documents pending verification of the claim for privilege. The privilege is the client’s to assert, it does not automatically attach to documents, and it may be waived by the client or lost if the contents of the communication are not kept secret (which is why taxpayers attach such a premium to ensuring that the documents do not enter the ATO’s possession initially). Finally, even documents which would ordinarily be privileged lose their immunity if they are made in order to facilitate the perpetration of a crime or fraud. Not all communications which pass between a lawyer and a client will be privileged and so the scope of the documents for which privilege may be successfully claimed is always a matter of serious dispute. The leading case in which the scope of privilege was discussed by the High Court is Baker v Campbell (1983) 153 CLR 52. The issue in the case was whether the claim of legal professional privilege could be raised against a search warrant issued under the former s 10 (now s 3E) of the Commonwealth Crimes Act. A similar issue had been raised in a prior decision in O’Reilly v Commissioners of the State Bank of Victoria (1982) 57 ALJR 130. In that case, the High Court held by a majority that since the privilege was primarily a rule of evidence, it could not apply to proceedings outside a court, such as an investigation under the former s 264 of the ITAA 1936 (now s 353-10 of Sch 1, TAA 1953), where the rules of evidence did not apply. In Baker v Campbell the High Court, again by a majority, overturned its earlier decision. Murphy J, who formed part of the majority with Wilson, Deane and Dawson JJ, said:

Baker v Campbell [19.460] Baker v Campbell (1983) 153 CLR 52 Client’s legal privilege The concept of client’s legal privilege is ancient. It has existed for over 400 years in English law … and in many other countries such as Belgium, Denmark, Germany, France, Greece, Italy, Luxembourg and Holland … In the United States the client’s legal privilege has been based on constitutional grounds – the fourth amendment guarantees against unreasonable 996

[19.450]

searches and seizures and the fifth amendment guarantees against self-incrimination. The privilege is commonly described as legal professional privilege, which is unfortunate, because it suggests that the privilege is that of the members of the legal profession, which it is not. It is the client’s privilege, so that it may be waived by the client, but not by the lawyer. Its rationale is no longer the oath and honour of the lawyer as a

Administering the Tax Regime

Baker v Campbell cont. gentleman. It is now supported as a necessary corollary of fundamental, constitutional or human rights. … Scope of the privilege Under common law as recently declared for Australia, client’s legal privilege protects from disclosure any oral or written statement, or other material, which has been created solely for the purpose of advice, or for the purpose of use in existing or anticipated litigation (Grant v Downs (1976) 135 C.L.R. 674). This defines the scope of the privilege more narrowly than elsewhere. In the United Kingdom it is enough if the dominant purpose for coming into existence of the material is legal advice or litigation. The privilege does not attach to documents which constitute or evidence transactions (such as contracts, conveyances, declarations of trust, offers or receipts) even if they are delivered to a solicitor or counsel for advice or for use in litigation. It is not available if a client seeks legal advice in order to facilitate the commission of crime or fraud or civil offence (whether the adviser knows or does not know of the unlawful purpose); but is of course available where legal advice or assistance is sought in respect of past crime, fraud or civil offence. Hence the subject matter of the privilege is closely confined: in brief it extends only to oral or other material brought into existence for the sole and innocent purpose of obtaining legal advice or assistance. Should the privilege apply outside the courtroom In O’Reilly v Commissioners of the State Bank of Victoria (1982) 57 ALJR 130, this court decided (Gibbs C.J., Mason and Wilson JJ., Murphy J. dissenting) that legal privilege was available to protect evidence from disclosure only in the actual course of judicial or quasi-judicial proceedings. … The privilege should not be confined to protecting evidence from disclosure only in judicial or quasi-judicial proceedings. As I said in O’Reilly’s case, “the important public policy which justifies the privilege would often be defeated if the privilege were not generally available”. The availability of the privilege against extra-judicial

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searches and seizures has been recognised in the United States. In Canada the courts have strongly asserted that the privilege is not restricted to judicial or quasi-judicial proceedings. The privilege applies against a search warrant. In New Zealand also the privilege has been held to apply outside judicial or quasi-judicial proceedings. The client’s legal privilege is essential for the orderly and dignified conduct of individual affairs in a social atmosphere which is being poisoned by official and unofficial eavesdropping and other invasions of privacy. The individual should be able to seek and obtain legal advice and legal assistance for innocent purposes, without the fear that what has been prepared solely for that advice or assistance may be searched or seized under warrant. Denying the privilege against a search warrant would have a minimal effect in securing convictions but a major damaging effect on the relationship between the legal profession and its clients. It would engender an atmo-sphere in which citizens feel that their private papers are insecure and that relationships they previously thought confidential are no longer safe from police intrusion. … In so far as a client’s legal privilege extends to material which was created for legal advice unassociated with pending or anticipated litigation, there is some force in the argument that legal advice should not be elevated above other professional evidence, such as medical or financial advice. However, in Grant v. Downs the privilege was held to extend to communications for advice and the question whether it should so extend has not been agitated in the present case. Further the privilege is necessary so that persons may confidently seek and receive advice about conduct which has, or may have, constituted crime, fraud or a civil offence. If the privilege does not avail outside the courts why should it continue to be available in the courts? Courts would have less access than non-judicial authorities to that which can expose the truth; thus lowering the authority of judicial findings and decisions in contrast with those of non-judicial bodies. The long-term tendency would be for law enforcement authorities to press for extra-judicial methods of investigation and decision making. Further, search and seizure is [19.460]

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Baker v Campbell cont. really a pre-trial investigative process closely connected with judicial proceedings. …

seizure or production of documents, unless Parliament unmistakably excludes or confines it. There is not the slightest indication that Parliament intended to do so.

Contrary to what was held in O’Reilly the privilege should apply to any form of compulsory

[19.470] The result of the case suggests that the doctrine of legal professional privilege will

protect from disclosure documents which are made by either the client or the lawyer for the purpose of giving and receiving legal advice, or for use in current or anticipated litigation. Where litigation has been commenced or is seriously threatened, there is probably not much difficulty identifying which documents are privileged. But the precise scope of privileged documents that are produced for the purpose of giving legal advice has been the subject of much litigation. For example, • In the Allens case it was argued that trust accounts could disclose privileged information. The Full Federal Court said that “only in the most unusual circumstances would entries of receipts and payments in trust account records reveal any matter for which a claim of privilege could be made”. • The decision in the Allens case confirmed the earlier decision of Packer v DFCT (1984) 84 ATC 4666, where the Supreme Court of Queensland held that legal professional privilege could not be asserted to defeat the operation of a notice under the former s 264 requiring a firm of solicitors to produce their trust account ledgers. • In FCT v Coombes (1999) 42 ATR 356 a solicitor tried unsuccessfully to claim that legal professional privilege attached to the names of his clients, so that he could refuse to provide the ATO with their names and addresses. The High Court in Esso Australia Resources Ltd v FCT (1999) 43 ATR 506 considered whether the document in question had to be produced for the sole purpose of giving legal advice to the client, or would also be privileged if it was produced for the dominant purpose of giving legal advice to the client. The High Court held by majority that the dominant purpose test should be preferred. It is one thing to know the test that is to be applied; it is another to make correct decisions in the heat of an unannounced raid by the ATO. Some of the litigation in this area is simply a holding device – to give the banks, advisers or taxpayers time to examine the documents before they release them to the ATO and their claim is lost forever. In the Citibank litigation, the Court held that the failure of the ATO’s delegate to take adequate precautions to protect potential claims of privilege that may have been open to clients was one ground for quashing the raid. Lockhart J said:

Citibank v FCT [19.480] Citibank v FCT (1989) 20 FCR 403; 89 ATC 4268 This case must be approached on the footing that the decision maker, being Mr Booth [the investigating officer], should have had regard to the question of legal professional privilege when 998

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deciding how the search was to be conducted. In addition, the search should in fact have been conducted so that any claim for legal professional privilege that might be asserted by Citibank or by

Administering the Tax Regime

Citibank v FCT cont. any of its clients whose documents were on Citibank’s premises and in whom the primary claim would repose, could be invoked. I turn first to Mr Booth’s decision. Mr Booth did consider the question of legal professional privilege before he decided to make the search. He decided that each team of officers should have appointed to it “competent, experienced officers” who were to consider questions of privilege. If a claim was made for privilege by an employee of Citibank, documents were to be put into an envelope to be sealed so that a court or some third party could rule on the claim. Whilst in some circumstances measures of this kind would be sufficient to justify a decision to make a search where the possibility of claims for legal professional privilege would arise, the measures taken were in my view inadequate in the present case. The premises to be searched were those of a large bank looking after the affairs of many clients. It was obvious to Mr Booth that

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there were numerous documents of various kinds on Citibank’s premises that would be inspected by the taxation officers and that some of them would be susceptible to claims of immunity from inspection on the ground of legal professional privilege. For a decision to be made leaving the question of a determination of legal professional privilege to officers who were competent and experienced, but who did not necessarily have any legal qualifications, in circumstances where the visit was made by some 37 officers who were instructed to complete their task within a maximum of two hours, was in fact to pay little more than lip service to the recognition of the possibility of the claim being made. It must be remembered that once a document has been inspected and copied by officers of the Australian Taxation Office, for all practical purposes a claim for privilege in any subsequent legal proceedings would be largely valueless, especially where a necessary party to any litigation involving Citibank or any of its clients would be the Commissioner or a Deputy Commissioner.

[19.490] In the appeal, the Full Federal Court confirmed this aspect of the decision of

Lockhart J. Another aspect of legal professional privilege which has been examined by the courts is the extent to which communications with third party experts are protected. For example, consider an adviser who is preparing an opinion which involves a piece of expert information or opinion – say the calculation of a share price for a foreign company weighted by volume of trading over a period. A third party would be required to provide this information. If the lawyer engages the third party, it seems clear that the document can be privileged. And if the client engages the third party and directs them to send the document to the lawyer, it seems clear that the document can be privileged. But what if the client engages the third party and has the document sent to them, not directly to the lawyer. This was the issue in Pratt Holdings Pty Ltd v FCT (2004) 136 FCR 357; [2004] FCAFC 122. In that case, Finn J said: What is surprising about these appeals is that the legal principle in issue can still be a matter of contest. It is well accepted that if a person prepares and then makes a documentary communication to a legal adviser for the dominant purpose of obtaining legal advice, that documentary communication attracts legal professional privilege. It is equally well accepted that if a person directs or authorises a third party (an agent) to prepare and then make a documentary communication on that person’s behalf to a legal adviser for the dominant purpose of obtaining legal advice, that documentary communication by the agent attracts legal professional privilege. But it is not accepted that, if a person (a principal) directs or authorises a third party who is not an employee of that person to prepare a documentary communication for the dominant purpose of its being communicated by the principal and not directly by the third party to a legal adviser for the purpose of obtaining legal advice, that documentary communication from the third party to the principal attracts legal professional privilege. [19.490]

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The Full Federal Court held that the document could be privileged. This is one area where the lawyer has an advantage over the accountant in tax matters. It is clear that the privilege does not attach to communications between an accountant and her or his client. That position, together with complaints from lawyers and accountants about their premises being raided by the ATO, understandably led to protracted negotiations between the ATO and representatives of tax advisers about the conduct of investigations. Those negotiations led to the production of the Information and Access Gathering Manual produced by the ATO to inform officers of the circumstances and manner in which these investigatory powers should be exercised. Its status is similar to that of an administrative announcement – merely a statement by the ATO of how it expects officers to act in pursuing investigations – rather than a formal (and binding) Ruling. One of the things that the guidelines set out in the Manual are designed to do is to give to communication with accountants the same degree of immunity that attaches to communications with lawyers. The status of the guidelines, and their impact on the ATO’s access powers, was considered in Deloitte Touche Tohmatsu v DFCT (1998) 40 ATR 435. In that case, the ATO sought information from a firm of accountants as part of its investigation of non-complying superannuation funds, one of the mass-marketed schemes to which we have referred. The ATO requested details of the services provided to clients in relation to these superannuation funds, the full names and addresses of the funds, the names and addresses of all clients involved with offshore superannuation funds, and the basis upon which fees and disbursements were charged to those clients. The accountants sought to strike down the s 264 notice on the basis that the information sought was protected from disclosure – they fell within one of the classes of documents that the ATO had said they would not seek to access under the guidelines. The Court held that the documents were not within the range of documents covered by the guidelines – the notices did not seek details of the advice given by the firm. [19.495] The Full Federal Court in FCT v Donoghue [2015] FCAFC 183 noted that legal professional privilege is an immunity from the exercise of powers requiring compulsory production of documents or disclosure of information not a bar to inspection. As noted above at [19.280], the case involved an auditor using documents supplied by a disgruntled former law clerk employed by the taxpayer’s solicitors, that the auditor was aware were possibly the subject of a claim for legal professional privilege.

FCT v Donoghue [19.497] FCT v Donoghue [2015] FCAFC 183 Full Federal Court On the issue of privilege the Full Federal Court noted: 52. With respect to the trial judge, whilst it is easy enough to see why privilege might be viewed as a bar to inspection this was not a correct view. The common law of legal professional privilege operates as an immunity from the exercise of powers requiring compulsory production of documents or disclosure of information. It is not a rule of law conferring individual rights, the breach of which may be actionable. Consequently, no action lies against a party who receives 1000

[19.495]

documents which are privileged merely because those documents are privileged. Gummow J explained the matter this way in Commissioner of Australian Federal Police v Propend Finance Pty Ltd (1997) 188 CLR 501 at 565-566: At common law, and in the absence of any statutory indemnity or other protection against liability, an officer who executed a search warrant in excess of the authority conferred by it, incurred

Administering the Tax Regime

FCT v Donoghue cont. a liability for damages in tort for trespass to land or goods, false imprisonment or for other misfeasance. However, the privilege itself is not to be characterised as a rule of law conferring individual rights, breach of which gives rise to an action on the case for damages, or an apprehended or continued breach of which may be restrained by injunction. It is true that if the use of privileged documents by the defendant is, or is a consequence of, a breach of confidence owed the plaintiff, then there may be an equity to protect that confidence. In Lord Ashburton v Pape, it was decided that the client whose privileged documents, being letters written to his solicitor, had fallen into the hands of a third party by a trick, might obtain injunctive relief requiring the return of the documents and restraining the third party from making use of them. On the other hand, in Calcraft v Guest, the defendant was permitted to adduce as secondary evidence copies of proofs of witnesses, with notes of the evidence, in a previous action brought in 1787 by the plaintiff’s predecessor in title and concerning the true boundary of the plaintiff’s fishery. The original documents remained privileged but the defendant, having obtained copies of the privileged documents, was not precluded by that privilege from tendering them as secondary evidence.

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It was held that the question of provenance of the documents tendered was a collateral issue. The distinction between these authorities may be seen to lie in the character of the privilege as a bar to compulsory process for the obtaining of evidence rather than as a rule of inadmissibility. The effect of the authorities has been identified as follows: “All that Calcraft v Guest decided was that when a privileged document was no longer in the hands of those entitled to claim immunity from production, there was nothing to prevent its use in evidence. Of course, a person who has a right to confidence in a document can enforce his right by injunction, and this is what lay behind Ashburton v Pape.” (footnotes omitted) 53. Four judges of the High Court adopted the same reasoning in Daniels Corporation International Pty Ltd v Australian Competition and Consumer Commission [2002] HCA 49; …. It follows that the common law of privilege is silent when the question which arises does not concern compulsory production. It is, no doubt, apt to confuse that the statutory law of privilege which governs the admissibility of privileged documents in Court proceedings is not a rule which operates as an immunity. Instead, provisions such as ss 118 and 119 of the Evidence Act 1995 (Cth) operate as a prohibition on the adduction of evidence of privileged communications. That is not a matter, however, which can distract from the true nature of common law privilege as an immunity.

(ii) Privilege against self-incrimination [19.500] There is a further limitation on the investigative powers of police and some other

authorities contained in the common law rule that no person has to answer a question the answer to which might reasonably expose the person to a criminal charge. The privilege is apparently available in administrative enquiry as well as in judicial proceedings but it has been questioned whether the privilege extends to investigations conducted by the ATO using its powers under ss 353-10 and 353-15 of Sch 1 of the TAA 1953. The operation of the privilege in the context of tax investigations was discussed in Scanlan v Swan (1983) 83 ATC 4112. Swan was served with a notice under the former s 264 requiring him to attend and give evidence about his own affairs and those of his companies but failed to do so. He was then charged and convicted of an offence under the former s 224 (now ss 8C [19.500]

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and 8D of the TAA 1953). He appealed to the Supreme Court of Queensland claiming that the privilege against self-incrimination relieved him of the obligations under the former s 264. The Court held that the privilege would only have been available if the taxpayer had attended and claimed the privilege in response to specific questions put to him. If his answers might have tended to incriminate him, then according to the judges, “he may well have been entitled to object to any particular question on the ground that his answer to it may have tended to incriminate him”. More recent decisions, however, have denied the operation of the doctrine in the context of tax investigations. In Stergis v FCT (1988) 88 ATC 4442 at 4457, Hill J said: Having regard to the purpose for which the powers under s. 264 are conferred, the context in which that section applies in the Act and the language now enshrined in ss 8C and 8D of the Taxation Administration Act, I am of the view that where an officer of the Australian Taxation Office acting properly and in accordance with s. 264 of the Act requires a person to furnish information or to answer any question, that person will not be entitled to refuse to furnish that information or answer that question on the grounds that to do so might tend to incriminate him.

This passage was quoted with approval and adopted by Wilcox J in Donovan v DFCT (1992) 92 ATC 4114, although his Honour acknowledged that “Parliament might have chosen clearer words to convey its intention to abrogate the privilege [against self-incrimination]”. The view that the privilege against self-incrimination is not available to thwart a notice issued under the former s 264 was confirmed by the Full Federal Court in DCT v de Vonk (1995) 31 ATR 481. The Court said, … we are of the view expressed in Stergis that the context of the legislation combined with the terms of ss 8C and 8D lead to the conclusion that the privilege has been abrogated. Clearly it is of the utmost importance that a taxpayer disclose to the Commissioner all sources of income. Failure so to do would constitute an offence. If the argument were to prevail that the privilege against self-incrimination was intended to be retained in tax matters, it would be impossible for the Commissioner to interrogate a taxpayer about sources of income since any question put on that subject might tend to incriminate the taxpayer by showing that the taxpayer had not complied with the initial obligation to return all sources of income. Such an argument would totally stultify the collection of income tax.

The De Vonk decision was confirmed in Binetter v DCT [2012] FCAFC 126.

(c) Obtaining Information from the ATO [19.510] We now look at the other side of the issue. This topic looks at the position of a

taxpayer who has a dispute with the ATO and wants to know more about the ATO’s views, information sources and so on. This is especially important for taxpayers who have embarked on the hazardous task of litigation, but it is also a more general issue. How does the taxpayer know what case it needs to answer in order to have its dispute resolved? Take a transfer-pricing dispute for example. The taxpayer will know eventually what adjustment the ATO has made in the amended assessment, but the taxpayer will want to know more and hopefully before a full-scale dispute has erupted. Has the ATO been looking at data that is really comparable? What adjustments were made to the data to get to the ATO’s assessment? Was the information collected and adjusted by qualified people? What assumptions did they make in performing those adjustments? Were those assumptions reasonable, and so on. Under the assessment system, the usual practice of the ATO when issuing an assessment that varied from the return filed by the taxpayer, was to include with the assessment a document 1002

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called an adjustment sheet which indicated, by referring to a code, any adjustments that had been made to the return which affected the taxable income. This adjustment sheet often conveyed little information to the taxpayer about the basis on which the adjustment and consequent assessment was made. A taxpayer who received an assessment from the ATO which varied from the return that was lodged may not have known enough about the adjustment to be able to decide whether to proceed through the objection and appeal procedure and have the matter litigated before a court. In these circumstances, the taxpayer may have had little option but to lodge an objection to find out why the assessment differed from the return. The lack of any obligation on the ATO’s behalf to disclose information hampered the taxpayer’s efforts to pursue even this possibility because if the taxpayer did not know why the adjustment was made, the taxpayer would necessarily also not know to what or how he or she should be objecting. The final insult was added when, if the taxpayer’s best guess about what the ATO had done proved to be wrong (and the objection did not address the attitude that the ATO had taken) the taxpayer could then do nothing to amend the objection to address the ATO’s real grounds. Under a self-assessment system, finding information about why the ATO has issued an assessment or amended assessment becomes a less significant issue. In regard to the initial return, the taxpayer’s own knowledge forms the basis of the assessment. In respect of amendments, they are likely to arise out of an investigation in which, one would hope, all issues have been thoroughly canvassed by each side before decisions are made and the amended assessment issued. Unfortunately, this practice is not always followed and taxpayers may still wish to secure access to the documents and information which disclose just how the ATO came to the decision it has reached. In addition, the taxpayer may need specific information about whether a discretion was exercised (and how) in making an amended assessment. So, while the problems of gaining access to information have declined, they still survive. Some of these problems were addressed by a variety of means: • Common Law Procedures. There are some authorities to support the view that where the ATO has exercised a discretionary power, it may be obliged to inform the taxpayer of the matters taken into account in exercising the discretion. This is discussed, for example, in Giris Pty Ltd v FCT (discussed above) and by the High Court in FCT v Brian Hatch Timber Co (Sales) Pty Ltd (1972) 128 CLR 28. There is also authority in Bailey v FCT (1977) 136 CLR 214 that, where an appeal against an assessment is argued before a court, the court has inherent power to require a party to the proceedings to give particulars to the other of the claim if that appears to the court to be just. • Freedom of Information Act 1982. The somewhat poorly defined common law rights were supplemented in 1982 with the introduction of the Freedom of Information Act 1982. The Act is intended to give citizens access to information held about them on file by administrative agencies (to facilitate the correction of inaccurate information) and also to give information to citizens about the workings of government and the ways in which policies will be implemented. While the Act is not primarily addressed to obtaining information which will disclose the processes which led to the making of an assessment, it has been used by taxpayers for this purpose. Not all information sought must be given and various classes of documents can be made the subject of an exemption. Most of the litigation under the Act motivated by income tax considerations has concerned the scope of these exemptions. The grounds for making a [19.510]

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document exempt are contained in ss 32 – 47. In broad terms, a taxpayer will not be able for income tax purposes to obtain access to documents which fall into the following classes: – Documents, usually termed internal working documents, which disclose opinions, advice or recommendations made for the “deliberative process” of the ATO where their disclosure would be contrary to public interest: s 36. – Documents, the disclosure of which would prejudice the conduct of an investigation of a possible breach of tax laws or which would prejudice the enforcement or administration of a tax law: s 37(1)(a). – Documents which disclose or identify a confidential source of information: s 37(1)(b). – Documents which disclose investigation procedures where disclosure would prejudice the effectiveness of those procedures: s 37(2). – Documents, the disclosure of which is prohibited in another Act: s 38. – Documents which unreasonably infringe personal privacy: s 41. – Documents to which legal professional privilege attaches: s 42. – Documents which disclose trade secrets, commercially valuable information or business affairs: s 43(1). – Documents which were obtained in confidence: s 45(1). • Tax Legislation Procedures. The legislation contains a few specific provisions which require the ATO to provide details of any decisions reached or facts relied upon in making the assessment. Section 14ZY(3) of the TAA 1953 requires the ATO to serve on the taxpayer notice in writing of the ATO’s decision in relation to an objection, though it does not require reasons to be stipulated. A similar provision is s 359-35(4) of Sch 1 of the TAA 1953. It requires the ATO to give reasons explaining its failure to issue a Ruling, though not its reasons for decisions made in the Ruling. Instead, much more common are provisions such as Pt IVC Div 4 of the TAA 1953 which modifies the operation of the AAT Act to relax the obligations that would otherwise be placed on the ATO. In particular, s 14ZZF relaxes the requirements imposed upon the ATO by s 37 of the AAT Act. Section 37 requires the administrative body whose decision is under review to lodge various documents with the Tribunal as a routine matter. • Rules of court. The final source of information comes too late to be of much help to taxpayers in framing their objections but it can help them fight their court action. The Federal Court has issued a Practice Note (Federal Court Practice Note Tax 1) for tax matters which lays down requirements for disclosure of documents and preliminary conferences with the aim of isolating issues. The Practice Note replaces, as from August 2011, more formal requirements previously set out in Order 52B rule (v) of the Federal Court Rules and is aimed at time management of the case as well as disclosure.

7. ENFORCEMENT AND PENALTIES [19.520] Our last topic is the “sharp end” of the tax system. The enforcement provisions in

the tax legislation are important but, for most taxpayers, they are rarely invoked. They do not impinge upon taxpayers because most voluntarily comply with their obligations, or their tax obligations are enforced in ways over which taxpayers have little control – that is, through the PAYG, TFN and other withholding systems described above. As we have noted already, for most taxpayers, the ATO collects amounts toward the assessed tax liability during the course of the year through relatively automatic PAYG 1004

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collection mechanisms and little tax remains to be collected at the end of the year. For those cases where it is necessary, the Act contains a series of measures which facilitate the collection of tax assessed but unpaid by a taxpayer. The usual collection procedure for recalcitrant taxpayers will simply be for the ATO to sue the taxpayer for the assessed tax. Section 255-5 of Sch 1 of the TAA 1953 says that tax which is due and payable is a debt due to the Commonwealth, and entitles the ATO to take steps to recover outstanding tax just as any other creditor would attempt to collect an unpaid debt. Once a judgment is obtained, the ATO will take steps to seize the taxpayer’s assets and sell them in order to recover the tax in the same way as any other creditor – garnishment, bankruptcy, winding up and so on. But the ATO’s general powers of recovery are also supplemented by further provisions in the Act. Section 260-5 creates a procedure by which the ATO can seize amounts from a third party and apply them to reduce the taxpayer’s debt. The procedure operates in the same manner as a garnishee order to require a third party who owes money to the taxpayer to pay that debt to the ATO instead of the taxpayer. The payment to the ATO will extinguish the third party’s obligations to the taxpayer. If the third party refuses to comply with the notice, the third party can become liable in her or his own right to the ATO. This procedure was used by the ATO in Brent’s case (discussed in Chapter 4) to permit the ATO to extract the tax claimed to be owed by Brent from the media company which was still holding some of the money payable under the contract. Similar provisions enabling the ATO to recover tax from third parties are contained in other sections such as ss 255 and 257 of the ITAA 1936. The Taxation Administration Act 1953 provides further remedies to assist the ATO in collecting tax. One of these remedies is contained in s 14S which allows the ATO to issue an order prohibiting a person owing outstanding tax from leaving Australia where the ATO “believes on reasonable grounds that it is desirable to do so for the purpose of ensuring that the person does not depart from Australia for a foreign country”.

(a) Tax Offences and Penalties [19.530] For most taxpayers the penalties contained in the Act provide merely a background against which they operate. For some recalcitrants, however, they are of primary concern. The penalty provisions arise in two situations – where the taxpayer has failed to determine their own tax liability correctly and pay it on time, and where the taxpayer has failed to comply with a related administrative obligation, such as lodging a document on time, record-keeping, reporting and so on. Where a taxpayer has failed to comply fully with their obligations, the ATO’s primary remedy is usually the imposition of a penalty in the form of additional tax, in lieu of a criminal penalty. Many administrative penalties, though by no means all, are created in Div 284 of Sch 1 of the TAA 1953. This entire penalty procedure is purely administrative and need not involve any criminal proceedings, or even proceedings before a court. The ATO simply issues another assessment under s 298-30 of Sch 1 of the TAA 1953 which states that an amount of penalty is payable no sooner than 14 days after issue – there is no obligation to charge the taxpayer with an offence and then recover the amount as if it were a court-imposed fine. The power of the ATO to impose a penalty in the form of additional tax was considered by the High Court in Trautwein v FCT (1936) 56 CLR 63. The taxpayer argued that the sections conferred on the ATO a power to impose a penalty which could only be exercised by a judicial officer in the forum of a court. An alternative argument was made that the sections imposed [19.530]

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tax other than on income and, as such, were contrary to s 55 of the Constitution. Evatt J in the High Court rejected both arguments. His Honour observed that the statute did not give the ATO a discretion to impose the tax but instead, by its own force, fixed the amount of the tax then gave to the ATO a power to remit: s 298-20 of Sch 1 of the TAA 1953. That power to remit was essentially an administrative power and was correctly conferred on the ATO. In regard to the second argument, his Honour observed that s 55 was not intended to prevent incidental penal provisions in Assessment Acts. The penalty system reflects the fact that under the self-assessment system, where disclosure to the ATO in tax returns is designed to be minimal and taxpayers must rely on their own judgment rather than having their position checked and verified by the ATO’s assessors, it is inappropriate to impose penalties on taxpayers for failing to furnish information in returns, or filing returns that are misleading because of what they omit. Some penalties exist where the taxpayer deliberately tries to conceal facts or mislead the ATO, but an important focus of the penalty system is simply accuracy. This is expressed in the concept of a “shortfall amount” (s 284-80 of Sch 1 of the TAA 1953) and it underpins the most commonly applied penalties. The penalty regime focuses on how much effort the taxpayer put into complying with its tax obligations, not who said what to whom. The system also isolates the penalty involved for making errors from the interest to be charged on tax shortfalls. Generally, if there is a shortfall of tax, the penalty system in Div 284 imposes penalties on taxpayers for making a statement which is false or misleading (s 284-75(1), for treating tax law as applying in a way that is not reasonably arguable (s 284-75(2) or for failing to provide relevant information by the due date (s 284-75(3)). Where a penalty can be imposed, the amount of the penalty depends on: • the size of the tax shortfall; • the degree of culpability displayed by the taxpayer’s actions (from intentional disregard of the law, to recklessness, to failure to take reasonable care), and whether the taxpayer obtained a private Ruling on the transaction; and • whether the taxpayer was engaged in a tax avoidance scheme. So, assuming there is a shortfall amount – the taxpayer’s return is considered on audit (and held after any objection, review or appeal) to be deficient – exactly what happens next depends on the amount of tax owed and the level of the taxpayer’s care. One important issue is whether the taxpayer was adopting a “reasonably arguable position” in taking the position that it did. This concept of the “reasonably arguable position” is defined in s 284-15 of Sch 1 of the TAA 1953 as a position which is more likely to be correct having regard to the “relevant authorities”. An “authority” is defined to include the income tax legislation, court and tribunal decisions, public Rulings and extrinsic material. Hill J has said of the words “reasonably arguable”: [T]he two arguments, namely that which is advanced by the taxpayer and that which is the correct view will be finely balanced. The case must be one where reasonable minds could differ as to which view, that of the taxpayer or that ultimately adopted by the Commissioner, was correct. There must, in other words, be room for a real and rational difference of opinion between the two views such that while the taxpayer’s view is ultimately seen to be wrong it is nevertheless “about” as likely to be correct as the correct view. A question of judgment is involved: Waldstern v FCT (2003) 138 FCR 1; [2003] FCA 1428 at para 108.

The Full Federal Court in Sanctuary Lakes Pty Ltd v FCT [2013] FCAFC 50 noted that the reasonably arguable position (RAP) and taking reasonable care are independent statutory 1006

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standards for the imposition of administrative penalties. In doing so they found that that the taxpayer had a RAP under income tax law, but had not to have taken reasonable care in making statements to the Commissioner. Edmonds J noted: 149. I agree with the Tribunal’s affirmation of the Commissioner’s objection decision in respect of the penalties imposed for failure to take reasonable care and its process of consideration to that end outlined in (1) to (3) in [144] above. 150. I reject Lakes’ contention that it necessarily follows that, a finding that its position was reasonably arguable, Lakes (and its tax agent) must have taken reasonable care in filing the relevant return. Similar arguments have been rejected in a number of recent decisions which have held that having a reasonably arguable position and taking reasonable care are independent standards: FCT v Traviati [2012] FCA 546; (2012) 205 FCR 136 at [10]–[22]; Pratt Holdings Ltd v Federal Commissioner of Taxation [2012] FCA 1075 at [167]. Similarly, I reject Lakes’ contention in [148] above. If having a reasonably arguable position and taking reasonable care are independent standards, there is no reason to suppose that the legal test for the application of the reasonable care penalty must include a consideration of whether the taxpayer has a reasonably arguable position

The principal penalties can be summarised as follows: • If the taxpayer has taken “reasonable care” in making its taxation statements, and either: the size of the tax shortfall is less than 1 per cent of the taxpayer’s proper tax and (i) $10,000; or (ii) the taxpayer has a reasonably arguable position, no penalty is applicable. (There is no provision which states that this is the consequence – it simply comes about because no penalty provision deals with this combination of facts.) • If the taxpayer has taken “reasonable care” in making its taxation statements, and both: (i) the size of the tax shortfall is greater than 1 per cent of the taxpayer’s proper tax or than $10,000; and (ii) the taxpayer did not have a reasonably arguable position, a penalty of 25 per cent of the tax shortfall is imposed (s 284-90 Item 4). • If the shortfall amount arose because the taxpayer did not take reasonable care to comply with its tax obligations, a penalty of 25 per cent of the tax shortfall is imposed (s 284-90 Item 3). • If the shortfall amount arose because the taxpayer was reckless, a penalty of 50 per cent of the shortfall is imposed (s 284-90 Item 2). • If the shortfall amount arose because the taxpayer intentionally disregarded the Act or regulations (which is the terminology used in these provisions to describe tax evasion), a penalty of 75 per cent of the shortfall is imposed (s 284-90 Item 1). Once the base penalty amount is established, it can then be varied in a variety of ways. • If the shortfall amount arose in relation to a tax avoidance scheme, the penalty can be increased by 25–50 per cent of the tax shortfall (s 284-160(a)(i) of Sch 1 of the TAA 1953). • If the shortfall amount arose in relation to an international transfer-pricing scheme, the penalty can be increased to 10–25 per cent of the tax shortfall (s 284-160(a)(ii) of Sch 1 of the TAA 1953). • The penalty will be reduced (by at least 80 per cent) if the taxpayer makes voluntary disclosure of the tax shortfall to the ATO before an audit commences (s 284-225(2) of Sch 1 of the TAA 1953). If the disclosure is made after an audit commences and if disclosure will save the ATO significant time or resources, the penalty can be reduced by 20 per cent (s 284-225(1) of Sch 1 of the TAA 1953). [19.530]

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• Each penalty can also be increased (by a further 20 per cent of the additional tax) if the taxpayer takes steps to hinder the ATO (s 284-220(1)(a) of Sch 1 of the TAA 1953). • No penalty can be imposed if the taxpayer was misled by advice given to the taxpayer by a taxation officer or followed a “general administrative practice” of the ATO (s 284-215 of Sch 1 of the TAA 1953). In this case, no shortfall amount arises and so no penalty can be imposed. Part III of the TAA 1953 creates a series of additional taxation offences which carry substantial fines and, in some cases, terms of imprisonment. These offences are generally used by the ATO in cases where he has decided to prosecute the taxpayer rather than merely impose penalty tax. The ATO’s policy whether to choose prosecution or penalty tax depends upon a series of criteria such as any desired deterrent effect, the administrative workload caused by each alternative, the seriousness of the offence and the degree of culpability of the person, the degree of cooperation of the person, and whether the person has previously offended. The offences contained in the TAA 1953 describe activities which amount to deliberately hindering tax collection such as failure to furnish information, failure to produce documents, failure to answer questions, failure to attend before the ATO and give evidence, making false or misleading statements, incorrectly keeping records, falsifying, concealing, destroying or altering records with intent to deceive or obstruct, and obstructing taxation officers. If an offence provided in Pt III of the TAA 1953 has been committed, the ATO will usually also be able in precisely the same circumstances to impose additional tax under Div 284 of Sch 1 of the TAA 1953. There is no general prohibition which prevents the ATO proceeding against the taxpayer for both penalties. Section 8ZE of the TAA 1953 provides some measure of relief from double punishment by remitting the additional tax unless, and until, the prosecution is withdrawn. In addition to a taxpayer’s own tax liability, a multitude of other offences can be committed by a taxpayer in relation to administrative obligations. They are found scattered throughout the Act. For example, s 262A of the ITAA 1936 requires a taxpayer to keep sufficient records of a business and prescribes a penalty for failure to keep sufficient records or to keep them in a form which properly discloses assessable income and allowable deductions. The ATO is given a general discretion in s 298-20 of Sch 1 of the TAA 1953 to remit any penalty either in whole or in part. The ATO has issued many Rulings indicating the manner in which the Commissioner will exercise his discretion to remit the additional tax for these purposes, and an assessment under s 298-30 imposing penalty additional tax can be objected to in the Administrative Appeals Tribunal in the same way as any other assessment. Finally, where an assessment has been amended to increase the amount of tax payable, s 298-25 of Sch 1 of the TAA 1953 provides that the taxpayer is liable to pay the General Interest Charge (“GIC”) on the amount of the increase. Again the ATO is entitled to remit the whole or any part of the interest payable by the taxpayer and this decision is subject to review under the ADJR Act.

(b) Hardship Relief [19.540] The tax legislation has for many years contained a provision for the release of

taxpayers from their liabilities on the grounds of serious hardship. The current provision, Div 340 of Sch 1 of the TAA 1953, gives the ATO, on application by the taxpayer, power to 1008

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cancel a liability, which can be in respect of penalties, interest, PAYG instalments and fringe benefits tax as well as income tax. Practice Statement PS LA 2011/17 notes that the ATO applies several tests to determine: 24. … whether the consequences of paying the tax would be so burdensome that the person would be deprived of what are considered necessities according to normal community standards. 25. Serious hardship would be considered to exist where payment of a tax liability would result in the person being left without the means to afford food, clothing, medical supplies, accommodation, education for children and other basic requirements at a reasonable level. On the other hand, elements of hardship may be regarded as marginal or minor rather than serious, if the consequences of payment of the tax are seen, for example, as a limitation of social activities or entertainment, or loss of access to goods or services of a more discretionary nature.

However it is not easy to persuade the ATO to act under Div 340. No debts were written-off in 2009-10 and single digit success in hardship application has occurred in subsequent years. If the ATO declines to act under Div 340 the matter can be taken to the AAT under Pt IVC of the TAA 1953. Alternatively, a taxpayer can apply to the Department of Finance and Deregulation (DoFD) or the Finance Minister for a waiver of their tax debt. Under section 63 of the Public Governance, Performance and Accountability Act 2013 (PGPA Act), the decision maker has a very broad discretion to consider each request for a waiver.

[19.540]

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CHAPTER 20 Containing Tax Avoidance and Evasion [20.10]

1. INTRODUCTION....................................... ................................................ 1012

[20.20]

2. EFFECTS OF TAX AVOIDANCE ............................. ..................................... 1013

[20.30]

3. RECOGNISING AND DEFINING TAX AVOIDANCE ............... ..................... 1014

[20.40]

4. THE ROLE OF THE COURTS ............................... ....................................... 1017

[20.50] [20.50] [20.60] [20.70] [20.80] [20.90] [20.100]

(a) Interpretation of Tax Legislation ......................................................................... (i) Styles of statutory interpretation ......................................................................... FCT v Westraders Pty Ltd ........................................................................................... (ii) Rules of statutory interpretation ......................................................................... (iii) Words and phrases ............................................................................................ (iv) Other statutory provisions ................................................................................. Cooper Brookes (Wollongong) Pty Ltd v FCT ...............................................................

[20.120] [20.130]

(b) Characterising Transactions ............................................................................... 1024 IRC v Duke of Westminster ........................................................................................ 1025

1018 1018 1019 1020 1021 1021 1022

[20.150] 5. CONTAINING TAX AVOIDANCE ............................ ................................... 1027 [20.160] [20.160] [20.170] [20.180] [20.187] [20.190]

(a) Judicial Responses to Tax Avoidance ................................................................... (i) Judicially developed anti-avoidance doctrines ..................................................... Fletcher v FCT .......................................................................................................... (ii) Sham transactions ............................................................................................. Millar v FCT ............................................................................................................. (iii) Fiscal nullity ......................................................................................................

[20.200] [20.210] [20.220] [20.230]

(b) Statutory Responses to Avoidance ...................................................................... 1036 (i) Penalties for promoters ....................................................................................... 1036 (ii) Non-commercial losses (Division 35 ITAA 1997) ................................................. 1038 (iii) Losses and outgoings incurred under certain tax avoidance schemes (ss 82KH to 82KL ITAA 1936) ..................................................................................................... 1038 (iv) Section 260 and Part IVA ................................................................................... 1038 FCT v Consolidated Press Holdings Ltd ....................................................................... 1040 British American Tobacco Australia Services Ltd v FCT .................................................. 1042 FCT v Spotless Services Ltd ........................................................................................ 1044

[20.240] [20.270] [20.285] [20.340]

1027 1027 1028 1031 1033 1034

Principal sections Acts Interpretation Act 1901 s 15AA

Effect This section requires a Court to prefer a construction that promotes the purpose or object underlying an Act to a construction that does not.

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s 15AB

This section permits a Court to consider certain material which does not form part of an Act to confirm the meaning of a provision or assist if the meaning of the provision is ambiguous or obscure.

ITAA 1936 s 177A s 177C

Effect This section defines a scheme for the purposes of Pt IVA. This section lists the kinds of “tax benefits” that a taxpayer might seek which are made susceptible to Pt IVA. This section modifies the operation of s 177C(1) by requiring that a “tax effect” (as defined in s 177CB) must first be identified. It requires that when postulating what would have occurred in the absence of the scheme, the scheme must be assumed not to have happened. This section lists eight matters to be considered in trying to determine whether a party entered into a scheme for the purpose of securing the tax benefit. This section applies to where a “significant global entity” has entered into a scheme that limits its taxable presence in Australia. This section is a specific anti-avoidance provision which specifies a dividend stripping scheme is a scheme to which Pt IVA applies. This section is a specific anti-avoidance provision aimed at schemes that involve the disposal of shares or equity instruments entered into to enable a taxpayer to obtain an imputation benefit. This section compliments the imputation benefit trading rules in s 177EA by applying them in the context of corporate consolidation by limiting the ability of taxpayers to shift franking credits to a group holding company where it can be concluded that the scheme was entered into for a purpose of enabling the franking credit to arise in the head company’s account. This section permits the ATO to cancel the tax benefit which would otherwise arise and to make compensating adjustments to the position of other parties. Prior to 1981, this section rendered void as against the ATO any arrangement which had the purpose or effect of defeating, evading or avoiding any income tax liability.

s 177CB

s 177D

s 177DA s 177E s 177EA

s 177EB

s 177F

s 260

TAA 1953 Div 290

Effect This Division allows the Federal Court to impose penalties on tax scheme providers.

1. INTRODUCTION [20.10] The terms “tax evasion” “tax avoidance” and “tax planning” are used

interchangeably to describe the process by which taxpayers organise their affairs to reduce their overall tax liability (ie in the most tax effective way). Where tax planning becomes commercialised (ie arrangements that are marketed), the Australian Taxation Office (ATO) takes the view that the line between legitimate tax planning and avoidance has been crossed. The ATO refers to this marketing process as “aggressive tax planning”. What these terms have 1012

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in common is the adverse impact that all of the activities encompassed by these terms has on the Government’s revenue collections. As a result they have become the target of legislative reform (referred to as “integrity measures”) and are a major focus of the ATO’s compliance and anti-avoidance strategies. The anti-avoidance measures sought to be countered by the application of common law principles of sham and the substance approach; specific anti-avoidance provisions; and the general anti-avoidance provisions (“GAAR”). This chapter examines the judicial principles and legislative schemes that are used to counter arrangements designed to avoid tax. The chapter first examines the effects, and in particular the costs, of tax avoidance for society and then considers how the tax system reacts. First, what does “tax avoidance” mean if legislators and administrators are to try to address it? Next, what are the features of our laws and administration that permit avoidance outcomes to occur, and in particular what role do the courts and administrators play in the control of tax avoidance? Finally, how have Parliament, the courts and the ATO tried to contain tax avoidance?

2. EFFECTS OF TAX AVOIDANCE [20.20] There has been debate in the tax profession about the appropriateness of tax advisers

participating in tax avoidance, a debate which generally assumes that the rights of the individual to organise her or his affairs to minimise tax liabilities are to be given significant weight. But what are the costs to society of tax avoidance? Some weighing of the relative social costs against the alleged personal rights must be undertaken if a debate about the desirability of advisers assisting or being even peripherally involved in avoidance activity is to be an informed one. Groenewegen has argued that tax avoidance (though largely unquantified) costs in terms of economic inefficiency and a loss of equity in the tax system (see “Distributional and Allocational Effects of Tax Avoidance” in D Collins ed, Tax Avoidance and the Economy, Sydney, ATRF, 1984, pp 23-38). As he puts it: There are a number of important resource allocation consequences of the tax avoidance industry. These arise from the direct application of scarce resources to tax avoidance activities, from the re-allocation of resources for investment, or employment of variations in pre-tax and post-tax returns as a result of tax avoidance, from the dead weight welfare losses associated with these re-allocations as well as from the free rider problem arising from tax avoidance. Unfortunately little quantitative light can be shed on these resource allocation matters.

He gives some examples of economic costs: • the allocation of the time of top executives to examine avoidance opportunities for their companies; • the allocation of legal and accounting resources and expertise to avoidance; • the need for the ATO to allocate staff to examine avoidance; • alteration to the employment and investment choices that would be made if the ability to avoid tax were not available – especially over-investment in owner-occupied housing, negatively-geared investment properties, and investments in assets that offer returns as capital gains rather than ordinary income. Groenewegen also notes some of the distributional consequences of tax avoidance. The inequity arises because taxpayers do not have equal access to tax avoidance opportunities. Rather, [20.20]

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tax avoidance opportunities are not evenly distributed among income classes and access to such opportunities tends to vary directly with income levels. The indivisibilities in the substantial cost of avoiding tax make it important to have a sufficiently high income level over which to spread these overheads.

The consequences of this include: • a substantial erosion to the progressivity of the tax rate scale; and • shifting the tax burden to others. Apart from these economic and social costs there are other more nebulous costs such as loss of respect for the rule of law. Further, the current complexity of the tax laws can be blamed in no small degree upon the tax avoidance excesses of the 1970s which flowed over into criminal evasion in what became known as the “bottom of the harbour” scandal. The history of this episode and some of its consequences are identified in A Freiberg, “Ripples from the Bottom of the Harbour: Some Social Ramifications of Taxation Fraud” (1988) 12 Criminal Law Journal 136 and in T Boucher, Blatant, artificial and contrived: tax schemes of the 70s and 80s, (Australian Taxation Office, 2010). These kinds of challenges to the tax system are by no means uncommon, nor are they confined to the annals of history. A similar story in the 1990s surrounds the so-called “tax effective mass marketed schemes”. This label is used to describe a series of aggressively marketed tax avoidance schemes with names like “Budplan”, “Main Camp”, “offshore superannuation schemes”, “controller superannuation schemes” and “employee benefit schemes”. The first two were examples of tax schemes involving agricultural, film and R&D investments sold most often to individual investors; the second two were schemes involving tax-effective remuneration packaging techniques sold to employers and the self-employed. They, and similar investments, were aggressively marketed in the mid- to late-1990s until the ATO tried to shut them down. These schemes caused substantial problems for the ATO and provoked a number of cases, most of which the ATO won, either because the schemes did not work under the general tax law, or because they were susceptible to attack under his special powers to deal with tax avoidance. Examples include Howland-Rose v FCT (2002) 118 FCR 61; [2002] FCA 246 (“Budplan”), Krampel Newman Partners Pty Ltd v FCT (2003) 126 FCR 561; [2003] FCA 123 (film scheme), FCT v Sleight (2004) 136 FCR 211; [2004] FCAFC 94 and Princi v FCT (2008) 68 ATR 938; [2008] FCA 441 (tea tree oil), Puzey v FCT (2003) 131 FCR 244; [2003] FCAFC 197 and FCT v Lenzo (2008) FCR 255; [2008] FCAFC 50 (sandalwood), and FCT v Cooke (2004) 55 ATR 183; [2004] FCAFC 75 (Australian wildflowers).

3. RECOGNISING AND DEFINING TAX AVOIDANCE [20.30] This chapter proceeds on the assumption that tax avoidance can be observed or

meaningfully defined, but defining it is not an easy matter. One light-hearted definition is that of Wheatcroft who defined tax avoidance as “the art of dodging tax without actually breaking the law”. In reality, however, we are faced with a continuum of behaviour in which one thing leads to another. All designers of business structures and transactions take tax into account; indeed for a professional adviser it is negligent not to. The next step, however, is for the structure or transaction to adopt the form it does primarily for tax reasons. Many businesses in Australia for example are constituted as partnerships or trusts to minimise tax, and professional 1014

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partnerships are often associated with service companies for the same reason. The dividing line between what is permitted and what is unacceptable tax avoidance in this area is by no means clear. The next step is to engineer a structure or transaction which comes into existence with the sole purpose of producing a tax benefit, such as the dividend stripping scheme in Newton v FCT (1958) 98 CLR 1 or the share trading scheme in FCT v Westraders Pty Ltd (1980) 144 CLR 55. Even here, some schemes have been upheld as “legitimate”, others struck down as unacceptable avoidance. Lastly, there are schemes which are deliberate fraud, and therefore evasion, but dressed up as bona fide plans. The “bottom of the harbour” activities of the 1970s were of this sort, though the vendor shareholders would argue they, if not the promoters, had honest intentions. Tax planning may take a wide range of forms: • income splitting using partnerships, trusts and companies; • the derivation of gain in a tax-free or tax preferred form – capital gains, superannuation, certain fringe benefits; • the postponement of realisation and capitalisation of income (“tax deferred is tax denied”); • intermediaries as tax shelters – companies and trusts; • deduction schemes; • “legitimate” tax shelters – primary production, films, superannuation; • offshore schemes, utilising the above methods, often relying on the ATO’s difficulty of access to information required for assessment. Such schemes may of course be simply fraudulent. Many verbal formulae attempting to describe and distinguish tax avoidance have been generated by a multitude of inquiries and commissions. For example: • the report of the Royal Commission on Taxation of Profits and Income (the Radcliff Report) in the UK in 1955, defined tax avoidance as “some act by which a person so arranges his affairs that he is liable to pay less tax than he would have paid but for the arrangement”; • the report of the Royal Commission on Taxation (the Carter Commission) in Canada in 1966, defined tax avoidance as “every attempt by legal means to reduce tax liability which would otherwise be incurred, by taking advantage of some provision or lack of provision in the law”; and • the Full Report of the Taxation Review Committee (the Asprey Committee) in Australia in 1975, defined tax avoidance primarily in terms of income splitting. It suggested that avoidance was “an act within the law whereby income, which would otherwise be taxed at a rate applicable to the taxpayer who but for that act would have derived it, is distributed to another person or between a number of other persons who do not provide a bona fide and fully adequate consideration”. When the revised general anti-avoidance provision, Pt IVA, was introduced into the ITAA 1936 in 1981 (which is discussed below), the then Treasurer John Howard (later Prime Minister) used yet another form of words but one which presumably means the same thing. During the Second Reading Speech, Hansard, House of Representatives, 27 May 1981, the Treasurer described both prohibited avoidance and those activities which might, on some definitions, be termed avoidance but which would nevertheless not be treated as avoidance: [20.30]

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We are acutely aware that “tax avoidance” means different things to different people. Reasonable men and women are bound to differ on this crucial question and on the subsidiary matter of the appropriate tests for determining what behaviour a general anti-avoidance provision ought to proscribe. The proposed provisions … seek to give effect to a policy that such measures ought to strike down blatant, artificial or contrived arrangements but not cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs.

According to this definition, there is apparently legitimate and illegitimate tax avoidance. For the purposes of the remainder of this chapter, in so far as a verbal formula is needed, we will use this definition: tax avoidance involves techniques to minimise tax through legal means which have as a major object the obtaining of tax benefits. Tax avoidance differs from tax evasion because it lacks any criminal culpability. Some tax advisers claim that there is a further distinction between tax avoidance and tax planning: the taking of legitimate steps to minimise tax but not involving means which are blatant, artificial and contrived. (Or perhaps, tax planning is tax avoidance which is not defeated by anti-avoidance rules.) Tax planning is presumably the same as the Treasurer’s legitimate tax avoidance. Both tax planning and tax avoidance are intended to take advantage of opportunities which exist in the legislation for desirable tax consequences to follow. While verbal definitions may have some benefits, another approach to defining tax avoidance seeks to define it in terms of the defeat of the policy apparent in the legislation – tax avoidance is a result rather than an activity. For example, in Income Taxation in Australia (Thomson Reuters, Facsimile Edition, 2011, 1985, paras 16.55-16.58), R W Parsons suggests that tax avoidance is taking the law as expressing only its words, rather than any underlying policy when there is an underlying policy in the legislation. One virtue of an approach such as this is that it attempts to identify some activities which, although they have the effect of reducing a tax liability, will not be caught, as they advance (or at least do not detract from) a policy in the legislation. The exercise of an election specifically given in the income tax assessment Acts (such as the valuation of trading stock) is the usual example of a non-avoidance activity which might otherwise be caught by a linguistic definition. Similarly, deciding to invest in a film or to put funds into superannuation, even though that type of investment generates a tax-preferred return (compared to another investment), ought not to be avoidance – the government is hoping (indeed, bribing) the investor to change their behaviour based largely on tax considerations. But in reality, avoidance is usually recognised by courts by the presence of a few telltale trademarks, rather than any detailed policy or linguistic analysis. According to G S Cooper in “The Taming of the Shrewd: Identifying and Controlling Tax Avoidance” (1985) 85 Columbia Law Review 657, most tax avoidance schemes rely upon the combination of three elements. And by reverse engineering, where the three elements are apparent there is tax avoidance. • The first element is the deferral of gain by incurring large tax deductions in the early years of any scheme. Gains may eventually be realised and taxed (although more commonly the scheme will be aborted before it starts to generate a positive return) but there is value in the mere deferral of the liability. • Second, any gain which must be taxed ought to be converted into capital gain rather than be taxed as income – a process known as arbitrage. The benefit from conversion flows in Australia in the form of access to CGT discount for individuals and superannuation funds. • The third element is leverage. Cooper describes leverage in this way: 1016

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The final step in building a tax shelter is to enhance the value of tax benefits by use of leverage. Economic leverage is, of course, a common investment tool. With economic leverage an investor seeks to take advantage of a favourable differential between the cost of borrowing and the return on invested funds. Tax leverage adds another dimension to this process. In addition to profiting from differentials from economic return, a taxpayer can also arbitrage differentials in the tax treatment of borrowing costs, on the one hand, and investment returns, on the other. If the tax arbitrage is favourable enough, it can even offset a deficit from economic leverage.

4. THE ROLE OF THE COURTS [20.40] Tax avoidance is apparently an inevitable consequence of any tax system.

Responsibility for tax avoidance might be attributed to a variety of factors: faulty policy design, poor legislative drafting, an interpretive approach of the courts in favour of taxpayers, tardy or ineffectual tax administration, taxpayer resistance to taxation, and aggressive tax positions promoted by professionals. Politicians and administrators no doubt see the main source of ongoing problems of avoidance in the attitude of the courts, especially the Barwick High Court of the 1960s and 1970s. There were undoubtedly many causes which led to the avoidance explosion and its continuance today in the mass marketed schemes. While it is facile to suggest that the courts were solely responsible, the role of courts in the tax process deserves some exploration. The issue to consider is: how do courts construct their role in interpreting and applying tax legislation? On one view, the courts took upon themselves a role of protecting the citizen from the excesses of government, by protecting taxpayers’ property from seizure by government. Brooks, in his article, “Computation of Business Income – Deductibility of Fines” (1977) 25 Canadian Tax Journal 16, suggests that the judiciary might have decided upon a role in which they conceived of courts as if in a cooperative venture with the legislature. The courts’ failure to pursue this route has been explained as an attempt by the courts to distance themselves from the legislature in the tradition of the separation of powers. As Lord Devlin put it, “in the past judges looked for the philosophy behind the statute and what they found was a Victorian Bill of Rights favouring the liberty of the individual, the freedom of contract, the sacredness of property and a high suspicion of taxation”: “Judges and Lawmakers” (1976) 39 Modern Law Review 1 at 14. Another judge, Lord Clyde, put it thus in a Scottish case, Ayrshire Pullman Motor Services v IRC (1929) 14 TC 754: No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property so as to enable the Inland Revenue to put the largest possible shovel into his stores. The Inland Revenue is not slow – and quite rightly – to take every advantage which is open to it under the taxing statutes for the purpose of depleting the taxpayer’s pocket. And the taxpayer is, in like manner, entitled to be astute to prevent, as far as he honestly can, the depletion of his means by the Revenue.

Even judges in Australia in the 1970s managed to find a similar Victorian “Bill of Rights”. Perhaps this role was appropriate when government was conducted through arbitrary decree by autocratic monarchs whose rule derived from divine right; but that has probably not been an accurate description of the Australian political scene for the last few years. However the judges view their role, it is clear that a court must perform two separate functions when deciding tax cases: to decide what the parties did and the legal effects of the [20.40]

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relevant transactions; and to decide what the rules which apply to the transaction mean. Both steps are critical. Ascertaining the facts is just as important as ascertaining the law. However, we will start with the second step.

(a) Interpretation of Tax Legislation (i) Styles of statutory interpretation [20.50] It is often said that the approach taken by English courts and followed in Australia

has been to adopt a literal approach to tax statutes: taxes must be exacted by clear and unambiguous words. The classic exposition of this approach is usually said to be the decision in IRC v Duke of Westminster [1936] AC 1 at 24. Lord Russell described the proposition in this way: I confess that I view with disfavour the doctrine that in taxation cases the subject is to be taxed if, in accordance with a court’s view of what it considers the substance of the transaction, the court thinks that it falls within the contemplation or spirit of the statute. The subject is not taxable by inference or analogy, but only by the plain words of a statute applicable to the facts and circumstances of the case.

Supporters of the literal approach claim that it is non-policy oriented and that it simply applies the law as it is stated. In blatant schemes where there is no ambiguity or uncertainty about the terms of the statute (Cooper Brookes (Wollongong) Pty Ltd v FCT (1981) 147 CLR 297, below, is probably an example of such a scheme) and the statute does not actually achieve what was probably intended, the only question is usually whether the court is sufficiently bold to take the step of filling the gaps to give effect to what the drafter had intended or would probably have intended if he or she had given his or her mind to it. In most difficult revenue cases there are often genuine ambiguities in the statute or uncertainty as to how it will apply to a specific fact situation. Indeed it is this ambiguity and uncertainty that the tax scheme is intended to exploit. If the statute were not ambiguous in this transaction, the transaction would not have been structured to take advantage of it. In “Judicial and Statutory Restrictions on Tax Avoidance” (Australian Taxation: Principles and Practice, R Krever, ed, Longman, Melbourne, 1987, pp 293-294), Geoffrey Lehmann says: The Duke of Westminster style of literalism developed by the Australian High Court in the 1970s, with Sir Garfield Barwick as Chief Justice, systematically resolved uncertainties or ambiguities in tax legislation in favour of taxpayers. Literalism which incorporates a pro-taxpayer policy is not literalism in the classic sense of the word. It is a disguised policy and is political in nature. Frequently it involves the substitution of judicial policy for the policy of Parliament which is to levy taxes from citizens according to their financial capacity.

The literalism to which Lehmann refers led to decisions such as Investment and Merchant Finance Corporation Ltd v FCT (1971) 125 CLR 249, Curran v FCT (1974) 131 CLR 409, FCT v South Australian Battery Makers Pty Ltd (1978) 140 CLR 645 and Europa Oil (NZ) Ltd (No 2) v IRC (1976) 5 ATR 744. It ought not to be thought, however, that this approach was uniformly adopted by the High Court on every occasion and by all its members, nor that its latent political content was not recognised. Some of the dissention which the approach caused was aired in the judgments in Westraders. This case involved a scheme to take advantage of the rollover for trading stock. Jensen had purchased shares at a cost of $6 m and had then performed a dividend stripping operation. It then sold the shares to a partnership (in which it was a member) for $115,000 but the partnership exercised the option under the 1018

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former s 36A of the ITAA 1936 to treat the shares as having the same cost to the partnership as their cost to Jensen. The partnership sold the shares for $125,500 and claimed that it had suffered a loss of almost $6 m. The taxpayer, Westraders, was another member of the partnership. Barwick CJ approached the matter by a careful, but not generous, reading of the Act:

FCT v Westraders Pty Ltd [20.60] FCT v Westraders Pty Ltd (1980) 144 CLR 55 The facts of this case disclose an ingenious use of the provisions of ss 36 and 36A of the Income Tax Assessment Act 1936 to produce what is claimed to be an allowable deduction from a taxpayer’s assessable income. It is for the Parliament to specify, and to do so, in my opinion as far as language will permit, with unambiguous clarity, the circumstances which will attract an obligation on the part of the citizen to pay tax. The function of the court is to interpret and apply the language in which the Parliament has specified those circumstances. The court is to do so by determining the meaning of the words employed by the Parliament which is discoverable from the language used by the Parliament. It is not for the court to mould or to attempt to mould the language of the statute so as to produce some result which it might be thought the Parliament may have intended to achieve, though not expressed in the actual language employed. I would endorse what was said by Deane J in his reasons for judgment in this case [in the Federal Court]. His Honour said: For a 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 and, indeed, to subvert the rule of law itself. Parliament having prescribed the circumstances which will attract tax, or provide occasion for its reduction or elimination, the citizen has every right to mould the transaction into which he is about to enter into a form which satisfies the requirements of the statute. It is nothing to the point that he might have attained the same or a similar result as that achieved by the transaction into which he in fact entered by some other transaction, which, if he had entered into it, would or might have involved him in a liability to tax, or to more tax than that attracted by the transaction into which he in fact entered. Nor can it matter that his choice of transaction was influenced wholly or in part by its effect upon his obligation to pay tax. The freedom to choose the form of transaction into which he shall enter is basic to the maintenance of a free society.

A different and more generous view was put by Murphy J (dissenting): The transactions in this case are conceded to be a major tax avoidance scheme. The supporters of the scheme seize upon the bare words of s. 36A and claim that these should be applied literally even if for purposes not contemplated by Parliament. This history of interpretation shows the existence of two schools, the literalists who insist that only the words of an Act should be looked at, and those who insist that the judicial

duty is to interpret Acts in the way Parliament must have intended even if this means a departure from the strict literal [words]. It is an error to think that the only acceptable method of interpretation is strict literalism. On the contrary, legal history suggests that strict literal interpretation is an extreme, which has generally been rejected as unworkable and a less than ideal performance of the judicial function. [20.60]

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FCT v Westraders Pty Ltd cont. It is universally accepted that in the general language it is wrong to take a sentence or statement out of context and treat it literally so that it has a meaning not intended by the author. It is just as wrong to take a section of a tax Act out of context, treat it literally and apply it in a way which Parliament could not have intended. The nature of language is such that it is impossible to express without bewildering complexity provisions which preclude the abuse of a strict literalistic approach. It has been suggested, in the present case, that insistence on a strictly literal interpretation is basic to the maintenance of a free society. In tax cases, the prevailing trend in Australia is now so

absolutely literalistic that it has become a disquieting phenomenon. Because of it, scorn for tax decisions is being expressed constantly, not only by legislators who consider that their Acts are being mocked, but even by those who benefit. In my opinion, strictly literal interpretation of a tax Act is an open invitation to artificial and contrived tax avoidance. Progress towards a free society will not be advanced by attributing to Parliament meanings which no one believes it intended so that income tax becomes optional for the rich while remaining compulsory for most income earners. If strict literalism continues to prevail, the legislature may have no practical alternative but to vest tax officials with more and more discretion. This may well lead to tax laws capable, if unchecked, of great oppression.

(ii) Rules of statutory interpretation [20.70] The ultimate goal of the process of statutory interpretation is usually said to be to

ascertain the intention of Parliament as it is expressed in the legislation so that it can be given effect. And yet at the same time, the courts, in interpreting revenue legislation, have chosen to limit the extent to which they might otherwise achieve that goal by two qualifications: that a tax can only be imposed by clear and unambiguous words; and that a court may not ignore the form in which a transaction is cast. We will examine first the general goal and then the constraint of clear and unambiguous words and why the courts have developed it. In the next section we will explore the conflict between taxing the substance of a transaction and subjecting tax consequences to the form in which it is cast. The process of statutory construction revolves around a series of common law canons of legislative interpretation and statutory rules in the Acts Interpretation Act 1901. The principal source for finding the intention of Parliament must be the Act itself, and the common law propositions about how to interpret legislation to find whatever intention might be expressed in an Act are many and varied. They are also indeterminate. Three approaches to the construction of statutes and portions of statutes are commonly used: • The literal rule. This approach was described in Amalgamated Society of Engineers v Adelaide Steamship Co Ltd (1920) 28 CLR 129 as “when we find what the language means in its ordinary and natural sense, it is our duty to obey that meaning, even if we think the result to be inconvenient, impolitic or improbable”. This approach was discussed by the High Court in Cooper Brookes. • The “golden rule”. Under this approach, if it appears evident that the draftsperson made some error so that the Act leads to an absurd result or to a result which is inconsistent with the rest of the Act, the result which a literal reading would require may be avoided. • The “mischief rule”. Under this approach, the court may read a statute and construe it so as to give effect to the purpose for which the law was passed. This method was evident in the High Court’s approach in FCT v Whitfords Beach Pty Ltd (1982) 150 CLR 355. The Court 1020

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considered that the meaning of s 26(a) should be ascertained against the background of its introduction into the ITAA 1936, as it was enacted in order to overcome the decision in Jones v Leeming [1930] AC 415. (iii) Words and phrases [20.80] There are also a series of propositions for construing individual words and phrases

within statutes. Some are listed for your amusement: • noscitur a sociis: the meaning of a word is defined at least in part by the meaning of the surrounding words; • ejusdem generis: a general word is to be defined by the meaning of any specific words which surround it; • expressio unius est exclusio alterius: the expression of specific matters impliedly excludes other matters which were not mentioned; • generalia specialibus non derogant: where general and specific words might conflict, the specific words should prevail. (iv) Other statutory provisions [20.90] These canons of interpretation are supplemented by s 15AA of the Acts Interpretation

Act 1901. It provides: 15AA(1) 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.

In certain circumstances, the court may also look beyond the terms of the Act to find evidence of Parliament’s intention in an extrinsic source. Again the Acts Interpretation Act 1901 encourages this process. Section 15AB provides: 15AB(1) Subject to sub-section (3), in the interpretation of a provision of an Act, if any material not forming part of the Act is capable of assisting in the ascertainment of the meaning of the provision, consideration may be given to that material – (a) to confirm that the meaning of the provision is the ordinary meaning conveyed by the text of the provision taking into account its context in the Act and the purpose or object underlying the Act; or (b) to determine the meaning of the provision when – (i) the provision is ambiguous or obscure; or (ii) the ordinary meaning conveyed by the text of the provision taking into account its context in the Act and the purpose or object underlying the Act leads to a result that is manifestly absurd or is unreasonable. (2) Without limiting the generality of sub-section (1)), the material that may be considered in accordance with that sub-section in the interpretation of a provision of an Act includes – (a) all matters not forming part of the Act that are set out in the document containing the text of the Act as printed by the Government Printer; (b) any relevant report of a Royal Commission, Law Reform Commission, committee of inquiry or other similar body that was laid before either House of the Parliament before the time when the provision was enacted; (c) any relevant report of a committee of the Parliament or of either House of the Parliament that was made to the Parliament or that House of the Parliament before the time when the provision was enacted; [20.90]

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(d) any treaty or other international agreement that is referred to in the Act; (e) any explanatory memorandum relating to the Bill containing the provision, or any other relevant document, that was laid before, or furnished to the members of, either House of the Parliament by a Minister before the time when the provision was enacted; (f) the speech made to a House of the Parliament by a Minister on the occasion of the moving by the Minister of a motion that the Bill containing the provision be read a second time in that House; (g) any document (whether or not a document to which a preceding paragraph applies) that is declared by the Act to be a relevant document for the purposes of this section; and (h) any relevant material in the Journals of the Senate, in the Votes and Proceedings of the House of Representatives or in any official record of debates in the Parliament or either House of the Parliament.

The High Court decision in Cooper Brookes shows the tension between the conflicting approaches to statutory interpretation and the indeterminacy of each approach. While ss 15AA and 15AB had not been enacted at the time of the decision, the canons of interpretation had been variously stated for many years and some of them are implicitly referred to in the extract below. The case concerned a scheme to maintain the deductibility of carry-forward losses after a takeover. Cooper Brookes sought to deduct prior year losses but the ATO argued that because of a change in the beneficial ownership of the shares in Wellington – the holding company of Cooper Brookes – the losses were no longer deductible. The shareholders in Wellington had entered an arrangement which gave the appearance that the beneficial ownership remained the same. The former s 80B(5) of the ITAA 1936 gave the ATO power to deny losses in situations where there was such an arrangement in relation to the shares of the loss company, but there was no power for the ATO to look through an arrangement in regard to the holding company’s shares and then to deny the deduction to the subsidiary. On a literal reading, both parties agreed that all that the ATO could do would be to disregard any losses suffered by Wellington, but of course it had suffered none. The result of the literal reading would have been that Cooper Brookes could continue to deduct the losses. The loophole was amended by Parliament but not until two years after the facts of this case arose. Gibbs CJ described his approach to the statute in this way:

Cooper Brookes (Wollongong) Pty Ltd v FCT [20.100] Cooper Brookes (Wollongong) Pty Ltd v FCT (1981) 147 CLR 297 [Counsel] for the appellant, submitted that even if this result might be regarded as surprising, it could not be described as unjust, capricious or irrational. He acknowledged that the construction for which the appellant contended would have the result that in some cases the subsidiary company would lose the deduction because a beneficial owner of shares in the holding company had entered into an arrangement designed to enable the holding company to take into account losses that it had incurred. [Counsel] conceded that this might be regarded as a gap in 1022

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the legislation, but urged that the court had no right to fill it, especially since the legislature had itself dealt with the question in the Income Tax Assessment Act 1973. It is an elementary and fundamental principle that the object of the court, in interpreting a statute, is to see what is the intention expressed by the words used. It is only by considering the meaning of the words used by the legislature that the court can ascertain its intention. And it is not unduly pedantic to begin with the assumption

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Cooper Brookes (Wollongong) Pty Ltd v FCT cont. that words mean what they say. Of course, no part of a statute can be considered in isolation from its context – the whole must be considered. If, when the section in question is read as part of the whole instrument, its meaning is clear and unambiguous, generally speaking nothing remains but to give effect to the unqualified words. There are cases where the result of giving words their ordinary meaning may be so irrational that the court is forced to the conclusion that the draftsman has made a mistake, and the canons of construction are not so rigid as to prevent a realistic solution in such a case. However, if the language of a statutory provision is clear and unambiguous, and is consistent and harmonious with the other provisions of the enactment, and can be intelligibly applied to the subject matter with which it deals, it must be given its ordinary and grammatical meaning, even if it leads to a result that may seem inconvenient or unjust. To say this is not to insist on too literal an interpretation, or to deny that the court should seek the real intention of the legislature. The danger that lies in departing from the ordinary meaning of unambiguous provisions is that it may degrade into mere judicial criticism of the propriety of the acts of the legislature, it may lead judges to put their own ideas of justice or social policy in place

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of the words of the statute. On the other hand, if two constructions are open, the court will obviously prefer that which will avoid what it considers to be inconvenience or injustice. Since language, read in its context, very often proves to be ambiguous, this last mentioned rule is one that not infrequently fails to be applied. In the present case the words of the Act which give rise to the question of interpretation are not substantive provisions which of their own force apply to the case of a holding company. The difficulty is caused by the application to the case of a holding company which is not the taxpayer of a provision intended to apply to the case of a subsidiary company which is the taxpayer. “On a full view of the Act, considering its scheme and its machinery and the manifest purpose of it” (to use the words of Earl Loreburn in Drummond v Collins [1915] AC 1011) I consider that when the Parliament applied s. 80B(5) to the case of a holding company, it intended that the reference to “company” in para (c) should apply to the subsidiary company, and that the expression of its intention miscarried. The case is one of some difficulty, but for the reasons I have given I conclude that the intention of the legislature sufficiently appears when ss 80A, 80B and 80C are read together and that it is permissible to depart from the literal meaning of the words of s. 80C(3) in order to give effect to that intention.

Aickin J dissented from the majority, preferring instead to interpret and apply the express text of the section as it appeared in the Act: The present case does not have any of the characteristics which have been regarded in the more recent authorities as sufficient to warrant filling a gap or apparent gap. No doubt the courts in recent years have taken a somewhat less strict view of reading words into statutes where the words actually used produce, for instance, an absurd result. It is however not permissible to rely on a supposed failure to express the real intention by reliance on what the reader thinks the Parliament or the draftsman should have intended or should have said.

This case is not one of ambiguity which a court may resolve by reference to the general purpose of the legislation, the mischief aimed at or some apparent logical scheme. Section 80C is not ambiguous or uncertain. The parties agreed that on the literal meaning of the words the result would be that the taxpayer could carry forward the earlier losses which would then be available as deductions in the year of income. There are a number of authorities which deal with the “filling of gaps” or altering words in statutes. If the words used by Parliament are plain, there is no room for the “anomalies” test, [20.100]

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Cooper Brookes (Wollongong) Pty Ltd v FCT cont. unless the consequences are so absurd that, without going outside the statute, one can see that Parliament must have made a drafting mistake. If words “have been inadvertently used”, it is legitimate for the court to substitute what is apt to avoid the intention of the legislature being defeated … This is an acceptable exception to the

general rule that plain language excludes a consideration of anomalies, that is, mischievous or absurd consequences. If a study of the statute as a whole leads inexorably to the conclusion that Parliament has erred in its choice of words, for example, used “and” when “or” was clearly intended, the courts can, and must, eliminate the error by interpretation … [but] this is not a case of manifest absurdity.

[20.110] This case probably represents the high point of purposive interpretation of the

statute and it was achieved without the assistance of s 15AA or s 15AB of the Acts Interpretation Act 1901. Indeed, those sections have not proved to be helpful in the process of statutory interpretation in tax. Subsequent cases have read many limitations into the apparent flexibility of those sections. For example, in Trevisan v FCT (1991) 21 ATR 1649, Burchett J criticised the AAT for making a purposive interpretation of the ITAA 1936 relying upon s 15AA. Instead, according to the judge, the section could only be used to prefer one of two interpretations, each of which was open from the actual terms of the section – it could not be used to extend the scope of the section to encompass a similar, though not specified, transaction. Similarly, in Gray v FCT (1989) 20 ATR 649, Sheppard J refused to read down the operation of s 160ZS so that it did not apply to a lease granted after 19 September 1985 of property acquired before 19 September 1985. The representative of the taxpayer had argued that the Treasurer’s statement of 19 September and the Explanatory Memorandum to the Bill which had introduced the CGT, each contained passages stating the “capital gains tax would not apply to assets acquired prior to 19 September 1985”. Sheppard J said that these extrinsic materials did not assist in the interpretation of s 160ZS because the language of the statute was clear. The implication of his observation was that s 15AB is only relevant where the meaning and effect of the statute is not clear from its terms. In AAT Case 5219 (1988) 20 ATR 3777; Case W58 (1989) 89 ATC 524, Hartigan J refused to interpret the scope of Pt IVA by reference to the Treasurer’s Second Reading speech, despite the terms of s 15AB saying: “I cannot use the Minister’s words to displace the plain language of Parliament”. This view was repeated by O’Loughlin J in Peabody v FCT (1992) 24 ATR 58. On the other hand, Sackville J referred to these extrinsic materials in W D & H O Wills (Aust) Pty Ltd v FCT (1996) 32 ATR 168 without mentioning s 15AB, but found in favour of the taxpayer on the facts. In Grollo Nominees Pty Ltd v FCT (1997) 36 ATR 424, the Full Federal Court refused to read Pt IVA down on the basis of statements in the Explanatory Memorandum.

(b) Characterising Transactions [20.120] The characterisation of transactions is another, but logically distinct, aspect of the

role of the courts. In interpreting the Act, the court is guided by canons of construction but in characterising transactions there is little formal assistance available except the common sense of the judge and previous practices of the courts. We have already seen some of the problems 1024

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of characterisation in cases such as Cecil Bros Pty Ltd v FCT (1964) 111 CLR 430, FCT v Phillips (1978) 8 ATR 783 and Europa Oil (NZ) Ltd (No 2) v IRC (1976) 5 ATR 744; 1 WLR 464. The debate about characterising transactions has always centred on “form versus substance” – the extent to which the court should be bound by the form in which a transaction has been cast; might the court look instead to the underlying transaction and mandate the tax consequences appropriate to that other transaction? If the court is not to be constrained by the form in which a transaction is cast many questions arise. Which steps in the transaction can be impugned? Why can those steps be impugned if they operate according to their apparent legal effect? What can the court substitute in the place of the challenged transaction? The adoption of a purely formalistic approach to characterising transactions was said to flow from the decision of the House of Lords in IRC v Duke of Westminster [1936] AC 1. The Duke was trying to obtain a tax deduction for some of his personal consumption expenditure: the salary he paid to his butler, valet, gardener and other domestic staff. The salary expenses were not deductible under English income tax law but a special provision in UK tax law provided that amounts payable under deeds of covenant which would be taxable to the recipient were deductible to the payer. The Duke executed several deeds under which he covenanted to pay weekly sums to the employees for seven years and obtained from them in a letter an assurance that, as long as the weekly payments were being made, they would refrain from asking for wages. The House of Lords held by majority that the sums met the description in the Act as amounts paid under a deed and consequently the Duke was entitled to exclude the sums from his income. Lord Atkin dissented. The difference in approach lies in what he believed happened. The nature of the transaction as he characterised it just did not bring into play the special provision in the UK Act:

IRC v Duke of Westminster [20.130] IRC v Duke of Westminster [1936] AC 1 The only remaining question is relatively simple. Is the contract one which radically alters the terms of the existing contract of service – I will make a new contract of service and I will serve you as gardener for 22 shillings a week; or, as in some of the other cases, I will serve you for nothing; or is it a contract which maintains the existing contract of service – I will continue to serve you as gardener for 60 shillings a week; but I will take in payment of that 60 shillings, as to 38 shillings, the payment under the deed, and as to the balance, the ordinary weekly payment. In the latter case the employer remains under an obligation to pay 60 shillings: and discharges 38 shillings of that obligation by making the payment under the deed, which has been delivered with that bargain in existence. I quite agree that the former is a possible bargain. A servant may agree to work for nothing, or for some sum which is merely a fraction of the

current rates of wages. But such agreements are in my experience very exceptional. In the present case they would apply, it is said, to about 100 employees. And I cannot contemplate so many servants consciously making bargains so alien to their traditions and for a period which would not be longer than seven years and might be shorter. The better construction appears to me to be that the servants were never asked to abandon the existing contractual rate. If it were otherwise one bears in mind the strange position of what were neatly called the uncovenanted servants, serving for higher wages, together with the other difficulties earlier referred to as wages statutes and wages in lieu of notice. I do not myself see any difficulty in the view taken by the Commissioners and Finlay J that the substance of the transaction was that what was being paid was remuneration. Both the Commissioners and Finlay J took the document of [20.130]

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IRC v Duke of Westminster cont. 13 August into consideration as part of the whole transaction, and in my opinion rightly. I agree that you must not go beyond the legal effect of the agreements and conveyances made,

construed in accordance with ordinary rules in reference to all the surrounding circumstances. So construed the correct view of the legal effect of the documents appears to me to be the result I have mentioned.

Lord Tomlin formed part of the majority: It is said that in revenue cases there is a doctrine that the court may ignore the legal position and regard what is called “the substance of the matter”, and that here the substance of the matter is that the annuitant was serving the Duke for something equal to his former salary or wages, and that therefore, while he is so serving, the annuity must be treated as salary or wages. This supposed doctrine (upon which the Commissioners apparently acted) seems to rest for its support upon a misunderstanding of language used in some earlier cases. The sooner this misunderstanding is dispelled, and the supposed doctrine given its quietus, the better it will be for all concerned, for the doctrine seems to involve substituting “the uncertain and crooked cord of discretion” for “the golden and straight metwand of the law”. Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of

Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax. This so-called doctrine of “the substance” seems to me to be nothing more than an attempt to make a man pay notwithstanding that he has so ordered his affairs that the amount of tax sought from him is not legally claimable. Here the substance is that which results from the legal rights and obligations of the parties ascertained upon ordinary legal principles, and, having regard to what I have already said, the conclusion must be that each annuitant is entitled to an annuity which as between himself and the payer is liable to deduction of income tax by the payer and which the payer is entitled to treat as a deduction from his total income for surtax purposes. There may, of course, be cases where documents are not bona fide nor intended to be acted upon, but are only used as a cloak to conceal a different transaction. No such case is made or even suggested here.

[20.140] Some people have claimed, however, that the effect of Duke of Westminster has been grossly overstated. For example, Sir Peter Millett in his article “Artificial Tax Avoidance – The English and American Approach” (1988) 5 Australian Tax Forum 1, wrote: Misunderstanding Lord Tomlin’s use of the word “substance,” the case was widely misunderstood as authority for the proposition that, in English tax law, form was to be preferred to substance. IRC v Duke of Westminster gave rise to two dangerous myths: that in tax cases, to an extent unknown in other areas of law, form prevails over substance, and that the substance of a transaction – and the only thing to be regarded – is its legal effect. These myths held sway for nearly 50 years.

Millett is drawing attention to a second aspect of the form versus substance debate: the extent to which the court can look beyond the enforceable legal rights created by a transaction to expected but not legally enforceable benefits, or whether the court is constrained to look only at the enforceable rights of the taxpayer. This limit upon the court confining it to look 1026

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only at enforceable legal rights was apparent in the decision of the Privy Council in which Sir Garfield Barwick participated in Europa Oil. Professor R W Parsons, Income Taxation in Australia, paras 2.420–2.427, describes this constriction to recognising only the form in which a transaction is cast and then only the legally enforceable elements of that form as an approach of “form and blinkers”. The “form” part that the term refers to is the preoccupation with legal form in characterising transactions. The “blinkers” part of the term is the deliberate restriction of the scrutiny of a transaction only to the legally enforceable parts of it. He criticises such an approach to the characterisation of transaction where the issue is whether an amount is “income” or “what has the taxpayer secured for its outgoing”? But he goes on to suggest there is a role for deferring to the form of a transaction where a specific statutory provision picks up form of the transaction and makes it the critical issue.

5. CONTAINING TAX AVOIDANCE [20.150] As mentioned above there are a number of ways to counter tax avoidance. There are

the judicial doctrines adopted by the courts, specific legislation aimed at countering specific avoidance activity (specific anti-avoidance) or general anti-avoidance rules (commonly referred to as “GAARs”). As the High Court in Fletcher v FCT [1991] HCA 42 suggested that the order in which the rules should be applied is: • first the common law rules (sham); • second, the statutory construction of s 8-1 to determine if the outgoing will be prima facie allowable as deductions (discussed above); • thirdly the application of a specific anti-avoidance rule or Part IVA; the following discussion will be structured in that order.

(a) Judicial Responses to Tax Avoidance (i) Judicially developed anti-avoidance doctrines [20.160] As well as judicial interpretation the courts have found anti-avoidance doctrines

inherent in the general deduction provision: s 8-1. In Fletcher v FCT (1991) 173 CLR 1, the High Court discovered in the former s 51(1) (now s 8-1), a general notion that an expense voluntarily incurred may not be deductible (or may not be deductible in full in the current year) when there is evidence that the amount of the deduction will exceed the likely income. That is an anti-avoidance rule, much like the legislative regime in Div 35 of the ITAA 1997, although more elastic in scope and application. The case involved a classic leverage and deferral scheme relying on the treatment of annuities under s 27H of the ITAA 1936. In essence, the taxpayers used $50,000 of their own money and borrowed a large sum of money from the promoter and its associates on limited recourse terms, and then immediately paid the total as the purchase price for a 15-year annuity. By the end of the 15-year period, the investors would get back about $170,000, giving a pre-tax return on their $50,000 investment of about 8.5 per cent. But the payments and returns were structured so as to give rise to a large tax loss in Year 1, further losses for Years 2–10, and turning tax positive only in Years 11–15. The tax losses arose because the size of the annuity receipts in the early years was small (growing larger toward the end of the annuity) and the taxpayer was able to exclude from its income the portion of each (small) annuity payment which was a return of the purchase price of the annuity (referred to as “the undeducted [20.160]

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purchase price”). The small amount of income was much more than the amount of the interest deductions they claimed for their substantial borrowings (even though the cash flows were about equal). But in the final five years, the taxable income would far exceed the cash flow, leading to the suspicion that the borrowers would then abandon the investment and leave the lenders to their limited recourse remedy to take the annuity – they would have made their return not from the cash flows under the annuity, but from the tax savings which the losses gave for their other income. The High Court denied a deduction for the interest expense to the taxpayers:

Fletcher v FCT [20.170] Fletcher v FCT (1991) 173 CLR 1 Two introductory points should be made about s 51(1). The first is that, as the words “to the extent to which” make plain, the subsection contemplates apportionment. In their joint judgment in Ronpibon Tin NL v FCT; Tongkah Compound NL v FCT (1949) 78 CLR 47 at 59, Latham CJ, Rich, Dixon, McTiernan and Webb JJ pointed out that there are at least two kinds of outgoings which require apportionment for the purposes of the subsection: One kind consists in undivided items of expenditure in respect of things or services of which distinct and severable parts are devoted to gaining or producing assessable income and distinct and severable parts to some other cause. In such cases it may be possible to divide the expenditure in accordance with the applications which have been made of the things or services. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently. As their Honours also pointed out, what represents the appropriate apportionment in the case of such items of expenditure is essentially a question of fact. The second introductory point to be made about s 51(1) is that the reference in it to “the assessable income” is not to be read as confined to assessable income actually derived in the particular tax year. It is to be construed as an abstract phrase which refers not only to assessable income derived in that or in some other tax year but also to assessable income which the relevant outgoing “would be expected to produce”. The taxpayers’ reliance in the present case is upon the first limb of s 51(1). That being so, the 1028

[20.170]

issue between the parties on this appeal resolves itself into the question whether, and if so to what “extent”, the outgoings of the amounts of interest payable to [the lenders] under the two loan agreements were, for the purposes of s 51(1), incurred during the tax years by the partnership “in gaining or producing the assessable income”. The question whether an outgoing was, for the purposes of s 51(1), wholly or partly “incurred in gaining or producing the assessable income” is a question of characterisation. The relationship between the outgoing and the assessable income must be such as to impart to the outgoing the character of an outgoing of the relevant kind. It has been pointed out on many occasions in the cases that an outgoing will not properly be characterised as having been incurred in gaining or producing assessable income unless it was “incidental and relevant to that end.” It has also been said that the test of deductibility under the first limb of s 51(1) is that “it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income”. So to say is not, however, to exclude the motive of the taxpayer in making the outgoing as a possibly relevant factor in characterisation for the purposes of the first limb of s 51(1). At least in a case where the outgoing has been voluntarily incurred, the end which the taxpayer subjectively had in view in incurring it may, depending upon the circumstances of the particular case, constitute an element, and possibly the decisive element, in characterisation of either the whole or part of the outgoing for the purposes of the subsection. In that regard and in the context of the subsection’s

Containing Tax Avoidance and Evasion

Fletcher v FCT cont. clear contemplation of apportionment, statements in the cases to the effect that it is sufficient for the purposes of s 51(1) that the production of assessable income is “the occasion” of the outgoing or that the outgoing is a “cost of a step taken in the process of gaining or producing income” are to be understood as referring to a genuine and not colourable relationship between the whole of the expenditure and the production of such income. Nonetheless, it is commonly possible to characterise an outgoing as being wholly of the kind referred to in the first limb of s 51(1) without any need to refer to the taxpayer’s subjective thought processes. That is ordinarily so in a case where the outgoing gives rise to the receipt of a larger amount of assessable income. In such a case, the characterisation of the particular outgoing as wholly of a kind referred to in s 51(1) will ordinarily not be affected by considerations of the taxpayer’s subjective motivation. If, for example, a particular item of assessable income can be earned by making a lesser outgoing in one of two possible ways, one of which is a loss or outgoing of the kind described in s 51(1) and the other of which is not, it will ordinarily be irrelevant that the taxpayer’s choice of the method which was tax deductible was motivated by taxation considerations or that the non-deductible outgoing would have been less than the deductible one. In such a case, the objective relationship between the outgoing actually made and the greater amount of assessable income actually earned suffices, without more, to characterise the whole outgoing as one which was incurred in gaining or producing assessable income. If the outgoing can properly be wholly so characterised, it “is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent”. The position may, however, well be different in a case where no relevant assessable income can be identified or where the relevant assessable income is less than the amount of the outgoing. Even in a case where some assessable income is derived as a result of the outgoing, the

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disproportion between the detriment of the outgoing and the benefit of the income may give rise to a need to resolve the problem of characterisation of the outgoing for the purposes of the subsection by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing. Where that is so, it is a “commonsense” or “practical” weighing of all the factors which must provide the ultimate answer. If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the entire outgoing will fall within the first limb of s 51(1) unless it is either somehow excluded by the exception of “outgoings of capital, or of a capital, private or domestic nature” or “incurred in relation to the gaining or production of exempt income”. If, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterised by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary. In the present case, the outgoings of interest in the tax years were incurred in the borrowing of money. The funds borrowed did not constitute assessable income. To the extent that the outgoings of interest incurred in the borrowing can properly be characterised as of a kind referred to in the first limb of s 51(1), they must draw their character from the use of the borrowed funds. That use was, in the case of the proceeds of the [main] loan, in the payment of the purchase price under the annuity agreement and, in the case of the proceeds of [another] loan, towards the repayment of interest in respect of both … loans. If the assessable income actually derived under the annuity agreement in each of the tax years had been at least equal to the actual outgoings of interest, there would, in the absence of any other [20.170]

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Fletcher v FCT cont. deductible expenses, have been little difficulty in characterising those outgoings as wholly incurred in gaining or producing that assessable income.

In fact, however, the assessable income derived from the annuity in each of the tax years was less than one-eighth of the adjusted outgoings of interest in that year.

The Court then went on to consider how it might apportion and allocate the interest expense if this was a case requiring apportionment, and how that might be affected by the possibility that the arrangement would be terminated when it started to reverse and generate large amounts of taxable income: The material before the court does not disclose the precise chain of reasoning underlying the Commissioner’s disallowance of the claim by each of the taxpayers to a deduction in respect of the alleged partnership loss in each of the tax years. … [W]here there were no outgoings other than interest, it arguably follows that … in the assessment of the net income or loss of the partnership in each of the tax years, a deduction in respect of interest should be allowed to the extent of the amount of assessable income derived by the partnership in that tax year. [T]hat is the approach which was adopted on behalf of the Commissioner in this court where it was conceded that a deduction for interest outgoings should be made in the calculation of the net income or loss of the partnership to the extent necessary to produce a nil result. That concession was, in our view, properly made. As has been seen, the outgoings of interest represented the cost of the partnership’s borrowing for the purchase of the rights under the annuity agreement. To the extent that the partnership’s outgoings of interest in a particular tax year did not exceed assessable income actually derived by the partnership under the annuity agreement in that tax year, they are properly to be characterised as incurred in gaining or producing that assessable income and were therefore deductible (pursuant to s 51(1)) in the calculation of the net income or loss of the partnership for tax purposes. Beyond that point, the mere relationship between outgoings actually incurred and the much smaller amounts of assessable income actually derived does not suffice, without more, to answer the question whether, and if so to what extent, the adjusted outgoings of interest are 1030

[20.170]

properly to be characterised as incurred in gaining or producing assessable income. That question must be answered by reference to a commonsense appreciation of the overall factual context in which the outgoings were incurred. It necessarily involves a consideration of the contents and implications of the overall contractual arrangements to which the partnership became a party and pursuant to which the outgoings of interest became payable. As will be seen, it also encompasses a consideration of the purpose which the members of the partnership, and those who advised them or acted on their behalf, had in view in incurring the outgoings. If the adjusted outgoings of interest are, on a commonsense appreciation of all the relevant facts, properly to be characterised on the basis that they were made pursuant to contractual arrangements which were expected to be fully performed in accordance with their terms with the result that the total of the projected annuity payments would actually be received by the partnership, the total assessable income which the partnership would be expected to derive would exceed the total of the adjusted outgoings of interest. On that basis, the adjusted outgoings of interest payable under the two loan agreements would properly be characterised as incurred in gaining or producing the totality of the assessable income payable under the annuity agreement over its purported fifteen-year term. So characterised, the adjusted out-goings of interest incurred in each of the tax years would be wholly deductible under the subsection. On the other hand, if the reality of the situation be that the outgoings of interest were

Containing Tax Avoidance and Evasion

Fletcher v FCT cont. incurred on the basis that the three agreements would be effectively terminated at some time during the first ten years of the fifteen-year “plan”, the total of the anticipated adjusted outgoings of interest would far exceed the total of the anticipated assessable income under the “plan”. On that approach, the excess of the adjusted outgoings of interest over assessable income in each of the tax years could not be explained by reference to surplus assessable income which was expected to be derived in subsequent years. To the contrary, it would be necessary to look for some other explanation of the planned expenditure of outgoings of interest which exceeded assessable income in the first ten years of the income. That explanation would obviously be found in the operation and anticipated consequences of the three agreements in the context of a planned termination of them all during the first ten years. To the extent that the surplus of partnership outgoings of interest over annuity receipts in each of the tax years were to be explained [by the very substantial tax advantages derived in the early years], the outgoings could not properly be characterised, for the purposes of s 51(1), as incurred in gaining or producing assessable income or as not being “of a capital, private or domestic nature”. It follows that, subject to the possible effect of Pt IVA and s 82KL of the Act, the

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deductibility under s 51(1) of the excess of the partnership’s adjusted interest outgoings over the partnership’s assessable income in each of the tax years turns upon whether those adjusted outgoings of interest are to be seen as payments made pursuant to a fifteen-year “plan” which could be expected to run its course or as payments made under a fifteen-year “plan” which was structured and expected to be terminated by the partnership before the commencement of its eleventh year. The question whether the outgoings of interest were incurred on the basis or in the expectation that the fifteen-year plan would in fact run its full course is a question of fact. As such, the onus of proof in relation to it lay upon the taxpayers. In the circumstances of the present case, its determination involves consideration not only of the purposes of the taxpayers but also of the purposes of those who advised them and acted on their behalf and whose “acts (and intentions)” as agents must be imputed to the principals. There is however no express finding in relation to it in the reasons or judgment. It is obviously regrettable that the already protracted proceedings in this case should be permitted to enter yet a further phase. Nonetheless, the appropriate course in all the circumstances is to remit the matter to the Administrative Appeals Tribunal to enable the necessary further finding of fact to be made.

(ii) Sham transactions [20.180] If the parties to a transaction enter into it while intending not to carry it out, or as a

disguise for some other transaction, they are said to have perpetrated a sham. As Diplock LJ put it in Snook v London West Riding Investments Ltd [1967] 2 QB 786 at 802: “If it has any meaning at law, ‘sham’ means acts done or documents executed by the parties to the sham which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.” Logic dictates that Pt IVA is not required to strike down a sham transaction which has no effect in law. A striking example of the effect of a sham in a taxation case came before the High Court in Raftland Pty Ltd v FCT (2008) 68 ATR 170; [2008] HCA 21. The taxpayer was the trustee of a discretionary trust established for the principals of a house-building business. In order to minimise tax on the forecasted substantial profits of the business the trustee acquired as a [20.180]

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beneficiary and became the trustee of a unit trust with accumulated losses. The unit holders otherwise remained the same. The taxpayer, Raftland, having received $2.849 m income from the business via another trust, then resolved to distribute it to the unit trust. Only $250,000 was actually paid and it was found that the parties never intended that the taxpayer would ever pay the balance owing. The plan was that it would be accepted that the unit trust would be treated as having derived the income and not be taxed, but that the balance owing would be retained by Raftland. The ATO did not invoke Pt IVA but argued that in substance there was a reimbursement agreement and that s 100A of the ITAA 1936 applied to tax Raftland on the balance it retained. The High Court accepted this argument, pointing out that this result came about precisely because it was intended by the parties to ignore the effect of adding the unit trust as a beneficiary, except for the payment of the $250,000. Kirby J, while agreeing, was concerned to point out that the sham doctrine had an important role to play in combating tax avoidance: 152. For a court to call a transaction a sham is not just an assertion of the essential realism of the judicial process, and proof that judicial decision-making is not to be trifled with. It also represents a principled liberation of the court from constraints imposed by taking documents and conduct solely at face value. In this sense, it is yet another instance of the tendency of contemporary Australian law to favour substance over form. As such it is to be welcomed in decision-making in revenue cases.

Another example of a sham was found in Case 111 (1981) 24 CTBR(NS) 898. In this case the taxpayers arranged to have a family discretionary trust established. The taxpayers then borrowed $6,000 which they paid to the trust as a fee for management services provided by the trust to the taxpayers’ business. That $6,000 was then credited to the taxpayers’ children who were the beneficiaries of the trust. The children then paid the $6,000 to their parents to reimburse them for the cost of their upbringing. The parents then repaid their loan. The trust employed no staff and provided no obvious services to the business. There was no communication setting out the nature of the services to be provided, nor the fee to be charged. The ATO denied the deduction for the service fee and increased the parents’ taxable income by $3,000 each. Dr Beck, Member, held that the transaction was a sham: Crediting trust income originating with parents back to them has all the hallmarks of a sham. On his own evidence it has to be concluded that [the father] never intended to pay over or lose control of any partnership funds and the trust did not do, and was not intended to do, what it purported by its terms to do, viz benefit certain beneficiaries by distributing trust income to them. The distributions were pretended as distinct from real transactions. A sham fails without the aid of s 260 but even if the sham aspect is ignored the arrangements entered into by the taxpayer seem likely to fall foul of s 260. That section has few teeth left [remember that Dr Beck is writing in 1981] but it does not require a very strong bite to annihilate arrangements such as those undertaken by this taxpayer.

In AAT Case 4708 (1988) 19 ATR 4040, the Tribunal held that since none of the transactions alleged to occur actually took place, the payment which purported to be a trust distribution was a sham. It needs to be remembered, however, that most sophisticated tax schemes are intended to operate in exactly the way the documents cast the transactions, and therefore the sham doctrine is of little use in such cases to the ATO. [20.185] The sham issue was again addressed by the Full Federal Court in Millar v FCT [2016] FCAFC 94. The taxpayers had entered into a loan facility agreement a Samoan bank (Hua Wang Bank Berhad (HWBB)) under which the bank loaned money to the taxpayers to purchase an apartment. The loan transaction required the taxpayers to place an equivalent 1032

[20.185]

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amount of $600,000 on deposit with HWBB, sourced from their superannuation fund. HBBB was an entity associated with Mr Gould, the taxpayers’ accountant and financial advisor. At first instance (Re Morrison and FCT [2015] AATA 114) the AAT held that the purported loan transaction, by which the taxpayers, husband and wife, “borrowed” from a bank in order to purchase an apartment, was a sham. In dismissing the taxpayer’s appeal to the Federal Court in Millar v FCT [2015] FCA 1104, Griffiths J noted: [133] It seems to me that the core of this appeal essentially relates to the applicants’ burden under s 14ZZK of the TAA 1953. To discharge this burden the applicants had to defeat the Commissioner’s claim that the loan was a sham. In the particular circumstances of this case it was insufficient for them simply to persuade the AAT (as they did) that they genuinely believed and intended that the transaction was a loan. The difficulty the applicants faced was that, as the AAT found, they placed their total trust and faith in Mr Gould ([83] of the AAT’s reasons for decision), such that Mr Gould’s actions were “properly imputed to the taxpayers” (at [84]). Once that point was reached, and given all the unanswered questions regarding the transaction which the AAT found Mr Gould could probably answer because of his prominent role in implementing and administering the arrangements (see [46]-[50]), it was a short and legitimate further step for the AAT to find that, because the evidence left unclear what Mr Gould’s intention was, the applicants failed to discharge their burden of demonstrating that the assessments were excessive. It may well be that, in a different set of circumstances, the taxpayers’ subjective intentions would carry more if not decisive weight. In my view, however, the applicants have failed to establish any legal error in the AAT’s approach in the particular circumstances here.

The taxpayers’ appeal to the Full Federal Court in Millar v FCT [2016] FCAFC 94 was also dismissed by the majority, Logan J dissenting.

Millar v FCT [20.187] Millar v FCT [2016] FCAFC 94 Full Federal Court Justice Pagone noted: [45] The Tribunal in the present case was not obliged to accept as sufficient the evidence of the Millars of a belief that their superannuation fund had made a deposit with the Samoan entity and that they had obtained a separate legally effective loan from the Samoan entity on the terms of the loan agreement rather than to have accessed their superannuation money by pretence. The evidence before the Tribunal gave rise to the question, as it did in Raftland, of whether the documents were to be taken at face value. I have had the benefit of reading the reasons of Davies J in draft before publishing our reasons and respectfully agree with her Honour’s conclusions and reasons that the approach taken by the Tribunal was correct. The Millars may well not have had a positive

intention to create a pretence, as the Tribunal found, but whether they had discharged their burden of proving that the transactions with the Samoan entity were not shams depended also upon establishing that they had created that which the impugned transactions purported to create. To discharge that burden it was necessary to look more broadly at the impugned transactions and at the complexity of Mr Gould’s position. Mr and Mrs Millar, like the taxpayers considered in Raftland, were not lawyers and relied upon what they had been told by Mr Gould. The Tribunal recorded at [12] that the Millars had asked Mr Gould to recommend any further funding sources to obtain the balance needed to cover the purchase price, stamp duty and incidentals and that Mr Gould had explained that they

[20.187]

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Millar v FCT cont. could obtain the funds needed through a dealing with the Samoan entity … Mr and Mrs Millar, like the Heran brothers and Mr and Mrs Thomasz in Raftland, may not have turned their minds to the complexity of the documents and transactions presented to them by their adviser, and may have had no reason to take them other than at face value. Mr and Mrs Millar, like the Heran brothers in Raftland, may have believed that their superannuation fund was making a legally effective deposit and that they were entering into a legally effective loan transaction which would have the legal effects they wished it to have, but the Tribunal was not bound to find, as his Honour observed at [133] on appeal, that they had discharged their burden of proof by their evidence of that belief. The evidence of Mrs Millar was little more than that she intended to effect whatever Mr Gould had advised and, to that extent, is of the same kind as that described in Raftland at [48] of an intention to do whatever their advisor regarded “as necessary to secure the fiscal objective of the

exercise”. Mr and Mrs Millar did not deal directly with anyone at the Samoan entity in respect of the transactions but dealt only through Mr Gould. The Millars needed to establish that they had entered into the transactions with the legal effects which the impugned transactions purported to have. They could not establish that only by their evidence that they believed Mr Gould when he informed them that the superannuation fund would be making a legally effective deposit and that they would be entering into a legally effective loan by contracting with the Samoan entity in the context in which they purported to do so. To rebut the shamming intention they needed, at least, to establish that they had entered into a legally effective loan with the Samoan entity and not merely that they believed Mr Gould that they had done so by accepting the arrangement he had put to them. They needed, in other words, to prove what the true position actually was and not only that they believed Mr Gould’s representation of it. The evidence which the Millars were able to give fell short of disproving sham because they could not prove without further evidence that the transactions were as they purported to be.

(iii) Fiscal nullity [20.190] An

interesting development development in judicial approaches to the characterisation of transactions is the development in England of the “fiscal nullity” doctrine. This doctrine was first expounded in a series of three judgments of the House of Lords beginning with WT Ramsay Ltd v IRC [1982] AC 300. The doctrine which these cases are said to have created is referred to as “fiscal nullity”, but its precise content and meaning is unclear. Ramsay was followed in 1982 by a further decision of the House of Lords, IRC v Burmah Oil Co Ltd [1982] STC 30 and a third decision of the House of Lords in Furniss v Dawson [1984] 2 WLR 226. In each case the Court struck down a “paper scheme” – that is, one which we would call “blatant artificial and contrived”. Lord Brightman attempted to specify the circumstances in which the Ramsay doctrine of “fiscal nullity” ought to be applied: The formulation by Lord Diplock in IRC v Burmah Oil Co Ltd [1982] STC 30, 33 expresses the limitations of the Ramsay principle. First, there must be a pre-ordained series of trans-actions; or, if one likes, one single composite transaction. This composite transaction may or may not include the achievement of a legitimate commercial (that is, business) end. The composite transaction does, in the instant case; it achieved a sale of the shares in the operating companies by the Dawsons to Wood Bastow. It did not in Ramsay. Secondly, there must be steps inserted which have no commercial (business) purpose apart from the avoidance of a liability to tax – not “no business effect”. If those two ingredients exist, the inserted steps are to be disregarded for fiscal purposes. The court must then look at the end result. Precisely how the end result will be taxed will depend on the terms of the taxing statute sought to be applied. 1034

[20.190]

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The doctrine represented by these cases is not one that has been welcomed in Australia. In FCT v Ilbery (1981) 12 ATR 563 the Federal Court observed obiter that this doctrine of fiscal nullity was possibly applicable to the Australian tax system but they expressed some caution in their adoption of it as our legislation has an express anti-avoidance rule. The less than wholehearted adoption of Ramsay was followed by its explicit rejection in Oakey Abbattoir Pty Ltd v FCT (1984) 15 ATR 1059 by the Federal Court. Fox, Fisher and Beaumont JJ rejected any potential application of the fiscal nullity doctrine in Australia, suggesting that the field was covered by our general anti-avoidance provisions: the former s 260 and Pt IVA. This view was reinforced by the High Court’s judgment in John v FCT (1989) 166 CLR 417 where the Court observed: One general rule [of statutory construction], expressed in the maxim, expressum facit cessare tacitum, is that where there is specific statutory provision on a topic there is no room for any further matter on the same topic. The Act, in s 260 and now in Pt IVA, makes specific provision on the topic of what may be called tax minimisation arrangements and thereby excludes any implication of a further limitation upon that which a taxpayer may or may not do for the purpose of obtaining a taxation advantage.

Subsequent developments in the UK on fiscal nullity seek to treat it not as a specific tax rule but as the expression of a general principle of statutory interpretation. For example in Macniven v Westmoreland Investments Ltd [2001] UKHL 6, Lord Nicholls said, “the very phrase ‘the Ramsay principle’ is potentially misleading. In Ramsay the House did not enunciate any new legal principle. What the House did was to highlight that, confronted with new and sophisticated tax avoidance devices, the courts’ duty is to determine the legal nature of the transactions in question and then relate them to the fiscal legislation.” He went on to speak of “the Ramsay principle or, as I prefer to say, the Ramsay approach to ascertaining the legal nature of transactions and to interpreting taxing statutes …”. Hence the UK courts have had some difficulty defining its scope, meaning and application and it is by no means clear when and how it will apply. Subsequent UK cases such as Craven v White (1988) 62 TC 1, Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226 have considered and downplayed the doctrine and it was thought to be in some decline until the decision in IRC v McGukian [1997] UKHL 22 which applied the Ramsay principle to a profit-stripping scheme. But then in 2001, in the House of Lords decision in Macniven v Westmoreland Investments Ltd [2001] UKHL 6, the House of Lords refused to apply it to another arrangement even though there was a “pre-planning” element, and the “no commercial effect” aspects of Ramsay seemed to be in play. In two cases decided together in 2004 the House of Lords applied the fiscal nullity doctrine in one case but not in another, even though both were examples of aggressive commercial tax planning: see IRC v Scottish Provident Institution [2004] UKHL 52 (where the taxpayer lost) and Barclays Mercantile Finance Ltd v Mawson [2004] UKHL 51 (where the taxpayer succeeded). Lord Hoffman who was a party to both decisions explained in a subsequent article in the British Tax Review [2005] BTR 197 that both were decided according to the ordinary rules of statutory interpretation. He wrote: “The primacy of the construction of the particular taxing provision and the illegitimacy of rules of general application have been reaffirmed by the recent decision of the House in Barclays Mercantile Business Finance v Mawson. Indeed it may be said that this case has killed off the Ramsay doctrine as a special theory of revenue law and subsumed it within the general theory of the interpretation of statutes…” This general theory, Lord Hoffman pointed out, includes the proposition that the court should give effect to what it divines to be the purpose of the statute. [20.190]

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Judicial attitudes to tax avoidance both in Australia and elsewhere are constantly evolving, but in the realm of general anti-avoidance doctrines the judicial role is crucial. Judges are being asked to make policy decisions, such as the permissibility of income splitting or the encouragement of certain forms of investment. It is not obvious that they are best placed to make such decisions, but for better or worse they are stuck with the task. It is no doubt some consolation to them that if the Treasury does not like the result, remedial legislation will soon follow.

(b) Statutory Responses to Avoidance [20.200] This section will explore the statutory provisions enacted to contain avoidance

activity. Parliament often enacts remedial legislation in an attempt to overcome specific court decisions – ss 82KJ and 82KL of the ITAA 1936 are examples of this, enacted to overcome the decision in South Australian Battery Makers. In most cases courts will not remedy the ills their interpretations have created – instances such as John v FCT (1989) 116 CLR 417, where the High Court overruled Curran, are extremely rare and always belated. So, in most cases it is left to Parliament to address problems arising from what it perceives to be unacceptable judicial decisions. Legislative responses to tax avoidance have included both specific and, in some cases, extremely general anti-avoidance provisions. We will start with the specific antiavoidance rules in. Examples of specific anti-avoidance rules included: • penal rates – certain income of children,; • allowing the ATO wide discretion – trusts, private company status, certain deductions; • specific anti-avoidance provisions to cover particular devices – eg trust stripping (s 100A of the ITAA 1936), anti-dividend streaming (s 45A of the ITAA 1936); • specific anti-avoidance provisions of general application – non-arm’s length trading stock purchases (s 70-20 of the ITAA 1997); payments to related persons (s 26-35 of the ITAA 1997); cost of a depreciable asset where not dealing at arm’s length and consideration is greater than market value (s 40-180(2) item 8 of the ITAA 1997); and transfer pricing (Subdivs 815-B and 815-C of the ITAA 1997); • more onerous criminal sanctions for evasion, backed up by resourced enforcement; • application of penalty tax to participants in unsuccessful tax avoidance schemes consistent with the penalty approach to tax evasion; and • fining the promoters of unsuccessful schemes – Div 290 of Sch 1 of the TAA. As there are numerous specific anti-avoidance rules it is not possible to discuss them in detail. Therefore, the following discussion will focus on three specific anti-avoidance rules: the promoter penalty rules; the non-commercial loss rules; and the specific rules dealing with “losses and outgoings incurred under certain tax avoidance schemes”. (i) Penalties for promoters [20.210] Following the proliferation of mass-market schemes in the 1990s and the report of

the Senate Economics Committee Inquiry into Mass-Marketed Tax Effective Schemes and Investor Protection in 2001–2002, the government introduced a penalty regime to be imposed on the promoters of “tax exploitation” schemes. This regime, Sch 1 Div 290 of the Taxation Administration Act 1953 (TAA 1953), is not limited to income tax. It empowers the ATO to request the Federal Court to impose a civil penalty of up to 5,000 penalty units on an individual promoter or up to 25,000 penalty units on a body corporate (the value of a 1036

[20.200]

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“penalty unit” is prescribed in s 4AA of the Crimes Act 1914), or twice the fees received by the promoter in respect of the scheme, whichever is the greater: s 290-50 of Schedule 1 of the TAA 1953. The ATO can also apply to the Federal Court for an injunction to stop the promotion of a scheme, or the implementation of a scheme not in accordance with a “product” ruling: Subdivision 290-B of Schedule 1 of the TAA 1953. This power requires the ATO to be more proactive than it has been in the past, and gives the ATO an opportunity to step in before major damage is done. A “tax exploitation scheme” is defined in s 290-65 as a scheme where it is reasonable to conclude that an entity has entered or carried out the scheme or would enter or carry out the scheme with the sole or dominant purpose of that or another entity getting a “scheme benefit” as defined in s 284-150 (in effect a tax benefit) from that scheme. Although the language closely parallels that of Pt IVA, the Full Federal Court in FCT v Ludekins [2013] FCAFC 100 held that unlike s 177C, s 284-150 did not require a determination of an “alternative postulate” (a comparative position). The Full Federal Court noted at [36] that: …[i]t is the assessment of a purpose attending activity (entering into or carrying out the scheme) at the time of conduct of a promotional kind, which is the mischief to which the provisions are directed. That purpose does not involve notions of alternative positions.

Also, for there to be a tax exploitation scheme, it must not be “reasonably arguable” that the benefit the scheme produces is available at law, a concept taken from the penalty provisions in Div 284 of Sch 1 of the TAA 1953. Section 290-60(1) defines a “promoter” as an entity who markets the scheme or otherwise encourages the growth of the scheme or interest in it, receives consideration for so doing and “having regard to all relevant matters, it is reasonable to conclude that the entity has had a substantial role in respect of that marketing or encouragement”. The Full Federal Court in FCT v Ludekins [2013] FCAFC 100, paras [248] to [278] noted held that the words used in paragraph 290-60(1)(a) are wide, and are not limited to making offers to participate in a scheme. The Full Federal Court noted at [257]: Whilst care needs to be taken with the use of dictionaries … “market” as a verb is not easily limited to making offers to participate. The Shorter Oxford English Dictionary (5th ed, Oxford University Press, 2002) includes in the definition of “market” (as a verb) the promotion or distributing for sale. The verb “to promote” is defined as including the furtherance of the growth, development, progress or establishment of (a thing); to encourage, help forward or support actively (a course or process); and to publicise (a product) or advertise so as to increase sales or public awareness. Once the potential width of such words is recognised, it is a mistake necessarily to exclude from them all conduct, which, looked at individually, answers the description of development or implementation. Such conduct may, in its proper context, form part of a body of conduct, which, examined as a whole, amounts to marketing, or encouraging the growth of or interest in, a scheme.

However, a “carve-out” is provided for the givers of advice, such as lawyers, accountants and financial advisers. Section 290-60(2) provides that an entity is not a promoter merely because it provides advice about the scheme, and s 290-60(3) provides that employees are not to be taken to have had a substantial role in respect of marketing or encouragement merely because they distribute information or material prepared by someone else. The difficulty is that the border between merely advising a client and encouraging him or her to go into a scheme is not clearly defined. If an adviser were to be remunerated according to the amount of tax saved by the scheme it could be argued the adviser was in substance a promoter. But even [20.210]

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an adviser charging “normal” professional fees could be classified as a promoter if he or she were to devise a tax-saving strategy for a client and then persuade them to adopt it. (ii) Non-commercial losses (Division 35 ITAA 1997) [20.220] Chapter 5 has already examined the provisions of Div 35 of the ITAA 1997. It serves

as an anti-avoidance measure designed to deal with prepayment and deferral-based tax avoidance schemes. It arose out of recommendations in Chapter 7 of the report of the Review of Business Taxation and was undoubtedly driven in large part by the mass-marketed tax-effective scheme phenomenon of the mid-1990s. Division 35 adopts a timing-based approach when it applies. It quarantines and defers an individual taxpayer’s loss from a relevant activity and prevents the loss reducing the taxpayer’s other income in that year. The loss can be carried forward and used in later years but again only to reduce assessable income from that activity. (iii) Losses and outgoings incurred under certain tax avoidance schemes (ss 82KH to 82KL ITAA 1936) [20.230] Another series of provisions we have already looked at briefly are ss 82KH – 82KL.

They were enacted in response to the South Australian Battery Makers case and deal with three types of tax avoidance schemes: 1.

Schemes where an excessive allowable deduction is incurred by the taxpayer in order that an associate can acquire another item of property at a reduced (non-deductible) cost: s 82KJ. 2. Schemes where payments are made between associated taxpayers which generate allowable deductions to one of them in the current year but give rise to income to the other only in a later year: s 82KK. 3. Schemes where the taxpayer effectively recoups an expenditure because the sum of the tax benefit and any additional benefit is greater than the amount of the expenditure: s 82KL. These sections are extremely technical because they were drafted with particular operations in mind. This approach should be contrasted with the approach of s 260 or Pt IVA, which have few specific transactions in mind. But because the provisions are so precisely drawn (and have had the effect of inducing taxpayers to substitute transactions which are differently cast) the ATO almost never uses them and, when it does try to apply them often does so to transactions which vary from the model. For example, the ATO unsuccessfully attempted to rely upon s 82KL in FCT v Lau (1984) 16 ATR 55. Hence, they sit in the legislation as an unexplored danger to which the ATO will often refer (as in TR 2000/8) but which rarely seem to be used. (iv) Section 260 and Part IVA

History [20.240] The federal income tax legislation has always contained a general anti-avoidance

provision, inherited from prior land tax enactments. Under the ITAA 1936 this was to be found in s 260 which provided that any arrangement which had the purpose or effect of altering the incidence of income tax was “absolutely void as against the Commissioner”. Although the ATO succeeded in invoking s 260 in some earlier decisions, it merely cancelled 1038

[20.220]

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transactions and did not allow him to reconstruct the taxpayer’s accounts. In the 1960s and 1970s the courts read into the section a number of further limitations which rendered it practically useless. As a result, Parliament enacted a new general anti-avoidance provision in Pt IVA of the ITAA 1936, to apply to arrangements made after 27 May 1981. It is ironic that post the enactment of Part IVA, s 260 seems to have acquired a vigour and potency which the courts denied during its currency: see FCT v Gulland, Watson, Pincus (1985) 85 ATC 4765 where the High Court applied s 260 to a group of doctors who had organised their medical practice through a company/trust structure to save tax. Given the history of judicial attitudes to s 260, the ATO was initially reluctant to apply Part IVA. Authorisations to make determinations were limited to the Second Commissioner level and it took 10 years before there was litigation involving Part IVA. The first matter argued was in 1987, the decision in favour of the Commissioner handed down by the AAT on 23 December 2007 – Case No V160 (1988) 88 ATC 1058 (AAT Case 4708 (1988) 19 ATR 4040) – an annuity scheme. Although it took 15 years before the High Court delivered a judgment on the main provisions of Pt IVA, the Court has refused to read down the provisions in the same way as occurred with s 260 and give it a broad operation. However, subsequently the courts have identified a number of situations where Pt IVA as originally enacted did not apply, which in turn has resulted in some major amendments.

Introduction to Part IVA [20.250] The key provision in Part IVA is s 177D. In order for s 177D to apply, the

transaction must have been entered into or carried out after 27 May 1981 (s 177D(4)) and the following criteria must be satisfied on the facts. There must be: • a scheme (s 177A); • a tax benefit (ss 177CB and 177C); and • having regard to eight matters stated in s 177D(2), it can be concluded that a person associated with the scheme entered into the scheme for the purpose (“sole or dominant”) of enabling the taxpayer to obtain a tax benefit. Following the 2013 amendments to Part IVA the first question to be answered when determining whether Part IVA applies to a scheme is to ask whether a participant in the scheme had the requisite purpose of securing a tax benefit for the taxpayer in connection with the scheme: ss 177D(1) and (2). The questions whether a tax benefit was obtained in connection with the scheme and whether the scheme was entered into or commenced to be carried out after 27 May 1981 follow as subsidiary questions: ss 177D(3) and (4). In defining the scope of Part IVA it is clear from the High Court’s decision in FCT v Spotless Services Ltd [1996] HCA 34, that previous court decisions in respect of s 260 have no operation in respect of Part IVA, as the Part is to be construed and applied in light of its own wording. The majority of the Court (Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ) stated: Part IVA is to be construed and applied according to its terms, not under the influence of “muffled echoes of old arguments” concerning other legislation. In this court, counsel for the taxpayers referred to the repetition by the Privy Council in IRC v Challenge Corporation of the statement by Lord Tomlin in IRC v Duke of Westminster that “[e]very man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be.” Lord Tomlin spoke in the course of rejecting a submission that in assessing surtax under the Income Tax Act 1918 (UK) the Revenue might disregard legal form in favour of “the substance of the matter”. His remarks have no significance for the present [20.250]

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appeal. Part IVA is as much a part of the statute under which liability to income tax is assessed as any other provision thereof. In circumstances where s 177D applies, regard is to be had to both form and substance (s 177D(b)(ii)).

Where both Part IVA and a “specific” anti-avoidance provision apply to a deduction, s 177B(3) and (4) makes it clear that Pt IVA is only to be applied to deductions which are otherwise allowable, that is to deductions not disallowed by a specific provision.

Scheme [20.260] The notion of a “scheme” is critical to the operation of Pt IVA. Section 177A(1)

contains a definition of a scheme which is supplemented by s 177A(3) to include unilateral schemes. It includes any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings, and any scheme, plan, proposal, action, course of action or course of conduct. Defining precisely the scope of the scheme is important. As noted by Gleeson CJ and McHugh J in FCT v Hart [2004] HCA 26 at [5] (agreeing with Hill J in the Full Federal Court): “the definition of the scheme is important because any tax benefit identified must be related to the scheme, as must any conclusion dominant purpose, and also the ultimate determination.” Section 177D(1) says that a person must have held a particular purpose when entering into or carrying out the scheme or any part of it, and s 177A(5) says it must be the sole or at least a dominant purpose. Logically, it would be expected that taxpayers will argue for a broad compass to their “scheme” – that the scheme comprises many steps and transactions – so that any tax avoidance purpose can’t be seen to be a dominant purpose because so much else was sought and achieved by this broad scheme. The ATO, on the other hand, would argue that the scheme comprises just a few steps to make it easier to argue that a scheme was entered into for the dominant purpose of obtaining a tax benefit. This issue was addressed in Peabody v FCT [1994] HCA 43. The High Court stated that: Pt IVA does not provide that a scheme includes part of a scheme and it is possible, despite the very wide definition of a scheme, to conceive of a set of circumstances which constitutes only part of a scheme and not a scheme in itself. That will occur where the circumstances are incapable of standing on their own without being “robbed of all practical meaning” (See Inland Revenue Commissioners v Brebner [1967] 2 AC 18 at 27). In that event, it is not possible in our view to say that those circumstances constitute a scheme rather than part of a scheme merely because of the provision made by ss 177D and 177A. The fact that the relevant purpose under s 177D may be the purpose or dominant purpose under s 177A(5) of a person who carries out only part of the scheme is insufficient to enable part of a scheme to be regarded as a scheme on its own. That, of course, does not mean that if part of a scheme may be identified as a scheme in itself the Commissioner is precluded from relying upon it as well as the wider scheme.

FCT v Consolidated Press Holdings Ltd [20.270] FCT v Consolidated Press Holdings Ltd (2001) 207 CLR 235; [2001] HCA 32 This view was reconfirmed in Consolidated Press Holdings v FCT [2001] HCA 32. The case considers both the application of the ordinary Pt IVA rules and dividend stripping which is a special form of avoidance dealt with specifically in s 177E. In this 1040

[20.260]

case, the High Court found tax avoidance to emerge from the way in which the Consolidated Press group had organised its corporate finance in connection with a proposed foreign takeover.

Containing Tax Avoidance and Evasion

FCT v Consolidated Press Holdings Ltd cont. As it turned out, the bid did not proceed. The structure was set up as follows: • Step 1. Consolidated Press Holdings borrowed $450 m in Australia in order to finance its participation in a takeover bid for a UK company, BAT Industries plc. • Step 2. This money was then used to subscribe for redeemable preference shares in Murray Leisure Group (MLG), an Australian subsidiary in the Consolidated Press group. • Step 3. MLG in turn subscribed for shares in another Consolidated Press subsidiary, the British company Consolidated Press International Ltd (CPIL(UK)). • Step 4. The directors of CPIL(UK) then agreed to lend the money to a Singapore company which would then invest in Hoylake Pty Ltd, the ultimate vehicle to be used for the takeover bid. While the takeover bid was being put together, Consolidated Press was incurring substantial amounts of interest expense on the borrowed funds. It claimed that the interest was deductible in Australia under s 51(1) because it had used the funds to subscribe for shares in a resident company (MLG) which would pay taxable dividends to Consolidated Press – in other words, the interest expense was incurred in earning Australian-source assessable dividend income. The ATO argued, however, that Pt IVA applied to the taxpayer because it had entered a scheme with the dominant purpose of securing a tax benefit – the deductibility of the interest expense against its Australian source income. The ATO argued Step 2 had been put in just for tax reasons. If tax considerations had not dominated, Consolidated Press would have bought the shares in CPIL(UK) itself but then it would have had a problem: it would have a small amount of foreign-source income and very large

CHAPTER 20

deductions relating to it. When that situation arises, the overall foreign loss is trapped by the former s 79D and is deferred to be used in later years – the foreign loss cannot be deducted from local income. But by interposing MLG at Step 2, Consolidated Press now was able to argue it was making Australian-source income in the form of dividends flowing from CPIL(UK) to MLG and then to Consolidated Press and so the interest was incurred to earn Australian-source dividends paid by MLG, and was not affected by s 79D. The High Court agreed with the ATO and applied Pt IVA to the transaction. In respect of the scheme the Court first examined the extent and nature of the scheme so far as the ATO had defined it: In contending that a tax benefit was obtained in connection with a scheme, the Commissioner identified, as the relevant scheme, part only of the total plan or course of conduct involved in the corporate arrangements that were made within the Group for the purposes of the BAT takeover bid. Subject to the arguments of the taxpayer considered below, this was open to the Commissioner. The essence of the scheme was said to be the interposition of MLG between ACP and CPIL(UK). The plan was said to have been conceived by the tax advisors, Arthur Young, and adopted by ACP and MLG. The key steps were the acquisition by subscription by ACP of redeemable preference shares in MLG and the acquisition by subscription by MLG of redeemable preference shares in CPIL(UK) and, in each case, the payment of the allotment moneys. The Court confirmed that the ATO can select a small part of a larger transaction (ie just Step 2 here) as the scheme for the purposes of Pt IVA, provided that the part identified could stand independently as a scheme in its own right.

[20.270]

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[20.280] What constitutes the “scheme” varies from case to case.

British American Tobacco Australia Services Ltd v FCT [20.285] British American Tobacco Australia Services Ltd v FCT [2010] FCAFC 130 Full Federal Court The Full Federal Court noted: 30 By the express terms of Pt IVA, a “scheme” is not necessarily limited to the “step” that “produces” a tax benefit. “Scheme” is defined broadly in s 177A for Pt IVA: Hart at [43], [47] – [50], [55]; Commissioner of Taxation v Consolidated Press Holdings (No 1) [1999] FCA 1199; (1999) 91 FCR 524 at [75] – [81]; Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 at 425 and Commissioner of Taxation v Peabody [1994] HCA 43; (1994) 181 CLR 359 at 378 and 380. Pt IVA does not provide that a scheme includes part of a scheme: Hart at [41] citing Peabody at 383. However, paragraph (b) of the definition of “scheme” in s 177A(1) provides that it includes a scheme, plan, proposal, action, course of action or course of conduct. The inclusion of the words in italics reflects that the definition of a scheme may not always permit the precise identification of what are said to be all of the integers of a particular scheme and that a scheme can encompass a series of steps which together constitute a “scheme” or “plan” or the taking of a single step (by reference to the word “action”): Hart at [39] – [47]. 31 Other sections in Pt IVA also expressly acknowledge that a “scheme” within the meaning of s 177A(1) is not necessarily limited to the step which produces the tax benefit. Section 177D, which identifies the schemes to which Pt IVA applies (Hart at [34]), provides that it applies where it would be concluded that the person or persons who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the taxpayer to obtain a

tax benefit in connection with the scheme. Section 177A(5) then goes on to provide that the reference to a scheme or part of a scheme being entered into or carried out for a particular purpose is to be read as including a reference to the scheme or the part of a scheme being entered into or carried out for two or more purposes of which that particular purpose is the dominant purpose: Hart at [34] – [36]. Each section proceeds on the assumption that it is at least possible that a scheme may be comprised of more than one step or part. 32 The Appellant’s reliance on the opening words in the definition of scheme in s 177A(1), “unless the contrary intention appears”, does not advance the argument. There is nothing to support the contention that it is necessary to read the definition of ″scheme″ in s 177A(1) more narrowly for the purposes of s 177C(2A): cf Hart at [54]. First, s 177C is directed to the issue of identification of the tax benefit. Subsection (1) identifies how a tax benefit can be obtained. Subsections (2), (2A) and (3) identify exclusions to a taxpayer obtaining a tax benefit in connection with a scheme. … 38 If parliament had intended to limit “scheme” in Pt IVA to a “step” that “produces” a tax benefit, it could have done so expressly. It did not. If Parliament had intended to adopt a different definition of “scheme” for the purposes of s 177C(2A) it could have done so expressly and at the time s 177C(2A) was enacted. It did not. The trial judge correctly identified the “Scheme” as a scheme within the meaning of s 177A(1).

A tax benefit [20.290] The tax benefit test is crucial to the operation of Part IVA as there must be a “tax

benefit” obtained in connection with the scheme, and it must be reasonable to conclude, after having regard to eight objective criteria (in s 177D(2) of the ITAA 1936) that a person entered into the scheme for the “sole or dominant purpose” of enabling a taxpayer to obtain the “tax benefit”. Part IVA countenances several people being involved in this transaction: it is clear 1042

[20.280]

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that the person who organised the scheme need not be the taxpayer who secures the tax benefit. However, the tax benefit must accrue to the person assessed – see Peabody v FCT [1994] HCA 43 (trust) and Channel Pastoral Holdings Pty Ltd v FCT [2015] FCAFC 57 cf, FCT v Macquarie Bank Ltd [2013] FCAFC 13 (formation of a consolidated group). Section 177C as originally enacted defined a tax benefit as: (i) an amount not being included in assessable income; or (ii) being allowed as a deduction which, but for the scheme, might reasonably have been expected to be included as income or denied deductibility. This definition was a major limitation on the definition of tax benefit as there are many other benefits that taxpayers can try to secure which would not be captured under this test. For example it did not cover withholding tax. As a result in 1997 Part IVA was amended, with effect from 20 August 1996, to deem a reduction in withholding tax to be a tax benefit: s 177CA. A number of other amendments followed. In 1999 s 177C(1) was amended, with effect from 29 April 1997, to treat additional entitlements to capital losses as a tax benefit (s 177C(1)(ba)) and, with effect from 13 August 1998, to treat a foreign tax offsets as a tax benefit (s 177C(1)(bb)). Ultimately, in 2013 this separate withholding tax rule in s 177CA was incorporated into s 177C(1), as s 170C(1)(bc), with effect from 16 November 2012. This last change was to ensure that a withholding tax benefit would be covered by the broader tax benefit changes that occurred in 2013. [20.300] A “tax benefit” is currently defined in s 177C(1) to be:

• an amount not included in assessable income in that year: s 170C(1)(a); • a deduction granted or an increase in an allowable deduction: s 170C(1)(b); • additional entitlements to capital losses: s 170C(1)(ba); • foreign income tax offset: s 170C(1)(bb); • loss carry back tax offset: s 170C(1)(ba); • withholding taxes: s 170C(1)(bc). The words “that year” in s 170C(1) allow prepayment and deferral schemes to be caught. Section 177C(2) excludes from the wide definitions of “tax benefits”, tax benefits which arise due to the making of an agreement, choice, election etc, where such elections, etc are provided for under this Act. These exemptions only operate in situations where the scheme was not entered into for the purpose of gaining the benefit of an agreement, choices, election, etc. [20.310] In many situations it is difficult to determine a “tax benefit” and the “requisite

purpose” in order to satisfy s 177D. To obviate these problems, the legislature enacted specific provisions that apply in respect of dividend stripping schemes (s 177E) and schemes that create or cancel franking credits (s 177EA). For a detailed examination of s 177E, see CPH Property Pty Ltd v FCT [1998] FCA 1276, per Hill J and judgment full High Court in FCT v Consolidated Press Holdings Ltd [2001] HCA 32 and in respect of 177EA see Mills v FCT [2012] HCA 51. Finally, in 2015 s 177DA was enacted, which applies where a foreign entity involved in the scheme is a “significant global entity” for a year of income in which the relevant taxpayer (or another taxpayer) obtains a tax benefit, or reduces or defers a tax liability under a foreign law, in connection with the scheme (the so called MAAL (multinational anti-avoidance law). [20.310]

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Counterfactual/alternative postulate [20.320] Section 177C(1) requires a comparison to be made of what the taxpayer actually did

and what “would have” happened or “what might reasonably be expected to have” happened “if the scheme had not been entered into or carried out”. The comparisons between the tax consequences of the scheme and the tax consequences of alternative scenarios provides a basis for identifying (and quantifying) any tax benefits that may have been obtained from the scheme. The prediction about events which would have taken place if the relevant scheme had not been entered into or carried out is known as the alternative postulate or the counterfactual. An alternative postulate could be merely that the scheme did not happen or it could be that the scheme did not happen but that something else did happen. However, there is a need to compare reality with some plausible alternative and that plausibility is to be judged on evidence. In determining the tax benefit the inquiry is not confined to the immediate tax consequences of the steps that comprise the scheme or the alternative postulate (see FCT v Futuris Corporation [2012] FCAFC 32). [20.330] This plausibility of the counterfactual is illustrated in FCT v Spotless Services Ltd

[1996] HCA 34. The taxpayer was a company that had realised substantial funds in a public float and did not require the funds for some period. It considered a number of short-term investment options for the funds not immediately required and eventually chose a bank deposit in the Cook Islands, where interest was subject to a low withholding tax. The arrangements took place prior to the adoption of a foreign tax credit system in Australia and at the time foreign-source interest would be exempt from Australian tax if it had been subject to any tax overseas, including very low withholding taxes. The interest rate paid on the deposit was 4 per cent less than the rate that would have been paid on a deposit in an Australian bank, but after-tax, the return was actually higher on the Cook Islands deposit since the tax was so much lower. The taxpayer was successful before the Full Federal Court, which concluded that attaining the greatest after-tax return was a sound commercial goal and the dominant purpose of the scheme was thus a commercial one, not achieving a tax benefit. On the ATO’s appeal to the High Court, Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ said:

FCT v Spotless Services Ltd [20.340] FCT v Spotless Services Ltd [1996] HCA 34 The taxpayers submit that the Full Court erred in holding that, if the scheme had not been entered into or carried out, an amount of income from the use of the sum on deposit would have been, or could reasonably be expected to have been, included in the assessable incomes of the taxpayers for the year of income. They submit that there is no possible way of knowing whether the amount actually derived from the investment, or any other particular amount, would have been included in the assessable income of the taxpayers had they chosen not to make the investment that they did. It is said that, if the taxpayers had not 1044

[20.320]

entered into the scheme, there would have been no interest and no amount would have been included in assessable income with the result that the definition of “tax benefit” set out above makes no sense in the context of the present case. The submission turns upon the use in para (a) of s 177C(1) of the expression “an amount not being included”. This applies where, but for the scheme, “that amount” would have been included in the assessable income or might reasonably have been expected to be so included. The submission is that the reference in this case is

Containing Tax Avoidance and Evasion

FCT v Spotless Services Ltd cont. to the amount of interest actually received from EPBCL after the imposition of withholding tax. It is said that without the scheme there would have been no investment in EPBCL, that amount would not have existed, and para (a) of s 177C(1) would have had no subject-matter upon which to operate. In our view, the amount to which para (a) refers as not being included in the assessable income of the taxpayer is identified more generally than the taxpayers would have it. The paragraph speaks of the amount produced from a particular source or activity. In the present case, this was the investment of $40 million and its employment to generate a return to the taxpayers. It is sufficient that at least the amount in question might reasonably have been included in the assessable income had the scheme not been entered into or carried out. … A particular application of the definition provision of “tax benefit” in s 177C(1) thus

CHAPTER 20

involves consideration of the particular materials answering the various categories in para (b) of s 177D. The taxpayers were determined to place the $40 million in short-term investment for the balance of the then current financial year. The reasonable expectation is that, in the absence of any other acceptable alternative proposal for “off-shore” investment at interest, the taxpayers would have invested the funds, for the balance of the financial year, in Australia. The amount derived from that investment then would have been included in the assessable income of the taxpayers. The interest rate in the Cook Islands was 4.5 per cent below applicable bank rates in Australia. It reasonably could be concluded that the amount the taxpayers would have received on the Australian investment would have been not less than the amount of interest in fact received from the investment with EPBCL. Accordingly, there is no error adverse to the taxpayers in identifying the amount of the “tax benefit” as an amount equal to the interest less the Cook Islands withholding tax.

[20.350] Concerns about the effectiveness of “tax benefit” definition have been raised and

Recommendations made in official inquiries since 1999 (Recommendations 6.1 to 6.5 of Review of Business Taxation, A Tax System Redesigned (1999)), including a recommendation that the operation of the existing reasonable hypothesis test needs to be improved by ensuring the counterfactual to tax avoidance schemes reflects the commercial substance of the arrangement (ie the sale would have taken place even without the scheme) (Recommendation 6.4). A further problem identified with s 177C(1) was that the meaning of the words “reasonably expected” (used to describe whether a taxpayer could be expected to have gained a tax benefit) was unclear. The term could encompass a range of expectations from a “reasonable belief” to the “actual holding” of that belief. It could encompass the existence of a greater than 50% chance of holding that belief. Another problem is that taxpayers have argued the most likely alternative is that nothing would have happened – no amount would have been included in anyone’s income, apart from the scheme, because none of the transactions that did occur would have taken place and no others would have taken place either. This argument succeeded for the taxpayer before the Full Federal Court in FCT v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 and in the Full Federal Court decision RCI Pty Ltd v FCT [2011] FCAFC 104 (restructure of James Hardie group). In RCI the Court rejected the Commissioner’s conclusion that the transaction in question was a tax avoidance measure, finding that a tax benefit had not been gained because, had the scheme not been entered into or carried out, the reasonable expectation is that the [20.350]

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Tax Administration

relevant parties would have done nothing or deferred their arrangements. See also FCT v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49. [20.360] The Government became concerned following the RCI Pty Ltd v FCT [2011] FCAFC 104 decision. Amending legislation to make the required technical changes was introduced into Parliament on 13 February 2013 and received royal assent on 29 June 2013 (Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013). The amendments apply to schemes that are entered into, or commenced to be carried out, on or after 16 November 2012, the day when the draft amendments were released for public comment. This change from the originally announced date of 2 March 2012 was done in recognition that the amendments may not have been in a form the public would have readily anticipated when the measure was first announced. [20.370] The amendments were intended to have a number of impacts (see The Explanatory

Memorandum to Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (2013 EM), para 1.71). The first aim of the legislation was to clarify that the “would have” and “might reasonably be expected to have” limbs in the paragraphs of s 177C(1) are alternative bases upon which the existence of a tax benefit can be demonstrated. The amends did not alter the existing procedural structure, but made significant changes to the tax benefit test. Although s 177C(1) test in form remained unaltered, in substance it has comprehensively changed as it must now be applied in accordance with s 177CB which requires that a “tax effect” (as defined in s 177CB) must first be identified. Section 177CB had the effect of splitting the tax benefit test into two tests, an “annihilation approach” and a “reconstruction approach”. Section 177CB(1) merely states that where there a conclusion that one of the paragraphs of s 177C(1) is satisfied there exists an underlying conclusion that one of the tax effects specified in that subsection (eg, the inclusion of an amount of assessable income) “would have”, or “might reasonably be expected to have”, happened absent a particular scheme. Section 177CB(2) sets out a so-called “annihilation approach”. Section 177CB(2) states where a decision is reached that a tax effect “would have” occurred if the scheme had not been entered into or carried out, that decision can only have been made solely on the basis of a postulate comprising all of the events or circumstances that actually happened or existed, other than those that form part of the scheme. It ensures you only look at the tax outcome based upon what remains after the scheme is deleted (annihilated). The 2013 EM at [1.78] states that: this provision makes it clear that, when postulating what would have occurred in the absence of the scheme, the scheme must be assumed not to have happened – that is, it must be “annihilated”, “deleted” or “extinguished”. Otherwise, however, the postulate must incorporate all the “events or circumstances that actually happened or existed”.

Section 177CB(3) sets out the so-called “reconstruction approach”. It requires that where decision that a tax effect “might reasonably be expected to have occurred” if the scheme had not been entered into or carried out that decision must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme (as determined in accordance with s 177CB(4), ie, having particular regard to the substance of the scheme and its effect for the taxpayer, but disregarding any potential tax costs). Under s 177CB(3) all other counterfactual postulates are eliminated so that the sole comparison is one between the overall facts, and those facts but excluding the scheme steps. 1046

[20.360]

Containing Tax Avoidance and Evasion

CHAPTER 20

Purpose of the scheme [20.380] The second purpose of the 2013 amendments ensure that the dominant purpose test

in s 177D is the “fulcrum” or “pivot” around which Part IVA operates, ie require the process for applying Part IVA starts with a consideration of whether a person participated in the scheme for the sole or dominant purpose of securing for the taxpayer a particular tax benefit in connection with the scheme (see The Explanatory Memorandum to Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (2013 EM), para 1.71). Section 177D was repealed and replaced with a revised version. Section 177D(1) notes that Part IVA applies to a scheme if it would be concluded (having regard to the “matters” listed in subsection (2)) that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling a taxpayer (a relevant taxpayer) to obtain a tax benefit in connection with the scheme. It also applies where it was entered into for the purpose of enabling the relevant taxpayer and another taxpayer (or other taxpayers) each to obtain a tax benefit in connection with the scheme. It applies whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers. Thus, it looks to a person’s purpose where that person is not necessarily the taxpayer. Where the taxpayer has several purposes in mind, s 177A(5) says that it is sufficient if the purpose of obtaining the tax benefit is the dominant purpose. The stipulated circumstances to be considered when determining whether the scheme was directed at obtaining a tax benefit are set out in s 177D(2). The list of relevant criteria is apparently intended to be exhaustive, although whether this is a real limitation is open to doubt. The list includes such nebulous circumstances as “the manner in which the scheme was entered into”, “the form and substance of the scheme”, “any change in the financial position of the relevant taxpayer [or any person] that has resulted” from the scheme, and “any other consequences for the relevant taxpayer or for any person”. Section 177D(2) is not concerned with the subjective intention of a taxpayer for entering the scheme, rather it is focused on whether the evidence elicited in respect of the eight criteria leads to the objective conclusion that the taxpayer entered the scheme with the requisite purpose (FCT v Mochkin [2003] FCAFC 15). In arriving at a decision the Commissioner must have regard to each and every one of the matters referred to in s 177D(b): Peabody v FCT [1993] FCA 74, per Hill J at [46]. This does not mean that each of those matters must point to the necessary purpose referred to in s 177D. Some of the matters may point in one direction and others may point in another direction. It is the evaluation of these matters, alone or in combination, some for, some against, that s 177D requires in order to reach the conclusion to which s 177D refers.

The High Court in FCT v Spotless Services Ltd [1996] HCA 34 agreed. The Court noted that: The eight categories set out in para (b) of s 177D as matters to which regard is to be had “are posited as objective facts” (FCT v Peabody (1994) 181 CLR 359, 382…). That construction is supported by the employment in s 177D of the phrase “it would be concluded that…”. This phrase also indicates that the conclusion reached, having regard to the matters in para (b), as to the dominant purpose of a person or one of the persons who entered into or carried out the scheme or any part thereof, is the conclusion of a reasonable person ... In the present case, the question is whether, having regard, as objective facts, to the matters answering the description [20.380]

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Tax Administration

in para (b), a reasonable person would conclude that the taxpayers entered into or carried out the scheme for the dominant purpose of enabling the taxpayers to obtain a tax benefit in connection with the scheme. The taxpayers were determined to place the $40 million in short-term investment for the balance of the then current financial year. The reasonable expectation is that, in the absence of any other acceptable alternative proposal for ″off-shore″ investment at interest, the taxpayers would have invested the funds, for the balance of the financial year, in Australia. The amount derived from that investment then would have been included in the assessable income of the taxpayers. The interest rate in the Cook Islands was 4.5 per cent below applicable bank rates in Australia. It reasonably could be concluded that the amount the taxpayers would have received on the Australian investment would have been not less than the amount of interest in fact received from the investment with EPBCL. Accordingly, there is no error adverse to the taxpayers in identifying the amount of the “tax benefit” as an amount equal to the interest less the Cook Islands withholding tax

In Macquarie Finance Ltd v FCT [2004] FCA 1170, Hill J, whilst commenting on the result in Hart, noted in respect of the determination of purpose: 94 If the right question to ask was what conclusion should be drawn as to the dominant purpose of the taxpayers entering into the two loans the answer may well have been the acquisition of the new residential property and the refinancing of the previous house for use as an investment property. This commercial factor was what caused the Full Federal Court to come to the conclusion it did that Pt IVA had no application. However, that was clearly not what the members of the High Court regarded as being the correct question to ask. 95 Part IVA requires the drawing of a conclusion from the eight matters listed in s 177D(b) as to the dominant purpose of some person, including the taxpayer, for entering into or carrying out the scheme. If the scheme is defined to be all the steps taken, including the loan itself but placing emphasis upon those matters which gave rise to the tax benefit (ie the differential interest) obtained by the taxpayer from the scheme, then the question required to be asked is whether having regard to the scheme as so defined which, while it includes the making of the loan has, as its emphasis the wealth optimiser features which produce the tax benefit, it would be concluded that some person entered into it to obtain the tax benefit. That, I think, is the explanation of the judgment of the Chief Justice and McHugh J. Another way this may be stated is that the conclusion in a case like Hart which has to be drawn by reference to the eight relevant factors is a conclusion which has to be drawn by reference to the way the borrowing is structured and not a conclusion as to the borrowing itself. It is a conclusion not as to why the borrowing itself is entered into but why a borrowing on the particular terms and conditions is entered into, that is to say the terms and conditions which were essential to the wealth optimiser product. On this basis the answer to be drawn is the obtaining of the differential interest saving and not any commercial purpose.

Cancellation of tax benefit [20.390] Section 260 was interpreted by the courts as an annihilating provision only, which

did not permit the ATO to reconstruct the taxpayer’s accounts. Part IVA has been drafted in an attempt to avoid this problem. Where all the elements of Pt IVA are satisfied, s 177F empowers the ATO to cancel the tax benefit by including the amount in assessable income or denying the taxpayer a deduction. Where this is done, the ATO is then empowered to make compensating adjustments in the return of any other taxpayer to prevent double taxation. Section 177F has been subject to several amendments as a result of the changes made to Pt IVA referred to above. Part IVA operates by cancelling transactions where they are found to give rise to a tax benefit. It is not a self-activating section. The Commissioner has a discretion whether to apply the Part to a transaction (s 177F(1)). The 2013 EM notes at para 1.20 “the Commissioner’s 1048

[20.390]

Containing Tax Avoidance and Evasion

CHAPTER 20

discretion to cancel the tax benefit” in s 177F “does not depend upon the Commissioner’s opinion or satisfaction that there is a tax benefit … it rather it requires that the existence of a scheme and a tax benefit must be established as matters of objective fact” (see FCT v Peabody (1994) 123 ALR 451 at pp 458-459). The 2013 EM also notes the amendment is made to s 177F(1) further emphasise that an examination of Part IVA should commence with the question whether there is a scheme to which Part IVA applies. A determination can be made by an ATO officer with delegated authority (Vincent v FCT (2002) 50 ATR 20), even as late as the objection stage or by the AAT on review of an objection decision (Kordan Pty Ltd v FCT (2000) 46 ATR 191), and the determination is not open to judicial review (Meredith v FCT (2002) 50 ATR 528). A determination under s 177F is usually given effect by an assessment and, in some circumstances, can be given effect by the issue of an amended assessment (Puzey v FCT (2002) 51 ATR 616). There are no time limitations on any amendments under Part IVA (s 177G). Having satisfied the requirements of s 177D (ie scheme, tax benefit and purpose), the Commissioner has a discretion to cancel all or part of the tax benefit arising under the scheme (s 177F(1)). Sections 177F(2) to 177F(3) empower the Commissioner to take any steps necessary to give effect to the determination under s 177F(1), including the making of any compensating adjustments (s 177F(3)). [20.400]

Questions

20.1

What is the High Court’s approach in Spotless to the view that a person is entitled to organise affairs so as to pay the least possible amount of tax?

20.2

What, if anything, does the High Court have to say about the application of the predication test, the choice doctrine or the antecedent transaction doctrine to Pt IVA in Spotless?

20.3

How does the High Court in Spotless deal with the issue of establishing what would have happened in the absence of the scheme? How does it deal with the argument that the taxpayer would just have done nothing?

20.4

A taxpayer sells bonds and buys shares paying fully franked dividends because the yield on the shares is higher after taking into account the imputation credit. Can Pt IVA be applied to this change of investment?

20.5

In the Full Federal Court in Spotless, Cooper J said: For example, the treatment of income from gold mining operations as exempt income (s 23(o) of the Act) may be a factor which influences an investment in a gold mine returning income at a lower rate as a percentage of capital invested than an investment of the funds on deposit at a higher gross rate of return but subject to the payment of full income tax.

Can Pt IVA be applied when the Act explicitly confers a tax concession to encourage taxpayers to engage in the tax-favoured activity? If so, how can legitimate uses of the tax concession be differentiated from uses subject to Pt IVA? 20.6

A taxpayer owns two companies, one of which has substantial tax losses and no prospect of deriving income in the future. The taxpayer arranges for income to be transferred to the loss company from the other company in order to use up the tax losses. Can Pt IVA be applied in such a case? To which company would it be applied and with what result? (See CC (NSW) Pty Ltd v FCT (1997) 34 ATR 604, Re Clough Engineering Ltd and DCT (1997) 35 ATR 1164.) [20.400]

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Tax Administration

20.7

The taxpayer was a tobacco company that set up a captive insurance company (ie a wholly-owned insurer servicing only the taxpayer and associated group companies) in a lower tax jurisdiction and paid premiums to the insurance company. It deducted the premiums paid to the insurer and the profits derived by the insurer were taxable only in the lower tax jurisdiction. The ATO sought to use Pt IVA of the ITAA 1936 to deny deductions for the insurance premiums. Will the taxpayer be successful? (See WD & HO Wills (Australia) Pty Ltd v FCT (1996) 32 ATR 168.)

1050

[20.400]

INDEX A

Accounting company accounts, [14.250]-[14.300] financial — see Financial accounting tax, for — see Tax accounting Adjustment sheet, [19.510] Administrative Appeals Tribunal (AAT) review of decisions by, [19.320], [19.330] appeal to Federal Court distinguished, [19.330] choice of forum, [19.330] further appeal, [19.330] justiciable issues, [19.340] onus of proof, [19.350] time limit, [19.320] Advance payments accounting for income, [11.340]-[11.360] warranties, [11.360]

fixed term, [7.640] former tax treatment, [4.890] income, whether, [2.70], [3.480], [6.370], [6.410]-[6.460] instalment sales, [3.490]-[3.530], [6.410]-[6.460] capital/revenue expense distinction, [9.200]-[9.220] implicit interest, [3.490]-[3.530] life annuities, [3.480], [6.460] living expenses, [6.330]-[6.370] lump sums, comparison of treatment, [4.890] modern, [3.480] monthly payments, [6.450], [6.460] ordinary income, [2.70] periodicity principle, [6.390], [6.410]-[6.460] private, [6.410] purchase price and revenue expenses, [9.200]-[9.220] purchased, [3.480] rent charge, [6.430], [6.440] timing preferred income, [7.640] undeducted purchase price, [4.890], [6.410] Anti-avoidance measures — see Tax

avoidance/evasion Alienation of income personal services income, [4.1220] employee/contractor distinction, [4.1220] personal services business, [4.1230] personal services entity, [4.1230] Alimony assessable income, whether, [6.360] non-residents, [18.270] Allowances assessable income, [2.190], [2.410] living-away-from-home, [4.330], [4.350] PAYG withholding, excluded from, [19.110] substantiation, [19.110] Amendment of assessment, [19.220] Amortisation prepayments, [11.460], [12.540] Ancillary benefits capital protected loan, [7.510] deductions, [7.490]-[7.530] dual purpose expenses, [7.10], [7.490]-[7.530] legal rights doctrine, [7.490] Annuities assessable income, [2.400], [6.370] capital/revenue expense distinction, [9.200]-[9.220] definition, [3.480] employee, paid to, [4.890]

Appeal AAT review distinguished, [19.330] appealable objection decisions, [19.320] choice of forum, [19.330] Federal Court, to, [19.320]-[19.330] justiciable issues, [19.340] onus of proof, [19.350] time limit, [19.320] validity of assessment, against, [19.330] Apportionment deductible expenses, [7.410]-[7.430] general power, recommendation for, [2.300] income, [2.280]-[2.300] Archer Brothers principle, [14.1030], [14.1040] Artists losses, [5.190] Asprey Report apportionment of income, [2.300] child care tax offset, [8.70] company tax, [14.450], [14.460] consolidation, [15.580] fringe benefits, [4.230], [4.290] gift and estate taxes, [1.120] tax accounting, [11.80] tax policy agenda, [1.40] Assessable income, [2.330] apportionment, [2.280]-[2.300] concept of income — see Income 1051

Income Taxation

Assessable income, — cont deemed dividends, [4.680] definition, [2.10], [2.330] determining whether amount included, [2.390]-[2.470] inclusions, [2.190], [2.330], [2.410] judicial concept of income, [2.400] ordinary income, [2.20]-[2.100], [2.330], [2.400] reconciling statutory income and, [2.430] overlapping assessment sections, [2.550] specific statutory provision, [2.410] statutory income, [2.330], [2.430] time dimension, [Pt4.10], [11.10] valuation, [2.220]-[2.270] what is, [2.190], [2.330] Assessing Handbooks, [19.80] Assessments adjustment sheet, [19.510] amending, [19.220] statute of limitations, [19.220] annual, [19.190] appeals, [19.320]-[19.350] challenging, [19.240]-[19.420] default, [19.200] disputed amounts, collection of, [19.420] objections, [19.250]-[19.310] accuracy, [19.290]-[19.310] lawfulness, [19.260]-[19.285] time limit, [19.310] payments system and, [19.90] review of decisions, [19.320]-[19.350] review of exercise of discretion, [19.360]-[19.410] ADJR Act, under, [19.400] Inspector-General of Taxation, [19.410] judicial review, [19.370]-[19.400] self-assessment, [19.190] Rulings as part of, [19.50] substantiation rules, [8.260] system, [19.90], [19.170] tax returns, [19.180] Assets business assets — see Business capital assets, expenses to acquire — see Capital

expenses CGT assets — see Capital gains tax (CGT) income from sale of, [4.720], [4.730], [5.220], [5.230] distinguished from income from services, [4.720], [4.730] loss or destruction of CGT event, [3.120], [3.140], [6.190] compensation for, [6.130]-[6.200] revenue assets, [9.360] tax value, [1.55] trading stock — see also Trading stock assets yielding, [12.300]-[12.310], [12.360]-[12.410], [12.420] converting assets into and from, [12.420]-[12.440] Assignment of income general law, [13.570] income splitting, [13.570], [13.580] 1052

Audits Commissioner, by, [19.430] computer programs and statistical computations, [19.430] pre-assessment audits, [19.430] risk differentiated framework (RDF), [19.430] Australian Business Number (ABN), [19.90] withholding tax where not quoted, [19.150] investors, [19.120], [19.150] unincorporated businesses, [19.130] Australian Taxation Office (ATO) — see also Commissioner of Taxation administration of tax system, [19.20] advisory and consultative Committees, [19.80] annual reports, [19.20] Assessing Handbooks, [19.80] audits, [19.20], [19.430] CGT Specialist Cell, [19.80] determinations — see Rulings and

Determinations development of legislation, [1.310] enforcement powers, [19.520], [19.530] functions, [19.20] industry partnership groups, [19.80] information issued by, [19.80] investigations, [19.440] privilege claims, [19.450]-[19.500] Law Administration Practice Statements (LAPS), [19.80] Rulings — see Rulings and Determinations tax reform process, [1.280] Taxpayer Alerts, [19.80] Taxpayer’s Charter, [19.20] unannounced raid by, [19.470], [19.480] work-related expenses problem, [8.280] Australian taxation system administration — see Tax administration business tax system, [1.55] Ralph Review, [1.55] constitutional constraints, [1.300] democratic process, [1.280]-[1.290] government’s cost of administering, [19.180] integrating elements of, [2.380] legislation — see Legislation penalty system, [19.530] policy — see Tax policy reforms — see Tax reform retirement/resignation/retrenchment payments, [4.890] reviews of, [1.40] voluntary compliance, [19.30] Avoidance — see Tax avoidance/evasion

B

Bad debts banks and financial institutions, [10.330]-[10.340] commercial debt forgiveness rules, [10.360]

Index

Bad debts — cont continuity of ownership test, [15.430] debt-equity swaps, [10.370] deductibility, [10.290]-[10.370] consolidated groups, [10.350], [10.360] financial institutions, [10.330] money lending business, [10.330], [10.340], [10.350] s 8-1 and s 25-35, under, [2.490], [2.500] written off during year of income, [10.300], [10.310] Banks deduction for bad debts, [10.330]-[10.340] realisation of investments, [5.700]-[5.720], [5.750] Beneficiaries — see Trusts Bills of exchange accounting for expenses, [11.440], [11.450] Black economy, [19.30] Black hole expenses, [9.80], [9.180], [10.250]-[10.260] Bonds stripped, [3.440] zero coupon, [3.440] Bonuses assessable income, [2.190] Buildings capital works deduction, [10.270] Business assets capital assets, [5.470] classification of, [5.470] contract rights, [5.500]-[5.590] know-how, [5.600]-[5.630] plant and equipment, [5.490] premises, [5.640]-[5.680] revenue assets, [5.470], [5.500]-[5.540] trade secrets, [5.600]-[5.630] trading stock, [5.470], [5.480] badges of trade, [3.10], [5.30] characterisation of transactions, [5.250] characteristics, [5.30] connection of transactions to, [5.250] continuing business, identifying, [5.20] contract rights compensation for income, [5.550]-[5.590] revenue assets, as, [5.500]-[5.540] transactions with, [5.500]-[5.590] definition, [5.30], [5.70] ending operations, [5.420]-[5.460] existence of, question of fact, [5.30] expenses prior to commencement of, deductibility, [7.290]-[7.310] gain from carrying on, [5.10] gambling or betting, whether, [5.40]-[5.60]

hobby distinguished, [5.40]-[5.110] farming, [5.60]-[5.100] horse racing and breeding, [5.50], [5.110] Rulings on, [5.110] illegal activities, [5.350] deductibility of expenses, [7.170], [10.500] income of — see Business income investment distinguished, [5.120], [5.690] investments, realising, [5.690]-[5.760] banks, [5.700]-[5.720], [5.750] insurance companies, [5.700]-[5.720], [5.750] investment trusts and companies, [5.730]-[5.760] isolated transactions, [5.200]-[5.240] continuing business distinguished, [5.20] income generating venture, [5.200]-[5.240] profit-making scheme, [5.210], [5.240] purchase and sale, [5.200], [5.220], [5.230] isolated ventures, [5.210]-[5.230] liabilities capital account, [5.780] classification of, [5.470] gains on, [5.770]-[5.790] nature of activities, [5.70] ordinary course of business, [5.250] unusual transactions, [5.360]-[5.410] organisation of activities, [5.70] passive investors, [5.120] pilot projects, [5.180] premises, transactions with, [5.640]-[5.680] primary production business, [5.60]-[5.100] benefits, [5.80] hobby farm distinguished, [5.60]-[5.100] indicators, [5.100] managed agricultural investment schemes, [5.120], [5.190] Rulings on, [5.90] start-up operations, [5.180] profit-making undertaking or scheme, [5.210], [5.240] incurring liabilities in, [5.780] profit motive, [5.130]-[5.150], [5.370] property income distinguished, [3.10] receipts as product of, [5.10] reservation agreement, payment for, [5.440], [5.450] restricting operations, [5.420]-[5.460] scope and ordinary course of, [5.250] start-up operations, [5.160]-[5.180] statutory profit-making schemes, [5.240] tax system, [1.55] Ralph Review, [1.55] tax treaties, [18.40] trading stock, [5.470], [5.480] unusual transactions, [5.360]-[5.410] Myer decision, [5.370]-[5.380] Business Activity Statement (BAS) companies, [19.140] PAYG instalment amounts on, [19.130], [19.140] unincorporated businesses, [19.130] Business income abnormal transactions, [5.360]-[5.410] assessable income, [2.400] banks, [5.700]-[5.720], [5.750] 1053

Income Taxation

Business income — cont carrying on business — see Business connection of transaction to business, [5.250] contract rights, transactions with, [5.500]-[5.590] compensation for income, [5.550]-[5.590] revenue assets, as, [5.500]-[5.540] debt forgiveness, [5.790] gains on liabilities, [5.770]-[5.790] gifts, [5.260]-[5.280] government subsidies, [5.310]-[5.340] illegal activities, [5.350] insurance companies, [5.700]-[5.720], [5.750] investments, realising, [5.690]-[5.760] banks, [5.700]-[5.720], [5.750] insurance companies, [5.700]-[5.720], [5.750] investment trusts and companies, [5.730]-[5.760] judicial concept of income, [2.400] know-how and trade secrets, [5.600]-[5.630] lease incentives, [5.640]-[5.680] machinery and equipment, disposal of, [5.490] non-residents, [18.30]-[18.60] ordinary course of business, [5.250] overview, [5.10] periodicity, regularity and recurrence, [5.370] permanent establishment — see Permanent

establishment (PE) personal exertion, income from, [5.50] premises, transactions with, [5.640]-[5.680] prizes, [5.260]-[5.280] property developers, [5.470], [5.640] tax accounting, [11.170] trading stock transactions, [5.480] unsolicited payments, [5.260]-[5.300] unusual transactions, [5.360]-[5.410] Rulings on, [5.390]-[5.410] what constitutes business — see Business windfalls, [5.260]-[5.290] Business judgment rule, [7.10], [7.430] Business Tax Working Group, [15.360]

C

Capital circulating, accounting for, [11.170] debt/equity capital distinction, [14.75], [14.720] income/capital distinction, [2.50], [3.420] trust law, [2.30] revenue/capital expenses distinction, [9.10] tests — see Capital expenses share capital — see Shares return of — see Return of share capital Capital allowances balancing adjustments, [10.220] black hole expenses, [9.80], [9.180], [10.250]-[10.260] buildings, [10.110], [10.270] business related costs, [10.250]-[10.260] capital works, [10.110], [10.270] car depreciation cap, [10.540] 1054

deductions, [9.10], [10.110], [10.270] calculation, [10.190]-[10.210] conditions, [10.120] wasting benefits not eligible for, [9.10] who can claim, [10.185] depreciation — see Depreciation general regime, [10.120]-[10.220] — see also Depreciation overview, [10.110] project pools, [10.230] repairs or replacement, [10.65]-[10.100] initial repairs, [10.90]-[10.100] rules, [10.120] small business taxpayers, [10.230], [10.410] pooling systems, [10.230], [10.410] tangible and intangible assets, for, [10.120] temporary business tax break, [10.420] wasting assets and benefits, [9.110]-[9.180] intangible assets, [9.40] not eligible for deductions, [9.10] Capital expenses current expenses distinguished, [9.10]-[9.35] deductibility, [9.10], [10.110] capital allowance rules — see Capital

allowances expenditure effect test, [9.20], [9.30] expenditure form test, [9.20] expenditure purpose test, [9.20], [9.25], [9.30], [9.40] interest expenses, [9.340], [9.350] judicial tests, [9.20]-[9.180] background, [9.20] legal expenses, [9.90]-[9.100] legal title, protecting, [9.80] long-term licences, [9.110]-[9.180] casino licences, [9.160], [9.170] nature of, [9.10] “once and for all”, [9.20], [9.30], [9.40] recurrent payments, distinction, [9.30] protecting, preserving or enhancing assets, [9.60]-[9.100] purchase price of capital asset, [9.200]-[9.360] annuity, [9.200]-[9.220] conditional or contingent price, [9.250] disguised as revenue expense, [10.580] finance lease payments, [9.290]-[9.330] instalments, [9.200]-[9.240], [9.290]-[9.330] interest on borrowing, [9.340]-[9.350] lump sum plus continuing payments, [9.250]-[9.270] operating lease, [9.290] periodical payments obligation, [9.200]-[9.240] prospecting and mining rights, [9.260], [9.270] rental payments, [9.230], [9.240], [9.290], [10.580] revenue nature, [9.220] sale and leaseback arrangement, [9.300], [9.310] purchase price of revenue asset, [9.360] restrictive covenants, [9.110]-[9.180] revenue expenses distinguished, [9.10] judicial tests, [9.20]-[9.180] recurrent or one-off, [9.20], [9.40] revenue assets, [9.360] structure/process distinction, [9.30], [9.40], [9.50], [9.60], [9.70]

Index

Capital expenses — cont sale and leaseback arrangements, [9.300], [9.310] wasting intangible assets, [9.40], [9.50], [9.110]-[9.180] black hole expenses, [9.80], [10.250]-[10.260] CGT rules, [9.180] lease premium arrangement, [9.140], [9.150] tied house agreement, [9.120], [9.130] Capital gains tax (CGT) accounting for, [12.610]-[12.700] accrual or realisation basis, [12.620] bunching, [12.620] discounts, [12.690] Draft White Paper, [12.620] locking in taxpayers, [12.610], [12.620] net gains and losses, [12.640]-[12.690] anti-overlap provisions, [3.40] background, [3.10] broadening tax base, [2.100] calculation of capital gain or loss, [3.30], [3.40], [3.300] CGT discounts, [12.690] cost base, [3.40], [12.660] disposal proceeds, [3.40] net gains and losses, [12.640]-[12.690] separate from other income, [3.30] trading stock disregarded, [3.300] capital gains also income, [2.10], [2.410], [2.460], [3.20] reconciling, [2.470], [12.700] capital loss by company — see Company

losses capital proceeds of CGT event, [12.650] GST on, [12.750] Cell Determinations, [19.80] CGT assets, [3.50]-[3.110] assignable property or rights, [3.50] bundle of rights, [3.80] confidential information, [3.50] debt forgiveness, [3.110] deemed disposal, [3.120], [3.130], [3.150]-[3.260] definition, [3.40], [3.50] disposal, [3.90], [3.120]-[3.140] examples, [3.50] information, [3.50] interpretation, [3.50] know-how, [3.60], [3.230] legal rights, [3.110] mining information, [3.60], [3.220], [3.230] motor vehicles, [3.50] part disposal, [3.90], [3.100] rights attaching to shares, [3.90], [3.250] shares, [3.90], [15.10] splitting, changing or merging, [3.260] time of acquisition, [3.270]-[3.290] CGT discount, [3.20], [3.40], [12.630], [12.690] trusts, [13.420], [13.450], [13.540] CGT events, [3.40], [3.110]-[3.140] asset, concept of, [3.40] beneficiary becoming presently entitled (E5), [13.520] capital proceeds of, [12.650] change of residence (I1), [18.90] creation of contractual right (D1), [3.150]-[3.260]

deemed disposal, [3.120], [3.120], [3.150]-[3.260] disposal of CGT asset (A1), [3.40], [3.120], [3.140] easement, grant of, [3.150] end of intangible asset (C2), [3.120], [6.190] expiry of lease (C2), [12.650] loss or destruction of asset (C1), [3.120], [3.140], [6.190] nature of, [3.120] pre-CGT shares (K6), [15.200] receipt for event relating to CGT asset (H2), [3.150]-[3.260] restrictive covenant, grant of, [3.150] return of share capital (G1 or C2), [14.170] share issue, [15.40] share redemption (C2), [14.1020] splitting, changing or merging asset, [3.260] tax-exempt beneficiary, asset passing to (K3), [13.440] time of acquisition of asset, [3.270]-[3.290] time of occurrence, [3.40] transfer of asset to trust (E2), [13.500] trust, creation of (E1), [13.500], [13.530] use without legal title changing (B1), [3.120] change of residence, [18.90] collectables, [3.410], [12.670] cost base, [3.40] calculation, [12.660] shares, [15.40] debt forgiveness, [3.110] deceased estates, [13.440] deduction of capital losses against capital gains only, [3.30] previous year losses, [3.20] demerger relief, [15.320], [15.330] entities, taxation of, [13.20] exclusions, [3.40], [3.370] decorations for valour, [3.370] exempted receipts, [3.370] lottery and gambling winnings, [3.370] main residence, [3.40], [3.350], [3.380]-[3.390] motor vehicles, [3.370] personal use assets, [3.410] small business, [3.350] transition rule, [3.40] foreign exchange gains and losses, [12.740], [14.620] framework, [3.20]-[3.40] income and capital gains, reconciling, [2.470], [12.700] income tax, relationship with, [2.100] anti-overlap provisions, [3.40] capital gains as income, [2.410], [2.460], [2.470], [3.20] common rules, [3.30] reconciliation, [2.470], [3.300], [12.700] indexation or discount option, [3.20] information CGT asset, whether, [3.50] confidential information, [3.50] mining information, [3.60], [3.220], [3.230] intermediaries, taxation of, [13.20] isolated transactions, [5.200]-[5.240] judicial concept of capital gain, [2.100] legislative provisions, [2.380], [3.10] liquidator distributions, [14.1020] 1055

Income Taxation

Capital gains tax (CGT) — cont main residence exemption, [3.40], [3.350], [3.380]-[3.390] method statement, [3.20] mismatched expenses to derive capital gains, [7.600], [7.610] net capital gains assessable income, [2.410], [2.460], [2.470], [3.20] calculation of, [3.30], [3.300], [12.640]-[12.690] net capital losses applicable against capital gains only, [3.30] calculation of, [3.300], [12.640]-[12.690] carry forward — see Carry forward of

losses deduction in later years, [3.20] non-residents, [18.70]-[18.90] change of residence, [18.90] domestic law, [18.70] treaties, [18.80] operation of, [2.100], [3.20] outlay subtracted from capital gain, [2.530] deduction reconciled with, [2.540] overview, [3.10], [3.40] partnerships, [13.250] personal use assets, [3.410], [12.670] post-CGT assets, [3.40] pre-CGT assets, [3.40] profit-making schemes, [5.240] Ralph Review, [1.55], [3.10], [3.310] record-keeping, [3.40] reduced cost base, [3.40] rollovers, [3.310]-[3.360] corporate groups, [15.340] death, [3.360] demerger, [15.320]-[15.330] involuntary disposal, [3.310], [3.320] licence renewal, [3.340] marital breakdown, [3.330] replacement asset, [3.310] scrip for scrip, [15.280]-[15.310] share transactions, [15.240]-[15.340] small business, [3.350] testamentary, [3.360] transfer of assets to wholly-owned company, [15.250]-[15.270] separate character, [3.10] share capital, return of CGT event C2, [14.170] CGT event G1, [14.170] shares, [3.90], [15.40] bundle of rights, [3.90] buy-backs, [15.70]-[15.90] cancellation, [3.80] CGT asset, [3.80], [15.10] cost base, [15.40]-[15.50] disposal, [3.80], [14.110] foreign subsidiaries, in, [17.60] issue of new, [15.40] part disposal, [3.90], [3.100] pre-CGT companies, [15.200] redemption of preference shares, [14.750] rights attaching to, [3.80] variation of rights, [15.10] small business, [3.350] 1056

exemption, [3.350] rollover relief, [3.350] small business entity test, [3.350] special regimes, [12.680] superannuation funds, [4.990] tax base broadening, [2.100] trading stock, disposal of, [3.300] transition rule, [3.40] trustees, capital gains of, [13.420] 12 months indexation rule, [3.10] valuation day, [3.40] Capital streaming rules, [14.840] Capital works buildings, [10.270] construction expenditure, [10.270] deduction, [10.110], [10.270] Car parking, [4.450] Carry forward of losses company losses, [15.350] continuity of ownership test (COT), [15.360]-[15.370] bad debts, [15.430] control of voting power test, [15.400] family trust election, [15.400] listed public companies, [15.420] majority ownership test, [15.400] non-fixed trusts, [15.400] passing, [15.400]-[15.430] realised losses, [15.390] same share rule, [15.410] ultimate individual controllers, tracing back to, [15.400] unrealised losses, extension to, [15.530] mineral exploration development incentive, [15.368] rules limiting, [15.360]-[15.390] rationale for, [15.380] same business test (SBT), [15.440] aspects of, [15.440] bad debts, [15.430] new business test, [15.440] new transactions test, [15.440] passing, [15.440]-[15.500] realised losses, [15.390] TR 1999/9, [15.480] unrealised losses, extension to, [15.530] tax losses, [10.10], [15.350] Taxation Review Committee, [15.380] trusts, [13.470] Cars — see Motor vehicles Case law concept of income, [2.20] Cash accounting — see Tax accounting Charitable gifts deductibility, [8.250], [10.60]

Index

Child beneficiaries, [13.330], [13.430] Child care deductibility of expenses, [8.50]-[8.70] FBT exemption for in-house facilities, [4.350] business premises, meaning, [4.560] Class Rulings, [19.50] Client legal privilege — see Legal

professional privilege Clothing deductible expenses, [8.180] non-compulsory uniforms, [10.490] Club and leisure facilities deduction denial for fees, [10.520] Collectables CGT rules, [3.410], [12.670] tax accounting for, [12.670]

carrying on business — see Business CGT on disposal of shares, [14.110] company tax, [14.10] Asprey Report, [14.450], [14.460] Australian scheme, [14.20] international context, [14.10] consolidated groups — see Consolidated

groups debt/equity capital, distinction, [14.75] — see also Debt/equity rules debt/equity rules — see Debt/equity rules deductions bad debts, [10.290]-[10.370] statutory restrictions, [10.450]-[10.580] definition, [14.30] distribution of profit — see Dividend dividends — see Dividend — see Dividend

imputation system double tax, avoiding, [14.450] imputation system, [14.60]-[14.75], [14.500] dual resident companies, [16.230] foreign-source income — see Foreign-source

income Collection of tax administrative processes, [19.90], [19.95] assessment system — see Assessments Commissioner’s powers, [19.520] disputed amounts, [19.420] garnishee orders, [19.520] PAYG system — see PAYG system prepayments, [19.95] third parties, from, [19.520] unpaid tax, [19.420], [19.520] withholding tax — see Withholding tax Commissioner of Taxation, [19.20] additional returns, requiring, [19.180] administration of tax system, [19.20] audits, [19.430] challenging decisions of, [19.240] appeal or review, [19.320]-[19.350] objection to assessment or Ruling, [19.250]-[19.310] review of exercise of discretion, [19.360]-[19.410] enforcement powers, [19.520], [19.530] information-gathering powers, [19.430] investigative powers, [19.440] privilege claims, [19.450]-[19.500] s 353-13 notices, [19.440] obtaining information from, [19.510] common law procedures, [19.510] freedom of information, [19.510] rules of court, [19.510] tax legislation procedures, [19.510] unpaid tax, powers in relation to, [19.420] Commonwealth-State taxation powers, [1.300] Commuting expenses deductibility, [8.20]-[8.40] Companies accounts, importance of, [14.250]-[14.300] agency principle, [14.620]

groups ad hoc relief prior to consolidation regime, [15.590] CGT, ad hoc rules inadequate, [15.600] CGT rollover relief, [15.590] consolidation regime — see Consolidated

groups gain duplication, problem of, [15.600], [15.610], [15.620] loss grouping rules, [15.530] value shifting rules, need for, [15.210]-[15.230] imputation system — see Dividend

imputation system income derived through, [Pt5.10] income splitting through, [13.590] losses — see Company losses non-resident, [14.50] PAYG instalment system, [19.140] private company, [14.40] deemed dividends — see Deemed

dividends definition, [14.40] disguised profit distributions, prevention of, [14.360]-[14.490] profit and capital accounts, [14.250]-[14.300] public company, [14.40] definition, [14.40] residence, [16.180]-[16.210] carrying on business in Australia, [16.180], [16.190], [16.210] central management and control, [16.180], [16.200], [16.210] dual resident companies, [16.230] TR 2004/15, [16.200], [16.210] treaties, [16.230] resident company definition, [14.50] non-resident, distinction, [14.50] separate legal person, [14.20] shareholder level, taxation at, [14.80]-[14.110] shares — see Shares tax losses — see Tax losses 1057

Income Taxation

Companies — cont tax rate, [Pt5.10], [14.10] taxation of, [14.10] trusts taxed as, [13.540] Company losses accruing to company not shareholders, [15.350]-[15.370] anti-avoidance rules, [15.350] carry forward — see Carry forward of losses debt forgiveness, [15.430] groups consolidation regime — see Consolidated

groups loss grouping rules, [15.530] loss companies, [15.430], [15.460] anti-avoidance rules, [15.430] change of control, [15.530] tax losses carry forward — see Carry forward of

losses consolidated groups — see Consolidated

groups debt forgiveness reducing, [15.430] tax treatment, [15.350]-[15.370] Company-shareholder imputation system —

see Dividend imputation system Compensation allowable deductions, for, [6.210]-[6.310] assessable income, [2.190], [6.10] assessable recoupments, [6.290] business context, [6.50] compensation receipts principle, [6.10]-[6.50] damaged, destroyed or confiscated assets, for, [6.130]-[6.200] CGT assets, [6.190] character of asset, [6.130] depreciable assets, [6.180] revenue assets, [6.150]-[6.170] structural assets, [6.190] trading stock, [6.140] underlying asset, [6.200] damages, [6.60]-[6.120] defamation, [6.30], [6.40] defective equipment, [6.120] personal injury, [6.60], [6.70] disposal of right to seek, [6.200] excessive consideration to acquire asset, [6.200] in kind, whether income, [1.80] insurance payments, [6.60]-[6.120] loss of asset producing income, [6.10]-[6.50] monthly payments, [6.20] overview, [6.10] receipts as income, [6.10] reimbursement of deducted expense, [6.210]-[6.310] revenue assets, [6.150]-[6.170] reward for services, as, [6.270] statutory payments, [6.60]-[6.120] TR 95/35, [6.200] trading stock, loss of, [6.140] wrongful dismissal, [4.740], [4.750] 1058

Compliance costs FBT, [4.630] income tax, [19.180] Concessional deductions, [10.10], [10.390]-[10.440] Conditional sales accounting for income, [11.360] Confidential information CGT asset, whether, [3.50] Consolidated groups Asprey Committee, [15.580] CGT rollover, restrictions, [15.600] concept of, [15.550] consolidation regime, [15.550] ad hoc group relief prior to, [15.590] double taxation, preventing, [15.730] overview, [15.560]-[15.670] defining, [15.650]-[15.670] entry history rule, [15.690] exit history rule, [15.870] formation of, [15.770] tax cost setting, [15.760], [15.770] franking credits, [15.780], [15.790] group tax liabilities, [15.780], [15.790] head company, [14.580] implications of consolidation argument, [15.780] intra-group assets transferred to non-group entity, [15.710] legislation, [15.630] losses, [15.800]-[15.840] deferred on asset disposal, [15.590] MEC groups, [15.670] overview, [15.560]-[15.670] policy and history of regime, [15.560]-[15.640] Ralph Review recommendations, [15.620] sale of subsidiary, [15.790], [15.850]-[15.870] exit history rule, [15.870] resetting tax cost of shares, [15.870] single entity rule, [15.680]-[15.710] application of, [15.700] internal and external transactions, [15.700], [15.710] outside entities not affected by, [15.710] TR 2004/11, [15.710] single entity treatment, [15.630] subsidiary members, [15.850]-[15.870] sale of, [15.850]-[15.870] tax cost setting, [15.720]-[15.770] complexities in applying rules, [15.750], [15.760] formation of consolidated groups, [15.770] method, [15.740]-[15.760] reasons for, [15.730] sale of subsidiary, on, [15.870] tax losses and, [15.760], [15.800]-[15.840] tax losses, [15.800]-[15.840] pre-consolidation tax return, utilisation in, [15.810] tax cost setting and, [15.760] transfer to head company, restrictions, [15.820] usage of transferred losses, restrictions, [15.830] transactions between members not taxed, [15.570]

Index

Constitutional issues constraints on tax system, [1.300] discrimination between States, [1.300] division of powers, [1.300] one matter in each tax law, [1.300] power to make tax laws, [1.300] Construction expenditure capital works deduction, [10.270] Constructive receipt income, of, [2.170], [11.200]-[11.220] Consultant — see Independent contractor Consumable stores trading stock, whether, [12.360]-[12.410] Consumer loyalty schemes, [4.180]-[4.200] Consumption taxes, [1.60], [1.100]-[1.110] GST — see Goods and services tax (GST) income distinguished, [1.80] indirect tax, [1.100] broad-based, [1.110] personal, [1.100] political history of, [1.100] Continuity of ownership test (COT), [15.360], [15.440] bad debts, [15.430] carry forward of losses, for, [15.360] control of voting power test, [15.400] family trust election, [15.400] genuine business transactions, [15.440] Ligertwood Committee, [15.380] listed public companies, [15.420]-[15.430] majority ownership test, [15.400] non-fixed trusts, [15.400] passing, [15.400]-[15.430] realised losses, [15.440] same share rule, [15.410] tracing rules for listed public companies, [15.420]-[15.430] ultimate individual owners/controllers, [15.400] ultimate individual controllers, tracing back to, [15.400] unrealised losses, extension to, [15.530] Contract rights business income from transactions with, [5.500]-[5.590] compensation for income, [5.550]-[5.590] revenue assets, as, [5.500]-[5.540] capitalisation, [4.740] payments for varying, [4.710], [4.740]-[4.810] capital nature, [4.800], [4.810], [4.840], [4.850] compensation for wrongful dismissal, measured as, [4.740], [4.750] lump sum paid in instalments, [4.810] monthly payments, [4.760], [4.770] ordinary income, whether, [4.740]-[4.810] substituted amount, [4.780]

Contractor employees and, differing tax treatments, [4.1220] independent, [4.1220] Controlled foreign company (CFC) attribution rules, [17.120] regime, [16.40], [17.120] definition, [17.120] Convertible notes debt/equity rules, [14.250] Corporations — see Companies Cum-dividend sales imputation rules, [14.910] Customer loyalty schemes, [4.180]-[4.200]

D

Damages — see also Compensation compensation receipts principle, [6.10]-[6.310] deductibility, [7.10], [7.80], [7.90], [10.500] income, whether, [6.60]-[6.120] loss or damage to reputation/goodwill, [6.120] Death CGT rollover, [3.360] Death benefits dependant of employee, to, [4.1140] superannuation death benefits, [4.1030] Debentures interest on, [2.130], [3.450] premium on redemption, [3.440], [3.450] Debt/equity rules anti-avoidance rules, [14.740] artificial categorisation of debt as equity, [14.710] background, [14.60]-[14.75], [14.680]-[14.690] company tax regime, [14.60]-[14.75] converting or convertible interests, [14.250] debt and equity capital, distinction, [14.75], [14.150]-[14.160] debt interests, [14.80], [14.710]-[14.750] converting interest, [14.730], [14.760] debt test, [14.720]-[14.740], [14.750] alternative test, Commissioner’s discretion to invoke, [14.740] anti-avoidance rule, [14.740] concept behind, [14.750] effectively non-contingent obligation, [14.740], [14.750] exclusions, [14.740] present value calculation, [14.750] redeemable preference shares, [14.750] return not less than original capital invested, [14.750] short term trade credit exception, [14.740] 1059

Income Taxation

Debt/equity rules — cont valuation rules, [14.750] dividend imputation system, [14.75], [14.660]-[14.670] Division 974, in, [14.700]-[14.720] equity interests, [14.710], [14.720], [14.760]-[14.770] equity test, [14.720]-[14.740], [14.760]-[14.770] alternative test, Commissioner’s discretion to invoke, [14.740] anti-avoidance rule, [14.740] at call loan exception, [14.740] converting interests, [14.770] exclusions, [14.740] return at discretion of company, [14.750] return contingent on economic performance, [14.760] financing arrangements, [14.720]-[14.740] imputation context, [14.150]-[14.260], [14.660]-[14.670] mischaracterisation of interest, effect, [14.710] New Business Tax System (Debt and Equity) Bill 2001, [14.710] non-equity shares, [14.720] non-share dividends, [14.720] non-share equity interests, [14.930], [14.960] object and effect, [14.720] overview, [14.150] purpose, [14.720] schemes, application to, [14.720]-[14.740] shares, [14.80], [14.720] statutory, [14.700]-[14.710] summary, [14.710] tests, [14.720]-[14.740] alternative debt test, [14.740] anti-avoidance rules, [14.740] debt test, [14.750] equity test, [14.760]-[14.770] exclusions, [14.740] profits test, [14.230] thin capitalisation context, [14.160], [14.710] Debt-equity swaps, [10.370] Debt forgiveness, [14.410] business income, [5.790] capital gains tax, [3.110] commercial, [5.790], [10.360], [15.430] debt-equity swap, [10.370] deemed dividend, [14.370], [14.400] rules, [5.790], [10.360], [15.430] value shifting between entities, [15.230] Debt interests — see Debt/equity rules Debt recovery accounting for, [11.170] Deceased estates capital gains or losses, [13.440] income of, [13.330]-[13.350], [13.440] testamentary trusts, [13.310], [13.440] Decorations for valour CGT exemption, [3.370] 1060

Deductions accounting for — see Tax accounting after derivation of income, expenses incurred, [7.340]-[7.400] allowable, [2.340], [Pt3.10] ancillary benefits, [7.490]-[7.530] apportionment of expenses, [7.410]-[7.430] bad debts, [10.290]-[10.370] allowable under s 8-1 and s 25-35, [2.500] business judgment rule, [7.10], [7.430] capital allowances — see Capital allowances capital expenses — see Capital expenses capital gain, outlay subtracted from, [2.530] deduction reconciled with, [2.540] capital works, [10.270] charitable gifts, [8.250], [10.60] child care expenses, [8.50]-[8.70] clothing, [8.180] club and leisure facilities, [10.520] collateral business benefits, [10.550] commuting expenses, [8.20]-[8.40] companies bad debts, [10.290]-[10.370] statutory restrictions, [10.450]-[10.580] concessional, [10.10], [10.30], [10.390]-[10.440] development allowance, [10.420] investment allowance, [10.420] purpose, [10.390] research and development, [10.440] small business, [10.410], [10.430] temporary business tax break, [10.420] cost and outlays, method, [2.480]-[2.540] damages, [7.10], [7.80], [7.90], [10.500] definition, [2.340] denial as surrogate tax on benefits, [10.510]-[10.550] depreciation — see Depreciation determining, [2.480]-[2.540] development allowance, [10.420] double, [10.20] dual purpose expenses, [7.10], [7.410]-[7.650] after-tax gains, [7.410] ancillary benefits, [7.490]-[7.530] income splitting, [7.510], [7.540]-[7.590] legal rights doctrine, [7.430], [7.440], [7.490], [7.580] mismatched expenses to derive capital gains, [7.600], [7.610] statutory restrictions, [7.650] timing manipulation, [7.620]-[7.640] transfer pricing, [7.440]-[7.480] education expenses, [8.80]-[8.100] employment contract, expenses to obtain, [7.320]-[7.330] entertainment expenses — see Entertainment fines, [7.10], [7.70] general deductions (s 8-1), [2.340], [2.490], [Pt3.10], [7.10], [10.10] negative limbs, [Pt3.10] nexus issues, [Pt3.10], [7.10] positive limbs, [Pt3.10], [7.10] restrictions, [Pt3.20] specific deduction also allowed under, [2.500], [Pt3.10], [10.20] GST, [7.40] hobby expenses, [8.230]

Index

Deductions — cont home office, [8.130]-[8.170] illegal business, expenses incurred, [7.170], [10.500] immediate write-offs, [10.30] income splitting, [7.510], [7.540]-[7.590] income tax payments, [7.30] intangible assets, [10.175] investment allowance, [10.420] land tax or rates, [7.50] legal expenses, [7.10], [7.100]-[7.160], [9.90]-[9.100] defence, incurred in, [7.120], [7.130] legal rights doctrine, [7.430], [7.440], [7.460], [7.490], [7.580] loss or outgoing, [Pt3.10], [7.10] deductible under s 8-1, [2.490], [Pt3.10], [7.10] gaining or producing assessable income, [2.490], [Pt3.10], [7.10] meaning, [7.10] nexus with assessable income, [Pt3.10], [7.10] temporal nexus with income, [7.10], [7.260]-[7.400] wholly and exclusively for producing income, [7.410] losses and timing rules, [10.280]-[10.285] medical expenses, [8.240] mining companies — see Mining and

quarrying misappropriation of funds, [7.10], [7.180]-[7.220] mismatched expenses to derive capital gains, [7.600], [7.610] non-commercial losses, [8.230] non-compulsory uniforms, [10.490] outlay subtractable from revenue in calculating profit, [2.530] deductions reconciled with, [2.520] outlays to reduce costs, [7.230]-[7.250] overview, [2.340], [Pt3.10] payroll tax, [7.50] personal expenses — see Personal expenses personal services income expenses, [10.560] petroleum resource rent tax, [7.30] prepaid expenses, [10.380] prepayments of interest or fees, [7.630] principal deduction provision, [Pt3.10] prior to commencement of business, expenses incurred, [7.290]-[7.310] private expenses — see Personal expenses prohibited deductions, [Pt3.10], [9.10], [10.20], [10.450] project pools, [10.230] quasi-personal expenses, [7.10], [7.60]-[7.170] statutory restrictions, [10.460], [10.490], [10.500] reconciling amounts deductible twice “most appropriate” section, [Pt3.10], [10.20] s 8-1 and specific deduction, [2.500], [Pt3.10] reduction of costs, expenditure on, [7.230]-[7.250] redundant provisions, [10.50] repairs, [10.65]-[10.100] research and development, [10.440] restrictions, [10.20] statutory, [10.450]-[10.580] special capital allowance, [10.230],

specific deductions, [2.340], [Pt3.10], [10.10], [10.30] also deductible under s 8-1, [2.500], [Pt3.10], [10.20] immediate write-offs, [10.30] life of the asset, [10.30] particular amounts, [10.30]-[10.100] preferred activities, [10.30] redundant provisions, [10.40] restrictions, [Pt3.20] stamp duty, [7.50] statutory restrictions, [7.650], [10.450]-[10.580] substantiation, [8.260], [8.270] superannuation contributions, [4.920] tax payments, [7.20]-[7.50] taxable income calculation, [2.320] timing issues, [11.20]-[11.40] temporal nexus between outlay and income, [7.10], [7.260]-[7.400] settlement payments, [7.380], [7.390] temporal break, [7.280], [7.370] theft losses, [7.10], [7.180]-[7.220] time dimension, [Pt4.10], [11.10] timing manipulation schemes, [7.620]-[7.640] timing-preferred income, [7.620], [7.640] timing rules, [10.30], [10.280], [11.20]-[11.40] transfer pricing, [7.440]-[7.480] travel expenses, [8.110], [8.120], [10.30] commuting, [8.20]-[8.40] immediate deductions, [10.30] Deemed dividends assessable dividend, [14.390] debt forgiveness, [14.370], [14.400], [14.410] disguised profit distributions, [14.360]-[14.490] distributable surplus, company with, [14.390] excessive remuneration, [14.480] exclusions, [14.380] FBT and, [4.350], [14.440] “golden handshakes”, [4.700], [4.1070], [14.480] interaction of Div 7A with dividend provisions, [14.370]-[14.440] exclusions from deemed dividend treatment, [14.380] transactions of private companies, [14.370] payment or transfer of value, [14.435] private companies, from, [14.360]-[14.490] private company payment or loan to associate, [4.680], [14.360] excessive remuneration, [14.480] exclusions, [14.380] remuneration or retiring allowances, [14.440] s 109, operation of, [14.480] tax consequences, [4.680]-[4.700] unfrankable, [14.430] written-off loan, [14.400] Deep discount debt securities, [3.460] Demerger dividends, [15.320], [15.330] rollover relief, [15.320], [15.330] subsidiary, [15.330] Depreciation — see also Capital allowances balancing adjustment, [10.220] 1061

Income Taxation

Depreciation — cont calculating deduction for, [10.190]-[10.210] diminishing value method, [10.210] effective life determination, [10.190] prime cost method, [10.210] car depreciation cap, [10.540] deduction, [9.10], [10.120] calculating, [10.190]-[10.210] conditions, [10.120] special capital allowances, [10.230] who can claim, [10.185] depreciating assets, [10.120] compensation for loss of, [6.180] components or entire, [10.140], [10.160], [10.170] composite asset, [10.160], [10.170], [10.175] copyright, [10.175] cost of, [10.195]-[10.200] definition, [10.130]-[10.170] effective life, [10.190] exclusions, [10.130] holder of, claiming deduction, [10.185] identifying, [10.130]-[10.170] foreign currency purchases, [12.740] initial repairs, [10.90]-[10.100] machines, [10.140] methods of calculation, [10.210] plant in residential investment properties, [10.140]-[10.150] pooling, [10.230] farming, mining and other projects, [10.230] small business pools, [10.230], [10.410] repairs or replacement, [10.65]-[10.100] small business taxpayers, [10.230], [10.410], [10.430] special capital allowance regimes, [10.230]-[10.240] tax reform, [10.240] Derivation of income deduction of outgoings related to — see

Deductions employee share schemes, [2.250], [4.670] preventing, by diverting receipt, [11.200] share options, [2.250], [4.670] Development allowance, [10.420] Discounts and premiums debentures, premium on redemption, [3.340], [3.350] deep discount debt securities, [3.460] discounted securities, [3.470] income/capital gain distinction, [3.440] income from property, [3.430]-[3.450] interest, in lieu of, [3.430] market discount, [3.440] original issue discount, [3.440] premium as assessable income, [2.190] stripped bonds, [3.440] traditional securities, [3.470] unincorporated businesses, [10.430] zero coupon bonds, [3.440] Dispute — see also Appeal — see also Objections tax liability, about, [19.420] 1062

collection of tax, [19.420] obtaining information from Commissioner, [19.510] Dividend account keeping, [14.250]-[14.300] anti-avoidance measures, [14.800]-[14.860] assessable income of shareholders, [2.400], [14.120]-[14.840] assignment, [14.310], [14.330] capital streaming rules, [14.840] circumstances of payment, [14.720]-[14.230], [14.320] TR 2012, [14.230] Corporations Act s 254T, effect, [14.230] debt due to shareholder, [14.310]-[14.340] deemed dividends — see Deemed dividends definition, [14.130], [14.150] demerger dividends, [15.320], [15.330] distributions of profit, [14.180] account keeping, [14.250]-[14.300] disguised distributions by private companies, [14.360]-[14.490] distribution, meaning, [14.130] exceeding recorded profit, [14.260], [14.270] existing property, [14.130] failure to keep proper financial records, [14.240] fraudulent or inaccurate records, [14.240] profits, meaning, [14.180], [14.200], [14.210] return of share capital, disguised as, [14.800]-[14.840] return of share capital distinguished, [14.140]-[14.170] foreign source — see Foreign source income imputation — see Dividend imputation

system income, whether, [2.50], [3.420] interim, [14.310], [14.330], [14.340] legal form of, [14.360] liquidator distributions, [14.280], [14.290], [14.300], [14.1000], [14.1010], [14.1020] Archer Brothers principle and company accounts, [14.1030]-[14.1040] net assets rule, [14.210], [14.230] no double tax, [13.20] non-equity shares, on, [14.710] non-residents, [18.120]-[18.130] imputation system, [14.650], [18.130] withholding tax, [18.120]-[18.130] non-share dividends, [14.710] payment of, [14.310]-[14.340] profits distribution out of, [14.180]-[14.230] distributions in excess of, [14.260], [14.270] meaning, [14.180], [14.200], [14.210] unrealised gain, [14.210]-[14.220] redemption of preference shares, [14.230] returns of share capital, [14.140]-[14.170] distribution of profit distinguished, [14.140]-[14.170] exceeding recorded share capital, [14.280]-[14.300] non-deductible to company, [14.150] tax treatment, [14.150], [14.170]

Index

trusts, [14.610] limits, [14.620]-[14.650] linked distribution rule, [14.880], [14.890] non-equity shares, [14.720] non-residents, [14.650] non-share dividends, [14.720] non-share equity interests, [14.930], [14.960] operation of, [14.70], [14.450] over-franking tax, [14.860] overview, [14.60]-[14.75] partnership distributions equivalent to interest on loan, [14.610] imputation through, [14.600] policy of, [14.450]-[14.490] purpose of, [14.60] securities loans, [14.910] share capital distributions unfrankable, [14.530] split-rate system, [14.460] tax-exempt bonus shares, substitution of, [14.350] tax-exempt shareholders, [14.520] tax offset, [2.360], [14.500] taxed Australian profit, distribution of, [14.70] taxed foreign profit not eligible for imputation, [14.620] trust distributions equivalent to interest on loan, [14.610] imputation through, [14.610] untaxed profit, [14.510], [14.620]

Dividend — cont unfrankable distribution, [14.530], [14.710], [14.720] sell-back rights, [14.130] share buy-backs, [14.150], [15.70]-[15.90] share capital and profits, partly out of each, [14.260] streaming, [14.850] stripping — see Dividend stripping timing of payment, [14.310]-[14.340] when paid, [14.310] withholding tax, [18.120]-[18.130] Dividend imputation system agency principle, [14.620] anti-avoidance rule, [14.940]-[14.980] anti-streaming rule, franking credits, [14.850], [14.900] basic scheme, [14.500] benchmark rule, [14.860]-[14.870] distributions in different franking periods, [14.870] franking percentage, [14.860] franking periods, [14.860] over-franking, [14.870] private companies, [14.860], [14.870] public companies, [14.860] cum-dividend sales, [14.910] debt/equity rules — see Debt/equity rules differential taxation of profit, [14.180] disclosure rule, [14.860] private companies, [14.860] public companies, [14.860] distribution statement, [14.510], [14.650] distributions by resident companies applicable to, [14.70] taxed Australian profit, [14.70] dividend stripping — see Dividend stripping double taxation, avoiding, [14.60]-[14.75], [14.450] foreign profit, distribution of, [14.75] taxed foreign profit not eligible, [14.640] frankable distributions, [14.530] benchmark rule, [14.860], [14.870] taxed profits, linked to, [14.550] franked dividends, [14.70] resident individual, paid to, [14.500], [14.510] tax-exempt bonus shares substituted for, [14.350] franking accounts, [14.540]-[14.550] franking credits, [14.500], [14.940] anti-avoidance rule, [14.940]-[14.980] consolidated groups, [15.780] exempting companies, of, quarantining, [14.650] 45 days/at risk rules, [14.920], [14.930] streaming, rules to prevent, [14.900]-[14.930] trading, [14.920], [14.930], [14.960] franking deficit tax, [14.540]-[14.550] imputation credit, [14.70] imputation tax rebates, [2.360] international taxation, [17.100] interposed entities, [14.560]-[14.610] at risk rules, [14.920], [14.930] companies, [14.570]-[14.590] partnerships, [14.600]

Dividend stripping, [14.990], [15.120]-[15.130], [15.170] anti-avoidance rule, [14.990] concept of, [14.990], [15.100] dividend stripper, [15.110] position of, [15.110]-[15.130] franking credits, use of, [14.990] legislative measures to counter, [14.990] shareholder, definition, [14.80], [14.90] shares as trading stock, [12.320] tax planning, [20.30] vendor shareholder, [15.150]-[15.190] position of, [15.150]-[15.190] Double tax agreements (DTAs), [16.70] Double tax conventions (DTCs), [16.70] Double taxation bilateral tax treaties, [16.70] business entities and owners, [13.20] companies, [14.60]-[14.75], [14.450] imputation system as relief, [14.60], [14.75], [14.450] share transactions, [15.10] foreign income, [17.10] international taxation of residents, [17.10] preventing, [11.590]

E

Education expenses deductibility, [8.80]-[8.100] 1063

Income Taxation

rules governing, [4.1070] tax free component, [4.1130] tax rate, [4.1130] tax treatment, [4.1080], [4.1130] overview, [4.870] termination, meaning, [4.1080] inconsequence of termination, [4.1100] voluntary payments, [4.1070] wrongful dismissal payment, [4.1120]

Embezzlement deductibility of losses, [7.220] interest on embezzled amounts, [2.70] Employee share schemes, [4.660]-[4.670] derivation of income, [2.250], [4.670] FBT exclusion, [4.320], [4.350], [4.670] qualifying shares or options, [4.670] specific provisions for, [2.270], [4.660], [4.670] tax concessions, [4.670] timing issues, [4.660] valuation of shares or options, [2.250], [2.260], [4.660]-[4.670] Employees contractors and, differing tax treatments, [4.1220] fringe benefits — see Fringe benefits tax

(FBT) gifts to, [2.90], [4.30]-[4.210] employer, from, [4.30]-[4.150] person other than employer, [4.160]-[4.210] income from service, [4.10] investment income, [19.120] non-resident, [18.210]-[18.220] PAYG withholding, [19.100]-[19.120] remuneration, special categories of, [4.650] restrictive covenants, payment for, [4.710], [4.820]-[4.860] substantiation rules, [19.110] superannuation — see Superannuation tax treaties, [18.210] uniforms, [10.490] varying contract rights, payment for, [4.710], [4.740]-[4.810] work effort and taxation, [4.20] Employment contract contract of service, [4.1220] deductibility of expenses to obtain, [7.320]-[7.330] Employment income foreign source, [17.50] non-residents, [18.200]-[18.260] Employment termination payments assessment, [4.1130] change of job payment, extension to, [4.1120] connection test, [4.1080]-[4.1110] death benefit payments, [4.1140] excessive payments deemed dividends, [14.480] FBT exclusion, [4.350] former tax treatment, [4.890] “golden handshakes”, [4.1070], [4.1080] excessive, deemed dividend, [4.700], [14.480] in consequence of termination, [4.1080]-[4.1120] causal nexus, [4.1100], [4.1110] time test, [4.1120] inclusions and exclusions, [4.1080] involuntary payments, extension to, [4.1120] lump sum payments, [4.890] multiple payments, [4.1080] redundancy payments distinguishing between ETP and, [4.1120] excluded from ETP definition, [4.1080], [4.1170] 1064

Enforcement of tax debt, [19.520] Commissioner’s powers, [19.520] penalties, [19.530] Entertainers non-resident, [18.240], [18.250] Entertainment deductibility of expenses deduction denial provisions, [8.210], [10.530] employees or third persons, [8.190]-[8.210] high personal elements, [8.210] legitimate business reasons, [8.190], [8.205] self, [8.220] substantiation, [8.260] definition, [8.220] fringe benefits, [4.330], [4.470], [8.210] meal entertainment, [8.210] taxable value, [4.470] what constitutes, [8.210], [8.220] Equipment leasing accounting for, [12.710] non-residents, [18.190] royalty withholding tax, [18.190] Equity consumption taxes, [1.100] distributional implications of taxes, [1.240] equity-efficiency trade-off, [1.200], [1.220] fringe benefits tax, [4.540] Henry Review, [1.240] “initial endowments” theory of inequality, [1.220] substitution effect of tax, [4.20] tax and transfer system, [1.240] tax policy, in, [1.30] Equity interests — see Debt/equity rules Estate taxes, [1.120] Exempt income, [2.330] definition, [2.330] determining, [2.400] exclusion from tax base, [2.420]

F Family tax benefit economic effect, [1.250] Federal Court appeals to, [19.320]-[19.350] AAT review distinguished, [19.330]

Index

Federal Court — cont appealable objection decisions, [19.320] justiciable issues, [19.340] onus of proof, [19.350] validity of assessment, against, [19.330] Finance leases, [9.290]-[9.330], [10.580] Financial accounting construction industry, [11.580] income tax based on, submissions re, [19.180] principles, [11.70]-[11.90] purpose, [11.90] tax accounting and, [11.70]-[11.90] relationship, [11.110] trading stock valuation, [12.70], [12.150] Financial arrangements — see Taxation of

financial arrangements (TOFA) Fines deductibility, [7.10], [7.70] First home saver account employer contributions, [4.210] Fiscal nullity doctrine, [20.190] Food and drink — see also Entertainment deductibility of expenses employees or third persons, [8.190]-[8.210] self, [8.220] meal allowances, [8.270] substantiation of expenses, [8.270] Foreign currency transactions, [12.740] Foreign exchange gains and losses, [12.740], [14.620] Foreign income tax offset (FITO), [16.240], [17.10], [17.80]-[17.90] Foreign losses thin capitalisation rules, [17.170]-[17.180] Foreign-source income attribution regimes, [17.110]-[17.150] controlled foreign company (CFC) regime, [16.40], [17.120] deduction regime, [17.10], [17.100] dividends, [17.50] foreign subsidiaries, from, [17.50] non-portfolio dividends, [17.60], [18.130] exemption regimes, [17.30]-[17.60] CGT on shares in foreign subsidiaries, [17.60] dividends from foreign subsidiaries, [17.50] income derived through foreign permanent establishments, [17.40] foreign currency transactions, [12.740] foreign investment fund (FIF) regime, [17.130] foreign permanent establishments, derived through, [17.40]

foreign subsidiaries, dividends from, [17.50] foreign tax offset (FITO), [16.240], [17.10], [17.80]-[17.90] non-portfolio dividends, [18.130] regime, [17.80]-[17.90] franking credits, [17.100] imputation system, [17.100] international tax rules for, [17.10] exemption regimes, [17.30]-[17.60] personal service income, [18.230] resident and source-based taxation, clash of, [17.10] temporary residents, [17.20] transferor trust regime, [17.140], [17.150] Freedom of information, [19.510] Frequent flyer schemes FBT consequences, [4.380] income, whether, [4.180]-[4.200] Fringe benefits tax (FBT) administrative difficulties, [4.260] airfare subsidies, [4.330] Asprey Committee, [4.230], [4.290] associate, provided to or by, [4.380] background, [4.230] broadening tax base, [2.100] business premises, meaning, [4.560] car parking, [4.330], [4.450] concessionary valuation rule, [4.570] taxation of space, not employee, [4.640] cars, [4.440] depreciation and, [10.540] operating cost valuation method, [4.440] statutory formula valuation method, [4.440] taxable value, [4.440] cash salary/fringe benefit comparison, [4.590] gross-up formulas, [4.600] child care, in-house facilities, [4.350], [4.560] business premises, meaning, [4.560] classification of benefit, [4.320], [4.350] compliance costs, [4.630] concessions, [4.500] constitutional issues, [1.300] criticism, [4.540] deemed dividends, [4.350], [14.440] definition of fringe benefits, [4.230], [4.330], [4.350] determining employer’s liability to, [4.320] difficulties in enforcement, [4.260], [4.270] Draft White Paper, [4.230], [4.310], [4.540] economist’s view, [4.240] employee benefit trusts, [4.640] employee incentive schemes, [4.640] employee share schemes excluded, [4.320], [4.350], [4.670] employees benefits to, [4.380] current, former and future, [4.380] reporting by, [4.530], [4.620] employer arranger, acting by, [4.380] benefit provided by, [4.380] current, former and future, [4.380] foreign, [4.630] 1065

Income Taxation

Fringe benefits tax (FBT) — cont liability, determining, [4.320] rebate against liability, [4.610] tax exempt, [4.610] employment, benefit in respect of, [4.320], [4.390]-[4.420] connection test, [4.320], [4.410], [4.420] entertainment, [4.330], [4.470], [8.210] taxable value, [4.470] exclusions, [4.350], [4.500] exempt benefits, [4.350], [4.500] expense payments, [4.330] FBT year, [4.320] foreign employer, [4.630] frequent flyer schemes, [4.380] fringe benefits also income, [2.10], [2.440] non-assessable non-exempt income, [4.530] reconciling, [2.450] fringe benefits provided, [4.320] concept of, [4.330]-[4.370] definition, [4.230], [4.330], [4.350] exclusions, [4.350], [4.350] in respect of employment, [4.390]-[4.420] parties to transaction, [4.380] PAYG withholding, excluded from, [19.110] provided, meaning, [4.370] timing, [4.320], [4.370] fringe benefits taxable amount, [4.320], [4.590] future employees, [4.380] grossed-up value, [4.600] GST-inclusive tax base, [4.600] housing and meals, [4.330] in-house benefits, [4.490], [4.570] income tax, relationship with, [2.100], [2.440], [4.220] integration into tax system, [2.100], [4.530] international placements, [4.630] ITAA 1936, former taxation under, [4.250] ITAA, integration with, [2.100], [4.220], [4.530] legal problems, [4.270] legislation, [2.380], [4.320] living-away-from-home allowance, [4.330], [4.350] loans and waivers, [4.330], [4.420], [4.460] taxable value, [4.460] mass-marketed tax schemes, [4.640] meal entertainment, [8.210] non-cash benefits, [4.230] PAYG withholding, excluded from, [19.110] non-individualised benefits, [4.640] non-residents, [18.220] non-taxation of fringe benefits, [4.250] possible solutions, [4.280]-[4.310] reasons for, [4.260]-[4.270] NZ Task Force on Tax Reform, [4.300] operation, [4.320] “otherwise deductible” rule, [4.510]-[4.520] double tax problem, [4.510] “once-only deduction”, [4.520] operation of, [4.520] over-inclusiveness of base, [4.550], [4.560] overview, [4.220] PAYG Payment Summaries, reporting on, [4.620] problems, [4.250], [4.270], [4.540]-[4.640] design, [4.540] property, [4.480] range of fringe benefits, [4.230] rate, [4.320], [4.580] 1066

reimbursement/allowance distinction, [4.360], [4.370] reportable fringe benefits, [4.620] residual benefits, [4.330], [4.340], [4.490] “external benefit”, [4.490] “in-house benefit”, [4.490] “non-period” benefit, [4.490] “period” benefit, [4.490] superannuation excluded, [4.320], [4.350] surcharges, interaction with, [4.620] tax base broadening, [2.100] FBT-inclusive, [4.590] GST-inclusive, [4.600] over- and under-inclusiveness, [4.550], [4.560] tax exempt employers, [4.610] taxable value of benefits, [4.430]-[4.500], [4.570] car parking, [4.450] cars, [4.440] entertainment, [4.470] loans and waivers, [4.460] problems of defining, [4.570] property, [4.480] timing of benefit, [4.320], [4.370] travel allowances, [4.350], [4.360] unallocable benefits, [4.640] under-inclusiveness of base, [4.550], [4.560] valuation, [4.320] difficulties with, [4.260], [4.570] “otherwise deductible” rule, [4.510]-[4.520]

G Gambling or betting business, whether, [5.40]-[5.60] winnings CGT exemption, [3.370] income, whether, [2.70], [5.60] non-residents, [18.270] Garnishee orders, [19.520] General interest charge (GIC) penalty system, [19.530] Gifts business income, whether, [5.260]-[5.280] gift-type payment, [5.270] charitable, deductibility, [8.250] customer loyalty schemes, [4.180]-[4.200] employees, to, [2.90], [4.30]-[4.210] employer, from, [4.30]-[4.150] Encouragement to Study Scheme, [4.130]-[4.150] person other than employer, by, [4.160]-[4.210] salvage reward, [4.160], [4.170] supplementary payments, [4.70]-[4.120] frequent flyer schemes, [4.180]-[4.200], [4.380] gift and estate taxes, [1.120] income, whether, [2.70], [4.30]-[4.210] methodology for determining cases, [4.110] motive of donor, [4.40], [4.50]-[4.60] Globalisation company tax and, [14.480], [14.510]

Index

hobby farm, whether business, [5.60]-[5.100] non-commercial losses, [5.190], [8.230]

Globalisation — cont international taxation, effect on, [16.40] Goods and services tax (GST) accounting for, [12.750] CGT event, capital proceeds of, [12.750] commencement of, [1.110] constitutional issues, [1.300] consumption tax, [7.40] deductibility, [7.40] FBT gross-up procedure including, [4.600] Howard government, [1.55] imposition Acts, [1.300] indirect consumption tax, [1.110] input tax credits, [7.40], [12.750] legislation, [1.300] political history, [1.110] States, allocation to, [1.300] tax base, inclusion in, [4.600] taxable supply, [12.750] Goodwill loss or damage to, [6.120] Government justification for existence, [1.20], [1.170] tax expenditures, [1.130]-[1.150] taxes meeting cost of, [1.20] Government subsidies business income, whether, [5.310]-[5.340] tax system used to deliver, [1.140] what constitutes, [5.330], [5.340] Gratuities assessable income, [2.190]

H

Hardship relief, [19.540] Health care cards, [6.400] Henderson Poverty Line, [1.240] Henry Review, [1.10], [1.230]-[1.260] company tax, [14.470], [14.480] government response, [1.250] international tax competition and cooperation, [16.350]-[16.460] recommendations, [1.250] criticism of, [1.260] tax and transfer system, [1.240] Higher Education Contribution Scheme (HECS) tax offsets not taken into account, [2.360] taxable income, based on, [2.360] Hire purchase transaction accounting for, [12.710], [12.720] Hobbies business distinguished, [5.40]-[5.110] deductible expenses, [8.230]

Holidays valuation as income, [2.230] Home office deductions, [8.130]-[8.170]

I

Illegal business deductibility of expenses, [7.170], [10.500] income from, [5.350] Imputation system — see Dividend

imputation system Income accounting for — see Tax accounting apportionment, [2.280]-[2.300] assessable — see Assessable income benefits received from intermediaries, [2.180]-[2.210] business — see Business income capital, distinguished, [2.50], [3.420] trust law, [2.30] capital gains as, [2.10], [2.100] characterisation, [4.710] comprehensive income tax base, [1.90], [16.20] concept of, [1.70]-[1.90], [2.10]-[2.200], [Pt2.10] constructive receipt, [2.170], [11.200]-[11.220] constructive valuation, [1.80] consumption distinguished, [1.80] definitions for purposes of Australian tax law, [2.10] economic concept, [1.80], [2.60], [2.70] judicial concept distinguished, [2.70] exempt, [2.330], [2.420] flow, as, [1.80], [2.60], [2.120]-[2.140] foreign source — see Foreign source income fringe benefits as, [2.10], [2.100] gain, as, [1.80], [2.50], [2.70], [2.130] nexus with source, [2.50], [2.60] global concept, [2.40] Haig-Simons approach, [1.80]-[1.90], [1.150], [1.210], [2.70], [2.100], [2.130] in kind earnings, [1.210] intended and unintended receipts, [2.20] intermediaries benefits received from, [2.180]-[2.210] income derived through, [Pt5.10] tax policy, [13.10]-[13.30] ITAAs, meaning in, [2.10] judicial concept of, [2.20], [2.60], [2.70], [2.400] economic concept distinguished, [2.70] elements of, [2.110]-[2.300] meaning for purposes of tax law, [2.10] net, definition in trust context, [13.390] non-assessable non-exempt, [2.330], [2.420] ordinary, [2.10], [2.20]-[2.100], [2.400] assessable income, part of, [2.330] determining, [2.400] “ordinary concepts” notion, [2.20] 1067

Income Taxation

Income — cont reconciling statutory income and, [2.430] statutory modifications, [2.100] overseas law, influence of, [2.40] partnership — see Partnerships personal, definition, [1.80] profits of employment, [2.80] property, from — see Income from property realisation requirement, [2.120]-[2.140], [11.260] receipt, timing of — see Tax accounting schedular systems of taxing, [1.90], [3.10] services, from — see Income from services social security law, [2.10] source rules, [16.240]-[16.270] specified time interval, relation to, [1.80] statutory, [2.10], [2.330] reconciling ordinary income and, [2.430] substituted amounts from third party, [4.780]-[4.790] tax base, [1.60], [1.70]-[1.90] broadening, [2.100] comprehensive income tax base, [1.90], [16.20] taxable — see Taxable income taxpayer, identifying, [2.150]-[2.210] time of taxable event, [2.200]-[2.210] trust — see Trusts trust law concept, [2.30], [2.130] UK approach, [2.40] US approach, [2.40], [2.50], [2.60] valuation, [2.220]-[2.270] amount changing after tax event, [2.270] basic valuation test, [2.220] non-cash income, [2.220], [2.230] pecuniary amount, [2.230] realisable value test, [2.250] wealth distinguished, [1.80] what is, [1.80], [2.10] Income from property annuities, [3.480] instalment sales, [3.490]-[3.530] assessable income, [2.400] business income distinguished, [3.10] capital gains distinguished, [3.420] capital gains tax — see Capital gains tax

(CGT) discounts and premiums, [3.440]-[3.450] deep discount debt securities, [3.460] income/capital gain distinction, [3.420], [3.440] original issue discount, [3.440] stripped bonds, [3.440] traditional securities, [3.470] zero coupon bonds, [3.440] disposal of property — see Capital gains tax

(CGT) gains from use of property, [3.420]-[3.610] fruit and tree analogy, [3.420] instalment sales, [3.490]-[3.530] implicit interest, [3.490]-[3.530] interest, [2.400], [3.430] discount or premium in lieu of, [3.430]-[3.450] instalment sales, [3.490]-[3.530] judicial concept of income, [2.400] lease improvements, [3.560] 1068

premiums, [3.540] rent, [3.540] repairs, [3.550] non-residents, [18.20] one-off sales, [3.10] overview, [3.10] profit-making scheme, [3.10] rent, [2.400], [3.420], [3.540] royalties, [2.400], [3.420], [3.570] use and sale of property, [3.10] Income from services assessable income, [2.400] employee share schemes — see Employee

share schemes FCT v Dixon judgment, [4.70]-[4.90] first home saver account contributions, [4.210] foreign source — see Foreign source income fringe benefits — see Fringe benefits tax

(FBT) general principle, [4.10] gifts to employees, [4.30]-[4.210] customer loyalty schemes, [4.180]-[4.200] employer, from, [4.30]-[4.150] Encouragement to Study Scheme, [4.130]-[4.150] frequent flyer schemes, [4.180]-[4.200] person other than employer, by, [4.160]-[4.210] salvage reward, [4.160], [4.170] supplementary payments, [4.70]-[4.120] judicial concept of income, [2.400] ordinary income, [4.210] overview, [4.10] prizes, [4.30], [4.160] quality of income, determining, [4.30] reimbursement of car expenses, [4.210] restrictive covenants, payment for, [4.710], [4.820]-[4.860] retirement income — see Retirement income return to work payment, [4.210] reward for providing services, [4.10] sale of assets distinguished, [4.720], [4.730] statutory regimes, [4.210] valuation rule, [4.10] varying contract rights, payment for, [4.710], [4.740]-[4.810] work effort and taxation, [4.20] Income splitting after-tax consequences, [7.580], [7.590] anti-avoidance measures, [7.540], [13.590] assignment of income, [13.570], [13.580] companies, [13.590] dual purpose outgoings, [7.10], [7.540]-[7.590] family groups, [13.560], [13.590] interposed entities, [7.540], [7.550], [Pt5.10], [13.590] legal rights doctrine, [7.570] partnerships, [13.590] pre-tax consequences, [7.580] service trust, [7.550], [7.560] spouses, between, [7.540], [13.570] tax planning, [20.30] trusts, [13.590] underage children, [13.590]

Index

Income tax administration — see Tax administration assessment — see Assessments broadening tax base, [2.100] capital gains and, [2.100] Commonwealth control, [1.300] compliance costs, [19.180] comprehensive income tax base, [1.90], [16.20] deductibility, [7.30] elements of system, [2.380] equation, [2.320] fringe benefits and, [2.100] overlapping assessment sections, [2.550] partnerships, [13.170]-[13.240] rate scales, [2.350] schedular system, [1.90], [3.10] statutory framework, [2.310] tax base — see Tax base Independent contractor, [4.1220], [4.1230] contract for services, [4.1220] deductions, [4.1230] Industry Partnership groups, [19.80] Information CGT asset, whether, [3.50] confidential information, [3.50] know-how, [3.60], [3.230] mining information, [3.60], [3.220], [3.230] Commissioner’s power to obtain, [19.430], [19.440] audit, [19.430] privilege, [19.450]-[19.500] s 353-13 notices, [19.440] obtaining from Commissioner, [19.510] common law procedures, [19.510] Federal Court Practice Note, [19.510] freedom of information, [19.510] rules of court, [19.510] tax legislation procedures, [19.510] Instalment Activity Statement (IAS), [19.120] Instalment payments annuities — see Annuities apportionment into principal and interest, [3.490], [3.500] contract rights, payment for varying, [4.810] hire purchase, accounting for, [12.710], [12.720] interest component, [3.490]-[3.530] judicial characterisation, [3.490] periodicity principle, [6.410]-[6.460] Instalment sales accounting for, [12.720] Insurance compensation payments, [6.60]-[6.120] assessability, [6.100], [6.110] characterisation as income receipt, [6.90] Insurance companies non-resident, taxation of, [18.60] realisation of investments, [5.700]-[5.720], [5.750]

Intangible assets capital expenses — see Capital expenses end of (CGT event C2), [3.120], [6.190] trading stock, [12.330] Intellectual property “keep out” covenants, [3.600] royalties, [3.570], [3.590]-[3.610], [18.170], [18.180] non-residents, [18.170], [18.180] Interest accounting for, [12.490]-[12.520] future payments, [11.420], [11.430] TOFA regime, [12.490]-[12.520] assessable income, [2.400] capital assets, purchase of, [9.340]-[9.350] debentures, on, [2.130], [3.450] deductions, [12.500] future payments, [11.420], [11.430] partnerships, [13.140], [13.150] discount or premium in lieu of, [3.430]-[3.450] embezzler not taxed on, [2.70] income from property, [3.430] instalment sales, [3.490]-[3.530] implicit interest, [3.490]-[3.530] non-residents, [18.140]-[18.150] withholding tax, [18.110], [18.140]-[18.150] non-share equity, on, [14.720] offshore banking units, [18.150] partnerships, [13.140], [13.150] prepayments, deductibility, [7.630] withholding tax, [18.110], [18.140]-[18.150] Intermediaries benefits received from, [2.180]-[2.210] superannuation contributions, [2.180] characterising for tax purposes, [13.100] companies — see Companies dual cost bases, [Pt5.10] foreign, [13.100] imputation through, [14.560]-[14.590] at risk rules, [14.920], [14.930] companies, [14.570]-[14.590] partnerships, [14.600] trusts, [14.610] income derived through, [Pt5.10], [13.10] income splitting through, [7.540], [7.550], [Pt5.10], [13.590] integration of ownership interests, [13.20] international taxation, [16.40] partnerships — see Partnerships residence, [16.40] tax policy, [13.10]-[13.30] tax shelters, [20.30] trusts — see Trusts unusual, [13.100] International taxation advance pricing arrangements (APAs), [16.390] capital export neutrality, [17.10] capital import neutrality, [17.10] comprehensive income tax base, [16.20] controlled foreign company (CFC) regime, [16.40], [17.120] 1069

Income Taxation

International taxation — cont cooperative activities, [16.330] cross-country cooperation, [16.460] exemption system, [16.30] foreign direct investment, [17.30] foreign-source income — see Foreign-source

income foreign tax offset, [16.30], [17.10], [17.80]-[17.90] fringe benefits tax, [4.630] globalisation, effect of, [16.40] intermediaries, [16.40] multinational enterprises, [16.40], [16.300] national neutrality principle, [17.10], [17.100] non-residents — see Non-residents overview, [Pt6.10], [16.10]-[16.110] passive income, [16.40] policy, [16.10]-[16.110] domestic tax rules, effect on, [16.20] individuals, [16.20]-[16.30] neutrality principle, [17.10] residence rules — see Residence residents, [17.10]-[17.20] definition, [16.120] foreign-source income — see

Foreign-source income international tax rules, [17.10] source rules, [16.240]-[16.270] modification, [16.240] non-residents, [16.240] passive income, [16.40] residents, [16.240] transfer pricing, [16.240] structure, [16.10]-[16.110] tax administration, [16.50] international cooperation, [16.330] tax competition, [16.330]-[16.460] tax havens, [16.60] temporary residents, [16.170], [17.20] transferor trust regime, [17.140], [17.150] treaties, [16.70]-[16.100], [16.230], [16.300] Interpretation of legislation Acts Interpretation Act, [1.340], [20.90]-[20.110] extrinsic sources, [20.90] promotion of purpose or object, [20.90] conflicting approaches, [20.90] context, [1.340] courts, by, [20.50]-[20.110] golden rule, [20.70] literal approach, [20.50], [20.60], [20.100] literal rule, [20.70] mischief rule, [1.340], [20.70] purposive interpretation, [1.330], [1.340], [20.100], [20.110] rules, [20.70] strict construction, [1.330] styles, [20.50]-[20.60] tax avoidance and, [20.50]-[20.110] tax legislation, [1.330]-[1.350], [20.50] words and phrases, [20.80]

formal investigative powers, [19.440] privilege claims, [19.450]-[19.500] s 263 notices, [19.440] Federal Police, by, [19.440] Investment business distinguished, [5.120], [5.690] managed investment schemes — see Managed

investment schemes realisation of, as business income, [5.690]-[5.760] banks, [5.700]-[5.720], [5.750] insurance companies, [5.700]-[5.720], [5.750] investment trusts and companies, [5.730]-[5.760] life insurance companies, [5.720] superannuation funds investment income, [4.990] regulation of, [4.1000] Investment allowance, [10.420] Investment companies realisation of investments, [5.730]-[5.760] Investment income PAYG instalment system, [19.120] superannuation funds, [4.990]

J

Judicial review administrative discretion, exercise of, [19.370]-[19.400] ADJR Act, under, [19.400] assessments, making of, [19.370]

K

Know-how business asset, [5.600]-[5.630] CGT asset, whether, [3.60] deemed disposal, [3.230] definition, [3.60] royalties, [3.590], [3.600]

L

Land trading stock, [12.300], [12.310] cost price, [12.190], [12.200] Land taxes or rates deductibility, [7.50]

Invalidity payments, [4.1180]

Law Administration Practice Statements (LAPS), [19.80]

Investigation Commissioner, by, [19.440] audit, [19.430]

Leases equipment leases, accounting for, [12.710] expiry (CGT event C2), [12.650]

1070

Index

Leases — cont finance lease, [9.290]-[9.330], [10.580] improvements, [3.560] income in relation to, [3.540]-[3.560] lease incentives, [5.640]-[5.680] leveraged leases, [10.580] luxury car leases, accounting for, [12.730] operating lease, [9.290] premiums, [3.540] purchase price, disguised, [10.580] rent, [3.540] rental payments and periodic payments distinguished, [9.290] repairs, [3.550] Leave accrued leave transfer payments, [5.790] deductions for future payments, accounting for, [11.380]-[11.420] liabilities, business relieved of, [5.790] unused payments, [4.1190] Legal expenses deductibility, [7.10], [7.100]-[7.160] capital expenses, [7.140] defence, incurred in. [7.120], [7.130] illegal activities, [7.110], [7.150]-[7.160] Legal professional privilege crime or fraud exception, [19.450] documents, [19.450], [19.470] investigations by Commissioner, [19.450]-[19.495] legal advice, [19.470] scope of, [19.460] third party experts, communications with, [19.495] waiver of, [19.460]

Licence CGT rollover on renewal, [3.340] Limitation periods amending assessments, [19.220] Limited partnerships, [13.70], [13.260], [13.270] Liquidator distributions by, [14.280], [14.290], [14.300], [14.1000], [14.1010]-[14.1020] Archer Brothers principle, [14.1030], [14.1040] company accounts, [14.1030], [14.1040] trading stock, disposal of, [12.250], [12.260] Listed public companies continuity of ownership test, [15.420] tracing rules, [15.420] Living-away-from-home allowances, [4.330], [4.350] Loans blended payment loans, [7.640], [9.290] capital protected loan, [7.510] fringe benefits, [4.330] interest on — see Interest timing preferred income, [7.640] TOFA rules — see Taxation of financial

arrangements (TOFA) Losses capital losses — see Capital gains tax (CGT) carry forward — see Carry forward of losses company — see Company losses consolidated groups — see Consolidated

groups

Legislation capital gains tax, [2.380] constitutional constraints, [1.300] design of laws — see Tax policy fringe benefits tax, [2.380] integrating elements of, [2.380] interpretation — see Interpretation of

foreign thin capitalisation, [17.170]-[17.180] foreign exchange, [12.740], [14.620] non-commercial — see Non-commercial

losses partnership, [13.110] tax losses — see Tax losses trust, [13.470]

legislation ITAA 1936, [2.370] partial replacement by ITAA 1997, [2.370], [2.380] ITAA 1997, [2.370] numbering system, [2.370] overlapping assessment sections, [2.550] overlaps and inconsistencies, [2.390] press release, amendment by, [1.320] retrospective changes, [1.320] Tax Law Improvement Project (TLIP), [2.370], [3.10] transition from 1936 Act to 1997 Act, [2.370] turning tax policy into, [1.270]-[1.350] constitutional constraints, [1.300] democratic process, [1.280]-[1.290] integrated process, [1.310] press releases, [1.320] public service, role of, [1.290] Tax Office recommendations, [1.320]

Lottery winnings CGT exemption, [3.370] income, whether, [2.70]

M

Machinery — see Plant and equipment Main residence CGT exemption, [3.40], [3.350], [3.380]-[3.390] Maintenance payments assessable income, whether, [6.360] non-residents, [18.270] 1071

Income Taxation

Managed investment schemes agricultural investment schemes, [5.120], [5.190] losses from, [5.190] mass-marketed tax-effective schemes, [5.120], [5.190], [20.20], [20.210] prepayment rules, [12.550] Marriage breakdown CGT rollover, [3.330] Mass-marketed tax-effective schemes agricultural investment schemes, [5.120], [5.190] FBT, [4.640] penalties for promoters, [20.210] tax avoidance, [20.20], [20.30], [20.210] Meals — see Entertainment — see Food and

drink Medical expenses deductibility, [8.240] Medicare levy tax offsets not taken into account, [2.360] taxable income, based on, [2.360] Mergers scrip for scrip rollover, [15.280]-[15.310] Mining and quarrying deductions apportionment of expenses, [7.410], [7.420] expenses incurred after derivation of income, [7.340]-[7.370] payments to dependants, [7.360] rehabilitation costs, [7.400] workers compensation payments, [7.340], [7.350] information CGT asset, whether, [3.60] deemed disposal, [3.220], [3.230] mining right distinguished, [3.60] royalties, [3.570], [3.580], [9.260], [9.270] Misappropriation of funds deductibility of losses, [7.10], [7.180]-[7.220] Motor vehicles CGT asset, whether, [3.50] CGT exemption, [3.370] definition, [4.440] fringe benefits, [4.440] car parking, [4.450] depreciation and, [10.540] operating cost valuation method, [4.440] statutory formula valuation method, [4.440] taxable value of car, [4.440] luxury car leases, accounting for, [12.730] reimbursement of expenses, [4.210] voluntary car loan scheme, [2.230]

N Natural resources mining — see Mining and quarrying 1072

non-residents’ income from, [18.20] royalties, [3.570], [3.580] Non-assessable non-exempt income, [2.330] definition, [2.330] determining, [2.420] early retirement scheme payments, [4.1150], [4.1160] exclusion from tax base, [2.420] GST on sale of trading stock, [2.330] redundancy payments, [4.1150], [4.1170] Non-commercial losses anti-avoidance provision, [20.220] artists, [5.190] deductibility, [8.230] quasi-hobby activities, [5.190], [8.230] relieving tests, [5.190] Non-residents alimony payments, [18.270] assessable income, [18.10] Australian-source income, [18.10] BEP project, [18.40] business income, [18.30]-[18.60] capital gains tax, [18.70]-[18.90] change of residence, [18.90] domestic law, [18.70] treaties, [18.80] consultancy services, [18.230] definition, [16.120] dividends, [18.120]-[18.130] BEPS final report, [18.130] imputation system, [14.650], [18.130] withholding tax, [18.120]-[18.130] employment income, [18.200]-[18.260] entertainers, [18.240], [18.250] FBT, [18.220] gambling winnings, [18.270] insurance activities, [18.60] interest, [18.140]-[18.150] withholding tax, [18.110], [18.140]-[18.150] maintenance payments, [18.270] non-discrimination, [18.320] other income, [18.270] permanent establishment (PE) in Australia, [18.40]-[18.60] personal services income, [18.200]-[18.260] professional services, [18.230] property income, [18.20] real estate, income from, [18.20] residence rules — see Residence royalties, [18.100]-[18.190] equipment leasing, [18.190] intellectual property, [18.170], [18.180] withholding tax, [18.110] shipping companies, [18.60] source of income, [16.240]-[16.270] sportspersons, [18.240], [18.250] tax treaties, [18.10], [18.280] taxation of, [18.10]-[18.320] treaty shopping, [18.280] Australian anti-avoidance rule, [18.300] Principle Purpose Test (PPT), [18.310] TD 2010/20, [18.310] withholding tax, [18.110]-[18.190], [19.160]

Index

Not-for-profit organisations, [4.610], [10.10]

O

Objections appeal against decision — see Appeal assessments, to, [19.250]-[19.310] accuracy, [19.290]-[19.310] lawfulness, [19.260]-[19.285] private Rulings, to, [19.250] review of decision — see Review of decisions time limit, [19.310] OECD countries company tax collections, [14.20] comparison of tax statistics, [1.60] tax administration, cooperation in, [16.330] tax competition, response to, [16.330] OECD Model Tax Convention, [16.90], [16.370], [16.390] OECD Transfer Pricing Guidelines, [16.300] Offences, [19.530] Commissioner’s remedies, [19.530] criminal, [19.530] penalties, [19.530] Offshore banking units interest withholding tax, [18.150] Ombudsman oversight of ATO, [19.20]

capital gains tax (CGT), [13.250] change of partners, [13.160], [13.200]-[13.240] work in progress, [13.240] creation, [13.160]-[13.190] definition, [13.50] disposal of trading stock, [13.170], [13.180] dissolution, [13.200] distributions disregarded for tax purposes, [13.110] franked income equivalent to interest on loan, [14.610] general law partnership, [13.60], [13.70] imputation through, [14.600], [14.840] at risk rules, [14.920] franked income equivalent to interest on loan, [14.610] income splitting through, [13.590] income tax, [13.170]-[13.240] interest deductions, [13.140], [13.150] limited partnership, [13.70], [13.260], [13.270] net income, [13.110] partners change of, [13.160], [13.200]-[13.240] death of, [13.200], [13.210] persons deemed to be, [13.90] taxation of, [13.40]-[13.270] transactions between partnerships and, [13.120]-[13.150] partnership loss, [13.110] property syndicate, [13.220], [13.230] receipt of income jointly, [13.80], [13.90] shares held through, [14.100] tax law partnership, [13.80], [13.90] tax return, [13.110] taxation of, [13.40]-[13.270] transactions between partners and, [13.120]-[13.150] types, [13.60]-[13.90] what are, [13.50]-[13.100]

Optimal taxation theory, [1.190], [1.210], [1.220] PAYE system, [19.95], [19.100] Options assessable income from allotment of, [4.670] capital protected loan, [7.510] CGT cost base, [15.40]-[15.50] derivation of income, [2.250], [4.670] employee share schemes, [4.660]-[4.670] start-up companies, [4.670] valuation, [2.250], [2.260], [4.660]-[4.670] Oral Rulings, [19.70] Ordinary income — see Income

P

Parking FBT area, [4.450] Partnerships assessable income, [13.110] attribution of income, [Pt5.10], [13.110] capital, [13.150]

PAYG system commencement of, [19.95] former regimes replaced by, [19.95] PAYG instalments, [19.95], [19.120]-[19.140] BAS, amounts on, [19.130], [19.140] companies, [19.140] high net worth investors, [19.120] Instalment Activity Statement, [19.120] investment income, [19.120] self-funded retirees, [19.120] unincorporated businesses, [19.130] PAYG Payment Summaries FBT, inclusion of, [4.620] PAYG withholding, [19.95], [19.100]-[19.120] ABN not quoted, [19.120], [19.130] allowances, tax free, [19.110], [19.110] employee, who is, [19.100] excluded payments, [19.110] non-residents, [19.160] PAYG Bulletin No 1, [19.110] payments from which payer must withhold, [19.110] substantiation rules, [19.110] TFN not quoted, [19.120] 1073

Income Taxation

Payment of tax administrative processes, [19.90], [19.95] assessment system — see Assessments disputed amounts, [19.420] final determination, [19.95] former systems, [19.95] PAYG system — see PAYG system prepayments, [19.95] withholding tax — see Withholding tax Payroll tax deductibility, [7.50] Penalties, [19.530] promoters of tax exploitation schemes, [20.210] Pensions assessable income, [2.400], [6.370] employee, paid to, [4.890] former tax treatment, [4.890] income, whether, [6.370] lump sums, comparison of treatment, [4.890] Periodic payments — see also Annuities alimony, [6.360] capital/revenue expense distinction, [9.290] compensation receipts principle, [6.350] income, whether, [6.320]-[6.460] instalments of purchase price, [6.410]-[6.460] living expenses, [6.330]-[6.370] maintenance payments, [6.360] pensions, [6.370] scholarships, [6.360] social security payments, [6.380]-[6.400] supplementary payments from employer, [6.330]-[6.350] Permanent establishment (PE) Australian company income through foreign PE, [17.40] definition, [16.80], [18.40] non-resident with PE in Australia, [18.40]-[18.60] tax treaty definition, [18.40] transfer pricing, [16.290], [16.300] Personal expenses administrative problem for ATO, [8.280] business expenses and, borderline, [10.490] “but for” concerns of taxpayer, [8.10] charitable gifts, [8.250] child care, [8.50]-[8.70] clothing, [8.180] commuting, [8.20]-[8.40] deductibility, [8.10], [10.460]-[10.490] condition of employment test, [8.10] essential character test, [8.10] general prohibition, [8.10] perceived connection test, [8.10] statutory restrictions, [10.460]-[10.490] education, [8.80]-[8.100] food, drink and entertainment employees or third persons, [8.190]-[8.210] self, [8.220] hobbies, [8.230] 1074

home office, [8.130]-[8.170] medical expenses, [8.240] nexus with derivation of income, [Pt3.10], [8.10] onus of proof, [8.130] quasi-personal, [7.60]-[7.170] — see also Quasi-personal expenses reasonable wages to relatives, [10.470], [10.480] substantiation, [8.260], [8.270] travel, [8.110], [8.120] Personal injury damages CGT exemption, [3.370] FBT exclusion, [4.350] income, whether, [6.60]-[6.70] insurance payments, [6.80]-[6.110] Personal services business, [4.1230] Personal services entity, [4.1230] Personal services income — see also Income from services alienation of, [4.1220], [4.1230] deductibility of expenses, [10.560] deductions, [4.1230] definition, [4.1220] demarcation problems, [4.1220] derivation, consequences, [4.1230] 80 per cent test, [4.1230] employee/contractor distinction, [4.1220] examples, [4.1220] interposed entities, [4.1230] legislation, [4.1220] non-residents, [18.200]-[18.260] personal services business, [4.1230] personal services entity, [4.1230] tax outcomes, [4.1220] Personal use assets CGT rules, [3.410], [12.670] definition, [3.410], [12.670] tax accounting for, [12.670] Petrol stations tied distribution sites, [5.420]-[5.430] tax cases, [5.440] Petroleum resource rent tax, [7.30] Plant and equipment business income on disposal of, [5.490] damages for defective equipment, [6.120] royalties for equipment leasing, [18.190] Politicians tax reform process, [1.280] Poverty trap, [6.380], [6.400] Premiums assessable income, [2.190] income/capital gain distinction, [3.440]

Index

Premiums — cont income from property, [3.430]-[3.530] interest, in lieu of, [3.430] leasehold premiums, [3.540] Prepayments accounting for, [11.460], [12.530]-[12.600] amortisation, [11.460], [12.540] avoidance-based timing rules, [12.580]-[12.600] deductibility, [7.630], [10.230], [12.540] deferral of deduction, [11.460] dual purpose outgoing, [7.630] managed investment schemes, [12.570] non-business deductions individuals, [12.550] non-SBE businesses, [12.560] SBE taxpayers, [12.550] Review of Business Taxation report, [12.540] tax avoidance, [7.630] tax, of, [19.95] PAYG system — see PAYG system tax shelters, [7.630] 13-month rule, [12.540] timing manipulation schemes, [7.620], [7.630] timing rules, [12.580]-[12.600] 12-month rule, [12.540] when expense incurred, [12.540] Press releases amendment of legislation by, [1.320] Primary production business hobby farm distinguished, [5.60]-[5.100] indicators, [5.100] Rulings on what constitutes, [5.90] start-up operations, [5.160]-[5.180] what constitutes, [5.60]-[5.100] disposal of trading stock, [12.250] outside ordinary course of business, [12.250], [13.170] partnership, [13.170], [13.180] hobby farms, [5.60]-[5.100] deductible expenses, [8.230] losses from, [5.190], [8.230] Private expenses — see Personal expenses Private Rulings, [19.60] Privilege investigations by Commissioner, claims in, [19.450]-[19.500] legal professional privilege, [19.450]-[19.495] self-incrimination, against, [19.500] Prizes athletes, [4.160], [5.140], [5.150] business income, whether, [5.260]-[5.280] profit motive, [5.140], [5.150] income, whether, [4.30], [4.160] Professional services income from accounting for, [11.140], [11.150]

non-residents, [18.230] Profit business, purpose of, [5.130]-[5.150] dividend payable out of, [14.180]-[14.230] meaning, [14.180]-[14.210] non-dividend form, [14.360] outgoings subtractable from revenue in calculating, [2.510] deductions reconciled with, [2.520] Profit and loss accounting, [11.510]-[11.590] alternative to receipts and outgoings, [11.510], [11.550] amounts to be calculated, [11.570] common law idea, [11.510] deemed costs in calculating income or profit, [11.590] recognition of profits, [11.580] statutory basis, [11.510] when applicable, [11.530]-[11.560] Profit-making scheme business, whether, [5.200], [5.240] gains from, assessable income, [2.410] profit and loss accounting, [11.510] property, sale of, [3.10] statutory, [5.240] overlap problem, [5.240] Promissory notes accounting for deductions, [11.440] TOFA rules — see Taxation of financial

arrangements (TOFA) Promoters mass-marketed tax effective schemes, [20.210] tax exploitation schemes, [20.210] Property capital gains from — see Capital gains tax

(CGT) fringe benefits, [4.480] income from — see Income from property Provisional tax PAYG instalment system replacing, [19.95] Public goods need for, [1.20] Public Rulings, [19.50] Public service tax policy formation, [1.290]

Q

Quasi-investment products carrying on business, whether, [5.190] losses, [5.190] 1075

Income Taxation

Quasi-investment products — cont managed agricultural investment schemes, [5.120], [5.190] Quasi-personal expenses deductibility, [7.10], [7.60]-[7.170], [10.500] damages, [7.80], [7.90], [10.500] fines, [7.70] illegal business, [7.170], [10.500] legal expenses, [7.100]-[7.160] statutory restrictions, [10.460]-[10.490], [10.500]

R

Ralph Review, [1.55] business tax reform, [1.55] CGT recommendations, [3.10], [3.310] consolidation regime, [15.620] proposed changes to tax system, [1.55] tax value method, [1.55] Ramsey taxes, [1.200] Rate of tax companies, [Pt5.10], [14.10], [14.360] top marginal rate, disparity, [14.360] fringe benefits tax, [4.320], [4.580] low income taxpayers, [6.380] marginal, [4.20] primary earners, [1.260], [4.20] scales, [2.350] secondary earners, [1.260], [4.20] superannuation funds, [4.980] Real estate non-residents’ income from, [18.20] Recoupments assessable, [6.290] reimbursement of deducted expenses, [6.210]-[6.310] Redundancy payments bona fide redundancy payments, [4.1170] ETP distinguishing from, [4.1120] excluded from definition of, [4.1080], [4.1170] non-assessable non-exempt income, [4.1170] tax treatment, [4.1170]

income from property, [3.420], [3.540] non-residents, [18.20] periodic payments distinguished, [9.290] purchase price disguised as, [10.580] Repairs capital allowances, [10.65]-[10.100] initial repairs, [10.90]-[10.100] deductibility, [10.65]-[10.100] lease agreement, under, [3.550] replacement cost compared, [10.70], [10.80] revenue expense, [10.65] specific deductions, [10.65]-[10.100] Research and development deductions, [10.440] tax avoidance, [20.20] Residence, [16.120]-[16.230] change of, [18.90] companies, [16.180]-[16.210] carrying on business in Australia, [16.180], [16.190] central management and control, [16.180], [16.200], [16.210] dual resident companies, [16.230] TR 2004/15, [16.200], [16.210] treaties, [16.230] definition of resident, [16.120], [16.140] domestic law, [16.120]-[16.230] domicile rule, [16.150], [16.160] individuals, [16.130]-[16.170] behaviour while in Australia, [16.140] Commonwealth public servant rule, [16.150] natural persons, [16.220] 183-day test, [16.150], [16.170] physical presence in Australia, [16.140] TR 98/17, [16.140] intermediaries, [16.220] international taxation and, [16.120]-[16.230] treaties, [16.230] trusts, [16.220] Residents Australian, [16.120] definition, [16.120] foreign, [16.120] foreign-source income — see Foreign-source

income international tax rules for, [17.10] permanent, [16.160] residence rules — see Residence temporary residents, [16.170], [17.20] withholding regimes, [19.150]

Refundable tax offsets, [2.360] Refunds excess payments, [2.360] income, as, [6.280] reimbursement of deducted expenses, [6.210]-[6.310] tax benefit doctrine, [6.310] tax offsets, distinguished, [2.360]

Restrictive covenant grant of, CGT event, [3.150], [4.860] payment for, [4.710], [4.820]-[4.860] assessable income, [4.860] capital amount, [4.830], [4.840] FBT exclusion, [4.350] substituted amounts, [4.860] wasting intangible benefits, [9.110]-[9.180]

Rent assessable income, [2.400] definition, [3.540]

Retirement income annuities, [4.890] early retirement schemes, [4.1160]

1076

Index

Retirement income — cont employment termination payments — see

Employment termination payments excessive payments deemed dividend, [4.700], [14.480] former tax treatment, [4.890] invalidity payments, [4.1150], [4.1180] lump sum payments, [4.890] pensions, [4.890] periodicity principle, [4.890] policy, [4.880], [4.890] provisions dealing with, [4.870] redundancy, [4.1170] retirement savings accounts (RSAs), [4.1000] retiring allowance, [4.760] self-funded retirees health care cards, [6.400] PAYG instalment system, [19.120] superannuation — see Superannuation tax concessions, [4.880], [4.890] unused leave payments, [4.1190] Return of share capital account keeping, [14.250]-[14.300] anti-avoidance measures, [14.800]-[14.610] bonus shares, [14.350] CGT event C2, [14.170] CGT event G1, [14.170] distribution of profit disguised as, [14.800]-[14.610] distribution of profit distinguished, [14.140]-[14.170] dividend, as, [14.150], [14.140]-[14.170] exceeding recorded share capital, [14.280]-[14.300] liquidator distributions, [14.280], [14.290], [14.300], [14.1000], [14.1010], [14.1020] non-deductible to company, [14.150] redeemable preference shares, [14.750] share buy-backs, [15.70]-[15.90] share capital account, definition, [14.150] tainted share capital account rules, [14.810]-[14.820] tax treatment, [14.150], [14.170] unfrankable distribution, [14.530], [14.830] Return to work payment, [4.210] Revenue assets, [9.360] Revenue expenses capital expenses distinguished — see Capital

expenses deductibility, [9.10] nature of, [9.10] purchase price, [9.200]-[9.360], [10.580] instalments or finance lease payments, [9.290]-[9.330] instalments or periodical payments, [9.200]-[9.240] interest on borrowing to acquire capital asset, [9.340]-[9.350] lump sum plus continuing payments, [9.250]-[9.270]

Review of business taxation — see Ralph

Review Review of decisions AAT, by, [19.320]-[19.350] appeal to Federal Court distinguished, [19.330] further appeal, [19.330] justiciable issues, [19.340] onus of proof, [19.350] administrative discretion, [19.360]-[19.410] ADJR Act, review under, [19.400] judicial review, [19.370]-[19.400] Ombudsman, [19.410] choice of forum, [19.330] Inspector-General of Taxation, [19.410] reviewable objection decisions, [19.320] time limit, [19.320] Reward income, whether, [4.160], [4.170] Rights payments for varying contract rights, [4.710], [4.740]-[4.810] Rollover relief CGT rollover, [3.310]-[3.360] corporate groups, [15.340] death, [3.360] involuntary disposal, [3.310], [3.320] licence renewal, [3.340] marital breakdown, [3.330] scrip for scrip, [15.280]-[15.310] small business, [3.350] testamentary, [3.360] transfer of assets to wholly-owned company, [15.250]-[15.270] demerger, [15.320], [15.330] Royalties assessable income, [2.400] copyright, [18.170], [18.180] definition, [3.570], [3.610] income from property, [3.420], [3.570] intellectual property, [3.570], [3.590]-[3.610], [18.180] non-residents, [18.170], [18.180] “keep out” covenants, [3.600] know-how, [3.590], [3.600] natural resources, [3.580], [3.580] non-residents, [18.100]-[18.190] equipment leasing, [18.190] intellectual property, [18.170], [18.180] natural resource income, [18.20] withholding tax, [18.110] ordinary income, [2.70], [2.410] software, [18.170], [18.180] withholding tax, [3.570], [18.110], [18.160] Rulings and Determinations advance opinions, [19.60] binding and reviewable, [19.50], [19.80] CGT Cell Determinations, [19.80] class Rulings, [19.50] drafts, [19.50] 1077

Income Taxation

Rulings and Determinations — cont legal status, [19.50] limited authority of, [19.50] oral Rulings, [19.70] private Rulings, [19.60] product Rulings, [19.50] public Rulings, [19.50] self-assessment, [19.50] system of, [19.40]

S Salary or wages cash basis accounting, [11.100] employee/employer definitions related to, [4.380] FBT exclusion, [4.350] income from services, [4.10], [4.1220] packaging — see Salary packaging salary sacrifice arrangements, [4.1210] non-salary benefits, [4.1210] superannuation, [4.910] substitution effect of tax, [4.20] Salary packaging benefits, [4.1210] concessional fringe benefits, [4.1210] effective marginal tax rate (EMTR), [4.1210] exempt fringe benefits, [4.1210] fringe benefits taxed to employer, [4.1210] non-salary benefits, [4.1210] pure fringe benefits, [4.1210] strategies, [4.1200] superannuation, [4.1210] tax exempt sector, [4.1210] tax treatment, [4.1210] Sale and leaseback arrangements, [9.300], [9.310] Same business test (SBT), [15.440] aspects of, [15.440] ATO view, [15.480] bad debts, [15.430] carry forward of losses, for, [15.440] construction, [15.460] new business test, [15.440] new transactions test, [15.440] passing, [15.440]-[15.500] question of fact, [15.490] rationale, [15.440] realised losses, [15.440] reform, [15.20] TR 1999/9, [15.480] trusts, [13.470] unrealised losses, extension to, [15.530] Savings taxation and, [1.260] Scholarships assessable income, whether, [6.360] Securities deep discount debt securities, [3.460] 1078

discounted, [3.470] loans, imputation rules, [14.910] qualifying, [12.500] TOFA rules — see Taxation of financial

arrangements (TOFA) traditional, [3.470] profit and loss accounting, [11.510] Self-assessment, [19.190] Rulings as part of, [19.50] substantiation rules, [8.260] Self-employed taxpayers PAYG instalments, [19.130] superannuation contributions, [4.940] Self-funded retirees health care cards, [6.400] PAYG instalments, [19.120] Self-incrimination, privilege against, [19.500] Service trust income splitting through, [7.550], [7.560] Sham transactions, [20.180] Share options — see Options Shareholders definition, [14.80]-[14.100] dividends paid to — see Dividends membership interest, [14.80]-[14.100] rights of, [3.80] taxation, [14.80]-[14.110] Shares aliquot interest, [3.80] bonus shares, [14.350] bundle of rights, [3.80] buy-backs, [15.70]-[15.90] CGT implications, [15.70] off-market, [15.80] on-market, [15.90] capital gain on disposal of, [3.80], [14.110], [15.40] CGT asset, [3.80], [15.10] cancellation, [3.80] cost base, [15.40]-[15.50] deemed disposal, [3.220], [3.230] disposal, [3.80] part disposal, [3.80] rights attaching to shares, [3.80] CGT rollover scrip for scrip, [15.280]-[15.310] transfer of assets to wholly-owned company, [15.250]-[15.270] debt/equity rules — see Debt/equity rules definition, [14.80]-[14.100] disposal of CGT implications, [3.80] sale/purchase price, [15.10]-[15.30] employee share schemes — see Employee

share schemes

Index

Shares — cont foreign subsidiaries, in, [17.60] issue of new, CGT event, [15.40] membership interest, [14.80] nature of, [3.80] partnership, held through, [14.100] pre-CGT companies, [15.200] preference shares redemption of, [14.750] right to convert, [3.90] purchase, [15.10]-[15.30] redeemable preference shares, [15.60] debt/equity rules, [14.230] dividend, whether redemption is, [14.750] profits, redeemed out of, [14.750] return of share capital — see Return of share

capital sale, [15.10]-[15.30] share capital account capital streaming rules, [14.840] definition, [14.150]-[14.160] return of share capital — see Return of

share capital tainted share capital account rules, [14.810]-[14.820] trading stock, [12.320] transactions involving, [15.10]-[15.230] trust, held through, [14.100] value shifting, [15.210]-[15.230] entities, between, [15.230] shares, [15.220] Small business entities (SBEs) aggregated turnover, [12.460] capital allowances, [10.230], [10.410] CGT rules, [3.350], [3.400] discount, [3.400] exemption, [3.400] rollover relief, [3.350] small business entity test, [3.350] concessions, [12.450] access to, [12.460] depreciation pools, [10.230], [10.410] prepayment rules, [12.550] SBE status, [12.460] qualification, [12.460] year-by-year basis, [12.460] simplified accounting rules, [12.450]-[12.480] STS rules (former), [12.450] trading stock, accounting for, [12.470] Social security health care cards, [6.400] interaction with income tax system, [1.60], [6.380] low income rebates, [6.380] payments, [6.380]-[6.400] poverty trap, [6.380], [6.400] Source rules, [16.240]-[16.260] modification, [16.240] non-residents, [16.240] passive income, [16.40] residents, [16.240] transfer pricing, [16.240] Spare parts trading stock, whether, [12.360]-[12.400]

Sportspeople business/hobby distinction, [5.110] profit motive, [5.130]-[5.150] non-resident, [18.240], [18.250] prizes, [5.140], [5.150] Spouse income splitting, [7.540], [13.570] rebate, [2.360] superannuation contributions by, [4.960] Stamp duty deductibility, [7.50] States division of powers, [1.305] exclusion from taxing income, [1.305] GST, impact on, [1.305] state taxes, [1.305] vertical fiscal imbalance, [1.305] Statistics, use of, [1.60] Statutory income, [2.330] reconciling ordinary income and, [2.430] Statutory interpretation — see Interpretation

of legislation STS taxpayers — see Small business entities

(SBEs) Subsidy business income, whether, [5.310]-[5.340] what constitutes, [5.330], [5.340] Substantiation employee allowances, [19.110] entertainment expenses, [8.260] meal expenses, [8.270] personal expenses, [8.260], [8.270] reasonable expenses, [8.270] travel expenses, [8.260] Superannuation, [4.900]-[4.1060] benefits, [4.1020]-[4.1050] access to, [4.1000] death benefits, [4.1030] income stream benefits, [4.1040] intermediaries, received from, [2.180] lump sums, [4.1030] non-complying funds, [4.1050] pensions, [4.1040] preservation, [4.1000] protection of, [4.1000] tax free component, [4.1030] taxable component, [4.1030] taxation of recipient, [4.1020]-[4.1050] complying fund, [4.900], [4.1000] culpability test, [4.1000] contributions, [4.910]-[4.960] concessional, [4.920] deductibility to employer, [4.920] 1079

Income Taxation

Superannuation, — cont employee, [2.180], [4.930] employer, [2.180], [4.920] excess contributions tax, [4.920] excess non-concessional contributions, [4.990] government co-contribution system, [4.930], [4.950] income of fund, [4.990] non-concessional, [4.990] salary sacrifice arrangements, [4.910] self-employed taxpayer, [4.940] spouse, for, [4.960] timing rules for employer contributions, [4.920] undeducted, [4.990] death benefits, [4.930], [4.1030] defined benefit fund, [4.920] elements of taxation, [4.900] employment termination payments — see

Employment termination payments FBT exclusion, [4.320], [4.350] funds, [4.970]-[4.990] capital gains and losses, [4.990] complying, [4.900], [4.1000] contributions as income of, [4.990] deductions, [4.990] former exemption, [4.970] imputation credits, use of, [4.970] investment income, [4.990] moving money between, [4.1010] payment out of, [4.1020]-[4.1050] regulation, [4.1000] related party income, [4.990] residence, [16.220] resident regulated fund, [4.1000] tax base, [4.990] tax liabilities, [4.970] tax rate, [4.980] government co-contribution system, [4.930], [4.950] government support, [4.880], [4.890], [4.900] non-complying funds, [4.920], [4.1050] payments, [4.1020]-[4.1050] components of, [4.1030] death benefits, [4.1030] employment termination — see

Employment termination payments lump sums, [4.1030] non-complying funds, [4.1050] pensions, [4.1040] pensions, [4.1040] policy, [4.880] preserved benefits, [4.1000] payment of, [4.1030] persons under preservation age, [4.1030] preservation age, [4.1030] protection of small amounts, [4.1000] retirement savings accounts (RSAs), [4.1000] spouse contributions, [4.960] Superannuation Guarantee Scheme, [4.900] tax base, [4.990] tax concessions, [4.880], [4.890] time periods for taxation, [4.900] transfer between funds, [4.1010] 1080

T

Takeovers scrip for scrip rollover, [15.280]-[15.310] Tax accounting accruals basis, [11.100], [11.250] cash basis compared, [11.100], [11.250] change from cash basis to, [11.470]-[11.500] choice of cash basis or, [11.100]-[11.180] deductions, recognising, [11.370]-[11.460] income, recognising, [11.260]-[11.360] annual accounting requirement, [11.20]-[11.60] arbitrary effects, [11.50] assets moving between categories, [11.590] assets moving into tax system, [11.590] bills of exchange, [11.440], [11.450] books of account, [11.170] business income, [11.170] capital gains and losses, [12.610]-[12.700] capital items, [11.170] cash basis, [11.100] accruals basis compared, [11.100], [11.250] choice of accruals or, [11.100]-[11.180] income, recognising, [11.190]-[11.220] outgoings, recognising, [11.230]-[11.240] receipt, what amounts to, [11.190]-[11.220] small business taxpayers, [11.100], [11.240] statutory rules, [11.180] wage and salary, [11.100] change of method, [11.470]-[11.500] choice of method, [11.100]-[11.180] statutory rules, [11.180] TR 98/1, [11.160], [11.170] circulating capital and consumables, [11.170] common law, [Pt4.10] compensating schemes, [11.50] contemporaneity principle, [11.40] debt recovery, [11.170] “deduction swallows”, [11.40] deductions, accounting for, [11.30] accruals basis, [11.370]-[11.460] advancing recognition of, [11.380]-[11.450] cash basis, [11.100]-[11.240] change of method, [11.470]-[11.500] choice of method, [11.100]-[11.180] deferring recognition of, [11.460] defining deductibility, [11.30] matching process, [11.370] prepayments, [11.460] recognising, [11.230]-[11.240], [11.370]-[11.460] small business taxpayers, [11.240] timing, [11.240] TR 97/7, [11.240] deemed costs in calculating income or profit, [11.590] double taxation, preventing, [11.590] financial accounting principles, [11.70]-[11.90] relationship, [11.110] financial arrangements — see Taxation of

financial arrangements (TOFA) foreign currency transactions, [12.470] general issues, [11.10]-[11.90] GST, for, [12.750]

Index

Tax accounting — cont income, accounting for accruals basis, [11.250]-[11.360] advance payments, [11.340] advancing recognition of, [11.260]-[11.330] business income, [11.170] cash basis, [11.190]-[11.220] change of method, [11.470]-[11.500] choice of method, [11.100]-[11.180] constructive receipt, [11.200]-[11.220] costs involved in earning, [11.590] deferring recognition of, [11.340]-[11.360] professionals, income of, [11.140], [11.150] realisation requirement, [11.260] receipt, what amounts to, [11.190]-[11.220] recognising, [11.190]-[11.220], [11.260]-[11.360] interest, accounting for, [12.490]-[12.520] deductions for future payments, [11.420], [11.430] TOFA rules — see Taxation of financial

arrangements (TOFA) leave payments, deductions for future, [11.380]-[11.420] overview, [11.10], [12.10] periodic accounting, [11.20]-[11.60] prepayments, [11.460], [12.530]-[12.600] deferral of deduction, [11.460] profit and loss accounting, [11.510]-[11.590] amounts to be calculated, [11.570] deemed costs in calculating income or profit, [11.590] recognition of profits, [11.580] when applicable, [11.530]-[11.560] promissory notes, [11.440] protecting exemptions, costs of, [11.590] question of fact, [11.120] small business entities, [12.450]-[12.480] access to concessions, [12.460] depreciating assets, [12.480] trading stock, [12.470] statutory regimes, [Pt4.10], [12.10] tax deferral, [11.60] timing issues, [11.10] TOFA rules — see Taxation of financial

arrangements (TOFA) trading stock, for — see Trading stock Tax administration appeals — see Appeal assessments — see Assessments audit and investigation, [19.430]-[19.510] Commissioner — see Commissioner of

Taxation enforcement, [19.520] goals, [19.10] international cooperation, [16.330] international taxation, [16.330] issues in decision-making, [19.10] offences and penalties, [19.530] overview, [Pt7.10], [19.10] review of decisions — see Review of

decisions self-assessment, [19.35] statutory remedial power, [19.87]

voluntary compliance, [19.30] Tax advisers proposed changes, advising clients on, [1.320] tax avoidance, participation in, [20.20] Tax agents, [2.360] Tax and transfer system, [1.240] Tax avoidance/evasion annual revenue loss from, [19.30] “bottom of the harbour” schemes, [20.30] characterisation of transactions, [20.120]-[20.140] containing, [20.150] costs to society, [20.20] courts, role in preventing, [20.40]-[20.140] characterisation of transactions, [20.120]-[20.140] interpretation of legislation, [20.50]-[20.110] cross-country tax cooperation, [16.460] debt and equity tests, [14.740] definition, [20.30] dividend streaming, [14.850] dividend stripping, [14.990], [20.30] economic costs, [20.20] effects, [20.20] fiscal nullity doctrine, [20.190] franking credit streaming, [14.850] franking credits anti-avoidance rule, [14.940]-[14.980] anti-streaming rules, [14.850], [14.900] general anti-avoidance provisions, [20.150] Pt IVA ITAA 1936, [20.210]-[20.250] s 260 ITAA 1936, [20.240], [20.390] income splitting, [7.540], [13.590], [20.30] judicial responses, [20.160] anti-avoidance doctrines, [20.160], [20.170] fiscal nullity doctrine, [20.190] sham transactions, [20.180] legitimate and illegitimate, [20.30] mass-marketed tax effective schemes, [5.120], [5.190], [20.20], [20.210] non-commercial losses, [20.220] overview, [20.10] prepayments, [7.630], [12.580]-[12.600] problem of, [20.20] promoters, penalties for, [20.210] recognising, [20.30] scheme, [20.240]-[20.250], [20.260], [20.280] counter-factual hypothesis, [20.320]-[20.340] notion of, [20.260] purpose of, [20.380] sole or dominant purpose, [20.210] what constitutes, [20.280] tax benefit from, [20.290] sham transactions, [20.180] specific anti-avoidance provisions, [20.150] statutory interpretation, [20.50]-[20.110] statutory responses, [20.200]-[20.230] cancellation of tax benefits, [20.390] Div 35 ITAA 1997, [20.220] Pt IVA ITAA 1936, [20.210]-[20.250], [20.270] s 260 ITAA 1936, [20.240], [20.390] ss 82KH – 82KL ITAA 1936, [20.230] tax advisers participating in, [20.20] 1081

Income Taxation

Tax avoidance/evasion — cont tax benefit, [20.290], [20.300] annihilation approach, [20.370] cancellation of, [20.390] definition, effectiveness, [20.350]-[20.360] reconstruction approach, [20.370] requisite purpose, [20.310] scheme, from, [20.290], [20.300] tax exploitation schemes, [20.210] tax planning, [20.30] tax shelters, [20.30] trust anti-avoidance measures, [13.460] Tax base alternative bases, [1.60]-[1.120] broadening, [2.100] comprehensive income tax base, [1.90], [16.20] consumption, [1.60], [1.100]-[1.110] defining, [1.60] income, [1.60], [1.70]-[1.90] Haig-Simons approach, [1.80]-[1.90], [1.150] methods for inclusions in, [2.390]-[2.470] superannuation funds, [4.990] wealth, [1.60], [1.120] Tax competition base erosion and profit sharing, [16.340], [18.310] BEPS Action Plan, [16.360]-[16.370] BEPS project, implementation, [16.380]-[16.400] Henry Review, [16.350] international, [16.330]-[16.350] policy, [16.340], [16.350] Tax compliance costs FBT, [4.630] income tax, [19.180] Tax deferral, [11.60] Tax expenditures, [1.130]-[1.150] accountability, [1.140] comparisons across countries, [1.60] controllability, [1.140] cost, measuring, [1.150] definition, [1.60] efficiency, [1.140] equity, [1.140] estimates, [1.150] review, need for, [1.140] Treasury Statement, [1.150] Tax File Number (TFN), [19.90] withholding tax where not quoted, [19.120], [19.150] Tax havens, [16.60] Tax instruments country comparisons, [1.60] range of, [1.140] Tax Law Improvement Project (TLIP), [2.370], [3.10] Tax liability assessment — see Assessments 1082

calculating, [2.310] rate scales, [2.350] Tax losses carry forward — see Carry forward of losses company — see Company losses consolidated groups — see Consolidated

groups debt forgiveness reducing, [15.430] tax loss companies, [15.430], [15.440], [15.460] trusts, [13.470] Tax offences — see Offences Tax offsets dividend imputation, [14.500] foreign income (FITO) regime, [17.80]-[17.90] HECS not affected by, [2.360] low income rebates, [6.380] Medicare levy not affected by, [2.360] purpose, [2.360] refundable, [2.360] refunds distinguished, [2.360] spouse rebate, [2.360] Tax policy achieving objectives, [1.30] alternative tax bases, [1.60]-[1.120] Asprey Report, [1.40], [14.450], [14.460] business taxation, [1.50] company tax policy company losses, [15.380] imputation system, [14.60]-[14.75] consistency, [1.240] criteria for assessing, [1.30] economic growth, [1.240] investment neutrality, [13.20] tax and transfer system, [1.240] tax incentives, [1.240] efficiency principle, [1.30] tax and transfer system, [1.240] equity principle, [1.30] Henry Review, [1.240], [14.460], [14.480] integrated process, [1.310] intermediaries, regarding, [13.10]-[13.30] international tax policy, [16.20]-[16.110] base erosion and profit sharing, [16.340] BEPS Action Plan, [16.360]-[16.370] BEPS project, implementation, [16.380]-[16.400] competition and cooperation, [16.340], [16.350] legislation, turning into, [1.270]-[1.350] constitutional constraints, [1.300] democratic process, [1.280]-[1.290] integrated process, [1.310] press releases, [1.320] public service, role of, [1.290] Tax Office recommendations, [1.320] lifetime wellbeing, [1.240] need for taxes, [1.20] neutrality principle, [1.30] international tax policy, [17.10] objectives and principles, [1.30] productivity, [1.240]

Index

Tax policy — cont reconciling objectives, [1.30] simplicity principle, [1.30] tax and transfer system, [1.240] simplification, [1.30] social security, interaction with, [1.60] special interest groups, [1.280] sustainability, [1.240] tax and transfer system, [1.240] tax competition, [16.330]-[16.370] welfare economics, [1.160]-[1.220] Tax process, [1.270]-[1.350] Tax reform A Tax System Redesigned (1999), [1.55] Asprey Report, [1.40] Australia’s Future Tax System, [1.10], [1.240], [14.470]-[14.490] base broadening measures, [2.100] business losses, [13.30] company tax, [14.470]-[14.490] consolidated groups, [15.640] constitutional constraints, [1.300] criteria for, [1.30] democratic process, [1.280]-[1.290] Draft White Paper, [1.40], [1.140] Fight Back!, [1.50] Henry Review, [1.10], [1.240] criticism of recommendations, [1.260] Howard Government, [1.50] integrated process, [1.310] managed investment trusts, [13.550]-[13.555] 1985 reforms, [2.100] ordinary income, concept of, [2.100] participants in process, [1.280] politicians, role of, [1.280] press releases, [1.320] public service, [1.290] Ralph Review, [3.10] Re: Think Tax Discussion Paper (2015), [1.10], [1.60], [14.490] retrospective changes, [1.320] tax and transfer system, [1.240] Tax Law Improvement Project (TLIP), [2.370], [3.10] Tax Reform – Not A New Tax, A New Tax System (1998), [1.50] tax value method of calculating taxable income, [1.50] trusts, [13.280], [13.550] unified entity tax regime, [1.55] Tax returns, [19.180] additional, Commissioner requiring, [19.180] obligation to file, [19.180] tax agents preparing, [2.360] Tax Rulings — see Rulings and

Determinations Tax systems Australian — see Australian tax system complexity, costs of, [1.240] criteria for assessing, [1.30]

economic growth and, [1.240] efficiency, [1.30], [1.240] equity, [1.30], [1.240] horizontal and vertical, [1.30] functions, [1.130] government spending programs, [1.140] objectives and principles, [1.30] policy — see Tax policy primary and secondary earners, [1.260] reform — see Tax reform savings and, [1.260] simplicity, [1.30], [1.240] tax expenditures, [1.130]-[1.150] uncertainty, [1.320] Tax treaties, [16.70] anti-avoidance measures, [18.310] bilateral, [16.70] business income, [18.40] capital gains tax, [18.80] collection of foreign taxes, assistance, [16.440] dispute resolution, [16.450] domestic law, enactment as, [16.80] double tax agreements (DTAs), [16.70] double tax conventions (DTCs), [16.70] equipment leasing, [18.190] exchange of information and transparency, [16.420]-[16.430] force of law, [16.80] fringe benefits, [18.220] implementation in domestic law, [16.80] interpretation, [16.100] non-discrimination, [18.320] non-residents, taxation of, [18.10] OECD Model Tax Convention, [16.90], [16.370], [16.390] “other income” article, [18.270] permanent establishment (PE) definition, [18.40] professional services, [18.230] residence for purposes of, [16.230] residents, international tax rules, [17.10] source rules, [16.240] structure, [16.90] tax administration agreements, [16.50] transfer pricing, [16.290], [16.300] treaty shopping, [18.280] Australian anti-avoidance rule, [18.300], [18.310] Principle Purpose Test (PPT), [18.310] TD 2010/20, [18.310] UN Model Double Taxation Convention, [16.90] Vienna Convention on Treaties, [16.80], [16.100] Tax value method, [1.55] Taxable event identifying, [2.150]-[2.210] time of, [2.200]-[2.210] Taxable income, [2.320] calculation, [2.320] definition, [2.10], [2.230], [11.20] income tax equation, [2.320] income tax levied on, [2.230] periodic calculation, [11.20] 1083

Income Taxation

Taxable income, — cont rate scales, [2.350] use of epithet, [2.10] valuation, [2.220]-[2.270] Taxation Determinations — see Rulings and

Determinations Taxation Liaison Group, [19.80] Taxation of financial arrangements (TOFA) accounting rules, [12.490]-[12.520] accrual or realisation, [12.510] application of TOFA rules, [12.490] balancing adjustments, [12.510] borrower, position of, [12.510] CGT issues, [12.500] changing circumstances, [12.510] deductions, [12.500] derivative instruments, [12.490], [12.520] Div 16E, continuation of, [12.490] elective timing rules, [12.520] fair value basis, [12.520] foreign currency retranslation, [12.520] forward currency contract, [12.520] forwards, swaps and options, [12.490], [12.520] hedge transactions, [12.520] income, [12.500] interest, accounting for, [12.490] lender, position of, [12.490]-[12.510] loss in gaining exempt or NANE income, [12.500] optional timing rules, [12.520] qualifying securities, [12.490] sales or part sales, [12.510] timing rules, [12.510], [12.520] derivative instruments, [12.520] elective, [12.520] standard, [12.510]

liabilities, release on hardship grounds, [19.540] self-evident, [2.160] shortfall in tax, [19.530] “reasonably arguable position”, [19.530] support for, [19.30]-[19.80] voluntary compliance, [19.30] assistance through Rulings system, [19.40] Taxpayer Alerts, [19.80] Taxpayer’s Charter, [19.20] Temporary residents definition, [16.170], [17.20] foreign source income, [17.20] special rules, [16.170], [17.20] Termination payments — see Employment

termination payments — see Retirement income Theft deductibility of losses, [7.10], [7.180]-[7.220] Thin capitalisation, [10.450], [14.710], [17.170]-[17.180] debt/equity rules, [14.710], [17.180] restrictions on deductions, [10.450], [17.170] Timing issues — see Tax accounting Timing manipulation schemes annuities, [7.640] deductions, [7.620]-[7.640] dual purpose outgoings, [7.620] prepayments, [7.630] timing-preferred income, [7.620], [7.640]

Taxation Rulings — see Rulings and

Determinations

TOFA — see Taxation of financial

arrangements (TOFA) Taxes alternative tax bases, [1.60]-[1.120] deductibility, [7.20]-[7.50] derivation of income, related to, [7.10], [7.20] GST, [7.40] income tax, [7.30] land tax or rates, [7.50] payroll tax, [7.50] petroleum resource rent tax, [7.30] stamp duty, [7.50] distributional implications, [1.240] lump sum, [1.170] surrogate measures of endowments, [1.190] need for, [1.20], [1.170] statistics from different countries, [1.60] Taxpayer amounts received for benefit of others, [2.215] company as, [Pt5.10] constructive receipt of income, [2.170], [11.200]-[11.220] education, [19.30] identifying, [2.150]-[2.210] 1084

Trading stock accounting for, [12.20]-[12.270] acquisitions and disposals, [12.230]-[12.270] deduction and re-inclusion, [12.30]-[12.50] small business entity rules, [12.470] valuation, [12.60]-[12.220] acquisitions accounting for, [12.230]-[12.270] expenses to acquire, [9.360] transfer pricing, [7.460], [12.240] asset becoming, [12.440] asset ceasing to be, [12.430] assets yielding, [12.300]-[12.310], [12.360]-[12.410], [12.420] business asset, [5.470] business transactions with, [5.480] CGT exclusion, [3.300] classification of assets as, [12.280]-[12.440] compensation for loss of, [6.140] consumable stores, [12.360]-[12.410] converting assets into and from, [12.420]-[12.440] cost price, determining, [12.100]-[12.210]

Index

Trading stock — cont absorption cost method, [12.150]-[12.210] average cost method, [12.120]-[12.140] first-in first-out (FIFO), [12.110], [12.140] IT 2350, [12.180] land, [12.190], [12.200] last-in first-out (LIFO), [12.110], [12.140] processed trading stock, [12.150]-[12.210] services, [12.210] standard cost method, [12.120]-[12.140] deductions, [12.30]-[12.50] definition, [5.480], [12.290], [12.420] disposals accounting for, [12.230]-[12.270] consumed by trader, [12.250] liquidator, by, [12.250], [12.260] outside ordinary course of business, [12.250], [13.170] partnership, [13.170], [13.180] primary producers, [12.250], [13.170] expenses to acquire, [9.360] revenue account, [9.360] GST on sale of, [2.330] income from sale of, [3.10] intangibles, [12.330] land, [12.300], [12.310] cost price, [12.190], [12.200] on hand, [12.50] stock becoming, [12.50] stock ceasing to be, [12.30] packaging items, [12.380], [12.390] property ceasing to be, [12.430] re-inclusion, [12.30]-[12.50] shares, [12.320] small business entity rules, [12.470] spare parts, [12.360]-[12.400] tax accounting for, [12.20]-[12.270] test for, [12.290] transfer pricing, [7.460], [12.240] valuation, [12.60]-[12.90] accounting rules, [12.70] changing methods, [12.90] cost price, [12.70] market selling value, [12.70], [12.220] obsolete items, [12.80] realisation basis, [12.70] replacement value, [12.70], [12.220] special valuations, [12.80] taxpayer’s options, [12.70] what is, [12.290] work in progress, [12.340], [12.350] Transactions business — see Business characterisation of, [20.120]-[20.140] commercial flavour, [3.10] isolated, [5.200]-[5.240] sham transactions, [20.180] Transfer pricing, [16.280]-[16.300] branches (PEs), [16.290], [16.300] definition, [7.440], [16.280] domestic law, [16.290] dual purpose outgoings, [7.10], [7.440]-[7.480] legal rights doctrine, [7.440], [7.460] OECD Guidelines, [16.300]

purpose of, [16.280] source of income, [16.240] tax treaties, [16.290], [16.300] trading stock acquisition, [7.460], [12.240] Transferor trust regime, [17.140], [17.150] attributable taxpayer, [17.140], [17.150] discretionary trusts, [17.140] exclusions, [17.150] non-resident family trust exclusion, [17.150] Travel allowances fringe benefit, whether, [4.350], [4.360] Travel expenses deductibility, [8.110], [8.120], [10.30] commuting, [8.20]-[8.40] overseas travel, [8.110], [8.120] substantiation, [8.260] Treasurer ATO reports to, [19.20] press releases, [1.320] Treasury ATO and, [19.20] Business Tax Working Group, [15.360] development of legislation, [1.310] employees and contractors, tax treatment, [4.1220] tax reform process, [1.280] Treaties — see Tax treaties Trustees capital gains of, [13.420] dealings between trust and, [13.390] definition, [13.300], [13.360] tax law, [13.300] tax liability, [13.300] tax paid by, [13.390] Trusts absolute entitlement, concept of, [13.490] anti-avoidance measures, [13.460] attribution of net income, [13.390]-[13.410] beneficial ownership, [13.20], [13.290] beneficiaries, [13.290] absolute entitlement, [13.490] change of, [13.390] children, [13.430] dealings between trust and, [13.390] owners of trust, [13.290] present entitlement, [13.320]-[13.380] taxation of, [13.300], [13.390] borrowings, [13.390] calculation of net income, [10.390]-[13.410] CGT discount, [13.420], [13.450], [13.540] CGT events, [13.480] beneficiary becoming presently entitled (E5), [13.520] creation of trust (E1), [13.500] transfer of asset to trust (E2), [13.500] unit trust, [13.530] 1085

Income Taxation

Trusts — cont companies, taxed as, [13.540] constructive, [13.290] creation, [13.480]-[13.530] CGT event E1, [13.500], [13.530] dealings in, [13.520] unit trusts, [13.530] deceased estates, [13.310], [13.440] assessment under s 99A, [13.330]-[13.350] definition, [13.290], [13.300] discretionary, [13.310], [17.140] borrowings, [13.390] losses, [13.470] present entitlement under, [13.380] transferor trusts, [17.140] dissolution, [13.500]-[13.530] continuity and, [13.510] distributions, [13.450] franked income equivalent to interest on loan, [14.610] postponing, [13.460] equitable ownership, [13.290] fixed, [13.310], [13.470] imputation through, [14.610] at risk rules, [14.920], [14.930] franked income equivalent to interest on loan, [14.610] income attributed to beneficiaries, [Pt5.10] concept of, [2.30] income/capital distinction, [2.30] net, calculation and attribution, [13.390]-[13.410] tax law and trust law distinguished, [13.400] income splitting through, [13.590] intermediaries, as, [13.290] legal ownership, [13.290] losses, [13.470] modern types, [13.310] nature of, [13.290] net income, calculation and attribution, [13.390]-[13.410] income streamed through trusts, [13.410] tax law and trust law distinguished, [13.400] non-fixed, [13.470] non-resident trustee beneficiaries, [13.460] present entitlement to trust income, [13.320]-[13.380] beneficiary becoming presently entitled, [13.520] default beneficiaries, [13.380] discretionary trusts, [13.380] meaning, limits of, [13.360] s 95A(2), under, [13.340]-[13.370] public unit trusts, [13.470], [13.540] residence, [16.220] Saunders v Vautier, rule in, [13.490] shares held through, [14.100] stripping, [13.460] tax law, [13.300] tax reform, [13.280], [13.550] taxation of, [13.280]-[13.550] testamentary, [13.310], [13.440] transferor trust regime, [17.140], [17.150] trust law income, [13.400]-[13.410] tax law income distinguished, [13.400], [13.410] 1086

trust deed affecting calculation of, [13.400], [13.410] types, [13.310] unit trusts, [13.310] CGT events, [13.530] companies, taxed as, [13.540] dealings in, [13.530] public, [13.470], [13.540]

U

UN Model Double Taxation Convention, [16.90] Unincorporated businesses Australian Business Number, [19.130] PAYG instalments, [19.130] Unit trusts, [13.310] CGT events, [13.530] companies, taxed as, [13.540] dealings in, [13.530] public, [13.470], [13.540] Unsolicited payments business income, whether, [5.260]-[5.300] Unused leave payments, [4.1190]

V

Valuation income, of, [2.220]-[2.270] amount changing after tax event, [2.270] basic valuation test, [2.220] non-cash income, [2.220], [2.230], [2.240] realisable value test, [2.250] share options, [2.250], [2.260], [4.660] trading stock — see Trading stock Value shifting, [15.210]-[15.230] entities, between, [15.230] overview, [15.210] shares, [15.220]

W

Wage tax, [1.100] Warranties accounting for income, [11.360] Wealth taxes, [1.60], [1.120] Welfare economics equity-efficiency trade-off, [1.200], [1.220] family tax benefit, [1.250] female labour supply, [1.260] Haig-Simons approach, [1.210]

Index

Welfare economics — cont market failure, [1.180] optimal taxation, [1.190], [1.220] Pareto efficient, [1.170] Ramsey taxes, [1.200] tax policy and, [1.160]-[1.220] tax reform and, [1.280] theorems, [1.170] Windfalls business income, whether, [5.260]-[5.290] income, whether, [4.30] petroleum resource rent tax, [7.30] Withholding tax ABN not quoted, [19.120], [19.150] debt/equity rules, [14.710] dividends, [18.120]-[18.130] interest, [18.140]-[18.150] non-residents, [18.110]-[18.190], [19.160] PAYG withholding — see PAYG system

royalties, [3.570], [18.110], [18.160] equipment leasing, [18.190] intellectual property, [18.170], [18.180] TFN not quoted, [19.120], [19.150] Work effort and taxation, [4.20] Work in progress partnership, change of partners, [13.240] trading stock, [12.340], [12.350] Workers compensation payments deductibility, [7.340], [7.350]

Z

Zero bond coupons, [3.440]

1087