The touchy subject of tax avoidance

With any strategy or transaction undertaken by a financial adviser on behalf of a client, consideration must be given to the anti-avoidance rules of the Income Tax Assessment Act. These rules are found in Part IVA of the Act and are often disregarded by many financial advisers.

With any strategy or transaction undertaken by a financial adviser on behalf of a client, consideration must be given to the anti-avoidance rules of the Income Tax Assessment Act. These rules are found in Part IVA of the Act and are often disregarded by many financial advisers.

Recent cases, however, have highlighted the broad powers the commissioner has under the anti-avoidance rules to strike down a transaction where the taxpayer enters into a transaction for the dominant purpose of obtaining a tax benefit. For example, see FCT v Spotless Services Ltd [1996] 186 CLR 404 and Eastern Ni-trogen Ltd v Commissioner of Taxation [1999] FCA 1536.

Moreover, the Government announced a significant broadening of the anti-avoidance rules late last year.

Tax avoidance

The Ralph Committee focused on the issue of tax avoidance and its ability to un-dermine income tax policy. On the subject of tax avoidance, the committee noted:

"Tax avoidance may be characterised as a misuse or abuse of the law rather than a disregard for it. It is often driven by the exploitation of structural loop-holes in the law to achieve tax outcomes that were not intended by the Parlia-ment but also includes manipulation of the law and a focus on form and legal ef-fect rather than substance."

Reviewing laws

The current tax avoidance laws are contained within Part IVA of the Income Tax Assessment Act. In essence, the rules enable the commissioner to exercise his powers where "...at least one taxpayer has entered into or carried out a scheme for the dominant purpose of obtaining a tax benefit in relation to the scheme."

The extent of these laws was seen in the Eastern Nitrogen case referred to above. Eastern Nitrogen was approached by a finance broker to enter into a sale-lease back transaction for its ammonia plant in Newcastle. The benefits of the transaction, according to the broker were: "...an estimated reduction in after-tax interest costs, increased reported profits and improved cash flow and bal-ance sheet structure."

The company sat on the finance broker's proposal for 18 months until it began constructing a new nitrate plant. For depreciation purposes, the delay ensured that any balancing charge resulting from the sale of the old ammonia plant could be carried to the new nitrate plant.

Prior to implementing the transaction, the company received sign off from coun-sel that the transaction would not offend Part IVA. Counsel replied that Part IVA should not apply where "...the primary purpose in entering into the transac-tion is to take advantage of the commercial benefits that a sale and lease back arrangement has over more traditional methods of financing. These benefits in-clude an estimated reduction in after-tax interest costs, increased reported profits and improved cash flow and balance sheet structure."

Notwithstanding the counsel's advice, the Federal Court held that the company had breached the anti-avoidance rules because of the following reasons:

* The transaction originated with the finance broker, rather than the company seeking to make changes to its financing structure first.

* The taxpayer could show no written evidence that its primary objective in en-tering into the transaction was to obtain an advantage that was not tax related.

* The transaction, although structured as a sale and lease back, had a number of elements of artificiality to it. The ammonia plant was a fixture of the land and thus could not be severed from the land itself; the market value of the land was by reference to the company's financial requirements not its actual value; and there was a high degree of certainty that the company would re-acquire the plant at the end of the lease.

* Completion of the transaction was timed to ensure that the tax advantages of-fered by it would not be diluted by the taxpayer having to pay any balancing charge in respect of the sale of the asset.

As a result of the court's decision, the company's assessments for the years in question were amended to reduce the amount of deductible lease income.

The Eastern Nitrogen case should prove instructive to all financial advisers. In that regard, we can take away the following concepts from the case in respect of the current anti-avoidance provisions:

Beware the promoter

One of the telling features of the case was the fact that the finance broker initiated the transaction, not the taxpayer. The court noted that the finance broker was involved in promoting a range of "financial product types".

Accordingly, financial planners should be careful not to be seen as a promoter of a tax avoidance arrangement. However, where a planner suggests a strategy to a client, based on being an adviser intimate with the client's details, the is-sue of promotion should not arise. The financial planner is fulfilling their du-ties to the client as an adviser.

Beware your documentation

In the Eastern Nitrogen case, the company suggested that the key reason for en-tering into the sale and lease back transaction was to comply with a new company policy seeking to replace short-term debt with long-term debt. However, no docu-mentary evidence (either a company policy document or board minutes) could be produced to show the reasoning behind the transaction.

In respect of Part IVA, unfortunately, the onus is on the taxpayer to show that the dominant purpose of entering into the transaction is other than tax avoid-ance.

Accordingly, financial planners should ensure that the documentation on file in respect of any strategy is thorough, comprehensive, easily understood as to its purpose, and is the subject of a director's or trustee minute, if it is intended for a family trust, company or super fund. Moreover, the documentation should canvass the possibility of the application of Part IVA to the transaction.

New Part IVA

On 11 November, the Government issued the second part of its tax changes follow-ing from the Ralph Committee.

Under the existing definition of tax benefit in Part IVA, a tax benefit arises where the scheme involves the reduction of assessable income, or an increase in deductions or an increase in foreign tax credits, capital losses or franking credits. As such, where a taxpayer enters into a scheme to attract a rebate, say under the pension rebate provisions, Part IVA may not apply.

The Ralph 2 changes propose to define tax benefit as any reduction or deferral of tax payable. In that regard, the committee notes that "practical application of the concept should not depend on the method used by the taxpayer to obtain the tax benefit."

Accordingly, a taxpayer will have received a tax benefit where they seek to pre-pay a deductible expense, as this amounts to a deferral of the taxpayer's cur-rent tax liability. As to whether the prepayment may be struck down under the new Part IVA, regard would need to be had to the purpose of the taxpayer in re-spect of entering into the scheme.

In using the new powers, the commissioner must make a separate determination in respect of each taxpayer who has obtained a tax benefit. This may be so even where all the taxpayers to the scheme have the same particulars. The commis-sioner is now empowered to issue a determination to a particular scheme, thereby catching all participants of the scheme.

For example, under a prospectus, an investment promoter offers an agricultural scheme that maximises the deductions available to a taxpayer. The promoter does not have a project-based tax ruling from the commissioner. The Australian Tax Office becomes aware of the scheme and is of the view that it breaches the new Part IVA. Consequently, the commissioner makes a determination to the promoter of the scheme and all investors that the scheme is struck down under the anti-avoidance rules.

With the new anti-avoidance rules, the tax commissioner now has some powerful teeth to attack any strategy offered by a financial planner to their clients, so be extra careful.