Taxation Anti Avoidance ProvisionsJustine Noy
UNCERTAIN and TAXING TIMES
Author:Justine Noy
associate
Chessell Williams Lawyers
Level 13, 379 Collins Street
Melbourne, Victoria
AUSTRALIA 3000
Date:17 June 2003
UNCERTAIN and TAXING TIMES
INTRODUCTION
In the 18th century, Charles Macklin suggested that “The law is a sort of hocus-pocus science, that smiles in yer face while it picks yer pocket; and the glorious uncertainty of it is of mair use to the professors than the justice of it.”[1]
In the 21st century, the uncertainty of Australia’s taxation laws are undoubtedly of use to the Tax Commissioner but well and truly pick the pockets of businesses.
This paper addresses the uncertainty surrounding the application of Part IVA of ITAA36, the attempt to widen the anti avoidance net with the Personal Services Income (PSI) legislation, the confusion surrounding similar rules in the UK, and finally, speculates whether the PSI concept of Principal Work is nothing more than modern hocus-pocus.
Tax Commissioner Michael Carmody announced in March that the Australian Tax Office will fund a number of test cases in the courts on arrangements involving the splitting of PSI by personal services businesses (PSBs).
Why? Surely the PSI regime, effective from 1 July 2000, was designed to fill any gaps in the ATO’s vast anti-avoidance armory.
As independent contractors fall through the cracks of the PSI regime and satisfy the PSB tests, the ATO wants to tighten the Part IVA net to catch arrangements which reduce income tax by income splitting or diverting PSI to interposed entities.
Mr Carmody informed an ICAA meeting[2] that although new contractor laws were introduced to provide a specific legislative code to address the more straightforward cases, they followed recommendations of the Ralph Report[3] that recognised the role of the general anti-avoidance provisions in dealing with less clear cut situations.
ATO concern stems from its loss in the Full Federal Court in Mochkin[4], which prompted the ATO to issue a fact sheet on the application of Pt IVA to PSI conducted through a company, trust or partnership.[5]
The ATO has stressed that if the PSI regime does not apply, Pt IVA may apply to deny income splitting benefits. This has always been the case, and the Commissioner’s views are well documented in tax rulings.[6]
The test cases aim to provide greater certainty on how the law operates in today’s environment.
Uncertainty is the problem. Taxpayers are entitled to rely on legislation and established interpretation of legislation at any particular time. The required certainty does not always exist in the case of taxation laws in Australia.
Interestingly, consideration of a General Anti-Avoidance Rule in the UK in 1998 highlighted the need for certainty.[7] The Inland Revenue (IR) said that the law should not unduly harm the levels of certainty which companies currently have about the tax treatment of a transaction while the British Chamber of Commerce said that a key issue is knowing at the start of a transaction whether a particular course comprises acceptable tax planning or unacceptable tax avoidance.
THE MISCHIEF
Traditionally, a common strategy for reducing or deferring income tax has been to alienate or divert income generated by an individual through companies, partnerships and trusts.
Subject to anti-avoidance legislation, individuals with appropriate structures in place have been able to –
1retain profits or earnings in companies (including corporate beneficiaries) at the corporate tax rate of 30%;
2take advantage of income splitting opportunities by distributing income to people with lower marginal tax rates, often people who did not carry out the service which attracted the income;[8]
3pay associates salary and making superannuation contributions for spouses;
4make taxation deductions of substantially more amounts than an employee would in a similar situation.
THE PERSONAL SERVICES INCOME REGIME
Pt 2-42 of ITAA97, introduced by the New Business Tax System (Alienation of PSI) Act 2000, restricts the alienation and changes the treatment of PSI of an individual.
Division 84 defines PSI and makes it clear that the legislation does not imply that individual contractors are employees, Division 85 limits individuals’ entitlements to deductions and Division 86 limits deductions available to the interposed entities (the Personal Services Entity or PSE) after the PSI has been alienated. Division 87 establishes procedures for taxpayers establishing whether they are conducting PSBs and therefore outside the regime.
Certain individuals are treated as having received their PSI directly from the customers of the PSE as a result of providing services directly to those customers. The end result is that PSI channelled through a trust, partnership or company cannot be diverted to associates or left in the entity to take advantage of a lower rate of income tax.
PSI is the ordinary or statutory income gained mainly as a reward for an individual’s personal efforts or skills (as opposed to a reward from the use of assets, sale of goods, or a business structure[9]), even if it is legally derived by the PSE. Application of the term “mainly” will be determined on a case by case basis and “will not create certainty”, one of the objectives of the PSI rules.[10]
PSI will not be attributed to the individual if the entity is conducting a PSB. Taxpayers self assess but may apply for a PSB Determination to confirm whether they fall within the alienation measures.
The PSB tests and the “results test” are based on the traditional tests of who is an independent contractor.[11] Identified problems with the PSB tests include –
1The definitions of “producing a result” and “supply of tools”. Why is writing a computer program different from making a repair? Why isn’t a computer sufficient plant and equipment or a tool of trade?[12]
2Two or more unrelated clients must engage the taxpayer “advertising” its services. This becomes difficult when the taxpayer is engaged by reputation or word of mouth.[13]
3Examples in s84-5 state that a truck owner-driver is unlikely to be earning PSI on the basis that the truck represents the main source of income, despite the owner-driver deriving the income. The term introduces uncertainty and puts the taxpayer at risk if he acts on a view which the ATO later disputes.[14]
4They are complex and confusing, and the ATO has issued 120 pages of rulings to try to explain how they work.[15]
5They are selective and fail to cover the full range of circumstances in which contractors operate genuine PSBs.[16]
Anti-Avoidance and Pt IVA
The PSI rules are not safe haven rules,[17] and the activities of PSBs may be caught by Part IVA, which will deny income splitting benefits if the sole or dominant purpose of a scheme was to obtain a tax benefit.
Part IVA applies to –
1the alienation of income earned from personal services;
2income splitting arrangements;
3retention of PSI in a company,
regardless of whether an individual or PSE is conducting a PSB.
“The ATO has made it very clear that it will apply general anti-avoidance provisions to curtail income splitting by personal services businesses. Accountants who are still coming to terms with the effects of the PSI provisions should not forget that even before PSI, the Commissioner could use part IVA to deny income splitting and claims for deductions where income was derived from personal exertion.”[18]
“Part 2-42 will not limit the scope of Part IVA … It will be possible to satisfy the provisions of Part 2-42 whilst falling foul of Part IVA.”[19]
Egan v FCoT[20] was a “timely reminder” of the potential application of Part IVA to income splitting arrangements.[21] A company established to provide consultancy services was held to be part of a scheme to obtain a tax benefit. The AAT found that the taxpayer’s PSI was either retained at a lower marginal tax rate within the company structure or diverted to associates, including his wife and a superannuation fund. The low salary (less than the market value for his work) paid to the taxpayer, unrelated to the services rendered, was a contributing factor to the AAT decision.
It is the recent case of Mochkinwhich tickled the ATO’s sensitivities.
THE MOCHKIN CASE
Mr Carmody said that Mochkinwas “on the face of it” a loss for the Tax Office.[22]
The ATO contended that the alleged scheme was use of a company to receive payment from stockbroking companies for the personal services of Mochkin, and use of a discretionary trust to divert income to third parties.
The court found that the dominant purpose of the arrangement to have commission income received by a corporate trustee was to protect the taxpayer from personal liability.
Of importance was the fact that Mr Mochkin had acted “under the shadow” of previous litigation, and had declined to personally guarantee the obligations of the companies (notwithstanding that the arrangement had income splitting benefits).
The ATO’s assessment of the case focuses on the court’s observation that the outcome may have been different if the scheme had been identified as the taxpayer using the relevant entity to distribute its net income as he directed, without regard to the value of the services he provided to the company.
Barrister Michael Bearman says the case is part of the growing jurisprudence on the operation of Part IVA and a decision of some importance with respect to the diversion of personal exertion income.[23]
Applying Hill J’s reasoning in Hart,[24] Ryan J at first instance weighed the commercial side of the scheme against its tax advantages, and found that Mochkin’s prevailing or most influental purpose was to avoid the possibility of personal liability. Mochkin was unwilling to accept personal liability for client defaults. It was therefore likely that the business would have been carried on through a limited liability entity.
The Full Court rejected a comparison with Tupicoff, Bunting and Case W58,[25] and found that there was nothing to suggest in those cases that the taxpayers were unwilling to provide services on their own account. Mochkin did not simply substitute a corporate entity for his own services, and the interposed companies had accepted liability for defaults of the clients, and on occasion made them good.
The case would have been closer to Case W58 if the Commissioner had identified a narrower scheme.[26] Mr Bearman noted that “It seems likely that the Commissioner will need to pay far greater attention to the identification of a scheme prior to the commencement of litigation.”
Mr Bearman identified the following questions as arising from Mochkin -
1When the Commissioner alleges a diversion of personal income, what evidence would establish a dominant purpose of limited liability?
2If a taxpayer contends that that was the dominant purpose, what evidence if any of an arm’s length salary is required?
3How late can the Commissioner change a scheme that he has particularised?
On 12 March 2003, the AFR described Mochkinas a “blow to the ATO’s campaign against income splitting?”[27]
However ATO Senior Tax Counsel Simon Matthews has explained Mr Mochkin’s specific circumstances as follows[28] –
He had been personally sued in relation to his stockbroking activities.
The corporate trustee of a family trust was ready at hand.
He had substantial facilities and a team of people – not a ‘one person’ business.
He was frequently absent.
He said Mochkin was decided on its own facts and warned enterprising accountants to “beware”, and identified the following questions as relevant –
1Is there a genuine commercial reason for using an entity?
2If the taxpayer is seeking asset protection, has protection been demonstrated?[29]
3Does the interposed entity comprise a cumbersome, complex or artificial structure?
4Is the taxpayer using an interposed entity to distribute its net income as he directs, without regard to the value of the services he provides to that entity?[30]
Mr Matthews said the test case program was intended to obtain judicial consideration of ATO views. Surely a confession of endemic uncertainty?
PART IVA – NOT ENOUGH?
The PSI regime was introduced following The Ralph Report Review of Business Taxation.
One of John Ralph’s guiding principles was that economic transactions having the same economic substance should be taxed similarly, irrespective of their legal form – not dissimilar to the UK concept of the employee and the “disguised employee”.
The guiding principle was reflected in Treasurer Peter Costello’s Second Reading Speech to the PSI legislation when he said that the object of the proposal was to treat all earnings from work in the same way under the income tax law, regardless of the legal structure used by the income earner.
The Ralph Review identified “a burgeoning tax loophole” as a result of the use of interposed companies, partnerships and trusts and confirmed the Federal Government’s view that the general anti-avoidance was not working adequately.[31]
Compare Peter Roach’s[32] views on a sole trader electing to bring a spouse into partnership or form a company, with neither the party nor fellow shareholders contributing to the result. Roach believes that we will “rue the day” we allow the ATO to direct taxpayers as to the form of business entities to be established, and that it is unjust to single out a group for special liability because they exercise a choice which the rules of the community offer, and seek to justify such discrimination because the individual has a reduced personal liability in tax without regard to other circumstances.
The ATO’s protracted efforts to prevent income splitting are reflected by the following –
The Commissioner’s “long running war” against alienation of PSI. Despite success in Tupicoffand the existence of IT 2121 and similar rulings, the Commissioner desired further strengthening of the legislation, and some sixteen years later the Commissioner was granted his wish.[33]
The release of IT2639 to give “guidance” on IT 2330 and IT2121 (which was released just 21 days after Tupicoff).
The use of Pt IVA to counter alienation practices on a case by case basis which is labour intensive and an inefficient use of ATO resources.[34]
The Explanatory Memorandum’s statement that the specific rules would provide certainty for Australia taxpayers but then concedes that the legislation should produce a similar outcome as that obtained from Part IVA.[35]
The Treasurer’s statement that the ATO had previously applied the general anti-avoidance rule to arrangements which avoided tax through the alienation of PSI. Why then was anything more than Part IVA called for?[36]
The uncertainty when drawing the fine line between personal services income and business income.[37]
The ATO’s delineation of business income from PSI lacks detail and clarity.[38]
The failure of Part IVA being identified by the government as the key reason for enacting the PSI legislation. Part IVA did not prove to be the “white knight” the government had hoped …[39]
Australian contract workers earning PSI being subject to numerous court cases, tax rulings, ATO audit programs and legislative changes.[40]
Uncertainty surrounding the application of the PSI regime being acknowledged by Parliament when the legislation was amended to meet perceived deficiencies.[41] For example, the independent contractors’ self-assessment was a significant withdrawal from original intended scope of PSI measures. Other changes introduced the results tests, provided that commission based payments to agents from principals would be treated on a look-through basis and allowed taxpayers under the Prescribed Payments System to avoid the alienation rules until 1 July 2002.
Uncertainty was demonstrated as early as 1992 when Justin Dabner and Mark Burton[42] contended that the decisions on Part IVA demonstrated a paucity of reasoning and that the more appropriate foundation for any personal services rule was outside and independent of Part IVA. They proffered options –
1Section 19 ITAA36 on the basis that the money has already “come home” to the taxpayer.
2Expanding the scope of the sham principle.
3Doctrine of Fiscal Nullity, the principle developed by the UK courts which allows revenue authorities to look behind the legal effect of certain aspects of a transaction and to determine the liability on the basis of the substance of the transaction. In Australia, fiscal nullity is generally rejected on the basis that the legislation contains a general anti-avoidance provision.
Submissions to the Review of Business Taxation’s Discussion Paper
“A Strong Foundation”[43]
The Government announced on 11 November 1999 that it would introduce legislative amendments to “improve” the operation of Part IVA.
The Ralph Report said that proposed structural reforms, by significantly reducing existing disparities and flaws in the tax law, would reduce the reward from undertaking activities purely for tax purposes.
“Nevertheless, where opportunities for tax avoidance remain the powers already available in the general anti-avoidance rule (Part IVA) … should generally be the measures used against them – rather than specific anti-avoidance measures.”
Institute of Chartered Accountants