House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 1 - The general anti-avoidance rule

Outline of chapter

1.1 Schedule 1 to this Bill amends Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) to ensure its effective operation as the income tax general anti-avoidance provision.

1.2 The principal role of Part IVA is to counter arrangements that, objectively viewed, are carried out with the sole or dominant purpose of securing a tax advantage for a taxpayer.

1.3 Broadly speaking, Part IVA operates to counter such arrangements by exposing the substance or reality of the arrangements to the ordinary operation of the income tax law.

Context of amendments

1.4 Some recent decisions of the Full Court of the Federal Court concerning the way in which Part IVA determines whether or not a tax advantage has been obtained in connection with an arrangement have revealed a weakness in the capacity of Part IVA to effectively counter arrangements that, objectively viewed, have been carried out with a relevant tax avoidance purpose.

1.5 The amendments in Schedule 1 to this Bill address this weakness and ensure that Part IVA is effective to counter tax avoidance.

1.6 This measure was announced by the Government on 1 March 2012.

1.7 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.

1.8 The amendments were prepared after consultation with a roundtable of independent experts and with the benefit of formal advice from senior barristers, as well as the normal consultation processes for tax measures.

Legislative history

1.9 Part IVA was enacted in 1981 to overcome deficiencies that judicial decisions had exposed in the operation of the previous general anti-avoidance provision - section 260 of the ITAA 1936.

1.10 The explanatory memorandum accompanying Part IVA explained that Part IVA was 'designed to overcome' the difficulties with section 260 and 'provide - with paramount force in the income tax law - an effective general measure against those tax avoidance arrangements that - inexact though the words may be in legal terms - are blatant, artificial or contrived' (see explanatory memorandum, Income Tax Laws Amendment Bill (No 2) 1981).

1.11 Further, the explanatory memorandum made it clear that the 'test for application' of Part IVA was 'intended to have the effect that arrangements of a normal business or family kind, including those of a tax planning nature' would be beyond the scope of Part IVA.

1.12 The distinction between tax avoidance and legitimate commercial and family arrangements was emphasised by the then Treasurer in his second reading speech on the Bill. There he stated that Part IVA was not intended to 'cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs'.

1.13 Part IVA gives effect to this distinction by requiring an examination of whether, having regard to eight objective matters (including the manner in which an arrangement was entered into, its form and substance, and the taxation results it produces), it would be concluded that the arrangement was entered into in the particular way it was for the sole or dominant purpose of obtaining a tax advantage.

1.14 Part IVA does not inquire into the subjective motives of taxpayers and it does not therefore strike at every arrangement that is entered into with an eye to tax minimisation. This has been established by decisions of the High Court of Australia. Their Honours Gleeson CJ and McHugh J said in Commissioner of Taxation v Hart (2004) 206 ALR 207 ( Hart ) at [15]:

'... the fact that a particular commercial transaction is chosen from a number of possible alternative courses of action because of tax benefits associated with its adoption does not of itself mean that there must be an affirmative answer to the question posed by s 177D. Taxation is part of the cost of doing business, and business transactions are normally influenced by cost considerations. Furthermore, even if a particular form of transaction carried a tax benefit, it does not follow that obtaining the tax benefit is the dominant purpose of the taxpayer in entering into the transaction. A taxpayer wishing to obtain the right to occupy premises for the purpose of carrying on a business enterprise might decide to lease real estate rather than to buy it. Depending upon a variety of circumstances, the potential deductibility of the rent may be an important factor in the decision. Yet, if there were nothing more to it than that, it would ordinarily be impossible to conclude, having regard to the factors listed in s 177D, that the dominant purpose of the lessee in leasing the land was to obtain a tax benefit. The dominant purpose would be to gain the right to occupy the premises, not to obtain a tax deduction for the rent, even if the availability of the tax deduction meant that leasing the premises was more cost-effective than buying them.'

1.15 It does not follow, however, that Part IVA is incapable of applying to arrangements that also advance wider commercial objectives. There is no 'dichotomy' between a 'rational commercial decision' and 'the obtaining of a tax benefit' (see Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [64]).

1.16 The High Court has confirmed on a number of occasions that Part IVA will apply to an arrangement if the particular form in which the arrangement is implemented evinces the requisite tax avoidance purpose (see Federal Commissioner of Taxation v Spotless (1996) 141 ALR 92 ( Spotless ) at pp 97-98 and 105, and Hart (2004) 206 ALR 207 at [16][52] and [94]).

1.17 More particularly, as Callinan J observed in Hart (2004) 206 ALR 207 at [94], 'an aspect of' the direction in Part IVA to consider the 'form and substance' of a scheme 'is whether the substance of the transaction (tax implications apart) could more conveniently, or commercially, or frugally have been achieved by a different transaction or form of transaction.'

The statutory regime ^[1]

1.18 The Commissioner of Taxation (Commissioner) may cancel a tax benefit obtained by a taxpayer in connection with a scheme 'to which Part IVA applies' (see subsection 177F).

1.19 Section 177D provides that Part IVA applies to a scheme in respect of which:

•

a taxpayer has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme (see paragraph 177D(a)); and

•

one or more of the persons who participated in the scheme (or part of the scheme) did so for the sole or dominant purpose, objectively ascertained, of enabling the taxpayer to obtain a tax benefit in connection with the scheme (see paragraph 177D(b)).

1.20 Although the Commissioner is entitled to put his case in relation to the scheme and the tax benefit in alternative ways, the existence of the Commissioner's discretion to cancel the tax benefit does not depend upon the Commissioner's opinion or satisfaction that there is a tax benefit or that, if there is a tax benefit, it was obtained in connection with a scheme. The existence of a scheme and a tax benefit must be established as matters of objective fact (see Peabody v Commissioner of Taxation (1994) 123 ALR 451 ( Peabody ) at pp 458-459).

1.21 Moreover, the 'bare fact' that a taxpayer can be shown to have obtained a tax benefit in connection with a scheme does not in itself compel the application of Part IVA (see Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [53] and Callinan J at [92]). The tax benefit must be obtained in connection with a scheme to which Part IVA applies.

1.22 In determining whether Part IVA applies to a scheme, the critical question - indeed the fulcrum upon which Part IVA turns (Callinan J in Hart (2004) 206 ALR 207 at [92]) - is whether a person or persons who participated in the scheme did so for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit that has been so obtained. The relevant purpose must be established objectively based on an analysis of how the scheme was implemented, what the scheme actually achieved as a matter of substance or reality as distinct from legal form (that is, its end effect) and the nature of any connection between the taxpayer and other parties (and each of the other factors in paragraph 177D(b)). A person's subjective motive is irrelevant.

1.23 Gummow and Hayne JJ observed in Hart ((2004) 206 ALR 207 at [37]) that each of the concepts of 'tax benefit', 'scheme' and 'scheme to which this Part applies' have their 'part to play' in deciding whether a section 177F determination is permitted, and each of them 'must be given operation in the interrelated way which section 177F(1) requires'. Further (at [36]):

'Although it will often be convenient to begin any consideration of the application of the Part by attending to the operation of these elucidating and definitional provisions [that is sections 177A and 177C], approaching a particular case in this way must not be allowed to obscure the way in which the Part as a whole is evidently intended to operate.'

The role of an alternative postulate

1.24 Implicitly, the Part IVA inquiry 'requires [a] comparison between the scheme in question and an alternative postulate' (Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [66]).

1.25 A comparison between the scheme and an alternative postulate serves the Part IVA inquiry in two ways:

•

first, comparisons between the tax consequences of the scheme and the tax consequences of alternative postulates provide a basis for identifying (and quantifying) any tax advantages (of the relevant kind) that may have been obtained from the scheme; and

•

second, a consideration of alternative postulates may, in the course of considering the paragraph 177D(b) matters, assist in reaching a conclusion about the purposes of the participants in the scheme (Gummow and Hayne JJ in Hart (2004) 206 ALR 207 at [66] to [68]): a consideration of whether there were other ways that the participants in the scheme could have achieved their non-tax purposes facilitates a weighing of those purposes against any tax purposes that can be identified.

1.26 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.

Tax benefit

1.27 The purpose and function of section 177C is to define the kind of tax outcomes that a participant in the scheme must have had the purpose of securing for the taxpayer, and which must have been secured in connection with the scheme, if Part IVA is to apply.

1.28 The tax outcomes with which section 177C(1) is concerned, and which are labeled 'tax benefits', are:

•

an amount not being included in assessable income;

•

a deduction being allowed;

•

a capital loss being incurred; and

•

a foreign income tax offset being allowed. ^[2]

1.29 In order to reach a conclusion that one of the specified outcomes has been secured, and to quantify it, it is necessary to compare the tax consequences of the scheme in question with the tax consequences that either would have arisen, or might reasonably be expected to have arisen, if the scheme had not been entered into or carried out. This involves a comparison with an alternative postulate.

1.30 A tax consequence of a scheme or of an alternative postulate is relevant if it arises in connection with the scheme or with the alternative postulate. The inquiry is not confined to the immediate tax consequences of the steps that comprise the scheme or the alternative postulate (see Commissioner of Taxation v Futuris Corporation [2012] FCAFC 32 ( Futuris ) at [34]).

Perceived weaknesses in the "tax benefit' concept

1.31 A number of recent decisions of the Full Federal Court have revealed weaknesses in the way in which the tax benefit concept in section 177C operates.

1.32 The Government is concerned that these weaknesses may reduce the effectiveness of Part IVA in countering tax avoidance arrangements.

Alternative bases for identifying tax benefits

1.33 Subsection 177C(1) contains two bases upon which the existence of a tax benefit can be demonstrated. The first is that, absent the scheme, a relevant tax outcome 'would have been' the case. The second is that, absent the scheme, a relevant tax outcome 'might reasonably be expected to have been' the case.

1.34 The first limb requires a comparison of the tax consequences of the scheme with the tax consequences that 'would have' resulted if the scheme had not occurred.

1.35 The second limb requires a comparison of the tax consequences of the scheme with the tax consequences that 'might reasonably be expected to have' resulted if the scheme had not occurred.

1.36 The two limbs have been viewed as alternatives (see Peabody v Commissioner of Taxation ([1993] FCA 74 at [36]) and Commissioner of Taxation v Consolidated Press Holdings [1999] FCA 1199 ( Consolidated Press ) at [85]).

1.37 One approach to the first limb has been to view it as satisfied in cases where a relevant tax advantage is exposed by applying the taxation law to the facts remaining once the statutory postulate has done its work in deleting the scheme. In those cases, a tax benefit exists if it can be demonstrated that the relevant tax advantage flows, as a matter of law, once the scheme is assumed not to have happened. This may be referred to as an 'annihilation approach'. Although this approach involves an alternative postulate, that postulate consists solely of deleting the scheme.

1.38 Cases that appear to have been decided on the basis of this approach to the first limb include the decisions of the Full Court of the Federal Court in Puzey v Commissioner of Taxation [2003] FCAFC 197 ( Puzey ) and Commissioner of Taxation v Sleight [2004] FCAFC 94 ( Sleight ). For example, in Puzey , at [66], Hill and Carr JJ (with French J concurring) identified the tax benefit on the basis that 'had Puzey not entered into the scheme he would not have had the deductions which became available to him'. However, no court has expressly considered whether this approach to the first limb is correct.

1.39 On this view, the second limb is a qualitatively different test that may be satisfied notwithstanding an element of uncertainty in the postulate. For example, it has been applied in cases where the mere deletion of the scheme would not necessarily leave a coherent state of affairs for the tax law to apply to - where a prediction is required about facts not in existence and/or about facts which are in existence not being in existence. In other words, it contemplates a postulate based on a reasonable reconstruction of either the scheme, or of the scheme and things that happened in connection with the scheme. This is sometimes referred to as a 'reconstruction approach'.

1.40 The second limb has also been applied in cases where a first limb tax benefit, resting as it does on a postulate that the scheme merely would not have happened, would be inconsistent with the non-tax results and consequences sought for the taxpayer by the participants in the scheme. In those cases a reconstruction of either the scheme, or of the scheme and things that happened in connection with the scheme, may expose other ways in which the non-tax results and consequences of the scheme could have reasonably been achieved without the impugned tax advantages (see, for example, Hart (2004) 206 ALR 207).

1.41 The High Court decisions in Peabody (1994) 123 ALR 451, Spotless (1996) 141 ALR 92, and Hart each concerned an application of the second limb. In each of those cases, the postulate upon which the Commissioner relied to identify the tax benefit was based upon what was argued to be a reasonable expectation about how the scheme, or the scheme and things that happened in connection with the scheme, could have been done differently to achieve the same commercial ends.

1.42 Another view of the operation of section 177C has become evident in a number of recent decisions.

1.43 The decision in Futuris is an example. Both at first instance and on appeal, the underlying suggestion seems to be that the reference in subsection 177C(1) to tax consequences that 'would have [occurred], or might reasonably be expected to have [occurred], ... if the scheme had not been entered into or carried out' is a composite phrase requiring, in every case, a postulate about what would have or might reasonably be expected to have happened in lieu of the scheme. On this view of the provision, 'would have' or 'might reasonably be expected to have' represent ends of a spectrum of certainty within which acceptable postulates must lie (see Futuris [2012] FCAFC 32 at [54], [59], [62] and [79] and Commissioner of Taxation v Trail Brothers Steel & Plastics Pty Ltd [2010] FCAFC 94 at [26] and [29]). It appears to be assumed that all acceptable postulates will involve a prediction about events or circumstances, as opposed to a mere deletion of the scheme.

1.44 The competing constructions of section 177C have yet to be directly considered by a court. To achieve the intended outcome, these amendments include provisions which put it beyond doubt that the 'would have' and 'might reasonably be expected to' limbs of each paragraph of subsection 177C(1) represent separate and distinct bases upon which the existence of a tax benefit can be demonstrated.

1.45 From a policy perspective, it is desirable that section 177C(1) should operate in this manner. As the Explanatory Memorandum accompanying Part IVA explained, a 'limitation' of section 260, which Part IVA was intended to overcome, was that once section 260 had 'done its job of voiding an arrangement' it, did not 'provide a power to reconstruct what was done, so as to arrive at a taxable situation (emphasis added)'. This was typically a problem in relation to income schemes where voiding the arrangement served to annihilate not only the tax shelter but also the underlying economic gain as well.

1.46 It is desirable that reconstruction be permitted in addition to, and not to the exclusion of, voiding an arrangement. Voiding an arrangement can be a simple and effective way to identify the tax advantage produced by an arrangement, particularly an aggressive arrangement directed at obtaining income tax deductions.

Nature of the inquiry permitted in constructing an alternative postulate

1.47 The second limb of subsection 177C(1) has been interpreted as permitting a broad-ranging inquiry into what into what might reasonably be expected to have happened absent the scheme, unconstrained by the matters that must be considered under section 177D(b) in testing purpose (see Epov v Federal Commissioner of Taxation [2007] FCA 34 at [62]) and the limits of what it is that the scheme has achieved (see Commissioner of Taxation v Axa Asia Pacific Holdings Ltd [2010] FCAFC 134 ( Axa Asia ) at [131]).

1.48 Put differently, it is viewed as an open-ended inquiry into what, if anything, the taxpayer might reasonably have done if it had not participated in the scheme.

1.49 While a consideration of what the taxpayer did in the commercial circumstances that existed is viewed as shedding light on what the taxpayer would have done in the absence of the scheme ( Commissioner of Taxation v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49 at [153]), the matters that can be taken into account in the inquiry are unlimited and can include evidence from the taxpayer as to what it would have done in the absence of the scheme (provided foundation facts are given to support what would otherwise be a bald speculative statement) (see McCutcheon v Federal Commissioner of Taxation [2008] FCA 318 (2008) 168 FCR 149 at [37], cited with approval in Axa Asia [2010] FCAFC 134 (at [140])).

1.50 Further, it is permissible to reject an alternative course of action on the basis that the tax costs involved in undertaking that action would have caused the parties to do nothing, including deferring or abandoning a wider transaction of which the scheme was a part (see, for example, RCI Pty Ltd v Commissioner of Taxation [2011] FCAFC 104 ( RCI ) at [145] to [150]).

1.51 From a policy perspective, the operation of Part IVA as a general anti-avoidance provision would be better served if the inquiry focused on whether or not there were other ways (for example, more convenient, or commercial, or frugal ways) in which the taxpayer might reasonably have achieved the substance and effect (tax implications aside) that it achieved from, or in connection with, the scheme. That inquiry would assist in exposing the purposes of the participants in a scheme and prevent taxpayers who achieve substantive non-tax effects from a scheme avoiding the normal tax consequences of what they have actually done by arguing that they would have done something completely different, or done nothing at all.

1.52 It is also not conducive to the effective operation of Part IVA for the inquiry to take into account the potential tax consequences of an alternative postulate in determining whether it is a reasonable alternative to the scheme.

1.53 The function of section 177C is to compare the tax consequences of the scheme with the tax consequences of a reasonable substitute for the scheme. Having identified a postulate that is in other respects functionally substitutable for the scheme, it would be undesirable to consider the tax consequences of that postulate to be a basis for disregarding it as unreasonable. To do so would be to allow the normal tax consequences of what it is that the taxpayer has achieved to function as a shield against the operation of Part IVA.

1.54 An inquiry of the kind proposed would better assist an analysis of the purposes of the persons who participated in the scheme and expose the tax advantages that they have in fact enjoyed.

Deciding whether Part IVA applies

1.55 In part, the weaknesses in the reconstruction limb of subsection 177C(1) may be an unintended consequence of the way that section 177D approaches the question whether Part IVA applies to a scheme.

1.56 Under the current law, the first question to be answered when determining whether Part IVA applies is whether a taxpayer has obtained a tax benefit in connection with the scheme (as defined in section 177C). Only if the answer is yes does attention turn to the section 177D inquiry and the question whether a participant in the scheme had the dominant purpose of securing a tax benefit for the taxpayer in connection with the scheme.

1.57 For instance, in RCI [2011] FCAFC 104 (at [151) the Full Federal Court concluded it was 'strictly unnecessary', in disposing of that matter, for it to consider the paragraph 177D(b) issue as to purpose (although it did in fact go on to consider the issue out of 'deference to the primary judge's reasons and to the submissions on the hearing of the appeal'). Similarly, a differently constituted Full Federal Court in Futuris [2012] FCAFC 32 was able to dismiss the Commissioner's appeal (at [81]) without considering the question of whether any person had the relevant tax avoidance purpose.

1.58 This approach is undesirable from a policy perspective. The objects of Part IVA are more likely to be served if the analysis starts with the section 177D inquiry about whether a person participated in a scheme for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit. This inquiry has two components, in that the relevant purpose must be about a tax benefit, but it is nonetheless a single inquiry.

1.59 The inquiry looks at how the scheme was implemented, what it achieved as a matter of substance or reality (that is, its end effect) and the nature of any connection between the taxpayer and other parties. A consideration of alternative possibilities should form part of that inquiry. Gummow and Hayne JJ indicated in Hart (2004) 206 ALR 207 [at 66] that subsection 177C(1) and paragraph 177D(b) must be read together.

The Government's response

1.60 On 1 March 2012, the Government announced that it would introduce amendments to ensure Part IVA continued to be effective in countering tax avoidance schemes.

1.61 The Government's announcement was made after reviewing a number of judicial decisions, including the decision of the Full Federal Court in RCI [2011] FCAFC 104, handed down on 22 August 2011. The High Court dismissed the Commissioner's application for special leave to appeal against that decision on 10 February 2012.

1.62 The Government was concerned that some taxpayers had argued successfully that they did not get a 'tax benefit' because, absent the scheme, they would not have entered into an arrangement that attracted tax - for example - because they would have entered into a different scheme that also avoided tax, because they would have deferred their arrangements indefinitely or because they would have done nothing at all.

1.63 The Government was also concerned that Part IVA might not be working effectively in relation to schemes that were steps within broader commercial arrangements.

1.64 Mindful that any amendments should not interfere with genuine commercial transactions, the Government established a comprehensive consultation process to assist it design the amendments. That process involved setting up a roundtable of industry representatives, legal academics and tax experts to assist Treasury identify and explore possible approaches to clarifying the law. It also involved the Government seeking advice on different design options from senior members of the bar with particular expertise in Part IVA.

1.65 The role of the roundtable was not to revisit the policy decisions announced by the Government on 1 March 2012. The roundtable was established because of the unique role that Part IVA plays in the income tax laws, in addition to the normal Treasury consultation processes, to improve the legislative response to the problems that have emerged with Part IVA.

1.66 The roundtable process was constructive, and significantly deepened the Government's understanding of the issues with Part IVA that the Government is seeking to address.

1.67 As originally announced, the amendments were to apply from 2 March 2012. However, the Government announced a deferral of the application date until the release date of the exposure draft (16 November 2012) to allow for the additional time taken to progress the amendments to the exposure draft stage (time that was spent in consultation) and to recognise that the amendments may not have been in a form the public would have readily anticipated when the measure was first announced.

Summary of new law

1.68 Schedule 1 to this Bill amends Part IVA of the ITAA 1936.

1.69 The amendments target deficiencies in section 177C, and the way it interacts with other elements of Part IVA, particularly section 177D, as revealed by recent decisions of the Full Federal Court.

1.70 The amendments are not intended to change the operation of Part IVA in any other respect.

1.71 Consistent with the policy underlying Part IVA, the amendments are intended to have the following effects:

•

to put it beyond doubt that the 'would have' and 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs represent alternative bases upon which the existence of a tax benefit can be demonstrated;

•

to ensure that, when obtaining a tax benefit depends on the 'would have' limb of one of the paragraphs in subsection 177C(1), that conclusion must be based solely on a postulate that comprises all of the events or circumstances that actually happened or existed other than those forming part of the scheme;

•

to ensure that, when obtaining a tax benefit depends on the 'might reasonably be expected to have' limb of one of the paragraphs in subsection 177C(1), that conclusion must be based on a postulate that is a reasonable alternative to the scheme, having particular regard to the substance of the scheme and its effect for the taxpayer, but disregarding any potential tax costs; and

•

to require the application of Part IVA to start 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; and so emphasising the dominant purpose test in section 177D as the 'fulcrum' or 'pivot' around which Part IVA operates.

Comparison of key features of new law and current law

Detailed explanation of new law

The bases for identifying tax benefits

1.72 Schedule 1 to this Bill amends Part IVA to address weaknesses that have come to light in how it works out whether there is a tax benefit in connection with a scheme and what that tax benefit is. [Schedule 1, item 5, section 177CB]

1.73 A conclusion that one of the paragraphs of subsection 177C(1) is satisfied requires a conclusion that one of the tax effects specified in that subsection (for example, the inclusion of an amount of assessable income) 'would have', or 'might reasonably be expected to have', happened, absent a particular scheme. [Schedule 1, item 5, subsection 177CB(1)]

1.74 The new provision puts it beyond doubt that the 'would have' and 'might reasonably be expected to have' limbs of each of the paragraphs in subsection 177C operate as alternative bases for identifying relevant tax effects. [Schedule 1, item 5, subsections 177CB(2) and (3)]

Alternative bases

1.75 Whilst the Commissioner, in exercising the discretion under subsection 177F(1) to cancel a tax benefit, is entitled to put his or her case in alternative ways (including by relying, in the alternative, on the different limbs of the paragraphs in subsection 177C), the tax benefit cancelled must be a tax benefit that has been obtained in connection with a scheme to which Part IVA applies.

1.76 As such, the question in every case will be whether or not it can be established, as a matter of objective fact, that the tax benefit the Commissioner is purporting to cancel is a tax benefit that was obtained in connection with a scheme that was entered into or carried out with the requisite tax avoidance purpose.

An annihilation approach

1.77 A decision that a tax effect 'would have' occurred if the scheme had not been entered into or carried out must be 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. [Schedule 1, item 5, subsection 177CB(2)]

1.78 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'.

1.79 In other words, the speculation that is permitted about any other state of affairs that might have come about if the scheme had not been entered into or carried out is limited to the removal of the scheme. A postulate cannot assume the existence of events or circumstances not in existence, nor can it assume the non-existence of events or circumstances that are in existence (other than those that form part of the scheme).

1.80 Under this approach, a taxpayer will have obtained a tax benefit in connection with a scheme if it can be demonstrated that a relevant tax effect would have flowed, as a matter of law, from the application of the taxation law to the facts remaining once the scheme is assumed away, that is, a tax effect less advantageous to the taxpayer than the tax effect secured by the taxpayer in connection with the scheme.

Example 1.1: Postulating the absence of the scheme

Sandy enters into a scheme from which he secures a large, up-front, tax deduction. The scheme is structured so as to provide him with a highly contingent right to income payable some years in the future. The potential investment returns are speculative and clearly subordinate to the tax deduction.

When postulating what the tax effects would have been absent the scheme, the events and circumstances comprising the scheme must be assumed not to have happened, and it is impermissible to speculate about events or circumstances that did not exist (for example, that Sandy would have done something else that would have also secured a tax deduction).

If the scheme is assumed not to have happened, Sandy would not have obtained a tax deduction. Sandy has therefore obtained a tax benefit in connection with the scheme that is equal to the amount of the tax deduction that he secured by entering into the scheme.

1.81 An annihilation approach is a simple and effective way to identify a tax benefit in a case where the mere deletion of a scheme exposes a coherent taxable situation - without the need to engage in any kind of reconstruction or speculation.

1.82 Typically, this will be the case where the scheme in question does not produce any material non-tax results or consequences for the taxpayer.

1.83 For example, a straightforward application of this approach would be expected to expose the same deduction benefits as the Full Federal Court found had been obtained in connection with the agricultural schemes at issue in Puzey [2003] FCAFC 197 and Sleight [2004] FCAFC 94.

1.84 Similarly, it can be expected that this approach would be effective to expose tax benefits obtained in connection with schemes that shelter economic gains already in existence.

Example 1.2: Changing the source of income

Deborah, a foreign resident, enters into an arrangement under which assessable income that would otherwise be derived by her from Australian sources is instead derived by her from foreign sources with the result that it is not assessable in Australia.

If the scheme had not been entered into, the income would have been included in Deborah's assessable income because the only operation of the scheme was to change the source of the income for taxation purposes. The tax benefit is the reduction in Deborah's assessable income.

No speculation is necessary or permitted in deciding what else might have happened if Deborah had not entered into the scheme.

A reconstruction approach

1.85 A decision that a tax effect 'might reasonably be expected to have' occurred if a scheme had not been entered into or carried out must be made on the basis of a postulate that is a reasonable alternative to the scheme, having particular regard to the substance of the scheme and its results and consequences for the taxpayer, and disregarding any potential tax results and consequences. [Schedule 1, item 5, subsections 177CB(3) and (4)]

1.86 The amendment makes it clear that when postulating what might reasonably be expected to have occurred in the absence of a scheme, it is not enough to simply assume the non-existence of the scheme - the postulate must represent a reasonable alternative to the scheme, in the sense that it could reasonably take the place of the scheme.

1.87 Such a postulate will necessarily require speculation about the state of affairs that would have existed if the scheme had not been entered into or carried out. This may include speculation about the way in which connected transactions would have been modified if they had had to accommodate the absence of the scheme.

1.88 Under this approach, a taxpayer will obtain a tax benefit in connection with a scheme if it can be demonstrated that a relevant tax effect would have flowed, as a matter of law, from the application of the taxation law to the alternative postulate; again, a tax effect that is less advantageous to the relevant taxpayer than the tax effect secured by the taxpayer in connection with the scheme.

Example 1.3: Reconstructing events

Mr and Mrs Heginbothom want to borrow money to acquire both a family home and a holiday house that they plan to rent to holidaymakers. They borrow the money under an arrangement in which the repayments are applied exclusively to the borrowing in relation to the family home. The result is that the deductible interest payments are increased for the holiday home borrowing and the non-deductible interest payments for the family home borrowing are minimised.

Merely annihilating the scheme would not leave a sensible result because there would be no borrowing at all, so some reconstruction is necessary. It is therefore necessary to consider what might reasonably be expected to have happened if the scheme had not been entered into. A reasonable alternative in this case might be that the Heginbothoms took out two loans, one for each of the homes they wished to acquire, each of which was entered into on normal commercial terms.

1.89 A reconstruction approach is an effective way to identify a tax benefit in relation to a scheme that achieves substantive non-tax results and consequences. In these cases, simply annihilating the scheme would be inconsistent with the non-tax results and consequences sought for the taxpayer by the participants in the scheme.

1.90 Typically this will be the case in an income scheme (or a withholding tax scheme) that both produces and shelters economic gains. In such cases an annihilation approach would be an ineffective way to expose the tax avoidance achieved by the tax shelter, since deleting the scheme would destroy both the gain and the shelter. In such cases, a prediction will necessarily be required about other ways in which a comparable gain could have been produced without the tax shelter.

1.91 The role of the reconstruction approach in relation to income schemes is usefully illustrated by the High Court decision in Spotless (1996) 141 ALR 92. There (at pp 103-104) the Court rejected a submission on behalf of the taxpayers, in relation to paragraph 177C(1)(a), that, had they not entered into the investment scheme, there would have been no interest, and no amount included in their assessable income that would satisfy the definition of 'tax benefit'.

'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.'

1.92 A reconstruction approach may also be effective in relation to schemes that result in a taxpayer obtaining a tax advantage of the kind mentioned in paragraphs 177CB(1)(b), (c), (d) and (e): a deduction benefit, a capital loss benefit, a foreign tax offset benefit or a withholding tax benefit.

1.93 If a postulate that the scheme merely would not have happened would be inconsistent with the non-tax results and consequences sought for the taxpayer by the participants in the scheme then a reconstruction of either the scheme, or of the scheme and things that happened in connection with the scheme, may expose other ways in which the non-tax results and consequences of the scheme could reasonably have been achieved without the impugned tax advantages.

1.94 This is usefully illustrated by the decisions in Consolidated Press [1999] FCA 1199 and in Hart (2004) 206 ALR 207.

1.95 In Consolidated Press the Full Federal Court concluded (at [89]) that, absent the scheme, an amount of interest on a borrowing 'might reasonably be expected ... not to have been allowable'. In so doing, it upheld the trial judge's hypothesis that, had the particular scheme not been entered into, it was reasonable to expect that the borrowed money would have been directly invested in a foreign subsidiary and therefore been non-deductible because of former section 79D of the ITAA 1936. The trial judge based his hypothesis on the way in which the actual investment had been structured ((1998) 98 ATC 4983 at 4998 per Hill J).

1.96 Similarly in Hart , where a husband and wife had borrowed money on unusual terms with advantageous taxation consequences, the High Court concluded that absent the scheme it was reasonable to expect the taxpayers would have still borrowed the money (for two purposes, one private and the other income producing) but that they would have done so on standard financing terms rather than the special terms which had produced the relevant tax advantages.

1.97 In each of Consolidated Press and Hart , the reasonable expectation as to what would have happened absent the respective schemes was informed by the commercial results to which the schemes were directed.

The matters to which particular regard must be had

1.98 The amendments make it clear that in determining whether a postulate is a reasonable alternative to the entering into or carrying out of the scheme, particular regard must be had to the 'substance of the scheme' and to 'any result or consequence for the taxpayer that would be achieved by the scheme' (tax results aside). [Schedule 1, item 5, paragraph 177CB(4)(a)]

1.99 These matters are ones to which regard must also be had under section 177D in determining whether it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit.

1.100 Particular regard must be given to the specified matters: they are not intended to be an exhaustive list of the matters to which regard may be had.

1.101 Particular attention is directed to the specified matters in order to ensure that postulates identified under the reconstruction limbs of the subsection 177C(1) paragraphs are reasonable substitutes for the scheme.

1.102 A tax advantage cannot meaningfully be linked to a scheme by comparing the tax consequences of the scheme to the tax consequences that would have flowed if the parties had chosen to pursue some other objective. To provide a meaningful comparison, the tax consequences of the scheme should be compared with the tax consequences of an alternative that is reasonably capable of achieving for the taxpayer substantially the same non-tax results and consequences as those achieved by the scheme.

Having particular regard to the substance of the scheme

1.103 An examination of the substance of a scheme [Schedule 1, item 5, subparagraph 177CB(4)(a)(i)] requires a consideration of its commercial and economic substance as distinct from its legal form or shape.

1.104 For example, in Sleight [2004] FCAFC 94, Hill J, when considering the substance of a tea tree oil scheme, said (at [81]):

'There is a difference between the form and the substance of the present scheme. In form there is an option whether to farm alone or to employ the management company. There is a management agreement and financing and interest payments. The form involving pre-payment of management fee and interest is, it may be concluded readily, designed to increase the taxation deductions available to an investor. The substance is, however, quite different. As senior counsel for the Commissioner put it, in substance the investor is a mere passive investor in what, once the tax features are removed, is a managed fund where no deduction would be available, or perhaps an alternative characterisation of the substance of the scheme is an investment in shares in the land company which at the expiration of 15 years is to own the tea tree plantation.'

1.105 Similarly, in Hart (2004) 206 ALR 207, Gummow and Hayne JJ (at [71]) agreed with Hill J below that the substance of the arrangement, in form two separate loans, was in fact one advance to be repaid by 300 instalments.

1.106 In order for a postulate to constitute a reasonable alternative to the entering into and carrying out of the scheme, the substance of the postulate should correspond to the substance of the scheme.

Example 1.4: A postulate with the same non-tax results and consequences

Assume Paul & Co placed $1 million dollars on deposit for 12 months for a return of $50,000, payable in arrears. The income produced by the investment is exempt for taxation purposes.

From Paul & Co's perspective, the substance of the transaction is an investment for a fixed term carrying a right to a non-contingent return.

A reasonable alternative to this transaction would be an investment of the same amount, for the same period at a comparable risk and for a comparable return.

An investment in ordinary shares would not represent an investment of comparable risk and comparable return.

Having particular regard to the results and consequences of the scheme for the taxpayer

1.107 An examination of the results or consequences for the taxpayer that would be achieved by the scheme (tax results aside) [Schedule 1, item 5, subparagraph 177CB(4)(a)(i)] requires a consideration of any financial or other consequences for the taxpayer that would be accomplished or achieved as an end result of the scheme having been entered into and carried out.

1.108 Such matters could include changes in the taxpayer's financial position that result from the scheme, including the impact of transaction costs, such as fees, stamp duties, payroll taxes, and also non-financial considerations, such as the effect that the scheme has on personal or family relationships.

1.109 The fact that the scheme satisfied certain regulatory requirements, such as directors' duties, workplace health or safety requirements and environmental standards, would also be relevant consequences of the scheme.

1.110 It would be expected that a postulate that is a reasonable alternative to the entering into and carrying out of a scheme would achieve for the taxpayer non-tax results and consequences that are comparable to those achieved by the scheme itself.

Example 1.5: The results achieved for the taxpayer

Gadget Co negotiates, with the assistance of its selling agent, Banker Co, to sell its Sydney factory to Widget Co for $500,000. However, rather than transferring the factory directly to Widget Co, Gadget Co enters into a complex transaction that involves the factory passing through the hands of Banker Co before it is finally transferred to Widget Co.

Gadget Co realizes $475,000 from the transaction and Banker Co takes the $25,000 balance. The transaction is constructed in such a way that Gadget Co is not liable for capital gains tax on the disposal of the property.

From Gadget Co's perspective, the end result achieved by the transaction was the disposal of its factory to Widget Co for $500,000. A reasonable alternative to the transaction, that would have achieved the same non-tax effect for Gadget Co, would have been for Gadget Co to dispose of the factory directly to Widget Co for $500,000 and for Gadget Co to have paid Banker Co a fee reflecting the value of its services in finding a buyer.

1.111 The amendments are intended to make it clear that the focus is on the results and consequences achieved by the scheme for the taxpayer, as distinct from the results and consequences achieved by the scheme for one or more of the other participants in the scheme (compare the emphasis that was placed on the fact that a direct sale of Axa Health to MB Health would have denied Macquarie Bank Limited its underwriting and sell-down fee in Axa Asia [2010] FCAFC 134 (at [143])).

1.112 More particularly, there is no need for the alternative postulate to involve all the same participants as the scheme itself comprised (see, for example, the alternative postulate relied upon by the High Court in Spotless (1996) 141 ALR 92).

Schemes within broader transactions

1.113 Where a scheme forms part of a broader commercial transaction, a postulate would be a reasonable alternative to the scheme if it performs the same role in relation to the broader transaction as the scheme itself performs, disregarding its tax effects.

1.114 Consequently, if the scheme itself has no non-tax results and consequences and the broader transaction remains effective without the scheme, there would be no warrant for an alternative postulate involving a reconstruction of the broader transaction (compare Futuris [2012] FCAFC 32).

1.115 Where, however, a scheme is integral to a broader transaction in the sense that it is intertwined with the broader transaction and facilitates it in some way, then it would be reasonable for an alternative postulate to involve a reconstruction of the broader transaction, so long as the reconstruction produces the same non-tax results and consequences as were in fact achieved by the broader transaction.

1.116 The extent to which the broader transaction should be reconstructed should be limited by the role the scheme plays in that transaction.

Example 1.6: A scheme that facilitates a broader transaction

Assume that in order for Kerry-Anne to secure a tax deduction for borrowing money to invest in an offshore company (Offshore Co) it is necessary for her to interpose a resident Australian company. She does this by using the borrowed funds to buy shares in an Australian shelf company (Oz Co). In turn, Oz Co buys ordinary shares in Offshore Co. Oz Co performs no other role.

The Commissioner makes a Part IVA determination on the basis that the interposition of Oz Co is a scheme to which Part IVA applies.

Objectively viewed, the interposition of Oz Co achieves two effects. One is securing a deduction for interest on the borrowing, and the other is the acquisition of shares in Offshore Co.

A correct alternative postulate should be another way in which Kerry-Anne could reasonably be expected to have acquired ordinary shares in Offshore Co. An alternative postulate that involved Kerry-Anne lending the borrowed monies to Offshore Co would achieve a different effect. So too would be a postulate that involved Kerry-Anne investing the borrowed monies in a completely different company.

Disregarding tax costs

1.117 The amendments make it clear that, in determining whether a postulate is a reasonable alternative to the entering into or carrying out of the scheme, regard should not be had to any tax costs that are generated for the taxpayer by the scheme itself or that would be generated for the taxpayer or any other person by the postulate. [Schedule 1, item 5, subparagraph 177CB(4)(a)(ii) and paragraph 177CB(4)(b)]

1.118 In other words, potential tax liabilities are not to be taken into account in assessing the likelihood or reasonableness of any alternative postulate.

1.119 Tax costs that are to be disregarded include the same tax costs that are taken into account under the purpose inquiry in paragraph 177D(2)(d).

1.120 The disregarding of the potential liability of a person to tax extends not just to the taxpayer and participants in the scheme but to any person who might be a potential participant in an alternative to a scheme.

1.121 This amendment is intended to make it clear that alternative postulates should not be rejected as unreasonable postulates on the grounds that the tax costs involved in undertaking those postulates (including denial of the tax benefit impugned by the Commissioner) would have caused the parties to either abandon or indefinitely defer the schemes and/or the wider transactions of which they were a part (compare RCI [2011] FCAFC 104 at [145]-[150] and Futuris [2012] FCAFC 32 at [71]).

When does Part IVA apply?

1.122 The amendments provide that 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. [Schedule 1, item 5, subsections 177D(1) and (2)]

1.123 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. [Schedule 1, item 5, subsections 177D(3) and (4)]

1.124 To support this, an amendment is made to subsection 177F(1) to further emphasise that an examination of Part IVA should commence with the question whether there is a scheme to which Part IVA applies. [Schedule 1, item 7, subsection 177F(1)]

1.125 These amendments complement section 177CB and ensure that Part IVA operates as an integrated whole: by emphasizing the central role of the dominant purpose test in section 177D (described by Callinan J in Hart (2004) 206 ALR 207 at [92] as the 'fulcrum' upon which Part IVA turns) and ensuring that section 177C, whose role is to define when a tax benefit has been obtained in connection with a scheme, is read with section 177D in the inter-related way envisaged by Gummow and Hayne JJ in the High Court in Hart .

Application provisions

1.126 The amendments apply in relation to schemes that were entered into, or that were commenced to be carried out, on or after 16 November 2012, the date on which an exposure draft of this Bill was released for public consultation. [Schedule 1, item 10]

1.127 The amendments apply from that date, rather than from some later date, such as the date of Royal Assent, to minimize the potential for taxpayers to obtain unintended tax advantages in the period before the amendments become law.

Consequential amendments

1.128 Section 177CA of the ITAA 1936 provides that a taxpayer who avoids paying withholding tax on an amount on which it would have, or could reasonably be expected to have, paid withholding tax, absent a scheme, is taken to have obtained a tax benefit.

1.129 The amendments bring the avoidance of withholding tax within the list of other tax benefits set out in section 177C. This ensures that the amendments concerning assumptions that can be made in relation to alternative postulates apply with equal force to withholding tax benefits. [Schedule 1, items 2 to 5 and 8 and 9, paragraphs 177C(1)(bb), (bc) and (g), section 177CA, subsection 177F(2A) of the ITAA 1936, and paragraph 18-40(1)(a) in Schedule 1 to the Taxation Administration Act 1953)]

1.130 A number of consequential amendments are also required by reason of the restructuring of section 177D. [Schedule 1, items 1 and 6, paragraphs 45B(8(k), 177EA(17)(j), and 177EB(10)(f)]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

General anti-avoidance rule

1.131 This Schedule is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 .

Overview

1.132 Part IVA is the income tax law's general anti-avoidance rule that operates to protect the integrity of the tax law from contrived or artificial arrangements designed to obtain a tax advantage.

1.133 Recent court cases have brought to light some weaknesses in Part IVA that put at risk its capacity to properly perform that operation. The amendments made by this Schedule ensure that Part IVA can continue to protect the integrity of the income tax law.

Human rights implications

1.134 This Schedule ensures that the income tax law continues to be protected from artificial or contrived schemes designed to avoid tax, and so improves the likelihood that the income tax law applies in the way Parliament intended. It does not change any legislative policy.

1.135 The amendments apply from 16 November 2012; that is, from a date before the amendments become law. 16 November 2012 was the date on which a draft of the amendments was released for public comment. Applying it from that date is necessary to ensure that taxpayers are not able to benefit from artificial or contrived tax avoidance schemes entered into in the period between that date and the date of Royal Assent. Application from that date does not affect the operation of any criminal law.

1.136 For those reasons, this Schedule does not engage any of the applicable rights or freedoms.

Conclusion

1.137 This Schedule is compatible with human rights as it does not raise any human rights issues.