A report on measures to combat rising compliance costs ... · costs through reducing tax law...

Beyond 4100 A report on measures to combat rising compliance

costs through reducing tax law complexity

C John Taylor

Associate Professor in the School of Business Law and Taxation University of New South Wales

Published by Taxation Institute of Australia

PublisherRenee McDonald

Production Manager & DesignerLouella Pedroche

Some parts of the report were based on submissions by the Taxation Institute of Australia to the Task Force on Reducing the Regulatory Burden on Business and the Board of Taxation’s Scoping Study on Small Business Compliance Costs. Many examples of practical difficulties in complying with the current legislation were provided by members of the Taxation Institute of Australia. Parts of the Report were also based in part on a paper presented by the author “An old tax is a simple tax: A back to the future suggestion for Australian corporate – shareholder tax simplification” presented at the 2006 Australasian Tax Teachers Association. Please note the views expressed are those of the author solely and do not necessarily reflect the views of the Taxation Institute of Australia.

This Report is current as at 26 May 2006.

© Taxation Institute of Australia.

All rights reserved. No part of this publication may be produced, stored in a retrieval system, or transmitted in any form or by any means, without prior consent of the authors and the Taxation Institute of Australia.

The author would like to thank Michael Dirkis, Senior Tax Counsel of the Taxation Institute of Australia, and Andrew Mills, President of the Taxation Institute and Director of Greenwood & Freehills, who made many comments and suggestions on earlier drafts of this report. Dale Boccabella of the School of Business Law and Taxation at the University of New South Wales and Peter Harris of the Faculty of Law at the University of Cambridge also made suggestions that were incorporated into the final draft of the report. As always, any errors or omission are the responsibility of the author.

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Table of ContentsBeyond 4100

FOREWORD 5

EXECUTIVE SUMMARY 6

1. Purpose and Scope 6

2. Background 6

3. Causes of Complexity 7

4. Recommendations 7

4.1 Repeal provisions rendered unnecessary by subsequent 7 developments in the law

4.2 Repeal or redrafting of the following provisions whose 7 literal meaning is rarely or never enforced

4.3 Rationalise rules through the adoption of common or more general rules 8

4.4 Recommendations relating to de minimis rules, deemed cost/proceedsrulesandtheCommissioner’sdiscretion 8

4.5 Recommendations for more comprehensive rewriting 8

5. Conclusions 9

CHAPTER ONE – INTRODUCTION 10

1. Purpose and scope 10

2. Background 10

2.1 The inoperative provisions project 10

2.2 The Taskforce on Reducing Regulatory Burdens on Business 11

2.3 TheBoardofTaxation’sscopingstudyofsmall

business compliance costs 12

3. Structure of this report 12

4. Methodology 13

5. Definitions/Terminology 14

5.1 Simplification of Policy 14

5.2 Simplicity/Complexity 15

5.3 Compliance Costs 16

6. Brief survey of compliance cost literature 16

CHAPTER TWO – CAUSES OF COMPLEXITY 18

1. Introduction 18

2. Causes of complexity related to consequential policies and operational rules 18

2.1 First, obscuring of fundamental policy framework through excessively detailed operational rules 18

2.2 Second, the use of complex anti-overlap rules reconciling different potentially operative provisions 19

2.3 Third, rules rendered unnecessary by subsequent developments 20

2.4 Fourth, situations where the literal meaning is never or rarely enforced 20

2.5 Fifth, duplication of interpretative/computational rules 21

2

2.6 Sixth, rules for exceptional circumstances assuming a disproportionate significance 22

2.7 Seventh, poor targeting of rules 22

2.8 Eighth, rules affecting the derivation of income and gains and the incurring of expenses and losses through entities where parts of the rules operate at different levels of the entity 23

2.9 Ninth, the use of specific anti avoidance provisions and the general anti avoidance provision concurrently 23

2.10 Tenth, the use of detailed computational steps (method statements) without indicating what the overall purpose and what is the effect of the computational steps 23

2.11 Eleventh, the inclusion of material that is irrelevant to some taxpayers in operative provisions and the computational steps 23

2.12 Twelfth, complex consequential policy choices 24

2.13 Thirteenth, inconsistency between domestic law and Australia’sDoubleTaxTreaty(DTA)obligations 24

3. Relationship of this chapter to subsequent chapters 24

4. Summary 25

CHAPTER THREE – CASE STUDIES ILLUSTRATING THE INTERACTION OF SOME CAUSES OF COMPLEXITY 27

1. Introduction 27

2. Case Study One: Treatment of non-cash benefits provided outside an employment relationship 27

3. Case Study Two: Cost rules in capital gains tax and capital allowance provisions 28

4. Case Study Three: Application of the dividend imputation system to most resident companies 29

4.1 Current policy results in Australian dividend imputation system 29

4.2 Concessional alternative approach: Dividend deduction system 30

5. Case Study Four: The operation of CGT Event E4 32

5.1 Example 1: Interrelationship between CGT and the trust rules 33

5.2 Example 2: Impact of the small business CGT concession 34

5.3 Example 3: Interrelationship of ITAA97 Division 43 and CGT 36

5.4 Some causes of complexity in the interaction of these provisions 37

6. Case Study Five: The boundary between Divisions 40 and 43 38

6.1 Example 39

7. Case Study Six: Application of CGT to depreciated property 40

7.1 Example 40

8. Case Study Seven: Problems with CGT anti overlap rules 41

8.1 Example One 41

8.2 Example Two 41

9. Case Study Eight: Personal Services Income Alienation Provisions 42

9.1 Introduction 42

9.2 Summary of the operation on the PSI rules 42

9.3 Comparing the common law outcome to that under the PSI rules 45

9.4 Conclusion 49

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4

10. Case Study Nine: The use of method statements in Thin Capitalisation Rules 49

10.1 Introduction 49

10.2 Example 49

10.3 Lessons from the case study 52

CHAPTER FOUR – PROVISIONS RENDERED UNNECESSARY BY SUBSEQUENT DEVELOPMENTS IN THE LAW OR THAT ARE RENDERED UNNECESSARY BY THE ADOPTION OFOTHER RECOMMENDATIONS 53

1. Introduction 53


2.1 Generic reasons for recommending repeal 53

2.2 Provisions recommended for repeal 53

2.3 Explanation of the grounds for recommending repeal 53

CHAPTER FIVE – PROVISIONS WHICH ARE RARELY OR NEVER ENFORCED 60

1. Introduction 60


3. Justification for repeal recommendations 60

CHAPTER SIX – RATIONALISATION OF THE RULES THROUGH THE ADOPTION OF COMMON OR MORE GENERAL RULES 62

1. Introduction 62


3. Justification for recommendations 62

CHAPTER SEVEN – THE ADOPTION OF DE MINIMIS RULES, DEEMED COST/PROCEEDS RULES AND A COMMISSIONER’S DISCRETION NOT TO APPLY CERTAIN RULES 71

1. Introduction 71


CHAPTER EIGHT – A CASE FOR A COMPREHENSIVE REWRITE OF AUSTRALIA’S INCOME AND FRINGE BENEFIT TAX LAWS 72

1. Introduction 72

2. The future 72

Beyond 4100

FOREWORD

On 5 April 2006 at the Taxation Institute of Australia’s National Convention, I announced that the Institute will be publishing research

papers around improvements to the tax law to reduce compliance costs. This paper, by the inaugural honorary Research Fellow of the

Taxation institute of Australia, Professor C john Taylor, who is an Associate Professor in the School of Business Law and Taxation at the

university of New South Wales, is the first.

The paper has its genesis in the Board of Taxation’s project to identify inoperative provisions of the two Income Tax Assessment Acts.

With the Government accepting the recommendation contained in the Board of Taxation’s report to the Treasurer, it released on 4 April

2006 Exposure Draft Legislation (Tax Laws Amendment (Repeal of Inoperative Provisions) Bill 2006) aimed at reducing the size of the tax

laws by 4100 pages. included are provisions that are not technically inoperative but are redundant, unnecessary or unenforced.

Although this house-keeping process of uncluttering is important, the project’s terms of reference did not encompass rewriting or

simplifying the detailed provisions of the law. The project did not look at instances where policy simplification could also give rise to a

reduction in complexity and the resultant reduction in compliance cost dividend.

Given these limitations imposed on the Board’s project, the Taxation Institute’s National Council endorsed a proposal by the National

Technical Committee to conduct a complementary research project, Beyond 4100, focusing on identifying provisions and concepts in the

income Tax Assessment Acts that would benefit from simplification (e.g. multiple pre-payment rules) or are otiose (e.g. unnecessary anti-

avoidance provisions when the matter at hand is already covered by Part iVA). i have been heartened that, at the same time as finalising

this report, the Federal Government’s 2006/07 Budget included sweeping simplification of the taxation of superannuation benefits.

Although at a cost to the Revenue, the compliance cost savings are likely to be substantial. The proposals in this report are also intended

to impact favourably on compliance costs, although at no or negligible cost to the Revenue.

The following independent report by Professor Taylor focuses on identifying generic causes of complexity in the Australian income tax

system, giving specific examples of complexities that may be regarded as being attributable to each generic cause. in doing so, he has

developed a series of detailed case studies illustrating the effects of the combination of multiple causes of complexity in the operation of

the current income tax rules. he has also made a number of recommendations for reform.

This report represents a good first step in the process of simplifying the tax laws leading to reduced compliance costs.

Further reports will follow.

Andrew mills

President

Taxation institute of Australia

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Beyond 4100 - A report on measures to combat rising compliance costs through reducing tax law complexity

6

C John Taylor

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Executive Summary

1. Purpose and scopeThis report was commissioned by the Taxation institute of Australia

(Taxation institute) to identify areas of the current tax law where

simplification of policy could give rise to reduced compliance

costs. Although it is clear that some fundamental policy choices

may have significant effects on the simplicity or complexity of

the tax system, numerous political and economic considerations

that are beyond the scope of the report are relevant to those

choices. hence the report does not consider possible changes

in fundamental policy and, in particular, does not consider policy

changes that would produce changes in the tax base. Rather, the

recommendations for simplification of policy in the report are not

concerned with questioning the basic policy underpinnings of the

tax law but place emphasis on adjusting the policy choices and

operational rules that give effect to those fundamental policies.

2. BackgroundThe Australian tax system is undoubtedly highly complex. in 2006

the income Tax, Fringe Benefits Tax (FBT), goods and Service Tax

(gST) and international Agreements and Superannuation legislation

(in some bindings) are published in five volumes that comprise

one of, if not the largest, set of tax statutes in the world. Empirical

evidence suggests that, for individuals, the sheer size of the statute

increases both the cost of compliance and the likelihood of non-

compliance. Company tax has been found to have still higher

compliance costs both in absolute terms and as a percentage of

revenue collected. The compliance costs of corporate taxation

have been found to be heavily regressive.

Within the past several months, several government-

commissioned reviews of different aspects of the Australian tax

system have either commenced or been completed. While relevant

to the subject matter of this report, constraints in the terms of

reference of these reviews may mean that they are unable to

address the issue of how simplification of policy could give rise to

reduced compliance costs.

The Taxation institute welcomed the release on 24 November

2005 of the long-awaited Board of Taxation’s report to the

Treasurer on removing operative provisions from the tax law1 and

the Treasurer’s announcement that inoperative provisions in the

Income Tax Assessment Act 1936 (iTAA36) and the Income Tax

Assessment Act 1997 (iTAA97) would be repealed.2 Nonetheless,

the Taxation institute considers that compliance cost benefits

for taxpayers and practitioners flowing from the repeal of merely

inoperative provisions are unlikely to be significant.

Empirical studies suggest that uncertainty and the detailed mass

of potentially applicable rules are major causes of non-compliance

by taxpayers. merely removing inoperative provisions will not

reduce either the sheer number of existing operative rules or the

uncertainty that surrounds their meaning and inter-relation. The

Board of Taxation’s brief did not encompass either the rewriting

or the simplification of the detailed provisions of the tax law. The

Taxation Institute took the view that the narrowness of the Board’s

brief meant that an opportunity was missed to ‘clean up the Act’.

Draft legislation aimed at implementing the Board of Taxation’s

recommendations3 (the Exposure Draft) was released on 4 April

2006.4 in developing the Exposure Draft, the Australian Treasury

and the Australian Taxation Office (ATO) identified additional

inoperative provisions that had not been identified in the Board’s

report. Some of these provisions were not technically inoperative

but are better described as redundant, unnecessary or unenforced

provisions. Subject to some caveats, this report welcomes the

proposals to repeal provisions on the grounds that they are

redundant, unnecessary or unenforced, but submits that many

more provisions in the iTAA36 and iTAA97 fit into this category.

Major recommendations in the report identify further provisions

that could be repealed or redrafted on these grounds.

The formation of the Taskforce on Reducing Regulatory

Burdens on Business was jointly announced by the Prime Minister

and the Treasurer on 12 October 2005.5 The objects of the

Taskforce are similar to those of this report, but the work of the

Taskforce covers the whole ambit of Commonwealth government

regulation, whereas this report focuses on areas of tax law where

simplification of policy could lead to reduced compliance costs.

The Taskforce’s report was released on 7 April 20066 and the

Government’s interim response was published on the day of the

report’s release.7

The recommendations made by the Taskforce in relation

to FBT were consistent with the submissions made by the

Taxation institute to the Taskforce. This report concurs with the

recommendations made by the Taskforce in relation to income tax

and notes that in some instances it calls for more comprehensive

reform in the directions proposed by the Taskforce.

The Treasurer commissioned the Board of Taxation on 4

November 2005 to undertake a scoping study of tax compliance

costs facing the small business sector and to identify the more

important areas where compliance costs might be reduced.8

The Board is required to take into account the purpose and

object of the law in making its recommendations. By contrast,

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the view taken in this report is that to reduce compliance

costs, attention needs to be paid not so much to fundamental

policies underpinning the law, but to the operational rules and

consequential policies that seek to give effect to fundamental

policies.

On 26 February 2006, the Treasurer commissioned Richard

Warburton and Peter hendy to undertake a study examining how

Australia’s tax system compares with other developed economies.9

The resultant report10 was released by the Treasurer on 12 April

2006. 11 The report is concerned with overall taxation levels and

rates and coverage of the indirect tax, income tax and company

tax systems. hence the report is concerned with fundamental

policy choices such as the tax base and tax rates and not, as

is this report, with simplification of policy through redesign of

operational rules and consequential policies.

3. Causes of complexityThe extensive literature on causes of complexity in tax systems

is examined in Chapters One and Two of the report. Chapter Two

identifies thirteen causes of complexity in the Australian income

and fringe benefits tax system. Chapter Three contains a series of

case studies illustrating the interaction of some of these causes of

complexity and suggests ways in which the complexity induced by

those causes could be reduced.

Overarching all these causes of complexity is the relative

absence of an obvious, coherent and consistently implemented

framework of fundamental policy objectives. The fundamental

design objectives of the tax law too often retreat into the

background and are obscured by detailed operative provisions that

are often poorly coordinated. While many tax laws develop these

features over time, Australian tax laws display them to an extreme

extent. The reason for this characteristic appears to be largely

historical.

The recommendations of the report in Chapters Four, Five, and

Six focus on dealing with those causes of complexity by reducing

the number of potentially operative rules and by clarifying the

circumstances in which particular rules will operate. Chapter

Seven calls for the review of de minimis rules, the development of

deemed cost/proceeds rules in certain circumstances and allowing

the Commissioner discretion not to apply certain rules in certain

circumstances.

The above recommendations should have the effect of

simplifying the law by removing much of the ‘noise’ in the existing

rules. With unnecessary and duplicated provisions removed, the

fundamental objectives of the law should become more prominent.

The operational rules that remained, however, generally would still

be extremely detailed. Where the fundamental policy intent of the

law is clearly expressed and judges apply a purpose interpretation

of statutes, there may be scope for considerable reductions in the

level of detail in taxing statutes.

Chapter Eight of the report contains a recommendation for

a process to be followed in rewriting tax laws so as to express

fundamental policies clearly and reduce the amount of operational

detail. Chapter Eight also contains recommendations that seek to

address several of the remaining causes of complexity identified in

Chapter Two and illustrated in Chapter Three.

4. Recommendations

4.1 Repeal provisions rendered unnecessary by

subsequent developments in the law

it is recommended that the following provisions be repealed,

as they have been rendered unnecessary by subsequent

developments in the law or would be unnecessary if other

recommendations in this report were adopted:

ITAA36: s 26(b); s 26(e); ss 38 to 42; s 94; s 102; s 108; s 109;

Part iii Div 3 Subdivision D; Part iii Div 6A; Part iii Div 9C; Part

iii Div Subdivision 11B; and

ITAA97: s 15-10; s 15-15; s 15-20; s 15-30; s 25-10; s 25-35;

s 25-40; s 25-45; s 26-30; s 26-35; s 26-40; Part 2-5 Division

32; Part 3-1 Subdivision 110-B; Part 3-3 Division 149; Part 2-

42.

A detailed discussion of the grounds on which this

recommendation is made is contained in Chapter Four of the

report.

4.2 Repeal or redraft the following provisions whose

literal meaning is rarely or never enforced

it is recommended that the following provisions be repealed, as

their literal meaning is rarely enforced:

ITAA36 s 95A(2), with consequential repeal of s 98(2) and

amendment to s 99; and

ITAA 36, Division 6D of Part ii (ultimate beneficiary non-

disclosure statement).

A redraft of iTAA36 s 44(1)(b) and s 99B is also recommended.

A detailed discussion of the grounds on which this

recommendation is made is contained in Chapter Five of the

report.

8

C John Taylor

8 9

4.3 Rationalise rules through the adoption of common or more general rules

it is recommended that the following common rules be developed:

Develop a common set of computational rules for gains and

losses from realisation events, enabling rationalisation of rules

in the following areas:

Concept of asset, e.g. in Part 3-1 and Division 40;

Concepts of cost, e.g. in Part 3-1 and Division 40;

Concepts of proceeds of realisation, e.g. in Part 3-1 and

Division 40;

Realisation events – scope for grouping and rationalising the

number of events recognised, e.g. in Part 3-1, Div 40 and

Div 70;

movements in foreign exchange rates to be taken into

account in computing gain or loss but not to affect capital/

revenue characterisation of gain or loss; and

Traditional security provisions – could be covered by general

computational rules.

Categorise gains and losses from realisation events into

mutually exclusive categories and treat them accordingly;

Replace existing and proposed regimes permitting deductions

for ‘black hole’ expenditures with more general and

comprehensive rules;

Develop timing rules for advance receipts/payments and

deferred receipts/payments and rules for discounts and

premiums – income/deductible character of receipt/payment

based on economic benefits/detriments obtained, and

separate these rules from rules that consider the income or

capital character of the receipt or payment;

Rationalise the trigger tests for small business concessions in

CgT, the at-call loan provisions, STS, and gST;

Develop a common set of valuation rules for non-cash

benefits and locate them in a general computational division

– coverage currently limited to employment and business

situations;

undertake a comprehensive review of all terms that denote

relationships between entities. Enact one definition for all

virtually synonymous terms where possible. Reorganise the

grouping of subsets of rules in the dictionary so that subsets

are grouped together under the term denoting the more

generic relationship in question;

Apply a general arm’s length substitution rule to most non-

arm’s length situations – subject to exceptions; and

Elections, choices, and notifications – develop common rules

for the timing and form of all elections.

A detailed discussion of these recommendations is contained in

Chapter Six of the report.

4.4 Recommendations relating to de minimis rules, deemed cost/proceeds rules and the Commissioner’s discretion

it is recommended that the following de minimis rules and Commissioner’s discretions be reformed, through the following process:

Review all de minimis thresholds and capping provisions in the income tax legislation;

index reviewed de minimis thresholds to inflation on an ongoing basis;

Develop deemed cost rules for longer term holdings of interests in listed entities;

Enact de minimis rules permitting a 100% capital allowance for costs of individual assets or sets of assets under $1000; and

give the Commissioner discretion not to apply Div 7A where it would be objectively concluded that the dominant purpose of the relevant transaction was not to obtain a tax benefit for the company, a shareholder or an associate.

A detailed discussion of these recommendations is contained in

Chapter Seven of the report.

4.5 Recommendations for more comprehensive rewriting

it is recommended that outside the above recommendations there

is still a need for a comprehensive rewriting of the income tax laws.

This may involve the following:

Develop a clear official statement of the fundamental

objectives that existing laws are intended to achieve;

Think critically about the level of detail that is required in

consequential policies and operative rules;

Rewrite the operative rules with only the level of detail that is

regarded as appropriate following the above analysis;

Where possible, target rules so that they only directly affect taxpayers who have the characteristics that make the rationale behind the rule relevant to them;

Develop different types of rules for different types of taxpayers, only where it can be shown that the characteristics of different types of taxpayers justify the development of separate sets of rules and that the development will result in reduced

compliance costs;

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minimise the effects of the inclusion of material in

computational rules that is irrelevant to some taxpayers by

stating the general rule or the rule that is applicable to most

taxpayers first, with the rules that apply only in exceptional

circumstances being stated subsequently;

Where method statements are used, the legislation should

contain a statement of the overall effect and intention of the

method statement;

in rules dealing with the derivation of income or gains or the

incurring of expenses or losses through entities, so far as

possible avoid adding and then subsequently subtracting the

same amount; and

in rules dealing with the derivation of income or gains or the

incurring of expenses or losses through entities, as far as

possible write rules that view the events concerned from the

perspective of one level in the entity consistently.

5. ConclusionsThe majority of recommendations made in this report would

represent only a first step towards the simplification of the

Australian income and fringe benefits tax systems. This step

would nonetheless be an important one, as it would involve

removing much unnecessary or unenforced operational detail and

rationalising some other operational rules through the development

of more general and common rules.

This process should enable us to begin a redrafting process that

enables the fundamental principles and policies of the legislation to

be seen in clearer focus. giving greater prominence to fundamental

principles and policies should enable a further reduction in

operational detail and a further reorganisation and rationalisation of

operational rules in a comprehensive redrafting project.

hopefully, the end result will be tax legislation that is not

only shorter but more principled and more logically structured.

Reduction in the size of the act will be a first step in this process.

10

C John Taylor

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CHAPTER ONEINTRODUCTION

1. Purpose and scopeThis report was commissioned to identify areas of the current

tax law where simplification of policy could give rise to reduced

compliance costs. A decision was made to only examine

Australia’s income and FBT rules in detail in addressing this

question. The applicability of the analysis and conclusions in the

report in the context of other Australian tax laws would be a matter

for further research.

The principal conclusion of the report is that excessively detailed

operational rules obscure the fundamental principles that the tax

law is trying to express.

The report begins by examining the meanings of the key terms

and expressions, such as ‘simplification of ‘policy’, ‘simplicity’,

‘complexity’ and ‘compliance costs’. The report then identifies

causes of complexity in the Australian income and FBT systems

and illustrates the interaction and compounding effects of these

causes through a series of case studies.

A major focus of the report is on identifying provisions in

the current tax law that could be repealed or redrafted, either

because they are unnecessary, often because they are duplicated

in different areas of tax law, or because they are not currently

enforced. The report also notes some areas where complexity

could be reduced through changes to the way the law is structured

and organised. Another section of the report identifies some areas

where policy could be simplified through greater use of de minimis

rules and/or deeming provisions.

having identified areas where the amount of unnecessary or

unenforced detail could be reduced, the report suggests a process

for redrafting the tax law so as to give greater prominence to

fundamental principles with further consequent reductions in the

amount of operational detail in tax law. The case study section of

the report contains examples of how particular issues would be

dealt with under a more principles-based drafting style.

2. BackgroundThe Australian tax system is undoubtedly highly complex. in 2006

the income Tax, FBT, gST and international Agreements legislation

will be published (in some bindings) in five volumes, comprising

one of the largest sets of tax statutes in the world. Empirical

evidence suggests that for individuals the sheer size of the statute

increases both the cost of compliance and the likelihood of

non-compliance.12 Company tax has been found to have higher

compliance costs than personal income tax both in absolute terms

and as a percentage of revenue collected. The compliance costs of

corporate taxation have been found to be heavily regressive.13

2.1 The inoperative provisions project

in 2004 and early 2005, the Board of Taxation engaged consultants

to identify inoperative provisions in the Income Tax Assessment

Act 1936 (iTAA 36) and the Income Tax Assessment Act 1997

(iTAA 97). Provisions that were regarded as inoperative were those

that either had no effect after a date in the past or because all the

transactions that they could affect had now concluded.

On the basis of these consultancies, the Board of Taxation

subsequently reported to the Treasurer.14 in November 2005,

the Treasurer released the Board’s report and announced that

inoperative provisions identified in the Board’s report would

be repealed following a further period of consultation on draft

legislation repealing the inoperative provisions.15

Draft legislation aimed at implementing the Board of Taxation’s

recommendations16 (the Exposure Draft) was released on 4 April

2006.17 in developing the Exposure Draft, the Treasury and the

Australian Taxation Office (ATO) identified some further inoperative

material. most of the additional inoperative material identified by

Treasury and the ATO were inoperative taxation Acts, such as

inoperative sales tax Acts, from the first half of the 20th century.

The Exposure Draft, in addition, proposes the repeal of some

provisions that are not inoperative in the sense that they have

no effect after a date in the past or because all transactions that

they did affect have concluded. Rather, some of the additional

inoperative provisions identified by Treasury and the ATO would

be better described as redundant, unnecessary or unenforced

provisions.

Among the additional provisions in this category recommended

for repeal in the Exposure Draft is one provision recommended for

repeal in this report, viz, iTAA36 s 26(b).

in addition, the Exposure Draft recommends the repeal of

iTAA36 Subdivision C of Division 2 of Part iii. While this report

agrees that these provisions should be repealed, it recommends

the co-location of all provisions relevant to ascertaining

business profits from international transactions and proposes

that the business profits of all non-residents only be regarded

as having an Australian source when they are attributable to a

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permanent establishment. The view taken in this report is that

iTAA36 Subdivision C of Division 2 of Part iii is intended to be a

source rule for business profits. it is not accurate to say, as the

Explanatory material to the Exposure Draft does (at paragraph

2.31), that these provisions, for all intents and purposes, ceased to

perform a role after the enactment of iTAA36 Division 13 of Part iii

in 1982.

This report also endorses the proposals in the Exposure Draft

to repeal iTAA36 s 23(kd), iTAA36 s 23(r), iTAA36 s 51(2B), and

iTAA36 s 221ZXL. The Exposure Draft also proposes the repeal of

iTAA36 s 25(2). While this report is not opposed to the repeal of

this provision, it is worth pointing out that, in the situation where

a double tax treaty is not applicable, the repeal of this provision

would mean that in all cases only general law source rules would

apply in determining the source of interest for foreign tax credit

purposes.

The Exposure Draft also proposes the repeal of iTAA36 s 260.

This report agrees with the analysis in the Explanatory material to

the Exposure Draft that iTAA36 s 260 is no longer necessary on the

basis that schemes to avoid tax entered into prior to 28 may 1981

were rendered void against the Commissioner by iTAA36 s 260 at

the time they were entered into.

The repeal of provisions that are inoperative, in the sense

that they have no effect after a date that is past or because all

transactions that they did affect have concluded, may contribute

to reduced compliance costs by making navigation through the

legislation easier. Any compliance cost benefits for experienced

practitioners, however, are unlikely to be significant. Empirical

studies suggest that uncertainty and the detailed mass of

potentially applicable rules are major causes of non-compliance by

taxpayers.18

merely removing inoperative provisions will not reduce either

the sheer number of existing operative rules or the uncertainty that

surrounds their meaning and inter-relation. The Board of Taxation’s

brief did not encompass either the rewriting or the simplification of

the detailed provisions of the tax law. The Taxation institute took

the view that the narrowness of the Board’s brief meant that an

opportunity was missed to ‘clean up the Act’.

As noted above, the Exposure Draft proposes to repeal several

provisions that are technically inoperative in the sense described

above, but are better described as redundant, unnecessary

or unenforced. This report welcomes the proposals to repeal

provisions on the grounds that they are redundant, unnecessary or

unenforced but submits that many more provisions in the iTAA36

and the ITAA97 fall into this category. Major recommendations

in this report identify further provisions that could be repealed or

redrafted on the grounds that they are redundant, unnecessary or

unenforced.

2.2 The Taskforce on Reducing Regulatory

Burdens on Business

On 12 October 2005 the Prime Minister and the Treasurer jointly

announced the formation of a Taskforce, chaired by mr gary

Banks of the Productivity Commission, to identify practical

options for alleviating the compliance burden on business from

Commonwealth government regulation.19

Among the issues that will be considered by the Taskforce are

specific areas of Commonwealth government regulation that are

unnecessarily burdensome, complex and redundant, or duplicate

regulations in other jurisdictions. In an issues paper published

by the Taskforce on 25 October 2005, the ‘regulatory impact of

taxation provisions’ was identified as an area of Commonwealth

Government regulation that was within the ambit of the Taskforce’s

review.

The Taxation institute made a submission to the Taskforce

on 28 November 2005. Some of the suggestions made in that

submission are incorporated in this report.

The objectives of the Taskforce are similar to those of this

report, but the work of the Taskforce covers the whole ambit

of Commonwealth government regulation, whereas this report

focuses on areas of tax law where simplification of policy could

lead to reduced compliance costs. Another difference is that

the focus of the Taskforce is on reducing regulatory burdens on

business, whereas this report is concerned with compliance costs

that can potentially be borne by any type of taxpayer.

The Taskforce’s report was released on 7 April 200620 and

the Government’s interim response was published on the day

of the report’s release.21 The Taskforce made a total of 19

recommendations in relation to Taxation Regulation. Seven of

these related to FBT, two related to gST, two related to Business

Activity Statements (BAS), four related to income tax, three related

to State taxes and the administration of State taxes, and the

final recommendation related to the Board of Taxation’s scoping

study of small business compliance costs. The government

responded to five of the FBT recommendations, one of the BAS

recommendations, two of the recommendations relating to State

taxes and the administration of State taxes, and to the final

recommendation.

The recommendations made in relation to FBT were consistent

with submissions made by the Taxation institute to the Taskforce.

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The recommendations made in relation to income tax were as

follows (the response of this report to each recommendation is in

italics):

“5.41 The Australian Government should incorporate the

medicare levy into personal income tax rates and abolish

the Medicare Levy Act 1986.

This report concurs with recommendation 5.41.

5.42 The Australian government should increase the PAyg

withholding threshold for quarterly remitters from $25,000

to $40,000.

This report concurs with recommendation 5.42 and goes further by

recommending that the appropriateness of all existing thresholds

be systematically reviewed and thereafter be indexed to inflation.

5.43 The Australian Government should take steps to align and/

or rationalise different definitions in the tax law, including

‘small business’, ‘employee’, ‘salary and wages’ and

‘associate’.

5.44 The Australian government should align the definitions

of ‘employee’ and ‘contractor’ used for superannuation

guarantee and PAyg withholding purposes.

This report concurs with recommendation 5.43 and

recommendation 5.44 and goes further by recommending the

rationalisation not only of duplicated definitions, but of multiple

provisions that are functionally equivalent. Most notably, this report

recommends the development of a common set of computational

rules for income tax purposes

5.48 The Board of Taxation should consider the following areas

in its scoping study of small business compliance costs:

the simplified tax system;

trust loss provisions and family trust elections;

possible benefits of including additional information on

activity statements to assist users;

ways of reducing the number of PAyg withholding tables;

and

developing a systematic approach to adjusting thresholds

in tax law.

This report concurs with recommendation 5.48 and notes that it

is consistent with submissions by the Taxation Institute to both

the Taskforce and to the Board of Taxation’s Scoping Study of

Small Business Compliance Costs. As noted above, the report

recommends a comprehensive review of the current level of

thresholds and recommends their subsequent indexation to

inflation.”

The Taskforce report also contains some important sections

on: causes of tax complexity; consequences of tax complexity;

overview of tax compliance costs; and principles of tax law design.

The observations of the Taskforce on these points are broadly

consistent with the recommendations in this report and with the

submission by the Taxation institute to the Taskforce.

in particular, this report strongly endorses the third principle of

tax law design espoused by the Taskforce; namely, “Measures to

protect the revenue base must balance the revenue risk against

the cost of compliance”. This principle is reflected in many of

the recommendations in this report for repeal of the provisions

where there may be some small risk of revenue leakage, which

is significantly outweighed by the compliance costs that would

otherwise be associated with the collection of that revenue.

2.3 The Board of Taxation’s scoping study of small business compliance costs

On 4 November 2005 the Treasurer commissioned the Board of

Taxation to undertake a scoping study of tax compliance costs

facing the small business sector and to identify the more important

areas where compliance costs might be reduced.22 Among the

matters that the Board will be required to take into account are the

purpose and object of the law.

The Taxation institute made a submission to the Board of

Taxation’s scoping study on 24 February 2006. The submission

criticised the terms of reference of the scoping study as being too

narrow by pointing out that often it is the methodology adopted to

achieve the purpose and object of the law that is a primary cause

of escalated compliance costs. Similarly, the view taken in this

report is that to reduce compliance costs, attention needs to be

paid not so much to fundamental policies underpinning the law,

but to the operational rules and consequential policies that seek to

give effect to fundamental policies.

Some of the recommendations made in the Taxation Institute’s

submission to the Board of Taxation’s scoping study have been

incorporated into this report. At the time of writing of this report the

Board of Taxation’s scoping study had not been released.

3. Structure of this reportThe structure of this report is as follows:

Balance of Chapter One

The methodology used in compiling this report is outlined

under Part 4.

Definitions and terminology used in this report are

explained under Part 5.

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A brief survey of compliance cost literature is made under

Part 6.

Chapter Two

Discusses causes of complexity in the Australian income

and fringe benefits tax systems.

Chapter Three

Contains a series of case studies illustrating the interaction

of various causes of complexity in the Australian income

and fringe benefits tax systems and, in some instances,

shows how some issues could be dealt with under a more

principles-based drafting style.

Chapter Four

Contains and discusses recommendations for the repeal

of provisions rendered unnecessary by subsequent

developments in the law or that would be unnecessary if

other recommendations in this report were adopted.

Chapter Five

Contains and discusses recommendations for the repeal or

redrafting of provisions whose literal meaning is rarely or

never enforced.

Chapter Six

Contains and discusses recommendations for the

rationalisation of rules through the adoption of common or

more general rules.

Chapter Seven

Contains and discusses recommendations for the adoption

or adjustment of de minimis rules, deemed cost/proceeds

rules, or allowing the Commissioner discretion not to apply

certain rules.

Chapter Eight

Contains and discusses recommendations for more

comprehensive rewriting of Australia’s income and fringe

benefits tax laws following the elimination of unnecessary

and unenforced detail.

4. MethodologyAn analysis of causes of complexity in the Australian tax system

was made by:

surveying academic literature on the question of tax

complexity generally;

surveying the history of the current Australian income and

fringe benefits tax legislation and the history of suggestions for

reforming the legislation;

analysing the operation of the legislation in case studies in

areas where examination of the relevant provision or anecdotal

evidence by Taxation institute members suggested that there

were high levels of legal and effective complexity.

A major recommendation in this report is for the repeal of

provisions rendered unnecessary by subsequent developments.

A list of provisions for repeal was compiled by identifying

situations where more than one provision was potentially relevant.

Consideration was then given to what the tax position would be

if one or more of the potentially relevant provisions did not exist.

The history of the potentially relevant provisions was traced.

Explanatory memorandums and second reading speeches were

examined in an effort to identify the mischief that each competing

provision originally sought to overcome. The provision that was

regarded as representing the more comprehensive solution to the

mischief was generally chosen as the one that should be retained,

while the less comprehensive provision was generally chosen as

the one that should be repealed.

Another major recommendation is for the repeal or redrafting

of provisions whose literal meaning is rarely or never enforced.

Provisions fitting into this category were identified by searching

databases of tax cases and rulings and secondary literature for

instances of provisions that have been rarely or never applied. An

analysis was then undertaken of each provision so identified to

ascertain circumstances where it might apply. An assessment was

also made of the possible enforcement difficulties associated with

each provision so identified.

A further recommendation is for the rationalisation of rules by

enacting common or more general rules in some instances. A list

of provisions that could be rationalised by the adoption of common

or more general rules was compiled following scrutiny of legislative

databases for terms and synonyms that are defined differently

in distinct parts of the income Tax Assessment Acts. Printed

versions of the legislation were also examined to identify terms

and concepts that are functionally equivalent, even though they are

called by different names.

Anecdotal evidence from Taxation institute members of practical

problems with the legislation was taken into account in all aspects

of this report. This evidence was particularly relevant in developing

the case studies in Chapter Three and in identifying areas where

greater use could be made of de minimis rules or deeming

provisions.

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5. Definitions/terminology The Taxation Institute project is concerned with identifying areas

of tax law where simplification of policy could lead to reduced

compliance costs. it is necessary therefore to discuss what will

be meant in this report by the key terms: simplification of policy,

simplicity (and its opposite - complexity); and compliance costs.

5.1 Simplification of policy

in making recommendations for simplification of policy, this report

draws a distinction between the fundamental policy underpinnings

of the tax system (such as having an income tax, generally only

taxing realised gains, and basic jurisdictional rules) and what can

be termed consequential policies that aim to give effect to the

fundamental policies in particular ways, and that are expressed

in the operational rules (legislation, rulings, case law and ATO

practices) of the tax law.

Tax policy literature often identifies vertical and horizontal equity,

efficiency/neutrality and simplicity as characteristics of a good tax

system. indeed these may be regarded as the most fundamental

objectives of the Australian tax system. Frequently, compromises

and trade-offs between these objectives are necessary and some

objectives may be more influential at particular times than others.

The tax system tries to achieve these broad objectives through

operational rules that apply in particular circumstances. in all

instances where there is an operational rule, a specific policy will

explicitly or, more commonly, implicitly underpin the rule. A policy

in this sense may be thought of as a statement as to why the rule

exists and of the result that it is intended to achieve.

For example, the current practice in the Australian dividend

imputation system is that neither payments of foreign tax nor the

granting of foreign tax credits generate franking credits. Several

policies might be thought to be implicit in these rules:

First, a policy that it is undesirable to refund payments of

foreign tax or to allow payments of foreign tax to offset

domestic tax liabilities on other sources of income.

Second, a policy that seeks to promote neutrality between

direct and indirect portfolio investment by resident individuals

in foreign companies.

Third, a policy of national neutrality at the level of underlying

shareholders of resident companies.

it is useful to draw a distinction between the fundamental policies

implicit in operational rules and policies that are consequential

on the design of particular operational rules.23 For example, both

the current Australian ‘benchmark’ rule on franking dividends and

the former ‘required franking amount’ rule can both be seen as

intending to produce a result that franking credits are allocated

to all shareholders in a company proportionately. From official

statements it may be deduced that this is the fundamental policy

behind both these rules. Both rules have the effect that a company,

when franking a dividend, is able to characterise its distributions

as coming from taxed profits and to characterise its retentions as

coming from untaxed profits. Such a policy might be thought of as

being a consequence of the methods chosen for implementing the

fundamental policy.

Other possible ordering rules in dividend imputation systems,

such as an allocation of franking credits in the same proportion

as the distribution represents of distributable profits, would have

different consequential effects. under such a system, where a

company had both taxed and untaxed profits, all distributions

would be regarded as coming partially from both taxed and

untaxed profits.

A proportionate allocation of franking credits would be a simpler

means of achieving the fundamental objective of the current and

former rules, but would not achieve the policy results that are

consequential on the current rules. hence, whether or not a change

would be made in this area would depend on the policy makers’

evaluation of the importance or otherwise of the policy results that

are consequential on the current rules.

Although it is clear that some fundamental policy choices

may have significant effects on the simplicity or complexity of

the tax system, numerous political and economic considerations

that are beyond the scope of this report are relevant to those

choices. hence this report will not consider possible changes

in fundamental policy and, in particular, will not consider policy

changes that would produce changes in the tax base.

The recommendations for simplification of policy in the report

will place emphasis on adjusting the operational rules and

consequential policy choices that give effect to fundamental

policies. hence, the simplification of policy that this report is

referring to principally involves the clear statement of fundamental

policies and the elimination of consequential policy choices and

operational rules that are not necessary for the implementation of

the more fundamental policy objectives of the tax law.

5.2 Simplicity/complexity

The literature on tax complexity and simplification is extensive.24

much of the literature is concerned with measuring complexity and

with comparing the extent of complexity in different tax systems.

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This review will focus on definitional and conceptual issues in

the tax complexity and simplification literature. Tax simplification

literature distinguishes between ‘legal’ and ‘effective’ simplicity/

complexity.

5.2.1 Legalsimplicity

The legal simplicity or complexity of a tax law is determined by the

ease or difficulty with which it can be read and understood. Tran

Nam suggests that legal simplicity/complexity depend on:

the comprehensibility of the language used to express

the law; and

content of the law.

Tran Nam regards the content of the law as encompassing such

matters as: the tax base; discretions; uncertainties; exemptions;

special concessions; allowable deductions; rebates; and multiple

tax rates.25

Tran Nam’s description of the content of tax law is largely

a classification of its elements based on their functions as

mechanisms in determining the taxable quantum in a given

instance. For the purposes of determining and measuring the

complexity of tax law, it may be more useful to identify the

policy underpinning the law and the operational rules involved in

implementing those policies in the law. Such identifications can be

drawn in each of the categories identified by Tran Nam.

given the binding nature of precedents and the binding nature

of public rulings on the Commissioner, an adequate definition of

the content of tax law needs to include the interpretations of tax

statutes developed by the courts and the Commissioner. if policies

underpinning the law are regarded as part of its content then

official government statements of intended policy in Explanatory

memoranda and elsewhere need to be regarded as expressions of

part of the content of the law.

To date most formal attempts to simplify the language

expressing the law have focussed on simplifying the language

of legislation. if official statements of policy are to be regarded

as part of the content of the law in the sense explained above,

then arguably attention should also be given to improving

the comprehensibility of official policy statements. Detailed

consideration of how such improvements could be made is beyond

the scope of the report, although some of the recommendations

involve the development of comprehensive policy statements.

Although technically not part of the content of the law, in

practical terms explanations of the tax law in Taxpack and in

practitioner texts are more commonly read than the statute itself.

The report will not discuss how these explanations of the content

of the law could be simplified, but works on the assumption that a

consequence of simplification of the statute would be to simplify

the content and organisation of these explanations of the content

of the law.

it is also important to appreciate that other statutes may add

to the legal complexity of tax law. The income tax law contains

numerous tax expenditure programs within it. Frequently

accessing these tax expenditures depends on complying with

regulatory regimes established in other statutes. Examples

include superannuation and the venture capital concessions. The

interaction of the tax system with direct expenditure programs

(such as social security payments) can also add to its legal

complexity as, in practical terms, the effects of changes in a

taxpayer’s circumstances need to be considered from both the

income tax and social security perspectives. Consideration of

these other statutory regimes and their interaction with the income

tax and FBT legislation is beyond the scope of the report but

would merit further research.

Research suggests that merely simplifying the language in

which the law is expressed does little to improve the overall legal

simplicity of tax law.26 Complexity in either the expression or the

content of the law can operate independently to make the law

more or less complex. Complex content will remain complex even

where it is expressed in simple language. Conversely, simple

content can become more complex as the language in which it

is expressed becomes less comprehensible. The focus of the

report is on making the law less complex through a reduction in

the number of operational rules, rather than on recommending

clarifications in the language in which the law is expressed.

A change in operational rules may, but will not necessarily,

involve a change in the policy behind the law. For example, prior to

the introduction of the simplified imputation system, the Australian

dividend imputation system contained rules designed to counteract

dividend streaming. These included rules dealing with the required

franking amount for a dividend. under the simplified imputation

system, rules relating to the required franking amount for a

dividend were replaced with an arguably more flexible set of rules

that nonetheless aim to counteract dividend streaming through the

use of the benchmark franking rule and other associated rules.

This example highlights the usefulness of the distinction

between the fundamental objectives and policies that the law is

trying to express and the operational rules that are used to express

those fundamental objectives and policies. The example also

illustrates that it often may be possible in the process of tax law

design to choose between alternative operational rules, each of

which achieves the fundamental objective. As discussed earlier, a

distinction can also be drawn between fundamental policies and

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objectives and, often implicit, policies that are consequences of

the operational rules chosen to achieve a more fundamental policy

objective.

To summarise the discussion under this heading, the primary

focus of this report is on recommending areas where the number of

operational rules could be reduced rather than on recommending

changes in more fundamental policy underpinnings or on

recommending mere clarifications of the language of the law.

5.2.2 Effectivesimplicity

Legal complexity or simplicity should be distinguished from

the broader concept of ‘effective simplicity’. Effective simplicity

measures the value of resources expended by society in raising

a given amount of revenue. Raising a given amount of revenue

involves ascertaining how the tax laws apply to a given set of

circumstances.27 As this process potentially involves taxpayers,

tax administrators, judicial officers and legislators, to measure

the effective simplicity/complexity of a tax system it is necessary

to ascertain and add together the costs borne by each of these

potential participants in the process of raising revenue.28 As Tran

Nam has noted, effective simplicity encompasses legal simplicity

but in addition is affected by:

the number of taxpayers and tax administrators;

the size distribution of taxpayers;

business cycle; and

the general level of tax avoidance and tax evasion in the

economy and the Government’s commitment to combat

these.29

Similarly, in summarising the concept of complexity as used in the

literature to 1993, Cooper noted that:

“a complex system would be one where neither taxpayers nor

the revenue authority could identify a taxpayer’s tax (425) liability

with an appropriate degree of certainty at reasonable cost, nor

could that liability be cheaply and easily satisfied, nor enforced.

Those outcomes could be caused by many factors such as

choosing inappropriate rules, poor expression of the rules chosen

or poor construction of the total system.”30

Proposals for reducing the effective complexity of the tax

system commonly involve removing a group of taxpayers or a

segment of transactions from the tax net. Although it may be

possible to achieve considerable reductions in effective complexity

through such steps, they would involve more fundamental shifts in

policy than this report is concerned with.

5.3 Compliance costs

Costs borne by the private sector in complying with the tax system

are usually referred to as compliance costs. it is important to note

that these are costs that would not be incurred by the private

sector but for the existence of obligations imposed by tax law.

Costs borne by the public sector in administrating the tax system

are usually referred to as administrative costs.

While it is conventional to define the operating costs of the tax

system as the sum of the compliance and administrative costs,

Tran Nam has rightly pointed out that in some instances these

costs may counteract each other, leaving no net cost to society.

For example, a reduction in administrative costs may be at the

expense of an increase in the compliance costs (or vice versa),

leaving no net simplification benefit. hence, the better measure of

the operating costs of the tax system is a net figure determined

by subtracting the gross operating costs (i.e. both administrative

and compliance costs) from the gross operating benefits (i.e. both

administrative and compliance benefits) of the tax system.31

given its purpose and scope, the principal concern of the report

is with measures aimed at reducing compliance costs as distinct

from administrative costs.

6. Brief survey of compliance cost literature

The complexity or simplicity of a tax system is sometimes

measured by estimating the net compliance and administrative

costs in the system. As discussed above, the more comprehensive

concept of complexity is “effective complexity”. The factors that

can affect the effective complexity of a tax system include:

linguistic complexity: complexity in the language of the statute,

in the language of cases and rulings interpreting the statute,

and the language of policy documents;

complex policy: complexity in the policy that the statute is

trying to implement; and

complex processes: complexity in the operational processes

implementing the policies behind the law.32

There is a considerable body of literature on linguistic factors that

contribute to the linguistic complexity of law and of social science

literature. As is discussed in more detail in Chapter One, the

literature suggests that merely reducing the linguistic complexity

of tax law has done little to reduce the effective complexity of

the tax system. Quantitative empirical research by mcKerchar on

complexity and compliance by self-completers of income tax

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returns found that factors other than language made the rules

difficult to interpret:

“It was therefore concluded that although the instructions and materials

(including TaxPack 2000) provided by the ATO were a cause of complexity

for at least half of the self-completers who participated in the survey, it

was the nature of the rules themselves that was the main cause. The rules

were difficult to interpret and required voluminous detailed explanatory

material that gave rise to ambiguities and uncertainties. Given that it was not

technical language that made rules difficult to interpret, it appeared that the

difficulties arose from the underlying complexity of tax policy and laws. The

rate of change was recognised as a contributing factor, but less important

than the difficulties caused by ‘ambiguities/uncertainties’, ‘details’ and

‘forms’.”33

This finding was also confirmed in McKerchar’s qualitative

research:

“Proposition 2, derived in part from the survey, was that the major cause of

complexity was ambiguity, or uncertainty. In order to address uncertainty,

considerable detail was provided in TaxPack. However, it was clear from

the case study that subjects were generally not prepared, or unable, to

read and understand the level of detail provided. While the survey found

that uncertainty was the major cause of complexity for subjects, it was

apparent from the case study that providing fuller explanations and details

of exceptions and so on, was not an effective way to reduce complexity for

taxpayers completing their own return. Subjects wanted certainty, but without

unnecessary detail.”34

An earlier survey by Long and Swingen of tax agents in a uS

state found that ‘the rate of change’ followed by ‘ambiguities

and uncertainties’, ‘details’ and ‘forms’ were perceived to be the

principal causes of complexity.35

hence, this discussion will not focus on causes of or on

rectifying linguistic complexity. Rather the focus will be on

identifying and rectifying causes of complex policy and of complex

processes. Consistent with the above research by mcKerchar and

by Long and Swingen, some emphasis will be placed on problems

in the organisation of the legislation and in the relationships

between different parts of the legislation.

Surveys of compliance costs in Australia have found that

company income tax has considerably higher compliance costs

than personal income tax both in absolute terms and as a

percentage of revenue collected.36 Of taxpayers paying personal

income tax, 36% with business and investment income incurred

74% of total estimated compliance costs.37 For companies, internal

costs represented 48% of compliance costs, with external costs

for professional fees representing 52% of compliance costs.38

Computational costs represented 76.2% of all corporate

compliance costs, with planning costs representing 23.8% of

corporate compliance costs. Planning costs represented a higher

percentage of the total compliance costs for smaller companies,

while computational costs represented a higher percentage of

the total compliance costs of the largest companies.39 Corporate

compliance costs were found to be heavily regressive.40

given the results of these surveys, some emphasis will be

placed in the report on measures that would be likely to reduce

compliance costs for smaller companies and small businesses and

investors.

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CHAPTER TWOCAUSES OF COMPLEXITY

1. IntroductionThe purpose of Chapter Two is to identify thirteen causes of

complexity in the Australian income and fringe benefits tax system.

This process involves reviewing the extensive literature that has

sought to examine the possible causes of complexity in tax

systems.41

Several commentators have noted that a major cause of

complexity in the tax system is the use of income as a tax base.42

The major alternative to the use of an income tax base is some

form, either direct or indirect, of a consumption tax. As the

consumption tax base at its broadest is in fact narrower than a

comprehensive income tax base, the complete replacement of

the income tax with a consumption tax would necessarily involve

higher rates of tax, if the switch were to be revenue-neutral. For

this reason alone a complete switch to a consumption tax base

is unlikely to be politically feasible in Australia in the reasonably

foreseeable future. hence, in identifying complex policies, the

assumption is made that the income tax is to be retained.

As the report does not focus on fundamental policy changes,

several commonly touted simplification suggestions are not

considered in this discussion of causes of complexity and possible

simplification measures. hence the following reform suggestions,

which would involve changes in fundamental policy, are not

considered in this analysis.

It is sometimes argued that the legal and/or effective simplicity

of an income tax can be increased by flattening tax rate scales

and/or by increasing tax-free thresholds. Whether flatter tax rates

reduce either the legal or effective simplicity of the tax has not

been established by research, and there are arguments both

for and against the proposition. increasing tax-free thresholds

should normally mean that effective complexity is reduced, as

fewer taxpayers have to comply with the tax system. The setting

of tax rate scales involves a range of political and economic

considerations beyond the scope of this report. Changes to

rate structures often accompany changes in the tax base. in

these circumstances, the changes in rate structure are part of

endeavouring to ensure that tax base changes are revenue-neutral.

Similarly, the use of standardised deductions for personal

expenses, or the elimination of personal expense deductions

accompanied by a lowering of tax rates, arguably would increase

both the legal and effective simplicity of the tax system, as it would

eliminate difficult and anomalous distinctions in the law and means

that a significant proportion of individual taxpayers are no longer

required to file returns. The elimination of deductions for personal

expenses amounts to a change in the tax base; as does, to a

lesser extent, the setting of standardised deductions for personal

expenses.

A further policy change involving a change in the tax base that

is likely to have simplification benefits would be changing the CgT

treatment of disposals of pre-CgT assets.

The assumption is also made that fringe benefits will continue

to be included in the tax base; and, given the rejection by the

government of the Review of Business Taxation’s recommendation

to the contrary, in the employer’s tax base at that.

in addition, the report does not consider simplification

suggestions that have recently been rejected following

comprehensive reports produced by either official enquiries,

Treasury, the ATO or the Board of Taxation, even where a

simplification suggestion might not involve a significant change

in the tax base. in particular, this report does not consider any

possible simplification, or complication, through the replacement

of the current tax system’s income calculation basis with an

alternative calculation basis (as proposed by the Review of

Business Taxation, and subsequently developed into the Tax Value

method).43

in instances where complex policy is identified, an effort was

made to determine whether the policy is a fundamental one that

drives the operating rules, or is a policy that is a consequence of

the operational rules previously chosen. An effort was made to

identify alternative policy choices where possible.

2. Causes of complexity related to consequential policies and operational rules

2.1 First, obscuring of fundamental policy framework through excessively detailed operational rules due to:

cumulative development of rules; and

insufficiently clear and explicit principles governing priorities

between rules.

The principal contention in the report is that the root cause of

the complexity of the Australian tax system is that, over time,

the cumulative development of detailed operational rules have

obscured the fundamental policies that those rules should be

trying to express. Overarching all of the other specific causes of

complexity discussed below is the relative absence of an obvious,

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coherent and consistently implemented framework of fundamental

policy objectives.

The fundamental design objectives of the tax law too often

retreat into the background and are obscured by detailed operative

provisions, which are often poorly coordinated. While many tax laws

develop these features over time, Australian tax laws display them

to an extreme extent. The reasons for this characteristic appear to

be largely historical.

Cases interpreting Australian income tax legislation adopted

a concept of income that had been used in interpreting English

income tax statutes. under this concept, numerous receipts (such

as, most notably, capital gains) that would be income under the

economist’s gain notion of income were not so regarded.

Over the years this ordinary concept of income has been

supplemented by numerous rules that generally bring Australian

income and fringe benefits taxes closer to taxing all realised gains.

in many instances, legislative rules broadening the income tax base

were developed in response to specific tax planning strategies that

exploited departures from horizontal equity in the tax system. in

many instances (with some notable exceptions), new specific rules

were added to but did not replace existing general rules and case

law.

The cumulative development of rules has meant that in many

instances more than one tax rule could apply to a particular

transaction, and that frequently the priorities between these

potentially conflicting rules are neither clear nor explicit. Rather the

approach has been to require the reader of the legislation to work

through each of the technical triggers for each of the potentially

applicable rules and, in instances where the technical requirements

of more than one rule are met, apply an anti-overlap rule.

The overall policy of the law in these situations often has to

be inferred from the end result of a technical analysis of detailed

operational rules and their interactions. Processes involved in

the operation of the law are commonly complex and may involve

considerable cross-referencing between trigger provisions and

definitions found in different parts of the legislation, or even in

different legislation. in these situations, the policy underpinning the

law is also complex in the sense that it is at best implicit and at

worst unclear and possibly internally inconsistent. The cumulative

development of excessively detailed operational rules eventually

obscures the fundamental principles that the law is trying to

express.

Cooper has noted a further consequence of the cumulative

development of rules. When earlier anti-avoidance provisions are

not repealed or substantially modified when new provisions are

introduced, the earlier provision can be transmogrified into a tax

shelter.44

2.2 Second, the use of complex anti-overlap rules reconciling different potentially operative provisions

Another consequence of the cumulative development of rules is the

existence of complex anti-overlap provisions reconciling different

potentially operative provisions. Examples include:

CgT and other inclusions iTAA97 s 118-20;

CgT and trading stock iTAA97 s 118-25;

CgT and capital allowances iTAA97 s 188-24;

Capital losses and revenue losses iTAA97 s 110-55(9);

FBT and assessable income iTAA36 s 23L; s 26

(e)(iv) and (v); FBTAA

s 136 definitions of

‘fringe benefit’ and

‘salary or wages’;

CFC and FiF iTAA36 s 494;

Capital allowances and Div 43 iTAA97 s 40-45(2)

and s 43-70(2)(e);

CgT and Buy Backs iTAA36

s 159gZZZQ(3); and

Foreign exchange gains/losses ITAA97 s 775-15

and s 775-30.

The use of complex anti-overlap provisions can add to the

complexity of tax laws in three ways.

First; for example, in the case of the CFC and FiF rules, the effect

of the anti-overlap rule may be unclear, leading to the development

of an unclear boundary between two sets of rules. unclear

boundaries are likely to add to the compliance costs of taxpayers

undertaking transactions, as they are likely to increase the need for

and cost of specialist tax advice.

Second; for example, in the case of the general CgT anti-overlap

rule in s 118-20, the anti-overlap rule might not come into operation

until the last step in the computation of amounts to be taxed.

Particularly where cost rules differ between different parts of the

tax legislation, this can mean that a taxpayer will need to calculate

two potentially taxable amounts and then apply an anti-overlap

provision. in these situations, some advisors may work on the

simplifying assumption in the case of CgT, that if an ordinary income

provision applies then CgT is irrelevant. Such an approach risks

inaccuracy in computation of the actual tax liability of the taxpayer,

with consequent adverse effects on subsequent administrative and

compliance costs.

Note that the second problem would not have arisen in relation

to CGT if Option Two/Tax Value Method proposed by the Review

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of Business Taxation had proceeded. under that approach, CgT

treatment would have been a concessional carve-out for particular

types of identified assets. in part, therefore, the existence of

this problem in relation to CgT can be seen as an operational

consequence of a fundamental policy choice of retaining the

ordinary concept of income, but supplementing it with specific

provisions like CgT. The complexities involved in the operation of

the general CgT anti-double counting provision can thus be seen

as being a consequence of the fundamental policy choice made in

designing Australia’s CGT regime and broader tax reform agenda.

Another broad policy choice also appears to be behind the

type of general anti-overlap rule used in Australia’s CGT. This is a

policy of applying CgT to receipts that were not within the ordinary

concept of income – not merely to capital gains. If the policy had

been to only tax capital gains, it would have been possible for

overlap between ordinary income and capital gains to be avoided

by expressly confining CgT to gains on capital account. An

example of this approach can be found in the Canadian capital

gains legislation. This method of preventing overlap would have

nonetheless involved some complexity, as it would have drawn

on the extensive and somewhat difficult case law distinguishing

between ordinary income and capital receipts. These problems

could be reduced by adopting the united States approach of

defining a capital asset in the statute.

A third problem with some Australian anti-overlap rules is

the complexity involved when the anti-overlap rule turns on a

distinction drawn in an extensive body of case law. This problem

can be seen in the anti-overlap rule between iTAA97 Division 40

and iTAA97 Division 43, which ultimately turns on whether or not

the item of depreciable property is ‘plant’ in the sense discussed in

an extensive body of case law.

2.3 Third, rules rendered unnecessary by subsequent developments

Tax rules are developed by enacting new legislation, by the

interpretation of existing legislation by the courts, and in rulings.

The combined effects of these forms of development can render

existing rules redundant.

judicially-developed rules are always a response to a specific

fact situation. While judicially-developed rules should be, and

usually are, consistent with what judges perceive to be the policy

behind a particular provision, it is unreasonable to expect the

development of judicial rules on a case-by-case basis to eliminate

overlaps in subject matter between particular statutory regimes,

or to develop or even coordinate a framework of relationships

between specific statutory regimes.

judicial respect for the sovereignty of Parliament means that

judicially-developed rules can only interpret rather than change

rules developed by Parliament. judges should try to interpret

rules so that the system as a whole has a rational operation,

but they cannot impose rationality where it is lacking due to an

uncoordinated development of statutory rules over time.

Economic developments; for example, in the way that

business is organised or financed or communicates, can call

for the application of judicial and statutory rules to changed

circumstances. For the reasons stated above, judicial rules

developed in response to such changed circumstances might

not result in a rational overall system of rules. Statutory rules

and rulings developed in response to changed economic

circumstances can often represent a response to the specific

circumstance in question. When this happens, new rules enacted

are often in addition to rather than in substitution for existing rules.

The development of more than one set of functionally similar

rules can add to the complexity of the tax system in several ways.

First, it adds to the sheer bulk of the statutory rules. As

discussed above, research has found that the sheer number

and length of rules contributes to the complexity of the

Australian tax system.

Second, the enactment of functionally equivalent rules at

different times often means that technical differences exist

between sets of rules. Often those technical differences

can be the product of extraneous factors, such as changes

in drafting styles, rather than being features that serve a

specific and necessary function when dealing with the subject

matter in question. The existence of unnecessary differences

between functionally equivalent rules is likely to distort

economic behaviour and to result in inefficient tax-motivated

transactions.

Third, a multiplicity of rules and unnecessary differences

between them obscures the principles the rules are trying

to express and the fundamental principles of the tax system

overall.

2.4 Fourth, situations where the literal meaning is never or rarely enforced

Administrative practice may sometimes be to not apply a provision

according to its literal tenor. At least three distinct reasons for this

administrative practice may be identified.

First, in many circumstances it may be difficult or impossible

as a practical matter to give effect to the provision in its literal

meaning. An example is iTAA36 s 44(1)(b).

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Second, administrative authorities might not believe that

the literal meaning of a provision reflects the intention of

Parliament in enacting the provision. An example is iTAA36 s

99B.

Third, administrative authorities might not believe that the

literal meaning of a provision produces an appropriate, fair or

practical policy result. An example is the treatment of capital

gains in discretionary trusts where the capital and income

beneficiaries differ.

When administrative practice is not to enforce rules according

to their literal tenor, in effect a layering of rules develops. The

statutory rule has to be read subject to administrative practice.

While such administrative practices might reduce administrative

costs, it may be that they have an adverse impact on compliance

costs.

Administrative practice by its nature is less accessible to

ordinary taxpayers than it is to tax professionals. Becoming

familiar with administrative practice is part of the training of a tax

professional, and forms part of the justification for the fees charged

by tax professionals. To the extent that administrative practices at

variance with the literal tenor of the statute increase the reliance of

taxpayers on tax professionals and contribute to the fees charged

by tax professionals, they contribute to an increase in compliance

costs.

2.5 Fifth, duplication of interpretative/computational rules

Another consequence of the cumulative development of

Australian income and fringe benefits tax rules is the duplication

of interpretative rules in different parts of the tax legislation. Some

examples include: (see table)

Type of rule Examples of provisions containing rules

of this type

Asset rules • CGT provisions

• Capital allowance provisions

• Securitised asset – for thin

capitalisation rules s 820-942(3)

• Many provisions use the term

‘asset’ in an undefined or an

incompletely defined sense (e.g.

s 715-145; s 995-1 definition of

equity capital of an entity; s 995-1

definition of market value of an

asset; s 995-1 definition of transfer

value of an asset; s 320-170

assets of a virtual PST)

Cost rules • CGT provisions


• Capital works allowance provisions

• Trading stock provisions

Proceeds rules • CGT provisions


• Capital works allowance provisions

• Trading stock provisions

Realisation events • CGT provisions


Relationship rules • CFC provisions

• Company loss provisions

• FBT provisions

• Thin capitalisation rules

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in some instances, there may be sound policy reasons for

interpretative/computational rules varying between different parts

of the tax legislation. in many cases, however, there do not appear

to be expressed or obvious policies for differences between

interpretative/computational provisions in different parts of the tax

legislation.

having distinct definitions of equivalent terms in different parts

of the tax legislation is likely to mean that a reader will need to

check the definition of a term more frequently than would be the

case if the practice were to only have separate interpretative/

computational rules, where there was a sound policy reason for

the use of separate rules. Thus the use of distinct definitions of

equivalent terms in different parts of the tax legislation is likely to

increase the compliance (and possibly the administrative) costs of

the tax system.

hence it would be desirable for a more comprehensive set of

common interpretative and computational rules to be developed,

which could be varied where necessary in particular cases.

2.6 Sixth, rules for exceptional circumstances assuming a disproportionate significance

As rules develop cumulatively, exceptional or problematic

circumstances are identified from time to time. Where the

exceptional or problematic circumstances were not foreseen when

the provisions dealing with particular transactions were originally

enacted, they are commonly dealt with by specific exceptions.

This technique can lead to the problems identified under (a)

above. Where the exceptional or problematic circumstances are

identified when the original provisions are enacted, the drafter

will try to take the exceptional or problematic circumstances into

account in designing the original provisions. in some instances

this process may affect the whole structure of and terminology

used in particular provisions. Where exceptional or problematic

circumstances influence the overall structure and terminology of

provisions, it is arguable that the influence of those circumstances

on the overall rules is disproportionate to their significance.

This disproportionate influence can contribute to the complexity

of tax rules in several ways. First, there can be a tendency to

develop terminology designed to accommodate both the usual and

the exceptional circumstances. This can produce terminology that

is inconsistent with commonly used commercial terminology. it also

means that consideration of usual situations is complicated by a

terminology designed to encompass an exceptional or problematic

situation that may rarely arise. A clear example of this tendency

can be seen in the capital allowance provisions. '

Second, allowing exceptional or problematic circumstances

to influence overall structure disproportionately can produce a

tendency towards a tabular drafting style, where rules dealing

with different categories of circumstance are set out in a series

of tables. While perhaps promoting readability, this drafting style

can have the effect of obscuring the recognition of key principles.

under this approach, the details of the provisions become more

readable at the expense of an appreciation of the overall effect

and architecture of the provisions. The clearest example of this

tendency can be seen in the CgT provisions.

2.7 Seventh, poor targeting of rules

Rules that are only relevant to entities with some characteristics or

in some circumstances are sometimes applied to a broader class

of entities and circumstances. Where the relevant circumstance

would otherwise give rise to a tax planning strategy, then typically

complex integrity measures are introduced to deal with those

circumstances. Complex rules can also develop to deal with

practical issues that arise for some but not all entities in the class

to which the rules apply. in both of these cases, some entities have

to work within a set of rules that is more complex than is necessary

to deal with their particular circumstances.

Examples of both instances of this cause of complexity can

be seen in the dividend imputation system. The complex rules on

maintaining a franking account, franking a dividend, anti-dividend

streaming and anti-capital benefit streaming are products of a

combination both practical and integrity concerns.

Practical concerns mean that a shareholder allocation system

of corporate-shareholder taxation (along the lines of the uS

sub-chapter S corporation) is not a viable option in widely held

companies with more than one class of shareholder. integrity

concerns (flowing from a policy of not giving credit for payments

of foreign tax in the dividend imputation system, a policy of not

wanting to impose a compensatory tax, and a policy of not giving

imputation credits to non-residents) give rise to the franking

account and franking rules, the anti-dividend streaming and anti-

franking credit trading rules.

Even though a small closely-held company may have only

one class of shareholders, no foreign source income, and only

resident shareholders, it still has to comply with the complex rules

of the dividend imputation system, even though it has none of the

characteristics that led to the development of those rules.

in these cases it would appear to be desirable to develop an

alternative simpler set of rules applicable to entities having defined

characteristics, and allowing those entities to opt for the simpler

treatment. A flawed example of this approach can be seen in the

simplified tax system rules.

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2.8 Eighth, rules affecting the derivation of income and gains and the incurring of expenses and losses through entities where parts of the rules operate at different levels of the entity

The processes involved in determining tax liability in a given

situation can become complex when different parts of the

legislation operate at different levels. A simple example can be

seen in the taxation of partnerships, where the trading stock,

depreciation and ordinary income provisions operate at the

partnership level while the CgT provisions operate at the individual

partner level.

Particularly complex processes can be involved where an

amount is included at one level; for example, in calculating the

net income of a partnership or trust, and then an adjustment is

made at another level; for example, an adjustment at the partner

or beneficiary level for the purpose of correctly applying provisions

such as the CgT provisions or the dividend imputation system.

in some instances in the existing legislation, the processes

involved appear to have been complicated unnecessarily by the

addition of amounts at one level and their subtraction at another

level. An example can be seen in the provisions dealing with

franking credits flowing through partnerships and trusts.45 A further

example can be seen in the interaction of CgT event E4 and the

rules for taxing capital gains flowing through trusts.

2.9 Ninth, the use of specific anti-avoidance provisions and the general anti-avoidance provision concurrently

iTAA36 and iTAA97 contain numerous specific anti-avoidance

provisions. in most instances, a transaction that satisfies the

requirements for exclusion from a specific anti-avoidance provision

is not thereby relieved from the potential operation of the general

anti-avoidance provision in iTAA36 Part iVA. This raises questions

about the true function of these specific anti-avoidance provisions.

One virtue of specific anti-avoidance provisions is that they

provide greater certainty than does a general anti-avoidance

provision. Where a specific anti-avoidance provision is nonetheless

subject to the general anti-avoidance provision, no greater

certainty is provided, as the possible application of the general

anti-avoidance provision is unaffected.

The principal functions of specific anti-avoidance provisions

in these instances appear to be as prophylactics against tax

planning, with a consequent reduction in administrative costs. in

these circumstances, it is likely that any reduction in administrative

costs would be offset by increases in compliance costs. The

personal services income alienation provisions might be thought

to be an example of specific anti-avoidance provisions having this

function.

2.10 Tenth, the use of detailed computational steps (method statements) without indicating the overall purpose and the effect of the computational steps

The method statement is a popular drafting technique within

iTAA97. it can have the advantage of enabling the production of a

precise numerical amount that can be taken into account for tax

purposes in particular circumstances.

method statements can sometimes be extremely lengthy and

complex, and working through them can involve cross-referencing

to definitions, operational rules and method statements. This in

itself is likely to increase the legal complexity of the particular rule

expressed in the method statement.

more importantly, the price that can sometimes be paid for

achieving precision and detail through the use of a method

statement is a loss of appreciation of the overall effect of a rule.

The forest is lost in the trees. The reader has to work through the

method statement and not only come up with a numerical answer

but then has to draw conclusions about what the overall effect of

the method statement was.

in some instances the reader may be able to conclude that,

because of particular steps in the method statement, different

tax effects would have been obtained if a particular transaction

had been structured differently. in some instances such analysis

may produce results that, while being consistent with the literal

language of the method statement, are probably at odds with its

intended effect.

Benefits, in terms of both reduced complexity and increased

integrity, may be likely to be produced if all method statements

were accompanied by a statement of the overall effect and

intention of the statement.

2.11 Eleventh, the inclusion of material that is irrelevant to some taxpayers in operative provisions and the computational steps

The basis on which rules are grouped together and organised in

legislation can mean that provisions that are only relevant to some

taxpayers are included in operational rules and method statements.

The most likely result of such grouping is that taxpayers and their

advisors need to read through or at least consider whether to

read sometimes large amounts of irrelevant material. This can only

add to the time taken to comply with the legislation and is likely

to increase the uncertainty of the application of the legislation.

The problem appears to be almost endemic in the iTAA. A good

example can be found in the operation of CgT event E4.

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Vann notes that the basic choices in tax design involve grouping

according to mechanical function (so that all income inclusions

are grouped together, all deductions are grouped together, all

credits are grouped together and so on) and grouping according

to subject matter (for example, all provisions dealing with foreign

source income are grouped together).46 Within a grouping, however,

further sub-groupings are possible, and these in turn may be

on the basis of either mechanical function or subject matter.

To the extent that the grouping at the macro level is according

to mechanical function, the likelihood of the rules containing

provisions that are relevant to only some taxpayers who read them

increases.

2.12 Twelfth, complex consequential policy choices

Complex fundamental policy choices can mean that some

complexity in the operational rules implementing the policy chosen

is virtually inevitable. most often, complexity will arise where the

tax treatment is given to taxpayers or transactions that, while

similar in a more general sense, differ according to whether they

have particular characteristics. One manifestation of this cause

of complexity arises where a different tax treatment is given to

economically equivalent transactions according to whether they

have a particular legal form. Tax preferences, such as the small

business CgT concessions, can be seen as another variant on this

cause of complexity. Such fundamental policy choices, however,

are outside the scope of this report.

Policy becomes particularly complex when the policy choice

is made that the treatment of tax preferences as they pass

through intermediate entities should differ according to the type

of preference and according to the type of entity. A good example

can be seen in the treatment of distributions of tax-preferred

income by unit trusts. This is an example of a second order or

consequential policy choice that is within the scope of this report.

in some instances, complex policy choices may be a

consequence of the cumulative development of rules noted in

(a) above. For example, Cooper has argued that assuming fringe

benefits are to be taxable to the employer, it would have been

simpler to tax all cash benefits to the employee and to subject all

non-cash benefits to FBT. instead, arguably due to the cumulative

development of rules, we continue to tax some non-cash benefits

under iTAA36 s 26 (e), and in addition include non-cash business

benefits in the assessable income of the recipient via the combined

operation of iTAA36 s 21A and iTAA97 s 6-5.47 This is a further

example of a second order or consequential policy choice that is

within the scope of this report.

Subsequent developments may also mean that an initial policy

choice that was thought to have lower operating costs over time

proves to have higher operating costs than alternative policies.

Again, an example is the gradual development of the FBT rules

as problems in their operation emerged. The introduction of the

obligation to disclose reportable fringe benefits amounts on group

certificates arguably negates the major operating cost savings that

initially formed a major justification for levying FBT on employers.

Whether fringe benefits should be taxed to the employer or to the

employee is an example of a second order or consequential policy

choice that is within the scope of this report.

2.13 Thirteenth, inconsistency between domestic law and Australia’s Double Tax Treaty (DTA) obligations

While it is common for countries to regard DTA as limiting their

taxing jurisdiction (for example, by imposing limits on withholding

taxes), Australia’s domestic law varies from its Double Tax Treaty

practice in some significant respects. Examples include:

the taxation of business profits of non-residents (our domestic

law in theory taxes Australian source business profits in

the absence of permanent establishment, whereas our DTA

practice is to only tax business profits that are attributable to a

Permanent Establishment (PE));

dividends paid to non-residents (our domestic law theoretically

taxes non-residents on an assessment basis on dividends

paid by non-resident companies funded from Australian

source business profits, while our DTAs prohibit such taxation);

and

taxation of capital gains by non-residents (our domestic law

currently taxes gains on shares in private companies and in

non-portfolio holdings in public companies,48 while our DTAs

impose more restrictive rules – although they have been

overridden in some circumstances).

in some instances, the relevant portion of domestic law is never

or rarely enforced, while in others the domestic law is a product

of practices that developed prior to the international consensus

embodied in the OECD model DTA. hence, not only does the

inconsistency increase complexity by requiring consideration of

whether the treaty or the non-treaty rule is relevant, but it also

can mean that Australian domestic law is inconsistent with more

standard international practice.

3. Relationship of this chapter to subsequent chapters

A comprehensive analysis of how the Australian tax system could

address all of these causes of complexity would be beyond the

scope of this report. Chapter Three contains a series of case

studies illustrating the interaction of some of the remaining causes

of complexity listed above and, in some instances, suggests ways

in which complexity induced by those causes could be reduced.

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A principal focus of this report is on dealing with the third and

fourth causes of complexity identified above. Both of these causes

can be seen as products of the cumulative development of rules

in the system and of paying insufficient attention to the broader

policy framework and objectives of the rules as a coordinated

whole. Removing unnecessary provisions and provisions that

are rarely enforced should also reduce the effect of the first and

second causes of complexity noted above. if there are fewer rules

interacting, logically there should be fewer priority issues between

rules and fewer occasions where anti-overlap rules are triggered.

The ninth cause of complexity identified above will also be seen

as forming part of this aspect of the report, as that cause can be

regarded as a sub-set of the third cause of complexity. Arguably,

certain specific anti-avoidance provisions are unnecessary given

the presence of the general anti-avoidance provision and the

case law interpreting it. in some respects, the thirteenth cause

of complexity can be seen both as a product of the cumulative

development of rules and an example of either the third or fourth

cause of complexity. One instance of conflict between Australia’s

domestic tax law and its international tax treaty obligations

that highlights the impracticality of Australia’s domestic rules is

examined in this report.

Chapter Four recommends the repeal of certain provisions on

the grounds that they are unnecessary. Chapter Five recommends

the repeal or redrafting of certain provisions on the grounds that

their literal meaning is rarely or never enforced. The fifth cause

of complexity identified above is another major focus of this

report. Chapter Six discusses how rules in certain areas could be

rationalised by the adoption of either common or more general

rules. Each of these chapters comments on the effect, history and

current status of the provisions that they discuss.

As noted above, much of the complexity in the Australian tax

system may be due to complex policy choices made in designing

the system. While consideration of major policy choices is not

within the scope of this report, Chapter Seven does contain a

discussion of some areas where policy could be simplified by

greater use of de minimis rules, by the use of deeming rules, or by

giving the Commissioner discretion not to apply rules in particular

circumstances.

The recommendations made in Chapters Four to Seven should

have the effect of simplifying the law by removing much of the

‘noise’ in the existing rules. With unnecessary and duplicated

provisions removed, the fundamental objectives of the law should

become more prominent. The operational rules that remained,

however, generally would still be extremely detailed. Where the

fundamental policy intent of the law is clearly expressed and

judges apply a purposive interpretation of statutes, there may be

scope for considerable reductions in the level of detail in taxing

statutes.

Chapter Eight contains recommendations for a process of

rewriting the law so as to further reduce the amount of operational

detail and to give greater prominence to fundamental principles.

The recommendations for a redrafting process made in Chapter

Eight also address some of the issues arising from poor targeting

of rules (the sixth cause of complexity noted in this chapter),

the inclusion of material that is irrelevant to some taxpayers in

computational steps (the eleventh cause of complexity noted in

this chapter), the absence of statements of the effect and intent

of method statements (the tenth cause of complexity noted in this

chapter), and problems arising when rules affecting the derivation

of income or gains and the incurring of expenses or losses through

entities operate at different levels of the entity (the eighth cause of

complexity noted in this chapter).

4. Summary There is extensive literature examining possible causes of

complexity in a tax system. This chapter has attempted to analyse

some of the particular causes of the complexity of the Australian

taxation system. The analysis assumes that the fundamental

features of the Australian tax system will remain unchanged. in

particular, the analysis assumes that Australia will continue to have

an income tax and will continue to apply FBT to employers.

Overarching all of the causes of complexity discussed in this

chapter is the relative absence of an obvious, coherent and

consistently implemented framework of fundamental policy

objectives. Rather than being obvious, fundamental policy is often

obscured by excessive operational detail. A key task in simplifying

the Australian tax system at present therefore becomes one of

reducing the amount of operational detail and stating fundamental

policy objectives clearly.

This chapter identified the following thirteen specific causes of

complexity in the Australian tax system.

First, obscuring of fundamental policy framework through

excessively detailed operational rules due to: (i) cumulative

development of rules; and (ii) insufficiently clear and explicit

principles governing priorities between rules.

Second, the use of complex anti-overlap provisions reconciling

potentially operative provisions.

Third, rules rendered unnecessary by subsequent

developments.

Fourth, rules whose literal meaning is rarely or never enforced.

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Fifth, duplication of interpretative and computational rules.

Sixth, rules for exceptional circumstances assuming a disproportionate significance.

Seventh, poor targeting of rules.

Eighth, rules affecting the derivation of income and gains or the incurring of expenses and losses through entities where parts of the rules operate at different levels of the entity.

Ninth, the use of specific anti-avoidance provisions and a general anti-avoidance provision concurrently.

Tenth, the use of detailed computational steps (method statements) without indicating the overall purpose and the effect of the computational steps.

Eleventh, the inclusion of material that is irrelevant to some

taxpayers in operative rules and computational steps.

Twelfth, complex consequential policy choices.

Thirteenth, inconsistencies between domestic law and

Australia’s Double Tax Treaty obligations.

Subsequent chapters will examine these causes of complexity

in greater detail through the use of case studies, and will make

recommendations for the repeal or redrafting of certain provisions

and for a process for rewriting tax laws so as to reduce the amount

of operational detail and to give greater prominence to fundamental

principles.

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CHAPTER THREE CASE STUDIES ILLUSTRATING THE INTERACTION OF SOME CAUSES OF COMPLEXITY

1. IntroductionThirteen causes of the complexity of Australian income and fringe

benefits tax laws were identified in Chapter Two. This chapter

contains ten case studies illustrating several of the causes of

complexity noted in Chapter Two. it is important to note that these

causes of complexity do not operate in isolation. As several of the

case studies show, in many circumstances more than one cause of

complexity will be operating and often the interaction of different

causes will exacerbate the complexity of the system.

2. Case Study One: Treatment of non-cash benefits provided outside an employment relationship

Case study illustrates the operation of the first and second

causes of complexity in Chapter Two.

Assume that the facts in FCT v Cooke and Sherden (1980) 10

ATR 696 occurred in 2006. For a reader unfamiliar with the result

in Cooke and Sherden, to determine whether the non-transferable

holidays are either included in the recipient’s assessable income

or whether the soft drink manufacturer was subject to FBT on the

provision of the holidays, it would be necessary to consider the

following questions:

(a) Does iTAA97 s 6-5 apply without the aid of any other

provision?

(b) Does iTAA36 s 21A mean that iTAA97 s 6-5 can apply?

(c) Does iTAA36 s 26(e) apply?

(d) is the provision of the holidays a fringe benefit for purposes of

FBTAA?

The analysis in relation to the above questions would then be as

follows:

(a) No. As the holidays are not convertible into cash, the rule

in Tennant v Smith [1892] AC 150 means that, absent the

operation of specific deeming provisions, they are not ordinary

income and s 6-5 will not apply without the aid of another

provision.

(b) No. Although s 21A means that a non-cash business

benefit that is not convertible into cash is treated as if it

were convertible into cash, s 21A(4) means that the amount

brought to account under s 21A(2) will be reduced by the

‘non-deductible entertainment percentage’. In the Cooke and

Sherden circumstances, arguably the whole of the soft drink

manufacturer’s expenditure on the holidays would fit within

the definition of ‘non-deductible entertainment expenditure’

in ITAA97 s 32-5. Hence the ‘non-deductible entertainment

percentage’ would be 100%, which would mean that no part

of the non-cash benefit would be brought to account under

ITAA36 s 21A(2).

(c) No. Following the decision in Cooke and Sherden itself, the

requirements for s 26(e) are not met, as the holidays are not

provided in respect of employment or services rendered.

(d) No. The soft drink distributors are not in receipt of ‘salary

or wages’ as defined. Hence they are not employees for

purposes of the FBTAA. hence the provision of the holidays is

not by an employer to an employee or associate. hence the

provision of the holidays is not a fringe benefit.

if an experienced practitioner were asked this question he or she

would abbreviate this process considerably if the facts were an

exact replica of those in Cooke and Sherden. A practitioner would

know that the overall policy of the current law is that where a

provision of entertainment to a non-employee is non-deductible

to the provider, it is not assessable to the recipient and is not

subject to FBT. The practitioner’s knowledge base contains the key

principle and statement of policy in this area.

This principle, however, has to be inferred from the result of

a technical analysis of the provisions and from statements in

extrinsic materials. Although an experienced practitioner might

‘cut to the chase’ in these circumstances, nothing in the legislation

directs the reader to what is really the operative question. The

‘bottom line’ of the interaction of the various provisions has to be

inferred.

Costs charged by the practitioner would rightly take into

account the value of the practitioner’s knowledge base, which

means that the mere fact that an experienced practitioner

may spend less time considering the issue would not of itself

necessarily reduce compliance costs. Rather, compliance costs

would be a function of both the length of time spent considering

the issue and of the extent and value of the knowledge base of the

person considering the issue.

Although the government proposes to remove s 26(e) of the

iTAA36 and replace it with a new s 15-2 iTAA97, this change will

not dramatically alter this compliance load. 49

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3. Case Study Two: Cost rules in CGT and capital allowance provisions

Case study illustrates the operation of the fifth cause of

complexity noted in Chapter Two.

The concept of ‘cost’ is a critical element in calculating capital

gains or losses for many CgT events. The concept is also central

to the capital allowance provisions in iTAA97 Div 40. Both the

capital gains provisions in iTAA97 and the capital allowance

provisions in ITAA97 Div 40 contain detailed definitions of ‘cost’ for

the purpose of those provisions. This section will compare the two

definitions of ‘cost’ to determine whether this is an example of an

area where the cumulative development of tax law has produced

unnecessary duplication of interpretative provisions.

The basis rules for determining the cost base of a CgT asset are

set out in iTAA97 s 110-25. Cost base consists of five elements.

The first of these is the total of:

the money you paid, or are required to pay, in respect of

acquiring it; and

the market value of any other property you gave, or are

required to give, in respect of acquiring it. The market value

of property given or required to be given is determined at

the time of acquisition of the asset. under the rule set out in

iTAA97 s 103-15, you are regarded as being required to pay

money at a particular time even if you do not have to pay it

until a later time or if it is payable by instalments.

in the Div 40 capital allowance provisions, iTAA97 s 40-185(1)(b) is,

in broad terms, the functional equivalent of the first element in the

cost base of a CgT asset. under s 40-185(1)(b), the first element

in the cost of a depreciating asset is the sum of the applicable

amounts set out in the table in s 40-185 for holding the asset or

receiving the benefit.

under the Table in s 40-185, an amount that you pay to hold

an asset or receive a benefit is included in the cost of the asset or

benefit, as is a liability incurred or increased to pay an amount that

is included when the liability is incurred or increased. The provision

of a non-cash benefit is included at its market value, as is a liability

incurred or increased to provide a non-cash benefit at the time it

is incurred or increased. The termination of a liability owed to you

by another entity or a liability owed to you to provide a non-cash

benefit is also included at the time of the termination.

As might be expected, the first element of cost for both CgT

and Div 40 capital allowances has much in common. This is

despite the fact that the definition of asset differs between Div

40 and CGT; that Div 40 refers to ‘holders’ of an asset and also

to recipients of a benefit while the CgT rules not only deal with

the cost of acquiring an asset but also with costs that relate to a

CgT event. The two sets of rules produce equivalent and arguably

identical results, except where a liability to pay an amount is

increased or is terminated.

in these situations, there are no specific CgT rules

corresponding to the Div 40 rules. There do not appear to be

any sound reasons why the CgT rules should not also deal with

these situations explicitly. it may be that an increase in a liability

would form part of the cost base of an asset for CgT purposes,

as a requirement to pay money in respect of acquiring it. greater

certainty would be produced if the CgT rules stated this explicitly.

There is no explicit rule that the termination of an existing liability

(for example by a forgiveness of debt) will be included in the cost

base of an asset for CgT purposes. Again the presence of an

explicit rule would clarify the position here.

The fourth element of the cost base of a CgT asset under

iTAA97 s 110-25(5) [capital expenditure to increase the value of

the asset] broadly corresponds with the second element in the

cost of a depreciating asset under iTAA97 s 40-190 [amounts that

have contributed to bringing the asset to its present condition and

location]. Section 40-190 is broader than s 110-25(5). Expenses of

obtaining delivery and duties, such as any customs duty payable,

would clearly be included within s 40-190. Such amounts would

not form part of the fourth element of the cost base of a CgT asset

but rather would probably be included in the second element of

CgT cost base as costs of transfer under s 110-35(3).

in some respects, the combined operation of the second and

fourth elements of the cost base of a CgT asset is wider than

the second element of the cost base of a depreciating asset. For

example, the second element of the cost base of a CgT asset

includes incidental costs of disposal, whereas such items are

subtracted in determining terminating value for Div 40 purposes

but are not included in the cost as such of a depreciating asset.

The Div 40 cost rules contain no precise equivalent to the fifth

element of CgT cost base (i.e. costs of establishing, preserving or

defending title). it is likely that such expenses would be included

via s 40-185(1)(b) as a cost of holding the depreciating asset.

modifications to the CgT and Div 40 cost rules also tend

to duplicate each other and frequently produce corresponding

results. Examples can be seen in the case of the following rules:

(see table)

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Situation CGT Rule Div 40 Rule

Splitting of assets s 112-25(2) and (3) s 40-205

merger of assets s 112-25(4) s 40-210

Non-arm’s length acquisition

s 112-20(1)(c) and (2) s 40-180 item 8

gifts s 112-20(1)(a) and (b)

s 40-180 item 9

Apportionment between two or more assets acquired

s 112-30(1) s 40-195

There are, of course, several respects in which the cost rules

differ between CgT and Div 40. For example, the third element

of CgT cost base specifically includes certain non-deductible

non-capital costs of ownership, while non-capital amounts are

specifically excluded from the cost of a depreciating asset for Div

40 purposes. Other differences are consequences of the general

characteristics of each regime. So, for example, CgT cost base

includes the indexation of its elements in certain circumstances,

whereas cost for Div 40 purposes does not. Conversely, Div 40

contains cost rules dealing with the car depreciation limit, which

the CgT provisions do not.

in many instances, the differences between these and other

cost rules in the iTAA appear to be consequences of the historical

development of rules over time. A strong case can be made for

having a common set of cost rules located in a part of the iTAA

dealing with the calculation of gains (whether capital or income)

generally. in instances where there is a sound policy reason to vary

the common rules, that variation could appear as an exception in

the common cost rules section. Recommendations to this effect

are made in Chapter Four.

4. Case Study Three: Application of the dividend imputation system to most resident companies

Case study illustrates the sixth and seventh causes of

complexity noted in Chapter Two.

Currently many of Australia’s rules for taxing companies and their

shareholders apply equally to public and private companies.

Several key features of Australia’s dividend imputation system

are consequences of a policy of not extending franking credits

to non-resident shareholders, and of a policy of washing out

corporate tax preferences when they are distributed to resident

shareholders. Where a company does not have any non-resident

shareholders, it may be desirable to allow the company the

option of using a simpler system of corporate tax integration that

produces equivalent results to the Australian dividend imputation

system.

in the 2002-2003 income year, 248,880 or 89% of tax-paying

companies were private companies. These companies paid

36.74% of the net company tax paid in 2002-2003. There were

also 349,733 private companies that either were loss-making or

that had zero taxable income. This represented 97% of non-tax-

paying companies. The total income of all private companies in

2002-2003 was $577,824,895,424, while the total taxable income

of all private companies was $47,417,578,189. Of all private

companies in 2002-2003, only 1,192 or 2% paid more than

$1,000,000 in company tax. This represented 47% of all tax-

paying private companies in 2002-2003.50

Clearly a significant proportion of private companies do not

have non-resident shareholders. Although the published Taxation

Statistics do not directly disclose the number of non-resident

shareholders in Australian companies, they are consistent with this

conclusion

in the 1999-2000 income year, the last year in which statistics

on dividend withholding tax payments were separately reported,

only 406 companies (excluding nominee companies of securities

dealers) paid a total of $60,849,000 in dividend withholding tax.51

in 2002-2003 a total of 225 non-taxable and a total of 246

taxable private companies claimed a total of $19,064,582 in

iTAA36 s 46FA deductions. A total of nine non-taxable and five

taxable public companies claimed a total of $75,684,082 in s 46FA

deductions in the same period. given that some companies may

have paid franked dividends to non-resident shareholders, the total

number of private companies with non-resident shareholders is

likely to be higher than the number of private companies that paid

unfranked dividends or claimed s 46FA deductions, but is still likely

to be a clear minority of private companies.52

4.1 Current policy results in Australian dividend imputation system

The Australian dividend imputation system is one of several

alternative approaches to integrating a country’s corporate and

shareholder tax systems. Currently the dividend imputation system

achieves the following policy results:

The overall rate of tax on taxed income passing through

a resident company to a resident individual shareholder

represents taxation of that income at the shareholder’s

marginal rate;

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Tax-preferred income (including tax-preferred foreign

source income) distributed by a resident company to a

resident shareholder (individual or corporate) is taxed at the

shareholder’s marginal rate;

Tax credits given to resident shareholders are limited to the

franked portion of the distribution that represents tax paid or

payable by the resident company;

Except where a resident company attaches franking credits to

a distribution in circumstances that ultimately trigger a liability

for franking deficit tax, a compensatory tax is not levied on

distributions of income that has not borne Australian corporate

tax;

Resident companies (because of the benchmark franking rule)

can retain untaxed income and distribute taxed income with

franking credits attached;

Taxed income retained by resident companies is only taxed at

the corporate rate until it is distributed, but personal services

income alienation provisions may mean that the income is

taxed at the marginal rate of the person providing the personal

services;

The streaming of franking credits away from shareholders

who have little or no use for them is circumvented by the

benchmark franking rule and by several specific anti-dividend

streaming rules;

Trading in franking credits by shareholders is circumvented by

specific anti-franking credit trading measures; and

To the extent that a distribution by a resident company to a

non-resident shareholder (individual or corporate) represents

taxed income, it is exempt from Australian withholding tax

but no gross up or tax offset is given to the non-resident

shareholders.

4.2 Concessional alternative approach: Dividend deduction system

Where a company has only resident individual shareholders, one

way in which substantially equivalent results to those produced

under the Australian dividend imputation system can be achieved

more simply is by permitting the company to use a form of

dividend deduction system. To achieve taxation of distributed

income (whether subject to corporate tax or not) at the resident

individual shareholder’s marginal rate, the company would need to

be permitted to carry tax losses resulting from dividend deductions

both forward and back. Companies would not be permitted to

carry losses back earlier than the year when they joined the

dividend deduction system. Adjustments would need to be made

in the value of losses carried forward or back for changes in the

corporate tax rate between periods, and an ordering rule for the

application of losses attributable to different periods would need to

be developed.

Because of the existence of the secondary market for shares

in listed companies, such a system would not be appropriate for

listed companies, or subsidiaries of listed companies. To prevent

dividends being diverted to non-residents through the use of

intermediate entities, it would also be necessary to limit the entities

who could own shares or other interests in an optional dividend

deduction company to resident individuals or intermediate entities,

in which the only stakeholders were resident individuals who were

not trustees.

A company electing for dividend deduction treatment would not

need to maintain a franking account, would not need to apply the

franking rules to distributions, and would not be subject to either

the anti-dividend streaming or the anti-franking credit trading rules.

Shareholders receiving dividends would simply be taxed on the

amount of the dividend without the need to apply the gross up and

credit mechanism.

Companies in the imputation system (and other interposed

entities, such as trusts and partnerships) receiving dividends from

dividend deduction companies would simply treat the dividend as

they would an unfranked dividend.

A rule would need to be developed for the situation where a

dividend deduction company received a franked dividend. One

possibility here would be to require the company to track franking

credits on dividends received and to attach them to dividends that

it paid using an ordering rule like the benchmark franking rule.

Such an approach would reintroduce much of the complexity that a

dividend deduction option was aimed at avoiding.

Another approach would be to treat the dividend deduction

company as a conduit in much the same way as partnerships and

trusts are treated in the dividend imputation system. A difficulty

with this approach is that the current rules giving conduit treatment

to partnerships and trusts for imputation purposes are premised

on the allocation of net income or of partnership losses on the

basis of entitlement rather than actual distribution. By contrast,

under a dividend deduction system corporate income is only

assessable to a shareholder on distribution. To make conduit

treatment of franking credits received by a dividend deduction

company dependant on actual distribution would again impose

the complexities of tracking and franking requirements on dividend

deduction companies.

A better alternative may be to pursue the trust analogy more

closely and to only allow a shareholder in a dividend deduction

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company a franking credit if, and to the extent that, the franked

distribution received was redistributed as a dividend in the year

of receipt. Such a rule might be thought to be appropriate in a

concessional measure and would be likely to lead to immediate

redistributions of franked dividends received.

it would not be practical to implement a rule of the type

discussed in the previous paragraph where a company had

more than one class of shareholder. hence it would appear to be

necessary that a company electing to receive dividend deduction

treatment only have one class of shareholder. if this limitation

were in place, an alternative approach would be to regard franked

dividends received by a dividend company as being included in

the assessable income of shareholders irrespective of their actual

distribution. This approach would be unfair to shareholders who

had no control over the distributions of the company, although

similar unfairness might be thought to be present in the existing

rules governing the taxation of trusts and partnerships. unfairness

in the application of this rule to companies opting for dividend

deduction treatment could be mitigated by imposing limits on the

number of shareholders that a company choosing the dividend

deduction option was permitted to have.

A company under an optional dividend deduction system

would be able to choose to retain its tax-preferred income and to

distribute its taxable income. To the extent that it did this it would

achieve the same end effect as does a company under Australia’s

dividend imputation system that chooses to retain tax-preferred

income and to distribute its taxed income as franked dividends.

An optional dividend deduction system could produce a result

that a company that distributed tax-preferred income generated

a larger loss carried forward, which could then be offset against

its future assessable income. The end result of such an action

would be equivalent to that produced in the Australian dividend

imputation system if the company had only distributed its taxed

income as franked dividends in both years. The combined

corporate and shareholder tax paid under both systems would be

identical if the companies adopted their dividend policies to the

characteristics of the two corporate tax systems.

under an optional dividend deduction approach, corporate

income would only bear tax at the corporate rate so long as it

remained in corporate solution. hence introducing an optional

dividend deduction approach would not of itself do anything to

counteract any tax planning that diverted personal services income

to companies.

Assuming that capital gains on shares would continue to be

given preferential tax treatment, there would be a continuing need

for functionally equivalent rules to those dealing with tainted share

capital accounts and anti-capital benefit streaming. Obviously

debits in franking accounts could not be used as a sanction in

these situations. in fact, the solutions to these problems are likely

to be simpler in a dividend deduction system.

For example, the problem of profits being capitalised and then

distributed as returns of capital could be dealt with by defining

the share capital account as excluding an account containing

capitalised profits or polluted in other ways, and by continuing

the current rule that distributions from a polluted share capital

account are regarded as dividends. Similarly, the rules concerning

off-market buy backs would need to be adapted to the optional

dividend deduction system, but this would not give rise to any

significant problems. Deemed dividend rules for loans and debt

forgiveness would also need to be adapted, but there would be no

point in applying deemed dividend rules in relation to excessive

salary payments.

The tax treatment of returns on domestic debt and equity

interests would be virtually identical under an optional dividend

deduction system. The only difference of substance between

the two treatments would be that losses attributed to dividend

deductions could be carried both backward and forward under

a dividend deduction system. hence if an optional dividend

deduction system were to be introduced, it may be desirable to

permit at least all dividend deduction companies to carry all losses

back to the year of entry into the dividend deduction system, as

well as forward.

Where no interests in a dividend deduction company were

controlled, directly or indirectly, by non-residents, there would be

no reason for applying the inbound thin capitalisation rules to them.

Whether the debt and equity rules would need to be applied to

them would depend on whether it was thought to be necessary to

apply the outbound thin capitalisation rules to them.

it is likely that it would be necessary to apply the outbound thin

capitalisation rules to dividend deduction companies. Otherwise

dividend deduction companies could obtain inflated deductions

in relation to non-assessable non-exempt income in the form of

foreign source non-portfolio dividends and branch profits. if a

dividend deduction company did not have any interest-holders

who were non-residents and did not have any offshore income in

the form of branch profits or non-portfolio dividends, it could be

exempted from the operation of both the debt and equity rules and

the outbound thin capitalisation rules.

Arguably there would be little or no need to apply outbound thin

capitalisation rules where the only offshore income of a dividend

deduction company was portfolio dividends. hence there would

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be scope for excluding optional dividend deduction companies

from the outbound thin capitalisation rules if either they did not

have non-assessable non-exempt foreign source income or if their

non-assessable non-exempt foreign source income was below a

specified percentage of their total income.

The legal complexity and associated compliance costs of

a dividend deduction system at both the company and the

shareholder level would be likely to be substantially less than the

legal complexity and associated compliance costs of the current

Australian dividend imputation system. As fewer companies and

shareholders would be subject to the greater legal complexity and

higher compliance costs of the dividend imputation system, the

effective complexity of the income tax system would also be likely

to be reduced.

it is also likely that administrative costs associated with a

dividend deduction system would be lower than those associated

with the current Australian dividend imputation system (auditing

of dividend deduction companies that did not maintain franking

accounts nor frank dividends would appear to be simpler, as would

assessing tax returns by shareholders who generally would not be

claiming a gross up and credit). This would also be likely to reduce

the effective complexity of the income tax system.

For these benefits to arise, the rules for electing for dividend

deduction treatment would need to be simply and clearly set out.

The key features of companies that would be permitted to elect for

dividend deduction treatment would be:

The company is a private company for tax purposes;

The company has only one class of shareholders;

All shareholders in the company are residents;

No shares or other interests in the company are held by tax-

exempt entities;

The only entities that are permitted to own shares in the

company are resident individuals or other resident intermediate

entities, in which the only stakeholders are resident individuals

who are not trustees; and

The number of shareholders in the company does not exceed

a specified number (e.g. the number equal to the number of

partners possible in a general partnership).

The company would also be excluded from the operation of the

inbound thin capitalisation rules, where no interests in the company

were held by non-residents. The company would be able to be

excluded from the operation of the debt and equity rules and the

outbound thin capitalisation rules on an annual basis if it either

had no non-assessable non-exempt foreign source income or if

its non-assessable non-exempt foreign source income fell below a

specified percentage.

Arguably the exclusion of both tax exempt entities and non-

residents from owning shares in an optional dividend deduction

company would mean that the system did not infringe non-

discrimination articles in Australia’s Double Taxation Agreements.

The argument being that the exclusion of both types of shareholder

shows that the intention is not to discriminate against companies

controlled by non-residents, but to prevent base erosion through

the payment of dividends in a dividend deduction system where

the shareholder rate of tax was either low or zero.

At a more general level, this case study illustrates the need to

examine in all cases whether the operational rules giving effect

to fundamental policy choices are properly targeted. Where the

rationale behind a particular rule only is relevant to a small minority

of taxpayers, then prima facie the rule should be regarded as

poorly targeted. in these cases, exceptional circumstances have

had a disproportionate influence on the design of tax rules.

The recommendations made in Chapter Eight for a more

comprehensive redrafting of Australia’s income and fringe

benefits tax laws take into account the need to first identify the

fundamental policies and principles sought to be legislated. This

report supports a principle that, where possible, rules should be

targeted so that they only affect taxpayers engaged in transactions

or with characteristics that make the rationale behind the rule

relevant to them. The targeting of rules in this manner could

result in the development of multiple sets of rules for different

types of taxpayers. The view taken in this report is that such

development should only be permitted where it can be shown

that the characteristics of different types of taxpayers justify the

development of separate sets of rules and that the development

will result in reduced compliance costs.

5. Case Study Four: The operation of CGT Event E4

Case study illustrates the first, second, tenth, eleventh and

twelfth causes of complexity identified in Chapter Two.

There is a high degree of legal complexity involved in the

interaction of CgT event E4, the calculation of the non-assessable

part of a trust distribution in s 104-71, the gross up rules for capital

gains flowing through trusts in s 115-215; the operation of the CgT

discount rules in Division 115, the application of the small business

concessions in Division 152, and the operation of the rules for

applying capital losses and net capital losses against capital gains.

moreover, these rules potentially affect any investor in a unit trust,

many of whom are retirees who might be thought to

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have either insufficient background or the economic resources to

either comprehend the rules or to pay for the services of experts to

interpret them.

The following examples illustrate some of the complexity that

can typically be involved in the interaction of these provisions.

Following the examples some observations are made on why

the interaction of these provisions is so complex. An attempt is

then made at redrafting the provisions. This is followed by an

explanation of the redraft, which points out the respects in which it

should reduce the legal and effective complexity of the interaction

of these provisions.

5.1 Example 1: Interrelationship between CGT and the trust rules

Alpha, Beta, Gamma Pty Ltd and Delta Pty Ltd each own 1000

units in the ABGD Unit Trust. Each of Alpha, Beta and Gamma

Pty Ltd are sui juris Australian residents and the units are post-

CGT assets to each of them. Each unit was acquired on 1 January

2004 at a cost of $1. In the year ending 30 June 2005, the ABG

Unit Trust has a trust income of $100,000 and a net income for

tax purposes of $50,000. The excess of trust income over net

income was due to the ITAA97 s 102-5(1) general 50% discount

applying to the calculation of the capital gain taken into account in

the trustee’s s 95 calculation of the net income of the trust estate.

On 30 June 2005, the ABGD Unit Trust makes a distribution of

$1 per unit to each of its unit holders. The trustee advises the

unit holders that 50c of each dollar distributed represents a net

capital gain taken into account in the trust’s s 95 calculation and

50c represents a distribution of the s 102-5(1) 50% discount

component.

For the year ending 30 June 2005 Alpha had no capital losses

from other activities, Beta had a capital loss of $600 from the sale

of shares in listed companies and a non-discounted capital gain

of $400 from another share sale, Gamma Pty Ltd had no capital

losses from other activities, while Delta Pty Ltd had a capital loss

of $800 from a sale of shares in other listed companies.

The effects of the distribution of $1000 to each of the unit

holders will be as follows:

Alpha

Assessment of distribution of net capital gain component:

Share of net capital gain included in assessable

income via s 97(1)$500

Extra assessable capital gain included via s 115-

215(3)(b)$1000

Apply 50% discount to s 115-215(3)(b) inclusion $500

Net s 115-215(3)(b) inclusion $500

Assessable income $1000

Deduction under s 115-215(6) of the part of the s

97(1) inclusion of the trust estate’s net capital gain

mentioned in s 102-5(1) $500

Taxable income from distribution $500

CGT effects of non-assessable component in distribution

The calculation of the non-assessable component for purposes of

CgT event E4 is determined by s 104-70. under s 104-70(1)(b),

the ‘non-assessable part’ is the part of the distribution that is not

included in your assessable income. In Alpha’s case, this is $500,

being the 50% discount component in the distribution. Subsection

104-70(1) goes on to state that in working out what part of the

payment is included in your assessable income, “disregard your

share of the trust’s net income that is subject to the rules in s 115-

215(3)”.

Unfortunately the phrase “your share of the trust’s net income”

is not used in s 115-215(3) itself. Subsection 115-215(1) does

state that the purpose of s 115-215 is to “ensure that appropriate

amounts of the trust estate’s net income attributable to the

trust estate’s capital gains are treated as a beneficiary’s capital

gains”. It is not clear from the terms of s 104-70(1) whether this

statement refers to the share of net income that is included in

the beneficiary’s assessable income via s 97(1) itself or whether

it refers to the additional capital gain included via s 115-215(3).

The former reading, however, appears to be inconsistent with the

Example that follows s 104-71.

hence the latter reading is to be preferred, even though it is

difficult to see how the extra capital gains that the beneficiary

is treated as having under s 115-215(3) can be said to be the

beneficiary’s “share of the trust’s net income that is subject to the

rules in s 115-215(3).” If this was the intent of Parliament, then

it would have been more clearly expressed if s 104-70(1) had

referred to “any extra capital gains that you are regarded as having

because of the operation of s 115-215(3)”.

In Alpha’s case, an adjustment to the non-assessable part is

then made via item 1 in the Table in s 104-71(4). This will mean

that so much of the distribution as reflects the 50% general CgT

discount, i.e. $500 at the trust level will be excluded from the non-

assessable amount.

Hence in Alpha’s case the non-assessable amount of the

distribution will be zero. hence no capital gain will be made by

Alpha under s 104-70(4) and there will be no reduction in the cost

base of Alpha’s units under s 104-70(6).

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Beta




Extra capital gain included in assessable income via s

115-215(3)(b)$1000

Capital gain from other share sale $400

Capital gain from other share sale after offsetting

capital loss of ($600) against it$0

Extra capital gain included via s 115-215(3)(b)

following offset of balance ($200) of capital loss$800

Apply 50% discount to s 115-215(3)(b) inclusion after

offsetting balance of capital loss$400

Net capital gain $400


Deduction under s 115-215(6) of the part of the

s97(1) inclusion of the trust estate’s net capital gain

mentioned in s 102-5(1)

$500

Taxable income $400


in these circumstances, the CgT effects for Beta of the non-

assessable component in the distribution will be the same as for

Alpha.

Gamma Pty Ltd




Extra capital gain included in assessable income via

s 115-215(3)(b) $1000



Deduction under s 115-215(6) of the part of the

s97(1) inclusion of the trust estate’s net capital gain




in these circumstances, the CgT effects for gamma Pty Ltd of the

non-assessable component in the distribution will be the same as

for Alpha as discussed above.

Delta Pty Ltd

Assessment of distribution of net capital gains component

Share of net capital gain included in assessable income via s 97(1)

$500

Extra capital gain included in assessable income via s 115-215(3)(b) $1000

Extra capital gain included via s 115-215(3)(b) following offset of capital loss ($800) from other share sale $200


Deduction under s 115-215(6) of the part of the s 97(1) inclusion of the trust estate’s net capital gain mentioned in s 102-5(1) $500

Taxable income $200


in these circumstances, the CgT effects for Delta Pty Ltd of the

non-assessable component in the distribution will be the same as

for Alpha as discussed above.

5.2 Example 2: Impact of the small business CGT concession

Assume the facts in Example 1 with the variation that the 50%

small business discount also applied to the capital gain derived

by the trust. hence the trustee would advise the unit holders that

the $1000 distributed to each of them consisted of a general 50%

discount of $500 a small business 50% discount of $250 and a net

capital gain of $250.



Alpha



$250

Extra capital gain included in assessable income via s 115-215(3)(c)

$1000

Apply the 50% discount to the s 115-215(3)(c) inclusion

$500

Apply the small business 50% discount to the s 115-215(3)(c) inclusion $250

Net s 115-215(3)(c) inclusion $250




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The calculation of non-assessable component for purposes of

CgT event E4 is determined by s 104-70. under s 104-70(1)(b) the

‘non-assessable part’ will be the part of the distribution that is not

included in your assessable income. In Alpha’s case this is $750,

which represents the 50% discount and the 50% small business

discount components in the distribution.

In Alpha’s case, an adjustment to the non-assessable part is



discount at the trust level, i.e. $500, will be excluded from the non-

assessable amount.

Hence in Alpha’s case, the non-assessable amount of the

distribution will be $250 or 25c per unit.. hence no capital gain will

be made by Alpha under s 104-70(4) but s 104-70(6) will reduce

Alpha’s cost base by 25c to 75c.

Beta



$250


$1000

Capital gain from other sale $400

Capital gain from other sale after offsetting of capital loss of ($600) against it

$0

Extra capital gain included via s 115-215(3)(c) following offset of balance ($200) of capital loss $800

Apply 50% discount to s 115-215(3)(c) inclusion after offsetting of balance of capital loss $400

Apply small business 50% discount to s 115-215(3)(c) inclusion after offsetting of balance of capital loss $200




Taxable income $200


Under s 104-70(1)(b) the ‘non-assessable part’ will be the part of

the distribution that is not included in your assessable income.

In Beta’s case this again is $750, being the distribution less the s

97(1) inclusion.

In Beta’s case, an adjustment to the non-assessable part is



discount at the trust level, i.e. $500, will be excluded from the

non-assessable amount. A further adjustment will be made under

item 3 in the Table in s 104-71(4). This will mean that one quarter

of the capital loss of $600, i.e. $150, will be excluded from the

non-assessable amount. hence the non-assessable part will be

reduced by $100 or 10c per unit. hence there will be no derivation

of a capital gain by Beta, but the cost base of Beta’s units will be

reduced by 10c per unit to 90c.

Gamma Pty Ltd




Extra capital gain included in assessable income via

s 115-215(3)(c)$1000

Apply the 50% small business discount to s 115-

215(3)(c) inclusion$500



Deduction under s 115-215(3)(c) of the part of the

s 97(1) inclusion of the trust estate’s net income

mentioned in s 102-5(1)$250




the distribution that is not included in your assessable income.

Again, in Gamma’s case this is $750, being the distribution less the

s 97(1) inclusion.

In Gamma’s case, an adjustment to the non-assessable part is



discount, i.e. $500, at the trust level will be excluded from the non-

assessable amount.

Hence in Gamma’s case the non-assessable amount of the

distribution will be $250 or 25c per unit. hence no capital gain

will be made by gamma under s 104-70(4), but the cost base of

Gamma’s units will be reduced by 25c per unit to 75c. The 25c

per unit effectively represents the 50% small business concession,

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which has meant that 25c per unit was not included in gamma Pty

Ltd’s assessable income via s 115-215.

Delta Pty Ltd



$250


$1000

Extra capital gain following application of capital loss of ($800) against it $200

Apply 50% small business discount to s 115-215(3)(c) inclusion following application of capital loss against it $100







the distribution that is not included in your assessable income. in

Delta’s case this again is $750, being the distribution less the s

97(1) inclusion.

In Delta’s case, an adjustment to the non-assessable part is



discount, i.e. $500, at the trust level will be excluded from the

non-assessable amount. There would be a further adjustment

under item 4 in the Table in s 104-71(4), which would mean that

the excess of Delta’s proportion of the small business reduction

applied at the trust level $250 over the small business reduction

of $100 applied at Delta’s level (i.e. $150) will further reduce the

non-assessable amount. hence the non-assessable amount will be

$100 or 10c per unit. This will mean that no capital gain will accrue

to Delta but that the cost base of Delta’s units will be reduced by

10c to 90c per unit.

5.3 Example 3: Interrelationship of ITAA97 Division 43 and CGT

Assume the facts in Example 1 with the variation that $500 of the

distribution to each unit holder is attributable to a non-discounted

net capital gain taken into account in the trust’s s 95 calculation,

and $500 (being the unit holder’s proportion of the excess of trust

income over net income) was attributable to Division 43 deductions

being allowed for tax purposes only.



Alpha



$500

Extra capital gain included in assessable income via s 115-215(3)(b) $500







Alpha’s case this is $500, being the distribution less the amount

assessable under s 97(1).

Hence in Alpha’s case the non-assessable amount of the

distribution will be $500 or 50c per unit. hence no capital gain will

be made by Alpha under s 104-70(4), but s 104-70(6) will reduce

the cost base of Alpha’s units by 50c per unit to 50c.

Beta



$500


$500

Net capital loss following offsetting of capital loss of ($600) against extra capital gain ($100)





Under s 104-70(1)(b)the ‘non-assessable part’ will be the part of

3636 37



Beta’s case this is $500, being the distribution less the amount


Hence in Beta’s case the non-assessable amount of the


be made by Beta under s 104-70(4), but s 104-70(6) will reduce the

cost base of Beta’s units by 50c per unit to 50c.

Gamma Pty Ltd

Gamma Pty Ltd’s position in these circumstances will be the same

as Alpha’s.

Delta Pty Ltd




Extra capital gain included in assessable income via s

115-215(3)(b) $500

Net capital loss following offsetting of capital loss of

$800 against extra capital gain ($300)


Deduction under s 115-215(6) of the part of the s

97(1) inclusion of the trust estate’s net capital gain






Delta’s case this is $500, being the distribution less the amount


Hence in Delta’s case the non-assessable amount of the


be made by Delta under s 104-70(4), but s 104-70(6) will reduce

the cost base of Delta’s units by 50c per unit to 50c.

5.4 Some causes of complexity in the interaction of these provisions

The above Examples are relatively simple, but nonetheless

calculation of the beneficiary’s capital gains and of the effect of

CGT event E4 on the cost base of the beneficiary’s interest or

units in the trust is highly complex. Some of the causes of this

complexity appear to be:

5.4.1 Complexpolicychoicesmeanthatalargenumber ofCGTconcessionsoperateattrustlevelanddifferent treatmentsareaccordedtoseveralofthemon distribution

As the above examples show, the treatment at the beneficiary

level of distributions representing an excess in the income of

the trust estate over the net income of the trust estate differs

according to the type of tax-preferred income that is distributed.

Where the excess is due to the general 50% discount

component in a capital gain made by the trust, a distribution of

the excess is not taxable to the beneficiary and does not reduce

the cost base of the beneficiary’s interest in the trust. Where

the beneficiary has capital losses or net capital losses, these

are absorbed against the grossed up capital gain portion of the

distribution, and hence may reduce the value of the discount to

the beneficiary.

The grossing up of the capital gain component in the

distribution at the beneficiary level and the reapplication of the

discount at the beneficiary level is to implement the general

policy that capital losses should be offset against capital gains

before any general discounts are applied. Where the beneficiary

is a company, the gross up occurs but no discount is allowed,

with the result that the capital gain is given equivalent treatment

to the treatment it would have received if it had been derived

directly by the company.

Where the excess is due to the small business 50% discount,

a distribution of the excess is not immediately assessable to

the beneficiary but reduces the cost base of the beneficiary’s

interest in the trust. For both individual and corporate

beneficiaries, the excess is grossed up and capital losses

and net capital losses are absorbed against the grossed up

distribution before the small business discount is applied.

Where the excess is due to a gain on a pre-CgT asset, a

distribution of the excess is not immediately assessable to

the beneficiary but reduces the cost base of the beneficiary’s

interest in the trust. The distribution is not grossed up and

the beneficiary’s share of the net income of the trust estate is

assessable via iTAA36 Div 6 (for example under s 97(1)). No

gross up or replication of the discount occurs, as no discount

arose at the trust level and no taxable capital gain was derived

by the trust.

Similarly, where the excess is due to Division 43 deductions

being available to the trust, a distribution of the excess is not

immediately assessable to the beneficiary but reduces the cost

base of the beneficiary’s interest in the trust. Again, for the

same reasons as applied in the case of a distribution of a gain

on a pre-CgT asset, the distribution is not grossed up and

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the beneficiary’s share of the net income of the trust estate is

assessed via Div 6 of iTAA36.

hence it can be seen that any one of the following treatments

of a distribution of the excess can occur at the beneficiary level:

Not immediately assessable on distribution; reduction in

cost base; grossed up for purposes of capital loss offsetting;

Not immediately assessable on distribution; no reduction in

cost base; grossed up for purposes of capital loss offsetting;

Not immediately assessable on distribution; reduction in cost

base; and

Not grossed up for purposes of capital loss offsetting.

5.4.2 Drafter’sapproachtoimplementingtheorderingrulefor applicationofcapitallossesanddiscountsat thebeneficiarylevelexacerbatescomplexpolicychoices

The complexities produced by the complex policy choices

are exacerbated by practical problems associated with

implementing them. The policy of grossing up the distribution

so as to offset capital losses before applying the general or

small business 50% discounts, and the approach adopted by

the drafter have resulted in the amount of the gross varying

according to whether only one or both of the discounts was

taken into account at the trust level. There is also artificiality in

grossing up the capital gains component by the multiplication

method rather than by simply adding together the various

capital gains and discount components in the distribution.

5.4.3Organisationofprovisionspromotesconsiderationof itemsirrelevanttomanytaxpayers

For unit holders in a listed unit trust, many of the items in s 104-

71 and in s 115-215 would be irrelevant (e.g. small business

concessions (15 year in s 104-71 and 50% discount in s 115-

215, PSi 86-15 exemption)).

For many unit holders, the items in s 104-71(3) would be

irrelevant (i.e. exempt income arising from shares in PDF and

infrastructure borrowings).

Simplicity would be improved by a differently organised

provision that stated the general rule or the rule for the most

common situations first, and then stated the rules for more

unusual circumstances. Also, a general statement of the policy

intent of the rules would be helpful. The recommendations for a

more comprehensive redrafting of Australia’s income and fringe

benefits tax laws in Chapter Eight adopt this approach at a

more general level.

5.4.4 Theinclusionofthecapitalgainscomponentinthe s97(1)amountinassessableincomeanditssubsequent subtraction

When s 115-215 is looked at in isolation, the inclusion of the

capital gains component in the s 97 (1) amount in assessable

income and its subsequent subtraction appears to be an

unnecessary and complicating step. it may be that the drafter

did this to simplify the identification of the non-assessable

amount in s 104-71. Nonetheless, the redraft below endeavours

to show that it would be possible to have merely one inclusion

in assessable income in these circumstances.

5.4.5 Shiftingperspectivefromwhichprovisionsviewthe distribution

in calculating the non-assessable amount in s 104-71, the

perspective from which the distribution is characterised

shifts several times. in some instances, the characterisation

is made by reference to the composition and calculation of

the net income of the trust estate, and in other instances the

characterisation is made by reference to the composition and

calculation of capital gains at the beneficiary level. This can

cause uncertainty as to which perspective is being adopted for

characterisation purposes.

6. Case Study Five: The boundary between Divisions 40 and 43

Case study illustrates the first and second causes of

complexity identified in Chapter Two.

under iTAA97 Division 40, capital allowances are deductible on a

useful life basis in respect of the decline in value of a depreciating

asset. under iTAA97 Division 43, expenditure on capital works

from 1997 onwards is generally deductible at a rate of 2.5% on

a straight line basis, where the capital works are used for the

purpose of gaining or producing assessable income. As capital

allowances based on the decline in an asset’s value over its

useful life will usually produce a greater rate of deduction than the

2.5% flat rate allowed in Division 43, the division that applies to a

particular asset will usually be a matter of considerable significance

to taxpayers.

The relationship between the two divisions is complex and

ultimately turns on applying the concept of ‘plant’ as developed in

case law. One boundary setting rule can be found in iTAA97 s 40-

45(2), which states that Division 40 does not apply to capital works

for which you can deduct amounts under Division 43.

3838 39


The relationship between the two divisions, however, becomes

more complex when the limits of the application of Division 43,

consequent on the definition of ‘construction expenditure’ in

iTAA97 s 43-70, are considered. iTAA97 s 43-70(2)(e) excludes

‘expenditure on plant’ from the definition of ‘construction

expenditure’.

The combined effect of s 40-45(2) and s 43-70(2)(e) is that,

although a building or other structural improvement does not

have to be ‘plant’ to be depreciable under ITAA97 Division 40,

expenditure on it will only give rise to Division 43 deductions,

unless (assuming that certain other exclusions from the definition

of ‘construction expenditure’ are not relevant) the building or

structural improvement is ‘plant’, in which case capital allowance

deductions will be available under Division 40.

The convoluted series of steps that the legislation takes a reader

through to reach this conclusion is indicative of the high degree

of legal complexity in the rules. As is commonly the case with the

iTAA, the relationship between the rules is not clearly stated but

has to be inferred through the application of technical rules.

The test of when a building is plant as developed in the case

law is whether the building plays an active functional role in the

taxpayer’s business that is specific to that business. This is a test

of uncertain application that depends on judgments being made

about the nature of the taxpayer’s business and the relationship

between the building and that business.

The position is further complicated where articles and machinery

become fixtures in a building. The definition of ‘plant’ in ITAA97 s

45-40 includes “articles, machinery, tools and rolling stock”.

The effect of the court decisions here is that once an article

becomes a fixture, it ceases to be an article and becomes part

of the building. Imperial Chemical Industries of Australia and New

Zealand Ltd v FCT (1970) 120 CLR 396. hence, the position here

appears to be that once an article becomes a fixture, Division 40

capital allowance deductions can only be obtained in respect of

it if it is ‘plant’, because it plays an active functional role that is

specific to the taxpayer’s business.

On the other hand, the effect of the decision in Carpenteria

Transport Pty Ltd v FCT (1990) 21 ATR 513 appears to be that

machinery does not lose its status as machinery when it becomes

a fixture. hence, Division 40 capital allowances will be available in

respect of affixed machinery because it is ‘machinery’ and thereby

‘plant’ as defined in s 45-40.

The law in this area would be considerably simplified if,

consistent with the approach to redrafting recommended in

Chapter Eight, the relationship between the two divisions was

clearly stated in positive terms at the beginning of each division.

The statement of the relationship between the two divisions should

be developed from a statement of principle as to why the two

divisions exist and differ from each other. Rather than have the

relationship turn on the meaning of the term ‘plant’ as developed

by case law relating to other provisions and in other contexts,

it would be preferable to have a clear and positive statement of

the circumstances (such as playing a specific functional role in

the taxpayer’s business) where fixtures can be depreciated under

Division 40.

6.1 Example

A dyer of yarns constructs a building post-1997 on land that it

owns. The building contains a complex ventilation and drainage

system specifically designed to assist in the dying process. Access

to the building is gained through electric roller shutter doors. A

moveable sound absorbing ceiling was installed in the building

to overcome excessive noise that would otherwise result from

the use of the dying machinery. Colourbond material is used

for the external cladding of the building due to its low cost, low

maintenance and long-lasting qualities.

under the high Court decision in Wangaratta Woollen Mills

Ltd v FCT (1969) 119 CLR 1, even if the complex ventilation and

drainage systems are regarded as fixtures, they will be ‘plant’,

as they play an active functional role in the taxpayer’s business.

hence, the combined operation of iTAA97 s 40-45(2) and s 43-

70(2)(e) will mean that Division 40 capital allowances can be

obtained in relation to them. under the same decision, the external

cladding on the building will only be regarded as excluding

the elements and not as plant. Thus, only iTAA97 Division

43 deductions can be obtained in relation to so much of the

expenditure as relates to the external cladding of the building.

On the other hand, under the decision in Carpenteria Transport,

the roller shutter doors will be regarded as plant on the basis that

they continue to be machinery, even if they have become fixtures

in the building. hence, Division 40 capital allowances can be

obtained in respect of the roller shutter doors.

however, under the decision in Imperial Chemical Industries, the

ceiling will be regarded as fixtures and merely part of a convenient

setting in which the taxpayer does business and not as plant.

hence only Division 43 deductions can be obtained in relation to

so much of the expenditure as relates to the moveable ceilings.

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7. Case Study Six: Application of CGT to depreciated property

Case study illustrates the sixth cause of complexity identified

in Chapter Two.

in most cases, CgT and the Division 40 capital allowance regime

are mutually exclusive. iTAA97 s 118-24 will generally mean that

where Division 40 deductions have been allowed in respect of the

asset and the CGT event is also a Division 40 balancing adjustment

event, any capital gain or loss from the CgT event is disregarded.

Two exceptions to this rule are expressly noted in s 118-24(2).

These are:

capital gains or capital losses made from CgT event K7

occurring; and

depreciating assets where deductions under Subdivisions 40-F

or 40-g either have been made or are allowable.

Another exception to the rule is implicit in the terms of s 118-24(1);

viz, the rule will not apply where the relevant CgT event is not a

balancing adjustment event for the purposes of Division 40. As

the lists of CGT events and balancing adjustment events do not

necessarily correspond, it is conceivable that there can be cases

where a CgT event that happens to a Division 40 depreciating

asset is not a Division 40 balancing adjustment event. In these

circumstances, CgT will apply to the event but no Division 40

balancing adjustment will be made.

CgT event K7 will potentially apply where a Division 40

balancing adjustment event happens to a depreciating asset that

has been held partly for a Division 40 taxable purpose and partly

for other purposes. That this is the scope of intended operation

of CgT event K7 is not stated explicitly in the operative provision

s 104-240, but has to be inferred from reading that provision and

s 40-25(2). ITAA97 s 40-25(2) will reduce the taxpayer’s Division

40 deduction by the part of the asset’s decline in value that is

attributable to its use for a purpose other than a taxable purpose.

This means that under the formula in s 104-240(1), the fraction

by which Termination Value minus Costs is multiplied will be less

than 1. Similarly it will mean that the fraction by which Cost minus

Termination Value in s 104-240(2) is multiplied will also be less than

1. For depreciating assets to which s 40-25(2) does not apply, the

product of the fraction used in both s 104-240(1) and (2) will be

1. This will mean that, although CgT event K7 will occur in these

circumstances, no capital gain or loss will be generated from its

operation.

7.1 Example

Greg runs a consulting business from home. He purchases a

computer and associated software on 1 July 2003 for $9000. Greg

intends to use the computer 60% for business purposes and 40%

for private purposes. Greg estimates the useful life of the computer

to be 3 years and uses the prime cost method to depreciate the

computer. The decline in value of the computer will be $3000 per

year. iTAA97 s 40-25(2) will mean that in the year ending 30 june

2005 Greg’s Division 40 deductions are reduced by the private use

component of $1200. This will mean that greg claims Division 40

deductions of $1800 in the year ending 30 june 2004. The opening

adjustable value of the computer as at 1 July 2004 will be $6000

(cost less decline in value to 30 june 2005). For the year ending

30 june 2005, the decline in value of the computer will be $3000,

but s 40-25(2) will mean that Greg’s Division 40 allowances are

reduced by $1200. The opening adjustable value of the computer

as at 1 july 2005 will be $3000. greg sells the computer for $4000

on 1 july 2004.

Because there has been a partially private use, the balancing

adjustment inclusion in income under s 40-285(1) of $1000 (being

termination value less adjustable value) is reduced by s 40-290(2).

The formula in s 40-290(2) requires the balancing adjustment of

$1000 to be multiplied by a fraction, being the sum of the s 20-

25(2) reductions (here $2,400) over the total decline in value (here

$6,000). Hence the balancing adjustment of $1000 will be reduced

by $1000 x 2400/6000 = $400. Hence the balancing adjustment

becomes $600.

CgT event K7 is also triggered but in this instance will produce

a capital loss. under s 104-240(2) the capital loss will be calculated

as Cost (here $9000) less Termination value (here $4000) x

2400/6000 = $2000.

The whole process is extremely convoluted. The absence of

a clear statement of principle anywhere means that the principle

that private use is subject to capital gains tax while business use

produces Division 40 deductions has to be inferred from working

through the interaction of a series of technical provisions. it seems

likely that the operational rules would be considerably simplified

if they were preceded by a clear statement that the intent of the

legislation is that the private element in any gain or loss is to be

subject to CGT, while the business element is to be dealt with

under Division 40.

Note also that the partial private use situation and other unusual

situations appear to have a disproportionate impact on the

4040 41


terminology used in Division 40. if these situations were treated

as exceptional with directions being given for only the business

component to be dealt with under Division 40, there would appear

to be scope for using the usual financial accounting terminology

for depreciation purposes throughout Division 40. The use of

a general direction might even enable more specific provisions

dealing with the private use and other exceptional circumstances

to be omitted, with reliance being placed on logical interpretations

of the general direction in these exceptional cases.

8. Case Study Seven: Problems with CGT anti-overlap rules

Case study illustrates the second and sixth causes of


There are two main problems with the general CgT anti-overlap

rule in s 118-20. First, it requires both a notional capital gain

and an actual revenue gain to be calculated before it comes

into operation. Second, having required both these calculations

to be made, it will normally reduce the capital gain to zero

unless specific provisions have meant that either the cost or the

proceeds from the relevant transaction differ for CgT and s 6-5

purposes. Except in the case of disposals of depreciated property

(as discussed earlier), it will only be in unusual situations that,

following an operation of s 118-20, one transaction will give rise to

both an s 6-5 inclusion and a capital gain.

hence s 118-20 is an example of a provision that applies a rule

in all situations that is only really relevant in exceptional situations.

The first example illustrates how s 118-20 theoretically requires

a taxpayer to make calculations only to then eliminate the capital

gain entirely. The second example illustrates one of the rare

situations where s 118-20 will leave a residual capital gain because

cost rules have differed between CgT and s 6-5.

8.1 Example 1

Beta Pty Ltd is in the business of investing in shares in Australian

listed companies with a view to maximising franked dividend yield.

As part of its investment strategy, it sells shares from time to time

when their franked dividend yield falls below set targets.

Consistent with the decision in London Australia Investment Co

Ltd v FCT (1977) 138 CLR 106, any profits that it makes on sales

of shares while it was pursuing this strategy would be assessable

income to it under iTAA97 s 6-5.

On 1 December 2005 it sold a parcel of shares for $200,000.

The cost of the parcel of shares to it was $100,000. For s 6-5

purposes, the profit of $100,000 will be included in Beta Pty Ltd’s

assessable income under s 6-5. Beta will also make a prima facie

capital gain of $100,000, but s 118-20 will reduce this capital gain

to zero.

An alternate method for dealing with this situation would have

been to characterise the shares as revenue assets from the outset

and make s 6-5 and CgT mutually exclusive categories. This

would mean that when the shares were sold, Beta Pty Ltd would

simply calculate the amount to be included in its assessable

income under s 6-5.

8.2 Example 2

Alpha Pty Ltd was involved in manufacturing operations for many

years. From time to time it invested a portion of its retained

earnings in shares in Australian resident listed companies, with a

view to obtaining long-term capital gains. On 1 July 2004 it sold

its manufacturing operations and invested all the proceeds of the

sale in shares in Australian listed companies. As its sole source

of income was now franked dividends, it switched its investment

strategy from the pursuit of long-term capital gains to maximising

the franked dividend yield on its shares. The new strategy meant

that from time to time it would sell shares when their franked

dividend yield fell below certain targets.

Consistent with the decision in London Australia Investment Co,

any profits that it made on the sale of shares while it was pursuing

this strategy would be assessable income to it under iTAA97 s 6-

5. Consistent with the decision in FCT v Whitfords Beach Pty Ltd

(1982) 150 CLR 355, when it sold shares that it had previously held

as capital assets prior to the change in the nature of its business,

it would be allowed a cost for the shares equal to their market

value as at 1 july 2004.

In the year ending 30 June 2005 it sold for $200,000 a parcel of

shares that it had acquired on 1 July 2003 for $100,000. As at 1

July 2004, the market value of the share parcel was $160,000.

For s 6-5 purposes, a profit of $40,000 will be included in Alpha

Pty Ltd’s assessable income. For CGT purposes Alpha Pty Ltd

will make a prima facie capital gain of $100,000, but the general

anti-overlap provision s 118-20 will mean that the capital gain is

reduced by the amount of the s 6-5 inclusion of $40,000, so that

the capital gain will become $60,000.

An alternate method for dealing with this situation would be to

have a rule to the effect that where there the nature of an asset

changed from being a capital asset to being a revenue asset, there

was a deemed disposal at market value at that time. in calculating

the gain or loss from a subsequent disposal of the asset, the

difference between cost and market value at the time of change of

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42 43

use would be accounted for as a capital gain, while the difference

between market value at the time of change of use and the ultimate

sale price would be accounted for under s 6-5.

9. Case Study Eight: Personal Services Income Alienation Provisions

Case study illustrates the first and ninth causes of complexity

identified in Chapter Two.

9.1 Introduction

Numerous cases have been decided over whether or not the

current general anti-avoidance provision iTAA36 Part iVA or the

former general anti-avoidance provision iTAA36 s 260 apply to

attempts to derive personal services income through an interposed

entity such as a company or a trust. 53 There are also several ATO

Rulings that deal with the application of the former s 260 or of Part

iVA in these situations. See iT 2121, iT2330, iT2373, iT2503 and iT

2639.

Despite these cases, the government enacted in 2000 Part

2-42 of the iTAA 97, dealing with Personal Services income. The

rules were in effect from 1 july 2000. Following complaints from

the tax profession about the unfairness of the provisions and the

high compliance costs associated with them, the legislation was

significantly amended in 2001.

9.2 Summary of the operation on the PSI rules

The following is a brief summary of the broad effect of the

legislation in its current form. Section 84-5 defines ‘personal

services income’ as your ordinary income or statutory income if

the income is mainly a reward for your personal efforts or skills.

Personal services income as defined also includes the income of

any other entity if the income can be viewed as being a reward for

your personal efforts, or skills if it were your income.

Division 85 prevents individuals from obtaining certain

deductions for the gaining or producing of their personal services

income, except where the expense relates to income from the

individual conducting a personal services business. Division 85 is

directed at limiting deductions for sole traders and is not directly

relevant to personal services income alienation.

Section 85-10 prevents an individual from deducting an amount

relating to the gaining or producing of personal services income

that is not payable to the individual as an employee, and that the

individual would not be able to deduct if the individual were an

employee.

Section 85-15 prevents rent, mortgage interest, rates or land tax

for all or some of an individual’s or an associate’s residence being

deducted, to the extent that it relates to gaining or producing your

personal services income (whether or not as an employee).

Section 85-20 prevents an individual from deducting payments

to associates to the extent that the payment relates to the gaining

or producing of the individual’s personal services income, except

where the payment relates to engaging the individual’s associate

to perform work that forms part of the principal work for which

the individual gains or produces their personal services income.

(For example, an electrician paying an associate to do work as an

electrician.)

Similarly, s 85-25 prevents an individual from deducting

contributions to a fund or an RSA to provide superannuation

benefits for an associate of the individual, to the extent that

the associate’s work relates to the gaining or producing of the

individual’s personal services income other than work that forms

the principal work for which the individual gains and produces their

personal services income. Where the contribution is deductible,

s 85-25(3) limits the deductible amount to the amount that the

individual would have to contribute, to ensure that the individual

did not have any individual superannuation guarantee shortfalls in

respect of the associate.

Division 86 treats personal services income that an individual

alienates to another entity as the individual’s assessable income,

unless the other entity is conducting a personal services business.

The income attributed to the individual is reduced by certain

deductions that the personal services entity would have otherwise

obtained in relation to the services provided by the individual. The

Division also puts limits on the deductions that a personal services

entity can claim in relation to personal services income.

Sub section 86-15(1) states that an individual’s assessable

income includes an amount of ordinary income or statutory income

of a personal services entity that is the individual’s personal

services income. A subsequent actual payment to the individual of

an attributed amount of personal services income is deemed by s

86-35 to be non-assessable non-exempt income to the individual

and not deductible to the personal services entity.

A personal services entity is defined in s 86-15(2) as a company,

partnership or trust whose ordinary or statutory income includes

the personal services income of one or more individuals.

under s 86-30, ordinary income or statutory income of the

personal services entity is neither assessable nor exempt income of

the entity, to the extent that it is personal services income included

in an individual’s assessable income via s 86-15. Section 86-15

does not apply to income from the personal services entity

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conducting a personal services business, to amounts that would

not be assessable to the personal services entity otherwise, nor to

payments that the personal services entity makes to the individual

as salary or wages.

Section 86-20 reduces the amount of personal services income

attributed to the individual by deductions, other than salary or

wages paid to the individual to which the personal services

entity is entitled, that relate to the individual’s personal services

income. Entity maintenance deductions are first offset against

other income of the personal services entity, and only any excess

entity maintenance deductions will reduce the amount of personal

services income allocated to the individual.

Where the reduction amount exceeds the personal services

income that would otherwise be allocated to the individual, the loss

produced is deductible to the individual under s 86-27. under s

86-87, the loss reduces the deductions that the personal services

entity is otherwise entitled to. Any excess of entity maintenance

deductions over the personal services entity’s personal services

income is apportioned between individuals, where the entity’s

ordinary or statutory income includes the personal services income

of more than one individual.

Subdivision 86B limits the personal services entity’s entitlement

to deductions incurred in relation to gaining or producing personal

services income. Section 86-60 states that a personal services

entity cannot deduct an amount to the extent that it relates to

gaining or producing an individual’s personal services income,

unless the individual could have deducted it or unless the entity

received the individual’s personal services income in the course of

conducting a personal services business.

The personal services entity is permitted to deduct ‘entity

maintenance expenses’ under s 86-65. Entity maintenance

expenses are exhaustively and narrowly defined under s 86-

65(2) as being expenses associated with opening and closing

an account, tax-related expenses, expenses incurred in relation

to the preparation or lodgement of documents required under

the Corporations Act 2001, and any fee payable by the entity to

an Australian government agency for any licence, permission,

approval, authorisation, registration, or certification under

Australian law.

Further provisions in Subdivision 86-B in certain circumstances

allow the personal services entity to deduct expenses relating to

car expenses, superannuation, salary or wages paid, and capital

allowances.

An individual or a personal services entity is regarded as

conducting a personal services business under s 87-15 if:

a personal services business determination is in force in

relation to the personal services income of the individual or

the personal services income of an individual whose income

is included in the personal services entity’s ordinary income or

statutory income; or

the individual or entity meets one of the four personal services

business tests in the relevant income year.

Under s 87-15(3), if 80% or more of an individual’s personal

services entity’s ordinary income or statutory income is from

the same entity (or that entity’s associates) and the relevant

individual does not pass the results test, then the individual’s

personal services income is not taken to be from conducting a

personal services business, unless a personal services income

determination is in force relating to that individual’s personal

services income and where the determination was made on the

application of the personal services entity that the individual’s

personal services income is from the entity conducting the

personal services business.

The results test is set out in s 87-18. An individual meets the

results test if at least 75% of the individual’s personal services

income (other than income received as an employee and certain

other types of personal services income) was for producing a result

where the individual is required to supply the necessary plant and

equipment, or tools of trade necessary to complete the work which

produced the result and where the individual is liable for the cost

of rectifying any defect in the work performed. Similarly, a personal

services entity meets the results test if, in relation to at least 75%

of the personal services income of one or more of the individuals

that is included in the entity’s ordinary or statutory income:

the income was for producing a result;

the entity was required to supply the plant and equipment, or

tools of trade needed to perform the work; and

the entity is liable for the cost of rectifying any defect in the

work performed. The results test is self-assessed.

The unrelated clients test is set out in s 87-20. An individual or

personal services entity passes the test if the individual or the

entity gains or produces income from providing services to two

or more entities that are not associates of each other and are not

associates of the individual or the personal services entity.

The employment test is set out in s 87-25. An individual meets

the employment test if the individual engages one or more entities

(other than non-individual associates of the individual) to perform

work and the entities perform at least 20% by market value of

the individual’s principal work for the year. Similarly, a personal

services entity meets the employment test if it engages one or

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more other entities (other than individuals, or their associates,

whose personal services income is included in the entity’s ordinary

income or statutory income) to perform work, and those entities

perform at least 20% by market value of the entity’s principal work

for the year. in addition, in a given year, both an individual and a

personal services entity that have one or more apprentices meet

the employment test.

The business premises test is set out in s 87-30. To meet the

test an individual or a personal services entity must maintain and

use business premises:

at which the individual or entity mainly conducts activities from

which personal services income is gained or produced;

for which the individual or entity has exclusive use;

that are physically separate from any premises that the

individual, the entity or an associate of either uses for private

purposes; and

that are physically separate from the premises of the clients

(or their associates) to which the individual or entity provides

services.

Section 87-40 applies to an individual or a personal services entity

that is a commission agent, where 75% of the income that the

agent receives from the principal is commissions or fees based on

the agent’s performance in providing services to customers on the

principal’s behalf. Subject to certain other conditions being met,

in applying the 80% rule any part of the agent’s personal services

income that is for services the agent provided to a customer on the

principal’s behalf is treated as if it were personal services income

from the customer, not personal services income from the principal.

Similarly, in applying the unrelated clients test, any services

that the agent provided by which the agent gained or produced

personal services income from the principal and that were provided

to a customer on the principal’s behalf are treated as if the agent,

not the principal, provided them to the customer.

Subdivision 87-B deals with personal services business

determinations. An individual or a personal services entity may

apply under s 87-70 to the Commissioner for a personal services

business determination or a variation of a personal services

business determination. The grounds on which the Commissioner

may make a personal services business determination in relation to

an individual are set out in s 87-60. The grounds on which a

determination may be made in relation to a personal services entity

are set out in s 87-65.

in making the determination, the Commissioner must be

satisfied that either:

the individual or entity could reasonably be expected to meet

or has met either the results test, the employment test, or

the business premises tests or more than one of those tests,

and the individual’s personal services income was (or could

reasonably be expected to be) from the individual or entity

conducting activities that met one or more of those tests;

but for unusual circumstances, the individual or entity would

have met either the results test, the employment test, or

the business premises test or more than one of those tests,

and the individual’s personal services income was (or could

reasonably be expected to be) from the individual or entity

conducting activities that met one or more of those tests; or

the individual or entity could reasonably be expected to meet

or met the unrelated clients test but because of unusual

circumstances 80% or more of the individual’s personal

services income (or of the individual’s personal services

income included in the entity’s income) could reasonably be

expected to be or would have been from the same entity (or

its associates), and the individual’s personal services income

(or the individual’s personal services income included in the

entity’s income) could be reasonably expected to be or was

from the individual or entity conducting activities that met the

unrelated clients test; or

but for unusual circumstances, the individual or entity could

reasonably be expected to meet or would have met the

unrelated clients test and 80% or more of the individual’s

personal services income (or of the individual’s personal

services income included in the entity’s income), but because

of unusual circumstances could reasonably be expected to be

or would have been from the same entity, and the individual’s

personal services income (or the individual’s personal services

income that was included in the entity’s income) could

reasonably be expected to be or was from the individual or

entity conducting activities that met the unrelated clients test.

For the purposes of the second alternative, unusual circumstances

include providing services to an insufficient number of entities

to meet the related clients test if the individual or entity starts

business during the income year, and can reasonably be expected

4444 45


Case Facts Part IVA/s 260 Decision Application Of PSI Provisions

Tupicoff Life insurance agent established discretionary family trust, with company controlled by taxpayer and wife as trustee. Resigned position as life insurance agent. insurance company then appointed corporate trustee as its agent. All sales of life insurance policies by corporate trustee continued to be solely due to the taxpayer’s selling ability.

The central feature of the transactions was to alter the incidence of taxation on income earned by the taxpayer from personal exertion. hence s 260 applied to annihilate the transactions. This exposed Tupicoff as the person who earned the income entirely by his own efforts. The transactions were not part of an arrangement that could be classified as an ordinary business or family dealing.

iTAA97 s 87-40 would mean that the 80% rule would not apply and that the unrelated clients test would be passed.

The PSi provisions would not apply.

Osborne Osborne became a registered valuer in 1967. The taxpayer formed Bellatrix Nominees Pty Ltd (Bellatrix) in 1975. Bellatrix undertook real estate development and share trading activities. Bellatrix was also trustee of the Osborrne Family Trust No1 (Trust No1), which was a discretionary family trust. The objects of Trust No1 included the taxpayer’s children and grandchildren and their spouses, and the taxpayer and his spouse. From 1980 onwards, Bellatrix conducted a valuation service under the name R&h Osborne Professional Services. The taxpayer’s services were utilised in providing valuations for R&h Osborne Professional Services. in late 1981, the taxpayer acquired Thornbridge Nominees Pty Ltd (Thornbridge), which became trustee of the Osborne Family Trust No2 (Trust No2), which was a discretionary family trust. The principal objects of Trust No2 were the taxpayer’s children and the secondary objects were various family relatives and Trust No1. in june 1983, Thornbridge became proprietor of the business name Ray Osborne & Associates. Valuation activities were carried on under this name from late 1983, and the name R&h.

Osborne Professional Services was allowed to lapse. in the 1984 financial year, both Bellatrix and Thornbridge returned income from valuation fees. in all subsequent years, all income from valuation fees was returned by Thornbridge. The taxpayer ceased doing valuation work in 1989 and the valuation practice was sold.

Section 260 did not apply, as the fees were earned as a result of contractual arrangements between Bellatrix and various clients. The taxpayer had not been employed as a valuer and had not used his skills as a valuer to earn valuation fees prior to his employment by Bellatrix. Neither Bellatrix nor Trust No1 were established to divert income derived from the valuation fees. Both were in existence long before any valuation fees were derived. hence there was no diverting of income and no alteration in the incidence of tax. Both before and after the taxpayer commenced providing valuations for Bellatrix, he was liable to be taxed on whatever distribution of income was made in his favour by Trust No 1. The arrangement changed nothing in this respect.

Part iVA did not apply.

Further information would be needed to determine whether or not the results test was passed having regard to the factors considered in Nguyen & Anor v FCT [2005] ATTA 876 2005 ATC 2304.

The 80% rule would be passed.

The unrelated clients test would be passed. The business premises test would also be passed.

The PSi provisions would not apply.

to meet the test in subsequent years, or the individual or entity

provides services to only one entity in the current year but met

the test in one or more preceding years and can reasonably be

expected to meet the test in subsequent years.

To assist in understanding its operation, the ATO has issued

several rulings and determinations on the PSi provisions and their

relationship with Part iVA. 54

9.3 Comparing the common law outcome to that under the PSI rules

The following table sets out the facts in several personal services

income alienation cases involving either iTAA36 s 260 or iTAA36

Part iVA. The result in the case is indicated in the third column and

the result that would probably occur under the PSi provisions is

indicated in the fourth column.

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AAT Case [1999] AATA 165

in 1974, the taxpayer was employed by a stockbroking firm. The taxpayer also established m Pty Ltd as trustee of a discretionary family trust, which periodically engaged in share trading but which was inactive between 1977 and 1982. in 1982 he negotiated an arrangement under which the firm was to pay him a commission on orders introduced by his advice, rather than on a salary basis. The taxpayer used m Pty Ltd as trustee of the family trust to carry on the business of investment advising for commissions. Verbal agreements were entered into between m Pty Ltd, the stockbroking firm and the taxpayer under which the taxpayer would be employed by m Pty Ltd, and in that capacity provide services and take buying and selling orders for clients of m Pty Ltd. m Pty Ltd would place the orders with the broking firm and m Pty Ltd would invoice the broking firm on a monthly basis for the commission on the orders. The taxpayer and his wife were directors of m Pty Ltd and the taxpayer was paid a salary. A dealer’s licence in the taxpayers name was provided by the broking firm. Subsequently, the broking firm was acquired by another firm, which entered into a formal agreement with m Pty Ltd in 1996. At various times the taxpayer’s wife and daughter and a third unrelated person were employed by m Pty Ltd on a salary basis as assistant advisors. All of these persons held dealer’s licences that were provided by the broking firm. m Pty Ltd was not permitted by the Corporations Act to hold a dealer’s licence. M Pty Ltd had no separate business premises and conducted its activities at the broking firm’s premises. The majority of clients were not aware of the existence of m Pty Ltd. All documentation received by clients was in the name of the broking firm. The AAT concluded that clients placed their orders with the taxpayer and the other assistant advisors as licensed representatives of the broking firm. The commission paid was on a basis of a percentage of the brokerage received by the firm for orders placed by clients of individual advisors. The taxpayer and the assistant advisors were covered under the broking firm’s professional liability insurance. During the years in dispute the net income of the family trust was principally distributed to the taxpayer’s wife and to a family company that had previously incurred losses from share trading.

The primary conclusion of the AAT was that m Pty Ltd was not carrying on business at all and was merely the passive recipient of personal exertion income that had already been derived by the taxpayer.

The AAT also held that if its primary conclusion was wrong, Part iVAapplied to cancel the tax benefit and allowed the Commissioner to make compensating adjustments. The case was not relevantly distinguishable from Tupicoff. In response to the taxpayer’s argument that the trust minimised the taxpayer’s liability for errors and bad debts, the AAT noted that the taxpayer was covered under the broking firm’s professional indemnity insurance. The AAT characterised the alleged risks of liability as minimal. The only objective purpose that could be seen for the arrangement was the reduction of the taxpayer’s personal tax liability and the diversion of income to family members and to the other family company with share trading losses.

Assuming that m Pty Ltd was in business, it is unlikely that it would pass the results test given that professional indemnity insurance for the taxpayer’s activities was covered by the share broking company. Further information would be required to consider whether the factors discussed in Nguyen & Anor v FCT [2005] ATTA 876 2005 ATC 2304 were present or not.

m Pty Ltd would fail the 80% rule. iTAA97 s 87-40would not protect m Pty Ltd from the 80% rule, as (assuming that m Pty Ltd is the agent of the stockbroking firm) the agent provided services to customers on the principal’s behalf using premises that the principal owned (assuming that arrangements in relation to m Pty Ltd’s use of the premises were not at arm’s length).

The PSi provisions would apply unless the Commissioner made a pubic services business determination. For part of the period it is possible that there were grounds for making a determination on the basis that m Pty Ltd might have met the employment test. Whether or not m Pty Ltd met the employment test would depend on whether the unrelated assistant advisor employed by m Pty Ltd performed at least 20% by market value of M Pty Ltd’s principal work for the year.


4646 47


Re Egan Taxpayer and his wife set up a company (Company) to provide iT consulting services to clients. Together with an associate the taxpayer set up another company (AOS) which was owned equally by the Company and by the associate’s company. The Company provided iT contracting services to AOS on a fee basis. The taxpayer’s wife was both the Company’s financial controller and the taxpayer’s personal assistant. The Company paid both the taxpayer and his wife a salary and made superannuation contributions for both of them. The salary paid to the taxpayer was considerably less than the fee the Company charged to AOS for the provision of iT consulting services. The excess remaining in the company after the payment of salaries, superannuation contributions and certain domestic expenses was retained in the Company.

There was a scheme for Part iVA purposes. The taxpayer obtained a tax benefit under the scheme. The whole of the fees charged to AOS was used for the benefit of the taxpayer and his family, with the major part of the fee not being included in the taxpayer’s assessable income. The dominant purpose of the scheme was to obtain a tax benefit. The only objective explanation for the payment of fees to the Company rather than to the taxpayer direct was to enable the taxpayer to split fees between himself, his wife and the Company.

unlikely that the results test would be met. Further information would be required as to whether the factors in Nguyen & Anor v FCT [2005] ATTA 876 2005 ATC 2304 were present or not.

The arrangement would not pass the 80% rule.

As more than 80% of the Company’s personal services income came from one client, the PSi rules will apply unless a personal services business determination is obtained from the ATO.

The preconditions for making a PSB determination would not be met.

macarthur Civil engineer and his wife had previously worked for the mains Road Department. The taxpayer resigned from employment with the main Roads Department, and the taxpayer and his wife worked overseas for four years. On their return to Australia, the taxpayer and his wife acquired a shelf company for the purpose of providing engineering consulting work facilitating superannuation contributions. The taxpayer and his wife owned different classes of shares in the company. The taxpayer provided engineering services to the company, while the taxpayer’s wife provided other services within her expertise. Both were paid salaries for the services they provided. The company won several engineering contracts with different clients, including the main Roads Department, over a period of years. in 1994, the company won two engineering consulting contracts with the main Roads Department. under the contract, and contrary to standard main Roads Department practice, the taxpayer (as the company’s nominated person) was to be located at the main Roads Department offices and would be provided with various services by the main Roads Department. The contract required the company to carry public liability, professional indemnity and workers compensation insurance, and to be liable for taxation, leave entitlement, superannuation guarantee levy, and workplace health and safety. The salary paid to the taxpayer was less than the consulting fees charged by the company to the main Roads Department. The Commissioner alleged that the salary paid to the taxpayer’s wife for her services was excessive. The excess of the consulting fees over the salaries was either retained by the company or was distributed to the taxpayer’s wife as dividends.

The AAT found that the arrangements constituted a scheme for Part iVA purposes but that there was no tax benefit as, in the absence of the scheme it could not be said that a relevant amount would have been included in the assessable income of the taxpayer. On appeal Dowsett j held that the AAT should have considered whether in the absence of the scheme it might have reasonably been expected that the taxpayer would have contracted with the Department in his own right. Dowsett j stated that there was every reason to expect that in the absence of the scheme the taxpayer would have continued to practice his profession in his own name and would have entered into the contracts with the main Roads Department in this capacity. The case was remitted back to the AAT for further consideration.

Provision of services by the main Roads Department may have meant that the results test was not passed. On the other hand, the fact that the company carried its own professional indemnity insurance would be relevant in deciding whether the results test was passed. Also, further information about the precise nature of the consulting work would be required in determining whether or not the results test was passed. Assuming that the results test was not passed, the company failed the 80% rule in the years in question. The PSi rules would apply unless a personal services business determination was obtained from the ATO.

given the fact that the company had done consulting work for other clients in previous years, it would be open to the Commissioner to find that in the years in question; but for unusual circumstances, the company would have met the unrelated clients test. if this were so, then a personal services business determination would be made and the PSi provisions would not apply.


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mochkin Stockbroker arranged for corporate trustee of one of his

family trusts (No2 Trust) to enter into two commission

sharing agreements with stockbroking houses. The

first agreement was entered into at a time when the

taxpayer was engaged in litigation in relation to an

earlier agreement with another stockbroking house over

losses made from defaults by clients the taxpayer had

introduced. The taxpayer’s evidence was that the trust

was established to shield the taxpayer from personal

liability. The taxpayer had entered into the earlier

agreement personally. The family trust was able to use

the services of several employees of the stockbrokers for

most of the relevant periods. The employees conducted

the trust’s business during periods when the taxpayer

was overseas. The stockbroking firms also provided the

family trust with floor space, research facilities and a

kitchen. The taxpayer was not paid a salary by the family

trust but several trust distributions were made to him. The

taxpayer also directed a listed company to pay a finder’s

fee in relation to a share placement to another of the

taxpayer’s family trusts. (No1 Trust).

The Full Federal Court held

that Part iVA did not apply in

relation to the diverting of the

commissions to No 2 Trust.

This was because it would

be concluded that, in the

circumstances, the dominant

objective purpose in establishing

the trust was to shield the

taxpayer from personal liability.

The Full Federal Court held

that Part iVA did apply to the

diversion of the finder’s fee

to No1 Trust, which had no

connection with the placement

of the shares. it would be

objectively concluded that the

dominant purpose of the taxpayer

in diverting the finder’s fee to No1

Trust was to obtain a tax benefit.

given that the intention was

that No2 Trust would bear

liability, it is possible that the

results test may have been

passed. The fact that the

stockbroking firms provided

No2 Trust with various services

and employees would count

against this view. Further

information would be required

to determine whether the

factors considered in Nguyen

& Anor v FCT [2005] AATA 876

were present.

Assuming that the results test

was not satisfied, No2 Trust

would fail the 80% rule. iTAA97

s 87-40 would not protect

No2 Trust, as (assuming that

No2 Trust is the agent of the

stockbroking firm) the agent

provided services to customers

on the principal’s behalf using

premises that the principal

owned (assuming that the No2

Trust’s use of the premises

were not at arm’s length).

The PSi provisions would

apply unless the Commissioner

made a pubic services

business determination. The

preconditions for making a

PSB determination do not

appear to have been met.

it will be seen from the Table that, as the tests applied for PSi

and Part iVA purposes differ, being within an exception to the PSi

provisions does not necessarily mean that Part iVA will not apply

to an alienation of personal services income. in this respect, the

PSi provisions may have the effect of lulling taxpayers into a false

sense of security. At the very least, the PSi provisions impose

additional compliance burdens on taxpayers without guaranteeing

a safe harbour from the general anti-avoidance provision.

Conversely, the Table also illustrates that the PSi provisions

would be likely to operate in some situations where neither Part

iVA nor s 260 did operate to either render transactions void or

to permit the Commissioner to cancel the tax benefit and make

compensating adjustments.

The detailed operational rules in the PSi provisions have the

effect of obscuring what appears to be confusion in underlying

policy between the PSi provisions and Part iVA. in practical terms,

neither the PSi provisions nor Part iVA can be said to be dominant

over the other. A taxpayer within an exception to the PSi provisions

does not thereby escape the operation of Part iVA.


4848 49


On the other hand, a taxpayer can be within the operation of the

PSi provisions in circumstances where it is unlikely that Part iVA

would give the Commissioner power to cancel the tax benefit or to

make compensating adjustments. No clear policy on alienations of

personal services income emerges from the relationship between

the two sets of provisions.

hence, this case study illustrates the first cause of complexity

noted in Chapter Two: a cumulative development of rules

leading to excessively detailed operational rules that obscure the

fundamental policy framework. The PSi provisions were enacted

against the background of Part iVA but did not attempt to codify

the effect of decisions in relevant s260 and Part iVA cases. The

PSi provisions were then amended in 2001 to allow taxpayers to

self-assess whether they were within the results test exception

to the PSi provisions. Arguably these amendments increased

the likelihood of taxpayers who passed the results test being

nonetheless caught by Part iVA. The cumulative development

of the rules exacerbated the policy conflicts between the PSi

provisions and Part iVA.

The case study also illustrates the ninth cause of complexity

noted in Chapter Two: the use of specific anti-avoidance

provisions and the general anti-avoidance provision concurrently.

Any certainty that the PSi provisions might have brought to the

tax treatment of the alienation of personal services income is

undermined by the fact that their operation is still subject to the

overriding operation of Part iVA.

As noted in Chapter Two, where specific anti-avoidance

provisions operate concurrently with a general anti-avoidance

provision, the function of the specific provision is as a prophylactic

against tax planning. The strategy would appear to be to reduce

the incidence of alienations of personal services provisions, thereby

reducing the number of instances in which tax administrators need

to consider whether to apply the general anti-avoidance provision.

The likelihood is that a saving in administrative costs, due to a

lessening of the need to consider whether or not to apply Part iVA,

comes at the expense of the increased compliance costs involved

in considering the possible application of the PSi provisions when

contemplating business structuring decisions.

9.4 Conclusion

given the above discussion, Chapter Four contains a

recommendation for the repeal of the PSi provisions on the basis

that avoidance activity in this area can be adequately dealt with via

Part iVA and by use of a general market value substitution rule in

related party transactions.

10. Case Study Nine: The use of method statements in thin capitalisation rules

Case study illustrates the tenth and eleventh causes of


10.1 Introduction

method statements are extensively used in the thin capitalisation

rules. The following very simple example of the application of

the outbound thin capitalisation rules shows the high degree of

legal complexity involved in using the thin capitalisation method

statements. To use the method statements, continual cross-

referencing to complex definition sections is necessary. Because

of the use of a debt to assets test, some items are added in one

part of a calculation, only to be excluded in a later part of the

calculation.

The overall effect of the rules, i.e. what debt to asset ratio is

acceptable, has to be determined by working through the complex

steps of the method statements. For the non-mathematically-

minded the end effect of the formulae in the method statement

might not be apparent until the final calculations are made.

Benefits in terms of both reduced complexity and increased

compliance costs would be likely to result in this area if method

statements were accompanied by a statement of the overall effect

and intention of the statement.

10.2 Example

in the following example, Aust Co (an Australian resident company

involved in the manufacture of widgets) has a paid-up capital or

$AuD 1,000,000. it borrows $AuD 20,000,000 at 6.5% from Bank

(an unrelated Australian Deposit Taking institution). it subscribes

$AuD 1,000,000 for all the shares in CFC (a controlled foreign

corporation) and lends $AuD 4,000,000 at 6.5% to CFC. CFC

conducts wholly active business operations. Any dividends that

Aust Co subsequently receives from CFC will be non-assessable

non-exempt income under either iTAA36 s 23Aj. Assume that

CFC’s operations have been proportionately more profitable

that Aust Co’s Australian operations and that a Bank in lending

the $AuD 20,000,000 to Aust Co regarded 30% of the loan (i.e.

$6,000,000) as being attributable to Aust Co’s investment in CFC.

The combined operation of iTAA97 s 8-1 and s 25-90 will

permit Aust Co to deduct debt interest on the loan to Bank. Aust

Co, however, is an ‘outward investing entity (non-ADI) general’ as

defined in iTAA97 s 820-85(2) item 1 in the Table. hence, the thin

capitalisation rule for outward investing entities (non-ADi) stated in

s820-85(1) may disallow all or part of the debt deduction (i.e. the

deduction for the interest payment).

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The following process needs to be followed in determining

whether s820-85(1) will disallow all or part of the debt deduction:

1. Type of entity

Aust Co will be an outward investing entity (non-ADI) general (see

the definition in iTAA97 s 820-85(2)).

2. Relevant thin capitalisation rule

Section 820-85(1) may disallow all or part of a debt deduction

of an outward investing entity (non-ADI) if its adjusted average

debt exceeds its maximum allowable debt. it is assumed that

the interest payable on the debt will be a debt deduction in

these circumstances. Where this is the case, the amount of debt

deduction disallowed is determined using the following formula set

out in s820-115:

Debt deduction x Excess debt/Average debt

hence to determine whether s 820-85(1) will disallow all or part

of the debt deductions, it is necessary to consider the meaning of

the terms ‘adjusted average debt’, ‘maximum allowable debt’ and

‘average debt’.

Meaning of ‘adjusted average debt’

‘Adjusted average debt’ for an outward investing entity (non-ADI) is

defined in s 820-85(3) as the result of applying a method statement

that it sets out. The following is a simplified version of the method

statement:

Add

The debt capital of the entity (i.e. Aust Co) that gives rise to debt

deductions for that year (i.e. $20m).

Subtract (a) and (b)

(a) “associate entity debt” (other than controlled foreign entity

debt). See definition in s 820-910. An associate entity is

defined in s 820-905. here associate entity debt (other than

controlled foreign entity debt) will be $0.

(b) “controlled foreign entity debt” is defined in s 995-1(1). Here

controlled foreign entity debt will be $4m.

Total of ‘adjusted average debt’ here will be $20M - $4M = $16M.

Meaning of ‘maximum allowable debt’

Where the entity is not also an ‘inward investing vehicle’, s 820-

90(1) means that its maximum allowable debt is the greatest of:

The safe harbour debt amount

The arm’s length debt amount

The worldwide gearing debt amount.

Determining the ‘safe harbour debt amount’

The ‘safe harbour debt amount’ for an outward investor (general)

is determined using a method statement set out in s 820-95. The

following is a simplified version of the method statement:

Step 1: Work out the average value of all assets of the entity

– i.e. $1M equity in CFC + $4M debt interest in CFC +

$16m (cash from surplus borrowing and paid up capital)

= $21M.

Step 2: Subtract average value of associate entity debt of the

entity (other than CFC debt), i.e. $0.

Step 3: Subtract average value of associate entity equity of the

entity (defined s 820-915), i.e. $0.

Step 4: Subtract average value of all CFC debt of the entity

(i.e. $4m).

Step 5: Subtract the average value of all CFC equity of the

entity (i.e. $1m).

Step 6: Subtract average value of all non-debt liabilities of the

entity. Non-debt liabilities are defined in s 995-1. here

the non-debt liabilities of the entity are assumed to be

$0.

The result of the steps to date is $16m

(i.e. $21M - $0 – $0 - $4M - $1M = $16M).

Step 7: Multiply the result by 3/4 (i.e. $16M x 3/4 = $12M).

Step 8: Add to the result of Step 7 the average value of the

entity’s ‘associate entity excess amount’. Associate

entity excess amount is defined in s 820-920. To

determine the associate entity excess amount we must

follow the following steps.

First – determine the ‘premium excess amount’ for an

associate entity under s 820-920(3). here this will be zero

(debt interests issued by the associate entity and equity

interests in CFCs are disregarded in the calculation); and

AUS CoEquity $1m Bank

Loan $20m

Debt $4m Equity $1m

CFC

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Second – determine the associate entity’s ‘attributable safe

harbour excess amount’ under s 820-920(4). To do this we are

required to treat the associate entity as if it were an outward

investing entity (non-ADi) on the day when the determination is

being made. We then determine what would be the associate

entity’s safe harbour debt amount if this assumption were

made.

Neither the legislation nor the Explanatory memoranda that

accompanied it and subsequent legislation amending it explicitly

state, in contrast to the position in relation to the premium excess

amount in the case of equity interests, that we are not to treat an

associate entity as if it were an outward investing entity where the

associate entity is a CFC. As only resident entities can be outward

investing entities, it may be that the drafter considered that a CFC

could therefore not be treated as if it were an outward investing

entity.

This interpretation receives some support from the example of

calculation of an associate entity’s attributable safe harbour excess

amount in the ATO’s Guide To Thin Capitalisation (Part B) 2005.

In that example, a calculation of the associate entity’s attributable

safe harbour excess amount is made for the resident associate

entity, but is not made for the CFC. This view also receives support

from the overall scheme of the outbound thin capitalisation

provisions.

in this instance, the issue is immaterial because, as will now be

demonstrated, when s820-920(4) is applied in relation to the CFC,

the result is zero.

Step 1: Calculate the safe harbour debt amount of the CFC as if

it were an outward investing entity (non-ADi).

The safe harbour debt amount of the CFC under these

assumptions is the assets $5M (i.e. cash) x 3/4 =

$3.75m.

Step 2: The method statement then requires the $3.75m to be

reduced by the adjusted average debt of the CFC. Here

this will be $4m. As this reduction produces a negative

amount, the second step in the method statement in s

820-920(4) requires that the result be taken to be nil.

Steps 3 These steps require further adjustments but in this

instance the result of each of them will be zero. This is

because Step 3 involves multiplying an amount by the

zero result in Step 2, hence producing a zero result.

Step 4 involves dividing the zero result in Step 3 by an

amount that in turn produces a zero result.

The end result is that the associate entity’s excess

amount is $0 + $0 = $0.

This means that the Australian company’s ‘safe harbour

debt amount’ is $12M.

Determining the ‘arm’s length debt amount’

The arm’s length debt amount is defined in ITAA97 s820-105.

Essentially, we must ask what amount of debt commercial lending

institutions, not associated with Aust Co, would have advanced in

relation to Aust Co’s Australian operations. To determine whether

the ‘arm’s length debt amount’ test is passed, we must make the

assumptions in s 820-105(2).

here, on the facts as stated, only 70% of the $20m or

$14,000,000 advanced by Bank was attributable to Aust Co’s

Australian operations. The fact that in this instance a commercial

lender actually lent $14m does not of itself determine the issue. in

this instance, however, it is assumed that $14M will be the arm’s

length debt amount.

Determining the ‘worldwide gearing debt amount’

The ‘worldwide gearing debt amount’ for an outward investor

(general) non-ADi is determined via the method set out in s 820-

110.

Step 1: Divide the entity’s worldwide debt (defined s 995-1),

here $20M (i.e. the borrowing from the Bank – note

that the debt issued by the CFC to the entity is not

counted), by the entity’s worldwide equity (defined s

995-1), here $1m (i.e. the equity capital in the Australian

company – note that the equity in the CFC is excluded).

$20M/$1M - = $20.

Step 2: Multiply the result in Step 1 by 12/10

(i.e. 20 x 12/10 = 24).

Step 3: Add 1 to the result of Step 2 (i.e. 24 + 1 = 25).

Step 4: Divide the result of Step 2 by the result of Step 3 (i.e.

24/25 = 0.96).

Step 5: multiply the result of Step 4 by the result of Step 6 in

the calculation of the ‘safe harbour debt amount’ (i.e.

$16M x 0.96 = $15,360,000).

Step 6: Add the entity’s associate entity excess amount. As

discussed, it is unclear whether this amount would be

added where the associate entity is a CFC. The better

view and ATO practice is that it is not. in any event, as

discussed above, the associate entity excess amount

for the CFC in this case would be zero.

hence the result is that the worldwide gearing amount

is $15,360,000.

and 4:

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The Australian company would thus choose

$15,360,000 as its maximum allowable debt. The

deduction disallowed under the formula in s 820-115

would be:

Debt deduction x Excess debt/Average debt

= Debt deduction x .64/20

= 0.032.

This means that 3.2 cents would be disallowed for each

$1 of interest deduction claimed.

10.3 Lessons from the case study

The case study illustrates the ways in which method statements,

while having the virtue of precision, can have the effect of making

the reader lose the ‘big picture’. The reader is left to wonder why

many of the steps in the method statement are taken. To determine

why the steps are there, it is sometimes necessary to

work through what would happen if particular steps were not there

in given situations. Secondary material that would be of assistance

in ascertaining the reason for the existence of a particular step is

not always readily available to the taxpayers (and their advisors)

who are likely to be affected by the thin capitalisation rules. This

is especially true of Explanatory memoranda, which usually are

not available for the year in question in the web-based services

maintained by commercial publishers.

Note that in several instances in the case study, no adjustment

was made as a result of several steps in the method statement.

These are all instances of the eleventh cause of complexity noted

in Chapter Two: the inclusion of material that is irrelevant to some

taxpayers in computational steps. As suggested in Chapter Two, it

may be that thinking differently about the way in which provisions

and computational steps are grouped together may be one

solution to this cause of complexity.

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CHAPTER FOUR PROVISIONS RENDERED UNNECESSARY BY SUBSEQUENT DEVELOPMENTS IN THE LAW OR THAT ARE RENDERED UNNECESSARY BY THE ADOPTION OF OTHER RECOMMENDATIONS

1. IntroductionAs noted earlier in this report, one consequence of the cumulative

development of rules in the Australian tax system is that frequently

more than one rule (or set of rules) is potentially applicable in a

given situation. The existence of more than one set of rules dealing

with similar subject matter adds to the bulk and (as discussed

in Chapter One) is likely to increase both legal complexity and

compliance costs.

2. Recommendations

2.1 Generic reasons for recommending repeal

This chapter recommends the repeal of several provisions on

the grounds that they are unnecessary given the existence of

other potentially applicable provisions in Australian income and

fringe benefits tax law. many of the provisions recommended for

repeal can be regarded as specific anti-avoidance provisions. it is

submitted that developments in the jurisprudence on the general

anti-avoidance provision iTAA36 Part iVA mean that in many

cases it will provide adequate protection for the revenue against

avoidance activity that the specific provisions were designed to

curtail.

The repeal of some other provisions is recommended on the

basis that they can only apply in limited circumstances, that their

application depends on the occurrence of events more than twenty

years ago, and that the administrative and compliance costs

associated with enforcing them is likely to outweigh the revenue

likely to be collected from them.

A recommendation for the repeal of some provisions, notably

iTAA36 s 109 and iTAA36 Sub Div 11B, on the grounds that

subsequent developments in corporate shareholder taxation and

in CgT respectively have meant that either no advantage is any

longer gained by the strategy the provision was originally directed

against or that the advantage intended to be provided by the

provisions is not available in the current year.

This chapter also contains a recommendation for the repeal

of the reduced cost base provisions in CgT. Repeal of these

provisions might enable deletion of all reference to the concept

of reduced cost base from iTAA97. The concept of reduced cost

base is relevant in respect of CgT events occurring in relation to

CgT assets that were acquired before 21 September 1999. As

indexation of the cost base of an asset is not available for any

taxpayer in relation to an asset acquired after that date, and as

otherwise deductible expenses are no longer included in the cost

base of a CgT asset, no meaningful differences persist between

cost base and reduced cost base. The recommendation for repeal

of the reduced cost base provisions envisages (as does the Board

of Taxation’s report on inoperative provisions) the publication of

a version of the iTAA that contains all provisions relevant where

all events occur in the current year, with a separate volume being

published containing provisions that only apply where some

relevant trigger transaction or event (such as the purchase of an

asset) occurred in an earlier period.

This chapter also recommends the repeal of iTAA97 Part 2-5

Division 32 on the basis that the private benefit to the employee

is already appropriately taxed under FBT and that the provision of

client entertainment should be a deductible legitimate business

expense. it is submitted that abusive tax-motivated transactions

can be adequately dealt with via iTAA36 Part iVA.

One of the provisions recommended for repeal in this section,

namely iTAA36 s 26(b), has also been recommended for repeal in

the Exposure Draft. As noted in Chapter One, this report obviously

concurs with that recommendation.

2.2 Provisions recommended for repeal

This report recommends that the following provisions be repealed:

in the ITAA36 s 26(b), s 26(e), s 94, s 102, s 108, s 109, Part iii

Subdivision 3D, Part iii Div 6A, Part iii Div 9C, and Part iii Div

Subdivision 11B; and

in the ITAA97, s 15-10, s 15-15, s 15-20, s 15-30, s 25-10, s

25-35, s 25-40, s 25-45, s 26-30, s 26-35, s 26-40, Part 2-5

Division 32, Part 3-1 Subdivision 110-B, Part 3-1 Division 149,

and Part 2-42.

2.3 Explanation of the grounds for recommending repeal

The following table summarises the subject matter dealt with by

the above provisions and comments on the reasons why repeal is

recommended: (see table on next page)

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Provision Subject matter Comment

iTAA36 s 26(b)

Beneficial interests in income derived under a will, deed of settlement, trust, etc.

Difficult to see what scope there is for the operation of the provision given the current scope of Part iii Division 6. The provision dates back to s 14(c) of the Income Tax Assessment Act (1915). iTAA(1915) did not have a mechanism for allocating tax liabilities in trust estates on the basis of present entitlement. Thus in iTAA(1915), the purpose of s 14(c) appears to have been to provide an explicit statement to the effect that beneficial interests in income derived via trusts were to be recognised as assessable income. The provision became s 16(c) of the iTAA (1922), which in s 31 introduced the forerunner to the present Div 6 of iTAA (1936). The Em to iTAB (1922) did not include a comment on s 16(c) and did not include a comment on s 31. Neither provision was discussed in the second reading speech of the then Treasurer (S m Bruce). The opening words of the present provision are in the same form as when introduced in iTAA36 s 26(b). The Em to iTAB (1935) made no specific comment on s 26(b). Although the Em to iTAB (1935) contained comments on how Div 6 differed from s 31 of iTAA (1922), it did not contain any comments on the relationship between s 26(b) and Div 6. iTAA36 s 26(b) was amended in 1979 so as to prevent it operating in relation to amounts dealt with under s 97, s 99B, s 98, s 99 or s 99A. The 1979 amendments clarified the application of iTAA36 Division 6 of Part iii to the foreign sourced income of trusts, and in doing so dealt with an area where s 26(b) had been thought to have an independent operation. iTAA36 s 26(b) was further amended in 1999 to prevent it operating in relation to amounts on which ultimate beneficiary non-disclosure tax was payable under iTAA36 Division 6D.

iTAA36 s 26(e)

Value of allowances, gratuities, etc. in respect of, or in relation to directly or indirectly, any employment of or services rendered.

Following the introduction of FBT, this provision only applies in limited circumstances. Recommended that FBT be an exclusive code for all non-cash benefits in relation to employment. Also recommended that a comprehensive set of valuation rules be developed for all non-cash benefits. general principles on nexus to income-producing activities should then be adequate to non-cash benefits falling outside the FBT net.

iTAA36 s 94 imposes additional tax on partners who do not have the real and effective control of the share of the net income of the partnership that is included in their assessable income.

Where pre-conditions for operation are met, it is likely that the general anti-avoidance provision iTAA36 Part iVA would apply on the basis that but for the scheme the share of net income would have been included in the assessable income of the controlling partner. The provision was first introduced in iTAA(1936) consistent with a recommendation by the Ferguson Royal Commission that whether or not a partnership is bona fide or fictitious should be determined through a factual enquiry, not on the basis of the taxpayer’s purpose in forming the ‘partnership’. Hence the original intent of the provision might be to combat sham partnerships. The original provision in iTAA(1936) proved to be ineffective in Robert Coldstream Partnership. Amendments following the decision in Robert Coldstream Partnership mean that s94 can apply where a partner does not have the whole real and effective control of a part of the partner’s share of the net income of the partnership. Amendments also extend the operation of s94 to trustee partners and adapt it to certain over Divisions of iTAA36 (e.g. to Div 392 dealing with the averaging of primary producers’ income). The amendments do overcome the difficulties posed by the decision in Robert Coldstream Partnership, which suggested that the section (as drafted in 1943) did not apply where the relevant partner had the whole control of part of the share of net income, and did not apply where the partner had some control of the entire share, as then no other partner could be said to have the whole control of that share. The present solution adopted to the second difficulty involves assessing the partner who does not have real and effective control of his/her share of net income at penal rates. given that such partners may have had little awareness of the existence of or their involvement in the partnership, their assessment at penal rates might be thought to be inappropriate in many cases.

Where a partner does not have real and effective control of a share of net income, the counter factual required for Part iVA purposes should be readily provable. The ability to cancel tax benefits and to make compensating adjustments in Part IVA should enable fairer and more appropriate remedies to be used.

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iTAA36 s 102 Where settlor has power to revoke or alter a trust so that the settlor acquires a beneficial interest, or where the trust is for the accumulation of income for the settlor’s minor unmarried children, the trustee may be taxed on the difference between the tax actually paid by the settlor and the tax that the settlor would have paid if the trust had not been created.

Section is routinely circumvented by using a third-party settlor. general anti-avoidance provision Part iVA adequately protects revenue against alienation of income to a revokable trust. Division 6AA protects revenue against alienation of income to minor children. in the case of personal services income, additional protection is provided by the personal services income alienation provisions.

iTAA36 s 108 Loans by private company to associated persons deemed to be dividends.

Adequate provisions deeming loans to associated persons to be dividends are contained in iTAA36 Div 7A. Consequential amendments to exceptions in Div 7A would be necessary following repeal of s 108.

iTAA36 s 109 Excessive payments by private company to associated persons deemed to be dividends.

Where associated person is a resident shareholder, the imputation system, since the introduction of refundable franking credits, means that the end result of a payment of remuneration is identical to payment of a dividend. Where associated person is a non-resident shareholder, a 29% tax rate begins from $1, so no advantage is gained by payment of excessive salaries. if revenue leakage to non-residents was thought to be a problem, then salary payments by companies to non-resident associates could easily, by regulation, be added to the list of payments subject to non-resident PAYG withholding. Deeming dividends paid to associated persons who are not shareholders makes the use of private companies as a family income splitting device more difficult. Repealing s 109 would be unlikely to result in significant additional revenue leakage through income splitting, as it is likely that most taxpayers with income that is able to be split already use discretionary trusts for this purpose.

iTAA36 Part iii , Division 3, Subdivision D

Denial of deductions for losses or outgoings under certain tax avoidance schemes involving advance payments, pre-payments and expenditure recoupment schemes.

The general anti-avoidance provision, iTAA36 Part iVA, provides adequate protection against such schemes. Development of case law, via the Coles Myer Finance decision, also means that there is less need for specific anti-avoidance provisions of this nature. Development of a general timing rule for advance and deferred expenditure, as suggested below, would deal with timing aspects systematically and concisely.

iTAA36 Part iii Div6A

Specific anti-avoidance provision aimed at alienations of income.

Second strand of reasoning in subsequent high Court decision in Myer Emporium and enactment of CgT mean that alienations of rights to receive income are not attractive tax planning strategies. Developments in the general anti-avoidance provision iTAA36 Part iVA mean that it should be adequate to combat any residual attempts at tax avoidance through these means. For pre-CgT rights to income, myer provides some protection to the revenue. Following on from the inoperative provisions report, we may move towards having a version of the Act that applies to transactions that take place in the current year and subsequent years, and another Act that contains provisions that only apply for earlier years.

iTAA36 Part iii Div 9C

income diverted to tax-exempt body under tax avoidance schemes taxable to tax-exempt body at corporate rate.

Tax effectiveness of original schemes depended on capital receipts for assignment of rights not being taxable to assignor. Schemes are thus less attractive following the introduction of CgT and the development of the Myer Emporium principle. Developments in the general anti-avoidance provision iTAA36 Part iVA mean that it should be adequate to combat any residual attempts at tax avoidance through these means.

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iTAA36 Sub Div 11B

Equity investments by lending institutions in SmEs taxed under CgT not under s 6-5 or s 8-1.

Purpose behind provisions was to allow indexation of cost base of equity investment. As neither indexation nor discounting are available to a company for equity investments made from 21/9/1999 onwards, lending institutions are no longer advantaged by these provisions. As capital losses are quarantined, lending institutions may now be disadvantaged by CgT treatment.

iTAA97 s 15-15

includes in assessable income profits from certain profit-making undertakings or plans that are not ordinary income and are not in respect of property acquired on or after 19 September 1985.

Following the decision in Myer Emporium and subsequent cases, the scope for the provision is limited. The case law based on the Myer Emporium decision broadly means that profits from isolated business transactions are taxed appropriately. given that the provision only applies to schemes in relation to property acquired more than 20 years ago, the potential scope for its operation is declining each year. The compliance and administrative costs associated with the provision may be likely to outweigh the revenue gains from it.

Following on from the inoperative provisions report we may move towards having a version of the Act that applies to transactions that take place in the current year and subsequent years, and another Act that contains provisions that only apply for earlier years.

iTAA97 s 15-20

Royalties in the ordinary meaning of that term that are not ordinary income are included in assessable income.

Provision only applies in rare and unusual cases. These cases can be adequately dealt with under CgT event D1 or CgT event h2. As neither capital losses nor discounting are applicable to either D1 or h2, the treatment, apart from the effect of capital loss quarantining rules, is essentially equivalent to an income treatment.

iTAA97 s 15-30

Amounts received by way of insurance or indemnity for loss of amounts that, if received, would have been assessable income, where amount received by way of insurance or indemnity is not ordinary income.

Scope of provision is very limited under iTAA97, as most amounts received by way of insurance or indemnity for loss of assessable amounts will be income under ordinary concepts. Application to amounts received in relation to anticipated profits is unsettled, but amounts received in relation to such profits will usually be ordinary income in any event.

iTAA97 s 25-10

Deduction for repairs Repairs to an income-producing asset would be deductible under the general deduction provision s 8-1. Specific provision is unnecessary. Technical differences do exist between s 25-10 and s 8-1 on nexus/relevance issues, but it is submitted that these are not significant. The provision traces back to iTAA 1915 and had antecedents in earlier State Acts and uK Acts before more comprehensive general deduction provisions had developed. Other comparable jurisdictions (e.g. Canada) seem to survive without a corresponding provision.

iTAA97 s 25-35

Deduction for bad debts Losses on receivables can be deducted on a realisation basis under iTAA97 s 8-1. under the present law, repeal of the specific provision would defer the time of recognition of the deduction. Deeming the writing off of a debt to be a realisation as part of a general set of realisation rules would produce substantially identical timing results to the present provision. Deeming a write-off to be a realisation would produce a uniform timing rule for s 8-1 and CgT purposes. This, with re-organisation of CgT suggested below, would result in fewer reconciliation issues between deduction provisions and capital loss provisions.

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iTAA97 s 25-40

Deduction for loss on profit-making undertaking or plan where profit would have been assessable under s 15-15.

Current provision has only limited application. The decision in Myer Emporium and subsequent court decisions mean that loss made from most isolated business transactions will be deductible under general deduction provision s 8-1.

Following on from the inoperative provisions report we may move towards having a version of the Act that applies to transactions that take place in the current year and subsequent years, and another Act that contains provisions that only apply for earlier years.

iTAA97 s 25-45

Deduction for loss from theft, embezzlement, etc. by taxpayer’s employees or agents, where amount lost was derived as assessable income.

Case law establishes that such losses are usually deductible under the general deduction provision s 8-1. Recent Fijian case law notes that such losses are an ordinary incident of the carrying on of business. Where the circumstances of theft or embezzlement are such as to deny the loss s 8-1 deductibility on the ground that the loss is of a capital nature under the general computational rules proposed below, the loss would still be recognised but would be characterised as a capital loss. The repeal of this provision might be thought be unfair to non-business taxpayers. in principle, however, it may be questioned whether a non-business taxpayer should obtain a deduction in these circumstances. Once a non-business taxpayer has derived income, a loss of that income is merely a loss of one of the taxpayer’s private assets and is unconnected with their income-producing operations. The position is different for a business taxpayer, as having employees and a business structure and the associated risks are part of carrying on your business.

iTAA97 s 26-30

Denial of deduction for travel expenses to the extent that they are attributable to a relative who accompanies the taxpayer when travelling.

Tests of relevance to income production and denial of deductibility for private or domestic expenditure in general deduction provision iTAA97 s 8-1 provide an adequate safeguard against claims of this nature. Current provision does not resolve difficulties of apportionment associated with some expenses of this nature.

iTA97 s 26-35

Payments to related entities only deductible where payment reasonable.

The general anti-avoidance provision iTAA36 Part iVA provides adequate protection against tax avoidance using this strategy. The introduction of a general market value substitution rule for non-arm’s length transactions would also obviate the need for this specific provision.

iTAA97 s 26-40

Denial of deductions for expenses of maintaining taxpayer’s spouse and children under the age of 16.

in most circumstances, such expenses would be denied iTAA97 s 8-1 deductibility on the grounds that they are of a private or domestic nature. Provisions are applied in situations where employed relatives are provided with accommodation or other services as part of remuneration for services. Consistent with treatment of other non-cash benefits, such provisions should be deductible to the employer and subject to FBT.

iTAA97 Part 2-5 Div 32

Denial of deductions for provision of non-employee entertainment.

Private benefit to employees is currently taxed correctly under FBT. Where no avoidance scheme is involved and where private benefit to employee is taxed appropriately, client entertainment should be seen as properly deductible under iTAA97 s 8-1. Any client entertainment provided as part of a tax avoidance scheme can be dealt with by general anti-avoidance provision iTAA36 Part iVA. FBT is taxing the private benefit to employees. Where expenses are incurred in entertaining clients, they should be seen as legitimate business expenses. Where there is an arrangement (e.g. where one firm entertains another firm one week, and then the process is reversed the next week) where it would be objectively concluded that the dominant purpose of the scheme was to obtain the tax benefit of a deduction, Part iVA would apply to deny the deduction.

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iTAA97 Part 2-42

Div 84 defines personal services income.

Division 85 limits the amounts that an individual can deduct in relation to personal services income. in broad terms, the individual is limited to deducting amounts that an employee would be able to deduct.

Sub Division 86A can include income derived from an individual’s personal services in that individual’s assessable income, notwithstanding that it was technically income derived by an interposed entity. The amount attributed is reduced by certain expenses that the interposed entity can deduct.

Subdivision 86B limits the deductions that can be claimed in relation to an individual’s personal services income derived through an interposed entity. The subdivision allows the interposed entity to deduct ‘entity maintenance expenses’ to deductions that would be available to an individual employee.

Divisions 85 and 86 do not apply to personal services income that is from conducting a personal services business.

Subdivision 87-A sets out the tests for determining whether a personal services business exists. Subdivision 87-B sets out when a personal services business determination may be made.

Following amendments introduced in 2001, taxpayers self-assess as to whether they are within the results test exception to the personal services income alienation provisions. The principal means available to the ATO for challenging alienation of personal services income to interposed entities remains the general anti-avoidance provisions iTAA36 Part iVA. Taxpayers who determine that they are within the results test exception to the PSi provisions are not thereby exempt from the operation of Part iVA, nor are taxpayers who are found to be within one of the other exceptions and thereby receive a personal services business determination. The PSi provisions therefore can have the effect of lulling some taxpayers and tax advisors into a false sense of security.

Prior to the introduction of the PSi provisions, alienation of PSi income to interposed entities was dealt with under ATO Rulings referring to potential Part iVA consequences. Those Rulings allowed interposed entities to be used for commercial reasons but required income to be distributed to the provider of personal services. The view of some practitioners was that this approach worked reasonably well.

Appendix 4(h) contains a consideration of what the result would have been under the PSi provisions in iTAA36 s 260 and Part iVA cases involving the alienation of personal services income to interposed entities.

Criticisms by practitioners of the PSi provisions have included the following:

(i) many family members working in interposed entities supplying the personal services of the principal perform legitimate functions for which legitimate salaries are paid: and

(ii) The PSi provisions distort economic behaviour by encouraging excessive distributions, as opposed to the financing of future growth through the retention of income.

Whether there is any overall benefit gained by the PSi regime is questionable. The splitting of rewards for personal services through an interposed entity where there is no genuine personal services business being carried on would be more simply dealt with by applying a general market value substitution rule to the salary paid to the related party providers of services to the interposed entity. A recommendation for a general market value substitution rule in non-arm’s length transactions is made below.

iTAA97 Part 3-1 Sub Div 110-B

Reduced cost base of CgT asset. For many CgT events this is the amount subtracted from capital proceeds in determining whether a capital loss has been incurred.

Original purpose behind reduced cost base provisions was to:

(i) prevent taxpayers from obtaining capital losses and deductions in respect of the one outgoing;

(ii) prevent indexation for inflation from being taken into account in calculating capital losses; and

(iii) prevent non-capital non-deductible costs of ownership from giving rise to capital losses. Subsequent amendments in 1997 have meant that otherwise deductible expenditure is excluded from cost base in any event, as are s 8-1 deductible losses on realisation. indexation for inflation is not available for assets acquired post-29 September 1999. The reduced cost base provisions could be replaced by a short provision stating that where cost base otherwise includes indexation and is less than capital proceeds, the indexation component in cost base is subtracted in determining whether a capital loss has been made. A similar provision could subtract non-capital non-deductible costs of ownership from cost base in calculating a capital loss. A specific provision would need to be introduced to deal with the situation currently covered by s 110-55(7). Currently s 110-55(9) prevents a taxpayer from obtaining both a revenue loss and a capital loss from the one realisation of an asset. The current scope of s 110-55(9) could be extended to subtract the revenue loss from cost base, even though the provision would be likely to only be operative where a capital loss was being calculated.

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iTAA97 Part 3-3 Div 149

Deems what would otherwise be pre-CgT assets of an entity to be post-CgT assets where there is a change in the majority underlying ownership of the entity. Cost base of deemed post-CgT assets taken to be market value of assets at time of change in majority underlying ownership.

These are anti-avoidance provisions aimed at preventing planning by acquiring control of pre-CgT assets by acquiring interests in entities that own those assets, rather than the assets themselves. if the Division were not present, however, the advantages obtained from this form of planning would be limited in any event. Where the entity owning the asset is a company, in circumstances where any gain from the pre-CgT assets would not be assessable to the company in the absence of Div 149, then the principal advantage obtained by the share purchaser would be non-taxation of the gain so long as it was retained at the corporate level. Once distributed, the provisions relating to dividends, deemed dividends and CgT on shares would normally ensure that the level of taxation imposed on the gain was broadly equivalent to the level of taxation that would have applied if the underlying asset had itself been purchased and sold. Previously, where the purchaser was a company, the iTAA36 s 46 inter-corporate rebate meant that the tax-exempt status of the gain could be passed on to the purchaser company via an unfranked dividend. Currently an equivalent result can only be obtained where the company acquired becomes part of a consolidated group. in those circumstances the consolidated group is seen as one tax entity, so it remains true that tax advantages only endure while the gain is retained by the consolidated group as a tax entity.

Where the entity owning the asset is a trust, as the gain will not form part of the net income of the trust estate, it also will not be taxed prior to its distribution. On distribution in a fixed trust, CgT event E4 would normally write down the cost base of the interests in the trust and may produce a capital gain at that time. in the case of discretionary trusts, the approach taken in ATO rulings on Div 149 has been that mere changes in the pattern of distributions do not trigger Div 149. In circumstances where, as a result of a resettlement, new object beneficiaries acquire interests in a discretionary trust for consideration, the ATO view appears to be that Div 149 applies. ATO rulings would suggest that CgT event E4 would apply to subsequent distributions to them.

in addition, as it is now over twenty years since the introduction of a general CgT in Australia, the need for anti-avoidance provisions directed at preventing planning utilising the pre CgT status of assets has diminished.

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Provision Subject Matter Comment

iTAA36 s 44(1)(b) Payment of dividend funded

from Australian profits to non-

resident shareholder.

Where dividend is paid by resident company and is subject to withholding tax, ITAA36 s

128D will mean that s 44(1)(b) does not apply. Following the enactment of the exemption

from withholding tax in iTAA36 s 128B(3E), the section will operate where a resident

company pays a dividend to a non-resident who is carrying on business in Australia

through a permanent establishment (PE), and the dividend is attributable to that PE.

Where dividend is paid by a non-resident and a Double Tax Treaty is applicable, Australia

usually forgoes the right to apply s 44(1)(b). Technically, provision can apply where a

non-resident company in a non-DTA country pays dividend funded from Australian

source profits to another non-resident. Provision is difficult, if not impossible to enforce in

these circumstances. With the extension of the conduit income regime to branches, the

potential revenue losses from repealing this provision would be confined to distributions

of Australian tax-preferred income by a non-DTA non-resident company to non-resident

shareholders.

The provision should be redrafted so that its operation is confined to payments of

dividends by resident companies to non-residents, where the dividend is not exempt

from withholding tax under either s 128D or s 802-15.

iTAA36 s 95A(2)

with possible

consequential

repeal of s 98(2)

and amendment

to s 99

Deems beneficiaries with

a vested and indefeasible

interest in trust income who

are not otherwise presently

entitled to that income to be

presently entitled.

Provision can only operate in rare and unusual circumstances. in over 20 years only two

decided cases (Dwight and Estate Mortgage) have found the provision to be applicable.

in Dwight this conclusion was reached only on the basis that s 95A(2) would apply if

the judge’s primary conclusion, that the beneficiaries were actually presently entitled,

was incorrect. in Estate Mortgage a decision was reached on s 95A(2) without deciding

whether the beneficiaries were actually presently entitled or not, as an s 95A(2) decision

circumvented the need to decide the actual present entitlement issue. Repeal of s

95A(2) would enable s 98(2) to also be repealed. Situations where a beneficiary would

be presently entitled but for an inability to demand payment (as in the Dwight and Estate

Mortgage situations) would be more easily dealt with by expanding the Commissioner’s

discretion to assess under s 99 to include these situations (i.e. where a beneficiary

would be presently entitled but for the absence of a right to demand payment).

CHAPTER FIVE

PROVISIONS WHICH ARE RARELY OR NEVER ENFORCED

1. IntroductionThis chapter recommends either the repeal or redrafting of

several provisions in iTAA36. in each case, administrative

practice is not to enforce the provision according to its literal

tenor. Some possible reasons why a tax administration might

decide not to enforce a provision according to its literal tenor

were discussed in Chapter Two. For the reasons discussed in

Chapter Two, a failure to enforce provisions according to their

literal tenor, while possibly reducing administrative costs, might

actually increase compliance costs.

2. RecommendationsThis report recommends that the following provisions, the literal meaning of which are rarely or never enforced, be either

repealed or redrafted:

ITAA36 s 44(1)(b), redrafted;

ITAA36 s 95A(2), with consequential repeal of s 98(2) and amendment to s 99;

ITAA 36 s 99B, redrafted; and

ITAA 36, Division 6D of Part ii (ultimate beneficiary non-

disclosure statement).

3. Justification for repeal recommendations

The following table summarises the subject matter dealt with by the above provisions and comments on the reasons why repeal or redrafting is recommended: (see table below)

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iTAA36 s 99B Literally can apply to

distributions of trust property

to a resident beneficiary

where income of the trust

estate exceeds net income

of the trust estate.

Commissioner’s practice has been to not apply provision in these circumstances.

Correctness of Commissioner’s practice has been confirmed by obiter dicta in the

Federal Court. Provision could be redrafted to clarify the law.

iTAA36 Division

6D of Part ii.

ultimate beneficiary non-

disclosure statements.

Commissioner’s practice has been to not require trusts that lodged a 1998-99 ultimate

beneficiary statement to lodge further statements where the trustee does not have an

ultimate beneficiary non-disclosure tax liability. ultimate beneficiary non-disclosure

statements, however, are required to be lodged by all new closely-held trusts. The

concession made by the Commissioner was in recognition of the high compliance costs

and draconian penalties for non-compliance in the provisions.

A better solution would be to empower the Commissioner to issue an access notice in

an audit context. Where the notice was not complied with, tax would be levied at the top

marginal rate plus medicare levy on distributions by the trust.


iTAA36 s 44(1)(b) Payment of dividend funded

from Australian profits to non-

resident shareholder.

Where dividend is paid by resident company and is subject to withholding tax, ITAA36 s

128D will mean that s 44(1)(b) does not apply. Following the enactment of the exemption

from withholding tax in iTAA36 s 128B(3E), the section will operate where a resident

company pays a dividend to a non-resident who is carrying on business in Australia

through a permanent establishment (PE), and the dividend is attributable to that PE.

Where dividend is paid by a non-resident and a Double Tax Treaty is applicable, Australia

usually forgoes the right to apply s 44(1)(b). Technically, provision can apply where a

non-resident company in a non-DTA country pays dividend funded from Australian

source profits to another non-resident. Provision is difficult, if not impossible to enforce in

these circumstances. With the extension of the conduit income regime to branches, the

potential revenue losses from repealing this provision would be confined to distributions

of Australian tax-preferred income by a non-DTA non-resident company to non-resident

shareholders.

The provision should be redrafted so that its operation is confined to payments of

dividends by resident companies to non-residents, where the dividend is not exempt

from withholding tax under either s 128D or s 802-15.

iTAA36 s 95A(2)

with possible

consequential

repeal of s 98(2)

and amendment

to s 99

Deems beneficiaries with

a vested and indefeasible

interest in trust income who

are not otherwise presently

entitled to that income to be

presently entitled.

Provision can only operate in rare and unusual circumstances. in over 20 years only two

decided cases (Dwight and Estate Mortgage) have found the provision to be applicable.

in Dwight this conclusion was reached only on the basis that s 95A(2) would apply if

the judge’s primary conclusion, that the beneficiaries were actually presently entitled,

was incorrect. in Estate Mortgage a decision was reached on s 95A(2) without deciding

whether the beneficiaries were actually presently entitled or not, as an s 95A(2) decision

circumvented the need to decide the actual present entitlement issue. Repeal of s

95A(2) would enable s 98(2) to also be repealed. Situations where a beneficiary would

be presently entitled but for an inability to demand payment (as in the Dwight and Estate

Mortgage situations) would be more easily dealt with by expanding the Commissioner’s

discretion to assess under s 99 to include these situations (i.e. where a beneficiary

would be presently entitled but for the absence of a right to demand payment).

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CHAPTER SIXRATIONALISATION OF THE RULES THROUGH THE ADOPTION OF COMMON OR MORE GENERAL RULES

1. IntroductionThis chapter contains recommendations for the rationalisation

of rules through the adoption of common or more general rules.

Although this chapter frequently deals with situations where the

iTAA36 of iTAA97 contain more than one set of rules dealing with

a similar topic, in contrast to Chapter Four, it does not simply

recommend the repeal of one of these sets of rules. Rather it calls

for the development of a further common set of rules in substitution

for two or more existing sets of rules. in some instances, this

chapter also calls for the broadening of the scope of existing

rules so that, so far as possible, all equivalent transactions are

covered by the relevant rule.

2. RecommendationsThe recommendations in this chapter also call for the disentangling

of computational, timing and characterisation rules. The cumulative

development of rules in the Australian income and fringe benefits

tax systems has meant that computational rules become

entwined with characterisation rules. in some instances, specific

computational rules do not exist. Differences in computational rules

between rules dealing with overlapping characterisations places

stress on and can produce anomalies in the operation of anti-

overlap rules. Similarly, in some instances in iTAA36 and iTAA97,

timing rules become entwined with characterisation rules. in the

case of the forex rules and in the proposed TOFA provisions, timing

rules become a characterisation rule. This approach tends to result

in a multiplication of exceptions to the general characterisation. The

existence of exceptions adds to the complexity of the rules and yet

always risks offering an insufficient coverage and being insufficient

adaptable to changes in business practices.

This report recommends the rationalisation of rules through the

adoption of common or more general computational rules for gains

and losses from realisation events. This requires the development

of a common set of computational rules that would enable

rationalisation of separate rules that exist in the following areas:

Concept of asset, e.g. in Part 3-1 and Division 40;

Concepts of cost, e.g. in Part 3-1 and Division 40;

Concepts of proceeds of realisation, e.g. in Part 3-1 and Division 40;

Realisation events – scope for grouping and rationalising the number of events recognised, e.g. in Part 3-1, Division 40 and

Division 70;

movements in foreign exchange rates to be taken into account

in computing gain or loss but not to affect capital/revenue

characterisation of gain or loss; and

Traditional security provisions could be covered under the

general computational rules.

Development of this common set of computational rules would

enable gains and losses from realisation events into mutually

exclusive categories – e.g. trading stock; gain/loss on realisation

of revenue asset; gain/loss on discharge of liability on revenue

account; depreciation recapture; gain/loss on realisation of a capital

asset; and gain/loss on discharge of capital liability. Gains and

losses so classified could then be treated accordingly. This would

obviate the need for many, if not all, of the existing anti-overlap

rules, such as s 118-20.

This report also recommends the rationalisation of rules through

the adoption of common or more general rules in the following

areas:

Trigger tests for small business concessions in CGT, the ‘at

call’ loan provisions, STS, and GST – common rules could be

developed;

Existing regimes permitting deductions for ‘black hole’

expenditures – existing rules could be replaced with more

general and comprehensive rules;

Timing rules for advance receipts/payments and deferred

receipts/payments and rules for discounts and premiums

– income/deductible character of receipt/payment should be

considered independently from timing issues;

Source rules for business profits and rules for calculation of

profits from international transactions;

Valuation rules for non-cash benefits – the coverage of the

current rules is limited to employment and business situations

– a general rule for valuing all non-cash benefits could be

developed– all non-cash employment benefits could be dealt

with under FBT;

Relationship rules – e.g. subsidiary, associate, etc.;

Arm’s length substitution rules – a general arm’s length

substitution rule could apply to most non-arm’s length

situations subject to exceptions; and

Elections, choices and notifications – develop common rules for

the timing and form of all elections.

3. Justification for recommendationsThe following table summarises the provisions currently dealing

with the subject matter where it is recommended that rationalisation

would be desirable, and comments on the type of rationalisation recommended: (see table on next page)

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Subject matter of rules

Provisions dealing with subject matter Comment

Deductions permitted for certain ‘black hole’ expenditures

Numerous provisions throughout the iTAA97 deal with various types of ‘black hole’ expenditures. These include:

iTAA97 s 25-15 (Amount paid for failure to comply with lease obligation to repair)

iTAA97 s 25-20

(Certain lease document expenses)

iTAA97 s 25-25 (Expenses of borrowing money for the purpose of producing assessable income)

iTAA97 s 25-30 (Expenses of discharging a mortgage used as security for a borrowing for the purpose of producing assessable income)

iTAA97 s 25-100 (Deductions for travel between different work places)

iTAA97 Subdivision 40-h

iTAA97 Subdivision 40-i

Current specific regimes exist because they deal with expenses that have been found not to have the requisite timing (or other) nexus to the process of income production to be deductible under iTAA97 s 8-1. Coverage of the current specific provisions is incomplete. Some specific provisions allow outright deductibility; others allow various forms of amortisation deduction.

Recommend that, except where expenditure produces an economic benefit extending beyond one year, it should be deductible outright in the year that is most appropriate. Where the expense was incurred prior to the commencement of the taxpayer’s business (or other activity directed towards the production of income), the appropriate year of deduction would be the year in which business commenced. Where the expense was incurred after the business had ceased, it would be appropriate to carry the expense back to the last year in which business was conducted. Refunds of tax would be appropriate in these circumstances. Where expenditure produces an economic benefit extending beyond one year, the general rule should be that it is deductible over the duration of that period. A similar approach has been taken to pre-commencement and post-cessation expenditure in the united Kingdom for many years.

The case law interpreting s 8-1 and its progenitors has traditionally adopted a narrow concept of business that is inconsistent with contemporary business organisation. general provisions dealing with black hole expenditure need to allow deductions for expenses that are relevant in a general sense to the taxpayer’s general business operations. At the same time, general provisions would need to guard against their abuse and would need to prevent deductions of spurious business expenses or expenses where the connection with another process directed at producing income is remote (for example, where no income-producing activity of any kind ever commences, or where the expense is related to obtaining educational qualifications by a person who has never earned income from activities for which that qualification is relevant).

in drafting a general deduction provision for black hole expenditures, consideration would also need to be given to whether the location of the current boundary between deductible expenses and private or domestic expenses is appropriate. The relevance of such consideration to the drafting of a general deduction provision for black hole expenditure is that expenses such as child care and commuting have often been denied deductibility, on the grounds that they are expenses preliminary to working, rather than expenses of working. Extending a general rule to cover these situations would involve additional considerations, as the key issue is not the allocation of an expense to tax accounting periods but the relevance of the expense to activities conducted within a tax accounting period. iTAA97 s 25-100 is illustrative of the problems associated with dealing with these issues.

Tax (measures No 1) Bill 2006 proposes to repeal iTAA97 s 40-880 and replace it with provisions that will permit a five-year straight line write-off for certain capital expenditures in relation to existing businesses, and for pre-commencement and post-cessation expenditure under certain conditions. The bill contains certain features aimed at protecting the integrity of the tax system, particularly in the pre-commencement context. The deductions proposed to be allowed under the bill will be quarantined via the non-commercial loss provisions. While producing some rationalisation of existing provisions, the bill is insufficiently comprehensive. Providing for a five-year write-off is arbitrary and will not accurately reflect economic income. As stated above, with the nexus for deductibility of pre-commencement and post-cessation business expenses effectively being broadened, consideration also should be given to what would be an appropriate tax treatment for expenses relating to gaining employment, child care and commuting costs.

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includes gains on traditional securities in income and allows deduction for loss on traditional securities

iTAA36 s 26BB and s 70B gain or loss can be calculated under general computation rules envisaged below. Except where trading stock specific would classify as assessable income and exclude from CgT treatment. The main change here would be in location and logical organisation of the rules with the tax law.

meaning of asset CgT asset s 108-5Depreciating asset s 40-30iTAA97 s 977-55 defines when a CgT asset will be a revenue asset.The term ‘asset’ is used a total of 4975 times in iTAA97. While many of the instances of the term ‘asset’ in ITAA97 depend on or refer to these definitions, other provisions use the term in an undefined sense, and meaning will depend on general law. The consolidation provisions use the term ‘asset in an undefined sense, which includes CgT asset, depreciating asset and trading stock. The thin capitalisation rules also use the term ‘asset’ in an essentially undefined sense. Some sense of the extent of the undefined use of the term ‘asset’ in ITAA97 can be seen from the following list of defined terms that include a use of the term ‘asset’ in an undefined sense: (a) the definition of ‘adjustable value’ for purposes of s 715-100 and for indirect value shifting purposes; (b) the s 995-1 definition of equity capital of an entity; (c) the s 995-1 definition of ‘market value of an asset’; (d) the s 995-1 definition of the ‘transfer value’ of an asset; and (e) the definition of ‘securitised asset’ in s 820-942 for thin capitalisation purposes.

There are very significant differences between the two statutory definitions. The definition of CgT asset is based on legal notions of property extended to cover non-proprietary rights. The definition of depreciating asset is based more on the accounting concept of economic benefits and depends on the asset having a limited effective life. Despite these differences, there is considerable overlap between the two definitions in their actual operation.

The term ‘asset’ is extensively used in an undefined sense throughout the iTAA. general rules of statutory interpretation will determine the meaning given to the term in those contexts.

The law would be clarified by the enactment of a general definition of ‘asset’. A depreciating asset, a CGT asset, trading stock, and a revenue asset could then be defined as sub-categories of assets. A CgT asset could be defined so as to exclude assets where the gain or loss on their realisation was ordinary income or deductible. This would remove the need for several anti-overlap provisions between CgT and other parts of iTAA. Specific reconciliation provisions could be retained for some situations, such as disposals of depreciating assets that have been the subject of partial private use; but these should be stated as special provisions dealing with exceptional situations.

Cost of an asset Major provisions include:

Cost of depreciating asset Sub Div 40-C

Cost base of CgT asset Sub Div 110-A

The trading stock provisions refer to the cost of trading stock as one of the methods for valuing trading stock at year-end. Cost as such is not defined for trading stock purposes, but some deeming provisions (such as s 70-30 and s 70-55) can deem the cost of trading stock to be a particular amount. Outside these deeming provisions, the general law will determine what the cost of trading stock is.

Although technical language of the two major sets of statutory provisions differs, in many instances the end result of the operation of the two provisions is virtually identical. The modifications to the general rules in both Subdivisions also largely duplicate each other and produce equivalent results. Differences between the two Subdivisions sometimes appear to be more a product of their historical antecedents rather than of the particular characteristics of the different regimes.

Cost differences between regimes (e.g. CgT, capital allowances, trading stock, revenue assets) can mean that there is a greater need to refer to relatively complex anti-overlap provisions.

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Other provisions generally use the term ‘cost’ in an undefined way. Case law on gains and losses on revenue assets depends on the concept of cost, but the concept is not defined in the iTAA. in these instances, the meaning of cost will depend on general law.

The consolidation provisions contain rules for determining the tax cost setting amounts for entities. These rules distinguish between retained cost base assets and reset cost base assets.

There is a case for having a common set of cost rules located in a part of the iTAA dealing with the calculation of gains (whether capital or income) generally. in instances where there is a sound policy reason to vary the common rules, that variation could appear as an exception in the common cost rules section.

Developing a common set of rules for determining the cost of assets should enable the consolidation rules in relation to both retained cost base assets and reset cost base assets to be simplified.

Realisation events in CgT, the relevant concept is CgT event. many CgT events, however, do not involve a change in the ownership of an asset. Not all of the CgT events that involve a change in the ownership of an asset compute capital gains and losses by reference to capital proceeds, cost base and reduced cost base.

The following CgT events involve a change in the ownership of a CgT asset and compute capital gains or losses by reference to capital proceeds, cost base and reduced cost base: A1, C1, C2, C3, E1, and E2. CgT event B1 computes capital gain or loss by reference to capital proceeds, cost base and reduced cost base. Currently the computation of a capital gain or loss is set out in detail in the operative provisions relating to each of these events.

CgT events that involve a change in the ownership of an asset calculate capital gains and losses by reference to market value, cost base and reduced cost base. These CgT events are: E5, E6, E7, i1, i2, j1, j4, K3, and K4.

Capital allowance provisions – concept of balancing adjustment event in s 40-295.

in other parts of the iTAA when realisation is referred to, it is usually an undefined term.

iTAA97 s 977-55 contains a definition of a realisation event for a revenue asset.

if CgT events that do not involve a change in the ownership of a CgT asset were to be isolated from other CgT events, it may be possible to reduce the number of the latter type of events considerably. This would provide an opportunity for a return to a central paradigm for CgT events based on changes in the ownership of an asset. Current events that did not fit within the paradigm would be dealt with by separate specific provisions.

Subject to the above comment, each of these CGT events could be classified as realisation events in relation to an asset, where normal computational rules apply. The differences between these events are due to the time when gain or loss is recognised, not to the method for quantifying gain or loss. There is no reason to confine recognition of realisation in these circumstances to events having CgT consequences.

general computational rules could state that gain or loss from these events would be computed by reference to proceeds and cost. These rules could apply for CgT purposes, capital allowance purposes, trading stock purposes, and s 6-5 and s 8-1 purposes. Classification of the gain or loss as capital gain, depreciation adjustment, or on revenue account would primarily depend on the status of the asset being realised.

Subject to the above comment, each of these CGT events could be classified as realisation events in relation to an asset, where proceeds are regarded as being market value. general computational rules could state that gain or loss from these events would be computed by reference to market value and cost. Resulting gains or losses would be classified according to the status of the asset that the event related to.

A balancing adjustment event for capital allowance purposes can be triggered by actions such as deciding to stop using an asset for any purpose. it would not be appropriate for such actions to be regarded as a realisation of an asset for other purposes in the iTAA. if a general statement of realisation events were to be developed, as suggested above, then it may be necessary to state special rules in relation the effect for capital allowance purposes of decisions to cease using an asset.

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Proceeds of

realisation

Major provisions relevant to determining the

proceeds of a realisation include:

Capital Allowances – depreciating assets.

The relevant concept is ‘termination value’.

A number of provisions are relevant in

ascertaining ‘termination value’. These

include:

iTAA97 ss 40-300, 40-305, 40-310, 40-315,

40-320, 40-325

Capital Gains Tax – ITAA97 Part 3-1

Subdivision 116 (Capital proceeds for

CgT). For some CgT events, the capital

proceeds are specified in the event itself

– the following provisions in ITAA36 are

also relevant in some circumstances: s

159gZZZP and 159gZZZg (cancellation of

shares in a holding company); s 159gZZZQ

and s 159gZZZS (share buy backs); ss 401,

422, 423, and 460 (CFCs); and s 613 (FiFs).

The trading stock provisions do not have a

general definition of proceeds of realisation,

but some provisions (such as s 70-95 to 70-

110) can deem the proceeds of realisation

to be particular amounts in certain

circumstances.

Capital allowance provisions

Traditional securities provisions: proceeds

are undefined and meaning will depend on

general law.

For s 6-5 and s 8-1 purposes proceeds are

not defined and will depend on the general

law.

Although technical language of the two major sets of statutory

provisions differs, in many instances the end result of the operation of

the two provisions is virtually identical. The modifications to the general

rules in both Subdivisions also largely duplicate each other and produce

equivalent results. Differences between the two Subdivisions sometimes

appear to be more a product of their historical antecedents rather than

of the particular characteristics of the different regimes.

There is a case for having a common set of rules on proceeds of

realisation located in a part of the iTAA dealing with the calculation of

gains (whether capital or income) generally. in instances where there is

a sound policy reason to vary the common rules, that variation could

appear as an exception in the common proceeds of realisation section.

Advance receipts Case law allows recognition over time

under the Arthur murray principle, but this is

restrictively interpreted by the ATO.

Structure of Act would be simplified if dealt with systematically under

general timing rules based on economic benefits/detriments obtained.

issues associated with the timing of a receipt should not be confused

with issues associated with the (income or capital) character of the

receipt.

Consideration would need to be given as to whether the general

timing rule would produce appropriate results when applied to capital

proceeds for CgT purposes. The current rule exposes the revenue to

tax-motivated strategies aimed at advancing recognition of the capital

losses.

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Deferred receipts iTAA36 Part iii Div16E recognises interest on deferred interest securities on an accruals basis.

Structure of Act would be simplified if dealt with systematically under general timing rules based on economic benefits/detriments obtained.

issues associated with the timing of a receipt should not be confused with issues associated with the (income or capital) character of the receipt.

Consideration would need to be given as to whether the general timing rule would produce appropriate results when applied to capital proceeds for CGT purposes. Here the revenue’s obvious concern would be with tax motivated strategies aimed at deferring recognition of gains. Arguably this concern is misplaced, and the application of a general timing rule would reduce overall distortions of economic behaviour in the CgT system.

Advance payments. iTAA36 Part iii, Division 3, Subdivision h.

Principle in Coles Myer Finance means that advance payments are only deductible if properly referable to the relevant year of income

Anti-avoidance aspects adequately protected under general anti-avoidance provision iTAA36 Part iVA. Development of case law, via the Coles myer Finance decision, also means that there is less need for specific anti-avoidance provisions of this nature. A general timing rule for advance and deferred expenditure could deal with timing aspects systematically and concisely.

issues associated with the timing of a payment should not be confused with issues associated with the (deductible or non-deductible) character of the payment.

Consideration would need to be given as to whether the general timing rule would produce appropriate results when applied to cost base for CgT purposes.

Deferred payments iTAA36 Part iii Div 16E allows deductibility on an accruals basis of interest on deferred interest securities.

general rule in case law is that liability is not deductible while it is still contingent on the basis that it is not yet incurred. Some case law looks to commercial realities of the situation and some, Coles myer Finance, suggests that liability may be incurred even if theoretically contingent.

Case law, Alliance holdings and Australian guarantee Corporation, also permits accruals recognition in certain circumstances but not comprehensively.

Structure of Act would be simplified if dealt with systematically under general timing rules based on economic benefits/detriments obtained.

issues associated with the timing of a payment should not be confused with issues associated with the (deductible or non-deductible) character of the payment.

Consideration would need to be given as to whether the general timing rule would produce appropriate results when applied to cost base for CgT purposes. The current timing rule advances the date of recognition of cost that might be thought to be disadvantageous to the revenue in some circumstances.

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Discounted securities iTAA36 Part iii Division 16E Structure of Act would be simplified if dealt with systematically under general timing rules based on economic benefits/detriments obtained.

Relationship rules There are many instances in iTAA97 and iTAA36 of multiple definitions of terms denoting relationships between entities. The task of listing them is complicated by the fact that in some instances different provisions in the legislation use terms that are different but are virtually synonymous. The following is a list of the number of times the term ‘subsidiary’ appears in iTAA97, iTAA36, FBTAA, and in the income Tax (international Agreements) Act, and of instances where the term is either defined or where a term that includes the word ‘subsidiary’ is defined.

For example, there are 1068 instances of the term ‘subsidiary’ in ITAA97. The term ‘100% subsidiary’ is defined in s 975-505, the term ‘demerger subsidiary’ is defined in s 125-65, the expression ‘subsidiary member of a consolidated group’ is defined in s 703-15, the expression ‘subsidiary member of a MEC group’ is defined in s 719-25, and the term ‘wholly owned subsidiary’ is defined in s 703-30. The term ‘subsidiary’ as such is not defined in iTAA97, although it is used in a sense that is not within any of the above definitions in instances. There are 575 instances of the term in ITAA36. The terms ‘100% subsidiary’, ‘demerger subsidiary’ and ‘subsidiary member of a consolidated group or a MEC group’ are defined in s 6(1) as having the same meaning as in iTAA97. For the purposes of iTAA36 s 26AAD, ‘subsidiary’ is defined as having the same meaning as in the Corporations Act 2001. A public company subsidiary is defined in s 103A(4) to s 103A(7).

A comprehensive review should be made of the use of all terms that denote relationships between entities. Where possible, terms that are virtually synonymous should be the subject of one definition. Where defined terms are subsets of a wider term denoting relationships between entities, the dictionary should be organised so that the subsets are grouped together under the term denoting the more generic relationship in question. For example, in the case of subsidiaries there should be a generic definition of ‘subsidiary’. The terms ‘wholly owned subsidiary’, ‘demerger subsidiary’ and so on could then be listed and defined alphabetically under the heading ‘subsidiary’. The cross-reference and hypertext link from the use of these terms in relevant operative provisions could take the reader to the definition of ‘subsidiary’ and note that the definition of the subset term is located there. A review should be made of the policy reasons behind the existence of the different subsets and differences between them with a view to reducing the number of subsets. Such a review, for example, could examine whether it is necessary to have separate, but very similar, definitions of ‘100% subsidiary’ in s 975-505 and ‘wholly owned subsidiary’ in s 703-30.

Non-cash benefits Examples include:iTAA97 s 103-5iTAA97 s 110-25iTAA97 s 116-20iTAA36 s 21iTAA36 s 21AiTAA36 s 26(e)FBTAA (numerous valuation rules)

Non-cash employment benefits are largely, but not exclusively, dealt with under FBTAA, with there being some residual operation of iTAA36 s 26(e). Non-cash business benefits are dealt with through the combined operation of iTAA97 s 6-5 and iTAA36 s 21 and s 21A, which interact with the provisions denying deductibility for client entertainment expenditure. Currently, restrictive operation of iTAA97 s 21A and the rule in Tennant v Smith mean that gains from property (such as dividends, interest, rent and royalties) are not ordinary income if the benefit provided to the recipient is not convertible into cash. The general rules for calculating cost and capital proceeds for CgT purposes also include provisions that substitute the market value of property other than cash for that property in determining the cost base of a CgT asset or the capital proceeds for a CgT event.

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A common set of valuation rules for non-cash benefits should be developed and located in a general computational division. The key elements would include: (a) substitution of the market value for non-cash consideration; (b) disregarding restrictions on convertibility in determining market value; (c) where the provider of the benefit is denied a deduction for its provision, reducing the amount of the benefit recognised by the amount at which the deduction was denied; (d) where the benefit would have been deductible to the recipient if the recipient had acquired the benefit itself, reducing the amount at which the benefit is recognised by the amount of the deduction that the recipient would have otherwise obtained; (e) where the recipient has contributed towards the cost of providing the benefit, reducing the amount at which the benefit is recognised by the amount of the recipient’s contribution; (f) a general de minimis rule for non-cash benefits; and (g) a set rule for valuing non-cash benefits for the purpose of the general de minimis rule. in the case of some benefits (such as cars), there may continue to be a need to have more particular valuation rules. Such specific rules would be easily implemented, however, if they were stated as exceptions to and variations on the more general rules.

having used the computational rules to determine the amount at which a non-cash benefit was to be brought to account, its tax treatment would then vary according to whether it was: (a) a benefit provided to an employee (to be the exclusive preserve of FBT); (b) ordinary income (to be taxed under s 6-5, s 44(1), etc.); or (c) capital gain (to be taxed under the CgT provisions).

Source rules for business profits and calculation of profits from international transactions.

ITAA36 ss 38 – 43

general law principles largely determine source in relation to export sales. The place of sale and the value added at stages in the production process are the most relevant considerations here.

iTAA36 Div 13 (Transfer Pricing) is also relevant to calculation.

Where DTA applies, Australia only taxes business profits of a non-resident if attributable to a permanent establishment.

much of the case law is very old, and the case law rules, particularly place of contract, are easily manipulated. Sections 38-43 are old provisions. The application of these provisions to export sales is unclear, as is their application to intangible property and to some modern forms of business organisation and distribution. Sections 38-43 deal with actual costs and proceeds and can have little or no application in transfer pricing situations.

Currently casual sales by non-residents are theoretically caught where no DTA applies. Where DTA applies, business profits of a non-resident are only taxed where conducted through a permanent establishment.

Propose that all business profits of non-residents only be regarded as having an Australian source when attributable to a permanent establishment. This would harmonise the treatment of non-residents from DTA and non-DTA countries and would be consistent with the 2005 amendments to the treatment of dividends paid to non-resident PEs.

Logical structure of the Act would be improved by co-locating all provisions (including transfer pricing provisions) relevant to the measurement of business profits from international transactions.

Division 13 is currently structured and enforced as an anti-avoidance provision. Notwithstanding this it is applied in situations where globally there may have been no overall reduction in tax paid. hence it is currently used in an effort to resolve inter-jurisdictional allocation issues. The use of an anti-avoidance approach in such circumstances seems inappropriate and sometimes results in the mutual agreement procedure under DTAs being invoked. Suggest that Division 13 be amended so that it does not apply where the taxpayer can demonstrate that there was no overall reduction in the global tax liabilities of the taxpayer and its associates.

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Rules substituting market value or arm’s length value

For example, the following in iTAA97 rules substitute either market value or arm’s length value in non-arm’s length transactions.s 40-180(2) item 8 in Table (mv)#s 40-190(3) item 1 in Table (mv)#s 40-300(3) (mv)##s 40-560 (mv)#s 40-660 (mv)#s 40-765 (mv)#s 70-20 (mv)#s 70-90 * (mv)s 70-95 * (mv)s 70-120(6) (mv)s 112-20(1)(c) (mv)+s 116-30(2) (mv) +s 240-3(1) (alv)s 240-7(1) (alv)s 240-25(5)(b) (alv)s 376-65 (alv)s 775-120 (alv)

# market value is only substituted where actual is greater than arm’s length value

## market value is only substituted where actual is less than market value

*Apply where disposal outside ordinary course of business that will include non-arm’s length transactions

+ Subject to exceptions

it is also common for market value or arm’s length value to be substituted for actual consideration in other situations; for example, where no consideration has been paid.

many of the current provisions (such as sss 40-560, 40-660, 40-765) are virtually clones of each other. There does not appear to be any sound reason why some provisions substitute market value in a non-arm’s length transaction, while others substitute arm’s length value. Exceptions to the rule could be clearly stated in the general rule. Despite the number of rules substituting market value or arm’s length value for actual consideration, the coverage of the existing rules is not comprehensive. For example, there is no general market value substitution rule dealing with non-arm’s length or no consideration transactions for ITAA36 s 6-5 or s 8-1 purposes.

There would appear to be clear scope for the rationalisation of these provisions by enacting a general market value substitution rule for non-arm’s length and no consideration transactions.

Tests for accessing small business concessions

For CgT small business concessions: less than $5 million net value.

For at call loans: $20 million annual turnover.

For Simplified Tax System: gateway threshold of average turnover of less than $1 million.

For gST cash accounting: gateway threshold of turnover of $1 million.

A common test based on turnover should be developed for accessing all small business concessions. The small business threshold should be set at a realistic level in the present economic environment and should be indexed to inflation.

Elections, choices and notifications

CgT choices are regulated through iTAA97 s 103-25. Numerous other elections, choices and notifications are spread throughout the iTAA36 and iTAA97.

A co-ordinated and comprehensive regime, with uniform terminology, should be developed. At a minimum this regime should co-locate rules on elections and notifications. The rules should clearly indicate when the relevant election or notification should be made and the manner in which it should be made.

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CHAPTER SEVENTHE ADOPTION OF DE MINIMIS RULES, DEEMED COST/PROCEEDS RULES AND COMMISSIONER’S DISCRETION NOT TO APPLY CERTAIN RULES

1. Introductionin general this report has refrained from making

recommendations for major policy changes, on the grounds that

such changes involve a set of economic, political and social

considerations not properly within the scope of this report.

The report has also, however, supported the view that revenue

collections from any provision should be balanced against the

administrative and compliance costs associated with it.

The existence of de minimis rules, deemed cost rules

and discretions not to enforce a provision usually represent

a judgment by the legislature that the compliance and

administrative costs associated with a provision outweigh the

revenue gained from enforcing it in certain situations.

The recommendations in this chapter for a review of de

minimis rules, for the enactment of further de minimis rules

and deemed cost rules are also based on a judgment that

in these situations the compliance and administrative costs

associated with enforcing these provisions outweigh the likely

revenue collected. The recommendation that the Commissioner

have discretion not to apply iTAA36 Division 7A in certain

circumstances has a somewhat different rationale. The basis

for this recommendation is that in its literal meaning Division 7A

affects transactions that are not part of the mischief that it was

intended to prevent.

2. RecommendationsThis report recommends:

Review of all de minimis thresholds and capping provisions

in income tax and FBT having regard to inflation since the

introduction of the relevant provision;

Ongoing indexation of revised de minimis rules to inflation;

Enactment of deemed cost rules for longer-term holdings of

interests in listed entities;

Enactment of de minimis rules permitting a 100% capital

allowance write-off for costs of individual assets or sets of

assets under $1000; and

giving the Commissioner discretion not to apply Division 7A

where it would be objectively concluded that the dominant

purpose of the transaction giving rise to the Division 7A

deemed dividend was not to obtain a tax benefit for the

company, a shareholder or an associate.

The following table summarises the provisions currently

dealing with the subject matter, where it is recommended that de

minimis rules or deemed cost rules be enacted, and summarises

the reasons behind the recommendations:

The recommendation made in relation to Division 7A is that

the Commissioner should be given discretion not to apply

Division 7A in situations where it would be objectively concluded

that the dominant purpose of the relevant transaction was not

to obtain a tax benefit for one of the parties involved in the

transaction or their associates. “Tax benefit” would be defined in

terms that parallel the definition of that expression in the general

anti-avoidance provision.

iTAA36 Division 7A can technically apply in situations (for

example, through a reorganisation of bank loans) where there

has been no intention to confer tax benefits on a shareholder

or an associate. The recommendation would mean that if the

Commissioner’s discretion were exercised, Division 7A would

not operate in circumstances where the dominant purpose

of the transaction was such that it would not have triggered

the operation of the general anti-avoidance provision. This

approach would align Division 7A with the purposive approach

to triggering anti avoidance provisions in iTAA36 Part iVA.

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CHAPTER EIGHT

A CASE FOR A COMPREHENSIVE REWRITE OF AUSTRALIA’S INCOME AND FRINGE BENEFITS TAX LAWS

1. IntroductionA principal argument in this report is that, over time, the cumulative

development of operational rules has obscured the fundamental

policy objectives of Australian tax laws. The recommendations

in this report for repealing unnecessary provisions, repealing or

amending provisions that are rarely enforced, rationalising rules

through adopting common or more general rules, updating de

minimis rules and introducing some deemed cost rules, should,

by eliminating much of the ‘noise’ in the system, enable the

fundamental policy objectives of the law to be more clearly

apparent. Nonetheless, the operational rules that remained would

still be extremely detailed and in many cases would be written in a

‘black letter law’ drafting style.

2. The future

going forward, it would be desirable to develop, through a process

of extensive community consultation, an official statement in clear

language of the fundamental policy objectives of the Australian tax

system. This would, in effect, amount to a statement of what we

consider the income and fringe benefits tax base in Australia to be.

This process would also involve identification of areas where tax

planning strategies could compromise the integrity of the tax base.

Following the development of a clear statement of fundamental

objectives, consideration could then be given to the level of detail

that was thought to be necessary in the operational rules giving

effect to those fundamental objectives. A clear statement of

fundamental objectives and clear directions to judges to interpret

provisions in a purposive manner should provide the opportunity

for reducing the level of detail in operational rules.

For example, under this approach it may be possible to state:

(a) general rules for computing gains and losses on the realisation

of assets or the discharge of liabilities;

(b) rules for characterising gains and losses into mutually

exclusive categories such as: those on revenue account;

capital gains or losses; or realisations of trading stock, etc.;

(c) rules for how the types of gains and losses identified in (b) are

to be taxed; and

(d) exceptions to the rules in (c).

This approach would mean that anti-overlap provisions should

not be necessary. it should also mean that if the taxing rules in

respect of gains and losses are stated clearly enough, it should

be possible to reduce the level of detail in the computational

rules in (a) above. under this approach, as discussed in relation

to the overlap between iTAA97 Divisions 40 and 43 in Case Study

5 in Chapter Three, the relationship between any potentially

overlapping provisions would be stated in clear and positive terms

that reflect the fundamental policy reasons for different treatment

under different divisions.

This report supports a principle that, where possible, rules

should be targeted so that they only affect taxpayers engaged

in transactions or with characteristics that make the rationale

behind the rule relevant to them. The targeting of rules in this

manner could result in the development of multiple sets of rules

for different types of taxpayers. The view taken in this report is

that such development should only be permitted where it can

be shown that the characteristics of different types of taxpayers

justify the development of separate sets of rules, and that the

development will result in reduced compliance costs. Consistent

with the discussion on poor targeting of rules in Chapter Two and

Case Study 3, there is a case for developing an alternative optional

set of corporate-shareholder rules for entities having defined

characteristics.

Similarly, redrafted legislation should be organised so as

to minimise the inclusion of material that is irrelevant to some

taxpayers in computational steps. This report recommends that,

in a series of computational steps, the general rule or the rule that

is applicable in the most common situations should be stated

first, with rules that apply only in exceptional circumstances only

being stated subsequently. Where method statements are used,

redrafted legislation should contain a statement of the overall

effect and intention of the method statement.

As noted in the discussion in respect of the eighth cause of

complexity in Chapter Two and in Case Study 4 in Chapter Three,

complex problems arise where rules affecting the derivation

of income and gains and the incurring of expenses and losses

through entities, operate at different levels of the entity.

The majority of recommendations made in this report would

represent only a first step towards the simplification of the

Australian income and fringe benefits tax systems. The step

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would nonetheless be an important one, as it would involve

removing much unnecessary or unenforced operational detail and

rationalising some other operational rules through the development

of more general and common rules. This process should enable

us to begin a redrafting process that enables the fundamental

principles and policies of the legislation to be seen in clearer focus.

giving greater prominence to fundamental principles and

policies should enable a further reduction in operational detail and

a further reorganisation and rationalisation of operational rules in a

comprehensive redrafting project. Hopefully the end result will be

tax legislation that is not only shorter but more principled and more

logically structured. Reduction in the size of the act will be a first

step in this process.

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Reference notes

1 Board of Taxation, Commonwealth, Identification and possible repeal of the inoperative provisions of the 1936 and 1997 Income Tax Assessment Acts (October 2005).

2 Treasurer, ‘Income tax act reduced by around 30 per cent’ (Press Release No 102, 24 November 2005).

3 Exposure Draft: Tax Laws Amendment (Repeal of Inoperative Provisions) Bill 2006.

4 Treasurer, ‘Bill to cut tax legislation by more than 4,100 pages’ (Press Release No 18, 4 April 2006).

5 Prime Minister and Treasurer, ‘Taskforce on Reducing Regulatory Burdens on Business’ (Press Release No 87, 12 October 2005).

6 Taskforce on Reducing Regulatory Burdens on Business, Commonwealth, Rethinking Regulation, (January 2006).

7 Prime Minister and Treasurer, ‘Government response to the report of the taskforce on reducing the regulatory burdens on business’ (Press Release No 19, 7 April 2006).

8 Treasurer, ‘Board of Taxation to undertake scoping study of small business tax compliance costs’ (Press Release No 95, 4 November 2005).

9 Treasurer, ‘Internationally benchmarking the Australian tax system’ (Press Release No 8, 26 February 2006).

10 Richard FE Warburton and Peter W Hendy, Commonwealth, International comparison of Australia’s taxes (3 April 2006).

11 Treasurer, ‘Release of Warburton-Hendy international benchmarking study’ (Press Release No 21, 12 April 2006).

12 See Margaret McKerchar, The impact of complexity upon tax compliance: A study of Australian personal taxpayers, Research Study No.39, Australian Tax Research Foundation, (2003), 140 and 192.

13 See J Pope, R Fayle and D L Chen, The compliance costs of companies’ income taxation in Australia, Research Study No 23, Australian Tax Research Foundation (1994), 69; J Pope, R Fayle, and D L Chen, the compliance costs of public companies’ income taxation in Australia 1986/87 , Research Study No 13, Australian Tax Research Foundation, (1991), 88; and J Pope, R Fayle, and M Duncanson, The compliance costs of personal income taxation in Australia, 1986/87, Research Study No 9, Australian Tax Research Foundation, (1990), 48.

14 Board of Taxation, Commonwealth, Identification and possible repeal of the inoperative provisions of the 1936 and 1997 Income Tax Assessment Acts (October 2005).

15 Treasurer, ‘Income tax act reduced by around 30 per cent’ (Press Release No 102, 24 November 2005).

16 Exposure Draft: Tax Laws Amendment (Repeal of Inoperative Provisions) Bill 2006.

17 Treasurer, ‘Bill to cut tax legislation by more than 4,100 pages’ (Press Release No 18, 4 April 2006).

18 McKerchar, above n 12 at 140 and 192. See also S Long and J Swingen, “An approach to the measurement of tax law complexity” (1987) The Journal of the American Taxation Association 22.

19 Prime Minister and Treasurer, ‘Taskforce on Reducing Regulatory Burdens on Business’ (Press Release No 87, 12 October 2005).

20 Taskforce on Reducing Regulatory Burdens on Business, Commonwealth, Rethinking Regulation, (January 2006).

21 Prime Minister and Treasurer, ‘Government response to the report of the taskforce on reducing the regulatory burdens on business’ (Press Release No 19, 7 April 2006).

22 Treasurer, ‘Board of Taxation to undertake scoping study of small business tax compliance costs’ (Press Release No 95, 4 November 2005).

23 A similar distinction was made in Stanley S Surrey “Complexity and the Internal Revenue Code: The problem of the management of tax detail” (1969) 34 Law and Contemporary Problems 673, 688.

24 For an insightful discussion of the literature up to 1993 see Graeme S Cooper, “Themes and issues in tax simplification” (1993) 10 Australian Tax Forum 417.

25 Bihn Tran-Nam, “Tax Reform and Tax Simplification: Some Conceptual Issues and a Preliminary Assessment” (1999) 21 Sydney Law Review500 at 506.

26 See, for example, Robin Woellner, Simon Gaylard, Margaret McKerchar, Cynthia Coleman, and Julie Zetler, “Once More Into The Breach…A Study of Comparative Compliance Costs Under the 1936 and 1997 Acts: Progress Report” in Chris Evans and Abe Greenbaum, (eds) Tax Administration: Facing the Challenges of the Future (1998) 195, 202 and Adrian Sawyer, “Rewriting tax legislation: Reflections on the New Zealand experience” (2003) 57 Bulletin for International Fiscal Documentation 578, 587.

27 Tran Nam, above n 25 at 507.

28 Tran Nam, ibid at 507.

29 Tran Nam, ibid at 508.

30 Cooper, above n 24 at 424 to 425.

31 Tran Nam, above n 25 at 510.

32 Similarly, Cooper (above n 24 at 432 to 448) identified the following sources of complexity: complexity in the choice of tax system; complexity in the implementation of the tax; complexity in the expression of the rules; complexity in achieving compliance and administration.

33 McKerchar, above n 12 at 140.

34 McKerchar, ibid at 192.

35 Long, above n 18.

36 See Pope (1994), above n 13 at 69; Pope (1991), above n 13 at 88; and Pope (1990), above n 13 at 48.

37 Pope (1990), above n 13 at 48.

38 Pope (1994), above n 13 at 69.

39 Pope (1994), ibid at 67.

40 Pope (1994), ibid at 69.

41 Again the review of the literature up to 1993 in Cooper (above n 24) is insightful.

42 For example, Cooper, above n 34 at pp 432 to 434 and Surrey, above n 23 at 674.

43 On 11 November 1999 (Treasurer, The New Business Tax System: Stage 2 Response, Press Release No 74, 3) the Government gave in principle support to the Tax Value Method (TVM) measures. TVM was designed to replace Australia’s current traditional income tax system (i.e. based upon the income/capital dichotomy) with a new income calculation method where taxable income or loss is calculated as the sum of net income (being the difference between receipts and payments (excluding private flows) plus the change in the tax value of assets over the period less the change in the tax value of liabilities) and tax law adjustments (i.e. the exceptions to the rules where government policy requires a different treatment (e.g. capital gains discount, gifts, R & D etc)). This proposal was comprehensively rejected by the Board of Taxation and that recommendation was accepted by the Government – see Treasurer, “Government decides against the Tax Value Method” (Press Release No 48, 28 August 2002).

44 Cooper, above n 24 at 438 and 439.

45 See C John Taylor, “Problems With Franking Credits Flowing Through Partnerships And Trusts In Australia: The 2004 Amendments And A Simpler Alternative” (2005) 34 Australian Tax Review 154.

46 Richard J Vann, “Improving Tax Law Improvement: An International Perspective” (1995) 12 Australian Tax Forum 193, 217.

47 Cooper, above n 24 at 434 to 435.

48 On 10 May 2005 the Government announced that Australia’s rules in this respect would be amended to bring them into line with OECD practice (Treasurer, ‘International tax reforms’ (Press Release No 44, 10 May 2005). At the time of writing of this report legislation implementing this announcement had not been introduced into Federal Parliament.

49 See, Exposure Draft: Tax Laws Amendment (Repeal of Inoperative Provisions) Bill 2006.

50 Australian Taxation Office, Commonwealth, Taxation Statistics 2002-03, (2005), 63 and Table 1: Company Selected items, by net tax and company type, 2002-03 income year.

51 Australian Taxation Office, Commonwealth, Taxation Statistics 1999-2000, (2001) Table 12.2.

52 Australian Taxation Office, Commonwealth, Taxation Statistics 2002-03, (2005), 63 and Table 2.

53 See for example, Tupicoff v FCT (1984) 15 ATR 655; Gulland; Watson v FCT; Pincus v FCT (1985) 17 ATR 1; Bunting v FCT (1989) 20 ATR 1579; Osborne v FCT (1985) 30 ATR 464; AAT Case [1999] AATA 165 41 ATR 1249; AAT Case [2001] AATA 449, Re Egan and FCT 47 ATR 1180; AAT Case [2002] AATA 1110, Re Macarthur and FCT (2002) 51 ATR 1042; FCT v Macarthur (2003) 53 ATR 636; FCT v Machkin (2003) 52 ATR 198; AAT Case [2004] AATA 349 55 ATR 1082; and AAT Case [2005] AATA 787, Re Iddles and FCT 60 ATR 1187. The facts and results in several of these cases are summarised in the table below.

54 See TR 2001/7; TR 2001/8; TR 2003/6; TR 2003/10 and TD 2002/24; and TD 2005/29.

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