Corporate Tax Masterclass

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Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The

Corporate Tax Masterclass

Practical application of the New Part IVA

Written and presented by:

Tim Kyle Director

Greenwoods & Freehills

NSW Division 11 September 2014

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CONTENTS

1 Introduction ... 5

2 Part IVA overview ... 6

2.1 The behavioural spectrum ... 6

2.2 Where should the line fall? ... 6

2.2.1 The structural distinction ... 6

2.2.2 Extrinsic materials ... 7

2.3 Where does the line fall? ... 8

2.4 What really gets the ATO’s goat? ... 9

2.4.1 Sources of understanding ... 9

2.4.2 Themes emerging ... 9

3 Tax benefit ... 11

3.1 Overview ... 11

3.2 The 2013 amendments ... 11

3.2.1 The replacement approach ... 13

3.2.2 The qualification approach ... 13

3.2.3 Practical differences arising from the competing approaches ... 14

3.3 Interaction with the scheme element ... 14

3.4 The annihilation limb ... 15

3.4.1 Automatic application in loss/outgoing/FITO situations? ... 15

3.4.2 Is certainty a gateway to the annihilation limb? ... 17

3.4.3 Other potential barriers to the application of the annihilation limb ... 18

3.5 The reconstruction limb... 18

3.5.1 How is reasonableness of alternative determined? ... 19

3.5.2 When is reasonableness determined? ... 21

3.5.3 Can there be more than one reconstruction counterfactual? ... 21

3.5.4 Statutory constraints on the reasonable alternative ... 23

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3.5.6 “Result or consequence” ... 25

3.5.7 Disregarding Australian income tax results ... 26

3.6 The statutory “choice principle” provisions ... 27

3.7 The primary statutory choice principle ... 27

3.8 The secondary statutory choice principle ... 30

3.9 Where are we on tax benefit? ... 32

4 Purpose ... 33

4.1 “Objective” purpose ... 33

4.1.1 Preliminary ... 33

4.1.2 The “why” is determined by the “how” ... 33

4.1.3 Changes of plans ... 34

4.2 The commercial/tax purpose interplay ... 35

4.3 Where tax benefit arises under a reconstruction provision ... 37

4.4 Avoiding unintended outcomes ... 38

4.5 Abuse is not a cumulative requirement ... 38

4.6 Conclusion ... 39

5 Example #1: Pre-sale dividend ... 40

5.1 The pre-sale dividend fact pattern ... 40

5.1.1 The (bare bones) fact pattern ... 40

5.1.2 Potential complicating matters ... 40

5.2 Why is Part IVA even relevant? ... 41

5.3 What features will interest the ATO? ... 41

5.4 Scheme ... 42

5.5 Tax benefit ... 43

5.5.1 The annihilation limb ... 43

5.5.2 The reconstruction limb ... 44

5.6 Purpose ... 45

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6 Example #2: share/asset sale ... 48

6.1 The share/asset sale fact pattern ... 48

6.3 Scheme ... 49

6.5 Purpose ... 51

7 Example #3: Funding choices... 53

7.1 The funding choices fact pattern ... 53

7.3 Scheme ... 54

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1 Introduction

The purpose of this paper is to remove the new(ish) Part IVA from its theoretical shackles and apply it in practice: a valiant (and likely foolhardy) task given the myriad of statutory construction issues raised by the 2013 amendments1.

The hope is that, by doing so, we may better understand the impact of the 2013 amendments - and better prepare ourselves for the challenges they pose.

To this end:

 sections 2 to 4 provide context and set out the main statutory construction issues likely to emanate from the 2013 amendments; and

 sections 5 to 7 of this paper contain worked examples of how Part IVA might apply to three real world situations.

The focus of this paper is on s.177D, to the exclusion of ss.177E, 177EA and 177EB.

Full citations for the familiar Part IVA cases referred to in this paper are set out in the appendix.

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2 Part IVA overview

2.1 The behavioural spectrum

It’s relatively rare that the actuating subjective motivation for conducting a transaction (in the sense of why bother to do it at all) was to achieve an advantageous Australian income tax outcome.

However, it can certainly be said that taxpayers always have any eye firmly on the costs associated with transactions - and Australian income tax is undoubtedly one cost to which regard will be had. To that end, it may often be said that various steps within a particular transaction (ie, which form a subset of the overall transaction) were introduced - or perhaps altered - with an eye at least partly to Australian tax.

At one end of the spectrum, it may be that these changes were motivated principally by a desire to accommodate non-tax issues. But at the other end of the spectrum it may be that at least some of the changes were motivated by a desire to produce an advantageous Australian tax outcome.

Most fact patterns fall somewhere between these ends of the spectrum.

The overwhelming challenge in relation to Part IVA is determining where “the line” falls.

2.2 Where should the line fall?

This is obviously different to the question “where does the line fall”, but it is an interesting point at which to start.

2.2.1 The structural distinction

The Australian tax system draws a structural distinction between:

 permissible tax planning/mitigation – to which Part IVA does not apply;  tax avoidance – to which Part IVA does apply; and

 impermissible tax evasion – to which criminal sanctions apply.

But how should these respective behaviours be delineated? The answer involves questions of statutory construction.

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2.2.2 Extrinsic

materials

The explanatory memorandum and second reading speech that accompanied the introduction of Part IVA provide an indication of what Parliament intended. We are all familiar with the comforting

statements to the effect that:

 Part IVA was directed towards “blatant, artificial or contrived” schemes; and

 arrangements of a normal business or family kind, including those of a tax planning nature are beyond the scope of Part IVA.

These comforting statements were repeated word for word in the explanatory memorandum to the 2013 amendments (2013 EM).

But, unhelpfully, these statements do not appear in the text of Part IVA. Consequently, they may be of (extremely) limited utility.

In this regard, the judicial appetite for resort to extrinsic material - such as explanatory memoranda and second reading speeches – waxes and wanes.

The period following CIC Insurance Ltd v Bankstown Football Club Ltd (1997) 187 CLR 384 was marked by a greater focus on the role of context (including extrinsic material) in statutory construction. However, this approach has been superseded (at least for the time being) by the more “black letter law” approach reflected in Alcan (NT) Alumina Pty Ltd v Commissioner of Territory Revenue (2009) 239 CLR 27. There, Hayne, Heydon, Crennan and Kiefel JJ stated at [47]:

“This Court has stated on many occasions that the task of statutory construction must begin with a consideration of the text itself. Historical considerations and extrinsic materials cannot be relied on to displace the clear meaning of the text. The language which has actually been employed in the text of legislation is the surest guide to legislative intention. The meaning of the text may require consideration of the context, which includes the general purpose and policy of a provision, in particular the mischief it is seeking to remedy.” [Footnote references

omitted]

Later in their joint judgment (at [51]), their Honours quoted with evident approval these observations made by Gleeson CJ in Carr v Western Australia (2007) 232 CLR 138 at [6]:

“[I]t may be said that the underlying purpose of an Income Tax Assessment Act is to raise revenue for government. No one would seriously suggest that s 15AA of the Acts

Interpretation Act has the result that all federal income tax legislation is to be construed so as to advance that purpose. Interpretation of income tax legislation commonly raises questions as to how far the legislation goes in pursuit of the purpose of raising revenue. In some cases, there may be found in the text, or in relevant extrinsic materials, an indication of a more specific purpose which helps to answer the question. In other cases, there may be no available indication of a more specific purpose. Ultimately, it is the text, construed according to such principles of interpretation as provide rational assistance in the circumstances of the particular case, that is controlling.”

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This resistance to considering extrinsic materials is more likely to produce consequences unintended by Parliament – but its adherents are unrepentant on the basis that remediating those consequences is exclusively a matter for Parliament: Commissioner of Taxation v Multiflex Ltd (2011) 197 FCR 580. Interestingly, the current approach to statutory construction is reminiscent of the approach of

O’Loughlin J at first instance in Peabody in 1992 - who rejected outright a taxpayer entreaty that regard should be had to whether the transaction was “blatant, artificial or contrived”.

It is also interesting that it is difficult to recall any court expressly relying on explanatory memoranda in construing Part IVA.

2.3 Where does the line fall?

The words of Part IVA themselves do not provide a clear delineation between acceptable tax planning and unacceptable tax avoidance. Even the 2013 EM observes at paragraph 1.10 that the words of the provisions are “inexact … in legal terms”.

Moreover, taxpayers are at an inherent disadvantage in Part IVA cases:

 parties enter into transactions based on their current understanding of the judicial approach to the application of Part IVA;

 the judicial approach to the application of Part IVA shifts over time, being impacted by the “cultural and attitudinal factors” prevailing at the time of the particular judicial decision2 - which may be many years after the transaction is implemented; and

 consequently, what may have been regarded as acceptable tax planning at the time of implementation may turn out to be unacceptable tax avoidance when later reviewed by the courts.

Of course, this is true of all tax provisions – but it is fair to say that Part IVA is subject to particularly large swings in judicial approach.

However, if we are working on a transaction today, accurately predicting the future approach of courts is beyond us.

One important risk minimisation strategy is to ensure as best as possible that a proposed transaction is likely to be acceptable to the ATO - based on their current approach to the administration of Part IVA.

This of course requires an understanding of what the ATO finds unacceptable.

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2.4 What really gets the ATO’s goat?

2.4.1 Sources of understanding

An understanding of the ATO approach to the administration of Part IVA can be gleaned from a number of sources such as:

 case law

 private rulings - although experience indicates that private Part IVA rulings can be short on analysis and the publicly available edited private rulings are almost always so redacted that they provide little guidance on Part IVA;

 public rulings – of which there are few dealing specifically with Part IVA;

 practice statements – however the current PS LA 2005/24 is now almost a decade old and provides little real world guidance. An update is expected, although the precise timing is unclear;

 taxpayer alerts – which are typically confined to a very specific style of transaction;  other ATO publications - such as the consolidation reference manual;

 consultation forums – the minutes of the 18 July 2013 NTLG consultative workshop on Part IVA amendments3 (NTLG minutes) being a rare example; and

 presentations by senior ATO officers – although Part IVA presentations are rare.

2.4.2 Themes

emerging

The features that really pique ATO interest (outside mass marketed schemes context) can perhaps be categorised as follows. The categories were developed while preparing an article on the potential application of Part IVA to group restructures – but they seem equally applicable in other situations.

Feature Examples

The taxpayer takes preparatory steps so that the beneficial effect of a primary taxing provision is activated

Futuris where the taxpayer took steps to activate value shifting

provisions to increase cost base in an entity before floating it.

RCI where a s.23AJ pre-sale dividend was facilitated by a

revaluation of assets

BAT where the asset sale occurred after the merger and

internal transfer so as to allow utilisation of losses

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http://www.ato.gov.au/Tax-professionals/Consultation--Tax-practitioners/In-detail/Technical-and-special-purpose-working-groups/NTLG-consultative-workshop-on-Part-IVA-amendments/

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Other non-case law examples include:

• where a corporate group takes steps to include or exclude particular entities from the consolidatable group before making a consolidation choice – as discussed in the ATO consolidation reference manual

• where a taxpayer takes preparatory steps in order to utilise CGT roll-overs – especially where successive rollovers are used

The taxpayer takes preparatory steps so that the detrimental effect of a primary taxing provision is not activated

CPH where the deduction quarantining provisions were

circumvented

AXA where the cost base transfer provisions in the scrip for

scrip CGT rollover rules were circumvented

Peabody where the minority interests were devalued, ensuring

that a subsequent sale (had it occurred) would not activate s.26AAA

Tax consequences arise without a real change in financial position

RCI where all but $20m of the $318m dividend was satisfied by

the issue of a promissory note

Noza where the asset acquisition was routed through Australia,

leaving back to back RPS in place - and the RPS dividends were satisfied by the issue of promissory notes

A (simpler) commercially equivalent transaction produces a worse tax outcome

News Australia where a share transfer (rather than a buy-back

and fresh issue) would not have produced a capital loss

But of course even where the ATO challenges a transaction, a rigorous examination of the tax benefit and purpose requirements is required. This inquiry may reveal that Pt IVA does not apply.

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3 Tax benefit

3.1 Overview

Part IVA has always been about taxing a taxpayer on the basis of something they didn’t actually do. To explain:

 The tax benefit inquiry is a two-step process.

 The first step involves identifying a permissible counterfactual (ie, what the taxpayer didn’t do) but instead would have done or might reasonably be expected to have done absent the scheme (ie, what the taxpayer actually did).

 The second step involves identifying the tax consequences that flow to the taxpayer from the counterfactual.

 A tax benefit arises if those tax consequences are less advantageous than those flowing to the taxpayer from the scheme.

 And, where the purpose element is satisfied and Part IVA is activated, the taxpayer is made to suffer the less advantageous tax consequences arising under the counterfactual.

Importantly, Part IVA has no operation if either:

 no permissible counterfactual can be identified; or

 the tax consequences that flow to the taxpayer from the counterfactual are no less advantageous than those flowing to the taxpayer from the scheme.

This section 3 considers:

 whether identification of a permissible counterfactual is now merely a “tick and flick” exercise – that is, whether, regardless of the relevant fact pattern, there will now always be a permissible counterfactual so that the only meaningful task is to quantify the relevant tax benefit; or  whether identification of permissible counterfactual(s) under the tax benefit inquiry is still a

substantive cumulative requirement of Part IVA.

3.2 The 2013 amendments

As we know, each head of the existing s.177C definition of “tax benefit” is expressed on the basis of “what would have happened or might reasonably have been expected to have happened”. This composite phrase was considered by many to identify different regions on the spectrum of certainty as to alternative outcome in which an acceptable counterfactual must lie.

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In essence, over the last 5 years, the ATO struggled to establish that a tax benefit arose in a number of group restructures and other fact patterns. For example, in a number of instances, courts held that corporate groups would have done nothing rather than suffer large tax liabilities associated with group restructures.

The ATO convinced the then Government that these outcomes were inappropriate and that legislative change was required to address this “perceived weakness”.

New s.177CB was introduced. On its face, it does two things:

 First, it bifurcates the composite phrase “what would have happened or might reasonably have been expected to have happened” (and so the sufficient certainty spectrum) in s.177C into two separate limbs:

 the “annihilation limb” in s.177CB(2); and  the “reconstruction limb” in s.177CB(3)

 Secondly, it provides (broadly) that a decision under s.177C that adverse tax consequences arise to the taxpayer from what would have occurred or might reasonably be expected to have occurred absent the scheme “must be based on a postulate” that is determined under the annihilation limb or the reconstruction limb.

The drafting of the second aspect of s.177CB is highly unusual. Initial points to note include:

 The existing tax benefit definition in s.177C was not repealed – and indeed was left untouched.  An alternative postulate produced under the annihilation limb or the reconstruction limb is not

expressly deemed (or defined) to be the thing that “would have happened or might reasonably have been expected to have happened” absent the scheme.

 Nevertheless, an undeniably strong link is drawn between the existing s.177C tax benefit definition and the alternative postulate(s) produced under the annihilation limb or the reconstruction limb.

This drafting technique raises a number of threshold statutory construction issues which courts will need to resolve.

A number of articles touch on these issues. The most fulsome discussion is in the Mark Brabazon SC article “The Hatter’s watch: Tax benefit in Part IVA”4 which provides a detailed analysis of the

“intolerable wrestle of words and meanings” associated with the introduction of s.177C.

Reviewing the literature, two approaches emerge as the main contenders for the way in which courts may construe the relationship between s.177C and s.177CB: the replacement approach and the qualification approach.

As will be seen, the replacement approach will tend to favour the ATO while the qualification approach will tend to favour taxpayers.

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3.2.1 The replacement approach

Under the replacement approach, the s.177CB inquiry completely replaces the existing s.177C inquiry.

A court may well be attracted to the replacement approach on the basis of the strength of the link that the provisions draw between the existing s.177C tax benefit definition and the alternative postulate(s) produced under the annihilation limb or the reconstruction limb.

In that regard, parts of the 2013 EM do indicate that the replacement approach was intended. However, as we have seen, there are serious questions about the extent to which regard can permissibly be had to extrinsic material in the statutory construction process.

The consequence of courts adopting the replacement approach would be that:

 an alternative postulate produced under the annihilation limb or the reconstruction limb automatically qualifies as a permissible counterfactual for the purpose of determining whether a tax benefit arises;

 it would not be necessary to perform a second step of testing that postulate to see if it satisfies the requirements in existing s.177C case law; and

 that is, on the replacement approach, existing case law on the meaning of tax benefit would be otiose.

3.2.2 The qualification approach

Alternatively, it may be that courts will be satisfied that Parliament deliberately chose to both leave s.177C untouched and not expressly give s.177CB a deeming or definition role - and will respect that choice by giving the existing s.177C definition of tax benefit a continuing role.

However, the precise role that s.177C would continue to play is far from clear. Two possibilities are considered below.

The “qualification lite” approach would give primacy to alternative postulates produced under the annihilation and reconstruction limbs. Nevertheless, courts may have resort to the existing s.177C tax benefit definition in certain circumstances. One such circumstance may be where the reconstruction limb produced more than one alternative postulate. In those circumstances, a court might conclude that only the single alternative postulate which is the next most likely to have happened absent the scheme is the permissible counterfactual. This issue is discussed further in section 3.5.3 below. It must be said that the full scope of the “qualification lite” approach is yet to be explored. Rather, the existing s.177C tax benefit definition may have a roving commission – with courts having resort to it in order to produce more appropriate outcomes than those achieved under the replacement approach. This approach respects the intention evident in the 2013 EM that s.177CB was introduced in order to both constrain and expand the range of postulates that can qualify as a permissible counterfactual.

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Mark Brabazon identifies a “qualification heavy” approach - which I will have badged the constraint approach in this paper. Under this constraint approach, two cumulative requirements must be satisfied in order for there to be a permissible counterfactual. The first step is to determine whether an alternative postulate arises under the existing s.177C tax benefit definition. If it does, then the second step is to determine whether that alternative postulate also satisfies either/both the

annihilation limb or the reconstruction limb. Presumably the same results would be produced if the order of the steps were reversed.

It is difficult to discern a clear statutory construction basis for dismissing the constraint approach. Nevertheless, in light of extrinsic materials such as the 2013 EM, it is clearly not the intended outcome – as it greatly reduces the circumstances in which a counterfactual can arise.

For that reason, in the balance of this paper, references to the qualification approach are to the “qualification lite” approach described above.

3.2.3 Practical differences arising from the competing approaches

Resolution of these competing approaches is far from an arid intellectual exercise. It has real significance for how Part IVA matters will be conducted. By way of example, the ramifications of this issue include:

 whether more than one reconstruction limb counterfactual is permissible – and, if so, whether it is open to the ATO to choose the counterfactual that produces the greatest quantum of tax benefit – see further section 3.5 below; and

 whether certainty as to alternative outcome is a gateway to the annihilation limb – see further section 3.4 below.

The ATO nails its colours firmly to the mast in the NTLG Minutes. The ATO vigorously believes in the replacement approach: the stated ATO view is that the reconstruction limb now requires an “entirely different inquiry" to that undertaken under the existing s.177C tax benefit definition. However, no reasoning is given for this conclusion and there are valid arguments in support of the qualification approach.

3.3 Interaction with the scheme element

It is noteworthy that precise delineation of the relevant scheme matters more than it did before the 2013 amendments.

To this end:

 Where it applies, the annihilation limb operates by excising the scheme from the other events or circumstances that actually happened or existed.

It may be the case that the annihilation limb can only be activated where the scheme is a subset of the “events or circumstances that actually happened or existed” – see further section 3.4 below.

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If so, this would mean that the annihilation limb will only apply where a narrow scheme is delineated – as too broad a scheme will necessarily incorporate all the relevant “events or circumstances that actually happened or existed”.

 In (overly) broad terms, the reconstruction limb produces a counterfactual that is (subject to certain constraints) commercially equivalent to the scheme actually entered into.

The task of identifying a commercially equivalent transaction to a particular scheme is made easier the more broadly the scheme is delineated.

 Clearly if the ATO ran the broad and narrow schemes as alternatives both limbs could potentially be activated.

It is clear from the NTLG Minutes that the ATO sees a tactical advantage for itself in the bifurcation of the composite phrase - and reserves its right to argue both limbs in the alternative.

 delineation of scheme determines (un)availability of the statutory “choice principle”.

The primary and secondary statutory “choice principle” in s.177C(2) and s.177C(2A) respectively are discussed in section 3.6 below. As will be seen, the application of these provisions depends on:

 in the case of the primary statutory choice principle: the scheme was not entered into or carried out by any person for the purpose of creating any circumstance or state of affairs the existence of which is necessary to enable the statutory choice to be made; and  in the case of the secondary statutory choice principle: the scheme consists solely of the

making of the agreement or election.

Clearly the ambit of the scheme will be critical to whether these provisions are activated. The broader the scheme, the less likely activation will be.

3.4 The annihilation limb

Section 177CB(2) provides as follows:

“A decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme).”

On its face, the annihilation limb involves a stunningly simple mechanical exercise: take the events/circumstances that actually happened and excise the scheme from them. No element of speculation or independent thought required.

Three points of particular interest in relation to the annihilation limb are discussed in the following sections.

3.4.1 Automatic

application

in

loss/outgoing/FITO situations?

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The categorisation of the relevant benefit may well be critical to the application of the annihilation limb.

“Negation” category benefits

Conceptually, the annihilation limb lends itself particularly well to being applied in cases where Part IVA is directed towards negating a particular tax advantage that arises from something that did in fact occur, such as:

 a taxpayer incurs an outgoing which produces a deduction – and Part IVA operates by cancelling that deduction;

 a taxpayer transfers an asset which produces a capital loss – and Part IVA operates by that cancelling a capital loss; and

 a taxpayer pays foreign tax which produces a FITO – and part IVA operates by cancelling a FITO.

The reasoning goes like this: if these benefits arise under the scheme, then if you excise the scheme, the element that is necessary to generate the benefit is not present – and so the benefit would necessarily not have arisen.

For example, if the relevant scheme comprises a taxpayer contributing $100 to an employee remuneration trust, then if the contribution had not been made (because it has been notionally

excised by the annihilation limb) then the Australian corporate would obviously not have had the $100 outgoing that generates the s.8-1 deduction – therefore a $100 tax benefit arises.

Indeed, there is a concern that the annihilation limb may so readily apply to this type of benefit that its application effectively becomes automatic.

However, there are still important potential barriers to the application of the annihilation limb (see below).

“Imputation” category benefits

The other category of tax benefits is where Part IVA is directed towards imputing something which did not in fact occur, such as:

 treating income as arising where none actually arose; and  treating a withholding tax liability as arising.

The annihilation limb may also have some role – albeit a more limited role - to play in imputation benefit cases

The 2013 EM indicates that the annihilation limb can apply in income cases where there is a sheltering of income already in existence (eg, a Spotless “switching” scenario): see the 2013 EM at paragraphs 1.83, 1.84 and example 1.2.

But, that fact pattern aside, it is more difficult to identify circumstances where the annihilation limb applies to imputation category benefits.

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Accordingly, the reconstruction limb is more readily applicable to imputation category benefits.

3.4.2 Is certainty a gateway to the annihilation limb?

The annihilation limb corresponds to the “would have” end of the certainty spectrum described in the existing s.177C tax benefit definition. That is, before the 2013 amendments, it was necessary to be certain what would have happened absent the scheme in order to activate that part of the compound expression in s.177C.

Under the replacement approach, the annihilation limb could be activated without courts being satisfied as to what would have happened absent the scheme.

However, under the qualification approach, courts could conceivably give the existing s.177C tax benefit definition a continuing role by making certainty of alternative outcome the gateway to the application of the annihilation limb. If so, courts would have to be satisfied as to what would have happened absent the scheme before the annihilation limb can be applied – putting the Commissioner at an evidentiary disadvantage which would likely prove a significant barrier to the application of the annihilation limb.

However, is this outcome likely? It does suffer some challenges.

First, the annihilation limb operates exclusively by excising the scheme from the events or circumstances that actually happened or existed. As the 2013 EM puts it at paragraph 1.79:

“… the speculation that is permitted about any other state of affairs that might have come about if the scheme had not been entered into or carried out is limited to the removal of the scheme”

Secondly, no part of the 2013 amendments themselves specifically refers to certainty of alternative outcome as a gateway to the annihilation limb.

Thirdly, it is difficult to identify clear support for that outcome in the 2013 EM. Rather, there is abundant material in the 2013 EM to support the contrary argument: that certainty as to alternative outcome is not necessary in order to trigger the annihilation limb.

Finally, complete logical disjunction between the certain alternative outcome and the alternative postulate produced by the annihilation limb is almost inevitable in imputation benefit cases and may often arise even in negation benefit cases.

An example can perhaps illustrate this point:

 a taxpayer rents factory A and claims rental deductions;

 had the taxpayer not rented the factory, evidence establishes with absolute certainty that the taxpayer would have borrowed to buy factory B;

 the annihilation limb operates by excising the relevant scheme from the transaction actually implemented;

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 where the scheme comprises renting factory A, renting factory A is excised and the annihilation limb produces a postulate whereby the taxpayer would have done nothing (ie, no renting or buying); and

 so it can be seen that the outcome of the annihilation limb (ie, doing nothing) has absolutely no regard to the certain alternative outcome (ie. borrowing to buy factory B).

In light of the above, it is difficult to fathom why certainty of alternative outcome should be the gateway to the annihilation limb.

3.4.3 Other potential barriers to the application of the annihilation limb

Although not provided for in the legislation itself, the 2013 EM introduces qualifications to the circumstances in which the annihilation limb can be applied that have nothing to with the certainty of alternative outcome.

The 2013 EM indicates that the annihilation limb will not apply:

 in cases where deletion of the scheme would not necessarily leave a coherent state of affairs for the tax law to apply to — where a prediction is required about facts not in existence and/or about facts which are in existence not being in existence: 2013 EM at paragraph 1.39;  if annihilation would be inconsistent with the non-tax results and consequences sought for the

taxpayer by the participants in the scheme: 2013 EM at paragraph 1.40;

 if the scheme in question produces material non-tax results or consequences for the taxpayer: 2013 EM at paragraphs 1.82, 1.89 and 1.93.

These are potentially extremely significant qualifications.

However, the ability to rely on them does suffer the statutory construction challenge of relying upon extrinsic materials such as EMs.

3.5 The reconstruction limb

Section 177CB(3) and (4) provides as follows:

“(3) A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme.”

(4) In determining for the purposes of subsection (3) whether a postulate is such a reasonable alternative:

(a) have particular regard to:

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(ii) any result or consequence for the taxpayer that is or would be achieved by the scheme (other than a result in relation to the operation of this Act); but

(b) disregard any result in relation to the operation of this Act that would be achieved by the postulate for any person (whether or not a party to the scheme).”

That is, the reconstruction limb involves the statutory command that a decision that a tax effect might reasonably be expected to occur if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme – albeit having “particular regard to”/“disregarding” the matters set out in s.177CB(4).

This raises a number of interesting points.

3.5.1 How is reasonableness of alternative determined?

The focus of the reconstruction limb is on “a reasonable alternative” that satisfies certain criteria. Reasonableness is a standard to which the legislature often has resort, and which creates fertile ground for dispute. Reasonableness, like beauty, is often in the eye of the beholder.

Nevertheless, it is tolerably clear that:

 reasonableness imports an objective test, determined from the perspective of a hypothetical representative third party.

 reasonableness is not determined in a complete vacuum. Rather, regard must be had to the objectively established prevailing factual circumstances.

Consequently, the “reasonable alternative” test removes from the reconstruction limb counterfactual identification task subjective considerations (ie, what the relevant parties may have actually done or not done instead of the scheme actually entered into) to the maximum extent possible. But of course there is often a blurring of objective and subjective

considerations: the “no tax no tax risk” policy considered in News Australia being a good example.

 the outcome of testing any particular alternative postulate for reasonableness is binary: either the alternative satisfies the reasonableness threshold or it does not.

What is less clear is how exactly the task of assessing reasonableness is to be performed in the context of the reconstruction limb. Of course, reasonableness must be determined having regard to/disregarding the matters identified in ss.177CB(3) and (4). But what is reasonableness really testing?

Two potential competing interpretations emerge: sufficient commercial equivalence and sufficient plausibility.

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Sufficient commercial equivalence

The literature on the 2013 amendments largely proceeds on the basis that reasonableness is directed towards determining whether the particular alternative postulate is sufficiently similar in its commercial outcomes to the scheme actually entered into.

Support for the sufficient commercial equivalence interpretation can be found in the fact that particular regard is required to be had to substance and results/consequences of the scheme - which can be seen as synonymous with the commercial features of the scheme. Why else bother having particular regard to these things?

Moreover, support for the sufficient commercial equivalence interpretation can be found in the 2013 EM which refers to a qualifying reasonable alternative achieving for the taxpayer non-tax results and consequences that are “substantially the same as” / “comparable to” those achieved by the scheme itself: see paragraphs 1.102 and 1.110.

The logical consequence of the sufficient commercial equivalence interpretation is that an alternative postulate with substance or results/consequences that are markedly different from those of the scheme cannot be a permissible counterfactual.

An obvious issue is divining the point beyond which differences make the alternative postulate unreasonable.

Interestingly, the sufficient commercial equivalence interpretation may well have unintended outcomes: it precludes from being permissible counterfactuals certain alternatives that would have been permissible counterfactuals under the existing s.177C tax benefit definition – and which many would think should appropriately continue be permissible counterfactuals.

Example 2 in section 6 below illustrates this point well: on the sufficient commercial equivalence interpretation, an asset sale by the subsidiary should not be a permissible counterfactual to a share sale by the parent because of the vastly difference in results/consequences for the subsidiary.

Sufficient plausibility

Mark Brabazon raises another interpretation which I have taken the liberty of expressing this way: that reasonableness is directed towards determining whether a hypothetical representative third party would conclude that it is entirely plausible that the parties would have entered into the particular alternative postulate instead of the scheme actually entered into.

This interpretation is potentially open on the face of s.177CB(3). After all, once particular regard has been given to substance and results/consequences of the scheme there is no statutory directive that the alternative postulate must share substantially all of these features.

An obvious issue with the sufficiently plausible interpretation is the degree of plausibility required. The threshold may be relatively low: the alternative postulate may only have to be “entirely plausible” – as a more stringent marker such as “likely” or “probable” would come close to replicating the existing s.177C case law test for a permissible counterfactual.

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3.5.2 When is reasonableness determined?

The gestation process for transactions may be lengthy.

In that context, it may well be that a particular alternative is properly characterised as being

reasonable at a particular point in that process – yet not reasonable at a later point due to changing circumstances.

The decision in AXA illustrates this point.

There, the relevant transaction was the culmination of a long process with the object of the taxpayer divesting AXA Health. Part of the way through that process, the taxpayer signed an underwriting agreement with MBL, which entitled MBL to a multi-million dollar fee. After that point, an alternative involving a direct sale of AXA Health would have been improbable because it would not have generated such a material fee for MBL. However, before entry into the underwriting agreement, this consideration did not impact the direct sale alternative.

So at what point was the reasonableness of the direct sale alternative to be tested?

The court looked only at a single point in time on or around 3 June 2002, which was after entry into the underwriting agreement – rendering the direct sale alternative unreasonable and so not a permissible counterfactual.

A separate but related issue arose in AXA. The transaction was to occur around the time that the Macquarie group consolidated on 1 October 2002. The transaction documents were signed in June 2002 and suggested that the sale of AXA Health might occur at any time between August 2002 and mid October 2002 (ie, a post-consolidation completion was possible). Given this, the court held that an alternative under which AXA Health became a wholly-owned subsidiary of MBL was not a permissible counterfactual.

3.5.3 Can there be more than one reconstruction counterfactual?

The drafting of s.177CB(3) raises a significant practical issue.

That issue is perhaps be teased out using an example. Let’s assume that:

 there are 5 different postulates, each of which satisfies the "reasonable alternative" requirements;

 the most likely of them (in a prediction sense) would produce a tax benefit of $100;  the least likely of them (in a prediction sense) would produce a tax benefit of $1,000; and  the others would produce tax benefits between $100 and $1,000.

Can the ATO issue a Part IVA determination on the basis of the postulate that produces the highest tax benefit (even if the least likely)?

If so, how does the taxpayer discharge the onus of proving that an amended assessment giving effect to the Part IVA determination is excessive?

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These issues are not addressed in either the 2013 amendments or the EM. Moreover, the NTLG Minutes do not provide any meaningful guidance as to the ATO views.

Rather, as will be seen, the answers depend on whether the courts adopt the replacement approach or the qualification approach.

And as will also be seen, taxpayers will be at a significant tactical disadvantage if the courts adopt the replacement approach.

Under the qualification approach

As discussed in section 3.2 above, one potential consequence of courts adopting the replacement approach may be that where there are a number of alternative postulates that are reasonable, only one of them can constitute a permissible counterfactual – being the one that is the next most likely of those alternative postulates to happen absent the scheme. This echoes the existing s.177C case law which very strongly suggested (although, it might be said, without conclusively determining the issue5) that the counterfactual was the single most reliable prediction of what the relevant parties would have done absent the scheme.

It would follow that any other less likely alternative postulate is incapable of qualifying as the permissible counterfactual.

If so, under the qualification approach, a taxpayer can discharge the onus of proof by establishing that the ATO asserted counterfactual is not, from among the reasonable alternative postulates, the one that would be regarded as the next most likely to happen if the scheme were not implemented.

Under the replacement approach

As discussed in section 3.2 above, the consequences of courts adopting the replacement approach include that the existing case law on the meaning of tax benefit would be rendered otiose. That is, the task of arriving at a reconstruction counterfactual would involve a “clean slate” application of statutory construction principles.

In that regard, primacy would be given to the text of the reconstruction limb.

It can be argued that, on its face, s.177CB(3) is capable of being satisfied by any number of alternative postulates – so long as each of them satisfies the "reasonableness" threshold. In this regard, it will be recalled that s.177CB(3) utilises the double indefinite article:

"A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme." [Emphasis added]

Had Parliament intended that there be only one permissible counterfactual, it was open to it to utilise the double definite article:

“… based on the postulate that is the reasonable alternative to entering into or carrying out the scheme."

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If multiple counterfactuals are permissible, then the ATO has a clear tactical advantage:  the ATO can identify a postulate that supports the highest tax benefit - and amend the

taxpayer’s assessment accordingly;

 it is insufficient to discharge the onus of proof for the taxpayer to establish that a different postulate (which produces no tax benefit or a smaller tax benefit) is more likely to have occurred; and

 rather, the taxpayer can only discharge the onus of proof by establishing to the court’s

satisfaction that the amended assessment is predicated on a postulate that does not satisfy the s.177CB(3) reasonableness requirement. This may prove a considerable challenge for

taxpayers.

Can the ATO pick the alternative that produces the highest tax benefit? If so, the ATO would certainly have a significant tactical advantage.

A number of barristers I have spoken with expect that the Federal Court would resist this outcome.

3.5.4 Statutory

constraints

on the reasonable alternative

The statutory directions in s.177CB(4) to have regard to/disregard certain matters are designed to:  turn the reconstruction limb from an “entirely unconstrained” inquiry into a more constrained

inquiry; and

 remove Australian income tax considerations from the counterfactual identification task. Accordingly, the amendments involve a simultaneous expansion and contraction of the range of circumstances in which postulates may be counterfactuals.

This section focuses on these statutory constraints – and the extent to which they impede a postulate being a permissible counterfactual.

In this regard, s.177CB(4) requires that “particular” (albeit not exclusive) regard is be had to:  the “substance” of the scheme; and

 any “result or consequence” for the taxpayer that is or would be achieved by the scheme (other than a result “in relation to” the operation of the Tax Acts).

Parliament’s choice to constrain the range of permissible counterfactuals by reference to these two matters is interesting.

It may be (as discussed in section 3.5(b) above) that the test is intended to require that the postulate be sufficiently commercially similar to the implemented scheme. Support for this interpretation can be found in the 2013 EM which refers to a qualifying reasonable alternative achieving for the taxpayer non-tax results and consequences that are “substantially the same … as those achieved by the scheme”/“comparable to those achieved by the scheme itself”: see paragraphs 1.102 and 1.110. However, a sufficient commercial similarity requirement does not appear on the face of s.177CB(4).

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Rather, detailed attention must turn to the terms actually employed by Parliament – see sections 3.5.5 and 3.5.6 below.

Of course, the matters identified in s.177CB(4) - while very important in formulating a reconstruction limb counterfactual - do not represent the universe of matters that can permissibly be considered. Accordingly, it is always open to a court to conclude that a reconstruction limb counterfactual arises even if either/both of the s.177CB(4) matters (if considered alone) indicate that the particular alternative postulate is unreasonable.

3.5.5 “Substance”

A number of observations can be made about Parliament’s choice to constrain the range of permissible counterfactuals by reference to the “substance” of the implemented scheme:  the “substance” of a scheme can be described as its commercial and practical effect – as

opposed to its legal form: see PS LA 2005/24 at paragraph 95;

 however, substance - like reasonableness - has the appearance of objectivity but can be remarkably difficult to pin down: the main issue is the depth of field that the observer chooses to apply – that is, whether a deep or a shallow focus should be applied in determining the substance of the scheme;

 a key question is to what extent the legal mechanics should be respected in determining substance;

 for example, is the substance of a sale and lease back transaction a secured loan over the relevant asset? Clearly there is a degree of commercial equivalence between these two transactions – but there are also real commercial and practical differences between them (as well as legal differences) which means that they are not perfectly fungible;

 the scheme’s substance is also relevant to determining whether the requisite dominant purpose is present: the s.177D(2)(b) matter is “the form and substance of the scheme”; and

 there is an existing body of case law demonstrating the approach taken by courts in determining what is meant by the “substance” of a scheme in the s.177D(2)(b) context.

It must be acknowledged that there are some differences between the s.177D(2) and the s.177CB(3) inquiries. Nevertheless, given the substantial similarity of context, both refer to substance and both are elements in Part IVA, it can reasonably be expected that courts will have regard to that case law in determining whether a postulate satisfies the s.177CB(3) requirement.

If so, case law suggests that a narrow focus is to be applied for s.177D(2)(b) purposes. A narrow focus highlights any differences in legal mechanics between scheme and the postulate – potentially precluding the postulate from being a permissible counterfactual.

The decisions in Eastern Nitrogen and News Australia reveal a narrow focus approach which may potentially be applied to the s.177CB(3) inquiry.

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Eastern Nitrogen

The transaction considered in Eastern Nitrogen was a sale and lease-back of an ammonia plant. If he had applied a wide focus, Carr J could conceivably have said that the substance of the scheme was a secured asset financing.

However, Carr J applied a narrow focus in holding at paragraph 101 that:

“… [t]he form and substance were the one and the same. The transaction was not dressed up as something which it was not. It was a sale and lease-back both legally and in

substance.”

If a court applied such a narrow focus to testing reconstruction counterfactuals for the sale and lease-back implemented in Eastern Nitrogen, any alternative postulate would have different legal mechanics and so would be expected to have a different substance to a sale and lease-back – in which case it may well fail the reasonable alternative test.

News Australia

In News Australia, the target company bought back its shares from the taxpayer then, later the same day, a related US company subscribed for exactly the same number of shares in the target.

The ATO argued that the buy-back element of the scheme was not in substance a share buy-back because there was only a temporary reduction in the target’s capital, which was replenished late the same day – being consistent with the substance of a transfer.

If it had applied a wide focus, the AAT could conceivably have said that the substance of the scheme was a transfer of shares.

However, the AAT applied a narrow focus in holding that this part of the scheme was a share buy-back in both form and substance - as the taxpayer was removed from the target’s share register and its shares cancelled.

If a court applied such a narrow focus to testing reconstruction counterfactuals for the scheme

implemented in News Australia, any alternative postulate would have different legal mechanics and so would be expected to have a different substance to the implemented scheme – in which case the alternative postulate may well fail the reasonable alternative test.

3.5.6 “Result or consequence”

The term “result or consequence” is undefined and does not appear to have a settled case law meaning.

It is often the case that taxpayers enter into the transaction that, in the circumstances, best balances the competing commercial considerations. Given this, it may well be that any alternative postulate will produce results and consequences that are necessarily sub-optimal compared to the transaction as implemented, even disregarding Australian income tax.

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 produce worse accounting outcomes than the transaction implemented;

 generate a material amount of foreign tax compared with the transaction implemented; or  cause the taxpayer to lose the comfort obtained under a foreign tax ruling.

If so, there will be a point at which the relative detriments of the potential alternative postulate render it unreasonable as an alternative - in which case the reconstruction limb cannot apply.

The facts in Noza illustrate this point perfectly. In that case, the taxpayer claimed deductions for dividends on RPS that were classified as debt under Australia’s debt-equity tax rules. The ATO

advanced a counterfactual under which all the companies in the chain instead issued ordinary shares. However, one of the offshore companies had already negotiated a tax ruling with US tax authorities on the basis that the share issues would be debt for US tax purposes, and the ATO was not able to identify any instrument that could successfully straddle the debt-equity divide in both countries, for both tax and commercial purposes. The ATO advanced counterfactual would have rendered that ruling inapplicable and so was held not to be reasonable because of this consequence.

Futuris

Moreover, what is carved out is (effectively) Australian income tax. This means that regard can permissibly be had to domestic stamp duty costs.

For example, in Futuris, the taxpayer wanted to float a portion of its business and, in order to do so, transferred a number of assets to other group companies, tidied up cross shareholdings and capitalised some existing debts. These transactions had the effect of triggering capital gains tax, deferred in some cases by rollovers, and invoking the value shifting rules.

The court rejected one possible counterfactual – that all of the assets would have been transferred to a new float vehicle – on the basis that it would have triggered a significant stamp duty liability. It may well be that under the new Part IVA the ATO advanced counterfactual would be considered

reasonable because of this adverse consequence.

3.5.7 Disregarding

Australian income tax results

The effect of the s.177CB(4)(b) statutory direction is that any result in relation to the operation of the Act that would be achieved under a particular alternative postulate for any person must be

disregarded in determining whether the alternative postulate is reasonable.

The reason for the introduction of s.177CB(4)(b) is well documented: a desire, following the decisions in Futuris and RCI, that the prospect of a large Australian income tax liability not be a barrier to alternative postulates being permissible counterfactuals.

Some have argued that disregarding Australian income tax consequences does not require other results associated with those consequences to be disregarded.

For example, the argument would be that if a pre-sale dividend were not paid so that a larger amount of tax were paid on the sale, the vendor would have correspondingly less cash proceeds from the sale – and this reduced cash position is a “result” to which particular regard can permissibly be had in

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determining whether a sale alone (ie, absent the pre-sale dividend) is a reasonable alternative postulate.

This argument is not particularly convincing. Apart from being the very thing to which the amendment was directed, what is excluded from particular regard is “a result in relation to the operation of the [Tax Acts]”. And one can easily imagine a court holding that a reduction of cash as a result of paying tax fairly and squarely answers that description.

3.6 The statutory “choice principle” provisions

Many common transactions involve statutory “choices”. For example:

 related companies transfer an asset between themselves and choose Subdivision 126-B roll over of the capital gain; or

 a wholly-owned company is interposed between a parent and subsidiary and the parent chooses Subdivision 124-G roll over of the capital gain on disposal of shares in the subsidiary. A tax benefit prima facie arising under either the annihilation limb or the reconstruction limb

“attributable” to such a choice is potentially disregarded under either:  the primary statutory “choice principle” provision in s.177C(2); or  the secondary statutory “choice principle” provision in s.177C(2A).

If so, no tax benefit arises and it follows that Part IVA is incapable of applying in the circumstances. However, despite their importance, there is surprisingly little guidance on these provisions.

3.7 The primary statutory choice principle

The primary statutory “choice principle” provision applies to all of the different types of tax benefit (ie, tax benefits in relation to income, deductions, capital losses and FITOs) other than withholding tax benefits – an apparent oversight in the 2013 amendments.

More specifically, s.177C(2) provides that no qualifying tax benefit arises if three cumulative requirements are satisfied:

 Requirement #1: the qualifying benefit is “attributable to” the making by any person of an agreement, choice, declaration, agreement, election, selection or choice, the giving of a notice or the exercise of an option expressly provided for by the Tax Acts;

(there are of course interpretational issues around when the tax benefit is or is not attributable to a statutory choice – although s.177C(3) provides that a tax benefit is taken to be “attributable to” a statutory choice where, if the statutory choice had not been made, the tax benefit would not have arisen – ie, a but/for test)

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 Requirement #2: the tax benefit is not attributable to the making of a choice under Subdivisions 126-B, 170-B (which are covered by the secondary choice principle) or 960-D (no choice principle applies); and

 Requirement #3: the scheme was not entered into or carried out by any person for the dominant purpose of creating any circumstance or state of affairs the existence of which is necessary to enable the statutory choice to be made.

Example: Subdivision 124-G roll over

Take the common example of a new company being interposed between existing companies in a holding structure. The top company would otherwise make a capital gain on the interposition, but that capital gain is rolled over under Subdivision 124-G.

The critical issue is whether it can properly be said that the relevant scheme was entered into or carried out by any person for the dominant purpose of creating any circumstance or state of affairs the existence of which is necessary to enable the Subdivision 124-G roll over relief to be chosen.

Whether the relevant scheme is broad or narrow will in turn be critical to this issue.

For example, the ATO has indicated in TR 97/18 that a shelf company is a pre-requisite to Subdivision 124-G roll-over relief (at least in the consolidated group context).

Experience indicates that the ATO will tolerate some existing activities in the shelf company provided they are not of a trading nature.

The correctness of the ATO position is debatable. But compliance with this ATO imposed

requirement means that the availability of Subdivision 124-G rollover almost always requires either a newly minted company or a shelf company. This in turn requires preparatory steps – either the establishment or purchase of the relevant company.

Are these preparatory steps part of the relevant scheme? If so, the primary choice principle may well be precluded.

The breadth of the definition of “scheme” clearly means that there is flexibility in the identification of the relevant scheme in any particular situation.

However, compliance with ATO imposed requirements should not preclude Subdivision 124-G relief because:

 the ATO has ruled favourably a number of times on the availability of Subdivision 124-G roll-over relief - and has not sought to apply Part IVA - in circumstances where an entity is brought into existence or acquired in order to perform the role of interposed company; and

 in TR 2005/19, the ATO expressed the view that preparatory steps precluded the primary statutory choice principle from applying in the context of Subdivision 124-M roll-over relief. However, the steps considered in that ruling were much more elaborate than merely establishing/purchasing the interposed company.

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In light of the above, it could reasonably be expected that the ATO would only seek to preclude the application of the primary statutory choice principle to Subdivision 124-G roll over relief if “something more” than mere acquisition/creation of the interposed company was present.

A public statement from the ATO to this effect would be welcomed.

Ashwick – loss transfer agreements

In Ashwick, the taxpayers claimed tax losses that had been transferred to them by other group companies.

At first instance, at paragraph 237, the primary judge held that the primary statutory choice principle applied. That is, no tax benefit arose because the deduction arose from the making of a choice to transfer losses – and the scheme was not entered into with a purpose of enabling those agreements to be made.

(The full Federal Court approached the matter somewhat differently, relying instead on a finding that the scheme was not carried out with the necessary purpose of securing the tax benefit.)

Noza – MEC group formation choice

In Noza, the taxpayer bravely asserted that s.25-90 deductions arising to the taxpayer (as the provisional head company of a MEC group) were “attributable to” the election to form a MEC group. It is true that absent a MEC group the outgoings on the RPS that generated the s.25-90 deductions would not have been deductible to Noza – rather, they would have been deductible to another group company.

However, unsurprisingly, the Court held that these deductions arose from matters insufficiently connected with the choice to form a MEC group – ie, the arrangements under which the relevant RPS were issued.

A similar approach was taken in Walters v Commissioner of Taxation [2007] FCA 1270.

ATO views on the tax consolidation choice

A number of tax benefits arise following formation of a tax consolidated group – such as non-inclusion of income in subsidiary member, deductions for the head company rather than subsidiary members, tax cost step ups, utilisation of transferred losses etc.

The ATO’s consolidation reference manual considers the application of the primary statutory choice provision in relation to a choice to consolidate.

The ATO view appears to be that, whenever any preliminary steps have been undertaken in order to facilitate formation of the consolidated group, it would readily be concluded that the purpose of those preliminary steps was to put the group into a position to make the tax consolidation choice – in which case the primary statutory choice provision cannot apply.

Despite a number of Part IVA cases dealing with tax benefits arising from formation of a tax consolidated group (eg, the debt creation and associated pumping up of ACA in Noza), has never directly been raised.

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But, as Tony Slater QC put it in his 2004 paper “Part IVA in Wonderland”:

“Absent the extraordinary advantages which flow from unlocking losses or reinflating cost bases, the dominant purpose of the parties to a choice to consolidate and the steps taken to make the choice possible will usually be to obtain the efficiencies resulting from consolidation – the very advantages the Review of Business Taxation identified and recommended should be facilitated.

It would be an excessively narrow view of the legislation, and an excessively wide reading of the reasons in Spotless Services, to say that the efficiency benefits obtained were a mere consequence of the tax benefits, so that a dominant purpose of obtaining the efficiency benefit was necessarily also a dominant purpose of obtaining the tax benefits.”6

Although this point was made in the context of the purpose requirement, it should apply equally to the primary statutory choice principle.

3.8 The secondary statutory choice principle

The secondary statutory choice principle is confined to benefits “attributable to” either:

 a choice made under Subdivision 126-B (in relation to the rollover of certain capital gains on transactions between members of a wholly owned but not tax consolidated group); or

 an agreement made under Subdivision 170-B (in relation to transfers of net capital losses within a wholly owned group that is not a tax consolidated group),

but only in circumstances where the scheme consists solely of the making of the agreement or election.

As can be seen, the ambit of the relevant scheme is very important.

(Interestingly, and apparently by design, the statutory choice principle expressly does not apply to a functional currency choice made under Subdivision 960-D.)

Example: Subdivision 126-B rollover

Subdivision 126-B rollover relief is commonly used.

This is because many restructures involve the movement of assets (by transfer or creation) from one entity to another within a wholly owned group in circumstances where the participants are not members of a wholly-owned group (eg, because one or more of them is a foreign resident). Where that transfer would otherwise give rise to a capital gain, that capital gain can be rolled over under Subdivision 126-B, subject to certain restrictions on the residence of the participants and the type of CGT asset.

Importantly, a modified version of Subdivision 126-B also applies for CFC purposes: s.419.

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Again, it may be that there were a number of preparatory steps which facilitate the relevant

transfer/creation. And so, again, whether the relevant scheme is broad or narrow will be critical to the availability of the secondary statutory choice provision.

In this regard, the explanatory memorandum to the bill that introduced s.177C(2A) states that Part IVA should not be applied to “normal” or “ordinary” roll over situations. There is no guidance as to what those concepts mean. Moreover, the statutory interpretation issue about the relevance of explanatory memoranda is reprised.

What is clear is that the secondary choice principle should apply where there is a transfer between 2 qualifying companies where the relevant asset was already held by the transferor and the companies were already in the requisite relationship. However, the existence of any preparatory step (eg, a preliminary asset transfer or creating the requisite relationship between the relevant companies) raises the prospect that the secondary statutory choice provision does not apply to a Subdivision 126-B roll over. However, it would be disappointing if the ATO took such a narrow approach.

Again, public ATO guidance on this issue would be welcomed.

BAT

In BAT, the taxpayer was about to be merged into the Rothmans corporate group - which had available capital losses. The competition regulator required that certain of BAT’s assets be sold. Those assets had latent capital gains.

BAT’s management deliberately sequenced events so that BAT became part of the Rothmans group, BAT then transferred the assets to a Rothmans group company (electing Subdivision 126-B roll over relief for the resulting gain), then the recipient group company sold the assets to an external buyer, triggering the capital gain, which was then grouped with the Rothmans group losses. On this

sequencing, the disposal was effectively tax free – whereas a direct sale to the external buyer by BAT pre-merger would have triggered a large taxable capital gain for BAT.

Part of BAT’s argument was that the scheme for Part IVA purposes consisted just of making the Subdivision 126-B election to roll-over the capital gain on the assets – and so the secondary statutory choice provision applied.

BAT lost this argument at first instance on the basis that its management was alive to the sequencing issues for a long period of time:

“… the planning for and implementation of the scheme identified by the Commissioner and described above, in relation to the making of the choice by the Taxpayer … commenced many months before the actual disposal by the Taxpayer of the [assets] on 3 September 1999 and continued for some time after that disposal. Thus, the scheme consisted of much more than the mere making of the rollover choice or election.”

Although the precise reasoning is elusive, the conclusion that the secondary statutory choice principle did not apply in the circumstances was upheld on appeal to the Full Federal Court.