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Focus: Part IVA: the burden of proving a tax benefit

31 August 2011

In brief: A recent Full Federal Court decision makes it much more difficult for the Commissioner of Taxation to apply Part IVA to corporate restructures. Tax Partner Larry Magid (view CV), Litigation Partner Malcolm Stephens (view CV) and Lawyer Tom Prince report on the case which involved a member of the James Hardie group of companies and whether there was a 'tax benefit'.

How does it affect you?

  • The Commissioner may apply Part IVA of the Income Tax Assessment Act 1936 (Cth) to deny a 'tax benefit' obtained in connection with a tax-avoidance 'scheme'.
  • In recent years, the Commissioner has increasingly sought to apply Part IVA to corporate restructures. In many of these cases, the restructure has had a clear commercial purpose other than avoiding tax. The Commissioner has, however, sought to apply Part IVA on the basis that the taxpayer has used a 'scheme' to reduce the tax that otherwise might have arisen if the restructure had been carried out in a different manner.
  • The Full Court judgment suggests that, if a taxpayer can prove that the reorganisation would not have proceeded if there had been a liability to pay tax in the amount the Commissioner claimed, then there is no 'tax benefit' to which Pt IVA can apply.

Background facts

During 1998, the James Hardie group of companies, of which the taxpayer (RCI Pty Ltd (RCI)) was a member, undertook a complex restructure. As part of the restructure, RCI and related companies entered into a number of transactions culminating, relevantly, in a transfer of RCI's shares in a subsidiary to another member of the James Hardie group, RCI Malta. Approximately seven months before the shares were transferred, the subsidiary paid a (non-assessable) dividend of US$318 million. One effect of this dividend was to reduce the capital gain RCI made on the subsequent transfer of shares.

In 2006, the Commissioner made a determination under Pt IVA to include in RCI's assessable income for the year ending 31 March 1999 a tax benefit of approximately $478 million. This represented the capital gain that would have been made on the share transfer to RCI Malta if a lower dividend had been paid and if certain other steps had occurred.

RCI objected against the amended assessment and the Commissioner disallowed the objection. In 2010, Justice Stone dismissed RCI's appeal against the Commissioner's objection decision. RCI appealed to the Full Court.

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The Full Court's decision

In allowing RCI's appeal, the Full Court made a number of points concerning the concept of a 'tax benefit' for the purposes of Pt IVA.

The court first emphasised that, although the taxpayer has the burden of proving that an assessment is excessive, it does not follow that the taxpayer must prove that the Commissioner's 'hypothetical' or 'counterfactual' (which is used to calculate the tax benefit) is unreasonable. The relevant question for the court is to determine 'objectively, and on all of the evidence, including inferences open on the evidence, as well as the apparent logic of events, what would have or might reasonably be expected to have occurred if the scheme had not been entered into.'

Second, the court noted that this enquiry will most likely be answered, not by consideration of the subjective evidence of what the taxpayer would have done, but by consideration of the 'objective indicia ascertained from the context and matrix of underlying facts as well as the logic of the taxpayer's counterfactual having regard to the commercial or financial aspirations and limitations of the parties to the scheme.'

Third, and most importantly, the court recognised that the transaction costs, including additional tax payable, of a suggested counterfactual will be an obvious relevant consideration in determining whether that counterfactual would, or might reasonably be expected to, have occurred.

The Commissioner's counterfactual was that, but for the 'scheme', RCI would have proceeded with the share transfer to RCI Malta via different steps. Those different steps would have resulted in an additional capital gain of $478 million and additional tax of $172 million. The Full Court rejected even the possibility, let alone the expectation, that this would have occurred. The contemporaneous documents showed that transaction costs of the restructure were uppermost in James Hardie's mind. On the Commissioner's counterfactual, the costs of the restructure would have increased from 2.5 per cent of market capitalisation to 15 per cent. According to the Full Court, if the dividend had not been paid, the reasonable expectation was that, given the additional tax costs, the share transfer to RCI Malta would never have taken place, since there was no commercial imperative for the share transfer to occur.

The Full Court therefore concluded that Pt IVA did not apply because no tax benefit was obtained in connection with the 'scheme'.

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Significance of the decision

The decision will make it difficult for the Commissioner to apply Pt IVA if the 'tax benefit' claimed to arise in connection with a scheme is the inclusion of such a large amount in assessable income that the Commissioner's 'counterfactual' is uncommercial.

However, the following should be noted.

First, as the Full Court noted, different considerations may come into play where the transaction involves the disposal of an asset to an unrelated third party. In those circumstances, it would clearly be more difficult to convince a court that the reasonable expectation is that no other transaction would have occurred if the actual scheme had not been carried out.

Secondly, the Commissioner argued that the long-term benefits of the restructure outweighed the up-front tax cost of $172 million, so that the court could conclude that the transfer to RCI Malta might still have occurred. One of the court's reasons for rejecting this argument was that the Commissioner produced no evidence to value the long-term benefits of the restructure. In future cases, the Commissioner may be able to produce evidence that shows the additional tax costs of a transaction would have been outweighed by other advantages.

Third, the Commissioner may seek special leave to appeal to the High Court, and the ultimate decision may give added impetus to the ATO's efforts to change the definition of 'tax benefit' in Pt IVA, although it is unlikely that any such changes would be retrospective.

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