What is Tax Avoidance

Taxation Partner Dennis Tomaras, asks the question – “What amounts to tax avoidance?”

Clients often asked their tax adviser whether a proposed course of action is within the law or whether it might be seen as “tax avoidance”. The general anti-avoidance provision in Australian tax legislation is known as “Part IVA”.

Briefly, Part IVA will apply when the following factors are met.

1. There must be a “scheme” entered into or carried out.
2. A “tax benefit” must be obtained in connection with that scheme.
3. After consideration of a number of specific factors, it must be concluded that a person who entered the scheme did so for the sole, or dominant, purpose of obtaining a tax benefit in connection with that scheme.

Once Part IVA is held to apply, the Commissioner of Taxation can cancel the tax benefits associated with the scheme and reconstruct the underlying transaction.

Part IVA was introduced into Australian tax legislation in May 1981. Even though many years have elapsed since it was enacted, (and there have certainly been a number of cases considering Part IVA during this period), since the 2004 decision of the Australian High Court in Hart’s case, it is difficult to know exactly where to draw the line with respect to when Part IVA might apply to a “scheme”.

As will be well known to anyone perusing the financial press, Hart’s case involved two taxpayers taking out a “Wealth Optimiser” split loan so as to enable them to purchase a new home and retain their former residence as a rental property. The Wealth Optimiser loan allowed for repayments in the early years to be directed towards paying off the home loan while allowing the interest on the rental property loan to be capitalised (and for compound interest to be imposed). The attraction of the Wealth Optimiser loan was that, in effect, it shifted some of the loan balance from the principal place of residence home to the rental property and hence, maximised the tax deduction for the Hart’s.

The case had a colourful evolution as it found itself first in the Federal Court (where a single judge held that Part IVA applied to the Wealth Optimiser scheme). Thereafter, on appeal, the case went before three Federal Court judges who unanimously held that Part IVA did not apply to the Wealth Optimiser scheme. However, on its eventual hearing in the High Court, five High Court judges unanimously (albeit via three different judgements) held that Part IVA did apply so as to deny the tax benefit of the Wealth Optimiser scheme.

In an earlier High Court case involving Part IVA, the High Court had held that a “ scheme” for Part IVA purposes could be defined in a number of ways but that each alternative definition of the relevant scheme could not be “robbed of all practical meaning”. The problem with the High Court decision in Hart’s case is that it is difficult to determine what the High Court have identified as the proper test to apply for when a Part IVA “scheme” exists. However, there does seem to be a view that the Hart’s case decision has narrowed what amounts to a scheme for taxation purposes. In other words, the thinking is that the wider the definition of a Part IVA scheme, the less likely that it will be motivated by tax minimisation. On the other hand, the narrower a scheme can be identified for Part IVA purposes, the more likely that it will be motivated by tax minimisation.

Certainly after the High Court handed down its decision in Hart’s case, the Commissioner of Taxation gave a speech suggesting that the case was a real win for the ATO.

Since the decision, at least one Federal Court judge has stated that he had great difficulty in identifying a precedent from the High Court decision in Hart’s case on the meaning of a scheme for Part IVA purposes. (In fact, the judge considered the High Court’s decision was drawn by the structure of the borrowing, rather than the purpose of the borrowing.) The comment needs to be made that if a Federal Court judge is having this difficulty, then it is also very difficult for us advisors to guide our clients on matters regarding Part IVA.

The other interesting aspect of the Hart’s case decision is that there have been more and more calls both by business and the tax profession for Part IVA to be reformed. This is because there remains considerable uncertainty as to whether a course of action amounts to a Part IVA scheme. In a sense, we will not know whether a Part IVA scheme exists until the Australian High Court considers the matter in question. Obviously, this is not a very practical form of revenue law.

No doubt there are extreme factual cases where clearly Part IVA should apply and, conversely, “regular” business transactions in which it should not. However, this still leaves a significant amount of “grey” in between where quite simply, we are not sure whether Part IVA would apply. This level of uncertainty regarding legislation that has been in existence since 1981 is not a healthy course of events. While there is no simple solution to the problem, it is certainly appropriate for a discussion to occur on the existing limitations of applying Part IVA to business transactions in Australia.

For a discussion on Part IVA or any other tax matter, please call Dennis Tomaras on 03 9608 0100 or email him on dtomaras@nexiaasr.com.au

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