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How the Guardian AIT decision gives Part IVA sharp, nasty teeth
17 February 2023
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Part IVA ITAA 1936 is the general anti-avoidance rule (GAAR) of income tax law, which is littered with specific anti-avoidance provisions. Part IVA sits over all of income tax law and the specific anti-avoidance provisions as “one GAAR to rule them all” (apologies to J. R. R. Tolkien).
The recent decision of the Full Federal Court in Commissioner of Taxation v Alexander Springer (a sister case to Commissioner of Taxation v Guardian AIT Pty Ltd as trustee for Australian Investment Trust [2023] FCAFC 3 has given Part IVA massive, sharp and nasty teeth.
I will now make a statement that readers of this article may, initially, find difficult to accept. I will explain this statement in the course of this article.
Here is the statement:
It is now the law in Australia, confirmed by the Full Federal Court, that a taxpayer can be assessed, with penalties, on a transaction they did not enter into and would never have entered into. That is, a taxpayer can be assessed, with penalties, on a completely fictitious transaction.
Understandably, you may have great difficulty in accepting that the above statement is correct. I will now explain why this is so. First, I must explain how Part IVA operates and a particular past problem for the ATO in successfully raising assessments using this provision.
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How Part IVA operates
Let us assume that a taxpayer entered into a set of actions. I will call that set of actions ABCD. That is, the taxpayer did “A”, then “B”, then “C” and then “D”. That set of actions had a particular tax outcome. Let us assume that actions “C” and “D” in that series resulted in a reduction of assessable income of the taxpayer, in the view of the ATO, by $1 million.
Due to this, the ATO decides it wants to apply Part IVA and increase the taxpayer’s assessable income by $1 million. The ATO believes that entering into the CD actions was a scheme that had the sole or dominant purpose of reducing the assessable income of the taxpayer by the $1 million amount.
With this being the case, the ATO must propose or postulate an alternative set of transactions that the Commissioner thinks the taxpayer would have entered into but for the scheme. Let us assume that this postulated set of actions is described as ABYZ. That is the taxpayer would have done YZ instead of CD.
This alternative set of actions, which did not occur, is referred to as the “alternative postulate”. That is, the ATO postulates that in the absence of doing the real actions (being ABCD) the taxpayer would have done ABYZ.
If the taxpayer had done ABYZ, the taxpayer’s assessable income would have been $1 million higher. So $1 million is therefore identified as the tax benefit under the scheme that had, according to the ATO, the sole or dominant purpose of obtaining that tax benefit. The ATO will then raise an assessment against the taxpayer including the extra $1 million in the taxpayer’s assessable income and will very likely apply penalties on top of that.
You will note that the actions under the alternative postulate did not happen. The ABYZ actions are only postulated as what would have happened if the taxpayer had not done ABCD. In putting forward this alternative postulate, what the ATO postulates must be reasonable.
Past difficulties with Part IVA
Prior to 2013, the ATO had lost some cases on Part IVA due to the taxpayer arguing that the alternative postulate proffered by the ATO was unreasonable. This was because the taxpayer would never have entered into those transactions postulated by the ATO due to the tax cost involved.
So, in the above example, the taxpayer might have argued that it would never have done ABYZ because those actions would have increased its assessable income by $1 million and the tax cost would have been too great. Therefore, it is unreasonable for the ATO to postulate that the taxpayer would have entered into those actions because the taxpayer would never have undertaken those actions due to the tax cost that would result from those actions.
This method of arguing that Part IVA did not apply proved to be a real problem for the ATO. Accordingly, Part IVA was amended with effect from the year ended 30 June 2013 to try and overcome this issue.
First time amendments considered
The Alexander Springer/Guardian AIT Full Federal Court decision is the first case where these amendments have been considered in detail. The intended purpose of the amendments was to remove the ability of the taxpayer to be able to argue that they would not have entered into a postulated set of transactions because the tax impost would have been prohibitive.
The primary judge of the Federal Court (not the Full Federal Court) said that the distribution of a certain type of income “would, never, ever have occurred” to Alexander Springer and dismissed the Commissioner’s Part IVA assessments. This is because the evidence was that no competent tax adviser would have recommended Alexander Springer engage in those transactions, on which the ATO raised Part IVA assessments. However, the Full Federal Court held that the primary judge was wrong due to the amendments to Part IVA to which I have just referred.
That is, the Full Federal Court affirmed that a taxpayer cannot argue an alternative postulate proffered by the Commissioner is unreasonable due to the prohibitive tax cost of undertaking the actions in that postulate. This is so even though the taxpayer, genuinely, would never have undertaken those transactions due to the tax cost being too high.
The implications are very significant
So, think about what this means.
It is now the law in Australia (confirmed by the Full Federal Court) that you can be taxed (with penalties) on a transaction that you did not enter into and would never have entered into. That is, you can be assessed on a completely fictitious transaction that would never have occurred in real life.
Can the ATO now just propose that a taxpayer would have entered into a transaction that would attract the maximum amount of tax and be successful? If the taxpayer cannot prove that the alternative postulate from which the maximum tax flows is unreasonable (without regard to any postulated tax impost), this will be the outcome.
It is to be remembered that the onus of proof rests on the taxpayer in Australian tax law. The responsibility is not on the ATO to prove the alternative postulate is reasonable. The taxpayer must demonstrate to a court that the alternative postulate is unreasonable. This may be a difficult thing to achieve without the potential tax impost argument.
Discretionary decisions of trustees
For discretionary trusts the trustees decide, in their absolute discretion, as to how the income of the trust is to be distributed each financial year.
This is the second case in just a few months where Part IVA has been applied to the discretionary decision of a trustee. The other case was the Federal Court decision of Minerva Financial Group v Commissioner of Taxation [2022] FCA 1092. This will be of significant concern to accountants. Tax advisers will all watch with interest as to what the ATO sees as the implication of these decisions.
I should say it has always been the case that Part IVA could be applied to a discretionary decision of a trustee where a distribution to a beneficiary saves tax when compared to a distribution to another beneficiary. In this situation it is relatively easy to come to the view that 3 of the 4 conditions necessary for Part IVA to apply have been satisfied. These are:
- There is a scheme.
- There is a tax benefit.
- The scheme was entered into for the sole or dominant purpose of obtaining the tax benefit.
The vast majority of trustee distributions, recommended by accountants, are motivated by tax saving. Hence, the first three conditions of Part IVA are nearly always satisfied when a trustee decides to distribute income based on a motivation of lowering the overall tax bill (usually) of a family group.
So why doesn’t the ATO apply Part IVA to these very common situations? It is because of the fourth condition that needs to be satisfied in relation to Part IVA. This simply is that the Commissioner must decide to apply it. History shows us that in 99.99 per cent of the situations where a trustee decides to distribute income based on tax motivation, the ATO simply chooses not to apply Part IVA.
It should be noted that Part IVA is not a self-actuating provision like most anti-avoidance provisions (e.g. section 100A). The legislation states that the ATO “may” apply Part IVA, and that is a major difference. This is why so many transactions or events that are motivated by tax saving are never assessed under Part IVA.
Bucket companies?
Could Part IVA apply to the distribution of income to a company beneficiary that pays tax at the rate of 25 per cent when there are other beneficiaries that are on the top marginal tax rate? The answer is “yes”, as long as it can be concluded that the distribution to the “bucket company” was done with the sole or dominant purpose of reducing the assessable income of the beneficiaries on the top marginal rate. This, frequently, is the main reason for using a corporate beneficiary.
The ATO could argue that the alternative postulate was that distributions would have been made to the beneficiaries with the high marginal tax rate and that the distribution to the corporate beneficiary would not have occurred.
In line with what was said in the Alexander Springer/Guardian AIT case, the beneficiaries on the top marginal rate would then need to show, in court, that the distribution to them (as per the alternative postulate) was unreasonable – remembering that they cannot use the fact that there would have been more tax to pay as an argument why the alternative postulate was unreasonable.
Unless there are specific facts that help the beneficiaries assessed under Part IVA, it is going to be difficult for them to prove that the postulate of them being distributed income from the trust was unreasonable.
Where is this going?
I am concerned where this might end. I am quite sure the tax technicians within the ATO will see that through the Minerva Financial Group and Alexander Springer decisions, the Federal Court has given Part IVA huge, sharp teeth.
Unfortunately, I think we are going to be left in the position that it will be up to the Commissioner, alone, to decide what Part IVA will or will not be applied to. If this be correct, this is a bad outcome for the Australian community. This is because the application of the GAAR will not be under some discernible rule of law, but on the whims of the ATO.
Further, accountants, lawyers and tax agents will not be able to advise their clients with certainty as to whether there is a risk of Part IVA applying unless they either:
- Advise clients to pay the maximum tax, or
- Seek a private ruling from the ATO.
John Jeffreys is director of John Jeffreys Tax Pty Ltd.
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