July's tax developments - in depth

This article is taken from the August issue of Taxation in Australia, the journal for members of The Tax Institute.


Government initiatives 

1. Better targeting the research and development tax incentive

In a 29 June 2018 joint media release, the Treasurer and the Minister for Jobs and Innovation announced the release of draft legislation (and explanatory material) to give effect to the 2018-19 Budget proposal in relation to the research and development tax incentive (R&DTI).

In the Budget, it was announced that the R&DTI would be reformed to better target the program and improve its integrity and fiscal affordability in response to the recommendations of the 2016 Review of the R&D tax incentive. The changes are to apply for income years starting on or after 1 July 2018.

The Treasurer said that the government is committed to backing R&D investment and the economic opportunities and jobs it generates. At the same time, it needed to be made sure that the investment of taxpayers’ money is well targeted by encouraging companies to do more, and not just be rewarded for R&D they would have conducted without an incentive.

2. Stapled structures: integrity measures 

In a 28 June 2018 media release, the Treasurer announced the release of a paper for public consultation in relation to the reform of the tax treatment of stapled structures and similar arrangements.

The package (which was envisaged in an announcement on 27 March 2018) ensures trading income for foreign investors is taxed at the corporate tax rate, and limits access to broader concessions for passive income utilised by foreign governments and foreign pension funds.

The consultation paper outlines the conditions stapled entities must comply with to access the proposed infrastructure concession and transitional arrangements. The conditions include:

  • the extension of existing integrity rules that apply to managed investment trusts (MITs) to ensure that all staples are required to set their rent at market prices; and 
  • the introduction of statutory caps on the amount of cross-staple rent that is able to access the concessional rate of withholding tax (available under the MIT regime) for new and existing infrastructure projects during the transition or concession period. 
The Commissioner’s perspective 

3. Central management and control: company

The Commissioner has issued a final ruling which sets out his view on how the central management and control test of company residency in s 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA36) operates following the decision of the High Court in the Bywater Investments Ltd case (Bywater) (TR 2018/5).

On the same day as the ruling was issued, the Commissioner also released a draft practical compliance guideline which contains practical guidance to assist foreign incorporated companies and their advisers to apply the principles set out in the central management and control ruling (PCG 2018/D3).

A company is a resident or a resident of Australia under the central management and control test of residency if it:

  • carries on business in Australia; 
  • has its central management and control in Australia. 
Some points of interest from the ruling are noted below.

Does a company carry on business in Australia? 

It is not necessary for any part of the actual trading or investment operations of the business of the company to take place in Australia. This is because the central management and control of a business is factually part of carrying on that business. A company carrying on business does so both where its trading and investment activities take place, and where the central management and control of those activities occurs.

What does central management and control mean? 

Central management and control refers to the control and direction of a company’s operations. It does not refer to a physical location in which the control and direction of a company is located, and may ultimately be exercised in more than one location.

The key element in the control and direction of a company’s operations is the making of high-level decisions that set the company’s general policies, and determine the direction of its operations and the type of transactions it will enter.

The control and direction of a company is different from the day-to-day conduct and management of its activities and operations. The day-to-day conduct and management of a company’s operations might be an exercise of central management and control in circumstances where they are effectively the same.

Merely because a person is a majority shareholder or has the power to appoint those who control and direct a company’s operations does not, by itself, mean the person controls and directs a company’s operations and activities.

Acts of central management and control 

Exercising central management and control of a company can involve:

  • setting investment and operational policy; 
  • appointing company officers and agents and granting them power to carry on the company’s business (and the revocation of such appointments and powers); 
  • overseeing and controlling those appointed to carry out the day-to-day business of the company; and 
  • matters of finance, including determining how profits are used and the declaration of dividends. 
Matters of company administration are not acts of central management and control. Examples of these are keeping a company’s share register and keeping and adopting a company’s accounts.

A starting point 

Normally, where a company is run by its directors in accordance with its constitution and the company law rules applicable to that company, which give its directors the power to manage the company, the company’s directors will control and direct its operations. It follows that ordinarily it is a company’s directors who exercise its central management and control.

However, the actions of a company’s directors, or others with the legal power and authority to control and manage the company, are not the end of the enquiry as to who exercises central management and control. There is no presumption that the directors of a company will always exercise its central management and control.

When determining who exercises a company’s central management and control, all the relevant facts and circumstances must be considered.

Mere legal power or authority 

A person who has legal power or authority to control and direct a company, but does not use it, does not exercise central management and control. For example, in Bywater, the court disregarded the role of those directors who were formally appointed but did not play any real role in the affairs of the company.

Tacit control 

A person may control and direct a company without actively intervening in the company’s affairs on an ongoing basis provided they:

  • have appointed agents or managers whom they tacitly control to conduct the company’s day-to-day business; 
  • tacitly control and regularly exercise oversight of the affairs of the company, including monitoring the company’s performance; and 
  • do not need to actively intervene because the company’s affairs are running smoothly and in the manner they desire. 
Where is central management and control exercised? 

A company will be controlled and directed where those making its high-level decisions do so as a matter of fact and substance. It is not where they are merely recorded and formalised, or where the company’s constitution, bylaws or articles of association require it be controlled and directed, if, in reality, it occurs elsewhere. This will not necessarily be the place where those who control and direct a company live.

Control and direction of a company may be undertaken by those controlling a company in multiple places. This means a company’s central management and control may be divided between more than one place. However, a company’s central management and control will only be exercised in a place for the purpose of the central management and control test if it is exercised in that place to a substantial degree, sufficient to conclude the company is really carrying on business there.

Relevance of a company’s activities 

Central management and control of a company is not necessarily exercised where the trading or investment activities of the company are carried on. However, the nature of a company’s business activities may dictate where its key decisions must be made as a matter of practice.

Residence of directors vs residence of a company 

Where a company’s central management and control is exercised is not determined by where the directors, or other persons, who control and manage it, are resident or live. What matters is where they actually perform the activities to control and direct the company.

4. Part IVA: restructures of hybrid mismatch arrangements 

A draft practical compliance guideline has been released which sets out the ATO’s compliance approach with respect to the general anti-avoidance provisions (Pt IVA ITAA36) and certain restructures that have the effect of preserving Australian tax benefits that would otherwise be disallowed under the hybrid mismatch rules (proposed Div 832 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) which are being enacted by the Treasury Laws Amendment (Tax Integrity and Other Measures No. 2) Bill 2018 (PCG 2018/D4).

The hybrid mismatch rules will implement into Australian taxation law the recommendations of the Organisation for Economic Co-operation and Development. The rules are intended to deter the use of certain hybrid arrangements that exploit differences in the tax treatment of an entity or financial instrument under the income tax laws of two or more countries.

The rules are to have a 1 January 2019 commencement which is intended to allow taxpayers time to review their existing hybrid arrangements and to unwind or restructure out of such arrangements in advance of the rules, if they so choose.

The draft practical compliance guideline states that concerns have been raised about the potential for the Commissioner to apply the general anti-avoidance provisions (Pt IVA) to cancel all or part of a tax benefit where a taxpayer restructures an existing hybrid arrangement to avoid the potential application of the hybrid mismatch rules. This may involve, for example, replacing a hybrid financing instrument with a debt instrument to eliminate tax benefits in another country but preserve tax benefits, in the form of deductible debt, in Australia.

The draft guideline is designed to assist taxpayers to manage their compliance risk in these circumstances where their intention is to eliminate hybrid outcomes. It does so by outlining restructuring that the Commissioner considers to be of “low risk” and to which he would not seek to apply Pt IVA.

The description of low risk arrangements is illustrated by scenarios involving straightforward restructuring that merely removes the hybrid element of existing arrangements while keeping the surrounding facts and circumstances unchanged (for example, relevant nexus to the derivation of assessable income). The draft guideline is not intended to provide more detailed technical guidance on when Pt IVA could potentially apply to more complex restructuring scenarios. Such guidance would be of limited practical utility given the nature of Pt IVA and the overriding importance of facts and circumstances in the particular case.

5. CGT improvement threshold 

For the 2018-19 income year, the indexed CGT improvement threshold is $150,386 (TD 2018/8).

The improvement threshold is determined for the purposes of s 108-70 ITAA97 (about when a capital improvement to a pre-CGT asset is a separate asset). It is also determined for the purposes of s 108-75 ITAA97 (about capital improvements to CGT assets for which a roll-over may be available).

6. Interest incurred by discretionary trust beneficiary 

A recent final taxation determination is to the effect that a beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a general deduction (under s 8-1 ITAA97) for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee (TD 2018/9).

The determination states that it is only where:

  • the beneficiary is presently entitled to income of the trust estate at the time the expense is incurred; and  
  • the expense has a nexus with the income to which the beneficiary is presently entitled, 
that some part of the interest expense might be deductible. Even then, the interest expense is likely to have been incurred in the pursuit of one or more objectives other than the derivation of assessable income by the beneficiary and will not be deductible to the extent of any non-income producing objective/s.

Although the determination is concerned only with interest deductibility, the principles described would also apply to other expenses incurred by a beneficiary of a discretionary trust to the extent that the beneficiary asserts that the expense is deductible by reason of its connection to an expected receipt of a trust distribution.

Examples of such expenses might include motor vehicle expenses, stationery and telephone expenses.

7. Cross-border related party financing arrangements 

A recently issued final practical compliance guideline outlines the ATO’s compliance approach to the taxation outcomes associated with a “financing arrangement”, or a related transaction or contract, entered into with a cross-border related party (called a “related party financing arrangement” (PCG 2017/4).

The ATO uses the framework in the guideline (and the accompanying schedules) to assess risk and tailor its engagement with the taxpayer according to the features of the related party financing arrangement, the profile of the parties to the related party financing arrangement and the choices and behaviours of the particular group. The tax risk associated with a related party financing arrangement is assessed having regard to a combination of quantitative and qualitative indicators.

If the related party financing arrangement is rated as low risk, then it can be expected that the Commissioner will generally not apply compliance resources to review the taxation outcomes other than to fact check the appropriate risk rating. If the related party financing arrangement falls outside the low risk category, it can be expected that the Commissioner will monitor, test and/or verify the taxation outcomes. The higher the risk rating, the more likely an arrangement will be reviewed as a matter of priority.

The guideline has effect from 1 July 2017 and applies to existing and newly created financing arrangements. The guideline does not cover financing arrangements characterised as equity in accordance with Div 974 ITAA97.

8. GST withholding rules 

The Commissioner has issued a law companion ruling that deals with the recently enacted GST notification and withholding requirements for vendors and purchasers of residential premises and potential residential land where (broadly) the contract is entered into on or after 1 July 2018 (LCR 2018/4).

Unless an exclusion applies, the purchaser’s liability to make a payment to the Commissioner arises if the purchaser is the recipient of a taxable supply by sale or long-term lease of new residential premises, or potential residential land. The vendor is then entitled to a credit for the amount paid to the Commissioner by the purchaser. The credit arises when the vendor’s net amount is assessed on their GST return.

The law companion ruling explains how the new rules apply, including:

  • the types of supplies for which purchasers are required to pay; 
  • when a purchaser is required to pay; 
  • the amount the purchaser is required to pay; 
  • the requirement for a vendor to provide a notice to the purchaser; and 
  • the penalties that may apply to vendors and purchasers. 
Recent case decisions 

9. Small business CGT concessions 

The Administrative Appeals Tribunal (AAT) has affirmed the Commissioner’s decision that the taxpayer did not satisfy the maximum net asset value test and, therefore, was not eligible for the CGT small business reliefs (Hookey and FCT1 ).

The taxpayer made an assessable capital gain in the 2008 income year when, by contracts dated 13 December 2007, he or entities which he controlled (that is, entities related to him) sold five child care centre businesses to ABC Development Learning Centres.

For the purpose of applying the maximum net asset value test, there were six liabilities in dispute. Two of these are of some interest.

One liability was the accrued interest on 90% of an RAB Finance Pty Ltd loan. The loan was taken out by a related entity predominately for purposes connected with the asset, secured by a registered mortgage on the asset, and the asset was one of the CGT assets on which the net assets were calculated. Both the Commissioner and the taxpayer treated 90% of the amount of the principal borrowed as a relevant liability. Interest accrued but unpaid on 13 December 2007 was disregarded in the Commissioner’s calculations and was asserted by the taxpayer to be a relevant liability. The taxpayer was a guarantor of the facility, and so far as he was concerned, the liability to pay interest (and principal as well) may properly have been regarded as a contingent liability. The Commissioner submitted that the liability to pay interest was only a contingent one, and therefore to be disregarded. However, so far as the borrower was concerned, no contingency affected its liability to pay interest and the AAT treated 90% of the whole of that loan, including interest, as a relevant liability.

When addressing a submission by the Commissioner, the AAT said that the word “liability” takes its ordinary English meaning in the ITAA97 which does not require that moneys be immediately due and payable, but simply that they be payable. On that view, interest which has already accrued would form part of the liabilities of the entity at the relevant date, and interest which has not yet accrued would not do so.

The other liability contended for which is of interest arose from the family law arrangements made by the taxpayer with his former wife. Under court-approved terms of settlement, the taxpayer was to pay to the wife the sum of $1,500,000. By order 2, the wife was to transfer to the taxpayer a number of assets, including her interests in the KA Penrith and KA Warnervale child care centres. Order 2 was not expressed to be the consideration for order 1. When the transfer document was entered into, dated 7 November 2007, no consideration for any particular asset was specified, no doubt because transfers under the Family Law Act 1975 (Cth) are free of stamp duty. The only consideration expressed was the family law settlement.

The AAT rejected a contention that a portion of the sum of $1,500,000 should be allocated to the Penrith and Warnervale centres. The AAT was not satisfied of that fact nor that the amount of $1,500,000 was outstanding on 13 December 2007. Whatever values may have been attributed by either or both of the parties to those assets did not appear, and more importantly, contributions may have been taken into account by the taxpayer or his wife, or both of them, when calculating the sum of $1,500,000. The fact that a transfer document was dated in November did not suggest that anything was still due in December.

10. Tax agent deregistration 

The AAT has affirmed a decision of the Tax Practitioners Board to terminate the registration of an individual as a tax agent on the ground that she was not a “fit and proper” person (Beckett and Tax Practitioners Board2 ).

The applicant’s current status was that of a person who had been convicted of two charges of using false documents to influence the exercise of a public duty. She had also publicly acknowledged her guilt of a further offence of knowingly making a false statement under oath. She had been sentenced to imprisonment for a, currently unexpired, period of 20 months, and was subject to a good behaviour bond. Those circumstances were, in the AAT’s view, incompatible with the applicant currently being regarded as a person who can properly be characterised as of “good fame”.

The AAT senior member said that he was conscious of the gravity of the present proceedings and the potential personal implications for the applicant, and for her family, of their adverse resolution. Nevertheless, on the basis of the material before the tribunal, he had reached a firm view of absence of satisfaction that the applicant was currently a person of either good fame, or a person of good integrity and character.

The decision of the AAT contains a comprehensive overview of the principles that are relevant to a “fit and proper person” analysis.

11. Onus not discharged 

The Federal Court (Steward J) has dismissed appeals by a taxpayer against objection decisions made by the Commissioner involving amended assessments for eight income years which increased the taxpayer’s taxable income for those income years by a total of $2.86m and imposed penalties of $2.08m (Bosanac v FCT3 ).

His Honour held that the taxpayer had failed in relation to each income year in dispute to demonstrate that any of the amended assessments issued to him were excessive. That was because, in addition to rejecting his evidence concerning the nature of the deposits into his bank accounts (other than in relation to a car), the taxpayer failed to positively adduce evidence as to the quantum and nature of his foreign and domestic earnings in each income year in dispute. The taxpayer needed to go further than his attack on the basis on which the Commissioner had issued the amended assessments to him, and positively prove what his taxable income was in each year. He needed to lead evidence constituting a wide survey and exact scrutiny of his business activities. This he never did.

Steward J said that the word “excessive” in the onus of proof provisions, might not, as the High Court observed in McAndrew v FCT, 4 have been a “good choice”, and certainly extended to the existence or non-existence of a condition for the exercise of power in a relevant case. But in the usual case, it directs attention to a number, being the difference between taxable income as assessed, and the taxable income contended for by the taxpayer. That number can only be adequately identified on the taxpayer proving — or otherwise demonstrating — what its taxable income was in any given income year.

Penalties 

Steward J also upheld the imposition of intentional disregard administrative penalties at the rate of 75%, increased by 20% for obstruction.

12. Residence: individual

The Federal Court (Derrington J) has held that, on the facts, a taxpayer who had an Australian domicile but worked overseas did not have a place of abode outside Australia and, therefore, was a resident of Australia for income tax purposes for the 2011 income year and was assessable on income derived from ex-Australian sources during that income year (Harding v FCT5).

As with most cases involving the question of whether an individual is a resident, there were quite a range of facts that the court needed to take into account.

Derrington J first found that the taxpayer was not resident in Australia within the ordinary concept of that term. It followed from a consideration of the objective facts surrounding the taxpayer’s circumstances that, in 2009, he left Australia and went to the Middle East with the intention of staying there indefinitely and with no intention to return to Australia and to continue to treat it as “home”. His absence from Australia and his formed intention not to return was sufficient to terminate his residency here to the extent that is determined by the ordinary concepts of residency.

However, the taxpayer was a resident under the domicile test in the definition of “resident” in s 6(1) ITAA36. The taxpayer conceded that his domicile was in Australia but failed to establish that his permanent place of abode was outside Australia. On this issue, Derrington J concluded:

“It follows that in the relevant income year Mr Harding [the taxpayer] did not establish a permanent place of abode in Bahrain. By its character it was a type of premises used for temporary or transitory accommodation and Mr Harding used it as such. By Mr Harding’s own acknowledgements in his affidavit, his presence in that accommodation in that year was temporary and only intended to continue until he was joined by his wife and youngest son at which time they would have acquired permanent accommodation.” 

The taxpayer has lodged an appeal to the Full Federal Court from the decision of Derrington J.


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References
1 [2018] AATA 1509.
2 [2018] AATA 1860.
3 [2018] FCA 946.
4 [1956] HCA 62.
5 [2018] FCA 837.

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