In its recent decision in Commissioner of Taxation v Lenzo [2008] FCAFC 50, the Full Federal Court found in favour of the Commissioner and held that Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) applied to disallow deductions claimed by the taxpayer in relation to his investment in an agricultural project in the 1998-2000 income years.
The taxpayer had originally been successful before a single judge of the Federal Court, who found that the taxpayer had not obtained a ‘tax benefit’ by entering into the scheme (Lenzo v Commissioner of Taxation [2007] FCA 1402).
The Full Court gave particular attention to what questions need to be answered to reach a conclusion about whether a taxpayer has obtained a ‘tax benefit’ for the purpose of Part IVA. This discussion is especially relevant in relation to identifying a proper valid counterfactual.
The Full Court also considered the criteria for identifying a ‘dominant purpose’ under section 177D (b) ITAA 1936, including the relevance of the commerciality of an arrangement.
Taxpayers should be mindful of the views expressed by the Court about obtaining a ‘tax benefit’ when assessing the potential application of Part IVA to an arrangement or transaction.
Tax benefit
The Full Court identified three matters that need to be taken into account when considering whether a taxpayer has obtained a ‘tax benefit’ pursuant to section 177C(1)(b) of the ITAA 1936.
Firstly, section 177C(1)(b) requires an assumption to be made that the scheme had not been entered into or carried out. This means that the entire scheme (as identified by the Commissioner) must be disregarded, not just a part of the scheme.
Secondly, account must be taken that section 177C(1)(b) requires the making of a sufficiently reliable prediction about events which would have occurred if the scheme had not been entered into or carried out; a mere possibility is not sufficient. This will impact on the identification of a valid counterfactual.
Finally, there is the question of what the expression ‘that deduction’ in section 177C(1)(b) means. The Full Court held that it refers to a deduction of the same kind as that which was claimed, and not to the actual liability incurred. If this were not the case, the Commissioner would always succeed in demonstrating a ‘tax benefit’ because if there was no scheme, a taxpayer would never be able to claim the identical deduction that was claimed.
Discharging the onus to show that a tax benefit was not obtained
The Full Court described how a taxpayer could satisfy the onus to show that a ‘tax benefit’ had not been obtained. The taxpayer would have to show, on a reasonable expectation basis, what activity would have been undertaken in lieu of the scheme, and that the activity would have resulted in an allowable deduction of the same kind as the deduction actually claimed by the taxpayer.
Replacing a single step in the scheme with another step will not be sufficient, nor will identifying a completely different course of action that might have been taken if the scheme had not been proceeded with.
The Full Court’s analysis of section 177C(1)(b) suggests that taxpayers will need to consider what evidence they can put forward that will:
- establish what other course of conduct they might reasonably have been expected to take if the scheme had not been entered into, and
- show that that other course of conduct would have resulted in a deduction of a similar character to the deduction that was claimed.
Dominant purpose
In relation to the commerciality of the project, the Full Court held that the consideration of this factor created a ‘false dichotomy’ between identifying a rational commercial decision and a dominant purpose of obtaining a ‘tax benefit’. The determination of whether Part IVA applies to an arrangement is not influenced by the commercial prospects of the arrangement.
On the facts of the case, the Full Court held that the taxpayer’s dominant purpose was to obtain a ‘tax benefit’. Indications of a tax driven purpose were found in the timing of the scheme, with the ‘flurry of activity at the very end of the taxation year’; in the ‘round-robin’ lending of funds; and in the structure of the scheme which meant that most liabilities were deferred many years into the future.
Conclusions
The Full Court’s analysis in relation to ‘tax benefits’ should be closely considered when Part IVA is in issue, particularly when identifying the counterfactual in response to the question of what the taxpayer would reasonably have been expected to have done had the scheme not been entered into or carried out.
The Full Court has also made it clear that end of year transactions and ‘round-robin’ financing will be factors that are more likely than not to weigh in favour of a finding of a dominant tax driven purpose.
For further information, please contact your usual PricewaterhouseCoopers adviser, or:
Michael Bersten, Partner
Phone: +61 2 8266 6858
michael.bersten@au.pwc.com
Chris Sievers, Partner
Phone: +61 3 8603 4208
chris.sievers@au.pwc.com
Steven Small, Senior Associate
Phone: +61 3 8603 3512
steven.a.small@au.pwc.com
