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Australian Tax Law Bulletin - Tax Issues for digital business - Part I - domestic issues

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Contents
page 62 General Editor’s introduction
Dr Helen Hodgson CURTIN LAW SCHOOL
page 63 Tax issues for digital business ...
General Editor’s introduction
Dr Helen Hodgson CURTIN LAW SCHOOL
We are now well into the election campaign. I spent
Budge...
Tax issues for digital business — a case study
Part I: domestic issues
Joanne Dunne and Antonella Schiavello MINTER ELLISO...
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Australian Tax Law Bulletin - Tax Issues for digital business - Part I - domestic issues

  1. 1. Contents page 62 General Editor’s introduction Dr Helen Hodgson CURTIN LAW SCHOOL page 63 Tax issues for digital business — a case study Part I: domestic issues Joanne Dunne and Antonella Schiavello MINTER ELLISON page 69 Government puts losses back on the table — when is similar not the same? Andrew Clements, Sylvester Urban and Anthony Mourginos KING & WOOD MALLESONS page 73 ATO’s new individual professional practitioner (IPP) taxing measure: background, context and policy analysis Dale Boccabella and Kathrin Bain SCHOOL OF TAXATION & BUSINESS LAW, UNIVERSITY OF NEW SOUTH WALES General Editor Dr Helen Hodgson, Associate Professor, Curtin Law School, Curtin University Editorial Panel Michael Blissenden, Associate Professor of Law, University of Western Sydney Andrew Clements, Partner, King & Wood Mallesons, Melbourne Gordon Cooper AM, Adjunct Professor in the School of Taxation and Business Law (incorporating Atax), University of New South Wales John W Fickling, Barrister, Western Australian Bar Dr Paul Kenny, Associate Dean Academic, Faculty of Social and Behavioural Sciences, Associate Professor in Taxation Law, Flinders Business School, Flinders University Craig Meldrum, Head of Technical Services & Strategic Advice, Australian Unity Personal Financial Services Limited Karen Payne, Chief Executive Offıcer, Board of Taxation Joseph Power, Senior Associate, King & Wood Mallesons Andrew Sommer, Partner, Clayton Utz Sylvia Villios, Lecturer in Law, Law School, University of Adelaide Chris Wallis, Barrister, Victorian Bar 2016 . Vol 3 No 4 Information contained in this newsletter is current as at May 2016
  2. 2. General Editor’s introduction Dr Helen Hodgson CURTIN LAW SCHOOL We are now well into the election campaign. I spent Budget week in Canberra when both parties set out their economic and tax priorities if elected. Given the timeline for publication of this Bulletin I don’t intend to repeat the commentary on the Budget measures, except to say that I was interested to see the proposed changes to superannuation, which I think address some of the issues around whether the superan- nuation scheme is fit for purpose. The introduction of the Low Income Superannuation Tax Offset to take effect when the Low Income Superannuation Contribution ceases will ensure that low income earners continue to see some tax advantage in superannuation savings, while restructuring the caps to allow the rollover of conces- sional caps combined with a lifetime non-concessional cap should allow middle to high income earners to accumulate an adequate sum to fund retirement while curbing some of the estate planning opportunities. There were also a number of lower profile measures in the Treasury portfolio that I expect would be adopted by whichever party is elected to government: notably the Div 7A measures that the Board of Taxation recom- mended, and refinements to the taxation of financial arrangements (TOFA) and consolidations regimes. As the campaign rolls on I expect that we will see more announcements regarding taxation and spending announcements. The three articles that we have for you this month have picked up three issues that are of current interest, and far less speculative than what might remain in the Budget after the election. The first article, from Joanne Dunn and Antonella Schiavello of Minter Ellison, uses a case study to set out the tax consequences of establishing a digital business. We considered the GST implications of cross-border intangible supplies in volume 3 issue 2 of this Bulletin. This article considers the income tax as well as the GST implications of a resident company providing digital services. The second part, which will be published in a future edition, will consider the consequences when the digital business expands to become a global enterprise. The second article, from Andrew Clements, Sylvester Urban andAnthony Mourginos at King & Wood Mallesons examine the exposure draft that was released in Decem- ber in relation to the carry forward loss measures. The proposed Bill would redefine the notion of what consti- tutes the “same business” for the purposes of the company and trust loss measures to allow losses to be claimed where the business is similar, rather than the same. It is hoped that this will remove a legislative hurdle that could prevent a business from changing its business model to become more profitable. The final article, which was contributed by Dale Boccabella and Kathrin Bain of the University of New South Wales takes another look at the Australian Taxa- tion Office (ATO) ruling on the possible application of Pt IVA to individual professional practitioners, and a comparison with the personal services income regime. I hope that you find these articles useful. Dr Helen Hodgson General Editor Associate Professor Curtin Law School Helen.Hodgson@curtin.edu.au www.curtin.edu.au australian tax law bulletin May 201662
  3. 3. Tax issues for digital business — a case study Part I: domestic issues Joanne Dunne and Antonella Schiavello MINTER ELLISON Introduction The digital economy is becoming harder to distin- guish from the rest of our economy as Australian businesses embrace technology across a wide variety of industries. Part I of this article uses a hypothetical case study to demonstrate some of the tax issues for a small retail business transitioning to have a digital presence in Australia. Part II of this article will address the addi- tional tax issues which arise when that business expands overseas and establishes an offshore subsidiary. Part II will also consider digital currency, including recent announcements in relation to bitcoin and GST. This article focuses on specific tax issues affecting digital business, as opposed to the more generalised tax and other non-tax issues that would apply to all busi- nesses, digital or otherwise. There are also other legal issues that are specifically applicable to digital businesses which are also not touched on in detail in this article. For example, when an Australian business establishes a digital presence, it will also need to consider the appropriate business structure, how to reward employees, how the website will be hosted, intellectual property law issues, consumer law issues, how to draft appropriate terms and conditions, payment security and cyber security, privacy law issues, cyber-insurance, compliance with the Spam Act 2003 (Cth), and how to promote the business in advertising and social media. Putting those other legal issues aside, this article seeks to demonstrate the tax issues that impact upon the digital economy by way of the following case study: Case study Paul Michaelson and Jane Johnson are fashion entrepreneurs from Fitzroy in Melbourne. Paul is a well-known personal shopper, and Jane is a stylist and personal grooming consultant. Paul and Jane employ four personal shoppers and their business enjoys a loyal Fitzroy clientele, and elite clientele from Brighton, Toorak and South Yarra, as well as Tasmanian based clients. Paul and Jane operate their business through an Australian company of which they are the direc- tors and their family trusts are 50/50 shareholders. The company, which is registered for GST, is called It’s The New Black Ltd (ITNB) and has an office in Melbourne (in Fitzroy). In the last finan- cial year ITNB’s aggregate turnover was $1.7 million. ITNB’s assets consist of inventory supply and advisory contracts with large department stores, client contracts and event contracts. These assets need regular renewal and are not long term assets. ITNB intends to expand its business beyond Victoria and its current Tasmanian clients. Paul and Jane have also decided that their business will grow and develop further in their current market in Australia if they have an online pres- ence. Paul and Jane have decided they first want to test interest in NSW, WA, Queensland, the ACT, the NT and SA by way of an online presence only. This will enable them to consider whether to open offices outside of Victoria, by monitoring who uses the website and where they are located. Paul and Jane tell you that: • a website has been designed for ITNB for a fee by an Australian based design company; • ITNB has entered into a short term hosting agreement with Macquarie Telecom in Austra- lia (with hosting via servers located in Austra- lia); • ITNB is currently negotiating an agreement with Paris and London Fashion Weeks to enable a live signal of particular avant garde fashion shows to be broadcast exclusively on the ITNB website; • ITNB has acquired off-the-shelf software, and over the past few months Paul has made innovative adjustments to that software to enable clients to input their measurements, upload a photo, advise the event they are attending, and be instantly recommended a range of outfits. The recommendations would be shown on the client’s body so they can see before they buy. An advisory fee and website access fee is charged by ITNB for this service; australian tax law bulletin May 2016 63
  4. 4. • they are working to ensure that the website has functionality so that clients can request groom- ing and design advice from the ITNB team. An advisory fee is charged by ITNB for this service; • they are also working to ensure that the website has functionality to enable shoppers to search for and request particular designer fashion. If a customer makes a booking, ITNB is paid a fee by the customer and a commission is also obtained from the particular designer if a pur- chase is made; • ITNB has entered into inventory contracts with a number of stores and designers in Australia to be able to access products; and • the website is expected to “go live” in the next 2 months. Paul and Jane have hired a technical person, Brian Block, to assist them to ensure that at all times the website is providing fast, effective service to its customers. A few months after the website goes live, the business grows at an exponential rate, with turn- over exceeding $20 million. ITNB has since developed, tested, and designed an app which provides the ability for clients to reserve particular items of inventory as soon as it comes in using their smart phones. This article proceeds to consider the tax issues arising for ITNB from its Australian domestic expansion into the digital economy. Income, tax deductions and tax offsets available to ITNB Income received through the website, such as ITNB’s advisory fees, website access fees, booking fees and commissions from designers will be assessable, as it is derived by an Australian resident taxpayer from carrying on a business in Australia.1 The core issue for Australian businesses such as ITNB is the deductibility of the expenses to develop and establish the website, and any tax offsets that may be available. Section 8–1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 97) provides for a deduction to the extent the loss or outgoing is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, s 8–1(2) may prevent a deduction if the expenditure is an outgoing of capital and, if that is the position, another avenue provided under the ITAA 97 or the Income Tax Assess- ment Act 1936 (Cth) (ITAA 36) for a tax offset or deduction may need to be considered. Website expenditure and development costs Website costs that are recurring in nature are likely to be revenue expenses, and may be deductible under s 8–1. For example, ITNB should be entitled to claim a deduction for the ongoing expenses of running and maintaining their website, such as domain name regis- tration costs, server-hosting package costs and ongoing fees paid to Macquarie Telecom. It is likely that other website development and design costs incurred by businesses in setting up a website are capital in nature, because the website establishes a new earning structure for the business. In 2009, the Australian Taxation Office (ATO) with- drew TR 2001/6, which addressed the deductibility of website development and establishment costs. In April 2016, draft ruling TR 2016/D1 was issued after consul- tation with tax and industry representatives.2 There has been a significant waiting period for this new ruling, which is proposed to apply retrospectively. The draft ruling considers the deductibility of expenditure incurred in acquiring, developing, maintaining, or modifying a website, and also the deductibility of content migration and social media accounts. Generally, the draft ruling states that the expenditure incurred on a commercial website may be deductible under s 8–1 if it is of a revenue nature. Otherwise, the expenditure may be classed as “in-house software” and deductible under the capital allowances/depreciation regime. Preliminary views are provided regarding the treatment of certain expenses, with practical examples. Recurrent business expenses such as licensing fees and expenses associated with routine maintenance are generally considered to be deductible revenue expenses, whereas acquisition, devel- opment, modifications, migrations and social media costs which upgrade, improve, or add new functionality or establish a business presence or structural advantage are generally considered to be capital. For a small business like ITNB, with an initial aggregated turnover of less than $2 million, the govern- ment’s small business tax changes announced in the 2015–16 Federal Budget may provide enhanced upfront asset write offs. Assuming the expenditure is incurred between 12 May 2015 and 30 June 2017, s 328–180 of the ITAA 97 provides that capital expenditure on depre- ciating assets can be claimed as a deduction in the income year that the expenditure was incurred (if the cost is less than $20,000). If the cost of those assets is $20,000 or more, the simplified depreciation rules in Subdiv 328–D of the ITAA 97 will be applicable if the business elects to use those rules, or Div 40 will need to be considered. Again, this is relevant only to the extent that there is a depreciating asset. The definition of “depreciating asset” australian tax law bulletin May 201664
  5. 5. refers to an asset with a limited effective life that can be reasonably expected to decline in value. The Commis- sioner has confirmed in TR 2016/D1 that a website is not a depreciating asset under Divisions 40 and 328, except to the extent that it can be classified as “in-house software” (considered separately below). TR 2016/D1 does not recognise that intellectual property, which is a depreciating asset, may also be contained in a website. The definition of “intellectual property” in s 995–1 requires there to be rights in a patent, copyright or registered design. For example, there may be rights in the design of the ITNB website that could be registered, or could comprise copyright. In TR 93/12, the ATO considered that a computer program is in essence knowledge or information and may be considered an item of intellectual property, and may be subject to copyright.3 Businesses such as ITNB may have copyright pro- tection over internally created computer programs, such as the innovations Paul has made to the software or the creation of the app described in the case study. The whole of the website will not be protected by copyright, however, component parts of the website such as text, images, logos, source code and files may be protected.4 For capital costs that do not qualify as in-house software, the following additional issues need to be considered: • capital gains tax (CGT) assets may arise (eg in the event that the intellectual property definition is not satisfied) and the costs may form the cost base for that asset;5 and • section 40–880 could apply, as a last resort, to provide a deduction over 5 years under the black holeexpenditureprovisions.PrivateRuling1011958172383 suggested that s 40–880 could be applicable. However, the new draft ruling TR 2016/D1 states that it would be unusual for commercial website development expenditure to be deductible under s 40–880, given the broad definition of a CGT asset. Off-the-shelf software and computer hardware TR 2016/D1 states that the purchase of off-the-shelf software is capital in nature and therefore not deductible under s 8–1 of the ITAA 97. However, periodic license payments made to a web developer for off-the-shelf software, that is licensed by the business, with no right to become the owner of the website, are considered to be deductible under s 8–1. This is contrary to the ATO’s previous guidance, which suggested that the cost of commercial off-the-shelf software was generally deduct- ible in the year of purchase. Computer hardware is depreciable under Div 40 or, if elected by a small business, under Subdiv 328–D of the ITAA 97. Alternatively, as stated above, the upfront asset write off of up to $20,000 is available to small busi- nesses, such as ITNB. Innovations to software and the app development — in-house software Special rules apply to deductions for the cost of developing in-house software for a taxpayer’s own use. In-house software is computer software that is acquired or developed and is mainly for use in performing the functions for which it was developed, and, importantly, for which no other provision of the ITAA 97 provides a deduction.6 For that reason, before considering whether Subdiv 328–D or Div 40 applies to the costs of making adjustments to the software and any other development costs, a busi- ness will first need to consider the research and devel- opment (R&D) provisions in Div 355 of the ITAA 97 and any other provisions in the Act. Research and development A business with aggregated turnover of less than $20 million may be entitled to receive the 45% refundable R&D tax offset for eligible R&D activities. In order to claim an R&D tax offset, the business must register the R&D activities at Innovation Australia,7 have notional deductions for the purposes of the R&D provisions of at least $20,000 for the income year, and carry out the activities for itself (generally) in Australia. There are a number of factors that a business such as ITNB will need to consider when determining whether innovative software amendments or the later design of an app are eligible R&D activities, including whether the software development or app development are core R&D activities or supporting R&D activities.8 For core R&D activities, it will be necessary to provide evidence of the work completed and show that the software innovations and app development are innovative. Case law highlights that evidence will be needed showing that the work done develops new knowledge, and that there was technical uncertainty about the outcome.9 For example, in the North Broken Hill and Commissioner of Taxation case10 innovations to off-the-shelf software were not held to comprise R&D activities because they were not innovative, as it could not be shown that the outcome of those innovations was uncertain. Innovation Australia issued Guideline 17 in relation to software development under the former R&D provi- sions. While that Guideline is not applicable to the current R&D provisions, it does refer to software devel- opment as needing to embody algorithms or methodolo- gies that did not previously exist, and needing to show sufficient innovation and outcome risk. It also provides australian tax law bulletin May 2016 65
  6. 6. guidance on how to evidence activities to support an R&D claim. For example, ITNB could conduct a litera- ture and technology review to conclude that no algo- rithm capable of performing image recognition and then “fitting” the clothes on the client’s photo existed previ- ously. Evidence would also need to be found that the outcome of the work done was uncertain. Evidence of a progressive experimental process will also be needed to meet the core R&D activities defini- tion in s 355–25. In the case study, the app was “developed, tested, and designed”. Evidence of that process will be needed to show the systematic progres- sion of work, and documentation will need to be kept, substantiating the process that was undertaken to develop the innovations in the software. To obtain certainty, an advance finding can be sought from Innovation Australia11 as to whether the activities are eligible R&D activities. If a finding was obtained, it would be binding on Innovation Australia and the ATO for the year in which the R&D is conducted and up to two subsequent years (if activities are being conducted over multiple years). ITNB would need to provide further evidence before an R&D claim can be substantiated. In-house software — Div 40 and Subdiv 328–D The software developed by ITNB (Paul’s innovations and the app) may satisfy the definition of in-house software assuming no other provision in the ITAA 97 (such as the R&D provisions) is applicable to provide a deduction. If the costs of development are less than $20,000, ITNB may be able to obtain an immediate deduction under s 328–180 of the ITAA 97. If ITNB’s software satisfies the definition of in-house software, the costs of development are greater than $20,000 and it commenced to be held after 1 July 2015, the software has a statutory effective life of 5 years and must be depreciated using the prime cost method.12 On 1 April 2016, the Australian Treasury released Exposure Draft legislation which, if enacted, will allow taxpayers to self-assess the effective life of intangible assets, so that in-house software can be assessed to have a life other than 5 years, for assets which started to be held from 1 July 2016.13 Alternatively a business can choose to allocate in-house software to a software development pool. There is no deduction in the income year in which the expenditure was incurred, but deductions are allowed at a rate of 40% in each of the next two years and 20% in the following year. Once allocated to a pool, all future in-house software expenditure must also be allocated to the pool.14 PaymentstoParisandLondonfashionweeks — royalties? Another issue for ITNB is whether any payments made for the fashion week broadcasting rights would be deductible. A critical factor is whether the payments would be royalties, as s 26–25 of the ITAA 97 may prevent a deduction unless withholding tax obligations have been met. The double tax treaty between Australia and the relevant countries would also need to be considered. In Seven Network Ltd v Commissioner of Taxation15 (Seven Network) the Federal Court considered whether payments (approx $97.7 million) made by the taxpayer to the International Olympic Committee for the broad- casting rights for the Olympic Games were a royalty within the meaning of the Australia/Switzerland Double Tax Treaty. The case revolved around Art 12(3), namely whether the use of the ITVR signal was “the right to use copyright, or any other like property or right” which could make payments in relation to the ITVR royalties. The court held that the signal could not be a cinematograph film (for copyright law purposes) and copyright did not arise in accordance with the Copyright Act 1968 (Cth) because an item must be able to be reproduced in tangible or material form to be an embodiment and comprise copyright. The court also held that the words “any other like property” in Art 12(3) referred to intellectual property rights protected under domestic law, and this required a tangible or material form. The court held that no such rights arose, and made a declaration holding that the payments were not royalties and therefore withholding tax was not required to be withheld. This Commissioner has appealed to the Full Federal Court and the outcome is expected in 2016. In considering whether ITNB’s payments for a live signal from Paris and London fashion weeks are royal- ties or not, the agreements between ITNB and the entities involved would need to be reviewed and the Australia/France and Australia/UK double tax agree- ments would need to be reviewed. The final outcome in the Seven Network case would also need to be consid- ered. In addition, whether the website access fees paid by customers are royalties may also need to be considered. This is not so much of an issue in relation to ITNB when it is operating the website domestically only as the fees will be taxable in any event, the website is hosted in Australia, and the customers are allAustralian residents.Care would need to be taken to describe those access fees appropriately as being for a service. However, the nature of those fees and the question of whether they are australian tax law bulletin May 201666
  7. 7. royalties paid in return for a non-transferrable, non- exclusive right to use the intellectual property or soft- ware comprised in the website may become relevant in the future if ITNB builds an international client base and derives fees from offshore, as withholding taxes might reduce ITNB’s expected return. The nature of digital business means that customers can come from other jurisdictions. GST ITNB must consider whether supplies made by way of its website are taxable supplies on which GST is imposed under the A New Tax System (Goods and Services Tax) Act 1999 (Cth) (GST Act). One of the requirements of a “taxable supply” is that the supply is connected with the indirect tax zone (being Australia). A supply of goods delivered to Australian customers is clearly connected with Australia and fees for such supplies are subject to GST. For a supply of anything other than goods, whether it is connected with Australia involves asking if the thing (which includes a service, information or right) is done in Australia or through an enterprise that the supplier carries on in Australia. GSTR 2000/3116 states that the location of where something is done will depend on the nature of the supply — generally for services this is the location the services are performed. In relation to ITNB, as services are performed by staff in Australia to customers in Australia, those fees are subject to GST. An interesting issue arises if the terms and conditions on the ITNB website which set out the arrangements with customers describes the service the customer receives as a limited, non-transferable license to use the software which is part of the website. In this event, for GST purposes, the thing refers to the computer software and done refers to where the services are performed.17 If the supply of services is online software, the location of the service provider and their servers are relevant. The Commissioner has in various private binding rulings determined that the supply of online services by a foreign company to Australian customers is a thing not done in Australia where the foreign company’s servers are not in Australia.18 Where the software was acquired and developed in Australia, the servers and related IT infrastructure which support the computer software are located inAustralia, and anAustralian Macquarie Telecom is providing hosting services, it is likely that the supply of the computer software is a thing done in Australia, and therefore is connected with Australia. Entitlements to input tax credits may arise for ITNB on certain expenditure if they are “creditable acquisi- tions”. This may include costs incurred to establish the website, the acquisition of the initial software, the hosting agreement and inventory contracts. To be a creditable acquisition, the thing being acquired must be a taxable supply and have the necessary connection with Australia. The acquisition of software should be a taxable supply, assuming that the software is supplied in Australia. The hosting agreement provided by Macquarie Telecom is likely to be considered a taxable supply because the server is in Australia and the service is supplied to ITNB in Australia. The inventory contracts provide that ITNB has access to a retailer’s stock on hand if an order is placed by an ITNB customer. This is a supply of a right to purchase the retailer’s stock as required. The supply of this right may be said to be done in Australia, as both the retailer/designer and ITNB are in Australia. This too should be considered a taxable supply. Record keeping Record keeping for tax purposes, including the require- ments of s 262A of the ITAA 36, need to be considered when operating a digital business. Records can be kept in written or electronic form, and include tax invoices, receipts, sales records, year end records and bank records. In TR 2005/9, the ATO reminds digital busi- nesses that:19 30. Where a taxpayer conducts business transactions through the internet or by EDI the Tax Office position is that the taxpayer is required to keep records explaining all such transfers that are relevant for any purposes of the ITAAs. All other require- ments relating to electronic record keeping systems, such as the need for controls, are equally applicable. 31. If electronic information systems are used to conduct business transactions such as those that may be conducted by websites, but do not function as record keeping systems, there will be no evidence of those transactions. Without this evidence your organisa- tion or business may not be considered to have complied with its record keeping requirements under section 262A of the ITAA 1936. There is an admin- istrative penalty if you do not keep or retain records as required by this section: see section 288–25 in Schedule 1 to the Taxation Administration Act 1953. Taxpayers should remember that the onus of proof is on them in showing that an assessment is excessive should the Tax Office amend their taxable income. The failure to keep sufficient records to explain relevant transactions for tax purposes would be inconsistent with the requirements of these obliga- tions. 32. The nature of e-commerce with the recording of transactions and information and subsequent record keeping implications will assist taxpayers in the design and implementation of systems to manage full and accurate records arising from e-commerce or EDI for the required periods. [Emphasis added.] This is a reminder that another factor ITNB will need to consider when establishing its website is the need for website functionality to ensure that sufficient and com- plete records are generated by transactions on the website to enable ITNB to meet its record keeping requirements. australian tax law bulletin May 2016 67
  8. 8. Conclusion Part I of this article demonstrates that when a small Australian business transitions to have a digital pres- ence, a myriad of legal and commercial issues arise. In addition, a number of quite specific tax considerations arise, particularly in relation to the deductibility of costs, the nature of income and expenses, and the nature of supplies being made. The functionality of the Australian business’ digital presence must also be tested to ensure that it meets tax record keeping requirements. Part II of this article will consider the tax implications when the hypothetical ITNB business transitions to become a global digital business. The issues of source, residence, whether there is a permanent establishment, the nature of income and expenses, and digital currency will be included in the discussion. Also considered will be potential law reform arising as a result of the Organisation for Economic Cooperation and Develop- ment’s (OECD) base erosion and profit shifting project, and at a domestic level on multinationals and how that impacts a business in the digital economy. Joanne Dunne Partner Minter Ellison Antonella Schiavello Senior Associate Minter Ellison Footnotes 1. For completeness, note that the company tax rate for small businesses, such as ITNB (ie with aggregated turnover of less than $2 million), was reduced from 1 July 2015 to 28.5%. 2. ATO Draft taxation ruling TR 2016/D1 Income tax: deduct- ibility of expenditure on a commercial website (6 April 2016). 3. Note that the Copyright Act 1968 (Cth) may apply to provide protection, and registration is not required for that protection to be applicable. For protection to arise the work must be in a material form. This means that a form of the work or an adaptation of the work is stored and capable of being repro- duced. The work must be made by a person who is an Australian citizen or resident of Australia when the work was made. The work must be an original work that is the result of the author’s skill and effort. 4. See Australian Copyright Council Websites and Copyright Information Sheet G057 (December 2014). 5. Given that ITNB is a small business, the various small business concessions may be available to it in the future in respect of any such CGT assets. 6. In the context of the research and development provisions, s 355–715 provides that other than where the adjustment provisions in ss 40–292 and 40–293 are applicable, if an R&D tax offset arises, depreciation cannot be claimed under Div 40 or any other Division of the Act as well. That provision also confirms that considering the research and development pro- visions first will be important. 7. Note the deadline for registration is 10 months after the end of an income year: see Research and development (R&D) tax incentive (2016) www.business.gov.au. 8. ITAA 97, s 355–20. 9. Re North Broken Hill Ltd and Commissioner of Taxation (1993) 26 ATR 1262; 93 ATC 2148; RACV Sales and Marketing Pty Ltd v Innovation Australia (2012) 129 ALD 32; (2012) 89 ATR 371; [2012] AATA 386; BC201204554. 10. Re North Broken Hill Ltd and Commissioner of Taxation, above n 9. 11. See R&D Tax incentive: Advance Finding Information Sheet at www.business.gov.au. 12. ITAA 97, ss 40–70(2)(a), 40–72(2)(a), 40–75 and 40–95(7). 13. Exposure draft inserts for Tax and Superannuation Laws Amendment (2016 National Innovation and Science Agenda) Bill: Intangible asset depreciation. 14. ITAA 97, ss 40–450 and 40–455. 15. Seven Network Ltd v Commissioner of Taxation (2014) 324 ALR 13; (2014) 109 IPR 520; [2014] FCA1411; BC201411357. 16. ATO Goods and services tax ruling GSTR 2000/31 Goods and services tax: supplies connected with Australia (30 June 2000). 17. GSTR 2000/31, para 65. 18. See for example Private Ruling 1011511098475 at ATO Authorisation Number: 1011511098475, Subject: supply of online advertising www.ato.gov.au. 19. Taxation Ruling TR 2005/9 Income tax: record keeping — electronic records (8 June 2005). australian tax law bulletin May 201668
  9. 9. Government puts losses back on the table — when is similar not the same? Andrew Clements, Sylvester Urban and Anthony Mourginos KING & WOOD MALLESONS Summary Under new measures, companies and listed widely held trusts should find it easier to utilise tax losses where there has been a change in ownership. On 7 December 2015, the government released expo- sure draft legislation (Exposure Draft) setting out the new “similar business test”.1 The Exposure Draft applies to companies and listed widely held trusts. The measures are expressed to encourage entrepreneurship by making it easier for loss-making companies to return to profit- ability. The measure is not limited to small innovation companies. The current same business test has produced harsh or uneconomical outcomes through its strict application. The new test is clearly wider than the existing test and is to be welcomed. These rules do not seek to alter the existing continuity of ownership tests. The new measures are proposed to apply to tax losses incurred on or after 1 July 2015. Current law The continuity of ownership and same business tests Under the current law, to claim a deduction for prior year losses,2 a company (or listed widely held trust) must satisfy either a “continuity of ownership” or “same business” test.3 The continuity of ownership test (COT) is failed when a company undergoes a substantial change in ownership or control where shares carrying more than 50% of all voting, dividend and capital rights are no longer beneficially owned by the same persons during the “test period” (being the period from the start of the loss year to the end of the income year in which the loss is to be deducted). A similar “50% stake test” is applied for listed widely held trusts, and there must additionally have been abnormal trading. No changes to the COT are proposed. To satisfy the same business test (SaBT) a company or listed widely held trust must show that it was carrying on the same business, during the relevant income year, which it was carrying on in the year immediately before the change of ownership or control which caused it to fail the COT. The so-called “negative limbs” that apply throughout the test period are the main obstacle to satisfying the SaBT. The limbs look at the undertakings and transactions of the company or trust and are met if the company or trust derives assessable income from: • business — a business of a kind that it did not carry on before the test time; or • transaction — from a transaction of a kind that it had not entered into in the course of its business operations before the test time. If either of these limbs apply, the entity will fail the SaBT and will not be entitled to claim a deduction for prior year losses. For prior year losses, the default “test time” to be used when applying the SaBT is the latest time that the entity satisfied the COT. Where it is not practicable for the entity to show that it has satisfied the COT for any period since incurring the loss, the default test time is either the start or end of the loss year, depending on whether the entity existed for the whole or part of the relevant year. Strict interpretation The Commissioner of Taxation (Commissioner), in TR 1999/9,4 notes the strict interpretation of the SaBT established in the High Court in Avondale Motors (Parts) Pty Ltd v Federal Commissioner of Taxation,5 requiring an “identical business” to be carried on after the test time. Currently, what is required is the continuation of the actual business carried on immediately before the test time. A company or trust may expand, grow, contract its activities and discard old operations without breaching the same business requirement,6 however if the entity changes its essential character or there is a sudden and dramatic change in the entity brought about by acquisi- tion or loss of activities on a significant scale, it may fail the SaBT. Whether the same business is actually being carried on after the test time is a question of fact and degree. The relevant factors include: australian tax law bulletin May 2016 69
  10. 10. • Products sold/manufactured: For example, if a business which traditionally grows cereals to sell as seed and grain ceases to do so and begins grazing cattle on the same land, it is likely a change of business has occurred. • Manufacturing process: For example, updating a model of a product manufactured is not enough to suggest a change of business. However, if a company stops producing its only product and begins manufacturing a separate and unrelated product this is likely to be a strong indicator that the business is not the same. • Market for goods/services: It is relevant to look at the persons to whom the product is sold or the service is provided. This factor will have varying levels of relevance depending on the size of the company and the number of costumers it usually has. • Method of selling: For example, a change from outright sale to sale on consignment, sale on terms, sale by hire purchase and so on may be a factor indicating a change of business. • Methods and sources of finance, working capital: A change in working capital is unlikely, of itself, to demonstrate a different business is being carried out. However, it may suggest that other factors have also changed which have been caused by a change in business. • Goodwill, trading name, trademarks, patents: A wholesale change of intellectual property rights is usually associated with a change in business, whereas minor changes may be associated with research and development within the same busi- ness. • Location: Distinction should be made between expanding a business by opening the business in more locations and closing an old business in a particular location. • Number of employees: Termination of all staff suggests the old business has ceased. However, an increase in staff in a particular area of the business may indicate growth. The former may suggest a change of business has occurred. • Management and directors: Resignation and replace- ment of existing directors or management is unlikely, of itself, to demonstrate a change of business. However, such a change coupled with other chang- ing factors may be indicative of a change of business. Essentially, the narrow interpretation allows minimal changes to the above mentioned factors, namely, those arising from “mere expansion or contraction” of the relevant business,7 leading to the potential for harsh outcomes on a strict application of the SaBT. Potentially harsh or non-economical outcomes The SaBT and COT were introduced with the follow- ing purpose in mind:8 The relevant sections of the Act show an intention on the part of the legislature to impose, in the case of companies, a special restriction on the ordinary right of a taxpayer to treat losses incurred in previous years as a deduction from income. … This restriction is imposed to prevent persons from profiting by the acquisition of control of a company for the sole purpose of claiming its accrued losses as a tax deduction. The strictness of the limitations may lead to harsh outcomes. Consider a shareholder who acquires a loss- making business in the hope of converting it into a profitable undertaking (by turning assets for profit, not offsetting taxable income). If the new shareholder alters certain elements of the company in order to make it profitable, on a strict application, the SaBT may be failed even though changes to the business are made for purely commercial (rather than tax) reasons. This may include, for example, if the company converts to an online selling platform, introduces new low-cost prod- ucts or significantly reduces the number of employees and alters the business management/directorship struc- ture. The irony of the SaBT is, of course, that a new owner of a loss-making enterprise is faced with a choice of either altering the business in an attempt to make it profitable, and consequently losing what may be a significant asset (ie, the tax loss), or keep the business unchanged to take advantage of the loss, with a detri- mental effect on profitability. Arguably, the need to satisfy a strictly interpreted SaBT in circumstances such as the above may discour- age taxpayers from innovating or from adapting to changes in economic circumstances. The strictness of the regime has produced harsh outcomes where the company or trust’s ownership changes for any other reason. For example, a listed multinational may have long-term plans to move into a business that is on the borderline between the “same” and “similar” to its current business. If the multination- al’s main shareholders change (failing the COT), the company may then inadvertently continue with its long term plans and lose (potentially very significant) losses. What are the proposed changes? Similar business test The Exposure Draft replaces the SaBT with a more flexible “similar business test” (SiBT). A company (or listed widely held trust) will satisfy the SiBT if its current business is similar to the former business. To determine this, there are three main factors that must be considered: australian tax law bulletin May 201670
  11. 11. • assets — the extent to which the company or trust generates assessable income from the same assets. The Explanatory Memorandum9 makes clear that the term “assets” extends to both physical and intangible assets (including goodwill, trade names, patents, royalty arrangements and other intellec- tual property (IP) rights of a company or trust). Goodwill, which is closely linked to an entity’s ability to draw custom, will be particularly rel- evant here; • sources — the extent to which the entity generates assessable income from the same sources. The Explanatory Memorandum refers to “sources” of the entity’s assessable income in a commercial or operational sense: “The sources of the company’s assessable income are the specific activities or operations from which it generates assessable income”;10 and • reasonable expectation — whether any changes to the former business are changes that would reasonably be expected to have been made to a similarly placed business. The Explanatory Memorandum requires taking a hypothetical business that is similarly placed to the former business, and asking whether or not a reasonable person would expect changes be made to that business. It is not sufficient that the change is a reasonable business decision in that it makes commercial sense, or is a good business opportu- nity. Rather, there must be something in the activities or operations of the former business that make the change “natural” having regard to the organic connection and continuity between the former and current business. Comparison with same business test Unlike the SaBT, the SiBT clearly provides for differences between the current and former business that result from growth or rehabilitation efforts. The SiBT does not depart from the central principle that there should be a similarity in the identity between the commercial operations and activities of the former and current entity. The rationale remains that corporate groups should not be incentivised to buy loss-making entities to shelter their own assessable income. It remains the case that it is not sufficient for the current business to be of a similar “kind” or “type” to the former business. The focus remains on the identity of the business. While the new test is clearly wider than the existing SaBT and is to be welcomed, it will continue to involve much subjectivity and debate, and in some circum- stances, a taxpayer’s only way to achieve certainty will continue to be through application for private ruling. This is because, as with the SaBT, in some instances, one of the factors may suggest that the SiBT is satisfied, whereas another factor suggests otherwise. This will require the factors to be weighed up with the relative importance of each factor depending on the facts of the case. It will be important to consider the effect of the new legislation on the current tax ruling dealing with the same business test: TR 1999/9. Practical examples and issues To illustrate the operation of the new provisions, we have worked through some of the examples in the Explanatory Memorandum. Example 1: Company switches from manufacture to retail If a business ceases to manufacture its own product and instead begins deriving income from purchasing and reselling another brand of that same product, there will have been a significant change in commercial operations and activities of the former and current business. The business no longer generates income from the same assets (ie its processing plant, equipment and brand name). The source of income has changed from manu- facturing to reselling which goes to the heart of the specific activities or operations from which the company generates its income. Even if it is assumed the third factor is satisfied (ie, the changes are changes that would have been expected of a similarly placed business), the business may not satisfy the SiBT. Although it is still selling the same product, this may be outweighed by the significance of the change from the business producing its own unique brand of product to reselling another brand. Because of this, the company’s current business may not be a similar business to the former business. Example 2: Addition of new product line For a successful application of the SiBT, consider the following: • A business changes ownership after making a tax loss in its fifth year of operation. • The business, which previously designed and sold householdfurniture(notincludingmattresses)branches into designing and selling mattresses. • The business retains its brand name and logo but moves into an online selling platform. • The company then becomes profitable (20% of sales are from mattresses and 80% is from the sale of furniture) and seeks to recoup the tax losses incurred prior to the ownership change. australian tax law bulletin May 2016 71
  12. 12. Although a question of fact and degree, the company would likely fail the SaBT but pass the SiBT. This is because it uses the same assets, generates income from the same sources (to the extent that it is generated from the online reselling of furniture items) and arguably took advantage of an opportunity that would reasonably be expected to be made by a similarly placed business. Although there has been a change, the change is one that supplements the former business as a subsidiary or ancillary business activity, rather than replacing it. This indicates that the current identity of the business is similar to its former identity. Proposed start date It is proposed that the SiBT will apply to tax losses incurred on or after 1 July 2015. If a company or listed widely held trust seeks to carry forward tax losses from pre-1 July 2015 periods, it will need to satisfy the SaBT for those losses (even though the losses will be utilised in future years). Andrew Clements Partner King & Wood Mallesons Sylvester Urban Solicitor King & Wood Mallesons Anthony Mourginos Solicitor King & Wood Mallesons The authors would like to acknowledge the assistance of Lara Moreton and Annabelle Paxton-Hall (Law Gradu- ates, King & Wood Mallesons). Footnotes 1. Exposure draft inserts for Tax and Superannuation Laws Amendment (2016 National Innovation and Science Agenda) Bill 2016: Access to losses. 2. “Tax loss” generally refers to previous years’ revenue losses, previous years’ net capital losses, trading stock losses, losses from writing off bad debts and losses transferred from a company joining a consolidated group, which has been incurred prior to a change of ownership or control. 3. Income Tax Assessment Act 1997 (Cth), ss 165–12, 165–13 (companies); Income Tax Assessment Act 1936 (Cth), Sch 2F, ss 269–55, 269–100 (listed widely held trusts). 4. ATO Taxation Ruling TR 1999/9 Income tax: the operation of sections 165–13 and 165–210, paragraph 165–35(b), section 165–126 and section 165–132 (23 June 1999). 5. Avondale Motors (Parts) Pty Ltd v Federal Commissioner of Taxation (1971) 124 CLR 97; 2 ATR 312; BC7100080. 6. Above n 4, at para 13. 7. Above n 4, at para 39. 8. Above n 5, at [13]. 9. Exposure draft Explanatory Memorandum to Tax and Super- annuation Laws 4 Amendment (2016 National Innovation 5 and Science Agenda) Bill 2016: Access to 6 losses. 10. Above n 9, at para 1.27. australian tax law bulletin May 201672
  13. 13. ATO’s new individual professional practitioner (IPP) taxing measure: background, context and policy analysis Dale Boccabella and Kathrin Bain SCHOOL OF TAXATION & BUSINESS LAW, UNIVERSITY OF NEW SOUTH WALES Introduction On 30 June 2015, the Australian Taxation Office (ATO) finalised its individual professional practitioner (IPP) guidelines.1 The guidelines effectively amount to a new taxing measure:2 practitioner principals in profes- sional firms who have been alienating taxable income to associated entities are likely to come under scrutiny should they fail to include a minimum amount in their assessable income from their firm’s activities. The main basis supporting the guidelines is that the principal practitioner’s personal efforts are largely responsible for the generation of the taxable income. Aside from this introduction and conclusion, the article is in three parts. Part 2 briefly sets out how the courts have approached attempts to alienate personal exertion income in the past, and also contains an outline of the personal services income (PSI) regime.3 Part 3 sets out the ATO’s IPP guidelines, and in particular, when they apply, to whom they apply and the “safe harbour” benchmarks within the guidelines. Part 4 analyses the merits and deficiencies of the IPP guide- lines. The article concludes that the guidelines represent a sensible and equitable development in tax policy con- cerning “personal exertion income” and “income from a business structure” in the context of a professional practice. However, there are considerable deficiencies in and around this area of the tax law, and the guidelines are not the best solution to address these deficiencies. Tax law in this area aside from the IPP guidelines Personal exertion income to be taxed to person that provided the services Putting aside for the moment the PSI regime, there seems to be two bases that prevent the alienation of most personal exertion income for income tax purposes. Provider of exertions or services has no present property interest to assign and is only assigning future income This basis draws on property law and rules of equity, rather than tax law principles, and reflects the idea that, subject to a particular tax provision, the tax law operates on the general law effect of transactions.4 The key idea is that only assignments of presently existing property are effective to alienate income from the property to an assignee.5 If the purported assignor does not have a presently existing property right to assign, it is likely the assignor is merely assigning future income (only an expectancy) when it arises.6 This is not sufficient to prevent the assignor from becoming entitled to the income under the general law when it arises. The tax law adopts this, and therefore treats the assignor as the one who has derived the income. This analysis explains why attempted assignments (diversions away from the employee) of salary or wages or earnings from services is not effective for tax pur- poses.7 It also explains why sole traders and a profes- sional practising on his or her own cannot effectively assign income from their activity so as to avoid deriva- tion of the income for tax purposes.8 General anti-avoidance rule (GAAR) If the provider of personal services has successfully alienated the relevant income by interposing a legally valid entity between themselves and the end user of the natural person’s services or has assigned part of their interest in a partnership, the relevant income is derived by the interposed entity9 or assignee.10 From there, all the usual rules that apply to that entity will apply.11 However, the ATO has consistently argued that if the alienated income is personal exertion income, the GAAR should apply to defeat the attempted alienation so that the relevant income is included in the assessable income of the person providing the personal services.12 In the context of professional services firms, the ATO states that if the firm has at least as many non-principal practitioners as principal practitioners, the income of the australian tax law bulletin May 2016 73
  14. 14. firm will be from the business structure, and not from the personal services of the firm’s principals.13 Where there are more principal practitioners than non-principal prac- titioners, it is likely that the income will be personal services income but all the circumstances need examin- ing.14 The ATO argument has been put under the old GAAR,15 and the new GAAR.16 The courts and the AdministrativeAppeals Tribunal (AAT) have overwhelm- ingly supported the ATO and applied the GAAR (both old and new provisions) in alienation of personal exer- tion income cases. Further, the courts and the AAT have applied the GAAR both where the firm comprises arm’s length parties,17 and where the firm comprises non- arm’s length parties (closely held entity).18 PSI regime (Divs 84–87) The PSI regime was introduced with effect from July 2000 to largely replace the need for the GAAR in respect of income alienation of personal services income. Apply- ing the GAAR on a case by case basis was considered “labour intensive and an inefficient use ofATO resources”.19 The PSI regime prevents individuals who provide per- sonal services through an interposed entity from divert- ing (alienating) their PSI to an associated entity.20 The PSI regime applies only to “personal services income”, which is defined as income that is “mainly a reward for your personal efforts or skills (or would mainly be such a reward if it was your income)”.21 Income that is mainly generated by the sale of goods, use of assets, or a business structure is not PSI. Income from a medium or large professional practice would be regarded as income from a business structure and not PSI of the principals.22 Even where there is PSI, attribution of the PSI to the individual will not occur under the PSI regime where the interposed entity23 is conducting a personal services business (PSB). A PSB exists if the interposed entity satisfies at least one of the four tests set out in Subdiv 87–A: • the results test; • the unrelated clients test; • the employment test; • the business premises test.24 The GAAR can still apply to PSI income derived by an interposed entity conducting a PSB, particularly if the dominant purpose of the arrangement is income split- ting.25 The IPP guidelines Criteria for application of guidelines and the target of the guidelines The guidelines will only apply if all three criteria set out below are satisfied.26 IPP provides professional services to the firm or clients, and IPP and/or associates have a legal or beneficial interest in the firm An IPP is an individual (natural person) professional practitioner, and he or she, putting aside for the moment legal structures, is a principal of the practice entity (firm). The IPP must either provide services to clients of the firm, or (less commonly) is actively involved in management of the firm (eg managing partner).27 The IPP must provide “professional services”. Those providing non-professional services are not within the guidelines. The distinction between professional and non-professional may be difficult to determine at times. Some guidance may be obtained from the ATO’s com- ment that the guidelines only apply to “thought related professions”. In a non-exhaustive list, the guidelines expressly mention accounting, architectural, engineer- ing, financial services, legal and medical professions.28 The firm, in the sense of the “entity” that (outside) clients are contracting with, could be a partnership or a company. It is less likely to be a trust.29 The focus is on whether the IPP, as a matter of practical reality, is providing services to clients of the firm. The fact the IPP may be an employee of the company-firm does not mean the IPP is not providing services to clients.30 The IPP and/or the IPP’s associated entities must have a legal or beneficial interest in the firm.31 It is suggested that all of the entities in column two of the table below will have a beneficial interest in the firm in column one.32 Firm type Entities holding a legal or beneficial interest in firm Partnership • IPP is a partner in firm; • spouse or relatives of IPP who has had IPP’s interest in the partnership (or part of it) assigned to them; • trustee of trust is a partner in firm, where the trust is owned and/or con- trolled by IPP and/or associates of IPP; • beneficiaries in trust (trustee) that is a partner in firm; and • company is partner in firm, where the company’s shares are owned by IPP and/or associates of IPP. Company • IPP is a shareholder in firm; • spouse or relatives of IPP are sharehold- ers in firm; • trustee of trust is shareholder in firm, where the trust is owned and/or con- trolled by IPP and/or associates of IPP; • beneficiaries in trust (trustee) that is a shareholder in firm; and • company is a shareholder in firm, where the company’s shares are owned by IPP and/or associates of IPP. australian tax law bulletin May 201674
  15. 15. It appears that the main focus of the guidelines is on firms with arm’s length principals (IPPs), for example, the medium-sized or large accounting firms. However, there is nothing to indicate that criterion one and the broader guidelines do not apply to firms that are closely held. Firm operates by way of legally effective entity This criterion confirms that the guidelines can apply no matter what legal structure (ie partnership, trust, company) is used by the associated parties as their practice entity (firm). Where the IPPs are arm’s length parties, one would expect the practice entity would be legally effective. Where the IPPs are not at arm’s length (eg spouses are partners), it is more likely that the practice entity may be seen as not being legally effective or a sham. Consistent with the law, the ATO notes that this will depend on contractual terms, and whether the practice is conducted in accordance with the contractual terms.33 Income of the firm is not personal services income The ATO states that in determining whether income earned by a firm is personal services income or income from the business structure, it will apply guidelines in its existing rulings.34 Accordingly, the outline at Sub- Part 2.1.2 applies here. ATO risk assessment benchmarks for remuneration of IPPs35 The ATO states:36 In some cases, practice income may be treated as being derived from a business structure, even though the source of that income remains, to a significant extent, the provision of professional services by one or more individuals. In this context, we are concerned that Part IVA [the GAAR] may have application, despite the existence of a business struc- ture. … Where an IPP attempts to alienate amounts of income flowing from their personal exertion (as opposed to income generated by the business structure), the ATO may consider cancelling relevant tax benefits under [the GAAR]. Despite this statement, the ATO acknowledges that historically, the GAAR has not been applied to income from a business structure of a professional firm.37 The ATO has created three risk assessment bench- marks applicable to IPPs and/or associated entities. Where the IPP satisfies one (or more) of the benchmarks, the ATO will allocate a “low risk” rating, and the taxpayer will not be subject to ATO compliance action in respect of income alienation. Where none of the bench- marks are met, the taxpayer will be allocated a “high risk” rating, and is more likely to be subject to audit action and potential application of the GAAR.38 The IPP can use a different benchmark from year-to-year to obtain a low risk rating.39 Each benchmark is discussed immediately below. Benchmark 1: equivalent or appropriate remuneration returned as IPP’s assessable income To meet this benchmark, the IPP must include in their assessable income an amount at least equivalent to remuneration40 paid by the firm to the lowest paid employee in the upper quartile of professional employ- ees who provide services to the firm that are equivalent to the services provided by the IPP.41 If there is no “equivalent employees” in the firm, which may be the case in smaller practices, like employees in comparable firms or industry benchmarks should be used. Benchmark 2: 50% of IPP and/or associated entities’ entitlements returned as IPP’s assessable income To meet this benchmark, the IPP must include in their assessable income at least 50% of the sum of all entitlements of the IPP and the IPP’s associated entities (ie collective entitlement flowing from the firm).42 Even where an associate entity’s entitlement accrues through a chain of interposed trusts, that entitlement will still be counted in the denominator of this benchmark.43 This also means that entitlements accruing to the IPP and/or associated entities from a service entity that services the firm will be counted in the denominator. An IPP’s entitlement from a service entity will be counted in the numerator under this benchmark. Benchmark 3: effective tax rate of at least 30% on IPP and/or associated entities’ entitlements To meet this benchmark, the effective tax rate must be 30%44 or more on both:45 (i) the income entitlement of the IPP from the firm; and (ii) the income entitlement of the IPP and the income entitlement of the IPP’s associated entities, from the firm. Arguably, if the IPP has no entitlements from the firm, which is possible, the first requirement ((i) above) would be satisfied rather than failed.46 In other words, testing for the 30% tax rate for the IPP is only necessary if the IPP has some entitlement. In regard to the second requirement ((ii) above), it is the collective entitlement of all parties that must bear at least 30% tax. There is no need for each associate that is entitled to bear the 30% minimum. Where the IPP has no non-firm income, the IPP would have to include approximately $172,500 of tax- able income from the firm to meet his/her 30% effective australian tax law bulletin May 2016 75
  16. 16. tax rate requirement.47 Where the IPP and/or associated entities have non-firm income, the ATO states that in determining the tax borne on income from the firm, the entitlement from the firm forms the “top slice” of a natural person’s taxable income.48 For example, for an IPP with non-firm taxable income of $60,000 and firm income of $80,000, the following result arises: Taxable income, and compo- nents of taxable income Tax on column one components Taxable income: $140,000 Non-firm taxable income: $60,000 Firm taxable income: $80,000 $39,747 $11,047 $28,700 The effective tax rate on the IPP’s firm income is 35.87% ($28,700/$80,000), which meets the 30% require- ment. Policy analysis Need for guidelines The ATO correctly asserts that a certain portion of an IPP’s entitlement from the firm, until now viewed solely as income from a business structure, is generated from the IPP’s personal exertion.49 The rules prior to the IPP guidelines (or the old view) of this area has been based on an “all or nothing” characterisation of the income (personal exertion or from business structure). The established rules regarding personal exertion income (PSI regime) cannot apply to an IPP’s return from the business structure. The ATO has generally not applied the GAAR to “alienations” of income from a profes- sional firm’s business structure. This is the gap filled by the IPP guidelines. The damage to the integrity of the income tax from a situation where an IPP could return zero taxable income from their firm was most likely the key thing that moved the ATO to [eventually] take this measure. Inter-taxpayer fairness may also have contributed, as may the parlia- ment’s failure to act. One could legitimately ask, why did the ATO take so long to act? Legal status of guidelines and use of guidelines by ATO The IPP guidelines and in particular, the three bench- marks, are not specific legislation and they do not derive from case law. However, they are ultimately grounded in the GAAR. That is, if the ATO seeks to defend their application to particular taxpayers, the ATO will need to convince either the AAT or the appropriate court that all elements of the GAAR are satisfied. It is also noted that the IPP guidelines are not a binding public ruling.50 The effect of this is that an IPP and associated entities cannot obtain the “estoppel type benefit” that comes from a binding public ruling.51 In terms of legal status then, the IPP guidelines are merely ATO website content. However, the ATO is likely to consider itself bound administratively to the guide- lines. While a taxpayer may be protected from a false or misleading statement penalty (and any shortfall interest), they will not be protected from a tax shortfall if the ATO’s guidelines are later found to be incorrect or misleading and the ATO seeks to depart from them.52 One would also expect that changes to the guidelines that are detrimental to taxpayers will only operate prospectively. In the first instance, the guidelines will act as a “risk management” or “audit selection” tool for the ATO. If a taxpayer complies with the guidelines, they will be rated as low-risk and are unlikely to face audit action. Here, the guidelines effectively act as a “safe harbour” for IPPs. While this may provide those taxpayers with increased certainty, it also means there would be no incentive for such taxpayers to include any more “per- sonal exertion income” in their assessable income than is required by the benchmarks. If a taxpayer does not comply with at least one of the benchmarks, they will be rated as high-risk, thus increas- ing the risk of audit action. However, a “high-risk” rating will not necessarily result in the ATO attempting to apply the GAAR to the arrangement; it simply means that they are more likely to examine the arrangement in order to determine whether the GAAR should apply. Appropriateness of taxpayer coverage and benchmarks Taxpayer coverage The guidelines are limited in their reach to “profes- sional firm arrangements” (eg accounting, engineering, legal, medical). This means that firms and businesses that provide services or products to the consuming public, for example, “blue collar” service providers (eg electricians, plumbers) and traders (eg coffee shops) are outside the guidelines. As with professional firms, part of the income in both of these categories of business is likely to be generated from the personal exertion of the principal(s). The ATO claims that the structure of professional practices in certain “thought related” professions is unique and has been driven by a combination of factors (eg reforms to regulatory environments) which has led to the adoption of a variety of structures. These factors differ from the commercial drivers in other sectors, such as those involving physical labour. And, in light of the greater flexibility provided by regulators, there is greater potential for the alienation of income.53 With respect, the ATO’s reasoning is not convincing. If the key objective is not permitting the full alienation of personal exertion income, it is very hard to see why this objective should not be pursued in the case of a australian tax law bulletin May 201676
  17. 17. “blue collar” business or other trading businesses. The ATO may be working on separate guidelines (although this is unknown), but at the moment, the absence from the guidelines of other businesses where a principal’s personal exertion contributes to the income offends inter-taxpayer equity and seems wrong in principle. Benchmarks The benchmarks should be evaluated in accordance with the overall purpose of the guidelines: to prevent the full alienation of personal exertion income away from the provider of the personal exertion. The presence of three alternative benchmarks and allowing the IPP to select a different benchmark each year, provides flex- ibility in determining the appropriate amount to be included in the assessable income of the IPP. However, this flexibility means that the benchmark chosen each year is likely to be the one that results in the smallest amount of assessable income for the IPP. Further, even if none of the benchmarks are satisfied, it does not neces- sarily mean that the ATO will seek to apply the GAAR. The guidelines provide an example where, due to valid commercial reasons, the ATO will not apply the GAAR even though none of the benchmarks are satisfied.54 The first benchmark is making an assumption that the remuneration being paid to the lowest paid employee in the upper quartile of employees providing equivalent services to the firm is an appropriate reflection of the IPP’s personal exertion. The IPP’s entitlement from the firm could be substantially higher than this remuneration figure. It is questionable whether any excess allocation above this figure is an accurate reflection of income from the business structure and compensation for busi- ness risk. The second benchmark, on the face of it, is not set by reference to an objective industry criterion concerning remuneration for personal exertion in the market place. Instead, it requires a minimum of 50% of the IPP’s overall income entitlement to be included in their assessable income. This suggests that the remaining 50% is due to the IPP’s portion of the business structure. The third benchmark makes no attempt to separate the IPP’s overall income entitlement into a personal exertion component and a business structure component. It is merely ensuring that a minimum rate of tax is paid on the IPP’s income allocation, even if a large portion of the tax is paid by the IPP’s associated entities. Strangely, the corporate tax rate, which is usually associated with the production of business income, has been chosen as the effective tax rate to apply.55 1 This may not be appropriate considering the IPP guidelines are based around the concept of appropriately taxing the IPP’s personal exertion income component. Conclusion While the guidelines are a sensible development, they may be somewhat generous, with IPPs being able to “pick and choose” between benchmarks each year. The ATO’s view may be that taxing some income in the hands of the IPP is better than nothing, which is what the current position permits. The guidelines are also narrow in taxpayer coverage in that they only apply to profes- sional services firms. This means that principals of other businesses where there is a contribution to business income from the principal’s personal exertion are tax advantaged. From a tax system point of view, the GAAR with the broad nature of its operative concepts, is not an appro- priate mechanism for taxation of personal exertion income. It is submitted that the enactment of the PSI regime in 2000 provides considerable support for this. Treasury and Parliament should therefore give serious consideration to introducing a policy-based legislative regime to appropriately tax IPP personal exertion income, rather than relying on non-legally binding ATO guid- ance. Dale Boccabella Associate Professor of Taxation Law School of Taxation & Business Law University of New South Wales d.boccabella@unsw.edu.au Kathrin Bain Lecturer School of Taxation & Business Law University of New South Wales k.bain@unsw.edu.au This article has been reviewed by an independent reviewer. Footnotes 1. Australian Taxation Office, Assessing the risk: allocation of profits within professional firms, 18 March 2016, www.ato.gov.au. The guidelines were modified on 18 March 2016. 2. There is some doubt about this though, because even where the guidelines apply to a professional firm, the ATO has conceeded that the general anti-avoidance rule (GAAR) will not neces- sarily apply: see heading “The IPP Guidelines” below. 3. The PSI regime is contained in Divs 84–87 of the Income Tax Assessment Act 1997 (Cth) (ITAA 97). 4. See for example, FCT v Whiting (1943) 7 ATD 179 at 184; FCT v Ramsden 2005 ATC 4136 at 4150; Kiwi Brands Pty Ltd v FCT 99 ATC 4001 at 4012, and the authorities there cited. australian tax law bulletin May 2016 77
  18. 18. 5. Norman v FCT (1963) 13 ATD 13 at 18–19 (per Menzies J) and at 20–22 (per Windeyer J). 6. Booth v FCT (1987) 87 ATC 5100 at 5103 (per Mason CJ) and 5109 (per Toohey and Gaudron JJ); Howard v FCT (2014) 309 ALR 1; 2014 ATC 20–457; [2014] HCA 21; BC201404440 at [40]–[41]. 7. FCT v Everett (1980) 80 ATC 4076 at 4083; Liedig v FCT (1994) 94 ATC 4269 at 4277. 8. FCT v Everett, above n 7, at 4083. 9. See for example: Tupicoff v FCT (1984) 56 ALR 151; 84 ATC 4851; FCT v Gulland; Watson v FCT; Pincus v FCT (1985) 62 ALR 545; 85 ATC 4765; BC8501057. 10. FCT v Galland (1984) 56 ALR 468; 84 ATC 4890. 11. For partnerships, it would be Pt III Div 5 of the Income Tax Assessment Act 1936 (Cth) (ITAA 36). For trusts, it would be Pt III Div 6 of the ITAA 36. For a company, the income would become that of the company as a taxpayer. 12. See for example, Taxation Rulings IT 25 Incorporation of medical practices (7 August 1981), IT 2121 Income tax: family companies and trusts in relation to income from personal exertion (12 December 1984), IT 2330 Income tax: Income Splitting (30 June 1986), IT 2503 Income tax: Incorporation of medical and other professional practices (3 November 1988) and IT 2639 Income tax: personal services income (20 June 1991). 13. Paragraph 10(a) of Taxation Ruling IT 2639. 14. Paragraph 10(b) of Taxation Ruling IT 2639. A principal practitioner is a practitioner with a share in the firm. Non- principal practitioners are full-time professional and non- professional staff (eg bookkeeper) that derives fees for the firm: paragraph 11 of Taxation Ruling IT 2639. 15. ITAA 36, s 260. 16. ITAA 36, Part IVA: ss 177A–177G. 17. See for example: Peate v FCT (1966) 14 ATD 198; [1966] 2 All ER 766; BC6600690; FCT v Gulland; Watson v FCT; Pincus v FCT, above n 9. 18. See for example: Tupicoff v FCT, above n 9; Daniels v FCT (1989) 20 ATR 1120; 89 ATC 4830; Bunting v FCT (1989) 90 ALR 427; 89 ATC 5245; Egan v FCT 2001 ATC 2185; (2001) 47 ATR 1180; [2001] AATA 449. 19. Paragraphs 1.12–1.13 in the Explanatory Memorandum to the New Business Tax System (Alienation of Personal Services Income) Act 2000 (Cth). 20. If the regime applies, there are also limitations in relation to deductions that can be claimed against PSI: see Div 85 and Subdiv 86–B of the ITAA 97. 21. ITAA 97, s 84–5(1). Paragraph 25 of Taxation Ruling TR 2001/7 Income tax: the meaning of personal services income (31 August 2001) states: “Implicit in the word ‘mainly’ is that more than half of the relevant amount of the ordinary or statutory income is a reward for the personal efforts or skills of an individual.” 22. See Example 7 at para 94 in Taxation Ruling TR 2001/7. The related ruling, Taxation Ruling IT 2639, also provides guidance as to whether income from a professional practice is considered personal services income or income from the business strucutre: see sub-heading “General anti-avoidance rule (GAAR)” above. 23. The legislation refers to the interposed entity as a “personal services entity” (PSE): ITAA 97, s 86–15. 24. If none of the tests are satisfied, a PSB determination must be obtained from the Commissioner: Subdiv 87–B. 25. Paragraph 264 in Taxation Ruling TR 2001/8 Income tax: what is a personal services business (31 August 2001). The ATO’s position on the application of the GAAR to arrangements for splitting personal exertion income are set out in Taxation Rulings IT 2121, IT 2330 and IT 2639. 26. See under “Intent of the guidelines” at above n 1. 27. Although not expressly stated, there is good reason to think that an IPP who only provides services “internally” should also satisfy this aspect of the criterion (eg education role to professional employees). 28. See third paragraph of document: above n 1. 29. It is not out of the question that the firm could be a fixed trust. A discretionary trust would introduce too much uncertainty where arm’s length IPPs are concerned. However, note the use of the discretionary trust as the service entity to a major accounting firm in Segelov v Ernst & Young Services Pty Ltd (2015) 89 NSWLR 431; [2015] NSWCA 156; BC201504847. 30. If the firm is a partnership of IPPs, an IPP cannot be an employee of the firm. 31. The term “associated entities” will generally reflect people and entities coming within the definition of “associate” in the income tax legislation: ITAA 36, s 318. 32. The table does not cover the situation where the firm (practice entity or operating entity) is a trust. However, adapted for the nature of a trust, the list of entities in column 2 in regard to the partnership and company would also feature for a trust. 33. See under “Legally effective partnership, trust or company”: above n 1. 34. Taxation Rulings IT 25, IT 2121, IT 2330, IT 2503 and IT 2639, above n 12. These rulings express the ATO’s views as to the possible application of the GAAR to attempted alienations of personal services income. One doubts that it would matter much, but the ATO ruling on s 84–5(1) of the ITAA 97 (personal services income is income mainly from your personal efforts and skills) is not strictly applicable here (TR 2001/7). 35. This heading roughly reflects a heading from the IPP guideline document as it best captures the role of the guidelines. 36. See under “Our concerns”: above n 1. 37. See above n 36. 38. An arrangement that does not satisfy any of the benchmarks may not be subject to compliance action. However, in such cases, the lower the effective tax rate of the arrangement, the higher the ATO will rate the compliance risk, which will increase the chance of compliance action: See under “Addi- tional information on the application of the benchmarks”: above n 1. 39. All IPPs in the same firm are not obliged to use the same benchmark. australian tax law bulletin May 201678
  19. 19. 40. The total remuneration package should be recognised. For example, fringe benefits, any related fringe benefits tax and superannuation have to be included. See Question 2 under “Further information: Applying benchmark 1”: above n 1. 41. See under “ATO risk assessment factors for remuneration of IPPs”: above n 1. A number of factors are taken into account in determining whether services provided by an employee are equivalent to IPP provided services. 42. See under “ATO risk assessment factors for remuneration of IPPs”: above n 1. 43. For example, the child of an IPP obtains a trust allocation at the end of a chain of three trusts. 44. Tax for these purposes does not include the Medicare levy, Medicare levy surcharge and any other levies. See Question 2 under “Further information: Applying benchmark 3”: above n 1. This operates to the detriment of the taxpayer as more taxable income is required to move the effective tax rate to 30%. 45. See under “ATO risk assessment factors for remuneration of IPPs”: above n 1. 46. This will be the case where the IPP has completely or fully alienated his/her firm income (eg firm partnership comprises of discretionary trusts of each IPP, and the IPP is not allocated any trust law income from the [family] discretionary trust for the year). For the remainder of this article, it is assumed that the IPP does have an entitlement. 47. Tax on $172,500 is $51,772, giving an effective tax rate of 30.01% ($51,772/$172,500). 48. See Questions 1 and 2 under “Further information: Applying benchmark 3”: above n 1. 49. The benchmarks could also, in a broad way, be viewed as deemed market value rules, similar to the numerous deemed market value realisation rules throughout the income tax legislation. 50. The key reason is that there is no statement saying the IPP guidelines (or benchmarks) are a public ruling: s 358–5(3)(b) in Sch 1 to the Taxation Administration Act 1953 (Cth). 51. Section 357–60(1) in Sch 1 to the Taxation Administration Act. 52. Australian Taxation Office, Levels of protection explained, 17 March 2016, www.ato.gov.au. 53. See Question 1 under “Further general guidance on the Benchmarks”: above n 1. 54. See Question 3 under “Further general guidance on the Benchmarks”: above n 1. 55. From 1 July 2015, the tax rate for “small business entities” (businesses with annual aggregated turnover of less than $2 million) has been reduced to 28.5%. With the current pressure to lower corporate tax rates for all companies, it will be interesting to see whether this benchmark is kept in line with corporate tax rates going forward, or whether it will remain fixed at 30%. australian tax law bulletin May 2016 79
  20. 20. For editorial enquiries and unsolicited article submissions please contact Laura Foss at laura.foss@lexisnexis.com.au or (02) 9422 2726. Cite this issue as (2016) 3(4) ATLB SUBSCRIPTION INCLUDES: 10 issues per volume plus binder www.lexisnexis.com.au SYDNEY OFFICE: Locked Bag 2222, Chatswood Delivery Centre NSW 2067 CUSTOMER RELATIONS: 1800 772 772 GENERAL ENQUIRIES: (02) 9422 2222 ISSN 2203-9481 Print Post Approved PP 255003/00764 This newsletter is intended to keep readers abreast of current developments in the field of tax law. It is not, however, to be used or relied upon as a substitute for professional advice. Before acting on any matter in the area, readers should discuss matters with their own professional advisers. This publication is copyright. Except as permitted under the Copyright Act 1968 (Cth), no part of this publication may be reproduced by any process, electronic or otherwise, without the specific written permission of the copyright owner. Neither may information be stored electronically in any form whatsoever without such permission. Inquiries should be addressed to the publishers. Printed in Australia © 2016 Reed International Books Australia Pty Limited trading as LexisNexis ABN: 70 001 002 357. australian tax law bulletin May 201680

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