Taxation Anti Avoidance Provisions Justine Noy

UNCERTAIN and TAXING TIMES

Author: JUSTINE NOY

AssociateChessell Williams LawyersLevel 13, 379 Collins StreetMelbourne, VictoriaAUSTRALIA 3000

Date: 17 June 2003

Taxation Anti Avoidance Provisions Justine Noy

UNCERTAIN and TAXING TIMES

INTRODUCTION

In the 18th century, Charles Macklin suggested that “The law is a sort of hocus-pocus science, that smiles in yer face while it picks yer pocket; and the glorious uncertainty of it is of mair use to the professors than the justice of it.”1

In the 21st century, the uncertainty of Australia’s taxation laws are undoubtedly of use to the Tax Commissioner but well and truly pick the pockets of businesses.

This paper addresses the uncertainty surrounding the application of Part IVA of ITAA36, the attempt to widen the anti avoidance net with the Personal Services Income (PSI) legislation, the confusion surrounding similar rules in the UK, and finally, speculates whether the PSI concept of Principal Work is nothing more than modern hocus-pocus.

Tax Commissioner Michael Carmody announced in March that the Australian Tax Office will fund a number of test cases in the courts on arrangements involving the splitting of PSI by personal services businesses (PSBs).

Why? Surely the PSI regime, effective from 1 July 2000, was designed to fill any gaps in the ATO’s vast anti-avoidance armory.

As independent contractors fall through the cracks of the PSI regime and satisfy the PSB tests, the ATO wants to tighten the Part IVA net to catch arrangements which reduce income tax by income splitting or diverting PSI to interposed entities.

Mr Carmody informed an ICAA meeting2 that although new contractor laws were introduced to provide a specific legislative code to address the more straightforward cases, they followed recommendations of the Ralph Report3 that recognised the role of the general anti-avoidance provisions in dealing with less clear cut situations.

ATO concern stems from its loss in the Full Federal Court in Mochkin4, which prompted the ATO to issue a fact sheet on the application of Pt IVA to PSI conducted through a company, trust or partnership.5

1 Charles Macklin, Irish actor/dramatist (1690-1797), Love a la Mode, Act ii. Sc. 1.2 Instituted of Chartered Accountants of Australia, Melbourne, 14/7/033 Review of Business Taxation in Australia, www.rbt.treasury.gov.au4 Commissioner of Taxation v Mochkin [2003] FCAFC155 http://www.ato.gov.au/content.asp?doc=/content/businesses/29402.htm

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The ATO has stressed that if the PSI regime does not apply, Pt IVA may apply to deny income splitting benefits. This has always been the case, and the Commissioner’s views are well documented in tax rulings.6

The test cases aim to provide greater certainty on how the law operates in today’s environment.

Uncertainty is the problem. Taxpayers are entitled to rely on legislation and established interpretation of legislation at any particular time. The required certainty does not always exist in the case of taxation laws in Australia.

Interestingly, consideration of a General Anti-Avoidance Rule in the UK in 1998 highlighted the need for certainty.7 The Inland Revenue (IR) said that the law should not unduly harm the levels of certainty which companies currently have about the tax treatment of a transaction while the British Chamber of Commerce said that a key issue is knowing at the start of a transaction whether a particular course comprises acceptable tax planning or unacceptable tax avoidance.

THE MISCHIEF

Traditionally, a common strategy for reducing or deferring income tax has been to alienate or divert income generated by an individual through companies, partnerships and trusts.

Subject to anti-avoidance legislation, individuals with appropriate structures in place have been able to –

1 retain profits or earnings in companies (including corporate beneficiaries) at the corporate tax rate of 30%;

2 take advantage of income splitting opportunities by distributing income to people with lower marginal tax rates, often people who did not carry out the service which attracted the income;8

3 pay associates salary and making superannuation contributions for spouses;

4 make taxation deductions of substantially more amounts than an employee would in a similar situation.

6 Taxation Rulings IT 2121,2330,2501,2503,26397 A General Anti-Avoidance Rule for Direct Taxes, www.inlandrevenue.gov.uk8 Consideration of Legislation Referred to the Senate Economics Legislation Committee June 2000 – A New Business Tax System (Alienation of PSI) Bill 2000, para 1.6

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THE PERSONAL SERVICES INCOME REGIME

Pt 2-42 of ITAA97, introduced by the New Business Tax System (Alienation of PSI) Act 2000, restricts the alienation and changes the treatment of PSI of an individual.

Division 84 defines PSI and makes it clear that the legislation does not imply that individual contractors are employees, Division 85 limits individuals’ entitlements to deductions and Division 86 limits deductions available to the interposed entities (the Personal Services Entity or PSE) after the PSI has been alienated. Division 87 establishes procedures for taxpayers establishing whether they are conducting PSBs and therefore outside the regime.

Certain individuals are treated as having received their PSI directly from the customers of the PSE as a result of providing services directly to those customers. The end result is that PSI channelled through a trust, partnership or company cannot be diverted to associates or left in the entity to take advantage of a lower rate of income tax.

PSI is the ordinary or statutory income gained mainly as a reward for an individual’s personal efforts or skills (as opposed to a reward from the use of assets, sale of goods, or a business structure9), even if it is legally derived by the PSE. Application of the term “mainly” will be determined on a case by case basis and “will not create certainty”, one of the objectives of the PSI rules.10

PSI will not be attributed to the individual if the entity is conducting a PSB. Taxpayers self assess but may apply for a PSB Determination to confirm whether they fall within the alienation measures.

The PSB tests and the “results test” are based on the traditional tests of who is an independent contractor.11 Identified problems with the PSB tests include –

1 The definitions of “producing a result” and “supply of tools”. Why is writing a computer program different from making a repair? Why isn’t a computer sufficient plant and equipment or a tool of trade?12

2 Two or more unrelated clients must engage the taxpayer “advertising” its services. This becomes difficult when the taxpayer is engaged by reputation or word of mouth.13

9 TR 2001/7; IT263910 Alienation of personal services income (PSI) through a structure, Burton, K. ABLR, 30(4) August 2002, p25811Alienation provisions – the truth is out there! Mulder, D. Charter Vol 72(4) May 2001,p37 12 Alienation of Personal Services Income – Have Contractors finally become Employees?, Moltoni, P – TIA Convention 2001, Sydney, para 4.1413 ibid para 5.19

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3 Examples in s84-5 state that a truck owner-driver is unlikely to be earning PSI on the basis that the truck represents the main source of income, despite the owner-driver deriving the income. The term introduces uncertainty and puts the taxpayer at risk if he acts on a view which the ATO later disputes.14

4 They are complex and confusing, and the ATO has issued 120 pages of rulings to try to explain how they work. 15

5 They are selective and fail to cover the full range of circumstances in which contractors operate genuine PSBs.16

ANTI-AVOIDANCE AND PT IVA

The PSI rules are not safe haven rules,17 and the activities of PSBs may be caught by Part IVA, which will deny income splitting benefits if the sole or dominant purpose of a scheme was to obtain a tax benefit.

Part IVA applies to –1 the alienation of income earned from personal services;2 income splitting arrangements;3 retention of PSI in a company,regardless of whether an individual or PSE is conducting a PSB.

“The ATO has made it very clear that it will apply general anti-avoidance provisions to curtail income splitting by personal services businesses. Accountants who are still coming to terms with the effects of the PSI provisions should not forget that even before PSI, the Commissioner could use part IVA to deny income splitting and claims for deductions where income was derived from personal exertion.”18

“Part 2-42 will not limit the scope of Part IVA … It will be possible to satisfy the provisions of Part 2-42 whilst falling foul of Part IVA.”19

Egan v FCoT20 was a “timely reminder” of the potential application of Part IVA to income splitting arrangements. 21 A company established to provide consultancy services was held to be part of a scheme to obtain a tax benefit. The AAT found

14 Shame Treasurer, Shame!, Roach, P, Charter Vol 71(1) Feb 2000, p2615 An Income Splitting Headache, Harrison G, Lawyers Weekly (97) 31 May 2002, p1216Master Builders Association opposing the proposed legislation, Above n8 para 1.4617 Alienation of PSI, Richards R, LSJ 39(4) May 2001,p41; Alienation of personal services income tax amendment, Richards R, LSJ 39(10) November 2001,p4418 Case Law Update, Athanasiou, A, National Accountant 17(4) August 2001, p4819 Above n12 para 2.620 2001 ATC 218521 Indirect Taxes, Mann G, Australian Tax Review, 30(4) 2001, p219

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that the taxpayer’s PSI was either retained at a lower marginal tax rate within the company structure or diverted to associates, including his wife and a superannuation fund. The low salary (less than the market value for his work) paid to the taxpayer, unrelated to the services rendered, was a contributing factor to the AAT decision.

It is the recent case of Mochkin which tickled the ATO’s sensitivities.

THE MOCHKIN CASE

Mr Carmody said that Mochkin was “on the face of it” a loss for the Tax Office.22

The ATO contended that the alleged scheme was use of a company to receive payment from stockbroking companies for the personal services of Mochkin, and use of a discretionary trust to divert income to third parties.

The court found that the dominant purpose of the arrangement to have commission income received by a corporate trustee was to protect the taxpayer from personal liability.

Of importance was the fact that Mr Mochkin had acted “under the shadow” of previous litigation, and had declined to personally guarantee the obligations of the companies (notwithstanding that the arrangement had income splitting benefits).

The ATO’s assessment of the case focuses on the court’s observation that the outcome may have been different if the scheme had been identified as the taxpayer using the relevant entity to distribute its net income as he directed, without regard to the value of the services he provided to the company.

Barrister Michael Bearman says the case is part of the growing jurisprudence on the operation of Part IVA and a decision of some importance with respect to the diversion of personal exertion income. 23

Applying Hill J’s reasoning in Hart,24 Ryan J at first instance weighed the commercial side of the scheme against its tax advantages, and found that Mochkin’s prevailing or most influental purpose was to avoid the possibility of personal liability. Mochkin was unwilling to accept personal liability for client defaults. It was therefore likely that the business would have been carried on through a limited liability entity.

22 Above n223 FCT v Mochkin – The Fiction of Personal Services Income, Bearman M, TIA, 25 March 2003, para 124 Hart v FCT 2002 ATC 4608

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The Full Court rejected a comparison with Tupicoff, Bunting and Case W58,25 and found that there was nothing to suggest in those cases that the taxpayers were unwilling to provide services on their own account. Mochkin did not simply substitute a corporate entity for his own services, and the interposed companies had accepted liability for defaults of the clients, and on occasion made them good.

The case would have been closer to Case W58 if the Commissioner had identified a narrower scheme.26 Mr Bearman noted that “It seems likely that the Commissioner will need to pay far greater attention to the identification of a scheme prior to the commencement of litigation.”

Mr Bearman identified the following questions as arising from Mochkin -

1 When the Commissioner alleges a diversion of personal income, what evidence would establish a dominant purpose of limited liability?

2 If a taxpayer contends that that was the dominant purpose, what evidence if any of an arm’s length salary is required?

3 How late can the Commissioner change a scheme that he has particularised?

On 12 March 2003, the AFR described Mochkin as a “blow to the ATO’s campaign against income splitting?”27

However ATO Senior Tax Counsel Simon Matthews has explained Mr Mochkin’s specific circumstances as follows28 – He had been personally sued in relation to his stockbroking activities. The corporate trustee of a family trust was ready at hand. He had substantial facilities and a team of people – not a ‘one person’

business. He was frequently absent.

He said Mochkin was decided on its own facts and warned enterprising accountants to “beware”, and identified the following questions as relevant –

1 Is there a genuine commercial reason for using an entity?

2 If the taxpayer is seeking asset protection, has protection been demonstrated?29

25 Tupicoff v FCT 84 ATC 4851 – main purpose of arrangement was splitting income, could not be explained as ordinary commercial or family dealings; Bunting v FCT 89 ATC 5245 – derivation personal exertion income; Case W58 89 ATC 524 – s260 and Part IVA26 Sackville J, para 8027 Tax win based on safeguarding assets, Buffini, F., The Australian Financial Review, 12/3/03,p3228 Commentary on Mochkin, Matthews, S, TIA, 25/3/0329 cf Tupicoff

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3 Does the interposed entity comprise a cumbersome, complex or artificial structure?

4 Is the taxpayer using an interposed entity to distribute its net income as he directs, without regard to the value of the services he provides to that entity?30

Mr Matthews said the test case program was intended to obtain judicial consideration of ATO views. Surely a confession of endemic uncertainty?

PART IVA – NOT ENOUGH?

The PSI regime was introduced following The Ralph Report Review of Business Taxation.

One of John Ralph’s guiding principles was that economic transactions having the same economic substance should be taxed similarly, irrespective of their legal form – not dissimilar to the UK concept of the employee and the “disguised employee”.

The guiding principle was reflected in Treasurer Peter Costello’s Second Reading Speech to the PSI legislation when he said that the object of the proposal was to treat all earnings from work in the same way under the income tax law, regardless of the legal structure used by the income earner.

The Ralph Review identified “a burgeoning tax loophole” as a result of the use of interposed companies, partnerships and trusts and confirmed the Federal Government’s view that the general anti-avoidance was not working adequately.31

Compare Peter Roach’s32 views on a sole trader electing to bring a spouse into partnership or form a company, with neither the party nor fellow shareholders contributing to the result. Roach believes that we will “rue the day” we allow the ATO to direct taxpayers as to the form of business entities to be established, and that it is unjust to single out a group for special liability because they exercise a choice which the rules of the community offer, and seek to justify such discrimination because the individual has a reduced personal liability in tax without regard to other circumstances.

30 Sackville J, para 3931 Above n1032 Above n14,p27

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The ATO’s protracted efforts to prevent income splitting are reflected by the following –

The Commissioner’s “long running war” against alienation of PSI. Despite success in Tupicoff and the existence of IT 2121 and similar rulings, the Commissioner desired further strengthening of the legislation, and some sixteen years later the Commissioner was granted his wish.33

The release of IT2639 to give “guidance” on IT 2330 and IT2121 (which was released just 21 days after Tupicoff).

The use of Pt IVA to counter alienation practices on a case by case basis which is labour intensive and an inefficient use of ATO resources.34

The Explanatory Memorandum’s statement that the specific rules would provide certainty for Australia taxpayers but then concedes that the legislation should produce a similar outcome as that obtained from Part IVA.35

The Treasurer’s statement that the ATO had previously applied the general anti-avoidance rule to arrangements which avoided tax through the alienation of PSI. Why then was anything more than Part IVA called for?36

The uncertainty when drawing the fine line between personal services income and business income. 37

The ATO’s delineation of business income from PSI lacks detail and clarity.38

The failure of Part IVA being identified by the government as the key reason for enacting the PSI legislation. Part IVA did not prove to be the “white knight” the government had hoped …39

Australian contract workers earning PSI being subject to numerous court cases, tax rulings, ATO audit programs and legislative changes. 40

33 Above n12 paras 1.1,1.834 Explanatory Memorandum to New Business Tax System (Alienation of Personal Services Income) Bill 2000, para 1.1235 ibid. para 1.1336 Above n1437 Impact of the New Business Tax System, Cassidy, J, ABLR, 30(2) April 2002,p9038 Contractors and Income Splitting, Szekely, L and Reilly, J, CCH 199739 Part IVA – A Toothless Tiger?, Cassidy, J, (2001) 11 Revenue LJ,p6540 An Income Splitting Headache, Harrison G, Lawyers Weekly (97) 31 May 2002, p12

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Uncertainty surrounding the application of the PSI regime being acknowledged by Parliament when the legislation was amended to meet perceived deficiencies.41 For example, the independent contractors’ self-assessment was a significant withdrawal from original intended scope of PSI measures. Other changes introduced the results tests, provided that commission based payments to agents from principals would be treated on a look-through basis and allowed taxpayers under the Prescribed Payments System to avoid the alienation rules until 1 July 2002.

Uncertainty was demonstrated as early as 1992 when Justin Dabner and Mark Burton42 contended that the decisions on Part IVA demonstrated a paucity of reasoning and that the more appropriate foundation for any personal services rule was outside and independent of Part IVA. They proffered options –

1 Section 19 ITAA36 on the basis that the money has already “come home” to the taxpayer.

2 Expanding the scope of the sham principle.

3 Doctrine of Fiscal Nullity, the principle developed by the UK courts which allows revenue authorities to look behind the legal effect of certain aspects of a transaction and to determine the liability on the basis of the substance of the transaction. In Australia, fiscal nullity is generally rejected on the basis that the legislation contains a general anti-avoidance provision.

Submissions to the Review of Business Taxation’s Discussion Paper“A Strong Foundation” 43

The Government announced on 11 November 1999 that it would introduce legislative amendments to “improve” the operation of Part IVA.

The Ralph Report said that proposed structural reforms, by significantly reducing existing disparities and flaws in the tax law, would reduce the reward from undertaking activities purely for tax purposes.

“Nevertheless, where opportunities for tax avoidance remain the powers already available in the general anti-avoidance rule (Part IVA) … should generally be the measures used against them – rather than specific anti-avoidance measures.”

41 Personal Services Income – Still a Death Trap (or is it?), Candy, G, TIA September 2001; The Taxation Laws Amendment Act (No 6) 2001; Treasurer’s Media Release 2001/047.42 Part IVA: Walking the Dog, Dabner, J, Burton, M, Taxation in Australia, 26(11) June 1992, p60743 Above n3

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Institute of Chartered Accountants

The ICAA acknowledged that specific anti-avoidance provisions add to the complexity of Australia’s tax laws, but usually specify the factors which a taxpayer must take into account in determining whether the anti-avoidance provisions have been triggered.

“In this sense, they provide some element of certainty. A general Part IVA anti-avoidance provision, by definition, lacks such guidance.”

The ICAA viewed with concern suggestions that the judiciary could “flesh out” the scope of general anti-avoidance provisions and noted the following – a revamped general anti-avoidance provision would become a de facto

“policy policeman”, used by the ATO against taxpayers whose tax planning is deemed outside the spirit, but not the literal wording, of the law;

business may be required to “second guess” the likely provisions at a time when it is entering into transactions and when filing income tax returns under the “self-assessment” environment.

“This has resulted in considerable uncertainty regarding many provisions in the taxation law, which in turn has resulted in many transactions which could have been of benefit commercially to business, not being proceeded with in light of the errors, ambiguities and unintended consequences evident in the black letter law or because there is only an announcement (no legislation) to assist analysis. It has also resulted in the ATO being inclined (or pushed?) to issue rulings or determinations or other announcements stating its view on particular provisions in circumstances where that view may not accord with the interpretation of judges who may have to consider the provision,” stated the ICAA submission.

“Unintended consequences” were also raised by Carswell LCJ in the Court of Appeal in Northern Ireland.44 when he said that “one of the recurring themes in the continuing struggle between taxpayers seeking loopholes in the tax laws and the Revenue striving to close them is the operation of the law of unintended consequences … other persons who have not been attempting to escape tax in the same way are caught by its provisions.” The case, which the taxpayer lost, focused on whether a loan was made in the ordinary course of business.

Taxation Institute of Australia

The TIA questioned the “sometimes imponderable responses of the ATO under Part IVA” and identified certainty as a critical objective of business taxation because of the need for entrepreneurs to plan their business activities so as to be able to meet the taxes properly due and payable by them.

44 Brennan v Deanby Investment Company Limited [2001] NIECA 1

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It said uncertainty flows from public rulings, the delays of the ATO in giving private rulings, the practice of legislating by press release (a poor substitution for prospective legislation).

“We are strongly of the view that simplification is not enhanced by merely enacting broad principles and leaving the taxpayer either to flounder in uncertainty, or worse, to have to work through a labyrinth of regulations or rulings in order to determine the amount of tax payable.

“The curtailing or curbing of tax avoidance is made easy by discretionary legislation but the resulting uncertainty for all taxpayers is unacceptable.”

The TIA questioned the extent to which activities of the business taxpayers in pursuing advantageous options under the tax law should be penalised because they have found the law more accommodating than Treasury expected, and whether in the attempt to embrace all possible prospects within a general anti avoidance measure, the law is deliberately destroying certainty.

The TIA supported the proposal to limit the practice of legislating by press release on the basis that until a bill introducing the amendments is introduced into Parliament, the tax rules affected by the announcement are uncertain, and taxpayers who relied on the announcement in the interim may find that their reasonable assumptions about the context of the amendments were incorrect.

It identified a need for the adoption of a doctrine of reasonable expectation which would operate as a basis of estoppel against the ATO from departing from positions, which have induced reasonable expectation of concessional behaviour from the ATO.

Law Institute of Victoria, National Tax & Accountants Association, National Institute of Accountants and Australian Taxpayers’ Association

The above lobby groups endorsed the proposal to reduce retrospective legislation and in particular “legislation by press release”, and submitted that the problem from the taxpayer’s point of view was that the legislative process was characterised by ambush and ambit claim, because legislation often has consequences that could not have been inferred from an ATO announcement.

The submission said that the failure to meet the objective of simplification was demonstrated by Mr Justice Hill in Consolidated Press Holdings Limited v FCT45 who said the legislative context of the case was one which “many would described as mind-numbing complexity”.

45 98 ATC 5009 at 5016

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THE FUTURE?

Tony Pagone QC has predicted that definition of a scheme and dominant purpose are likely to be at the core of much litigation in the immediate future. 46

He questioned whether it was permissible to structure a “commercial” transaction in such a way that the taxpayer’s risk is limited wholly or substantially to the tax saved by entering into the transaction. He said that in Vincent, Hart, Eastern Nitrogen and Metal Manufacturers47 the Commissioner advanced the proposition that Part IVA can apply to a transaction that owes its shape to the tax advantage secured by the structure.

“… the decision in Hart raises squarely the question of the extent and interrelationship permitted under Part IVA between tax effective structuring and impermissible tax avoidance. There can be no doubt that the tax consequences of a transaction are taken into account in ordinary commercial dealings and that the shape and form of a transaction will often have its explanation in the tax consequences which arise.”

Robert Richards believes that Part IVA cases are growing fast and furious but that decisions are still confused and no rules have yet emerged which would indicate what schemes are subject to Part IVA. 48

“Rather, whether Part IVA will apply or not seems to depend upon the subjective view of that judge deciding the case – which in the end is another way of saying that whether Part IVA will apply or not might be just a question of luck.”

UNITED KINGDOM – IR35

The UK, USA and many European countries do not have a general statute to counter tax avoidance.

Legislation in the UK treats certain independent contractors as disguised employees. IR35 was introduced in 2000 with the robust objective of “countering avoidance in the provision of personal services”.49

It aims to reduce avoidance of PAYE income tax and National Insurance Contributions through the use of intermediaries such as service companies, and the rules investigate whether –

46 Part IVA: future issues, Pagone, T QC, TIA, 41st Victorian Convention, 12/9/0247 Vincent v FCT 2002 ATC 4742; Hart v FCT 2002 ATC 4608; Eastern Nitrogen Ltd v FCT 2001 ACT 4164; FCT v Metal Manufacturers Ltd 2001 ATC 415248 Richards, R., Anti-Avoidance: a year end review, www.cpaaustralia.com.au, December 200249 Compare the object of Division 86 of ITAA97 (s86-10)

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(a) the taxpayer is genuinely self-employed and has established a structure which can be regarded as a legitimate business;

(b) in the absence of the arrangement or the intermediary, the taxpayer would be treated as an employee;

(c) the arrangements amount to “disguised employment”.

IR35 requires freelancers or “Monday to Friday workers” to self assess and take “reasonable steps” to ascertain their status.50

Information Technology contractors unsuccessfully challenged the legality of IR35 on the basis that it restricts workers’ freedoms, is anti-competitive and incompatible with European Law, including Human Rights conventions.51 Justice Burton found in favour of the Inland Revenue on 2 April 2001. An appeal was dismissed in December last year, and permission to appeal to the House of Lords was refused.

Criticism has labelled IR35 an “unfair, anti-competitive law” which has caused a brain-drain from the UK and an exodus of contractors to foreign shores. IR35 has also been criticised for blatantly attempting to change the employed/self-employed boundaries, and therefore contributing to uncertainty for contractors.52

Justice Burton found that service contractors, as a result of IR35, are uncertain as to whether IR35 will or will not apply to a particular arrangement, and that some service contractors may not continue to operate in the UK as a result of IR35.

In the Stutchbury case,53 the High Court held that a contractor was a “disguised employee” for tax purposes rather than operating a business on his own account and as a result was caught by IR35.

Unfavourable reactions to the case focused on the uncertainty of the application of IR35. For example, Freelancers Outside IR35 (FO35), an advisory network established as a result of the uncertainty, devotes thousands of words to the subject.54 Another lobby group representative said that “after three years of confusion, we are no closer to knowing who’s inside the legislation and who’s outside.”55

50 Living with IR35, Notes on IR35 – 8.1.2002 Abell Morliss51 Professional Contractors Group Ltd, Ruud van Zundert and Square Miles Projects Ltd v The Queen and Commissioners of Inland Revenue, High Court of Justice, Queens Bench Division, Administrative Court Case No CO/2302/0052 www.contractoruk.co.uk; How to Operate Outside IR35 and Defeat the Revenue, www.lawspeed.com53 Synaptek v IR, 28 March 200354 www.shout99.com55 David Ramsden (PCG)- www.contractor.com/article1053

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UK Professor Judith Freeman spoke in 2001 of the difficulty in drafting a statutory rule in this field (employee or self employed) and said no other country has managed it.56

Notwithstanding the criticism, IR35 was extended in April 2003 to cover domestic workers (nannies and butlers) who provide services to non-business clients through a limited company.

General Anti-Avoidance Rule

Consideration of a GAAR in the UK drew claims of uncertainty.

In 1997, IR started consulting on a GAAR. In the 1999 UK Budget, a GAAR was floated as an option for the future. In July 2001, it was described as shelved not binned.

IR’s Consultative Document for a GAAR offers insight57-

“The UK is unusual among developed countries in having neither a statute nor an established legal principle to counter tax avoidance in general. Many other countries in the developed world have found such a rule or principle to be a very useful remedy for countering tax avoidance, although not a universal cure…

“The aim of a GAAR would be to reduce tax avoidance. It should not unduly harm the level of certainty of tax treatment enjoyed by businesses that are not engaged in avoidance…

“The traditional way in the UK of countering such schemes has been to litigate or to introduce specific anti-avoidance legislation to stop them…The need for targeted anti-avoidance legislation will remain …”

The Institute for Fiscal Studies, while acknowledging that most OECD countries adopt some form of general rule as a backstop to avoidance, stated that specific legislation should remain the government’s main response to tax avoidance.58

“The issue is whether it is for the courts to develop a general rule (as in the USA) or whether Parliament should intervene to do so (as the Parliaments of Canada, Australia and New Zealand have done). The Committee believes that a statutory rule can provide a better framework for the rule in the UK than can further action by the Law Lords.”

56 Dependent or Self-Employed? Courtnage, S, The Tax Journal, 30/7/01, p1957 Above n758 www.ifs.org.uk – Tax Avoidance: A Report by the Tax Law Review Committee

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The IFS concluded that proposed GAAR failed to offer appropriate safeguards for taxpayers.

The British Chamber of Commerce59 strongly opposed the introduction of a GAAR on the basis that it would result in far greater uncertainty and restrain genuine commercial activity.

Industry group the Tax Faculty, felt it was difficult if not impossible to draft a provision successfully.60

“We consequently believe that it is better to tackle problematic areas of tax avoidance with specific anti-avoidance provisions. We also believe such provisions will be necessary even if a GAAR is introduced”.

The Tax Faculty commented unfavourably on the success of the GAAR regimes in Canada, New Zealand and Australia. The report quotes Deakin University’s Professor Jeffrey Waincymer saying that “too many key policy questions have been left for judges to answer”.

It also refers to a 1994 Labour Party leaflet which says that as a matter of principle, a citizen is entitled to know where he or she stands before the tax law.

The Tax Faculty submitted –

A catch-all provision that came into play when all else fails is unacceptable in a fair tax system.

Every taxpayer is entitled to know with a reasonable degree of certainty the tax impact of any transaction he or she undertakes. The GAAR as suggested will take away from that certainty.

The heart of the problem is the fact that no one has ever been able to define “tax avoidance”.

There has been a worrying tendency in recent years for the word “avoidance” to be used loosely to cover any tax planning situation which the IR finds unacceptable.

The proposed GAAR would introduce an unacceptable degree of uncertainty into the UK tax system.

59 www.britishchambers.org.uk 60 www.taxfac.co.uk – TAX 38/98

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There are examples of tax planning that result in a reduction in the overall tax burden, are within the confines of the law, are not of an artificial nature and are not perceived as avoidance by most people. Examples include husband and wife transactions or incorporation. “Neither of these are the type of transactions that we believe should be attacked as avoidance. The uncertainty that such a wide-ranging definition would introduce runs counter to the principle of a fair tax system.”

In this regard, IR is considering using existing legislation, s660 of the Income and Corporation Taxes Act 1988, to challenge family businesses distributing corporate income to lower taxpayers.

Freelancers may once again find themselves in a grey area of uncertain legislation where a husband and wife share business profits via dividends, but one party does the majority of work while the other assists in running the business. 61

Experts are divided on the issue of whether IR can interpret s660 in this way but have raised the possibility of taxpayers receiving retrospective tax demands for the last six years. “For many, who had no knowledge of this legislation now being used in this manner by the Inland Revenue, it will represent an additional worry on top of a very uncertain legislative environment.”

The US system allows married persons to elect to file joint tax returns on the basis of a combined taxable income. Family unit taxation offers income splitting to all taxpayers, not just those who can legally structure ways to achieve such a result because of the character of their earnings.

Interestingly, the Australian Treasurer said, during the Second Reading Speech to Part IVA, that a husband and wife who choose to run a business as partners will need have no fear of having their arrangements affected by Part IVA.

“PRINCIPAL WORK” IN AUSTRALIA – A FLAWED PRINCIPLE?

PSI legislation addresses the perceived over-claiming of income tax deductions under s8-1 by individual contractors and interposed entities providing personal services (such as deductions for travel between home and work). 62

61 The married couple’s business tax, www.shout99.com (17/4/03)62 Above n34 para 1.8 and practical examples; Divisions 85,86

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The prohibition of deductions (including superannuation contributions) does not apply to the extent that an amount relates to engaging an individual’s associate63 to perform work that forms part of the Principal Work for which the individual’s PSI is received.64

The employee must contribute at least 20% by market value of the entity’s principal work. The valuation exercise is fraught with uncertainty.65

Contractors will therefore still be entitled to claim some of deductions which may not be available to employees. Previously, reasonable amounts paid to (and reasonable superannuation contributions for) an associate for non-Principal Work were deductible.

“Principal work” is not defined by the legislation and therefore has its ordinary meaning. Whether an associate is performing Principal Work from which the PSI is derived is a question of fact that must be decided on a case by case basis.

Generally, Principal Work is – essential to the generation of the PSI; central to meeting the individual’s key contractual obligations; and directly contributes to meeting the end result of agreements between the

individual and the acquirer of the personal services.

It does not include work which is associated with the administration of the PSE, amounts to support services or ancillary in nature, and the adjective principal has been used in the legislation to exclude work that is “not in a commercial sense integral to” the fulfilment of the contractual obligation or the work that generates the income.66 Non-principal work usually includes secretarial duties and preparing invoices (the nominal duties traditionally delegated to associates).

However, the administrative work may be essential to or may BE the work to be performed under the relevant engagement. The FPA has suggested that the importance of Principal Work must not be underestimated, and that financial planners are required to spend significant time performing administrative duties such as preparing investment updates. 67

The FPA cited an AAT case68 in which Judge Beddoe concluded that the applicant obtained more business “because of the fact that he had arrangements whereby his wife performed the more routine task of creating the file of documents for each loan application”.63 s318 ITAA36, s995-1(1) ITAA9764 Above n34 para 1.4765 Above n12 para 5.3066 Above n34 para 1.53; TR 2001/8 para 18467 www.fpa.asn.au/value/members/membDocs/principalWork.doc. 68 Wells v FCoT 2000 ATC 2077

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Burton believes that the test will be subject to as many interpretations as Part IVA.69

Whether a task amounts to Principal Work is a fine distinction which remains untested by Australian courts. There are many legitimate business arrangements where payments to a spouse or other family member are acceptable.

Consider the example in TR 2001/8 of a builder’s wife who assists with contract administration, pays subcontractors, keeps track of costs, records times worked, records contract variations and makes progress payments. Ignoring the fact that the builder may satisfy the results test and fall outside the PSI net, the Commissioner says that this work is not Principal Work. However, if the wife mixes sand and cement and lays bricks, her work would be integral to and part of the Principal Work of building a brick wall.

Hardly a wise example. Without the documents, there is no brick wall, indeed no building.

The CFMEU70 has stated that the PSI employment tests would pose “no barrier” to contractors “intent” on alienating their PSI and that the test would not prevent income splitting as it would be hard for the ATO to “identify the division of labour” in a partnership.

MORE UNCERTAINTY – THE LEGAL RELATIONSHIP

The fact that income is payable under a contract for services does not stop the income being mainly a reward for personal efforts or skills. Income is still PSI if the income is for producing a result, traditionally a characteristic of an independent contractor at common law. 71

Trusts, partnerships and companies receive income paid for personal services provided by taxpayers on an employee-like basis and the new regime therefore goes to the heart of the fundamental difference between an employee and an independent contractor

For the purposes of the PSI regime, the rules imply that the individual is an employee of the service acquirer. The rules are tax measures only and will not affect workplace arrangements. Individuals will not be considered employees for the purposes of any Australian law or industrial agreement.

69 Above n1070 Above n8 para 1.4271 s84-5(4); Above n34 para 1.25; TR 2001/7 para 41, World Book (Australia) Pty Ltd v FC of T 92 ATC 4327

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It follows that being deemed an employee for tax purposes, does not bring with it employees’ entitlements such as long service leave. Critically, it does not bring the person within the unfair dismissal legislation and associated rights.

A UK case in 2001 highlighted the potential that tax measures have to impose on workplace relations. The Employment Tribunal considered that a contract between a computer consultant operating through his service company and the client was an employment contract. His contract was terminated and he successfully applied for unfair dismissal compensation as an employee. This effectively took the worker out of IR35 and into the PAYE system. This would have undermined IR35 and the traditional tests of employment and was overturned by the Employment Appeal Tribunal72.

CONCLUSION

Mr Carmody said in March 2003 that drawing the line as to when income splitting is possible for tax purposes has been, and always will be, a source of tension (or does he mean uncertainty?). The combination of PSI laws and Pt IVA appears to have increased the ATO’s tension.

Will the test cases meet Mr Carmody’s objective of providing greater certainty on howthe law operates in today’s environment?

Mr Carmody conceded that there are many who have disagreed with the breadth of the conclusions the ATO has drawn from the cases in the 1980s, and that there is a view that concepts of employment, business and entrepreneurship have moved on since the 80s.

“On the face of it”, Mr Carmody may be endorsing Lord Tomlin’s comment of 1936 when he said that every man was entitled if he can to order his affairs so that tax attaching under the appropriate Act is less than it otherwise would be.73

In real terms, the outcome of the test cases will guide the ATO’s future activities in the area. The ATO is obviously concerned about the courts’ application of the principles to income splitting arrangements. Taxpayers ought to be concerned that the ATO is concerned.

Consider the more recent comment made in respect of employees who become contractors and “grasp the opportunity” to generate increased incomes and build large businesses. “It is a terrible shame that this natural and healthy development is sometimes altogether stymied and always seriously obstructed by complex and restrictive considerations.”74

72 Hewlett Packard Ltd v O’Murphy Appeal No EAT/612/0173 Internal Revenue Commissioners v Duke of Westminster (1936) AC 1, p19:74 Above n38

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The liability argument in Mochkin may offer taxpayers some relief although they will be required to prove that the asset protection purpose was a real one. 75

The ICAA has said that the legal form of a (private, family) company is used for limited liability purposes and the prime function of trusts for centuries has been the protection of family assets.76

The PSI rules aims to neutralise the taxation position and eliminate the taxation advantages of operating through an interposed entity. When they fail to curb taxpayers’ savings on tax, the ATO will adopt a fallback position with Part IVA.

Whether the test cases are a show of strength or a genuine bid to test the application of Part IVA to modern arrangements is largely irrelevant. It is the outcome of the cases which will count and perhaps establish a clearer set of rules within which taxpayers may conduct their personal and business affairs with certainty.

75 Above n2776 Above n3

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REFERENCES

Brown, A. (Publisher), Australian Master Tax Guide 2003, 34th edition CCH Australia Ltd, January 2003

Coleman, C.F., Hart, G.E., and Boccabella, D.A., Australian Tax Analysis: Cases, Commentary, Commercial Application and Questions, 4th edition Sydney, ATP, April 2001

Explanatory Memorandum and Consideration of Legislation Referred to the Senate Economics Legislation Committee June 2000 for

A New Business Tax System (Alienation of PSI) Bill 2000A New Business Tax System (Alienation of Personal Services Income) Tax Imposition Bill (No 1) 2000A New Business Tax System (Alienation of Personal Services Income) Tax Imposition Bill (No 2) 2000

ATO Taxation Rulings 2001/7, 2001/8, IT 2121,2330,2501,2503,2639

TA 2002/4

Internet References

http://

www.inlandrevenue.gov.uk/ir35/www.contractoruk.co.ukwww.taxreform.ato.gov.aulaw.ato.gov.auwww.fpa.asn.auwww.lawspeed.com/ir35www.shout99.com/contractorswww.rbt.treasury.gov.auwww.bailli.orglawsocnsw.asn.auwww.aibf.com.auwww.austlii.edu.auwww.cpaaustralia.com.auwww.tved.net.auwww.courtservice.gov.ukwww.cch.com.auwww.butterworthsonline.comwww.ifs.org.auwww.taxfac.co.ukwww.taxarticles.co.uk

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