Tax Avoidance & Tax Administration - Part IVA (5 marks)

Question 23.1

John is a full-time teacher and also a keen cyclist. He spends most of his spare time
practicing and training and spends a lot of money on his bike and gears. He regularly enters
cycling competitions and sometimes wins small amounts of prize money.
Advise what he can do to be in a position to argue for deductions of his expenses incurred
on cycling, and assuming he is regarded as a professional cyclist, whether he can offset his
losses from cycling against his salaries.
Answer
 
If John can find a sponsor for his cycling, he may be able to rely on the Stone case to argue
that he is a professional cyclist and thus in a position to argue for deductions of his expenses
under s 8-1 ITAA 1997.
 
His losses from his professional cycling business are subject to the non-commercial losses
regime in Division 35 ITAA 1997.If Division 35 applies, John’s cycling losses will be
quarantined and can only be used to offset income from cycling activities, and not his salary.
Exceptions to this quarantine rule include: assessable income from the cycling business in
the income year is at least $20,000; and total value of assets used in the cycling business is
at least $100,000.
These exceptions will not be available to John if his adjusted taxable income is $250,000 or
more.
 
 
Question 23.2
P, a company incorporated in the United States, is in the business of providing online cloud
services. It has a subsidiary in Australia, A, which promotes and liaises with customers in
Australia. It also negotiates the terms of contracts with customers in Australia. The finalised
contracts are entered into between the customers and another subsidiary in Singapore, S.
The two subsidiaries have entered into a service agreement under which A provides the
marketing services as well as after-sale supporting services to S for a service fee calculated
on a cost plus basis. S has entered into similar agreements with P’s subsidiaries in other
Asian countries.
Discuss whether the structure may be subject to Pt IVA, including the arguments that the
group may put forward to support its position.
Answer
 
The three elements to be considered in relation to Part IVA are as follows:
- scheme: the structure under which S books the profits from the arrangements with the
customers while A performs the essential activities to secure the customers and provide
after-sale support services, only charging S a cost-plus amount for those services
- tax benefit: less assessable income earned by A in Australia as the income is instead
booked to S in Singapore
- dominant purpose:
- this is the most difficult factor for the ATO to argue
      - in practice, the ATO admits that it is very difficult to argue for Part IVA in this
kind of complex international structures of multinational enterprises
      - arguments of the group: other commercial justifications for the structure, e.g.
centralised Asian operation in Singapore for efficiency; Singapore provides favourable
business environment as the Asian hub, including multilingual staff, central location in
Asia.
International structures such as these could also raise an argument by the ATO that the
Diverted Profits Tax (DPT) could apply. These rules are within the scope of Ch 22. Outside
of Part IVA, the transfer pricing rules could also operate: see Ch 22.
 
Question 23.3
Since 1960, X Co Ltd has owned and operated a factory which manufactures ammonia for
supply to the fertiliser industry. The factory was built at a cost to the taxpayer of $3 million.
Of that $3 million, $2 million was attributable to the cost of the building and $1 million for the
cost of the plant. The factory and plant, which consists of heavy machinery firmly attached to
the base of the factory, is now worth $15 million. X Co Ltd currently draws down loans on the
short-term money market at 8% interest.
In the previous income year, X Co Ltd was approached by a financier, Y Co Ltd, which
suggested that if X Co Ltd entered into a sale and leaseback agreement in respect of the
land, factory and plant, finance could in effect be obtained at 5%, which would result in
considerable savings. X Co Ltd does not wish to sell the land because it is a pre-CGT asset
and is expected to increase in value in years to come.
Y Co Ltd then proposes that X Co Ltd retains the land and, instead, sells the factory and
plant to Y Co Ltd for $15 million, and Y Co Ltd will lease the factory and plant back to X Co
Ltd for 10 years at $2 million per year. The lease agreement provides that (1) X Co Ltd
acknowledges that the factory and plant are personal property and they vest in Y Co Ltd;
and (2) after 10 years Y Co Ltd will sell the factory and plant at a residual value of $2 million.
The lease explicitly provides that X Co Ltd has no option to purchase the factory and plant at
the end of the lease.
On 1 July, this income year, the sale and leaseback agreement on the above terms was
executed by Xo Co Ltd and Y Co Ltd. X Co Ltd claimed a deduction of $2 million in respect
of the lease payments and Y Co Ltd claimed depreciation of $2 million in respect of the
plant.
Advise X Co Ltd and Y Co Ltd as to the tax implications of the sale and leaseback
agreement.
Answer
The following issues should be covered in the answer:

 The lease in question has been structured to avoid being characterised as a hire
purchase arrangement, as X Co Ltd does not have the option to purchase the factory
and plant, so that Div 240 of ITAA 1997 does not apply. It would instead be treated
as an operating lease. This should allow X Co to deduct the lease payments, the
relevant cases being Eastern Nitrogen and Metal Manufactures.
 The arrangements will also be structured so that Y Co is treated as the ‘holder’ of the
fixtures and therefore can claim the Div 40 capital allowances in relation to them.
 There is also the possible application of Part IVA, including analysis of the concept of
scheme, tax benefit and dominant purpose.
 TR 2006/13 explains the ATO’s position on sale and leaseback transactions,
including the potential application of Part IVA.

Question 23.4

George is an accountant with an income of $300,000 per year and he is looking for a tax-
effective investment in agriculture. He decides to invest in Hardwood Forests Pty Ltd, the
promoter of a scheme for growing trees in northern New South Wales. 49 other investors
have already signed for the scheme. The promoter has a private ruling from the
Commissioner that the non-commercial loss rules will not apply to the investment.
George was supplied with contractual documents that give him the right to be informed of
the progress of the venture and the right to remove the promoter and substitute another by
majority vote of the investors. On 29 June this income year, George writes out a cheque for
$50,000 and hands it to Smith, a director of the promoter, who in turn hands him a cheque
for $200,000 made out to George. George endorses the cheque to Hardwood Forests Pty
Ltd and hands it back to Smith.
The promoter has 50 hectares of land in northern New South Wales and one hectare is
allocated to George, but it is not identified by the end of the income year. The clearing and
planting of the trees commences on 29 June this income year. No returns are expected from
the venture until at least ten years later.
Advise if George can claim a tax deduction of $250,000 in this income year.
Answer
The answer should address the following issues:
 Whether George is regarded as carrying on a business: likely yes: Hance v FCT
(2008) 74 ATR 644.
 Whether the payments are capital in nature: likely no: Hance.
 Division 394 ITAA 1997 which is the statutory regime (effective since 2007)
stipulating the conditions for investors in forestry managed investment schemes to
obtain a deduction for payments made under such schemes, including the general
rule of allowing deduction for initial contributions to the scheme provided they hold
the interest for at least 4 years. Before the enactment of Div 394, a range of pre-
payment rules applied to the deductibility of prepaid expenditure with regard to
agricultural schemes, including ss 82KZL to 82KZO, and 82KZMG ITAA 1936.
The possible application of Part IVA, including the concepts of scheme, tax benefit and
dominant purpose. It should be noted that the Commissioner now in general accepts that
investments in managed investment schemes similar to the one considered in Hance are tax
effective
Tax Avoidance & Tax Administration - Part IVA (5 marks)

Question 23.1
John is a full-time teacher and also a keen cyclist. He spends most of his spare time
practicing and training and spends a lot of money on his bike and gears. He regularly enters
cycling competitions and sometimes wins small amounts of prize money.
Advise what he can do to be in a position to argue for deductions of his expenses incurred
on cycling, and assuming he is regarded as a professional cyclist, whether he can offset his
losses from cycling against his salaries.
Answer
 
If John can find a sponsor for his cycling, he may be able to rely on the Stone case to argue
that he is a professional cyclist and thus in a position to argue for deductions of his expenses
under s 8-1 ITAA 1997.
 
His losses from his professional cycling business are subject to the non-commercial losses
regime in Division 35 ITAA 1997.If Division 35 applies, John’s cycling losses will be
quarantined and can only be used to offset income from cycling activities, and not his salary.
Exceptions to this quarantine rule include: assessable income from the cycling business in
the income year is at least $20,000; and total value of assets used in the cycling business is
at least $100,000.
These exceptions will not be available to John if his adjusted taxable income is $250,000 or
more.
 
 
Question 23.2
P, a company incorporated in the United States, is in the business of providing online cloud
services. It has a subsidiary in Australia, A, which promotes and liaises with customers in
Australia. It also negotiates the terms of contracts with customers in Australia. The finalised
contracts are entered into between the customers and another subsidiary in Singapore, S.
The two subsidiaries have entered into a service agreement under which A provides the
marketing services as well as after-sale supporting services to S for a service fee calculated
on a cost plus basis. S has entered into similar agreements with P’s subsidiaries in other
Asian countries.
Discuss whether the structure may be subject to Pt IVA, including the arguments that the
group may put forward to support its position.
Answer
 
The three elements to be considered in relation to Part IVA are as follows:
- scheme: the structure under which S books the profits from the arrangements with the
customers while A performs the essential activities to secure the customers and provide
after-sale support services, only charging S a cost-plus amount for those services
- tax benefit: less assessable income earned by A in Australia as the income is instead
booked to S in Singapore
- dominant purpose:
- this is the most difficult factor for the ATO to argue
      - in practice, the ATO admits that it is very difficult to argue for Part IVA in this
kind of complex international structures of multinational enterprises
      - arguments of the group: other commercial justifications for the structure, e.g.
centralised Asian operation in Singapore for efficiency; Singapore provides favourable
business environment as the Asian hub, including multilingual staff, central location in
Asia.
International structures such as these could also raise an argument by the ATO that the
Diverted Profits Tax (DPT) could apply. These rules are within the scope of Ch 22. Outside
of Part IVA, the transfer pricing rules could also operate: see Ch 22.
 
Question 23.3
Since 1960, X Co Ltd has owned and operated a factory which manufactures ammonia for
supply to the fertiliser industry. The factory was built at a cost to the taxpayer of $3 million.
Of that $3 million, $2 million was attributable to the cost of the building and $1 million for the
cost of the plant. The factory and plant, which consists of heavy machinery firmly attached to
the base of the factory, is now worth $15 million. X Co Ltd currently draws down loans on the
short-term money market at 8% interest.
In the previous income year, X Co Ltd was approached by a financier, Y Co Ltd, which
suggested that if X Co Ltd entered into a sale and leaseback agreement in respect of the
land, factory and plant, finance could in effect be obtained at 5%, which would result in
considerable savings. X Co Ltd does not wish to sell the land because it is a pre-CGT asset
and is expected to increase in value in years to come.
Y Co Ltd then proposes that X Co Ltd retains the land and, instead, sells the factory and
plant to Y Co Ltd for $15 million, and Y Co Ltd will lease the factory and plant back to X Co
Ltd for 10 years at $2 million per year. The lease agreement provides that (1) X Co Ltd
acknowledges that the factory and plant are personal property and they vest in Y Co Ltd;
and (2) after 10 years Y Co Ltd will sell the factory and plant at a residual value of $2 million.
The lease explicitly provides that X Co Ltd has no option to purchase the factory and plant at
the end of the lease.
On 1 July, this income year, the sale and leaseback agreement on the above terms was
executed by Xo Co Ltd and Y Co Ltd. X Co Ltd claimed a deduction of $2 million in respect
of the lease payments and Y Co Ltd claimed depreciation of $2 million in respect of the
plant.
Advise X Co Ltd and Y Co Ltd as to the tax implications of the sale and leaseback
agreement.
Answer
The following issues should be covered in the answer:

 The lease in question has been structured to avoid being characterised as a hire
purchase arrangement, as X Co Ltd does not have the option to purchase the factory
and plant, so that Div 240 of ITAA 1997 does not apply. It would instead be treated
as an operating lease. This should allow X Co to deduct the lease payments, the
relevant cases being Eastern Nitrogen and Metal Manufactures.
 The arrangements will also be structured so that Y Co is treated as the ‘holder’ of the
fixtures and therefore can claim the Div 40 capital allowances in relation to them.
 There is also the possible application of Part IVA, including analysis of the concept of
scheme, tax benefit and dominant purpose.
 TR 2006/13 explains the ATO’s position on sale and leaseback transactions,
including the potential application of Part IVA.

Question 23.4

George is an accountant with an income of $300,000 per year and he is looking for a tax-
effective investment in agriculture. He decides to invest in Hardwood Forests Pty Ltd, the
promoter of a scheme for growing trees in northern New South Wales. 49 other investors
have already signed for the scheme. The promoter has a private ruling from the
Commissioner that the non-commercial loss rules will not apply to the investment.
George was supplied with contractual documents that give him the right to be informed of
the progress of the venture and the right to remove the promoter and substitute another by
majority vote of the investors. On 29 June this income year, George writes out a cheque for
$50,000 and hands it to Smith, a director of the promoter, who in turn hands him a cheque
for $200,000 made out to George. George endorses the cheque to Hardwood Forests Pty
Ltd and hands it back to Smith.
The promoter has 50 hectares of land in northern New South Wales and one hectare is
allocated to George, but it is not identified by the end of the income year. The clearing and
planting of the trees commences on 29 June this income year. No returns are expected from
the venture until at least ten years later.
Advise if George can claim a tax deduction of $250,000 in this income year.
Answer
The answer should address the following issues:
 Whether George is regarded as carrying on a business: likely yes: Hance v FCT
(2008) 74 ATR 644.
 Whether the payments are capital in nature: likely no: Hance.
 Division 394 ITAA 1997 which is the statutory regime (effective since 2007)
stipulating the conditions for investors in forestry managed investment schemes to
obtain a deduction for payments made under such schemes, including the general
rule of allowing deduction for initial contributions to the scheme provided they hold
the interest for at least 4 years. Before the enactment of Div 394, a range of pre-
payment rules applied to the deductibility of prepaid expenditure with regard to
agricultural schemes, including ss 82KZL to 82KZO, and 82KZMG ITAA 1936.
The possible application of Part IVA, including the concepts of scheme, tax benefit and
dominant purpose. It should be noted that the Commissioner now in general accepts that
investments in managed investment schemes similar to the one considered in Hance are tax
effective