DOMINANT PURPOSE: THE HOLY GRAIL OF TAX ADVISORS
DOMINANT PURPOSE: THE HOLY GRAIL OF TAX ADVISORS
Christopher Bevan
Barrister, Wentworth Chambers, Sydney and Chancery Chambers. Melbourne
Introduction
It is a self-evident aspect of tax practice in the modern era that a transaction must not be entered into for the dominant purpose "of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme" which is the transaction. For to do otherwise will render the entry into the transaction futile in consequence of the Draconian fiscal consequences visited on the head of that taxpayer by a determination by the Commissioner to cancel those tax benefits.
The loss of the tax benefits flowing from a transaction which has been made the subject of a Part IVA determination will follow inevitably in many cases because there will invariably have been an alternative way to proceed with the transaction and no realistic option to preserve the status quo and enter into no transaction at all.
Therefore, having a clear, concise and unequivocal test for determining whether or not a client will have "crossed the Rubicon and marched on Rome" for the purposes of Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA36) is as important to the successful practice of taxation law in a transactional context as clear water, food and sunlight is to mankind.
The statutory criteria for assessing dominant purpose
Section 177D of the ITAA36 is the engine room of Part IVA, the general anti-avoidance rule. Section 177D performs two critical functions. First, it specifies the requisite linkage between the obtaining of a tax benefit on the one hand with the entry into or carrying out of the scheme on the other: see s177D(a). It does so by reference to a broad noun, "connection". It also gives that noun free rein to operate by linking it to the scheme without the constraints of engagement of the noun by the perfect participles which constrain its linkage to dominant purpose in s177D(b), namely, without connecting the tax benefit to the actual entry into, or carrying out of, the scheme.
No more need be said about the first limb of s177D – the tax benefit linkage limb – for present purposes. The purpose of this article is, rather, the philosophical nature of the enquiry into a person's "dominant purpose" for entry into, or carrying out of, a transaction (for every tax scheme is, in substance, just that).
Nor does this article address the identity of the person whose "dominant purpose" is the subject matter of the enquiry undertaken in s177D. The late, great Justice Graham Hill put that issue to rest in CPH Property Pty Ltd v FCT (1998) 98 ATC 4983 at 5000 (column 1, par 1); affirmed on appeal in the Full Federal Court at (1999) 99 ATC 4945 and also in the High Court at (2001) 207 CLR 235; 2001 ATC 4343, at [98].
For the philosophical nature of the enquiry as to a person's dominant purpose, objectively determined, is not assisted by asking whether the person is a taxpayer or an advisor.
Section 177D(b) contains eight criteria by reference to which the objective determination of dominant purpose must be assessed.
Those eight criteria are well known to all readers. They involve a common sense encapsulation of all those factors which inform a person's reasoning for entering into a legal transaction.
Manner of acting, form and substance of the transaction, timing of its implementation in the year of income, its fiscal result, the changes in financial position of its taxpayer participants, or of its other participants, other relevant consequences and the nature of the relationship between its participants would seem to cover the field on factors to be relied on to make an objective assessment of a person's purpose for entering into a transaction which creates tax benefits.
In FCT v Hart (2004) 217 CLR 216 (Hart) at [14]-[18] (Gleeson CJ and McHugh J); [57]-[71] (Gummow and Hayne JJ); and 256-257 (Callinan J), the High Court put beyond doubt the objective nature of the enquiry enunciated in FCT v Spotless Services Ltd (1996) 186 CLR 404 (Spotless Services) at 416 and 423.
A recent complication in the dominant purpose enquiry
In FCT v Ashwick (Qld) No 127 Pty Ltd & Ors 2011 ATC 20-255 ([2011] FCAFC 49) (Ashwick), one of the very few recent successes by a taxpayer in a Part IVA tax appeal, Edmonds J, delivering the leading judgment in the Full Court (Bennett J agreeing at [1] and Middleton J agreeing at [208]) pointed out either in obiter dicta or per in curiam an aspect of the dominant purpose test that appears to have gone unnoticed since it was first enunciated a decade ago.
In Ashwick, in the course of reviewing the treatment of Ryan J at first instance of the dominant purpose of the scheme the subject of that appeal to the Full Court (the restructure of the Fosters Brewing Group), the Full Court drew attention (at [162]-[163]) to the apparent criticism (according to the Full Court, anyway) made by Gummow and Hayne JJ in their joint judgment in Hart (at [63]-[66]) of the enunciation of the nature of the enquiry into dominant purpose called for in s177D(b) by Hill J in the Full Court in Hart: see (2002) 121 FCR 206; 2002 ATC 4608.
In Hart in the Full Court, Hill J spoke of "the dominant purpose of a scheme" (at [73]) (emphasis added). On appeal to the High Court, Gummow and Hayne JJ said (at [63]), after extracting the relevant part of Hill J's judgment in the Full Court, that:
"Several points must be made about this reasoning. First, if some distinction was intended to be drawn between identifying the dominant purpose of a relevant person and the dominant purpose of the scheme, the latter enquiry is not required by s177D and is irrelevant. Section 177D requires consideration of the purposes to be attributed to relevant persons who entered into or carried out the scheme". [Original emphasis]
In Hart v FCT (2004) 217 CLR 216 at [66] Gummow and Hayne JJ said:
“In the present matters, the respondents would obtain a tax benefit if, in the terms of s. 177C(1)(b), had the scheme not been entered into or carried out, the deductions ‘might reasonably be expected not to have been allowable’. When that is read with s. 177D(b) it becomes apparent that the enquiry directed by Part IVA requires comparison between the scheme in question and the alternative postulate. To draw a conclusion about purpose from the eight matters identified in s. 177D(b) will require consideration of what other possibilities existed. To say, as Hill J did, that ‘the manner in which the scheme was formulated and thus entered into or carried out is certainly explicable only by the taxation consequences’ assumes that there were other ways in which the borrowing of moneys for two purposes (one private and the other income producing) might have been effected. And it further assumes that those other ways of borrowing would have had less advantageous taxation consequences.”
In Ashwick, after noting this criticism of Hill J in Hart, the Full Court said (at [163]) that:
"Accepting for present purposes the correctness of what Gummow and Hayne JJ said in Hart at [66] extracted in [162] above, it is difficult to discern its legislative foundation. It [the statement of Gummow and Hayne JJ in Hart at [66]) certainly does not appear as one of the matters enumerated in s177D(b) and, as their Honours [Gummow and Hayne JJ] said (at [47]) in Hart [citing the High Court decision in Peabody at 384):
'There is no basis to be found in the words in Pt IVA for the introduction of some criterion additional to those identified in the Act itself'."
The question which this observation by the Full Federal Court raises is as follows:
Is there a statutory basis for the proposition of Gummow and Hayne JJ in Hart at [66] which requires the conclusion on dominant purpose in s. 177D(b) to be founded on a consideration of what other possibilities existed?”
This question can be restated in terms of the Full Federal Court’s extension of the opinion of Gummow and Hayne JJ in Hart at [6] made in British American Tobacco Services Limited v FCT (2010) 189 FCR 151 at [53] (British American Tobacco) (as noted by the Full Court in Ashwick at [162]) where the Full Federal Court said that dominant purpose enquiry in s. 177D(b) “usually require(s) … assessing the dominant purpose of a scheme [to undertake a] … comparison between the scheme carried out and the counterfactual …” and not merely “other possibilities”.
The restated question then becomes:
Is there a statutory basis for the proposition of the Full Federal Court in British American Tobacco at [53] which requires the conclusion on dominant purpose in s. 177D(b) to be founded on a comparison between the scheme carried out and the counterfactual?
Hereafter this question (in either formulation) will be referred to as "the Ashwick question".
In British American Tobacco the Full Federal Court went from a discussion about “other possibilities” and attributing reliance on them to the High Court in Hart whereas in Hart the matter was approached in a reverse fashion, with the “alternative postulate” being considered first and “other possibilities” second. Considered in the limited context of the identification of the tax benefit, there appears to be no significance in the order in which these two factors are treated with. But the Ashwick question raises an issue as to whether there is any significance in the order in which these two factors are treated with for the purposes of s. 177D(b) and the linkage between the obtaining of the tax benefit in connection with the scheme on the one hand and the dominant purpose of the parties for their entry into the scheme on the other.
Ascertaining a person's dominant purpose – a philosophical conundrum
The Ashwick question goes to the heart of not only the statutory enquiry prescribed by s177D(b) but also to a deeper philosophical question, namely: How does one make an objective determination of another person's motivation for doing something?
Ordinarily only a subjective determination gives a reliable result in an enquiry about a person's motivation for performing an act. But in the field of taxation, self interest self-evidently precludes such an approach.
Although "[t]axes are what we pay for civilised society": see Compagnia de Tabacos v Collector of Internal Revenue (1927) 275 US 87 at 100, cited in Spotless Services 186 CLR, 416 footnote 34, "the tax laws exist as an economic reality in the businessman's world, much like the existence of a competitor. Businessmen plan their affairs around both, and a tax dollar is just as real as one derived from any other source": see Commissioner of Inland Revenue v Brown (1965) 380 US 563 at 579-580, cited in Spotless Services at 186 CLR 415-416.
That is to say, income tax is a cost of doing business like any other cost. Sworn evidence by businessmen and other classes of taxpayers to the effect that they placed little or no weight on the inevitable taxation consequences of their transaction when deciding whether to enter into or carry out the transaction is, in all probability, an irrelevancy, and if not, then it must necessarily be given little probative weight in the grand scheme of things. Self-interest strips the evidence of most of its probative weight: see CC (NSW) Pty Ltd (In liq) v FCT (1997) 34 ATR 604 at 629, where Sackville J at first instance found that "the [proposition that the] actual motivation of the persons involved in any 'scheme' is relevant to the question posed by s177D(b) of the ITAA ... does not appear to be justified" because the test calls for a "conclusion of a reasonable person", citing Hill J in Peabody v FCT (1993) 40 FCR 531; 25 ATR 32 at FCR 542, ATR 41 as authority.
How, then, does one decide what the "casual bystander" would conclude another person's motivation for doing an act to be? In the case of s177D(b), one considers the eight criteria it specifies. This inescapable statutory conclusion brings us back to the Ashwick question.
Was a further criterion for ascertaining dominant purpose enunciated in Hart?
As an intermediate step in answering the Ashwick question, the better interpretation of what Hill J meant in Hart at [73] is that he was referring to all those persons who entered into or carried out the scheme when he used the shorthand term "scheme" to encapsulate the entire class of persons whose objective motivation is the quest that s177D(b) requires a Court to undertake.
In Hart it is tolerably clear that Gummow and Hayne JJ were not purporting to attribute such a meaning to Hill J's statement of the difficult task called for in s177D(b). Their Honours in the High Court prefaced their remarks at [63] in Hart with the proviso:
"...if some distinction was intended to be drawn between ... a relevant person and ... the scheme ..." (Emphasis added]
Taken in its proper context, the purported criticism of Hill J should more fairly be interpreted as being, in truth, no more than an admonition not to read Hill J's statement of the task called for in s177D(b) as a task focussing on an objective determination of an inanimate concept (namely, the scheme) and instead focus on the motivation of the people who created and implemented it.
To do otherwise not only involves an egregious departure from the text of s177D(b); it also involves a question as fruitless as that for the Holy Grail. No amount of effort will ever produce a sensible conclusion about the motivation of the subject matter of the dominant purpose quest, namely, the scheme (transaction) itself.
The same observation can be made about the Full Federal Court’s reference in British American Tobacco in [53] (referred to above) to “assessing the dominant purpose of a scheme”.
This then brings one back to the Ashwick question and the reasoning for its affirmative answer.
An affirmative answer is called for to the Ashwick question
The Ashwick question (in either formulation as postulated above) should be answered: “Yes, there is a statutory basis for the requirement for a comparison between the scheme as carried out and the counterfactual in assessing the dominant purpose of those who entered into or carried out the scheme”, for the reasons which follow.
Section 177C(1) defines not merely the concept of a “tax benefit”, but more accurately, it defines the act of “obtaining a tax benefit in connection with a scheme”.
That is to say, s. 177C(1) defines both the act of benefiting in a fiscal sense and also the relationship – the “connection” – of that benefit to the amorphous concept of “a scheme”. The scheme, of course, is whatever the Commissioner says it is in his formulation of its terms and participants, subject to the Court upholding that formulation as having a logical foundation.
The counterfactual has its genesis – indeed it is its only statutory source – in s. 177C(1). The Full Federal Court observed in Ashwick at [163] that there is no “legislative foundation” for the counterfactual’s role in the terms of s. 177D(b). If it has a “legislative foundation” – and the Full Court in Ashwick is keeping an open mind on the question (“it is difficult to discern its legislative foundation”) – then it must be elsewhere in Part IVA.
In all four limbs of s. 177C(1), defining the four categories of tax benefits and their accrual to taxpayers in connection with a scheme, the accrual of the tax benefit (the “obtaining” of it) must be tested against the counterfactual – what the scheme participants would have done had they not entered into or carried out the scheme.
This requires in a practical sense the Commissioner to identify a counterfactual which a Court would uphold on appeal on the balance of probabilities in order to sheet home the accrual of the identified tax benefit he has identified and its connection with the scheme he has formulated. I This requirement is one which exists in a purely procedural sense but not an evidentiary sense, as the Commissioner bears no onus of proof in a tax appeal: see sections 14ZZK(b) and 14ZZO(b) of the Taxation Administration Act, 1953 (Cth).
When one comes to the purpose test in s. 177D, one must be able to conclude that s. 177D, once engaged on the facts, operates by reference to, and in reliance on, the concurrent engagement of s. 177C(1), or else the proposition that there is a legislative foundation for the affirmative answer to the Ashwick question cannot be made good.
The statutory function of s. 177D(b) is to attribute a purpose (a dominant purpose by virtue of s. 177A(5)) to a person who entered into or carried out a scheme. It is an objective test: “it would be concluded” (see s. 177D(b) and Peabody v FCT (1994) 181 CLR 39 at 382)).
Section 177D has two limbs. The first limb, paragraph (a), establishes the accrual (“obtaining”) of a tax benefit and its statutory relationship (“connection”) to the relevant scheme. It can be termed “the fact of obtaining limb” for present purposes.
The second limb is paragraph (b). It attributes a dominant purpose of obtaining a tax benefit to a person who satisfies the first limb by reference to the eight specified criteria. It can be termed “the purpose of obtaining limb” for present purposes.
The lowest common denominator of the two limbs is the “obtaining of a tax benefit” integer. It is an aspect of both limbs. That lowest common denominator necessarily takes the operation of s. 177D(b) back into s. 177C(1) (which defines the circumstances for the obtaining of the nominated tax benefit). That is, as a matter of statutory interpretation, the former provision informs the operation of the latter as an essential ingredient or step in the latter’s operation.
Section 177D(b) prescribes eight criteria for assessing whether a person entered into or carried out a scheme for the dominant purpose of enabling the taxpayer to obtain the nominated tax benefit. That necessarily takes one back into a consideration of the counterfactual because s. 177C(1) operates as a step or ingredient in the operation of s. 177D(b) and s. 177C(1) employs the counterfactual as an essential ingredient in its own operation is determining the necessary connection between the accrual of the tax benefit (the “obtaining” of it) and that accrual occurring with the necessary relationship (“in connection with”) the nominated scheme.
Accordingly, the Ashwick question can be answered in the affirmative.
There is, on close analysis, a legislative foundation for the reliance on the counterfactual in the operation of s 177D(b) (which Gummow and Hayne JJ enunciated in Hart at [66] and the Full Federal Court enunciated in British American Tobacco at [53]). That legislative foundation is the concurrent operation of s. 177C(1) with s. 177D(b), once the latter is engaged on the facts.
Conclusion – the way forward in applying the dominant purpose test
By way of conclusion, it is submitted that taxpayers and their advisors must approach the application of Part IVA to the facts of transactions, at the stage of formulating them, or where they are already implemented, at the later stage of formulating grounds of objection or appeal to an assessment made to give effect to a s177F determination to cancel the tax benefits obtained from their implementation, with a handful of fundamental considerations in the forefront of their collective minds.
First, focus on the eight specified criteria in s177D(b) as a reasonable bystander. This is best left to advisors not involved in the formulation and implantation of the transaction (scheme). Those involved with the transaction’s formulation and implementation are far too close to it to make any subsequent objective assessment of the dominant purpose of those who entered into or carried it out. Besides, they are within the permissible class of persons whose dominant purpose is relevant for the test specified in s177D(b), so they are disqualified on two counts.
Secondly, apply the criteria to each and every person named by the Commissioner as a party to every version of the scheme formulated in his s177F determination (including the subsequent particulars he provides of it at the appeal stage).
Thirdly, forsake any resort to a concept of the purposes of "the scheme" in the abstract and stay on target, which is the named persons who enter into or carry out the scheme. A taxpayer and its directors, trustees and agents enter into a scheme. A taxpayer's professional advisors carry it out with or without those who enter into it. Since Consolidated Press a decade ago the class of persons whose objective purpose is engaged by the enquiry in s177D(b) is very wide.
But its width is also a two-edged sword for the Commissioner. The more people he names as parties to the scheme, the greater the risks of catching in his net people who lack the requisite purpose or whose purpose lacks the requisite quality of dominance will be decisive in the final exercise of weighing up the evidence.
The Commissioner found to his great detriment in Ashwick that the wider a scheme is cast, the greater the body of evidence that is admissible against him to prove that, on the balance of probabilities, the transaction or transactions constituting the scheme were implemented for good, self-evident commercial reasons, such that their undisputed tax benefits can be readily seen to be incidental to their implementation.
Fourthly, appreciate that s177D(b) is an exercise in fine balancing. It is like weighing gold dust. The outcome of many cases turns on that unpredictable quality: human nature. What one judge may find to be five factors against a tax avoidance purpose and three in its favour may be found vice versa from another. The same goes for the outcome in intermediate appellate courts.
One only needs to analyse successful appeals to the High Court against unanimous Full Federal Court decisions in tax appeals involving Part IVA in its 30 year history (noting that those Full Courts were in most cases constituted by specialist Tax Panel judges) to appreciate just how finely balanced these scales are. A puff of wind or a change in humidity can alter the weight of the gold dust at any given moment in time (and, more often than not, to the taxpayer's great detriment, for it bears a heavy burden of proof, and that is often the decisive factor, which the Commissioner of Taxation regularly reminds the Courts of, wearing his ‘model litigant’ mantle).
Part IVA will always be a source of unpredictability because its heart and mind is human motivation: 'dominant purpose". No amount of hard work, attention to detail or indeed good luck can assure a satisfactory outcome to the quest for it (whether at the transaction or appeal stage).
The objective quality of the dominant purpose test on s. 177D assures all who embark on the quest of an uncertain outcome, for who can predict what a reasonable bystander will make of a complex commercial transaction or series of related transactions?
What may seem a clear mind and strong heart at the outset will, in time, be seen as an Achilles heel. Just consider all of the Part IVA appeals heard by the Full Federal Court in 2010 and the first half of 2011. Ashwick stands out as a beacon for safe navigation in those dangerous shoals.