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                         The Taxpayer
14 February 2011                            www.taxpayer.com.au                        Issue 15 • 2010/2011




                   Demolition, subdivision and
                   the main residence exemption
                   By Andy Nguyen and Roger Timms
                   The main residence exemption contained in Subdivision 118-B of the Income
                   Tax Assessment Act 1997 (ITAA97) allows individuals who meet the legislative
                   requirements to disregard a capital gain or loss arising from the disposal of their
                   family home. However, the ability to fully access the exemption may be lost
                   where an existing main residence is demolished, the land subdivided and units
                   constructed on the site. This article examines taxation implications on the main
                   residence exemption where these events occur.
                   Note: All legislative references relate to the ITAA97 unless otherwise specified.



                   Demolition and                                  •    Scenario 2: Subdivide the
                                                                       land, build a home unit on the
                   subdivision scenarios                               previously vacant land and sell the
                      The scenarios considered in this article         unit (with the original residence
                   involve a dwelling which has been                   staying intact)
                   lived in by an individual taxpayer(s) as        •   Scenario 3: Subdivide the land
                   their main residence and the following              and sell the non-main residence
                   choices are made:                                   block (with original dwelling
                    •   Scenario 1: Demolish the                       staying intact)
                        dwelling, subdivide the land, build         When dealing with these situations,
                        two home units, sell one and live         taxpayers should consider the following
                        in the other                              pertinent tax questions:

                                                                                         Continued – page 226
                    inside…




                               Editorial: Flood levy: Policy on the run?
                               Taxing royalties
                               Service entity arrangements – Where are we now?




                                                                                            pages 225-240
Demolition, subdivision and the main residence exemption (continued from page 225)

  •     Whether demolition of the original main
        residence would trigger a CGT event and if so,

  •
        what is the capital gain or loss (if any)?
        What are the CGT implications of subdividing
                                                                                                       The Taxpayer contents
        the property?
                                                                                                       Demolition, subdivision and the
  •     Would the sale of the home unit or vacant
                                                                                                       main residence exemption. . . . . . . . . . . . . . . . 225
        land constitute a sale on capital or revenue
        account? This leads to the question of whether                                                 Editorial: Flood levy: Policy on the run? . . . 227
        the land is the subject of a ‘mere realisation’                                                Taxing royalties . . . . . . . . . . . . . . . . . . . . . . . . . . 233
        or whether there is a profit-making activity
        conducted.                                                                                     Service entity arrangements –
                                                                                                       Where are we now? . . . . . . . . . . . . . . . . . . . . . . 238
  •     How would the original dwelling/unit retained
        and lived in by the taxpayer be treated for CGT
        purposes?
                                                                                                   •       a unit of accommodation that is a caravan,
      Table 1 below summarises the outcomes.
                                                                                                           houseboat or other mobile home, and
Note: This article does not deal with the GST
                                                                                                   •       any land immediately under the of unit
implications associated with the sale of home
                                                                                                           accommodation.
units or land under these scenarios; however, it
does indirectly refer to whether the taxpayer is                                                   It is worth noting that the maximum land area
conducting an ‘enterprise’ for GST purposes.                                                     which is covered by the exemption is two hectares.
                                                                                                 An apportionment of any capital gain is required
Recap: main residence exemption                                                                  where the land area upon which a main residence is
                                                                                                 located exceeds this limit (s118-120(2)).
   By way of background, to qualify for the exemption,
the following relevant conditions contained in s118-
                                                                                                 Analysis of scenarios
110 must be satisfied:
  • the taxpayer must be an individual                                                           Scenario 1: Demolish dwelling, subdivide
  • the ‘dwelling’ must be the taxpayer’s ‘main                                                  land, build two units, sell one unit and
      residence’ throughout the ‘ownership period’.                                              retain other unit as main residence
      This is normally the period that the taxpayer
                                                                                                       The following example illustrates this scenario:
      has a legal or equitable interest in the dwelling
      (s118-125 and s118-130(1)(a)), and                                                           •       Jim acquired a dwelling in May 2006 and
                                                                                                           resided in the dwelling as his main residence.
  • certain CGT events must apply – this includes
      CGT event A1 – disposal of a CGT asset and                                                   •       The land is less than two hectares.
      CGT event C1 – loss or destruction of a CGT                                                  •       Due to the poor state of the dwelling, it was
      asset (s118-110(2)(a)).                                                                              demolished in June 2010. No consideration
      ‘Dwelling’ is defined under s118-115 to include:                                                     was received as a result of the demolition.
  •      a unit of accommodation that is a building or                                             •       The land was subdivided into two blocks and
         is contained in a building (eg. an apartment)                                                     Jim then commenced to build a unit on each
         and consists wholly or mainly of residential                                                      block. Jim continued to be the owner of both
         accommodation                                                                                     blocks.
                                                                                                                                                         Continued – page 228
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226 | The Taxpayer | 14 February 2011
                                                                                                               editorial
Flood levy: Policy on the run?
                       The aftermath of the                                     the levy approach include:
                    Queensland and Victorian                                     •   is there any real imperative to return the
                    floods have exercised the minds                                  budget to surplus by the 2012-13 year, which
                    of the community in general,                                     has been a constant message delivered
                    and politicians in particular,                                   widely by the government
                    over recent weeks. With unusual
                                                                                 •   could government expenditure be redirected
                    speed Prime Minister Julia
                                                                                     from other areas of the budget to the flood
                    Gillard has announced that a
                                                                                     reconstruction effort without significant
flood levy will be imposed on taxable incomes of
                                                                                     adverse consequences, and
individual taxpayers for the 2011-12 year (if not
longer). The levy rates announced are:                                           •   the impact of imposing a further tax (albeit
                                                                                     under a different name) on the sector which is
     Taxable income                                                  Levy
                                                                                     most likely to engage in the spending which
     $50,001 to $100,000 . . . . . . . . . . . . . . . . . . . .0.5%                 is needed to drive the economy generally.
     $100,001 + . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1.0%     If questions of this type have not been addressed
  Businesses will not be required to pay the levy but                           by the government in depth, and that fact made
will be required to adjust payroll withholding levels                           generally known, the levy may face a rocky path in
to include the levy. All dependent, of course, on the                           the parliament.
levy passing the Federal Parliament!                                               If the levy is successfully legislated, a further
   Much public comment has occurred regarding                                   challenge faces the government. Taxpayers who are
the appropriateness of the levy in the economic                                 required to pay the levy may obtain some comfort
circumstances we presently face as a nation. Many                               if it is clear that the funds raised have in fact been
commentators (and non-government politicians)                                   directed to the reconstruction of flood-affected
have strongly opposed the additional impost                                     communities.
notwithstanding the Prime Minister’s view that,                                   To achieve this outcome separate accounting
for most affected taxpayers, the cost will be the                               for amounts collected and expended would be
equivalent of a weekly cup of coffee.                                           necessary. If the revenue merely drops into general
  Putting hyperbole to one side, the simple                                     revenue in the budget (as is the case with the
question remains – is the imposing of a levy a                                  Medicare levy) it will be very likely perceived by the
sound idea?                                                                     majority of taxpayers as merely additional tax and
  That would seem to be a question for learned                                  therefore unpopular. That would, presumably, have
economists rather than humble tax practitioners.                                electoral consequences. n
However, the levy has been announced prior to
                                                                                Roger Timms - Head of Tax & Superannuation
there being a clear understanding of:
 •       the true cost of reconstruction, and
 •       the impact of the floods on tax revenues
         given that preliminary estimates of lost
         export revenue for the mining and agriculture
         industries alone is in the range of $3-$5
         billion.
  Further questions which could usefully exercise
the minds of economists considering the merits of


                                                                                                       14 February 2011 | The Taxpayer | 227
Demolition, subdivision and the main residence exemption (continued from page 226)

 •    Upon completion in January 2011, Jim moved           Subdivision of land
      into one of the units as his main residence            The subdivision of land results in each new block
      (as soon as practicable after completion) in         registering a separate title.
      January 2011.
                                                              For CGT purposes, the splitting of a CGT asset by
 •    The unoccupied unit was sold in February             way of subdividing land in itself would not trigger
      2011.                                                a CGT event provided the taxpayer continues to be
 •    Jim lived in rental accommodation from June          the beneficial owner of the assets (s112-25(1)(a) and
      2010 until January 2011.                             (2)). However, the subdivision does create two new
  Under this scenario, the tax implications which          separate CGT assets.
relate to the demolition, subdivision and sale of the        A further consequence of subdividing the land into
unit are as follows:                                       two blocks is that the cost base of the land is required
                                                           to be apportioned to each new block in a ‘reasonable
Demolition of the dwelling                                 way’ (s112-25(3)). The Commissioner of Taxation
   When the dwelling is demolished, CGT event C1           accepts the use of a land area or a market valuation
is triggered at the time that the destruction occurs       basis to achieve this objective (refer TD 97/3).
(s104-20). A capital gain (loss) would arise where
the capital proceeds received from the demolition
                                                           Sale of the non-main residence unit
exceed (is less than) the cost base attributable to the    Capital or revenue account?
dwelling.                                                    In disposing of the non-main residence unit, a
  In this case, the demolition of the dwelling would       question arises as to whether Jim’s intention to
not give rise to any capital gain or loss (refer ATO       subdivide the land and to build the units:
ID 2002/633). This outcome is due to the manner in          •   was by way of enhancing the land in order to
which the proceeds and cost base of the dwelling is             maximise the sale price as a ‘mere realisation’
determined.                                                     of the asset and therefore, taxed on capital
  Specifically, s112-30 requires that the cost base of          account, or
the property be apportioned between the dwelling            •   whether the sale was undertaken by him as an
and land to the extent that a CGT event happens to              isolated transaction with a view to profit or as
some part of the property (in this case the dwelling)           part of a property development business, and
but not to the remainder of it (s112-30(2)).                    therefore, on revenue account.
  A formula is prescribed under s112-30(3) which              Whether the building of the unit and its subsequent
requires the cost base of the property to be allocated     sale is a mere realisation or a profit derived from an
to the dwelling to the extent that capital proceeds        isolated transaction is not alway clear. It is a question
are received from the demolition.                          of fact and requires consideration of all the necessary
   As no proceeds are received from the demolition         factors. Taxation Ruling TR 92/3 outlines the factors
by Jim, no amount would be attributed to the cost          which taxpayers should consider in determining
base of the dwelling. Instead, the cost base of the        whether there is a profit from an isolated transaction.
property would be allocated entirely to the land             Further, in MT 2006/1, the Commissioner outlines
(s112-30(4)).                                              certain situations whereby a subdivision of land
  It follows that if no proceeds are received (noting      and building of units constitutes an ‘enterprise’ and
that a market value substitution rule does not             necessitates the application for an ABN for GST
apply to CGT event C1 pursuant to s116-25) and no          purposes.
amount is attributed to the cost base of the dwelling,       Various comments in MT 2006/1 indicate that the
there would be no capital gain or loss to Jim upon         Commissioner believes the factors which indicate the
demolition.                                                existence or otherwise of an enterprise will also be
   In effect, any potential capital gain on the property   relevant in determining whether or not a disposal of
is essentially deferred until the land (including any      land will constitute a ‘mere realisation’. For example,
dwellings subsequently built) is sold at a later date.     the ruling states that:


228 | The Taxpayer | 14 February 2011
The term ‘profit making undertaking or scheme’                   •       water meters, telephone and electricity to be
like the term ‘an adventure or concern in the nature                     supplied to the new houses, and
of trade’ concerns transactions of a commercial                  •       a real estate agent to market and sell the
nature which are entered into for profit-making                          houses.
but are not part of the activities of an on-going
business. Both terms require the features of a                   Prakash and Indira carry out their plan and make
business deal . . .                                              a profit. They are entitled to an ABN in respect of
                                                                 the subdivision on the basis that their activities go
Examples 29 and 31 in the ruling are relevant:
                                                                 beyond the minimal activities needed to sell the
  Example 29 (para. 273-276)                                     subdivided land. The activities are an enterprise as
  Tobias finds an ocean front block of land for sale in a        a number of activities have been undertaken which
  popular beachside town. He devises a plan to enable            involved the demolition of their house, subdivision
  him to afford to live there. He decides to purchase            of the land and the building of new houses.
  the land and to build a duplex. He plans to sell one
                                                              Examples 29 and 31 indicate that where land
  of the units and retain and live in the other. The
                                                            has been enhanced by way of subdividing and
  object of his plan is to enable him to obtain private
                                                            construction of a unit, with intention of resale, the
  residential premises in an area that would otherwise
                                                            gain from disposal of the unit will typically be on
  be unaffordable for him.
                                                            revenue account.
  Tobias carries out his plan. He purchases the land,
                                                              If so, the revenue gain on disposal of the unit may
  and lodges the necessary development application
                                                            be calculated by:
  with the local council. The development application
  is approved by the council, Tobias engages a builder       •       recognising the receipts and payments in
  and has the duplex built. He sells one unit, and lives             relation to the acquisition and disposal of unit
  in the other.                                                      for each income year, or
  Tobias is entitled to an ABN. His intentions and           •       recognised on a ‘profit emerging basis’ (where
  activities have the appearance of a business deal.                 the activity extends across two or more income
  They are an enterprise.                                            years).
  Further, there is a reasonable expectation of profit         As any assessable gain is on revenue account, the
  or gain (see paragraphs 378 to 405 of this Ruling) as     application of the main residence exemption and the
  his plan has enabled him to be able to keep and live      ability to access the CGT 50% general discount is not
  in one of the units.                                      a consideration.

  Example 31 (para. 284-287)                                Treatment of main residence unit
  Prakash and Indira have lived in the same house on
                                                              Unlike the non-main residence unit, the main
  a large block of land for a number of years. They
                                                            residence unit continues to be held on capital
  decide that they would like to move from the area
                                                            account and subject to the CGT provisions.
  and develop a plan to maximise the sale proceeds
  from their land.                                            Notwithstanding that the original dwelling has
                                                            been demolished, Jim can still extend the main
  They consider their best course of action is to
                                                            residence exemption to the newly built unit provided
  demolish their house, subdivide their land into two
                                                            that certain conditions are met.
  blocks and to build a new house on each block.
                                                              More specifically, he can choose under s118-150
  Prakash and Indira lodge the necessary development
  application with the local council and receive            to treat the vacant land as his main residence for a
  approval for their plan. They arrange for:                maximum period of four years from the time that he
                                                            ceases to occupy the demolished dwelling until the
  •    their house to be demolished
                                                            replacement unit becomes his main residence (‘the
  •    the land to be subdivided                            four year rule’).
  •    a builder to be engaged                                It is possible for the choice under s118-150 to
  •    two houses to be built                               provide an unbroken period of occupancy from the


                                                                                        14 February 2011 | The Taxpayer | 229
Demolition, subdivision and the main residence exemption (continued)

time that the demolished dwelling was acquired until            •   As their adult children have left home and,
the replacement dwelling ceases to be the Jim’s main                requiring cash to fund their retirement, Mary
residence (refer ATO ID 2003/232).                                  and John have intentions of downsizing their
  If Jim sells the main residence unit at a later date,             living arrangements.
some of the factors that he would need to keep in               •   In December 2010, they removed the
mind with respect to ‘the four year rule’ (s118-150)                swimming pool and subdivided the land into
are as follows:                                                     two blocks (retaining their existing home).
 •        The choice can only be made provided that:            •   They built a unit on the vacant block which
           -- Jim-moves-into-the-constructed-dwelling-as-           was completed in June 2011 and sold the unit
              soon-as-practicable-once-the-work-is-finished-        in July 2011.
              (a-requirement-which-may-result-in-the-four-       Under this scenario, the tax implications associated
              year-maximum-period-being-reduced),-and          with the subdivision, and construction and sale is as
           -- it-continues-to-be-his-main-residence-for-at-    follows:
              least-three-months.                              Subdivision of land
           Note: TD 92/147 provides guidance on the
                                                                 As noted above, the subdivision of land does
           meaning of ‘as soon as practicable’.
                                                               not trigger a CGT event provided that Mary and
 •        Jim can treat the vacant land as his main            John continue to be the beneficial owners of the
          residence for a maximum period of four               subdivided blocks.
          years from the time he ceases to occupy the
                                                                  The cost base of the property would need to be
          demolished dwelling until the move into the
                                                               allocated to each block of land on a reasonable basis
          replacement dwelling as his main residence
                                                               (s112-25(3)).
          (subject to the ‘as soon as practicable’ rule). In
          this case, the period is less than four years (ie.   Sale of non-main residence unit
          June 2010 to January 2011). Had the period
                                                               Capital or revenue account?
          exceeded four years, a partial main residence
                                                                 Similar to Scenario 1, Mary and John would need
          exemption will apply.
                                                               to consider whether their undertaking is on capital
 •        During this period, once a choice is made, Jim
                                                               or revenue account (ie. mere realisation versus profit-
          cannot treat any other dwelling as his main
                                                               making venture). Again, this is a question of fact to be
          residence.
                                                               considered on a case by case basis.
  At this point, Jim satisfies the relevant conditions           However, taking into account the factors described
such that a choice can be made under s118-150                  under Scenario 1, and drawing on Examples 29 and
to extend the main residence exemption from the                31 contained in MT 2006/1, it should follow that the
original dwelling to the new unit.                             sale of the home unit would be on revenue account.
Note: The choice would be reflected in the way that              Where a gain is assessed on revenue account,
the tax return for the income year in which the CGT            neither the main residence exemption nor the CGT
event occurred is prepared (s102-30).                          general discount applies.
                                                                 Even if the gain was on capital account, the fact
Scenario 2: Subdivide land, build a home                       that the unit was constructed on land which was
unit on the previously vacant land and sell                    originally subject to the main residence exemption
the unit (original residence stays intact)                     (as part of the two hectare area upon which Mary and
     The following example illustrates this scenario:          John’s residence was situated) provides no basis to
 •        Mary and John acquired a dwelling in April           argue that some part of the gain on disposal should
          1990 which was their main residence.                 be free of tax pursuant to that exemption.

 •        The home had a swimming pool on land                 Treatment of main residence dwelling
          adjacent to the dwelling.                              Unlike the non-main residence unit, the main
 •        The land is less than two hectares.                  residence continues to be held on capital account


230   |   The Taxpayer | 14 February 2011
and subject to the CGT provisions, including the main                       Sale of vacant block
residence exemption. The subdivision of the land has
                                                                            Capital or revenue account?
no effect in this regard.
                                                                             Consideration should be given by Bob as to
  The cost base of the block containing the original
                                                                            whether the sale is on capital or revenue account (ie.
dwelling would be reduced following allocation of
                                                                            mere realisation versus profit-making undertaking).
cost base between the two blocks pursuant to s112-
25(3).                                                                        In Example 33 (para. 291-293) contained in MT
                                                                            2006/1, the Commissioner indicates that situations
Scenario 3: Subdivision of land with main                                   similar to Bob would not necessarily result in an
residence and dispose vacant block                                          ‘enterprise’ for GST purposes.
     The following example illustrates this scenario:                           Example 33 (MT 2006/1)
 •       Bob acquired a dwelling in August 1990 for                             Ursula and Gerald live on a 2.5 hectare lot that they
         $400,000 which was his main residence.                                 have owned for 30 years.
 •       The land is less than two hectares.                                    They decide to sell part of the land and apply to
 •       In September 2006, the property was                                    subdivide the land into two 1.25 hectare lots. The
         subdivided into two blocks with one block                              survey and subdivision are approved. They retain
         containing the dwelling (front block) and the                          the subdivided lot containing their house and the
         other block being vacant (rear block). Bob                             other is sold.
         continued to be the owner of both blocks.
                                                                                Ursula and Gerald are not carrying on an enterprise
 •       The legal costs for the subdivision were                               and are not entitled to an ABN in respect of the
         $10,000.                                                               subdivision as the subdivision and sale are a way of
 •       At the time of subdivision, Bob’s real estate                          disposing of some of the land on which their home
         agent advised that the value of front block and                        is situated. It is the mere realisation of a capital asset.
         rear block be split 50/50.
                                                                              For income tax purposes, it follows that the
 •       The rear block was sold in December 2008 for                       Commissioner would likely consider that Bob has
         $400,000.                                                          disposed of the land by way of ‘mere realisation’ as
  Under this scenario, the tax implications associated                      opposed to realising a gain from a profit-making
with the subdivision and sale of vacant land are as                         undertaking.
follows:                                                                       Accordingly, the sale of the vacant block would be
                                                                            on capital account and subject to the CGT provisions
Subdivision of land
                                                                            (ie. CGT event A1). The CGT general discount is also
   As noted above, the subdivision of land does not
                                                                            available if the asset is owned for at least 12 months.
trigger a CGT event provided Bob continues to be the
beneficial owner of the blocks.                                               The net capital gain to Bob from the sale of the rear
                                                                            block is $97,500 (ie. [$400,000 less $205,000] x 50%
  In this case, the cost base of the property would
                                                                            general discount1).
need to be apportioned between the front and rear
block on a reasonable basis.                                                Main residence exemption
  As the advice received is that the split is 50/50, the
                                                                              The net capital gain on the sale of the vacant
cost base for each block is:
                                                                            land would not attract the operation of the main
     Acquisition cost (s112-25(3))                                          residence exemption.
     (50% of $400,000) . . . . . . . . . . . . . . . . . . . . . $200,000
                                                                              As a general rule, adjacent land would be subject
     Legal fees (s112-30) (50% of $10,000) . . . $5,000                     to the exemption if it was primarily used for private
     Cost base per block . . . . . . . . . . . . . . . . . . . . $205,000   and domestic purposes in association with the


1: The land has been held for at least 12 months (from August 1990 until December 2008). The subdivision of land does not
   change the day in which the rear block was considered to be acquired.


                                                                                                      14 February 2011 | The Taxpayer | 231
Demolition, subdivision and the main residence exemption (continued)

dwelling (refer s118-120(1)). However, the exemption              dwelling would remain unchanged for the block
only applies if the same CGT event happens to the                 of land containing the dwelling following the
land and dwelling (ie. the land and dwelling is sold              subdivision.
together) (s118-120(1), s118-165 and TD 1999/73).                   Bob may continue to treat the dwelling and any
  As a result, the net capital gain of $97,500 would              land immediately under it as his main residence until
remain assessable to Bob.                                         sold (provided that the relevant conditions under
                                                                  s118-110 still apply).
Treatment of main residence dwelling                                 Table 1 below summarises the tax outcomes
  The income tax treatment of the main residence                  arising from these scenarios. n




 Table 1: Summary of tax implications from demolition, subdivision and sale

 Event                      Scenario 1                    Scenario 2                       Scenario 3
                              •    Demolish                •    Retain dwelling             •    Retain dwelling
                              •    Subdivide               •    Subdivide                   •    Subdivide
                              •    Build two units         •    Build unit                  •    Sell vacant land
                              •    Live in one unit        •    Sell unit
                              •    Sell other unit

 Demolition of              CGT event C1 triggered        N/A                              N/A
 original dwelling          No CGT on demolition
                            (if no proceeds)

 Subdivision of land        No CGT event triggered provided blocks held by the same beneficial owners
                            Cost base of property allocated between subdivided blocks on a reasonable basis

 Sell new unit              Capital or revenue account?                                    N/A
                            Should be revenue account (refer MT 2006/1)
                            No main residence exemption
                            No CGT discount available

 Sell vacant land           N/A                                                            Capital or revenue account?
                                                                                           Likely to be on capital
                                                                                           account (refer MT 2006/1)
                                                                                           Main residence exemption
                                                                                           does not apply
                                                                                           CGT discount available

 Retained dwelling          N/A                           Main residence exemption may apply

 Unit occupied as           Full/partial main residence   N/A
 main residence             exemption available if
                            s118-150 choice made
                            Partial main residence
                            exemption if s118-150
                            choice not made


232 | The Taxpayer | 14 February 2011
Taxing royalties
By Tiffany Douglas
Many commercial arrangements give rise to the payment of royalties. This article discusses the ways in which
the Australian taxation law contemplates how royalties will be assessable to taxation as well as the associated
withholding tax requirements where they have been paid cross border.


Assessability of royalties                                   1. it is a payment made in return for the right to
                                                                exercise a beneficial privilege or right
General law royalties – ordinary income                      2. the payment is made to the person who owns
   To the extent that common law royalties constitute           the right to confer that beneficial privilege or
ordinary income, they are assessable under s6-5                 right
ITAA97. The meaning of a royalty at common law is            3. the consideration payable is determined on the
best illustrated by contrasting the landmark decisions          basis of the amount of use made of the right
of McCauley v FCT (1944) 69 CLR 235 and Stanton v FCT           acquired, and
(1955) 92 CLR 630. The taxpayer in both cases was a
                                                             4. the consideration payable will usually be paid
landowner who granted a right to remove standing
                                                                as and when the right acquired is exercised.
timber from their land although neither were in
the business of selling standing timber. Under the            Accordingly, the following constitute royalties at
McCauley agreement, the liability for payment of the        common law:
right was directly referable to the quantity of timber       •   payments for the use of intellectual property,
actually cut and removed from the land. The Stanton              know-how and scientific and industrial
agreement however provided for the removal of a                  equipment ie. patents, copyrights and
stipulated amount of timber for a stipulated lump                industrial processes where calculated by
sum amount with a proportionate rebate being                     reference to actual use
available where there was insufficient timber on
                                                             •   payments for the exploitation of real property
the land. The High Court held that the payments
                                                                 eg. the right to remove minerals and natural
in McCauley constituted royalties whilst in Stanton
                                                                 resources, where calculated by reference to
they did not, the distinguishing characteristic of the
                                                                 actual exploitation, and
two arrangements being calculation of the payment
by reference to the actual exploitation or usage of          •   licence fees relating to the assignment of
the right. In this regard, the High Court in McCauley            copyrights where calculation is referable
considered that at its essence, a royalty represents:            to actual sales of the product for which the
                                                                 copyright was transferred eg. an assignment
  ... a payment for each thing produced or sold or               of a copyright under a licence agreement
  each performance or exhibition in pursuance of                 granting the right to use ‘digital information’
  the licence ...                                                where the licence fee is payable by reference
and that inherently the:                                         to the quantity of digital information actually
  ... payments should be made in respect of the                  sold.
  particular exercise of the right to take the substance       The Commissioner also states in IT 2660 that a
  and therefore should be calculated either in respect      royalty does not include a payment for services or work
  of the quantity or value taken on the occasions           done unless the services are ancillary to, or part and
  upon which the right is exercised ...          (at 642)   parcel of, enabling relevant technology, information,
   Based on these decisions and those that followed,        know how, copyright, machinery or equipment to be
the Commissioner of Taxation (the Commissioner) in          transferred or used. The Commissioner also considers
IT 2660 identifies the following four key features of a     most concern is caused in distinguishing between
common law royalty:                                         a payment for services rendered and a payment


                                                                                    14 February 2011 | The Taxpayer | 233
Taxing royalties (continued)


           Table 1: Payment for supply of know-how or for services rendered?

           Contract for the supply of ‘know-how’           Contract involving the performance of
                                                           services

           A product ie. knowledge, information,           The contactor undertakes to perform services
           technique, formula, skills, process plan        which will result in the creation, development or
           etc, which has already been created or          the bringing into existence of a product (which
           developed or is already in existence is         may or may not be know-how)
           transferred

           The product which is the subject of the         In the course of developing a product, the
           contract is transferred for use by the buyer    contractor would apply existing knowledge,
           ie. it is supplied                              skills and expertise – there is not a transfer (ie.
                                                           supply) of know-how from the contractor to the
                                                           buyer as such but a use by the contractor of his
                                                           knowledge for his own purpose

           Except in the case of a disposition where       The product created as a result of the services
           the seller divests himself completely of any    belongs to the buyer for him to use without
           further interest in the product, the property   having to obtain any further rights in respect of
           in the product remains with the seller. All     the product
           that is obtained by the buyer is the right to   In the course of rendering services, the
           use the product                                 contractor would, in most cases, also produce as
           Subject to the terms of the contract the        a by-product a work plan design, specification,
           seller retains the right to use the product     report etc – which could contain knowledge etc
           himself and to transfer it to others            not otherwise known to the buyer and in which
                                                           copyright would subsist unless otherwise agreed
                                                           the contractor is the owner of the copyright



for know-how and provides a discusstion of the                 s6(1) ITAA36 to include amounts paid or credited as
distinguishing elements as summarised in Table 1               consideration for:
above.                                                           (a)   the use of, or the right to use any copyright,
                                                                       patent, design or model, plan, secret formula
General law royalties – capital in nature
                                                                       or process, trademark, or other like property
  Section 15-20 ITAA97 assesses payments that                          or right
constitute royalties at common law and are capital
                                                                 (b)   the use of, or the right to use any industrial,
in nature however to date, case law provides no
                                                                       commercial or scientific equipment
example of amounts assessable under this provision.
In view of the comments by the High Court in                     (c)   the supply of scientific, technical, industrial
Commissioner of Taxation v McNeil [2007] HCA 5                         or commercial knowledge or information
regarding the exploitation of property without                   (d)   the supply of any assistance that is ancillary
disposal, s15-20 may have limited application.                         and subsidiary to, and is furnished as a
                                                                       means of enabling the application or
Statutory royalties – income in nature                                 enjoyment of, any such property, right,
  The ordinary meaning of royalty is expanded further                  equipment knowledge or information as is
in s995-1 ITAA97 using the definition contained in                     mentioned in paragraphs (a) to (c)


234   |   The Taxpayer | 14 February 2011
  (da) the reception of, or the right to receive,          Statutory royalties – capital in nature
       visual images or sounds, or both, transmitted          Statutory royalties that are capital in nature and
       to the public by satellite; or cable, optic fibre   not a royalty at common law are neither assessable
       or similar technology                               under s6-5 nor s15-20 ITAA97 however may be
  (db) the use in connection with television               assessable as a capital gain. For example, in the
       broad-casting or radio broadcasting, or the         decision of Case U33 87 ATC 250 (1987) 18 ATR 3194,
       right to use in connection with television          a lump sum payment made to a licensor as a non-
       broadcasting or radio broadcasting, visual          refundable advance against royalties was held to be
       images or sounds, or both, transmitted              capital in nature and therefore not assessable as a
       by satellite or cable, optic fibre or similar       royalty however such payment is now likely to trigger
       technology                                          CGT Event D1. Given that the general discount does
  (dc) the use of, or the right to use, some or all        not apply to this event, it may only be beneficial that
       of the part of the spectrum (within the             a statutory royalty be assessable as a capital gain
       meaning of the Radio communications Act             to the extent that the taxpayer has available capital
       1992) specified in a spectrum licence issued        losses. The distinction between capital and revenue
       under that Act                                      might also be relevant where trust beneficiaries have
                                                           different capital and income entitlements.
  (e)   the use of, or the right to use motion
        picture films, films or video tapes for use in
                                                           Computer software
        connection with television or tapes for use in
                                                             In TR 93/12, the Commissioner characterises the
        connection with radio broadcasting, and
                                                           following payments in relation to computer software
  (f)   a total or partial forbearance in relation to      as royalties:
        any property, right, equipment, knowledge
                                                            •   a payment by a distributor for the right to
        or information, assistance, visual images or
                                                                make copies of a program from a master
        sounds, such part of the spectrum specified
                                                                copy, whether the payment is a one-time or
        in a spectrum licence as are mentioned in
                                                                periodical payment or a fee calculated by
        paragraphs (a) to (e).
                                                                reference to the number of times the program
   To the extent that statutory royalties constitute            is reproduced eg. a distributor licenses a
ordinary income, they are assessable under s6-5(1)              master copy of a program from the developer,
ITAA97. The definition also works in conjunction                the distributor then reproduces the program
with s6C ITAA36 to ensure that statutory royalties              and pays the developer a per copy fee
paid to non residents will have an Australian               •   a payment to the copyright owner by a
source and accordingly be subject to withholding                software house or a computer programmer
tax (note however that Australia’s Double Taxation              for the right to modify or adapt a program
Agreements (DTAs) also assert this jurisdiction                 to meet the individual needs of a computer
and that the definition of royalty contained within             user eg. a software development company
Australia’s DTAs prevails over the statutory definition         purchases the right to alter the source code of
to the extent that there is a conflict; s3(9) Income Tax        a program to cater to the very specific needs
(International Agreements) Act).                                of their corporate client ie. adapting ‘Database
   The Tax Office also states in IT 2660 that the form          Management Software’ to integrate with the
of a payment and the way that it is computed will               corporate client’s existing network infrastructure
not be conclusive in determining whether or not it          •   payments received as damages for infringement
constitutes a statutory royalty nor will its description        of copyright in a computer program eg. a
in any agreement. Crucially, the Tax Office also                company purchases a single license version
confirms that as distinct from its ordinary meaning,            of Microsoft Windows, or any licensed-based
it is not necessary for a payment to be calculated by           software. The organisation infringes copyright
reference to the degree of use of the property, right           by installing the software on more than one
or know how to fall within the statutory definition.            computer, or by altering the source code of the


                                                                                  14 February 2011 | The Taxpayer | 235
Taxing royalties (continued)

          software without permission, and is now liable                PE-of-the-payer-in-a-foreign-country,-or-
          to pay damages, and                                           a-foreign-resident-in-connection-with-an-
 •        payments made by a distributor or retailer in                 Australian-PE-(s128B(2C)-ITAA36).
          respect of software which has been licenced           The prescribed rate of WHT is 30% unless modified
          through their agency eg. a distributor acts as an   by the operation of a DTA which most commonly
          agent for a Developer’s software and pays the       imposes a rate of 10% (or 5% under the US and UK
          developer an amount for every copy distributed.     agreements).
  In TR 93/12, the Commissioner also considers that              Furthermore, the amount withheld is to be
the following payments are not royalties:                     calculated based on the GST inclusive amount of
 •        payments for the transfer of all rights relating    the royalty payment (ATO ID 2010/89). The WHT
          to copyright in a program in the course of          essentially operates as a final tax in that the royalty
          carrying on a business                              will constitute non-assessable, non-exempt income
 •        payments for the grant of a licence which           of the recipient and accordingly, there is no
          allows only simple use of the software              requirement to lodge an Australian income tax return
          (note that annual software licence fees are         in regards to this income (s128D ITAA36). Any related
          deductible under s8-1 ITAA97 and accordingly,       expenditure is also not allowable as a tax deduction
          that the rights to use the software are not         (s8-1(2)(c) ITAA97).
          items of ‘in-house software’ as defined in s995-      The Act also deems a non resident beneficiary of
          1 ITAA97 and thus are not ‘depreciating assets’     an Australian resident trust who is presently entitled
          for the purposes of Division 40 ITAA97 (ATO ID
                                                              to a royalty to have derived the income and thus
          2010/14))
                                                              any potential related WHT liability must also be
 •        payments for the provision of services in the       considered (s128A(3) ITAA36).
          modification or creation of software, and
 •        proceeds for the sale of goods (eg. the sale of a   Collection of withholding tax
          copy of a software program or where hardware          So as to ensure collection, the obligation to pay
          and software are sold together as a complete        the WHT is placed on the payer of the royalty. WHT
          computer system).                                   collection falls under the Pay As You Go provisions
                                                              contained within Subdivision 12F of Schedule 1
Royalties paid to non-residents                               Taxation Administration Act 1953 (TAA). In accordance
                                                              with these provisions, WHT is required to be withheld
Liability to withholding tax
                                                              and remitted to the Tax Office by the payer where:
   Division 11A of ITAA36 imposes withholding tax
(WHT) on Australian sourced royalties paid to non              •   a royalty is paid to a place outside Australia or
residents where:                                                   where the recipient has an overseas address
                                                                   (s12-280 TAA), or
  • it is paid by a resident to a non resident except
      where it is wholly incurred by the payer in              •   an Australian resident has received royalty
      carrying on a business outside Australia at or               income on behalf of a foreign resident (s12-285
      through a Permanent Establishment (PE) (the                  TAA).
      definition of PE is contained in s6(1) ITAA36)             If no WHT is payable on the royalty, then no
      (s128(2)(b)(i) ITAA36), or                              amount is required to be withheld (s12-300 TAA).
  • it is paid by a non resident to another non               The amount must be withheld when the payment
      resident and is incurred by the non resident            is made (s16-5 TAA) and any failure to do so is an
      payer in carrying on business in Australia at or        offence punishable by 10 penalty units (s16-5 TAA).
      through a PE (s128(2)(b)(ii) ITAA36), or                Subdivision 16-B of Schedule 1 TAA contains the
  • a royalty derived by a resident in carrying on            rules relating to when and how amounts withheld
      business in a foreign country at or through a PE        are to be remitted to the Tax Office which essentially
      in that country that is paid by either:                 depends on the withholder status of the payer (see
       -- a-resident,-but-not-in-connection-with-a-           Table 2 on page 237).


236   |   The Taxpayer | 14 February 2011
Note: Notwithstanding the decision in Century                 until the associated WHT has been remitted to the
Yuasa Batteries Pty Ltd v Commissioner of Taxation            Tax Office.
[1997] FCA 193, the Commissioner considers that
                                                              Foreign sourced royalties paid to
an amount paid to a non resident recipient under
an ‘indemnification of tax clause’ within a royalty           residents
agreement, (that is, to compensate for amounts                  Where foreign sourced royalties are paid to an
withheld under the WHT provisions) may constitute             Australian resident taxpayer and WHT has been
a royalty and therefore be subject to WHT. The                deducted by the payer at source, the recipient must
circumstances where this may occur are set out in             include the gross amount of the royalty in their
                                                              income tax return however may be entitled to a
TR 2004/17.
                                                              foreign income tax offset (FITO). The rules concerning
 Section 26-25 ITAA97 also ensures collection of the          FITO entitlement and calculation are contained
WHT by disallowing a deduction for royalties paid             within Division 770 ITAA97. n




 Table 2: When and how amounts withheld are to be remitted to the Tax Office

                              Due date for payments (s16-75)
 Withholder
                                                                                  Method of payment (s16-85)
 status
                If withholder withholds on:     Withholder must pay by:

 Large           •   Saturday or Sunday          •     The second Monday          Electronic payment via direct
 (s16-95)        •   Monday or Tuesday                 after that day             credit, BPay or direct debit

                 •   Wednesday                   •     The first Monday after
                                                       that day
                 •   Thursday or Friday
                                                 •     The second Thursday
                                                       after that day
                                                 •     The first Thursday after
                                                       that day

 Medium         Payment due by the 21st day after the end of the month in         Electronic payment or other
 (s16-100)      which the amount was withheld                                     means including cheque or
                                                                                  money order to the Tax Office

 Small          Payment due by the 21st day after the end of the quarter in       Electronic payment or
 (s16-105 or    which the amount was withheld                                     other means as for medium
 s16-110)                                                                         withholders




                                                                                    14 February 2011 | The Taxpayer | 237
Service entity arrangements –
Where are we now?
By Tiffany Douglas
Following the flurry in 2006 there has been no obvious widespread Tax Office activity in relation to service
entity arrangements in recent years. Does this mean that the topic is dead and buried?


Background                                                     considers that it is not authority for the
                                                               proposition that expenditure made under a
   Typically, a service entity arrangement involves
                                                               service entity arrangement and calculated
the establishment of a wholly owned services entity
                                                               using the particular mark up adopted in that
(trust or company) to provide particular services (eg.
                                                               case will always be deductible under s8-1 of
staff hire and recruitment, secretarial, clerical and
                                                               the ITAA97
administrative services and the lease of premises and
plant and equipment) to an associated professional         •   for the service fees to be deductible under
practice conducted by either a sole practitioner               s8-1 ITAA97, the service arrangement must
or partnership. The service fees and charges are               provide an objective commercial explanation
calculated by way of a mark-up on some or all of               for the expenditure. This may be determined
the costs to the service entity and claimed as a               from the service arrangement alone or
tax deduction by the professional practice. Income             from a broader examination of all of the
of the professional practice is thus effectively               circumstances surrounding the expenditure ie.
diverted into the service entity for distribution to its       the relationship between the taxpayer and the
members which usually comprise the principals of               service entity, the manner in which they have
the professional practice and their associates.                dealt with each and the taxpayer’s subjective
                                                               purpose, motive or intention in incurring the
  The use of service arrangements was first accepted
                                                               expenditure
as explicable on commercial grounds by the Full
Federal Court in FC of T v Phillips ATC 4361, at which     •   a broader inquiry must always be resolved by
point their establishment by certain professional              a commonsense or practical weighing of the
practices became commonplace. Although                         whole set of objects and advantages which the
the Commissioner had accepted the decision as                  taxpayer sought in making the outgoing
reasonable (refer to IT 276), concern mounted as           •   a service arrangement will not suffice to
arrangements began to deviate significantly from               provide an objective commercial explanation
Phillips. In response, the Tax Office issued TR 2006/2         where the service fees and charges:
and its accompanying guide Your Service Entity                 -- are-disproportionate-or-grossly-excessive---
Arrangements on 20 April 2006, to draw a refocus to               in-relation-to-the-benefits-conferred-by-
the ‘commerciality’ of these arrangements. The Tax                the-service-arrangement-or-guarantee-
Office website also contains 15 Frequently Asked                  the-service-entity-a-certain-profit-
Questions on Service Entity Arrangements which                    outcome-without-reasonable-commercial-
provide further clarification as to the guide.                    explanation,-or
                                                               -- generate-profits-in-the-service-entity-
TR 2006/2: Deductibility of service fees
                                                                  without-any-clear-evidence-that-the-service-
paid to associated service entities
                                                                  entity-has-added-any-value-or-performed-
  The key points of the ruling can be summarised as               any-substantive-functions.-For-example,-
follows:                                                          this-might-occur-where-there-is-no-clear-
 •        whilst the Commissioner accepts the                     separation-between-the-service-entity’s-
          correctness of the decision in Phillips, it             business-activities-and-those-of-the-taxpayer


238   |   The Taxpayer | 14 February 2011
 •   where a broader inquiry determines that the          professional practice are earned by the service entity,
     expenditure was in fact incurred wholly or           a taxpayer will remain at low risk of audit. The
     partly in pursuit of an independent advantage,       indicative rates can be summarised as follows:
     based on a fair and reasonable apportionment,
                                                               Activity                                      Indicative rates %
     the expenditure will not be deductible, and
                                                               Labour hire
 •   service entity arrangements may be challenged
     under Part IVA ITAA36 where a reasonable                        • Gross mark up (30% - 18%) . . . . . 12
     person would conclude that it has been                          • Net mark up . . . . . . . . . . . . . . . . . . . . 10
     entered into for the dominant purpose of                  Recruitment . . . . . . . . . . . . . . . . . . . . . . . . . . 10
     enabling the taxpayer to obtain a tax benefit in          Expense payments. . . . . . . . . . . . . . . . . . . 10
     connection with the arrangement.
                                                               Equipment hire . . . . . . . . . . . . . . . . . . . . . . 10

Practical guidelines (Your Service                             Rental . . . . . . . . . . . . . . . . . . . . . Market rates

Entity Arrangements – NAT 13086)                            In many cases the level of service entity profit
  The Tax Office’s guide Your Service Entity              generated from these rates would make the use of
Arrangements (the guide) provides information to          the arrangement of questionable commercial value.
assist in the practical application of the ruling. In     Note: Rates higher than the indicative rates may
this regard, it provides step by step guidance to         be acceptable in individual circumstances however
assist taxpayers in identifying the commercial benefit    those circumstances will need to be supported with
provided by a service entity arrangement and in           appropriate evidence.
determining whether the service fees and charges
have been correctly calculated.                           Market benchmarks
Step 1: Can you explain how the service                     The Tax Office recognises the use of two methods
entity arrangement helps you run your                     which allow taxpayers to establish a market
                                                          benchmark by which the service fees and charges of
business?
                                                          the service entity can be compared:
   There must exist a necessary business connection
                                                           •       Comparable market prices method:
between the services entity and the professional
                                                                   Comparison against service fees and charges of
practice. This contemplates that the arrangement
                                                                   independent third parties.
provides the professional practice with certain
commercial benefits, eg. the provision of staff and        •       Comparable profits method: Comparison of net
the management of certain functions (recruitment                   or gross profits against those of independent
and payroll) as well as relieve it of certain risks and            third parties measured as a net or gross mark
financial and legal obligations.                                   up on particular costs.
                                                            These methods however pose a practical difficulty
Step 2: Are the service fees and charges                  for private practitioners in that comparable market
correctly calculated?                                     data is extremely difficult, if not impossible to obtain.
  The guide identifies the following methodologies        On this basis, the indicative rates method is probably
for determining the acceptability of service fees and     the only plausible method available to such taxpayers.
charges:
                                                          Medical practice exception
Indicative rates method                                     Service entity arrangements for medical practices
  This is the simplest method which allows taxpayers      differ significantly from the conventional service
to adopt the Commissioner’s indicative rates as           entity arrangements in that they typically charge for
outlined in Chapter 4 of the guide. To the extent         services on a percentage of gross practice fees basis
that the service fees and charges fall within these       instead of using a mark up on costs approach. The
indicative rates and that no greater than 30% of          guide therefore provides that most medical practices
the combined profits of the service entity and            will be able to claim a tax deduction for service fees


                                                                                              14 February 2011 | The Taxpayer | 239
Service entity arrangements – Where are we now? (continued)

paid to a service entity where they equal up to 40%                  in its general compliance program. Clearly, where
of gross practice income (increasing to 45% for sole                 taxpayers have adhered to the Tax Office guidance,
practitioners and rural medical practitioners). The Tax              the risk of audit will be low whilst non commercial
Office has however advised that these benchmark                      arrangements will attract Tax Office scrutiny with
rates cannot be applied to specialist medical                        any audit likely to be conducted retrospectively
practitioners and describes the type of practice that                (with the potential for adjustment of up to four
will fall within this exception on page 25 of the guide.             years increasing to six years where Part IVA ITAA36
Note: The Tax Office accepts use of the Rural, Remote                is applied).
and Metropolitan Areas (RRMA) classification to
identify what is rural in determining the eligibility                Where to now?
of GP’s to apply the higher benchmark rate of 45%.                     In light of the above, it may now be prudent to
                                                                     pose the following questions:
Step 3: What documentation do you need?                                •   Is it time to conduct another review of the
  The Tax Office requires that records be kept                             service entity arrangement so as to ensure
which explain the transactions with the associated                         that current circumstances mirror the existing
service entity and provides a list of documentation                        agreement?
acceptable for this purpose at page 10 of the guide.                   •   Are there arrangements in place for periodic
                                                                           payments to be made within a reasonable time
Tax Office compliance activity                                             in accordance with the existing agreement?
   The Tax Office amnesty concerning review of
                                                                       •   Do current outcomes conform to the
existing service arrangements by taxpayers ended
                                                                           Commissioner’s benchmarks?
on 30 April 2007. Thus any changes in line with the
Tax Office guidance should have been implemented                       •   Where operating outside the Commissioner’s
by no later than this date. The Tax Office also recently                   benchmarks, is there evidence in place to
advised that it will manage ongoing tax compliance                         support this in the event of a challenge?
for service entity arrangements in accordance with                     •   Is the service entity arrangement still serving
its general risk assessment approaches, and also                           the purpose for which it was originally put in
indicated that these arrangements may be included                          place? n




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  Seminar overview                                                 Cost and CPD hours                       a 2011 FBT checklist plus
                                                                   v Members: $209;                           interactive proforma
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                                                                     Non-members: $242 (incl GST)             declarations for 2011.
            - matching vehicle registrations with FBT returns
            - failure to lodge FBT return cases                    v CPE/CPD Hours: 3.5 hours
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  v         Comparison of the ‘actual’ and ‘50/50 split’ methods
            for meal entertainment                                 Dates and venues
  v         How to distinguish travel from LAFHA situations        Brisbane: Tuesday 15 February: 9am-12:30pm
  v         Salary packaging update                                Royal on the Park, Cnr Alice & Albert Sts, Brisbane, QLD
  v         Comprehensive review of Tax Office announcements       Sydney: Thursday 17 February: 9am-12:30pm
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240   |   The Taxpayer | 14 February 2011

				
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