The Taxpayer

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                       The Taxpayer
29 August 2011                           www.taxpayer.com.au                        Issue 5 • 2011/2012




                 More on split loans and Part IVA
                 By Andy Nguyen
                 It has been long held by the Commissioner of Taxation (the Commissioner) that
                 split loan facility arrangements are likely to attract the operation of the general
                 anti-avoidance rules contained in Part IVA of the Income Tax Assessment Act 1936
                 (Part IVA). The High Court in Commissioner of Taxation v Hart & Anor (2004) HCA
                 26 (Hart) subsequently affirmed this view and essentially ‘put to bed’ the notion
                 of taxpayers being able to successfully claim ‘additional’ interest deductions by
                 entering into a split loan facility in the circumstances evident in the case. In the
                 recently issued draft TD 2011/D8, the Commissioner forms a similar conclusion in
                 relation to an arrangement which adopts essential elements of a split loan facility.
                 This article compares the arrangements in Hart and TD 2011/D8 and outlines the
                 principles considered by the courts when applying Part IVA in such circumstances.


                 Part IVA explained                             •   whether a tax benefit has been
                                                                    obtained that would otherwise
                   Part IVA provides the Commissioner
                 with the discretion to cancel a ‘tax               not have been available.
                 benefit’ (or part thereof) that has been        Broadly, a ‘tax benefit’ is something
                 obtained, or would be obtained if it          that affects the amount of income tax
                 was not cancelled, by a taxpayer in           that someone has to pay under tax law
                 connection with a scheme.                     whether now or in the future. Typically,
                   In making such an assessment, the           this may include an amount not
                 Commissioner is required to consider,         included in the taxpayer’s assessable
                 amongst other things:                         income, a deduction claimed, the
                  •    the scheme entered into by the          availability of a certain tax offset, etc.
                       taxpayer (which is very widely            To determine whether the ‘tax
                       defined,) and                           benefit’ would otherwise have been
                                                                                      Continued – page 66
                  inside…




                            Editorial: The vigilant professional adviser
                            CGT implications of buy/sell arrangements
                            Expanded trust TFN withholding rules



                                                                                           pages 65-80
More on split loans and Part IVA (continued from page 65)

available, it is necessary to identify what might
reasonably have been expected had the scheme
not been entered into (commonly referred to as the
counterfactual).                                                                                         The Taxpayer contents
  Once the ‘scheme’, ‘tax benefit’ and in essence,
the ‘counterfactual’ are established, an objective                                                       More on split loans and Part IVA . . . . . . . . 65
assessment is required to be made having regard to                                                       Editorial: The vigilant professional
the eight factors outlined in s177D(b) ITAA36 as to                                                      adviser . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
whether the scheme has been carried out for the sole
                                                                                                         CGT implications of
or dominant purpose of obtaining the tax benefit.
                                                                                                         buy/sell arrangements . . . . . . . . . . . . . . . . . 74
  Note: Consideration of the eight factors in s177D is
                                                                                                         Expanded trust TFN withholding rules . . 79
outside the scope of this article. However, guidance
on the Commissioner’s application of Part IVA can be
found in PS LA 2005/24 and the publication entitled                                              A comparison between the arrangements in Hart
Part IVA: the general anti-avoidance rule for income tax.                                      and TD 2011/D8 and the application of Part IVA to
                                                                                               these arrangements is summarised in Table 1 on
Commissioner’s views on split loan                                                             page 71.
arrangements                                                                                   Hart’s case
  Split loan facility arrangements typically apply
                                                                                               Facts
to taxpayers who own a residence and investment
property.                                                                                         •     The taxpayers borrowed funds from their lender
                                                                                                        to finance and refinance two properties, one
  Prior to the decision in Hart in 2004, the
                                                                                                        being their private residence and the other
Commissioner      viewed     such    arrangements
                                                                                                        being an investment rental property.
unfavourably and considered that Part IVA was
capable of being applied to disallow particular                                                   •     At the time, the split loan facility enabled the
interest deductions. The decision in Hart validated                                                     taxpayers to nominate and ‘partition’ their
that view and resulted in the Commissioner issuing                                                      single loan account into sub-loan accounts.
the following pronouncements:                                                                     •     The partitioning treated each sub-account as if
                                                                                                        they were separate loans; however, the same
  •     TR 98/22: Income tax: the taxation
                                                                                                        variable interest rate applied to each loan
        consequences for taxpayers entering into
                                                                                                        sub-account. The taxpayers opted to partition
        certain linked or split loan facilities
                                                                                                        their loan into sub-loan accounts between
  •     TD 1999/42: Income tax: do the principles set                                                   their residence (home loan sub-account) and
        out in Taxation Ruling TR 98/22 apply to line of                                                investment property (investment loan sub-
        credit facilities?                                                                              account).
  •     ATO ID 2006/297: Income Tax: Deductibility of                                             •     The monthly repayments made by the
        compound interest on a split loan facility                                                      taxpayers from their cash flows were applied
  TD 2011/D8 considers a variation to split loan                                                        against the home loan sub-account. As a result,
arrangements which has recently caught the attention                                                    the accrued interest on the investment loan
of the Commissioner.                                                                                    sub-account was capitalised and compounded.
                                                                                                                                                               Continued – page 68
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66 | The Taxpayer | 29 August 2011
                                                                                        editorial
The vigilant professional adviser
                      Experienced     participants            open for such a beneficiary to commence
                    in the tax industry would be              a pension. Those seeking to minimise the
                    aware of the need for constant            amount of income ‘counted’ for the purposes
                    vigilance, even where a                   of Centrelink income tests would very
                    pronouncement from the                    often adopt that approach. If the use of the
                    Commissioner of Taxation may              term ‘automatic’ in the draft ruling means
                    appear benign.                            that a reversionary beneficiary must be
                       This    is   evident     from          nominated under the original pension, and
the recently issued draft tax ruling TR 2011/D3               the Commissioner’s interpretation of the law
which considers when a superannuation pension                 is correct, there is the potential for significant
commences and ceases. At face value these may                 adverse implications for taxpayers. It then
seem relatively straight forward questions, however           may be necessary to address the question
an examination of the Commissioner’s conclusions              as to whether that was the intention of the
will quickly indicate to the contrary. The key issues         relevant legislation.
surround the circumstances in which a pension             2. If the pension standards were breached – say,
may cease. The identification of that time is critical       for an account based pension paying less
because the income generated from assets which               than the minimum annual drawdown amount
discharge pension liabilities is exempt income.              - the ruling indicates that this would cause
When the pension ceases the superannuation                   the pension to cease and a new pension to
fund returns to the accumulation phase and the               commence if the breach was rectified in a
previously exempt income becomes assessable.                 subsequent year.
  The greatest concern to taxpayers is likely to be        It would seem that the ramifications of such a
the conclusion that a pension ceases:                    breach would be:
 1. Upon the death of the pension recipient,              •   the fund reverting to accumulation phase for
    unless there is a reversionary beneficiary                the full year in which the breach occurs,
    who becomes automatically entitled to                 •   a breach of the superannuation industry
    the pension. This appears to indicate that                regulations if the draw-downs are lump sums
    there must be a specific nomination of a                  for which there is not a condition of release.
    reversionary beneficiary by the pension                   This raises the possibility of a fund becoming
    recipient; a situation where the beneficiary              non-complying.
    of the deceased was empowered to receive
                                                           That outcome must surely be ruled out by the
    a pension, but would have to stipulate a
                                                         Commissioner where all that may have occurred
    desire to commence such a pension, would
                                                         is a shortfall in benefit withdrawals due to
    seem to result in the original pension ceasing
                                                         administrative error. n
    and a new pension commencing. In these
    circumstances the fund would for a brief             Roger Timms - Head of Tax & Superannuation
    time, return to accumulation phase and
    therefore any capital gains arising from the
    realisation of assets would be subject to
    tax. Many superannuation pensioners do
    not nominate an automatic reversionary
    beneficiary but rather leave the option



                                                                                  29 August 2011 | The Taxpayer | 67
More on split loans and Part IVA (continued from page 66)

Decision                                                        The taxpayers’ ability to pay off their home
  Ruling in favour of the Commissioner, the High                earlier, as outlined in the marketing brochure,
Court made the following observations with respect              did not change the court’s view that the
to certain elements contained in Part IVA:                      dominant purpose for entering into the scheme
                                                                was to obtain a tax benefit by way of additional
 •    Scheme – Relying on FC of T v Peabody 94
                                                                interest deductions.
      ATC 4663 as guidance, the court established
      that the scheme in question, defined widely,         Deductibility of compound interest?
      comprised of all steps leading to, entering into
                                                             It is worth noting that because the High Court
      and implementing of the loan arrangement
                                                           decided that Part IVA was correctly applied, the
      (including directing the repayments to the
                                                           Commissioner’s alternative argument in relation
      home loan sub-account).
                                                           to whether compounded interest (ie. interest on
 •    Tax Benefit – The ‘tax benefit’ was the              interest) on the investment loan was deductible was
      ‘additional interest’ calculated as the difference   not considered.
      between the interest incurred on that part
                                                             Initially the Full Federal Court had found that the
      of the loan which related to the investment
                                                           compounded interest accruing on the investment
      property, and the interest that would have
                                                           loan was deductible to the taxpayers under s8-1
      been incurred if the borrower had applied the
                                                           ITAA97. This proposition was subsequently
      payments to the separate accounts.
                                                           accepted by the Commissioner in ATO ID 2006/297.
 •    Counterfactual – In determining the                  Notwithstanding the interest deduction would
      alternative arrangement that would have been         otherwise be available, the Commissioner indicated
      entered into by the taxpayers but for the split      that like in Hart’s case, Part IVA would apply to
      loan facility, the court referred to the marketing   disallow the interest deductions for split-loan facility
      materials used by the taxpayer’s lender which
                                                           arrangements.
      identified the relevant advantages.
      One brochure demonstrated the ability of             TD 2011/D8
      taxpayers to:
                                                             In this draft determination, the Commissioner
       (i) pay-off their home loan earlier and             considers whether a taxpayer’s purpose to pay off
       (ii) obtained increased deductible interest on      their home loan sooner means that Part IVA cannot
            their investment loan portion –                apply to a variation of a split loan arrangement which
            all by paying exactly the same monthly         the TD refers to as an ‘investment loan repayment
            amount as the taxpayer otherwise would         arrangement’ (TD 2011/D8 arrangement).
            have (ie. by making principal and interest
            repayments).                                   Arrangement contemplated
 •    Dominant purpose – The majority were                   The arrangement contemplated by the
      unable to uphold the decision of the Full            Commissioner (refer Diagram 1 on the following
      Federal Court (in Hart v Federal Commissioner of     page) contains the following features:
      Taxation (2002) 121 FCR 206) that the taxpayers       •   The taxpayer owns at least two properties:
      entered into the arrangement for the dominant              -   one property being their residence, and
      purpose of obtaining borrowed money to
                                                                 -   an ‘investment property’
      purchase a new home and to refinance their
      rental property.                                      •   The taxpayer has:

      Referring to the decision in FC of T v Spotless            -   an outstanding loan which was used to
      Services Limited & Anor 96 ATC 5201, the High                  acquire their residence (or have refinanced
      Court considered that there can still be a                     an earlier loan used to acquire the
      dominant purpose of obtaining a tax benefit                    residence) (‘home loan’),
      even though the arrangement also advances a                -   an outstanding loan which was used to
      wider or discernible commercial purpose.                       acquire the investment property (or have


68 | The Taxpayer | 29 August 2011
        refinanced an earlier loan used to acquire            •      The line of credit is drawn down to pay the
        the investment property) (‘investment                        interest on the investment loan as it falls due.
        loan’), and                                                  -   Where no repayments are required – the
    -   a line of credit with an approved limit (‘line                   taxpayer does not make any repayments,
        of credit’).                                                     which results in interest on the line of
    All three loan products are typically (but not                       credit being capitalised and compounded.
    always) provided by a single lender.                             -   Where monthly interest repayments
•   The interest rates on the home loan and                              are required – the taxpayer meets such
    investment loan are typically the same. The                          repayments from their cash flows.
    interest rate on the line of credit is normally           •      Typically, all the taxpayer’s cash inflows
    (but not always) higher by a small margin (eg.                   (including that which the taxpayer otherwise
    0.15%).                                                          might reasonably be expected to use to
•   The investment loan is typically an interest-                    pay the interest on the investment loan)
    only loan for a specified period with principal                  are deposited into their home loan or an
    and interest repayments required thereafter.                     ‘acceptable loan account offset account’, which
    Alternatively, the interest-only period may be                   reduces the interest otherwise payable on the
    extendable.                                                      home loan.
•   The line of credit typically has no minimum               •      If the line of credit reaches its approved limit
    monthly repayment obligations provided the                       before the home loan has been repaid, the
    balance remains below the approved limit.                        taxpayer may apply to increase the limit
    Otherwise, it may require that minimum                           on the line of credit in conjunction with a
    monthly repayments equal to the accrued                          corresponding decrease in the available
    interest be made.                                                ‘redraw’ amount in the home loan.
•   The home loan, investment loan and the line of          Note: The above arrangement can apply to more
    credit are each secured against the taxpayer’s          than one taxpayer (eg. if the properties are held
    residence and/or investment property.                   jointly).



           Diagram 1: Investment loan interest payment arrangement



                                         F                         H
                      Residence and/or investment property used as a security against loans




                                                                                       Line of credit
                    Home Loan                     Investment Loan
                                                                                    (interest capitalised
              (principal and interest)              (interest only)
                                                                                    and compounded)




                               Taxpayer uses own cash
                               flow to pay home loan              Funds from line of credit
                               (and line of credit if             used to pay interest on
                               required)                          investment loan as it falls due




                                                                                           29 August 2011 | The Taxpayer | 69
More on split loans and Part IVA (continued)

Outcomes                                                       would have met the interest payments on the
                                                               investment loan using their own cash flow
  The Commissioner identifies the outcomes of the
                                                               rather than using the line of credit.
arrangement as follows:
                                                           •   The taxpayer would not have incurred any
 •    The real effect and substance of the
                                                               interest on the line of credit referable to the
      arrangement is to purportedly make the
                                                               payment of interest on the investment loan
      payment of interest on the capital sum paid in
                                                               and so would not have been entitled to such
      reduction of the home loan tax deductible.
                                                               deductions.
 •    As a result, taxpayers may enter into these
      arrangements with the purpose of ‘paying their         Accordingly, the relevant tax benefit obtained is
      home loan off sooner’.                              an allowable deduction for interest incurred on the
                                                          line of credit.
 •    Taxpayers who have entered into this type of
      arrangement have sought to claim deductions         (iii) Dominant purpose
      for the interest incurred on the line of credit
                                                            As to whether the arrangement was entered into
      under s8-1 ITAA97.
                                                          for a dominant purpose of obtaining a tax benefit,
Deductibility of interest on line of credit?              the Commissioner, referring to Hart and Spotless,
  As a general rule, a deduction for interest costs       observes:
requires an examination of the purpose of the              •   An objective purpose of the taxpayer of ‘paying
borrowing and the use to which the borrowed                    their home loan off sooner’ does not prevent
funds are put (refer TR 2004/4). In TD 2011/D8, the            Part IVA from applying to an investment loan
Commissioner accepts that the interest accruing on             interest payment arrangement.
the line of credit facility would be deductible under      •   In the context of applying the eight objective
s8-1 ITAA97 but does not provide any analysis as to            factors (s177D(b) ITAA36) to the arrangement:
deductibility.                                                 - The manner in which the scheme is entered
   Absent such an analysis, there may be questions               into is generally explicable only by the
as to whether there is a sufficient nexus between the            taxation consequences. For instance, apart
draw down between the accrued interest on the line of            from the purported availability of additional
credit and the use of those funds to repay investment            tax deductions, it makes little financial sense
loan interest to warrant a tax deduction. The fact that          for the taxpayer to fund repayments on a
the accrued interest may be likened to ‘compounded               home loan using a line of credit with a higher
interest’ accruing on the investment loan sub-account            interest rate than the home loan.
in Hart may be a reason as to the Commissioner                 - The total interest deductions purportedly
accepting the accrued interest as being deductible               available to the taxpayer under the scheme
(refer comments on ATO ID 2006/297 above).                       are greater than under the counterfactual.
                                                               - Apart from the purported availability of
Application of Part IVA
                                                                 additional tax deductions, the taxpayer’s
  Taking into account the relevant requirements                  financial position under the scheme is
under Part IVA, the Commissioner makes the                       generally no different than under the
following observations:                                          counterfactual.
(i)   Scheme                                                   - If the taxpayer’s residence is used as security
  The ‘scheme’ in this case would encompass the key              for either the investment loan or the line of
elements of the arrangement as described.                        credit, the taxpayer will not actually own an
                                                                 unencumbered home any faster under the
(ii) Counterfactual/ tax benefit                                 arrangement than under the counterfactual.
  In establishing the tax benefit, the Commissioner            - Where a single lender is involved, that
considers that:                                                  lender’s financial position is substantially
 •    The ‘counterfactual’ would be that the taxpayer            the same under the scheme and the


70 | The Taxpayer | 29 August 2011
          counterfactual in terms of its total lending               of credit) is left to accumulate deductible interest
          exposure and interest income earned across                 which would not otherwise have been available,
          the three loan products.                                   the likelihood of Part IVA applying to disallow those
                                                                     deductions is increased.
(iv) Conclusion                                                         Further, the fact that a taxpayer’s motivation to
  On an objective basis, the Commissioner considers                  pay off their home loan sooner does not necessarily
that the TD 2011/D8 arrangement would be                             preclude the Commissioner from applying Part IVA
entered into for the dominant purpose of enabling                    if a conclusion can be formed that the taxpayer’s
the taxpayer to obtain a tax benefit. Accordingly,                   prevailing purpose is to obtain a tax benefit.
Part IVA would apply and any deduction for the                          As no two arrangements are the same, the
relevant interest incurred on the line of credit may be              possibility of Part IVA applying needs to be assessed
disallowed by the Commissioner.                                      on a case by case basis having regard to the relevant
                                                                     facts. For example, would the Commissioner’s
Operative date                                                       conclusion in TD 2011/D8 change if the assets
  When issued in final, the TD is to apply before                    secured against the various loans involve the
both and after its date of issue. Given the broad                    taxpayer’s residence and a parcel of listed shares? Or,
application of Part IVA, it is likely that the final TD              if each loan facility was financed through different
would be issued relatively unchanged.                                lenders with varying interest rates?
                                                                        Therefore, given the varied nature of these
Comment                                                              arrangements, taxpayers and practitioners should
  Irrespective of the differences between the two                    exercise caution and ensure that the steps involved and
arrangements, the Commissioner appears committed                     the intended commercial and tax outcomes resulting
to the view that where an investment loan (or line                   from such arrangements are fully understood. n

 Table 1: Distinctions between split loan and TD 2011/D8 arrangements
 Arrangement      Split loan facility (per Hart)                           TD 2011/D8 arrangement
 Number of loan Single facility with one lender with the ability to        Three separate facilities including home loan,
 facilities     create sub-accounts treated as separate loans              investment loan, and line of credit; each with the
                (ie. investment loan and home loan sub-account)            same or a different lender
 Distinguishing   •	 All loan repayments directed to home loan sub-        •	 Loan repayments directed to home loan
 features            account                                               •	 Line of credit used to make monthly interest
                  •	 Interest accrues and compounds on investment             payments on investment loan
                     loan sub-account                                      •	 Line of credit accrues interest
 Does Part IVA
                  Yes                                                      Yes
 apply?
 Scheme           All steps leading to, entering into and implementing     All relevant steps as outlined in TD 2011/D8
                  the loan arrangement (including directing
                  repayments to home loan account): per Hart
 Dominant         Obtaining of a tax benefit via ‘additional’ interest     Obtaining of a tax benefit via interest deductions
 purpose          deductions on investment account                         accruing on line of credit
 Counterfactual   Payment of principal and interest on investment          Interest payments met on investment loan out of
                  loan (instead of directing funds to home loan sub-       personal cash flow rather than use the line of credit.
                  account)
 Deductibility of Interest (including compounded interest) on              Interest on line of credit accepted by Commissioner
 interest (aside  investment loan account accepted as being                as being deductible (TD 2011/D8)
 from Part IVA)   deductible (ATO ID 2006/297)
 Tax benefit      Additional interest deduction being interest which       Additional interest deduction being interest accruing
                  would have been charged had principal and interest       on line of credit. Essentially, it allows the conversion
                  repayments been made to investment loan                  of non-deductible interest into deductible interest ie.
                                                                           that would otherwise be payable on the home loan



                                                                                                   29 August 2011 | The Taxpayer | 71
Taxpayers AustrAliA inc
Superannuation AustrAliA                                                                     Taxpayers
(A wholly owned subsidiary of taxpayers Australia inc)




                                                          TAXPAYERS AUSTRALIA INC
                                                   NOTICE OF DIVISIONAL COUNCIL ELECTIONS


         Nominations for election as Divisional Councillors are hereby called for. Any Voting Member, or a partner,
         director or nominee of a Person who is a Voting Member is eligible to nominate for election for the state in
         which they reside. For the purpose of these elections, residents of the ACT qualify for election to the New
         South Wales Divisional Council and residents of the Northern Territory qualify for election to the South
         Australia Divisional Council.

         Nominations must be in writing, signed by the candidate and by one other Voting Member, or a partner,
         director or nominee of a Person who is a voting Member, who resides within the territory covered by the
         Divisional Council. Divisional Councillors will serve a two-year term. Each Divisional Council shall be of
         not less than 3 nor more than 12 Divisional Councillors.

         A nomination form is enclosed with this notice and is also available on the website at www.taxpayer.com.au/
         notice

         Nomination forms should be lodged with the Secretary of the Divisional Council before the close of business
         on Wednesday 14 September 2011.

         The mailing/facsimile address for the receipt of nomination forms is:

               The Secretary of the Divisional Council
               Taxpayers Australia Inc
               PO Box 292, Kew East Vic 3102
               1405 Burke Road, Kew East Vic 3102
               Facsimile (03) 8851 4588

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         Should you have any queries about these elections, please contact the Secretary of the Divisional Council in
         your state or Jan Richards at the National Secretariat on (03) 8851 4555.




         Barbara Crook
         Secretary




72   |   The Taxpayer | 29 August 2011
Taxpayers AustrAliA inc
Superannuation AustrAliA                                                                           Taxpayers
(A wholly owned subsidiary of taxpayers Australia inc)




       In accordance with Rule 56(c) of the Constitution, notice is given:
       i.         That the listings below disclose the retiring Divisional Councillors who are eligible for re-election to
                  their respective Divisional Councils:


                  New South Wales                                  Victoria
                  Mr John Brogan                                   Mr Alan Baker
                  Mr Edward Codd                                   Mr Stephen Brennan
                  Mr David Scott                                   Mr John Dodgshun
                  Mr Stephen Ware                                  Mr Bill Hackett
                  Ms Elizabeth Whittle                             Mr Jaya Naidu
                                                                   Mr Brian Spurrell
                  Queensland                                       Ms Sophia Stavropoulos
                  Mr Mark Dodds                                    Mr Bob Taylor
                  Mr Marzban Engineer                              Mr John Van Delft
                  Mr Lance Hogg
                  Mr Winston Hughes                                Western Australia
                                                                   Mr Terence Blenkinsop
                  South Australia                                  Mr Rami Brass
                  Mr Peter Cocks                                   Mr Bill Levitt
                  Mr Paul Tanti                                    Mr Ross Ludwig
                  Dr Andrew Trott                                  Mr Michael Prendergast
                                                                   Mr Cyril Tolsen
                  Tasmania
                  Mr Tony Culberg
                  Mr David Jones
                  Mr Bruce Lord
                  Mr Roger Menadue
                  Mr Eric Pinkard
                  Mr Warren Ross
                  Mr John Taylor




                                                                                                29 August 2011 | The Taxpayer | 73
CGT implications of buy/sell arrangements
By Tiffany Douglas
An issue that often arises when selling a business or business assets is that the final sale value cannot
be definitively determined at the contract date because it is contingent upon the future performance
of the business. Buyers and sellers in these situations therefore commonly structure the sale contract to
include either provision for additional contingent payments to be made by the buyer (a standard earnout
arrangement) and/or reduction in the sales price received by the seller (a reverse earnout arrangement).
This approach may have CGT implications for both the buyer and seller. This article considers those
implications by way of example.


  The original tax ruling which dealt with the CGT         Application date and transitional
implications for buyers and sellers under a standard
                                                           provisions
earnout arrangement was TR 93/15 which applied
until immediately prior to 17 October 2007, at which        From date of        Proposed look through
time draft taxation ruling TR 2007/D10 became               Royal Assent        approach to apply to all
operative. A concern for taxpayers under TR 93/15                               earnout arrangements
was the lack of symmetry between the CGT position
                                                            Between             Buyers and sellers can apply
for the buyer and seller. Whilst the seller was required
                                                            12 May 2010         either the proposed ‘look
to treat as consideration the capital proceeds for the      and date of         through’ approach or TR
underlying asset and the earnout right as a separate        Royal Assent        2007/D10
CGT asset, the buyer in contrast, merely included all
                                                            From 17             Buyers in a standard earnout
amounts paid under the arrangement (the original
                                                            October 2007        arrangement have the choice
payment and amounts paid pursuant to the right) in
                                                                                of applying the proposed
the cost base of the underlying assets.
                                                                                look through approach.
   The replacement draft ruling TR 2007/D10
                                                                                The same opportunity to
essentially did two things; it expressed publicly                               apply the look through
for the first time the views of the Commissioner                                approach has not been
of Taxation (the Commissioner) in relation to CGT                               extended to sellers.
implications for reverse earnout arrangements and it
                                                            Pre-17 October      Seller and buyer to apply
also aligned the CGT treatment for both the buyer and
                                                            2007                TR 93/15
the seller under both standard and reverse earnout
arrangements. It was however heavily criticized as
                                                           The proposed ‘look through’ approach will only
being commercially and technically unsound and
                                                           apply to genuine arrangements which have the
in response, the Government announced in the
                                                           following characteristics:
2010-11 Federal Budget, a proposal to move to
                                                            •   a maximum time limit for the earnout
a ‘look-through’ treatment for ‘qualifying’ earnout
                                                                arrangement (eg. five years)
arrangements. Whilst a Treasury discussion paper
                                                            •   payments must be genuinely contingent and
has issued outlining the proposed ‘look through’
                                                                related to the performance of the asset
rules, no legislation has yet been enacted. In the
meantime, taxpayers buying and selling business             •   the earnout right must exist due to uncertainty
assets subject to earnout arrangements must be                  about the value of one or more of the assets
careful to correctly apply the following transitional       •   the transaction must be arms length, and
provisions which have been proposed as part of the          •   the asset(s) is not a revenue asset or trading
impending legislation:                                          stock.


74   |   The Taxpayer | 29 August 2011
Standard earnout arrangement and                            TR 2007/D10
CGT implications                                            When the CGT event happens to the original
   Under this arrangement, consideration for the            asset
transaction includes the creation of an ‘earnout right’     Seller
in the seller of the asset, calculated by reference to        Capital proceeds include both the monies received
the earnings generated by the asset at a defined            and the market value of the earnout right which must
period (usually between two and five years) following       be ‘independently’ determined at the time of CGT
the sale.                                                   event A1.
                                                            Buyer
    ExAMPlE: Standard earnout arrangement                     The cost base of the asset is equal to the cash paid
                                                            at the time of the contract plus the market value
    Ralph wishes to dispose of all of the shares in a
                                                            of the earnout right at the contract date which is a
    company which operates a small business. The
                                                            separate CGT asset.
    shares have a cost base of $300,000 and qualify for
                                                              Any amounts actually paid in excess of the value of
    the small business CGT concessions.                     the earnout right are not included in the cost base of
    Ralph considers that the market value of the shares     the underlying asset but may constitute ‘blackhole’
    is $600,000. This valuation is based on projections     expenditure for which taxation relief may be obtained
                                                            over five years provided the requirements of s40-880
    that the business will generate sales of $450,000 per
                                                            ITAA97 are satisfied.
    annum. The buyer Kenneth however considers that
    the shares are worth somewhere in the vicinity of       Earnout ‘right’
    $400,000 to $600,000.                                   Seller
                                                               The earnout right commences to be owned and
    Ralph agrees to sell the shares to Kenneth on terms
                                                            is acquired by the seller at the contract date for CGT
    that will take into account the performance of the
                                                            event A1.
    business in the succeeding two years.
                                                               The first element of the cost base of the earnout
    The parties enter into a contract in which Kenneth      right is that part of the market value of the original
    agrees to pay the following consideration for the       asset given by the seller in exchange for the earnout
    shares:                                                 right as is reasonably attributable to its acquisition
                                                               The seller’s ownership of the right comes to an
     •    a lump sum of $400,000, and
                                                            end when satisfied by the payment of an amount or
     •    50% of the amount by which its gross annual       amounts by the buyer, or by expiring without any
          turnover exceeds $250,000 in each of the next     amounts becoming payable. In each of these situations,
          two years.                                        CGT event C2 (about cancellation, surrender and similar
                                                            endings) happens.
    The market value of the earnout right is determined
                                                               An earnout right is not an ‘active asset’ as defined
    to be $200,000 at the contract date.
                                                            in s152-40 and is therefore ineligible for concessional
    In each of the next two years the gross annual sales    treatment under the small business CGT provisions
    of the business is $450,000 for year 1 and $500,000     contained in Div 152.
    for year 2. Accordingly, Kenneth is required to pay     Buyer
    a further amount of $100,000 at the conclusion of         The first element of the buyer’s cost base of the
    year 1 and $125,000 at the conclusion of year 2. The    asset includes the market value of the earnout right
    market value of the remainder of the earnout right      (worked out at the time of acquisition).
    at the end of year 1 is determined as $120,000.           Any money later paid pursuant to the earnout
                                                            arrangement is not paid to acquire the original asset,
    Assume that the parties are seeking to minimise any     but is paid to discharge the buyer’s obligation under
    CGT consequences arising from the transaction.          the earnout arrangement.


                                                                                     29 August 2011 | The Taxpayer | 75
CGT implications of buy/sell arrangements (continued)

         ExAMPlE
                                                                                                                                                Capital proceeds from the CGT
         CGT consequences of the share sale                                                                                   Cost base/         event happening to the part
                                                                                                                               reduced
         Ralph                                                                                                                              x   The capital proceeds plus the
                                                                                                                             cost base of
                                                                                                                               the right        market value of the remainder
         CGT Event A1 happens as a result of the sale of                                                                                                 of the asset
         shares. Ralph’s capital proceeds from this event
         include the lump sum cash payment and the market                                                                                             $100,000
                                                                                                                             = $200,000     x
         value of the earnout right. At the time of the sale                                                                                    ($100,000 + $120,000)
         contract, the earnout right has a market value of                                                                   = $90,909
         $200,000 (the right to both the first and second
         payment under the earnout each having a market                                                                    The capital gain is therefore $100,000 – $90,909 =
         value of $100,000). Total proceeds are therefore                                                                  $9,091.
         calculated as $400,000 + $200,000 = $600,000.                                                                     Cost base of the remaining part of the right is
                                                                                                                           calculated as $200,000 – $90,909 = $109,091.
         At the time of the sale contract, Ralph acquires a
         CGT asset (an earnout right) in the form of a chose                                                               The general CGT discount can be applied to the
         in action comprising his rights under the earnout                                                                 capital gain to reduce it by 50% where the earnout
         arrangement.                                                                                                      right has been held for at least twelve months at
                                                                                                                           the time that CGT event C2 happens. The small
         The capital would be calculatd as follows:
                                                                                                                           CGT concessions cannot be used to further reduce
         Capital proceeds ($400,000 + $200,000) . . $600,000                                                               or eliminate the capital gain as the right is not an
         Less: Cost base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300,000)          active asset.
         Capital gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000       Year 2
         Less: CGT discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150,000)
                                                                                                                           CGT Event C2 happens to the remainder of the
                                                                                                      $150,000             earnout right.
         Less: 50% reduction (Division 152) . . . . . . . . . . . ($75,000)                                                Capital proceeds = $125,000
                                                                                                       $75,000             Reduced cost base = $109,091
         Retirement exemption* . . . . . . . . . . . . . . . . . . . . . . . . . . . ($75,000)                             Capital gain = $125,000 – $109,091 = $15,909
         Taxable amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .              0         Again, as the asset has been held for at least 12
         *if legislative requirements are satisfied                                                                        months Ralph can apply the general CGT discount
                                                                                                                           to reduce the capital gain by 50%.
         Kenneth
                                                                                                                           Kenneth
         The first element of Kenneth’s cost base for the
         shares is based on the total of the amount of the                                                                 The additional $25,000 paid by Kenneth at the end
         lump sum cash payment and the market value of the                                                                 of year 2 may be deductible over five years pursuant
         earnout right. The cost base is therefore calculated                                                              to s40-880 ITAA97.
         as $600,000.
                                                                                                                       Proposed ‘look through’ approach
         CGT consequences of the earnout arrangement                                                                   The cost recovery method:
         Ralph                                                                                                         CGT consequences
         Year 1
                                                                                                                       Seller
         In year 1, CGT event C2 happens to a proportionate                                                              The seller reduces the cost base of the asset sold as
         part of the earnout right.                                                                                    and when amounts they are due to receive become
         Capital proceeds from the event are the amount that                                                           certain (including the initial capital proceeds and
         Ralph is entitled to receive under the arrangement                                                            subsequent payments).
         in that year.                                                                                                   After the cost base of the asset is reduced to
         The cost base/reduced cost base for CGT event C2 in                                                           zero, the seller realises a capital gain on all further
         year 1 is determined as follows:                                                                              amounts. This ensures that the seller’s capital


76   |   The Taxpayer | 29 August 2011
proceeds for the sale of the business asset reflect               ExAMPlE: ‘Reverse earnout’ arrangement
the total amount received. Any capital gain is treated            Ray wishes to sell to Amanda of all of the shares in
as realised on the business asset and is eligible for             a company which owns and operates a business.
any CGT concessions that were available when the                  Ray and Miranda agree that the business is valued
asset was sold. Accordingly, the small business CGT               at $1,700,000 however, that this amount would be
provisions would be available in relation to all capital          increased to $2,000,000 if a new recently introduced
gains made.                                                       product line is successful. Due to this uncertainty, Ray
                                                                  and Miranda agree to the following arrangement:
Buyer                                                             •    Miranda agrees to pay $2,000,000 consideration
  Payments are included in the asset’s cost base as                    for the shares, and
and when the buyer pays them ensuring that the cost               •    Ray makes an undertaking to pay Miranda 50%
base reflects the actual amount paid for the asset.                    of the amount (if any) by which the business
                                                                       turnover falls below $250,000 of each of the
    ExAMPlE                                                            two years following the sale, up to a maximum
    Proposed tax treatment for Ralph                                   of $100,000 in each year.
                                                                  Business profits for the next two years are $180,000
                Cost   Capital Adjusted    Capital
                                                                  and $160,000 requiring repayments by Ray of
                base proceeds cost base gain/(loss)
                                                                  $35,000 and $45,000 respectively. The shares have
     Yr 0   $300,000 $400,000               0    $100,000         a cost base of $1,200,000 and qualify for the small
     Yr 1           0 $100,000              0    $100,000         business CGT concessions.
     Yr 2           0 $125,000              0    $125,000         It is determined that $300,000 is reasonably
     Total $300,000 $625,000                0    $325,000         attributable to the acquisition of the reverse earnout
                                                                  right which has a market value of $150,000 at the
    Overall, Ralph’s capital proceeds were $625,000,              end of the first year after the repayment has been
    resulting in an overall capital gain of $325,000              made.
    realised as three separate gains of $100,000 for year         Assume that the parties are seeking to minimise any
    0 and year 1 and $125,000 in year 2. Ralph will have          CGT consequences arising from the transaction.
    access to any CGT concessions for the subsequent
    capital gains that he was able to access in relation to   TR 2007/D10
    the original capital gain.
                                                              Seller
    Proposed tax treatment for Kenneth                          The initial payment received by the seller is
                                                              received in connection with a transaction that relates
              Amount paid         Cost base
                                                              to a CGT event (the disposal of the original asset) and
     Yr 0        $400,000          $400,000                   the creation of the reverse earnout right in the buyer.
     Yr 1        $100,000          $500,000
                                                                The seller’s capital proceeds from the CGT event
     Yr 2        $125,000          $625,000
                                                              exclude so much of the payment as is reasonably
                                                              attributable to the granting of the right.
‘Reverse earnout’ arrangement and                               Although a reverse earnout right is created by the
CGT implications                                              seller in the buyer, no CGT implications arise for the
  Under this arrangement, the seller of an asset              seller at this time in relation to the right.
accepts a nominated sum by way of consideration,              Buyer
but undertakes to pay an amount or amounts (post                The buyer acquires a CGT asset in the form of the
sale payments) to the buyer calculated by reference           reverse earnout right. The buyers cost base for this
to an agreed measure tied to the performance of               CGT asset is so much of the original purchase price
the asset (such as sales or profit) during a specified        as is reasonably attributable to the acquisition of
period after completion of the sale.                          that right.


                                                                                          29 August 2011 | The Taxpayer | 77
CGT implications of buy/sell arrangements (continued)

  When an amount becomes payable in respect of                                                                                  Miranda
the right or part of the right (or when the right or part                                                                       A CGT event happens as a result of the partial
of the right expires with no amount being payable),                                                                             satisfaction of the CGT asset comprised by Miranda’s
CGT event C2 happens to the right or relevant                                                                                   reverse earnout right.
part. The capital proceeds from the CGT event will                                                                              Applying the cost base apportionment formula in
generally be the amount payable by the seller under                                                                             ss112-30(2), Miranda’s capital gain or loss resulting
the reverse earnout arrangement.                                                                                                from the repayments are as follows:
                                                                                                                                Year 1
         ExAMPlE
                                                                                                                                Reduced cost base = $300,000 x [$35,000/$35,000 +
         CGT consequences of the share sale                                                                                     $90,000] = $84,000
         Ray                                                                                                                    Capital proceeds = $35,000
         Ray has total capital proceeds of $2,000,000 relating                                                                  Capital loss = $49,000
         to:                                                                                                                    Year 2
         •    the disposal of the business assets (CGT event                                                                    Reduced cost base = $216,000
              A1) - $1,700,000, and                                                                                             Capital proceeds = $45,000
         •          the creation in Miranda of a reverse earnout                                                                Capital loss = $171,000
                    right - $300,000.
                                                                                                                              Proposed ‘look through approach’
         The relevant capital gain in relation to the share sale                                                                Subsequent payments from the seller to the buyer
         is calculated as follows:                                                                                            would effectively be treated as a partial refund.
         Capital proceeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700,000                     Note: The repaid method should not be confused
         Less: Cost base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,200,000)              with the ‘repaid rule’ in s116-50 ITAA97 which most
                                                                                                        500,000               commonly involves an adjustment to the purchase
         Less: CGT discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (250,000)                     price of an asset as a result of a contractual dispute.
                                                                                                        250,000
                                                                                                                                ExAMPlE
         Less: 50% reduction (Division 152) . . . . . . . . . . . . (125,000)
                                                                                                                                Proposed tax treatment for Ray
                                                                                                        125,000
         Less: Retirement exemption* . . . . . . . . . . . . . . . . . . . (125,000)                                                   Payments/      Capital              Capital
                                                                                                                                                              Cost base
         Taxable amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0           repayments proceeds               gain/(loss)
                                                                                                                                 Yr 0 $2,000,000 $2,000,000 $1,200,000 $800,000
         *if legislative requirements are satisfied
                                                                                                                                 Yr 1    ($35,000) Amend to $1,200,000 Amend to
         Miranda                                                                                                                                   $1,965,000            $765,000
         For CGT purposes, Miranda acquires:                                                                                     Yr 2    ($45,000) Amend to $1,200,000 Amend to
         •          the business assets, and                                                                                                       $1,920,000            $720,000

         •          a CGT asset in the form of the reverse earnout                                                              Ray must amend his income tax returns at the end
                    right.                                                                                                      of each income year in which he makes (or becomes
     The first element of the cost base for each asset                                                                          obligated to make) a payment.
     acquired, is so much of the total purchase price as is                                                                     Proposed tax treatment for Miranda
     reasonably attributable to each asset.
                                                                                                                                                  Amount paid/
                                                                                                                                                                       Cost base
     CGT consequences of the reverse earnout                                                                                                         recouped
     arrangement                                                                                                                 Year 0              2,000,000         2,000,000
                                                                                                                                 Year 1                (45,000)        1,955,000
     Ray
                                                                                                                                 Year 2                (35,000)        1,920,000
     According to TR 2007/D10 the repayment of amounts
     by Ray each year does not give rise to a capital gain or                                                                   It is presently unclear as to when amending
     loss in Ray’s hands and has no effect on the calculation                                                                 legislation relating to the ‘look through’ approach
     of his capital gain or loss from the disposal of the shares.                                                             will be enacted. n


78   |   The Taxpayer | 29 August 2011
Expanded trust TFN withholding rules
By Tiffany Douglas
From 1 July 2010, new TFN reporting rules contained at s202DN to s202DR of Income Tax Assessment Act 1936
(ITAA36) were introduced, apparently to ensure that assessable distributions made to beneficiaries of closely
held trusts align with the amounts returned by these beneficiaries in their tax returns. The rules apply to
resident trust estates that are closely held trusts.


  A closely held trust is defined in ss109UC(1) ITAA36           number of days to which the payment applies,
to include:                                                      divided by 365)
 •   a trust with up to 20 beneficiaries who in            •     distributions in respect of income of the trust
     aggregate have entitlement to 75% or greater                that were subject to the TFN withholding
     share in the income or capital of a trust, and              rules in an earlier income year (amounts that a
 •   a discretionary trust                                       beneficiary was presently entitled to but which
                                                                 the trustee did not distribute)
  However excluded from the definition for TFN
reporting purposes are:                                    •     distributions to trustee beneficiaries, where
                                                                 the trustee is required to make a TB statement
 •   a complying superannuation fund, a complying
                                                                 under the trustee beneficiary reporting rules
     approved deposit fund (ADF), a pooled
     superannuation trust (PST) or a First Home            •     distributions in respect of income of the trust
     Savers Account (FHSA) trust                                 that the beneficiary was presently entitled to
                                                                 and related to an income year before the TFN
 •   trustees of deceased estates (for the first five
                                                                 withholding rules applied
     income years after the individual’s death)
                                                           •     distributions to a beneficiary
 •   a fixed trust that is a unit trust with only
     exempt beneficiaries                                         -   which is an exempt entity, or
 •   a unit trust whose units are listed on the                   -   under a legal disability for the purposes of
     Australian Stock Exchange                                        s98 ITAA36
 •   a trust that is a discretionary mutual fund               Under the new rules:
     according to the meaning in ss5(5) and 5(6) of        •     All beneficiaries:
     the Financial Sector (Collection of Data) Act 2001
                                                                  -   may quote their TFN to the trustee, and
 •   an employee share trust for an employee share
                                                                  -   are entitled to claim a credit in their
     scheme that meets the definition under ss130-
                                                                      income tax return for amounts withheld by
     85(4) of the Income Tax Assessment Act 1997
                                                                      the trustee.
 •   a law practice trust, which is a trust regulated
                                                           •     Trustees must:
     by a state or territory law for the regulation of
     legal practices or legal services.                           -   provide to the Commissioner of Taxation
                                                                      (the Commissioner) a TFN report in the
  Note: The TFN withholding provisions will apply to
                                                                      approved form within one month after the
a discretionary trust notwithstanding the lodgement
                                                                      end of the quarter to which it relates (that
of a family trust election, due to the operation of
                                                                      is, the quarter in which the distribution
paragraph 12-175 (1)(c)(ii) of Schedule 1 to the
                                                                      occurs) or within such further time as
Taxation Administration Act 1953.
                                                                      the Commissioner allows. To assist with
  The following distributions are excluded from the                   transition, the due date for lodgement
rules:                                                                of 30 June 2011 TFN reports has been
 •   distributions below $120 for the whole income                    deferred to 31 August 2011. A further
     year (where the distribution relates to part of                  extension is available for tax agents
     the income year, use 120 multiplied by the                       who lodge electronically. In this regard,


                                                                                      29 August 2011 | The Taxpayer | 79
Expanded trust TFN withholding rules (continued)

               lodgement can be deferred to the due                            -   lodge an Annual TFN withholding report
               date for lodgement of the 2011 tax return                           detailing all payments together with
               subject to the TFN report, the 2011 tax                             amounts withheld (if any). Amounts
               return and all future tax returns being                             withheld must be paid by the 28th day of
               lodged electronically.                                              the month following the month in which
                                                                                   the Annual TFN withholding report is due
               The TFN report must include the
                                                                                   to be lodged ie. where the trustee has a 30
               beneficiary’s:
                                                                                   June balancing date, the payment will be
                • TFN                                                              due by 28 October
                • full name                                                    -   lodge annually an Annual trustee payment
                • date of birth (individuals only)                                 report detailing all distributions made to
                • postal address                                                   each beneficiary during the income year
                                                                                   even where the beneficiary has quoted a
                • business or residential address
                                                                                   TFN and pay any amounts withheld (this
                • entity type, and                                                 report is lodged by completing in full the
                • ABN (non individual beneficiaries only).                         details in the statement of distribution in
                                                                                   the trust’s tax return)
               TFN reports can be lodged electronically
               or in paper form and are only required                          -   issue a payment summary to a beneficiary
               to be lodged in respect of any new TFNs                             showing amounts withheld within 14 days
               reported to the trustee (available at http://                       of the due date the lodgement of the
               www.ato.gov.au/content/downloads/                                   annual TFN withholding report.
               BUS00281767NAT73651.pdf).                                   A trustee’s failure to withhold is an offence and also
                                                                        attracts an administrative penalty equal to the amount
           -   withhold from distributions made
                                                                        that should have been withheld or paid. Penalties will
               to beneficiaries at 46.5% where the

               TFN to the trustee before payment. A
                                                                        also be imposed for failing to:
               beneficiaries have not provided their
                                                                          •   issue an annual trustee withholding report
               distribution may be from the ordinary                      •   lodge a trustee payment report annually, and
               or statutory income of the trust or a                      •   issue payment summaries to beneficiaries.
               beneficiary’s share of the net income of a                 Trustees should immediately advise beneficiaries
               trust where they are presently entitled to a             who have not yet quoted TFNs in the approved
               share of trust income                                    manner that any distributions from the trust will be
           -   register for PAYG withholding for closely                subject to a withholding at 46.5% until such time as
               held trust purposes where required                       a TFN is quoted. n




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80   |   The Taxpayer | 29 August 2011

				
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