U13

TAX AVOIDANCE

prepared by

Pet er Fulche r
Welcome to Week 13 of AF308.

This week we look at the topic of tax avoidance. Most tax courses place this
topic, as we do here, towards the end of the course. One learns incrementally.
Avoidance is an advanced topic in tax. Hence it comes towards the end of an
income tax course.

This week we begin with some terminology that is used in this area. Thereafter
we look at an important question: Is tax avoidance illegal? The short answer is
no. As regards any particular avoidance initiative the important question is
whether it is efficacious.

In assessing the efficacy of any tax planning initiative one needs to take account
of rules that aim to curtail too clever initiatives to minimize the tax burden of a
taxpayer. These rules, commonly referred to as anti-avoidance rules, constitute
the main topic within this unit. We look at some examples of specific anti-
avoidance rules and an example of a general anti-avoidance rule.

Let’s get started.

2
Some Definitions
At the outset this week let me introduce some terminology.

‘tax avoidance’
This expression refers to the practice of designing one’s affairs so as to minimize
one’s tax liability while still accomplishing one’s substantive economic or
business goals. Alternative expressions, designedly more neutral in tone, are ‘tax
minimization’ and ‘tax planning’.

Example One
Landlord grants a 3 year lease to Tenant. The deal could require Tenant to pay an
initial sum for the grant of the lease (a premium) and an annual rent.
Alternatively the deal could require only annual rental payments. [The premium
and rent in Deal One and the rent in Deal Two are priced so as to be
economically equivalent.] On general principles a premium is a capital receipt
while rent is an income receipt. Hence Deal One produces a lesser chargeable
income figure for Landlord. If Landlord chooses to do Deal One rather than Deal
Two because of the tax treatment, Landlord can be said to have engaged in tax
avoidance.

‘tax evasion’
This expression refers to situations where tax is not assessed or not paid because
of some illegal action. Here is an example.

Example Two
Landlord in his annual return reports a lower rental income than that actually
derived; or makes no report of rental income; or falsely reports expenses not
actually incurred; or pays a bribe to the assessor in return for a reduced
assessment. This sort of activity is illegal. Landlord if caught can be subject to
administrative penalties and criminal prosecution.

‘sham transaction’
The OED defines a sham as ‘a pretence; something that is not genuine’. The
courts have defined a sham as ‘acts done or documents executed by the parties to
the ‘sham’ which are intended by them to give to third parties or to the Court the
appearance of creating between the parties legal rights and obligations different
from the actual legal rights and obligations (if any) which the parties intend to
create.’ (emphasis added)

Example Three
A and B sign a loan agreement and A advances money to B. Additionally A and B
have a secret, undisclosed understanding that B need not pay any interest nor
repay the principal; that A has no right to receive either interest or principal. Here
the ‘loan’ is a sham. There is in fact no loan. The loan document is a pretence
created only to give an appearance of a loan. The real transaction here is that A
has made a gift to B.

3
A sham transaction is like a piece of theatre. It has no legal effect. It need not be
voided or nullified. By its very nature it is a nullity. The practical challenge
presented by a sham is to discover the full facts that will ‘expose’ the sham. For
example, in the case above of A and B, the practical problem is to discover and
prove the secret undisclosed understanding between A and B.

‘artificial transaction’
An artificial transaction is different from a sham transaction. An artificial
transaction is a genuine transaction in the sense that it does create the legal rights
and obligations it purports to create. Its legal effect is exactly that which it
appears to be. However, the transaction is at the same time contrived or artificial.
It has no underlying substantive purpose other than satisfying the letter (as
distinct from the spirit) of a tax rule.

4
Is tax avoidance wrongful?
Is tax avoidance wrongful? This is an important question. It is discussed in Vid
13.2. Make sure you watch the video.

Here is a brief summary.

The question itself could be construed in two ways.

Is tax avoidance morally wrongful?
Alternatively: Is tax avoidance legally wrongful?

As regards the first alternative, opinion may vary and may well depend on the
particular tax avoidance activity in issue. As regards the second alternative there
is a clear answer. No. Tax avoidance is not and cannot be legally wrongful.

Our answer, clear and incontrovertible, to the second of these questions is

dictated by ‘the system’. A tax is a levy imposed by law. The law is a system of
rules. Taxpayers by their actions and decisions create the facts. We apply the
rules to the facts. End of story. There is no larger story that the taxpayer should
legally create a factual situation that falls within the tax rule. (Any such larger
story can only be a moral or political story, not a legal story.)

This brings us to an important conclusion. As regards avoidance activity the only

legal issue that arises concerns the efficacy of the activity. Does the taxpayer
engaged in avoidance activity achieve the legal outcome the taxpayer hoped for?

5
Tax as dancing
I said earlier that tax avoidance is an advanced topic in tax and thus comes
towards the end of an income tax course. Of course, in the real world, this is not
the chronology at all. The Landlord in Example One, before he does any deal
with Tenant, considers the tax treatment of the two alternative deals. Planning, by
its nature is something that one does at the beginning, in advance of events.

What is true of the taxpayer is also true of the legislature. In drafting a tax law the
Parliament often attempts to anticipate how a taxpayer might act to minimize his
tax burden and then creates rules with the aim of frustrating the taxpayer’s
avoidance activity. We call these anti-avoidance rules.

Successful avoidance activity also often produces a legislative response.

Parliament passes fresh legislation that thereafter prevents a successful repetition
of the activity. The taxpayer and the legislature thus appear to be locked in a
dance with each responding to the other’s initiatives. If one prefers more
combative language, the two parties could be said to be locked in competition as
in a game.

In this dance or game each party has a competitive advantage. The taxpayer is in
control of the facts. The taxpayer chooses what economic or business initiative to
undertake and how to pursue it. Since the rules are known in advance the
taxpayer may create facts that take best advantage of the rules. The Parliament
meanwhile is in control of the law. The Parliament sets the rules that provide the
tax treatment for any particular economic or business transaction.

Where Parliament sees or anticipates avoidance activity, Parliament can pass

rules that aim to frustrate the avoidance activity. Rules created with this objective
are commonly known as anti-avoidance rules.

6
General and specific anti-avoidance rules
Rules that aim to frustrate tax avoidance come in two forms.

Specific anti-avoidance rules

A specific anti-avoidance rule is a rule that aims to defeat or frustrate (i.e. render
ineffective) a particular avoidance tactic. My earlier Example One concerned a
landlord who structured a lease transaction to require a premium and along with
that a reduced rent. How could we render this ineffective? One obvious answer is
to expand the tax net and include in gross income any sum received as a premium
for the grant of a lease. The ITA 2015 in fact does this. Property income includes
rent. Section 2 extends the definition of the word rent to include a premium.
What we have here is a specific anti-avoidance rule.

Specific anti-avoidance rules have three particular features.

First, they are concerned with a specific or particular avoidance tactic.
Second, the rule itself makes no reference to tax avoidance. We deduce that the
rule aims to frustrate avoidance activity.
Third, a specific anti-avoidance rule concerns itself with a quite specific set of
facts. This third feature is the Achilles heel of a specific anti-avoidance rule. The
rule fails to frustrate avoidance tactics that fall just outside the specific facts of
the rule.

Here is another example of a specific anti-avoidance rule. Section 62 is headed

‘Thin capitalisation’. Section 62(1) provides:
‘(1) … if a foreign-controlled resident company, other than a
financial institution, has a debt-to-equity ratio in excess of 2 to 1 at
any time during a tax year, a deduction is disallowed for the interest
paid by the company during that year on that part of the debt that
exceeds the 2 to 1 ratio for the period the ratio was exceeded.’

What marks this as a specific anti-avoidance rule? Nothing, on its face. That is
one of the features of such rules. That this rule exists to render ineffective a
particular avoidance tactic is something we deduce.

Here is the larger background. Suppose Sco, a Samoa company, wishes to

establish a wholly owned subsidiary in Fiji. The new company, Fco, requires
capital of say $500,000. How could this money come into Fco? There are two
choices - debt or equity. Sco could hand money to Fco in exchange for bonds or
in exchange for shares. From a tax viewpoint, does it matter whether the money
comes in as debt or equity? Prima facie, yes. We know that as regards the tax
treatment of companies and dividends, Fiji (until amendments in the latter half of
2017) adopted a classical tax treatment re Fiji companies and nonresident
shareholders. The Fiji company is subject to Income Tax of 20% on its profits.
Dividends paid to a nonresident shareholder (the Samoan parent company) are
subject to NrWT of 9%. If Sco’s money comes in as equity, Sco faces the
problem of double tax on income derived through a company. By contrast, if
Sco’s money comes in as debt, debt payments on the bonds will be an expense
for Fco reducing chargeable income and thus Fco’s Income Tax liability. Interest

7
paid to Sco will be subject to NrWT of 10%. If you were Sco, how would you put
your half million into Fco?

This then is the specific avoidance tactic. Section 62(1) is created to counter this,
to render it ineffective. And it is all done very simply. Fco’s interest expense,
once it exceeds a stated ratio cannot be deducted in calculating chargeable
income.

Note that once one exceeds the ratio at which the rule kicks in, it is marginally
more tax effective for Sco to contribute money to Fco as equity. This is because
the NrWT tax rate for dividends is 9% (until amendments in the latter half of
2017) and for interest is 10%.

General anti-avoidance rules

Over the years, income tax legislation in Fiji has contained several different
general anti-avoidance rules. Here is a provision found in the early years of the
ITA 1974. This was copied from Australian tax legislation.

‘Every contract, agreement or arrangement made or entered into,

orally or in writing, shall, so far as it has or purports to have the
purpose or effect of in any way, directly or indirectly—
(a) altering the incidence of any tax;
(b) relieving any person from liability to pay any tax or make any
return;
(c) defeating, evading or avoiding any duty or liability imposed on
any person by this Act; or
(d) preventing the operation of this Act in any respect,
be absolutely void, as against the Commissioner, … but without
prejudice to such validity as it may have in any other respect or for
any other purpose.’

A general anti-avoidance rule has three particular features.

First, the rule does not concern a specific avoidance tactic. The rule aims to apply
to a range of different avoidance initiatives, both known initiatives and as yet
unknown initiatives.
Second, the rule will make express reference to avoidance as a purpose or
objective of the transaction or of the taxpayer (or other parties).
Third, the rule will be expressed in general or abstract language. This is a
corollary of the first point. General or abstract language is required if the rule is
to apply in a broad range of cases. This third feature often has the unhappy
consequence of introducing uncertainty as to whether the rule will or will not
apply in a particular instance. In place of the ‘rule of law’ we have rule by
administrative discretion (the Commissioner) or judicial opinion.

8
Related parties and profit shifting
Net profit of a business is revenues less expenses. Presuming constant revenues,
an increase in expenses will produce lower profits and in consequence less tax.
Conversely, presuming constant expenses, a decrease in revenues will produce
lower profits and in consequence less tax.

Expenses are one of the more fertile grounds for ‘manipulating’ profit for tax
purposes. There are many ways to increase business expenses. Equity capital (as
in the Sco story above) can be replaced with loan capital (interest is an expense,
dividends paid out of profits are not): increased prices may be paid for trading
stock: the business's wage and salary expense may be increased: services
previously done more cheaply in-house may be contracted out. Etc etc.

Of course there is no point in suffering a ‘real’ reduction in income just to reduce

tax. From the business owner's point of view the challenge is to take profit out of
a business in the form of deductible expenses without losing the benefit of that
money. This requires that sums paid as expenses be derived by a related party.
This could be a flesh and blood relative of the taxpayer (presuming the taxpayer
to be an individual) or an entity directly or indirectly owned by the business
owner or persons interested in the business owner.

The practice of manipulating profit by these means is commonly known as profit

shifting. Profit that would otherwise be derived by a business is shifted to a third
party in the form of deductible expenses of the business.

For there to be any tax advantage in all of this, it must be the case that the related
party is subject to a lower rate of tax than the original business owner. This could
be the case because the related party has tax losses, or is a non-resident, or is an
individual subject to a lower average rate of tax (by virtue of the progressive rates
of tax applied to individuals).

The case law provides numerous examples of taxpayers engaged in profit

shifting. FCT v Phillips, an Australian tax case, illustrates the use of outsourcing
to shift income between spouses. In this case a large firm of accountants
organized the creation of a trust. Beneficiaries of the trust were directly or
indirectly the spouses (or other family members) of partners and senior
employees of the firm. (At the outset beneficiaries subscribed money to the trust
in proportion to the size of their beneficial interests. The trust was thus an
example of a unit trust.) Office equipment owned by the firm was then sold to the
trustee and secretarial and support staff of the firm were terminated and re-
employed by the trustee. Thereafter the trustee leased the office equipment to the
firm and provided secretarial and support services to the firm. Lease and service
fees paid to the trustee were at reasonable commercial rates but exceeded the
costs incurred by the firm prior to the re-organization of its business in this
fashion. The full expense actually incurred by the firm under this arrangement
was deductible. The firm's profit for tax purposes (and thus the total income of
each partner) fell. Meanwhile profits of the trust from the supply of equipment
and services was distributed to the family members as beneficiaries of the trust.
9
Absent other sources of income the family members would be taxed at a lower
average rate than the partners.

Read: FCT v Phillips

Transfer pricing
Profit shifting can occur where the business activities of the taxpayer are wholly
domestic. It can also occur, and perhaps more often occurs, where there is some
international element in the taxpayer's business. An international element can aid
profit shifting (from the taxpayer's perspective) in two ways. First, international
dealings present a greater practical challenge to any tax audit of the taxpayer's
affairs. In particular the CEO's investigative powers under the Tax
Administration Decree are largely ineffective outside of Fiji. Second, profit
shifting, if it is to be of any utility, requires that the third party to whom profit is
shifted, is subject to a lesser or nil rate of tax. In a domestic situation possible
candidates are generally limited to individuals subject to progressive rates of tax
or a taxpayer with losses. However, once an international element is introduced,
the possibility arises of shifting income to a third party located in a low tax
country.

The standard example of profit shifting in an international context is transfer

pricing in international trade. Transfer pricing occurs where goods or services are
sold at an undervalue or acquired at an overvalue.

Example
A taxpayer exports copra from Fiji to a buyer in Taiwan. The Taiwanese buyer is
prepared to pay $300 a tonne. The copra is first sold to a related party in Vanuatu
for $240 a tonne. The related party resells to the Taiwanese buyer at $300 per
tonne. Revenue of $60 per tonne has been transferred to the related party in
Vanuatu where there is no income tax.

Example
A taxpayer operates a retail jewelry business in Fiji. Jewelry is sourced from
wholesale suppliers in Singapore. A related party is interposed between the
taxpayer and supplier, again in Vanuatu. The taxpayer acquires its jewelry from
the related party at a mark-up on the Singapore price. Retail prices in Fiji remain
constant, the cost of stock has risen, Fiji profit decreases by an equivalent amount
and is replaced by an equivalent profit in Vanuatu.

In each of these examples the related party to whom profit is shifted is a non-
resident and not carrying on business in Fiji.

Note that each dealing concerns the legal dealings, the sale of the copra or
purchase of the jewelry, as distinct from the physical dealing with the product.
The copra and jewelry in these examples would be shipped in the usual fashion

10
and never pass through Vanuatu. The overall dealing is thus sometimes referred
to as ‘re-invoicing’.

Example
In transfer pricing the related party need not always be the middleman.

A taxpayer operates a retail jewelry business in Fiji selling jewelry produced by

Fijico in Fiji using materials obtained from Supplyco in Singapore. The taxpayer
is related to Supplyco and unrelated to Fijico. Materials are supplied to Fijico at
an overvalue. Worked jewelry is then sold by Fijico to the taxpayer at prices
reflecting the cost of materials. The transaction is neutral for Fijico. Increased
supply costs are balanced by increased sale prices. The taxpayer meanwhile has
reduced profits reflecting its expensive stock and Supplyco in Singapore has
increased profits reflecting its supply at inflated prices. Profit of the taxpayer
Fijico has been shifted to Singapore.

Transfer pricing is not confined to dealings between separate legal entities. It may
also take place between branches of a business owned by a single legal person.
The banking industry provides an example. Imagine a foreign bank that operates
in Fiji as a branch (rather than by incorporating a Fiji subsidiary). As we have
earlier seen (week 12) under s.10(6) the permanent establishment is deemed to be
a resident company and subject to Income Tax on its Fiji sourced income. In
determining profit of the permanent establishment, prices must be placed on
services provided and credit extended between the head office and the Fiji branch
and vice-versa. Inflated prices on say computing services provided by the head
office to the branch office, or the apportionment of fee revenue on money
transfers, could shift (nominal) profit from the branch to the head office or other
branch that is a counterparty to the service.

Simple stories
Avoidance strategies that use a related party can be very simple. Here is an
example.

Example
X, a sole trader, owns a car that has been utilized in her business. The car is no
longer required and X plans to dispose of it. The car’s market value is $10,000.
Its wdv is $5,000. Option one is to sell the car to a stranger. This will result in
X’s chargeable income increasing by $5,000 (s.34(1)(a)) and presuming X is
taxed at 20%, Income Tax of $1,000. Option two is to gift the car to her son.
Prima facie this produces a deduction of $5,000 (s.34(1)(b)) and X’s Income Tax
is reduced by $1,000. From the vantage point of X alone, option two makes no
economic sense. From the vantage point of the family, option two makes perfect
economic sense.

11
In all of these stories it is the presence of the related party that ensures the
transaction makes economic sense. (The involvement of the related party will
also, of course, excite suspicion by the tax authority.) Unsurprisingly therefor, the
ITA gives considerable attention to identifying related parties.

Section 2 adopts a very broad definition of relative:

“relative” in relation to an individual, means –
(a) an ancestor, a descendant of any of the grandparents, or an
adopted child, of the individual;
(b) an ancestor, a descendant of any of the grandparents, or an
adopted child of a spouse of the individual; or
(c) a spouse of the individual or of any person specified in paragraph
(a) or (b);’

All of the lengthy s.4 is given over to defining the term ‘associate’. Section 4
provides:
‘(1) Subject to subsection (2), two persons are associates if the
relationship between the two persons is such that one person may
reasonably be expected to act in accordance with directions, requests,
suggestions or wishes of the other person, or both persons may
reasonably be expected to act in accordance with the directions,
requests, suggestions or wishes of a third person.

(2) Two persons are not associates solely by reason of the fact that
one person is an employee or client of the other, or both persons are
employees or clients of a third person.

(3) Without limiting the generality of subsection (1), the following

are treated as associates -
(a) an individual and a relative of the individual, except if the CEO
is satisfied that neither person may reasonably be expected to
act in accordance with the directions, requests, suggestions or
wishes of the other;
(b) a partner in a partnership and the partnership, if the partner,
either alone or together with an associate or associates under
another application of this section, controls more than 50% of
the rights to income or capital of the partnership;
(c) a trust and a person who benefits under the trust or who may
benefit under the trust through the exercise of a power of
appointment or otherwise;
(d) a member of a company and the company, if the member,
either alone or together with an associate or associates under
another application of this section, controls either directly or
through one or more interposed persons
(i) more than 50% of the voting power in the company;
(ii) more than 50% of the rights to dividends; or
(iii) more than 50% of the rights to capital;
(e) two companies, if a person, either alone or together with an
associate or associates under another application of this
section, controls either directly or through one or more
interposed persons
(i) more than 50% of the voting power in both companies;
12
 (ii) more than 50% of the rights to dividends in both companies;
or
(iii) more than 50% of the rights to capital in both companies.

(4) In applying subsection (3)(b), (d) or (e), holdings that are

attributable to a person from an associate are not reattributed to
another associate.’

Anti-avoidance provisions then focus on the pricing used in dealings between

related parties.

Section 89 (headed ‘Non-arm’s length transaction’) provides:

‘Subject to section 63, if an asset is disposed of by a person in a
transaction that is not an arm’s length transaction –
(a) the person disposing of the asset is treated as having received
consideration equal to the fair market value of the asset
determined at the time the asset is disposed of; and
(b) the person acquiring the asset is treated as having a cost equal
to the amount determined under paragraph (a).’

Section 63 (headed ‘Transfer pricing’) provides:

‘(1) Subject to subsection (2), the CEO may, in respect of any
transaction between persons who are associates, distribute, apportion,
or allocate income, gain, deductions, or tax credits between the
persons as is necessary to reflect the income that the persons would
have realised in an arm’s length transaction.

(2) If a party to a transaction between associates is located in and

subject to tax in Fiji, and another party to the transaction is located
outside Fiji, any distribution, apportionment, or allocation of income,
gain, deductions, or tax credits under subsection (1) must be made in
accordance with the Regulations.

(3) The allocation of income and deductions to –

(a) a permanent establishment in Fiji of a non-resident person; or
(b) a permanent establishment outside Fiji of a resident person,
must be made in accordance with the Regulations.’

13
Further specific anti-avoidance rules
I want to look at two further examples of specific anti avoidance rules.

Trading in loss companies.

One of the beautiful transactions seen in Vid 13.1 is the transaction known as
trading in loss companies. In this story the owner of the profitable business and
the shareholders of the loss company each benefit at the expense of the State.
Unsurprisingly Parliament takes a dim view of this and creates rules to frustrate
the avoidance activity.

Frustrating the tax plan is relatively straightforward. The loss company’s past
losses cannot be deducted following a change in ownership of the loss company.
Section 59(1) provides:
‘(1) If there is a change of more than 50% in the underlying
ownership of a company, any carry forward loss incurred for a tax
year before the change is not allowed as a deduction in a tax year
after the change, …’

One difficulty with this rule is its breadth. Not every business story involving the
sale of a loss company is tax driven. Thus the initial rule is qualified. Section
59(1) continues:
‘… unless the company –
(a) carries on the same business after the change as it carried on
before the change until the earlier of either the loss has been
fully deducted or the period for carrying the loss forward under
the Act has expired; and
(b) does not, until the earlier of either the loss has been fully
deducted or the period for carrying the loss forward under the
Act has expired, engage in any new business or investment
after the change if the principal purpose of the company or the
members of the company is to utilise the loss so as to reduce
the Income Tax payable on the amounts derived from the new
business or investment.’

Section 55 and ‘settlor trusts’

Imagine you are an individual with a large chargeable income in excess of
$270,000. Once your income exceeds this figure you face a tax problem. This
problem has a particular name: SRT. Chargeable income beyond $270,000
attracts SRT, initially at a rate of 23% and then increasing by steps of 1% all the
way to 29% (chargeable income beyond $1 million).

Suppose further that the income in issue is unearned income, or in other words,
property income.

How could you avoid SRT? The obvious answer is to dispose of the income
producing property. Place the property in the hands of somebody not subject to
SRT. One such person is a trustee. Trustees are subject to a flat tax of 20%. Easy.

14
But suppose further, that you do not wish to ultimately lose the income nor the
income producing property. How can this be done? Perhaps you could settle the
income producing property on a trustee to hold on trust for yourself but on terms
that income of the trust is to be accumulated.

Will this solution work? No. It overlooks the rule in Saunders v Vautier now
identified in s.55 as an ‘absolute beneficiary trust’. Per s.55(2) you as the
beneficiary will be treated as owning the trust property and all the income it
produces. (See week 11 pp.15-16.)

How else then could things be arranged? You could settle the property on the
trustee on terms that the income is to be accumulated and then name someone
else as the beneficiary. To ensure that it is yourself who ultimately benefits, you
could retain a power to revoke the trust or to name yourself as the beneficiary, the
plan being to exercise such power before any distributions become due to the
named beneficiary. Fantastic. Only ….

What is being proposed here is not new or novel. Trusts designed in this fashion
have a long history in income tax law. Parliament (or more precisely the
draftsperson) is familiar with such tactics and legislates to frustrate the tax plan.

Section 55 does this in two steps. First, a trust with such terms is identified and
given a particular name. It is called a ‘settlor trust’. Section 55(3) provides:
‘(3) In this section –
“settlor”, in relation to a trust, means a person who –
(a) has transferred money or an asset, or has provided a benefit to
the trust;
(b) has the power to revoke or alter the trust so as to acquire a
beneficial entitlement in the whole or part of the capital or
income of the trust, or has a reversionary interest in the capital
or income of the trust; and
(c) if the person is a non-resident person, the only income of the
trust is derived from sources in Fiji and the only assets of the
trust are Fiji assets; and
“settlor trust” means a trust in relation to which there is a settlor.’

Note that paragraphs (a), (b) and (c) are cumulative. We need (a) and (b) and if
the person is a nonresident then (c) also before the person is labelled a ‘settlor’
and the resultant trust a ‘settlor trust’.

Second, s.55(1) sets out the tax treatment for a ‘settlor trust’. Section 55(1)
provides:
‘(1) For all purposes of this Act, the following apply to a settlor trust -
(a) a settlor trust is not treated as an entity separate from the settlor
of the trust;
(b) amounts derived, and expenditures and losses incurred, by the
trustee of a settlor trust are treated as derived or incurred by the
settlor;
(c) the assets of a settlor trust are treated as owned by the settlor
and any dealing in the assets by the trustee is treated as a
dealing of the settlor.’

15
The tax treatment in s.55(1) completely frustrates the avoidance tactic. The
taxpayer with the tax problem that prompted creation of the trust is back where
he or she started from.

16
ITA 2015 Part 8
Part 8 of the ITA 2016 is headed Tax Avoidance.

Part 8 contains just two sections; s.101 headed ‘Income splitting’ and s.102
headed ‘Tax avoidance schemes’.

Section 101
This section is formally a general anti-avoidance rule in that it makes express
reference to an avoidance objective. That said, it also has in part the character of
a specific anti-avoidance rule in that it focuses on a particular avoidance tactic.
That tactic is what the section calls ‘income splitting’.

Income splitting is not a term of art (i.e. an expression with a precise legal
meaning). Conventionally understood it refers to the practice of structuring
matters to change the identity of the recipient of a given income.

Here is an example.
Uncle dies and I inherit his house. I rent out the house and derive income. If I
already have income in excess of $50,000, then my rental income will be taxed at
20%. Suppose my mother, a widow, lives with me and my family. Mother has no
income. My after tax income supports us all. If I transfer the rental property to
mother, the first $30,000 of rental income (mother’s income) will be tax free
(using Income Tax rates post August 2017). Since we all live as family sharing
resources, the rental money still comes into the family. Only now the family has a
greater after tax income. Terrific. Finally, mother’s will provides that on her
death I inherit the house.

A variation on this story, is that I transfer a half interest in the house to mother.
This scenario clearly brings out why we call this income splitting.

Here is another example. It is another family story.

I own a business as a sole trader. My two sons study at USP. My after tax income
supports us all. How could we enlarge the family’s after tax income? My two
sons could join me in the business. Converting the sole trader into a three person
partnership will split the business profit three ways taking full advantage of the
progressive tax rates applying to resident individuals. In the day to day running of
the business, nothing actually changes. The boys keep studying. I keep running
the business.

Section 101 provides:

(1) If a person attempts to split income with another person, the CEO
may adjust the chargeable income and tax credits of both persons to
prevent any reduction in tax payable as a result of the splitting of
income.

(2) A person is treated as having attempted to split income when –

17
 (a) the person transfers income or the right to income, directly or
indirectly, to another person; or
(b) the person transfers property, including money, directly or
indirectly, to another person with the result that the other
person receives or enjoys the income from that property,
and the reason or one of the reasons for the transfer is to lower the
total tax payable upon the income of the transferor and the transferee.

(3) In determining whether a person attempts to split income, the

CEO must consider the value, if any, given for the transfer.

In the application of s.101 the critical matter concerns the last two lines of
subs.(2). When can the CEO safely infer that the reason for the transfer is tax
driven? I suggest that in my two examples the family facts (the family functions
as an economic entity) in combination with the fact that the transfer is a gift
(subs(3)) is probably a sufficient foundation for the CEO to exercise his or her
powers in subs(1).

Section 102
Section 108 of the ITA 1974 set out a general anti-avoidance rule in great detail.
The section was modelled, word for word, on Australian tax legislation known as
Part IVA. Section 102 of the ITA 2015 is a slimmed down version of the former
s.108 and Part IVA.

Note that s.102 was subject to minor amendments by the IT (Budget

Amendment) Act 2017.

Section 102 now provides:

‘(1) Notwithstanding this Act, if the CEO is satisfied that –
(a) a tax avoidance scheme has been entered into or carried out;
and
(b) a person has obtained a tax benefit in connection with the tax
avoidance scheme;
the CEO may determine the tax liability of the person who obtained
the tax benefit as if the tax avoidance scheme had not been entered
into or carried out and can make compensating adjustments to the tax
liability of any other person affected by the tax avoidance scheme.

(2) When a resident person has entered into a transaction that directly
or indirectly has the effect that income is foreign-source income
derived through a non-resident entity that is connected to a tax haven,
the CEO may adjust the income and foreign tax credit position of the
resident person to reverse the tax effect of the transaction.

(3) If a determination or adjustment is made under this section, the

CEO must issue an assessment giving effect to the determination or
adjustment.

18
 (4) A determination or adjustment under this section must be made
within 7 years from the last day of the tax year to which the
determination or adjustment relates.

(5) In this section –

“non-resident entity” means a partnership, trust or company that is
not a resident person;
“scheme” includes a course of action and an agreement,
arrangement, promise, plan, proposal, or undertaking,
whether express or implied and whether or not enforceable;
“tax avoidance scheme” means any scheme, whether entered into
by a person affected by the scheme or by another person, that
directly or indirectly –
(a) has tax avoidance as its purpose or effect; or
(b) has tax avoidance as one of its purposes or effects, if the tax
avoidance purpose or effect is not merely incidental;.
“tax benefit” means –
(a) a reduction in a liability to pay tax;
(b) a postponement of a liability to pay tax;
(c) an entitlement to a refund;
(d) an increase in a tax credit;
(e) any other advantage arising because of a delay in payment
of tax; or
(f) anything that causes gross income to be exempt income, a
capital gain to be an exempt capital gain, or a fringe benefit
to be an exempt fringe benefit;
“tax haven” means a foreign country or part of a foreign country
that has –
(a) effective tax rates significantly lower than those of Fiji; or
(b) laws providing for the secrecy of financial or corporate
information that facilitate the concealment of the identity of
the real owner of any income or asset.’

The main story is in subs(1) and subs(5).

A tax avoidance scheme is any scheme in which a main purpose of a party to the
scheme is to avoid or reduce any person’s tax liability. The person with the
purpose could be different from the person gaining from the scheme.

If a tax avoidance scheme exists, and in consequence any person obtains a tax
advantage, then the CEO becomes empowered to counter the scheme. The CEO
is entitled to assess tax as if the scheme had not been undertaken.

The Australian experience

Part VIA, the model for the former Fiji s.108, has been considered by the
Australian High Court on a number of occasions. These decisions remain of
interest and relevance to s.102.

One of the early Australian High Court cases is FCT v Spotless Services Ltd.
I want you to read this case. Here is an introduction.

19
The taxpayer was an Australian public company carrying on business in
Australia. It held a large sum of money from a share issue that was not
immediately required in its business. The company invited proposals from a
number of bankers for investment of the idle funds for a short period. Proposals
received included a proposal to place the funds with EPBCL, a Cook Islands
bank, on a term deposit. The proposal came from the Australian merchant bank,
Bankers Trust Australia, and was accompanied by promotional material prepared
(formally) by EPBCL.

The interest to be paid by EPBCL on a term deposit was considerably below that
which could be earned (at that time) on a comparable Australian investment.
However, the net after tax return was greater on a EPBCL deposit. This resulted
from the approach taken at this time by Australian tax legislation to foreign
sourced income. Income derived outside Australia and subject to tax in the
foreign jurisdiction became exempt income for Australian tax purposes (ITAA
s.23(q)). Interest earned in the Cook Islands would be subject to Cook Islands
withholding tax of only 5%.

As a general rule no investment could be simpler than a term deposit with a bank.
However, on this occasion the actual legal mechanics of making the investment
were quite complex. The complication largely arose in providing security for the
deposit.

When a customer deposits money with a bank, the customer is lending money to
the bank. It is common and usual for a banker lending money to a customer to ask
for security. It is uncommon and unusual for a customer depositing money with a
bank to ask for security from the bank. However, security was necessary in this
case for two reasons. First, Spotless required a risk free investment. Second,
EPBCL was a tiny bank, carrying on business only in the Cook Islands and with
no name recognition.

Security was provided by a standby letter of credit issued by Midland, a large,

sound, reputable British bank.

A bank issuing a letter of credit and making payment in accordance with the
undertaking, looks to be reimbursed by the party on whose initiative the letter
was issued. In this case this would be EPBCL. Midland thus needed its own
security for EPBCL's reimbursement obligation. The funds deposited by Spotless
with EPBCL were in turn to be deposited by EPBCL with Bankers Trust Asia.
Midland held a charge over this deposit as security for the reimbursement
obligation.

Effecting the Spotless deposit with EPBCL and simultaneously putting in place
the security arrangement produced technical legal complexities in making the
investment. (In fact EPBCL met its obligations to its customer Spotless and no
resort was ever made to the security.)

The tax issue arose when the Commissioner's assessment included in total income
the interest earned on the term deposit with EPBCL. The Commissioner proposed
two bases for the assessment.

20
First, the interest income was actually derived in Australia and not in the Cook
Islands. In consequence, it was not exempt income.
Second, in the alternative and assuming the first ground was wrong, there was
here a scheme caught by Part IVA. The tax benefit obtained was the omission
from chargeable income of the interest earnt. Under Part IVA, the Commissioner
determined to include in chargeable income an amount equal to the whole of the
tax benefit.

The taxpayer challenged the assessment. Both the trial court and Full Federal
Court held the interest income was derived in the Cook Islands. On the second
and alternative ground, the Full Federal Court ruled 2/1 against the
Commissioner. The majority held there was no scheme to which Part IVA
applied because no party had the requisite (dominant) purpose to enable the
taxpayer to obtain in connection with the scheme the tax benefit. The purpose of
the taxpayer (and other parties) was that the taxpayer obtain the best possible net
return on its investment after all costs including tax.

The Commissioner appealed the decision of the Full Federal Court on the second
ground of assessment, the Part IVA issue, to the High Court.

The essential facts of Spotless, once one leaves aside the legal mechanics of
putting the investment in place, are very simple. An Australian resident with idle
cash places the funds on deposit with a bank outside of Australia and earns
interest. The interest income is taxed in the source country. That's it.

The policy issues presented by the case are as complex as the facts are simple.
First, there is the ‘Cook Islands issue’. The Cook Islands is a tax haven. The
Cook Islands government makes money by means of licence fees paid by people
like EPBCL and from levying tax at low rates (as in this case) on investments
attracted to the Cook Islands by these low rates. In this story, Spotless is happy
because it has a better after tax return on its investment. EPBCL is happy because
it gets hold of the Spotless money at a low rate of interest and is able to redeposit
those funds elsewhere at market rates, making a profit on the difference. The
Cook Islands government is happy because of the licence and tax revenues
generated. The only unhappy person in the story is the Australian government
which sees its tax base eroded because of the subversive position taken by the
Cook Islands. Allowing the taxpayer to succeed in its objective involves
accepting the unrealistic tax competition from the Cook Islands, which, has
nothing to lose and everything to gain.

Second, there is the very simplicity and ordinariness of what has been done.
Importantly, the taxpayer in this case is not engaging in an artificial transaction.
This is a genuine business transaction. There is idle cash that needs to be
invested. The particular investment is shaped by the tax environment. But this is
true of most investments. Here in a real business transaction the taxpayer
deposited idle funds with a Cook Islands bank. What's the problem? Would
anybody even ‘see’ a problem if the deposit was in say New Zealand (a non-tax
haven country)? Almost certainly, no. If this transaction is permitted, in the sense
it is not precluded by any specific anti-avoidance provision, should it be attacked
by a general avoidance provision? If yes, then where does this stop? A ruling for
the Commissioner in effect says to the taxpayer you should have invested in
Australia and ignored the possibility presented by the general tax law. This is
21
taxation on a wholly hypothetical basis. What point remains for the general tax
law if tax is to be levied on a hypothetical basis?

The case, of course, is not to be decided on policy grounds. It must be decided as

the law dictates, i.e. in accordance with Part IVA. What is the correct application
of Part IVA in this story?

The High Court rules in favour of the Commissioner.

The scheme is; the proposal to invest $40 million on deposit in the Cook Islands
and to pay Cook Islands withholding tax on the interest earned, and the taking of
all necessary steps to implement the proposal.
The tax benefit in connection with the scheme is the omission of the interest from
chargeable income.
The critical issue in the case is the element of purpose. This issue, as shaped by
the Federal Court decision might be stated as follows; is the dominant purpose to
obtain the best net return after all costs including tax, or, is the dominant purpose
to obtain the tax benefit?

The High Court begins by noting that tax is part of the environment in which
business operates, that tax affects most if not all business decisions and that it is
generally true one aims for the best net return after all costs including tax. The
very generality of these propositions is not helpful in deciding the legal issue of
dominant purpose. In consequence, the contrast (the dichotomy) implicit in the
Federal Court decision between a purpose of maximum after tax return and
purpose of obtaining a tax benefit is a false contrast. What Part IVA requires is
that attention be focused specifically on the matters listed in the legislation. The
question is not simply: what is the dominant purpose? The question is: what is the
dominant purpose as determined having regard to the matters listed in the
legislation? This is the legal issue for decision.

The first two matters, (the manner in which the scheme was entered into and its
form and substance) required consideration of the way in which and the method
or procedure by which the particular scheme was established. Here this involved
reference to the taxpayer's solicitation of proposals and the marketing materials
for the EPBCL deposit with their emphasis on the exempt character of income
earned. An examination of the procedure by which the scheme was carried out
showed that much of the banking activity took place in Australia. Of the
proposals received, only one other concerned an off-shore investment and this
was not attractive for regulatory reasons. The choice for the taxpayer thus
concerned off-shore in the Cook Islands or on-shore in various investments in
Australia. Looking at all of this the High Court agreed with the dissenting
decision in the Federal Court. The form and substance of the EPBCL proposal
was to take steps to ensure interest was sourced in the Cook Islands. The
dominant purpose of the taxpayer was to achieve a tax benefit in Australia. The
court said:
"In those circumstances, a reasonable person would conclude that the
taxpayers in entering into and carrying out the particular scheme had,
as their most influential and prevailing or ruling purpose, and thus
their dominant purpose, the obtaining thereby of a tax benefit, in the
statutory sense. The scheme was the particular means adopted by the
taxpayers to obtain the maximum return on the money invested after
payment of all applicable costs, including tax. The dominant purpose
22
 in the adoption of the particular scheme was the obtaining of a tax
benefit." (emphasis added)

Read: FCT v Spotless Services Ltd

This concludes our examination of specific and general anti-avoidance rules.

23