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Income Tax Part IVA Tax Policy

Unfortunate facts for those who want more tax from multinationals

I once worked for one of these multinationals. It was a US Company with a direct investment in Australia. The US company charged the Australian subsidiary management fees for head office costs, legal, finance…

We were subject to a transfer pricing review by the ATO and at the same time the IRS in the US subjected the US parent to a transfer pricing review. The ATO initially indicated they were of the opinion the management fees were too high for the services provided and so would consider denying deductions. Two months later the IRS indicated the management fees were too low and they would be considering substantially increasing the taxable income of the US entity.

In the end we had to get the ATO and the IRS officials on the same phone call and remind them that in their desire to collect taxes they had to remember that in international transactions, every additional dollar of tax one country collects, due to the various international tax agreements, is one less dollar collected in the other country. Both finally agreed that the management fess were appropriate (months and months and months later…).

With our wonderful politicians and media outlet screaming for more tax from multinationals they need to learn the same lesson.

The US Treasury’s top international tax official, Robert Stack, is also concerned about Australia forming an alliance with Britain and lining up US digital companies to be slugged with a so-called Google tax. The mooted changes would divert to Australia money that was potentially in line for US government coffers, triggering a cross-country fight over taxing rights… “We understand that governments are under enormous pressure to raise revenue and it must be tempting to target non-residents,” Mr Stack said in an interview with The Australian Financial Review in his Washington office. “However, we hope and expect that all companies, including US companies, will be treated fairly and in accordance with international norms of taxation.”

Let me explain it by looking at a multinational’s presence in Australia, my favourite example company, Banana IT.

The IP in the Banana products is owned by Banana US. It licences the right to use this to Banana Singapore (Owned by Banana US) with the rights to sell the product in South East Asia. Banana Singapore pay Banana US a fee for this right. Banana Singapore makes the products (by contracting third parties in China) and sells them to Banana Australia (Owned indirectly by Banana US) at an arms length wholesaler price (as required by international tax agreements). Banana Australia sells the product and makes a retailers profit.

The reason they chose Singapore for the South East Asia hub is the low company tax rate.

Now the Australian Government wants to get more tax in Australia on this supply chain. This is done by increasing the profit in Australia, thereby decreasing the profit in Singapore, meaning less tax in Singapore and more in Australia (Singapore not happy).

But remember, when Banana US is in a bit of financial trouble or wants to make a big acquisition it calls in all of its profits in subsidiaries and dividends get paid back to the US. Banana US has to pay tax on these dividends less the tax already paid in Australia, Singapore… So for every additional dollar of tax paid in Australia is a dollar less tax paid in the US in the future.

If I was the US Treasury, with a $17 Trillion deficit, I would not be happy with Australia claiming taking my future tax revenues from US companies…

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Income Tax Part IVA Planning Idea Planning Stuff

Partnerships of Discretionary Trusts on the nose…

Late last year the Commissioner released a Taxpayer Alert on the use of partnerships of discretionary trust by professional practices to avoid tax.

In the Taxpayer Alert late last year the Commissioner stated that he was concerned that the dominant purpose for setting up a partnership of discretionary trusts for a professional practice was to gain a tax benefit. Therefore, Part IVA could apply.

In this Taxpayer Alert the Commissioner did state that he would not be considering the use of partnerships of discretionary trust for years before 1 July 2013.

The Commissioner has taken this a step further by releasing a document to assist taxpayers to assess the risk that the Commissioner will apply Part IVA to the allocation of profits within professional firms.

Now in this new document, titled “Assessing the risk: allocation of profits within professional firms”, the Commissioner states what type of arrangements he will be reviewing.

In summary he states he will not review a partnership of discretionary trust structure for professional firms where any of the following three tests are met.

The first test is where the individual working in the practice receives assessable income from the firm in their own hands as an appropriate return for the services they provide to the firm. In determining an appropriate level of income, the taxpayer may use the level of remuneration paid to the highest band of professional employees providing equivalent services to the firm. If there are no such employees in the firm, comparable firms or relevant industry.

The second test is where 50% or more of the income to which the individual and their associated entities are collectively entitled in the relevant year is assessable in the hands of the individual.

The third test is that the individual working in the practice, and their associated entities, both have an effective tax rate of 30% or higher on the income received from the firm.

So if a taxpayer passes any of these three tests the structure will not be reviewed.

But lets be honest… almost no structure will fit within any of these three rules. So the Commissioner is saying “I am coming” to almost every professional practice!

You now have a choice… Stay at what the Commissioner calls “high risk” or decide to comply with one of these three test. If you are going to comply with these rules it is probably easiest to ensure the individual working in the practice receives the same as the highest paid staff member, or 50% of the trust distributions, whichever is the lowest.

Or you can just take the risk… The Commissioner says he will be looking at running cases in this area.

UPDATE: .In the media release launching this document the Commissioner refers to these as “draft guidelines”. He also states that these will only be applied to the 2014/15 year and later years. So it looks like we can lodge the 2014 year returns without having to comply with these tests. But once the guidelines are no longer draft, we will need to talk to clients about the risks that may exist if the structure is used to reduce tax substantially.

UPDATE 2: I keep getting asked about incorporated practices that use discretionary trusts as shareholders. Well the guideline states it applies to any structure. You will still need to ensure 50% of the dividends to the trust shareholder (or the amount the company pays to the top employee of the company) are distributed to the individual professional.

And just a couple of examples…

Example 1

A professional firm subject to these guidelines has three equal trustee partners (with representative IPPs) and 10 employees. It generates a profit of $1.5 million for the year. The three highest paid professional employees of the firm earned between $240,000 and $250,000 during the year. The IPPs at the firm bring in new clients, personally endorse the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.

Trust Partner 1 distributes the $500,000 as follows:
$300,000 to IPP 1
$200,000 to a company owned and controlled by IPP 1.

Trust Partner 2 distributes the $500,000 as follows:
$230,000 to IPP 2
$20,000 to the spouse of IPP 2
$250,000 to a company owned and controlled by IPP 2.

Trust Partner 3 distributes the $500,000 as follows:
$60,000 to IPP 3
$80,000 to the spouse of IPP 3
$260,000 to a trust with losses
$100,000 to a company owned and controlled by IPP 3.

Based on the guidelines above, IPP 1 will be considered low risk because they meet all three of the guidelines. IPP 1 is unlikely to be specifically reviewed for their allocation of profits.

IPP 2 does not meet two of the guidelines, because the amount returned by IPP 2 is less than that paid to the band of the highest paid professional employees of the firm, and IPP 2 does not receive 50% or higher of the profits in their own hands. However, IPP 2 satisfies the effective tax rate measure, and on the basis that IPP 2 demonstrates no aggravating factors, they will be considered low risk.

IPP 3 is considered high risk – they do not meet any of the guidelines. IPP 3 is likely to face additional enquiry from the ATO.

Example 2

A small professional firm has two equal trustee partners (with representative IPPs) and generates profits of $400,000 for the year. The three highest paid professional employees at the firm earned $90,000 each for the year. The IPPs at the firm bring in new clients, personally endorse the work of the employees, provide supervisory services, and represent clients in high-risk and high-value matters.

The Alphabet Trust distributes its $200,000 as follows:
$130,000 to Sam Letters (the IPP)
$70,000 to Letters Pty Ltd, a company owned and controlled by Sam.

The Numeral Trust distributes its $200,000 as follows:
$75,000 to Jo Numbers (the IPP)
$75,000 to Alex Numbers (the IPP’s spouse)
$25,000 to Jamie Numbers (the IPP’s adult child)
$25,000 to Numbers Pty Ltd, a company owned and controlled by Jo.

Sam would be considered low risk – he satisfies both the comparable remuneration and 50% or greater distribution guidelines, even though he does not meet the 30% effective tax rate test.

Jo would be considered high risk – she does not meet any of the guidelines provided, because she does not receive comparable remuneration, or 50% or greater of the distribution, and does not have an effective tax rate of 30% or greater. Jo is likely to face additional enquiry from the ATO.

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FBT Income Tax Part IVA Planning Idea Planning Stuff

Employee Benefit Trusts And “Deep Throat”

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Many years ago I received a call from a very junior ABC journalist (her career has very much blossomed since the and she is now a household name). We met in a meeting room where I worked an she provided me with two private rulings – both about employee benefit trusts.

The first was a very simple arrangement and the private ruling was favourable – deductible contributions, no FBT…

The second was pretty much the same arrangement, so much I suspected it was written by the same firm. BUT THIS ONE WAS NEGATIVE!

I said that I could not believe that the ATO had stuffed this up so badly… And that was the end of our discussion.

What I did not know is that this very quick meeting started an investigation about whether an employee at the ATO was providing positive rulings to “friendly” applicants.

Since then I have steered away from Employee Benefit Trusts – but now the Commissioner has released a draft taxation ruling (TR 2014/D1) that clears up his position. He has also released a guide on these trusts.

What are the three most important things in these documents…

1. If you are an employer, contributions you make to the trustee of an ERT are generally deductible if you have a genuine purpose for it being applied within a relatively short period towards remunerating employees. What is a relatively short period? It must be less than 5 years – any longer and there will be no deductions. This is a big change to many earlier private rulings.

2. As an employer, if you made a contribution to an ERT at the direction of, or on behalf of, your employee and that contribution is remuneration, you are required to withhold an amount from the contribution as a Pay as you go Withholding amount.

3. Fringe Benefits Tax and Division 7A can apply to contributions made by an employer to the trustee of an ERT, to benefits provided by the trustee of the ERT and on loans provided by the trustee of the ERT to employees. SO WATCH OUT!

These documents also remind us that the Commissioner has applied Part IVA to these types of arrangements. So don’t jump in without clearly documenting the purpose of the arrangement. But at least we have some more clarity now.

But this does mean I may never get to have cloak and dagger meetings with investigative journalists about tax again…

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Income Tax Part IVA Planning Stuff Rulings

Part IVA and partnerships of discretionary trusts

The most annoying habit of the Commissioner is to let everyone do something for years and then to finally try to close it down. Take the Commissioner’s announcement on 16 December 2009 that an unpaid present entitlement from a trust to a corporate beneficiary is a loan to which Division 7A applies. So 12 years of saying every trust should have a corporate beneficiary and 12 years of auditing these structures saying nothing is overturned overnight… Well it is about to happen again I fear…

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Thirty years ago, every accounting and legal partnership was a partnership of individuals. But this has changed to the point where the most common structure today is a partnership of discretionary trust rather than individuals. Actually these partnerships of discretionary trusts are becoming old hat as everyone moves to a company where the shareholders are discretionary trusts.

But in Taxpayer Alert TA 2013/3, the Commissioner raises concerns about the restructure from a partnership of individuals to a partnership of discretionary trusts. He does his norm “sham” argument but it is obvious he thinks these restructures may be schemes to which Part IVA might apply. The Commissioner states that professional practices may operate as a partnership of discretionary trusts, but may not be used for the to avoid tax obligation through income splitting.

This is only a Taxpayer Alert. And the Commissioner is very clear he is only considering tax benefits arising in the 2013/14 and later income years. So if you undertook a restructure like this before 1 July 2013 it appears it is safe.

But it starts to look like December 2009…

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Income Tax Part IVA Planning Stuff

Part IVA applies to small businesses

I don’t get that so many small business advisors think Part IVA can not apply to their clients. Yes it does not happen often but if it does your business is on the line. And here is where it is most likely to apply…

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You just read my post below and want to inject income into a loss trust. So a professional working though a company that has multiple clients, business premises, works for results and employs a second staff member (a PSB 100% sure) decides to inject income into a loss trust. To do this the company makes the trust its manager and pays the trust a management fee. This management fee would have been paid out to the professional otherwise as a salary but now it goes into the trust to use up the losses.

The Commissioner has made it clear that alienating personal services income, even if you managed to avoid the PSI rules as your are a personal services business, can still be subject to Part IVA (see NAT8028 factsheet). Sending the personal service income to a trust with losses so that no tax is payable is more likely to be subject to Part IVA than just leaving it in the company to be taxed at 30% as this fact sheet states. The scheme has one extra step (not leaving it in the company but paying to the trust as a management fee) and the tax benefit is larger (not paying 30% tax on the income but paying no tax on it at all.

If you advice ignores that the Commissioner has already got a position on Part IVA and personal services income in entities, you are not giving good advice.

I should mention that my former boss at KPMG, Chris Jordan, is more likely to go after the big end of town rather than the small end… but is that an excuse for bad advice?