The Tax Commissioner is on the lookout for: taxpayers who dispose of assets and claim tax benefits but continue to enjoy the economic benefits of owning those assets; and advisers recommending these arrangements. Tax benefits can be cancelled. And penalties may apply. 2008's first ATO tax ruling clarifies the Commissioner's position regarding Part IVA of the ITAA36 and 'wash sales'.
Julian Smith and Amber Chew
A new ATO ruling1 cautions practitioners, and their clients, against being involved in, or recommending, schemes which crystallise capital losses without changing the taxpayer's economic interest in the disposed asset.
Examples of the transactions which may be caught
Stephen transfers shares he holds personally to himself to hold as trustee and appointor of a discretionary family trust for no consideration. The shares had little prospect of financial benefit for the trust beneficiaries and no shareholder received any return on the shares when the company was eventually wound up.
- Most likely, tax benefit cancelled — because there was no reason for the gift of shares from Stephen to the trust other than obtaining the tax benefit.
Oscar transfers shares between two discretionary trusts for which he is sole trustee and claims the resulting capital loss as a tax benefit.
- Most likely, tax benefit cancelled — because it is reasonable to conclude that, but for the scheme, Oscar would not have entered into the transactions.
More examples below. First, some theory.
What are wash sales?
The term, 'wash sale' loosely describes a transaction in which a taxpayer disposes of an asset while effectively preserving their interest in that asset.
The key features of a wash sale arrangement are as follows:
- the taxpayer disposes of an asset;
- the taxpayer acquires an identical, or substantially similar, asset; and
- the taxpayer continues to enjoy the financial benefits of the asset or experiences no significant change in their economic exposure to, or interest in, the asset (or substitute asset).
The acquired asset may be similar to the disposed asset either in terms of substance or economic benefit (or both).
Why are the tax avoidance provisions (Part IVA) relevant?
Part IVA of the Act2 gives the Commissioner discretion to cancel all or part of tax benefits if:
- the taxpayer has obtained a 'tax benefit'3, for example, a capital loss or an allowable deduction (or would have obtained the benefit unless the Commissioner cancelled it);
- the tax benefit was, or would have been, obtained in connection with a 'scheme';4 and
- the scheme was entered into for the sole or dominant purpose of obtaining a tax benefit — considering the eight factors listed in section 177D of the Act. (You can read the factors at the end of this article) .
What does the new ruling apply to (and when)?
The new ruling applies to all taxpayers who obtain a tax benefit in the form of a capital loss or an allowable deduction in connection with a wash sale or similar arrangement.
Although the ruling was issued on 16 January 2008, it applies both before and after that date. (However, it does not apply to taxpayers to the extent that it conflicts with a private dispute settled before that date.)
What is the existing relevant test?
Whether the Commissioner may cancel a tax benefit obtained in connection with a wash sale arrangement depends on the circumstances of each case. However, in general, the Commissioner?s discretion under Part IVA applies if a taxpayer obtains a 'tax benefit' in connection with a 'scheme' and a 'counterfactual' is established, having regard to the factors listed in section 177D of the Act (and summarised at the end of this article). v
The key concepts of a "tax benefit", a "counterfactual" and a "scheme" are explained here:
- A 'tax benefit' exists if it might reasonably be expected that the benefit (including a capital loss, allowable deduction or foreign tax credit) would not have been obtained but for the taxpayer's participation in a 'scheme'.
- A 'counterfactual' is established if, but for the scheme:
- the taxpayer would not have disposed of or otherwise dealt with the asset (at all, or in the manner that they did); and
- the taxpayer would, or could, be expected to have continued to beneficially own or have an interest in the asset during that income year.
- A 'scheme' is broadly defined and may consist of one or more of the steps taken to dispose or otherwise deal with an asset. This will commonly include:
- a CGT event;
- incurring a capital loss or deduction; and
- entering into any arrangements with the effect that the taxpayer's economic exposure or interest in the asset is not significantly affected.
It may also include:
- obtaining or benefiting from financial, taxation or legal advice;
- incorporating or acquiring control of a company, which later acquires the asset; or
- entering an understanding or arrangement which enables the taxpayer to financially benefit from the disposed asset.
- It is reasonable to conclude that a scheme was entered into for the sole or dominant purpose of obtaining a tax benefit if the eight section 177D factors are satisfied (see the end of this article). If any of these factors are not satisfied, then the Commissioner may conclude that Part IVA does not apply.
If the Commissioner disallows the whole or part of a tax benefit, then the Commissioner may make a 'compensating adjustment' to the taxpayer's taxation situation under sub-section 77F(3) of the Act.
How does the Tax Ruling change things?
What this means for practitioners
This ruling cautions practitioners, and their clients, against recommending or being involved in schemes which crystallise capital losses without changing the taxpayer's economic interest in the disposed asset. In particular, it appears that the Commissioner will cancel the tax benefit of the transaction if there does not appear to be any commercial or family reason for the transactions, other than obtaining the tax benefit.
Common transactions effected to crystallise capital losses
The new ruling makes clear that the following types of common transactions may attract the application of Part IVA and have their tax benefit cancelled:
Transaction 1 If a taxpayer:
- sells and buys an identical, or substantially similar, asset in a short period; and
- the sale and purchase effectively cancel each other out so that the taxpayer continues to be exposed to the same risks and opportunities of that asset as if it had not been sold.
Transaction 2 If a taxpayer:
- deals with an asset of a company or trust in which the taxpayer has an interest, control or influence;
- the financial benefits of the asset are not distributed to other members or beneficiaries; and
- the taxpayer effectively maintains the same economic exposure to the asset as if the asset had not been disposed of
Transaction 2 If a taxpayer disposes of an asset and enters into derivatives, financial instruments or an agreement to receive future income from that asset.
Consider the Tax Ruling applied to the following examples:
- At the same time as Catherine sells a parcel of shares, she buys an identical parcel and claims the resulting capital loss from the sale as a tax benefit.
- Most likely, benefit cancelled — because it appears there was no objective reason for disposing of the shares other than claiming the tax benefit.
- Maria sells and buys identical parcels of shares within 24 hours and claims the resulting capital loss as a tax benefit.
- Most likely, benefit cancelled — despite the 24 hour delay between the sale and re-purchase, it appears that the only impetus for entering into the scheme was to obtain the tax benefit.
- Liam transfers shares he holds personally to himself to hold as trustee and appointor of a discretionary family trust established for the maintenance and education of his four children for no consideration. The share dividends were distributed to the beneficiaries.
- Most likely, benefit allowed because the scheme is consistent with an ordinary family dealing and the financial benefits of the shares are enjoyed by the trust beneficiaries, not Liam. This is despite Liam effectively maintaining his economic exposure to the asset.
- David sold and bought equivalent parcels of shares within three days and claims the resulting capital loss as a tax benefit. Over those three days, the share price of the disposed shares improved markedly.
- Most likely, benefit allowed because the scheme appears to reflect market conditions.
Does the Tax Ruling apply to Super Funds paying a pension?
Sometimes super funds sell assets while paying pensions, then re-buy similar assets. This type of transaction may be caught by Part IV of the Act (and the tax benefit cancelled) - however, such arrangements do not appear to be the focus of this ruling.
Assets in a super fund which are segregated to fund the payment of a pension are now free from tax when paid to a member who is at least 60 years of age and who has satisfied a condition of release. However, on the member's death, payment of those segregated assets as death benefits will not necessarily be tax free. The taxable (or 'non-concessional') component of any death benefit which is paid to a non-dependant will be taxed at 15%.
Converting to cash
Before paying the death benefit, the trustee may sell the underlying assets and convert them into cash. As the fund is no longer paying a pension, this may involve the realisation of capital gains on which tax is payable by the fund. However, it is common for trustees to reduce the overall tax liability by:
- while the fund is paying a pension, selling assets to realise capital gains and;
- re-purchasing equivalent listed securities.
This helps reduce the overall tax because the capital gains tax payable by the fund after the member's death will be assessed on the value of the listed securities as re-purchased.
The Tax Ruling
The Tax Ruling focuses on capital losses, allowable deductions and foreign tax credits. It does not focus on reducing future capital gains tax liabilities while in pension mode. Consequently, the Tax Ruling does not seem to address any precluded 'tax benefits' in these circumstances.
However, that is not to say that the ATO would not cancel the tax benefit on the basis that such a reduction of future capital gains tax liabilities resulted in a 'tax benefit' being obtained by the fund in contravention of Part IVA.
For more information in relation to this article or taxation generally, please contact Maddocks on 03 9288 0555 or 02 8223 4100 and ask for a member of the Maddocks Tax & Revenue Team.
Whether Part IVA of the ITAA36 applies to a scheme depends on consideration of the following eight factors listed in section 177D:
- the manner in which the scheme is carried out;
- any discrepancy between the form and substance of the scheme;
- the period over which the scheme is carried out;
- the result achieved by the scheme;
- any change in the taxpayer's financial position;
- if the asset is dealt with to an associate, any change in the associate's financial position;
- whether the person to whom the asset is disposed benefits in substance from their ownership or interest in the asset; and
- any relationship between the taxpayer and person to whom the asset is disposed.
Examples of how each factor may invoke Part IVA are set out below:
- The manner in which the scheme was carried out:
- In comparison to the usual way in which an asset is disposed of to a third party, the scheme appears:
- artificial; or
- explicable only by reference to the tax benefit obtained.
- The taxpayer continues to beneficially own or have an interest in the asset without being required to do anything to the asset to ensure the continuing beneficial ownership or interest.
- Under the scheme, the taxpayer enters into transactions which effectively cancel each other out or otherwise provide the taxpayer with continued economic exposure to the asset.
- The arrangement produces no other benefit other than the tax benefit.
- Discrepancy between form and substance of the scheme:
- The scheme allows the taxpayer to appear as if they have disposed of an asset whilst effectively leaving them in materially the same economic position with regard to that asset.
- Period over which the scheme is carried out:
- The scheme is:
- carried out over a short period and close to the derivation of a tax benefit;
- carried out at the end of an income year; or
- is otherwise unrelated to ordinary business or family reasons.
- The result achieved by the scheme:
- The scheme reduces the taxpayer's income tax payable in that income year or in subsequent years.
- Any change in the taxpayer's financial position:
- The taxpayer's financial position remains essentially unchanged, apart from:
- any transaction costs associated with the scheme; and
- the resulting increase in the taxpayer's financial resources because of not having to pay tax.
- If the asset is dealt with to an associate, any change in the associate's financial position:
- The financial position of the associate remains essentially unchanged or is offset by an inverse change in the taxpayer's financial position.
- Whether the person to whom the asset is disposed benefits in substance from their ownership or interest in the asset:
- The taxpayer continues to enjoy the financial benefits of the asset whilst the person to whom the asset is disposed does not benefit from their interest in that asset.
- Any relationship between the taxpayer and person to whom the asset is disposed:
- The taxpayer has control, influence or a family connection with the person to whom the asset was disposed.