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Tax issues: Strike the right note

Every Issue

Cite as: (2005) 79(7) LIJ, p. 84

It is a company’s board which is responsible for setting the right tone as regards tax compliance issues.

In March 2003 the ASX Corporate Governance Council released its 10 principles of good corporate governance.

By June of that year the Commissioner of Taxation had already begun to publicly connect good corporate governance with tax compliance.[1]

The Commissioner has made a number of further statements in the two years since then. It therefore seems an appropriate time to consider the interaction between the applicable corporate governance and tax compliance principles.

Note that in this article the term “the board” refers to any company directors, officers and executives who have corporate governance responsibilities.

Setting the right “tone at the top”

There can be no doubt that the board of a company is responsible for establishing the right “tone at the top” in relation to tax compliance issues. As Martin Lipton, one of the top US mergers and acquisitions attorneys, observed recently:[2]

“One of the single most important factors in ensuring that a board meets all of its duties is having the right ‘tone at the top’ of the corporation. The tone at the top will form the culture of the corporation and permeate the corporation’s relationship not only with investors, but also with employees, customers, suppliers, local communities and other constituents. If the CEO and senior management are not personally committed to high ethical standards, principles of fair dealing, full compliance with legal requirements and resistance to Wall Street pressures for short-term results, no amount of board process or corporate compliance programs will protect the board from embarrassment”.

Unfortunately, it can be difficult for a board to determine what “high ethical standards” mean in a tax context because views are so polarised on the relevance of ethics to the direction and management of a company’s tax affairs. At one extreme we find a long line of judicial authority that includes Lord Clyde’s candid statement in the Ayrshire Pullman case:[3]

“No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores. The Inland Revenue is not slow – and quite rightly – to take every advantage which is open to it under the taxing statutes for the purpose of depleting the taxpayer’s pocket. And the taxpayer is, in like manner, entitled to be astute to prevent, so far as he honestly can, the depletion of his means by the Revenue”.

At the other extreme we find the more collectivist observations of Lord Simon LC in Latilla:[4]

“My Lords, of recent years much ingenuity has been expended in certain quarters in attempting to devise methods of disposition of income by which those who were prepared to adopt them might enjoy the benefits of residence in this country while receiving the equivalent of such income without sharing in the appropriate burden of British taxation. Judicial dicta may be cited which point out that, however elaborate and artificial such methods may be, those who adopt them are “entitled” to do so. There is, of course, no doubt that they are within their legal rights, but that is no reason why their efforts, or those of the professional gentlemen who assist them in the matter, should be regarded as a commendable exercise of ingenuity or as a discharge of the duties of good citizenship. On the contrary, one result of such methods, if they succeed, is, of course, to increase pro tanto the load of tax on the shoulders of the great body of good citizens who do not desire, or do not know how, to adopt these manoeuvres”.

It may help to understand the reasons for these contrasting views if one notes that Lord Clyde gave his judgment at the start of the Great Depression whereas Lord Simon wrote during the Second World War.

A board should determine the acceptable level of tax risk by weighing up the potential benefit (in terms of any reduction or deferral of primary tax) against the potential costs (in the form of penalties, interest, legal and other litigation costs, and damage to the company’s reputation). It should then establish appropriate procedures to ensure that the company’s tax function adopts the same level of risk.

Reviewing compliance

The Commissioner has made two significant recent statements concerning the questions boards should ask when reviewing the tax implications of a transaction.

In January 2004 the Commissioner indicated that boards should ask their tax advisers the following 10 (rather pointed) questions in relation to any major corporate transaction:[5]

  1. What level of confidence do you have in the correctness of your advice?
  2. How likely is it that the Australian Tax Office (ATO) will take a different view of the application of the law and assess the company accordingly?
  3. If the ATO takes a different view and the matter proceeds to litigation, what is the risk of the Federal Court or the High Court deciding the matter in favour of the ATO?
  4. What is the potential downside if the company is unsuccessful in litigation with the ATO?
  5. If there is a dispute with the ATO, what is the likelihood of the ATO being prepared to settle the dispute and, if so, on what terms?
  6. How likely is it that the ATO will identify the tax issues which arise from the proposed course of action? Allied with that, to what extent will embarking on the proposed course of action increase the tax risk profile of the company and increase the possibility of audit scrutiny?
  7. In light of the potential risk, would it be desirable to approach the ATO for guidance in the form of a private binding ruling?
  8. Where a position has been taken on a tax issue, would it be desirable, in the interests of appropriately managing any risk, to be upfront with the ATO in identifying the issues before or when lodging the tax return and endeavouring to constructively handle any disagreements which may ensue?
  9. Is the advice based on the actual transaction or on an expectation of how the transaction will be implemented?
  10. Are you satisfied that the factual basis for your opinion to the board has been properly checked?

In March 2005 the Commissioner indicated that boards should ask themselves the following seven additional questions to determine whether the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 are likely to apply to a major corporate transaction:[6]

In offering this checklist, it is assumed that boards would only be considering arrangements that have some underlying commercial purpose, that is, that they are not dealing with paper schemes.

In this context boards might like to consider the following questions. They are not designed to determine the application of Part IVA. Rather, consistent with board roles, they are intended to provoke inquiries that assist boards in assessing the tax risk associated with particular proposals.

  1. Does the arrangement accord with your view of the sort of arrangements ordinarily used to achieve the particular commercial objective?
  2. Does the arrangement seem more complex than is necessary to achieve the commercial objective?
  3. Are there steps or a series of steps involved in the arrangement that appear to serve no real purpose other than to gain a tax advantage?
  4. Does the tax result appear at odds with the commercial or economic result?
  5. Do you have little or no risk in circumstances where significant commercial risks would normally be expected? Alternatively do you need to eliminate substantial risks that arise because of the steps introduced to secure the tax advantage?
  6. Are the parties to the arrangement operating on non-commercial terms or in a non-arm’s length manner?
  7. Is there a gap between the substance of what is being achieved under the arrangement (or a part of it) and the legal form it is being presented in?

General anti-avoidance rules were targeted at blatant, artificial or contrived arrangements (usually referred to as “paper schemes”) rather than normal commercial transactions and in his second reading speech the (then) federal Treasurer reassured any concerned taxpayers that:

“The proposed provisions – embodied in a new Part IVA of the Income Tax Assessment Act – seek to give effect to a policy that such measures ought to strike down blatant, artificial or contrived arrangements, but not cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs”.

Surprisingly, the Commissioner’s speech seems to directly contradict the Treasurer’s original reassurances as to the scope of the general anti-avoidance rules. However, it would still be prudent for the directors, officers and senior executives of a company to ask these seven questions in relation to major corporate transactions.

These 17 questions can also help boards to inject a healthy note of scepticism into their review of a major corporate transaction. However, boards should generally assess their tax advisers’ answers by reference to the “tone at the top” they have already established (as opposed to the Commissioner’s innately conservative approach to the direction and management of a company’s tax affairs).

DUNCAN BAXTER is a consultant with Blake Dawson Waldron, specialising in corporate and international tax and structured finance.

[1] Refer to “Large business and tax compliance – a corporate governance issue”, a speech by the Commissioner of Taxation Michael Carmody on 10 June 2003 to the Australian Financial Review Leaders’ Luncheon.

[2] Refer to page 2 of a memorandum entitled “Some thoughts for boards of directors in 2005”, 7 January 2005, by Martin Lipton, a partner in Wachtell, Lipton, Rosen & Katz.

[3] Ayrshire Pullman and Ritchie Motor Services v IRC (1929) 14 TC 754 at p763.

[4] Latilla v IRC (1943) AC 377 at p381.

[5] Refer to the letter dated 29 January 2004 from the Commissioner of Taxation to the boards of 1500 publicly listed companies.

[6] Refer to “Corporate governance and tax”, a speech by the Commissioner Carmody on 17 March 2005 to the National Convention of the Taxation Institute of Australia.


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