Australian Tax Law Bulletin - Tax Issues for digital business - Part I - domestic issues

Contentspage 62 General Editor’s introduction

Dr Helen Hodgson CURTIN LAW SCHOOL

page 63 Tax issues for digital business — a case study

Part I: domestic issues

Joanne Dunne and Antonella Schiavello MINTER

ELLISON

page 69 Government puts losses back on the table — when is

similar not the same?

Andrew Clements, Sylvester Urban and Anthony

Mourginos KING & WOOD MALLESONS

page 73 ATO’s new individual professional practitioner (IPP)

taxing measure: background, context and policy

analysis

Dale Boccabella and Kathrin Bain SCHOOL OF

TAXATION & BUSINESS LAW, UNIVERSITY OF NEW

SOUTH WALES

General EditorDr Helen Hodgson, Associate

Professor, Curtin Law School, Curtin

University

Editorial PanelMichael Blissenden, Associate

Professor of Law, University of

Western Sydney

Andrew Clements, Partner, King &

Wood Mallesons, Melbourne

Gordon Cooper AM, Adjunct

Professor in the School of Taxation

and Business Law (incorporating

Atax), University of New South Wales

John W Fickling, Barrister, Western

Australian Bar

Dr Paul Kenny, Associate Dean

Academic, Faculty of Social and

Behavioural Sciences, Associate

Professor in Taxation Law, Flinders

Business School, Flinders University

Craig Meldrum, Head of Technical

Services & Strategic Advice,

Australian Unity Personal Financial

Services Limited

Karen Payne, Chief Executive Offıcer,

Board of Taxation

Joseph Power, Senior Associate, King

& Wood Mallesons

Andrew Sommer, Partner, Clayton

Utz

Sylvia Villios, Lecturer in Law, Law

School, University of Adelaide

Chris Wallis, Barrister, Victorian Bar

2016 . Vol 3 No 4

Information contained in this newsletter is current as at May 2016

General Editor’s introduction

Dr Helen Hodgson CURTIN LAW SCHOOL

We are now well into the election campaign. I spent

Budget week in Canberra when both parties set out their

economic and tax priorities if elected.

Given the timeline for publication of this Bulletin I

don’t intend to repeat the commentary on the Budget

measures, except to say that I was interested to see the

proposed changes to superannuation, which I think

address some of the issues around whether the superan-

nuation scheme is fit for purpose. The introduction of the

Low Income Superannuation Tax Offset to take effect

when the Low Income Superannuation Contribution

ceases will ensure that low income earners continue to

see some tax advantage in superannuation savings, while

restructuring the caps to allow the rollover of conces-

sional caps combined with a lifetime non-concessional

cap should allow middle to high income earners to

accumulate an adequate sum to fund retirement while

curbing some of the estate planning opportunities.

There were also a number of lower profile measures

in the Treasury portfolio that I expect would be adopted

by whichever party is elected to government: notably the

Div 7A measures that the Board of Taxation recom-

mended, and refinements to the taxation of financial

arrangements (TOFA) and consolidations regimes.

As the campaign rolls on I expect that we will see

more announcements regarding taxation and spending

announcements.

The three articles that we have for you this month

have picked up three issues that are of current interest,

and far less speculative than what might remain in the

Budget after the election.

The first article, from Joanne Dunn and Antonella

Schiavello of Minter Ellison, uses a case study to set out

the tax consequences of establishing a digital business.We considered the GST implications of cross-borderintangible supplies in volume 3 issue 2 of this Bulletin.This article considers the income tax as well as the GSTimplications of a resident company providing digitalservices. The second part, which will be published in afuture edition, will consider the consequences when thedigital business expands to become a global enterprise.

The second article, from Andrew Clements, SylvesterUrban and Anthony Mourginos at King & Wood Mallesonsexamine the exposure draft that was released in Decem-ber in relation to the carry forward loss measures. Theproposed Bill would redefine the notion of what consti-tutes the “same business” for the purposes of thecompany and trust loss measures to allow losses to beclaimed where the business is similar, rather than thesame. It is hoped that this will remove a legislativehurdle that could prevent a business from changing itsbusiness model to become more profitable.

The final article, which was contributed by DaleBoccabella and Kathrin Bain of the University of NewSouth Wales takes another look at the Australian Taxa-tion Office (ATO) ruling on the possible application ofPt IVA to individual professional practitioners, and a

comparison with the personal services income regime.

I hope that you find these articles useful.

Dr Helen Hodgson

General Editor

Associate Professor

Curtin Law School

[email protected]

www.curtin.edu.au

australian tax law bulletin May 201662

Tax issues for digital business — a case studyPart I: domestic issuesJoanne Dunne and Antonella Schiavello MINTER ELLISON

IntroductionThe digital economy is becoming harder to distin-

guish from the rest of our economy as Australian

businesses embrace technology across a wide variety of

industries. Part I of this article uses a hypothetical case

study to demonstrate some of the tax issues for a small

retail business transitioning to have a digital presence in

Australia. Part II of this article will address the addi-

tional tax issues which arise when that business expands

overseas and establishes an offshore subsidiary. Part II

will also consider digital currency, including recent

announcements in relation to bitcoin and GST.

This article focuses on specific tax issues affecting

digital business, as opposed to the more generalised tax

and other non-tax issues that would apply to all busi-

nesses, digital or otherwise.

There are also other legal issues that are specifically

applicable to digital businesses which are also not

touched on in detail in this article. For example, when an

Australian business establishes a digital presence, it will

also need to consider the appropriate business structure,

how to reward employees, how the website will be

hosted, intellectual property law issues, consumer law

issues, how to draft appropriate terms and conditions,

payment security and cyber security, privacy law issues,

cyber-insurance, compliance with the Spam Act 2003

(Cth), and how to promote the business in advertising

and social media.

Putting those other legal issues aside, this article

seeks to demonstrate the tax issues that impact upon the

digital economy by way of the following case study:

Case study

Paul Michaelson and Jane Johnson are fashion

entrepreneurs from Fitzroy in Melbourne.

Paul is a well-known personal shopper, and Jane is

a stylist and personal grooming consultant. Paul

and Jane employ four personal shoppers and their

business enjoys a loyal Fitzroy clientele, and elite

clientele from Brighton, Toorak and South Yarra,

as well as Tasmanian based clients.

Paul and Jane operate their business through an

Australian company of which they are the direc-

tors and their family trusts are 50/50 shareholders.

The company, which is registered for GST, is

called It’s The New Black Ltd (ITNB) and has an

office in Melbourne (in Fitzroy). In the last finan-

cial year ITNB’s aggregate turnover was $1.7

million. ITNB’s assets consist of inventory supply

and advisory contracts with large department stores,

client contracts and event contracts. These assets

need regular renewal and are not long term assets.

ITNB intends to expand its business beyond Victoria

and its current Tasmanian clients.

Paul and Jane have also decided that their business

will grow and develop further in their current

market in Australia if they have an online pres-

ence. Paul and Jane have decided they first want to

test interest in NSW, WA, Queensland, the ACT,

the NT and SA by way of an online presence only.

This will enable them to consider whether to open

offices outside of Victoria, by monitoring who

uses the website and where they are located.

Paul and Jane tell you that:

• a website has been designed for ITNB for a fee

by an Australian based design company;

• ITNB has entered into a short term hosting

agreement with Macquarie Telecom in Austra-

lia (with hosting via servers located in Austra-

lia);

• ITNB is currently negotiating an agreement

with Paris and London Fashion Weeks to enable

a live signal of particular avant garde fashion

shows to be broadcast exclusively on the ITNB

website;

• ITNB has acquired off-the-shelf software, and

over the past few months Paul has made

innovative adjustments to that software to enable

clients to input their measurements, upload a

photo, advise the event they are attending, and

be instantly recommended a range of outfits.

The recommendations would be shown on the

client’s body so they can see before they buy.

An advisory fee and website access fee is

charged by ITNB for this service;

australian tax law bulletin May 2016 63

• they are working to ensure that the website has

functionality so that clients can request groom-

ing and design advice from the ITNB team. An

advisory fee is charged by ITNB for this

service;

• they are also working to ensure that the website

has functionality to enable shoppers to search

for and request particular designer fashion. If a

customer makes a booking, ITNB is paid a fee

by the customer and a commission is also

obtained from the particular designer if a pur-

chase is made;

• ITNB has entered into inventory contracts with

a number of stores and designers in Australia to

be able to access products; and

• the website is expected to “go live” in the next

2 months.

Paul and Jane have hired a technical person, Brian

Block, to assist them to ensure that at all times the

website is providing fast, effective service to its

customers.

A few months after the website goes live, the

business grows at an exponential rate, with turn-

over exceeding $20 million. ITNB has since

developed, tested, and designed an app which

provides the ability for clients to reserve particular

items of inventory as soon as it comes in using

their smart phones.

This article proceeds to consider the tax issues arising

for ITNB from its Australian domestic expansion into

the digital economy.

Income, tax deductions and tax offsetsavailable to ITNB

Income received through the website, such as ITNB’s

advisory fees, website access fees, booking fees and

commissions from designers will be assessable, as it is

derived by an Australian resident taxpayer from carrying

on a business in Australia.1

The core issue for Australian businesses such as

ITNB is the deductibility of the expenses to develop and

establish the website, and any tax offsets that may be

available. Section 8–1 of the Income Tax Assessment

Act 1997 (Cth) (ITAA 97) provides for a deduction to

the extent the loss or outgoing is necessarily incurred in

carrying on a business for the purpose of gaining or

producing assessable income. However, s 8–1(2) may

prevent a deduction if the expenditure is an outgoing of

capital and, if that is the position, another avenue

provided under the ITAA 97 or the Income Tax Assess-

ment Act 1936 (Cth) (ITAA 36) for a tax offset or

deduction may need to be considered.

Website expenditure and development costs

Website costs that are recurring in nature are likely to

be revenue expenses, and may be deductible under

s 8–1. For example, ITNB should be entitled to claim a

deduction for the ongoing expenses of running and

maintaining their website, such as domain name regis-

tration costs, server-hosting package costs and ongoing

fees paid to Macquarie Telecom.

It is likely that other website development and design

costs incurred by businesses in setting up a website are

capital in nature, because the website establishes a new

earning structure for the business.

In 2009, the Australian Taxation Office (ATO) with-

drew TR 2001/6, which addressed the deductibility of

website development and establishment costs. In April

2016, draft ruling TR 2016/D1 was issued after consul-

tation with tax and industry representatives.2 There has

been a significant waiting period for this new ruling,

which is proposed to apply retrospectively. The draft

ruling considers the deductibility of expenditure incurred

in acquiring, developing, maintaining, or modifying a

website, and also the deductibility of content migration

and social media accounts. Generally, the draft ruling

states that the expenditure incurred on a commercial

website may be deductible under s 8–1 if it is of a

revenue nature. Otherwise, the expenditure may be

classed as “in-house software” and deductible under the

capital allowances/depreciation regime. Preliminary views

are provided regarding the treatment of certain expenses,

with practical examples. Recurrent business expenses

such as licensing fees and expenses associated with

routine maintenance are generally considered to be

deductible revenue expenses, whereas acquisition, devel-

opment, modifications, migrations and social media

costs which upgrade, improve, or add new functionality

or establish a business presence or structural advantage

are generally considered to be capital.

For a small business like ITNB, with an initial

aggregated turnover of less than $2 million, the govern-

ment’s small business tax changes announced in the

2015–16 Federal Budget may provide enhanced upfront

asset write offs. Assuming the expenditure is incurred

between 12 May 2015 and 30 June 2017, s 328–180 of

the ITAA 97 provides that capital expenditure on depre-

ciating assets can be claimed as a deduction in the

income year that the expenditure was incurred (if the

cost is less than $20,000).

If the cost of those assets is $20,000 or more, the

simplified depreciation rules in Subdiv 328–D of the

ITAA 97 will be applicable if the business elects to use

those rules, or Div 40 will need to be considered. Again,

this is relevant only to the extent that there is a

depreciating asset. The definition of “depreciating asset”


refers to an asset with a limited effective life that can be

reasonably expected to decline in value. The Commis-

sioner has confirmed in TR 2016/D1 that a website is not

a depreciating asset under Divisions 40 and 328, except

to the extent that it can be classified as “in-house

software” (considered separately below).

TR 2016/D1 does not recognise that intellectual

property, which is a depreciating asset, may also be

contained in a website. The definition of “intellectual

property” in s 995–1 requires there to be rights in a

patent, copyright or registered design. For example,

there may be rights in the design of the ITNB website

that could be registered, or could comprise copyright. In

TR 93/12, the ATO considered that a computer program

is in essence knowledge or information and may be

considered an item of intellectual property, and may be

subject to copyright.3

Businesses such as ITNB may have copyright pro-

tection over internally created computer programs, such

as the innovations Paul has made to the software or the

creation of the app described in the case study. The

whole of the website will not be protected by copyright,

however, component parts of the website such as text,

images, logos, source code and files may be protected.4

For capital costs that do not qualify as in-house

software, the following additional issues need to be

considered:

• capital gains tax (CGT) assets may arise (eg in the

event that the intellectual property definition is not

satisfied) and the costs may form the cost base for

that asset;5 and

• section 40–880 could apply, as a last resort, to

provide a deduction over 5 years under the black

holeexpenditureprovisions.PrivateRuling1011958172383

suggested that s 40–880 could be applicable.

However, the new draft ruling TR 2016/D1 states

that it would be unusual for commercial website

development expenditure to be deductible under

s 40–880, given the broad definition of a CGT

asset.

Off-the-shelf software and computer hardwareTR 2016/D1 states that the purchase of off-the-shelf

software is capital in nature and therefore not deductible

under s 8–1 of the ITAA 97. However, periodic license

payments made to a web developer for off-the-shelf

software, that is licensed by the business, with no right

to become the owner of the website, are considered to be

deductible under s 8–1. This is contrary to the ATO’s

previous guidance, which suggested that the cost of

commercial off-the-shelf software was generally deduct-

ible in the year of purchase.

Computer hardware is depreciable under Div 40 or, if

elected by a small business, under Subdiv 328–D of the

ITAA 97. Alternatively, as stated above, the upfront asset

write off of up to $20,000 is available to small busi-

nesses, such as ITNB.

Innovations to software and the appdevelopment — in-house software

Special rules apply to deductions for the cost of

developing in-house software for a taxpayer’s own use.

In-house software is computer software that is acquired

or developed and is mainly for use in performing the

functions for which it was developed, and, importantly,

for which no other provision of the ITAA 97 provides a

deduction.6

For that reason, before considering whether Subdiv 328–D

or Div 40 applies to the costs of making adjustments to

the software and any other development costs, a busi-

ness will first need to consider the research and devel-

opment (R&D) provisions in Div 355 of the ITAA 97

and any other provisions in the Act.

Research and development

A business with aggregated turnover of less than $20

million may be entitled to receive the 45% refundable

R&D tax offset for eligible R&D activities. In order to

claim an R&D tax offset, the business must register the

R&D activities at Innovation Australia,7 have notional

deductions for the purposes of the R&D provisions of at

least $20,000 for the income year, and carry out the

activities for itself (generally) in Australia.

There are a number of factors that a business such as

ITNB will need to consider when determining whether

innovative software amendments or the later design of

an app are eligible R&D activities, including whether

the software development or app development are core

R&D activities or supporting R&D activities.8

For core R&D activities, it will be necessary to

provide evidence of the work completed and show that

the software innovations and app development are

innovative. Case law highlights that evidence will be

needed showing that the work done develops new

knowledge, and that there was technical uncertainty

about the outcome.9 For example, in the North Broken

Hill and Commissioner of Taxation case10 innovations to

off-the-shelf software were not held to comprise R&D

activities because they were not innovative, as it could

not be shown that the outcome of those innovations was

uncertain.

Innovation Australia issued Guideline 17 in relation

to software development under the former R&D provi-

sions. While that Guideline is not applicable to the

current R&D provisions, it does refer to software devel-

opment as needing to embody algorithms or methodolo-

gies that did not previously exist, and needing to show

sufficient innovation and outcome risk. It also provides


guidance on how to evidence activities to support an

R&D claim. For example, ITNB could conduct a litera-

ture and technology review to conclude that no algo-

rithm capable of performing image recognition and then

“fitting” the clothes on the client’s photo existed previ-

ously. Evidence would also need to be found that the

outcome of the work done was uncertain.

Evidence of a progressive experimental process will

also be needed to meet the core R&D activities defini-

tion in s 355–25. In the case study, the app was

“developed, tested, and designed”. Evidence of that

process will be needed to show the systematic progres-

sion of work, and documentation will need to be kept,

substantiating the process that was undertaken to develop

the innovations in the software.

To obtain certainty, an advance finding can be sought

from Innovation Australia11 as to whether the activities

are eligible R&D activities. If a finding was obtained, it

would be binding on Innovation Australia and the ATO

for the year in which the R&D is conducted and up to

two subsequent years (if activities are being conducted

over multiple years).

ITNB would need to provide further evidence before

an R&D claim can be substantiated.

In-house software — Div 40 and Subdiv 328–D

The software developed by ITNB (Paul’s innovations

and the app) may satisfy the definition of in-house

software assuming no other provision in the ITAA 97

(such as the R&D provisions) is applicable to provide a

deduction. If the costs of development are less than

$20,000, ITNB may be able to obtain an immediate

deduction under s 328–180 of the ITAA 97.

If ITNB’s software satisfies the definition of in-house

software, the costs of development are greater than

$20,000 and it commenced to be held after 1 July 2015,

the software has a statutory effective life of 5 years and

must be depreciated using the prime cost method.12 On

1 April 2016, the Australian Treasury released Exposure

Draft legislation which, if enacted, will allow taxpayers

to self-assess the effective life of intangible assets, so

that in-house software can be assessed to have a life

other than 5 years, for assets which started to be held

from 1 July 2016.13

Alternatively a business can choose to allocate in-house

software to a software development pool. There is no

deduction in the income year in which the expenditure

was incurred, but deductions are allowed at a rate of

40% in each of the next two years and 20% in the

following year. Once allocated to a pool, all future

in-house software expenditure must also be allocated to

the pool.14

Payments to Paris and London fashion weeks— royalties?

Another issue for ITNB is whether any payments

made for the fashion week broadcasting rights would be

deductible. A critical factor is whether the payments

would be royalties, as s 26–25 of the ITAA 97 may

prevent a deduction unless withholding tax obligations

have been met. The double tax treaty between Australia

and the relevant countries would also need to be

considered.

In Seven Network Ltd v Commissioner of Taxation15

(Seven Network) the Federal Court considered whether

payments (approx $97.7 million) made by the taxpayer

to the International Olympic Committee for the broad-

casting rights for the Olympic Games were a royalty

within the meaning of the Australia/Switzerland Double

Tax Treaty. The case revolved around Art 12(3), namely

whether the use of the ITVR signal was “the right to use

copyright, or any other like property or right” which

could make payments in relation to the ITVR royalties.

The court held that the signal could not be a cinematograph

film (for copyright law purposes) and copyright did not

arise in accordance with the Copyright Act 1968 (Cth)

because an item must be able to be reproduced in

tangible or material form to be an embodiment and

comprise copyright. The court also held that the words

“any other like property” in Art 12(3) referred to

intellectual property rights protected under domestic

law, and this required a tangible or material form. The

court held that no such rights arose, and made a

declaration holding that the payments were not royalties

and therefore withholding tax was not required to be

withheld.

This Commissioner has appealed to the Full Federal

Court and the outcome is expected in 2016.

In considering whether ITNB’s payments for a live

signal from Paris and London fashion weeks are royal-

ties or not, the agreements between ITNB and the

entities involved would need to be reviewed and the

Australia/France and Australia/UK double tax agree-

ments would need to be reviewed. The final outcome in

the Seven Network case would also need to be consid-

ered.

In addition, whether the website access fees paid by

customers are royalties may also need to be considered.

This is not so much of an issue in relation to ITNB when

it is operating the website domestically only as the fees

will be taxable in any event, the website is hosted in

Australia, and the customers are allAustralian residents.Care

would need to be taken to describe those access fees

appropriately as being for a service. However, the nature

of those fees and the question of whether they are


royalties paid in return for a non-transferrable, non-

exclusive right to use the intellectual property or soft-

ware comprised in the website may become relevant in

the future if ITNB builds an international client base and

derives fees from offshore, as withholding taxes might

reduce ITNB’s expected return. The nature of digital

business means that customers can come from other

jurisdictions.

GSTITNB must consider whether supplies made by way

of its website are taxable supplies on which GST is

imposed under the A New Tax System (Goods and

Services Tax) Act 1999 (Cth) (GST Act).

One of the requirements of a “taxable supply” is that

the supply is connected with the indirect tax zone (being

Australia). A supply of goods delivered to Australian

customers is clearly connected with Australia and fees

for such supplies are subject to GST. For a supply of

anything other than goods, whether it is connected with

Australia involves asking if the thing (which includes a

service, information or right) is done in Australia or

through an enterprise that the supplier carries on in

Australia. GSTR 2000/3116 states that the location of

where something is done will depend on the nature of

the supply — generally for services this is the location

the services are performed. In relation to ITNB, as

services are performed by staff in Australia to customers

in Australia, those fees are subject to GST.

An interesting issue arises if the terms and conditions

on the ITNB website which set out the arrangements

with customers describes the service the customer receives

as a limited, non-transferable license to use the software

which is part of the website. In this event, for GST

purposes, the thing refers to the computer software and

done refers to where the services are performed.17 If the

supply of services is online software, the location of the

service provider and their servers are relevant. The

Commissioner has in various private binding rulings

determined that the supply of online services by a

foreign company to Australian customers is a thing not

done in Australia where the foreign company’s servers

are not in Australia.18 Where the software was acquired

and developed in Australia, the servers and related IT

infrastructure which support the computer software are

located in Australia, and an Australian Macquarie Telecom

is providing hosting services, it is likely that the supply

of the computer software is a thing done in Australia,

and therefore is connected with Australia.

Entitlements to input tax credits may arise for ITNB

on certain expenditure if they are “creditable acquisi-

tions”. This may include costs incurred to establish the

website, the acquisition of the initial software, the

hosting agreement and inventory contracts. To be a

creditable acquisition, the thing being acquired must bea taxable supply and have the necessary connection withAustralia. The acquisition of software should be ataxable supply, assuming that the software is supplied inAustralia. The hosting agreement provided by MacquarieTelecom is likely to be considered a taxable supplybecause the server is in Australia and the service issupplied to ITNB in Australia. The inventory contractsprovide that ITNB has access to a retailer’s stock onhand if an order is placed by an ITNB customer. This isa supply of a right to purchase the retailer’s stock asrequired. The supply of this right may be said to be donein Australia, as both the retailer/designer and ITNB arein Australia. This too should be considered a taxablesupply.

Record keepingRecord keeping for tax purposes, including the require-

ments of s 262A of the ITAA 36, need to be consideredwhen operating a digital business. Records can be keptin written or electronic form, and include tax invoices,receipts, sales records, year end records and bankrecords. In TR 2005/9, the ATO reminds digital busi-nesses that:19

30. Where a taxpayer conducts business transactionsthrough the internet or by EDI the Tax Officeposition is that the taxpayer is required to keeprecords explaining all such transfers that are relevantfor any purposes of the ITAAs. All other require-ments relating to electronic record keeping systems,such as the need for controls, are equally applicable.

31. If electronic information systems are used to conductbusiness transactions such as those that may beconducted by websites, but do not function as recordkeeping systems, there will be no evidence of thosetransactions. Without this evidence your organisa-tion or business may not be considered to havecomplied with its record keeping requirements undersection 262A of the ITAA 1936. There is an admin-istrative penalty if you do not keep or retain recordsas required by this section: see section 288–25 inSchedule 1 to the Taxation Administration Act 1953.Taxpayers should remember that the onus of proof ison them in showing that an assessment is excessiveshould the Tax Office amend their taxable income.The failure to keep sufficient records to explainrelevant transactions for tax purposes would beinconsistent with the requirements of these obliga-tions.

32. The nature of e-commerce with the recording oftransactions and information and subsequent recordkeeping implications will assist taxpayers in thedesign and implementation of systems to managefull and accurate records arising from e-commerce orEDI for the required periods. [Emphasis added.]

This is a reminder that another factor ITNB will needto consider when establishing its website is the need forwebsite functionality to ensure that sufficient and com-plete records are generated by transactions on thewebsite to enable ITNB to meet its record keepingrequirements.


ConclusionPart I of this article demonstrates that when a small

Australian business transitions to have a digital pres-

ence, a myriad of legal and commercial issues arise. In

addition, a number of quite specific tax considerations

arise, particularly in relation to the deductibility of costs,

the nature of income and expenses, and the nature of

supplies being made. The functionality of the Australian

business’ digital presence must also be tested to ensure

that it meets tax record keeping requirements.

Part II of this article will consider the tax implications

when the hypothetical ITNB business transitions to

become a global digital business. The issues of source,

residence, whether there is a permanent establishment,

the nature of income and expenses, and digital currency

will be included in the discussion. Also considered will

be potential law reform arising as a result of the

Organisation for Economic Cooperation and Develop-

ment’s (OECD) base erosion and profit shifting project,

and at a domestic level on multinationals and how that

impacts a business in the digital economy.

Joanne Dunne

Partner

Minter Ellison

Antonella Schiavello

Senior Associate

Minter Ellison

Footnotes1. For completeness, note that the company tax rate for small

businesses, such as ITNB (ie with aggregated turnover of less

than $2 million), was reduced from 1 July 2015 to 28.5%.

2. ATO Draft taxation ruling TR 2016/D1 Income tax: deduct-

ibility of expenditure on a commercial website (6 April 2016).

3. Note that the Copyright Act 1968 (Cth) may apply to provide

protection, and registration is not required for that protection to

be applicable. For protection to arise the work must be in a

material form. This means that a form of the work or an

adaptation of the work is stored and capable of being repro-

duced. The work must be made by a person who is an

Australian citizen or resident of Australia when the work was

made. The work must be an original work that is the result of

the author’s skill and effort.

4. See Australian Copyright Council Websites and Copyright

Information Sheet G057 (December 2014).

5. Given that ITNB is a small business, the various small business

concessions may be available to it in the future in respect of

any such CGT assets.

6. In the context of the research and development provisions,

s 355–715 provides that other than where the adjustment

provisions in ss 40–292 and 40–293 are applicable, if an R&D

tax offset arises, depreciation cannot be claimed under Div 40

or any other Division of the Act as well. That provision also

confirms that considering the research and development pro-

visions first will be important.

7. Note the deadline for registration is 10 months after the end of

an income year: see Research and development (R&D) tax

incentive (2016) www.business.gov.au.

8. ITAA 97, s 355–20.

9. Re North Broken Hill Ltd and Commissioner of Taxation

(1993) 26 ATR 1262; 93 ATC 2148; RACV Sales and

Marketing Pty Ltd v Innovation Australia (2012) 129 ALD 32;

(2012) 89 ATR 371; [2012] AATA 386; BC201204554.

10. Re North Broken Hill Ltd and Commissioner of Taxation,

above n 9.

11. See R&D Tax incentive: Advance Finding Information Sheet at

www.business.gov.au.

12. ITAA 97, ss 40–70(2)(a), 40–72(2)(a), 40–75 and 40–95(7).

13. Exposure draft inserts for Tax and Superannuation Laws

Amendment (2016 National Innovation and Science Agenda)

Bill: Intangible asset depreciation.

14. ITAA 97, ss 40–450 and 40–455.

15. Seven Network Ltd v Commissioner of Taxation (2014) 324

ALR 13; (2014) 109 IPR 520; [2014] FCA 1411; BC201411357.

16. ATO Goods and services tax ruling GSTR 2000/31 Goods and

services tax: supplies connected with Australia (30 June 2000).

17. GSTR 2000/31, para 65.

18. See for example Private Ruling 1011511098475 at ATO

Authorisation Number: 1011511098475, Subject: supply of

online advertising www.ato.gov.au.

19. Taxation Ruling TR 2005/9 Income tax: record keeping —

electronic records (8 June 2005).


Government puts losses back on the table —when is similar not the same?Andrew Clements, Sylvester Urban and Anthony Mourginos KING & WOOD MALLESONS

SummaryUnder new measures, companies and listed widely

held trusts should find it easier to utilise tax losses where

there has been a change in ownership.

On 7 December 2015, the government released expo-

sure draft legislation (Exposure Draft) setting out the

new “similar business test”.1 The Exposure Draft applies

to companies and listed widely held trusts. The measures

are expressed to encourage entrepreneurship by making

it easier for loss-making companies to return to profit-

ability. The measure is not limited to small innovation

companies.

The current same business test has produced harsh or

uneconomical outcomes through its strict application.

The new test is clearly wider than the existing test and is

to be welcomed. These rules do not seek to alter the

existing continuity of ownership tests.

The new measures are proposed to apply to tax losses

incurred on or after 1 July 2015.

Current law

The continuity of ownership and samebusiness tests

Under the current law, to claim a deduction for prior

year losses,2 a company (or listed widely held trust)

must satisfy either a “continuity of ownership” or “same

business” test.3

The continuity of ownership test (COT) is failed

when a company undergoes a substantial change in

ownership or control where shares carrying more than

50% of all voting, dividend and capital rights are no

longer beneficially owned by the same persons during

the “test period” (being the period from the start of the

loss year to the end of the income year in which the loss

is to be deducted).

A similar “50% stake test” is applied for listed widely

held trusts, and there must additionally have been

abnormal trading. No changes to the COT are proposed.

To satisfy the same business test (SaBT) a company

or listed widely held trust must show that it was carrying

on the same business, during the relevant income year,

which it was carrying on in the year immediately before

the change of ownership or control which caused it to

fail the COT. The so-called “negative limbs” that apply

throughout the test period are the main obstacle to

satisfying the SaBT.

The limbs look at the undertakings and transactions

of the company or trust and are met if the company or

trust derives assessable income from:

• business — a business of a kind that it did not

carry on before the test time; or

• transaction — from a transaction of a kind that it

had not entered into in the course of its business

operations before the test time.

If either of these limbs apply, the entity will fail the

SaBT and will not be entitled to claim a deduction for

prior year losses.

For prior year losses, the default “test time” to be

used when applying the SaBT is the latest time that the

entity satisfied the COT. Where it is not practicable for

the entity to show that it has satisfied the COT for any

period since incurring the loss, the default test time is

either the start or end of the loss year, depending on

whether the entity existed for the whole or part of the

relevant year.

Strict interpretation

The Commissioner of Taxation (Commissioner), in

TR 1999/9,4 notes the strict interpretation of the SaBT

established in the High Court in Avondale Motors

(Parts) Pty Ltd v Federal Commissioner of Taxation,5

requiring an “identical business” to be carried on after

the test time.

Currently, what is required is the continuation of the

actual business carried on immediately before the test

time. A company or trust may expand, grow, contract its

activities and discard old operations without breaching

the same business requirement,6 however if the entity

changes its essential character or there is a sudden and

dramatic change in the entity brought about by acquisi-

tion or loss of activities on a significant scale, it may fail

the SaBT.

Whether the same business is actually being carried

on after the test time is a question of fact and degree.

The relevant factors include:


• Products sold/manufactured: For example, if abusiness which traditionally grows cereals to sellas seed and grain ceases to do so and beginsgrazing cattle on the same land, it is likely achange of business has occurred.

• Manufacturing process: For example, updating amodel of a product manufactured is not enough tosuggest a change of business. However, if acompany stops producing its only product andbegins manufacturing a separate and unrelatedproduct this is likely to be a strong indicator thatthe business is not the same.

• Market for goods/services: It is relevant to look atthe persons to whom the product is sold or theservice is provided. This factor will have varyinglevels of relevance depending on the size of thecompany and the number of costumers it usuallyhas.

• Method of selling: For example, a change fromoutright sale to sale on consignment, sale onterms, sale by hire purchase and so on may be afactor indicating a change of business.

• Methods and sources of finance, working capital:

A change in working capital is unlikely, of itself,to demonstrate a different business is being carriedout. However, it may suggest that other factorshave also changed which have been caused by achange in business.

• Goodwill, trading name, trademarks, patents: Awholesale change of intellectual property rights isusually associated with a change in business,whereas minor changes may be associated withresearch and development within the same busi-ness.

• Location: Distinction should be made betweenexpanding a business by opening the business inmore locations and closing an old business in aparticular location.

• Number of employees: Termination of all staffsuggests the old business has ceased. However, anincrease in staff in a particular area of the businessmay indicate growth. The former may suggest achange of business has occurred.

• Management and directors: Resignation and replace-ment of existing directors or management is unlikely,of itself, to demonstrate a change of business.However, such a change coupled with other chang-ing factors may be indicative of a change ofbusiness.

Essentially, the narrow interpretation allows minimalchanges to the above mentioned factors, namely, thosearising from “mere expansion or contraction” of therelevant business,7 leading to the potential for harshoutcomes on a strict application of the SaBT.

Potentially harsh or non-economical outcomesThe SaBT and COT were introduced with the follow-

ing purpose in mind:8

The relevant sections of the Act show an intention on thepart of the legislature to impose, in the case of companies,a special restriction on the ordinary right of a taxpayer totreat losses incurred in previous years as a deduction fromincome. … This restriction is imposed to prevent personsfrom profiting by the acquisition of control of a companyfor the sole purpose of claiming its accrued losses as a taxdeduction.

The strictness of the limitations may lead to harsh

outcomes. Consider a shareholder who acquires a loss-

making business in the hope of converting it into a

profitable undertaking (by turning assets for profit, not

offsetting taxable income). If the new shareholder alters

certain elements of the company in order to make it

profitable, on a strict application, the SaBT may be

failed even though changes to the business are made for

purely commercial (rather than tax) reasons. This may

include, for example, if the company converts to an

online selling platform, introduces new low-cost prod-

ucts or significantly reduces the number of employees

and alters the business management/directorship struc-

ture.

The irony of the SaBT is, of course, that a new owner

of a loss-making enterprise is faced with a choice of

either altering the business in an attempt to make it

profitable, and consequently losing what may be a

significant asset (ie, the tax loss), or keep the business

unchanged to take advantage of the loss, with a detri-

mental effect on profitability.

Arguably, the need to satisfy a strictly interpreted

SaBT in circumstances such as the above may discour-

age taxpayers from innovating or from adapting to

changes in economic circumstances.

The strictness of the regime has produced harsh

outcomes where the company or trust’s ownership

changes for any other reason. For example, a listed

multinational may have long-term plans to move into a

business that is on the borderline between the “same”

and “similar” to its current business. If the multination-

al’s main shareholders change (failing the COT), the

company may then inadvertently continue with its long

term plans and lose (potentially very significant) losses.

What are the proposed changes?

Similar business testThe Exposure Draft replaces the SaBT with a more

flexible “similar business test” (SiBT).

A company (or listed widely held trust) will satisfy

the SiBT if its current business is similar to the former

business. To determine this, there are three main factors

that must be considered:


• assets — the extent to which the company or trust

generates assessable income from the same assets.

The Explanatory Memorandum9 makes clear that

the term “assets” extends to both physical and

intangible assets (including goodwill, trade names,

patents, royalty arrangements and other intellec-

tual property (IP) rights of a company or trust).

Goodwill, which is closely linked to an entity’s

ability to draw custom, will be particularly rel-

evant here;

• sources — the extent to which the entity generates

assessable income from the same sources. The

Explanatory Memorandum refers to “sources” of

the entity’s assessable income in a commercial or

operational sense: “The sources of the company’s

assessable income are the specific activities or

operations from which it generates assessable

income”;10 and

• reasonable expectation — whether any changes

to the former business are changes that would

reasonably be expected to have been made to a

similarly placed business.

The Explanatory Memorandum requires taking a

hypothetical business that is similarly placed to

the former business, and asking whether or not a

reasonable person would expect changes be made

to that business. It is not sufficient that the change

is a reasonable business decision in that it makes

commercial sense, or is a good business opportu-

nity. Rather, there must be something in the

activities or operations of the former business that

make the change “natural” having regard to the

organic connection and continuity between the

former and current business.

Comparison with same business test

Unlike the SaBT, the SiBT clearly provides for

differences between the current and former business that

result from growth or rehabilitation efforts.

The SiBT does not depart from the central principle

that there should be a similarity in the identity between

the commercial operations and activities of the former

and current entity. The rationale remains that corporate

groups should not be incentivised to buy loss-making

entities to shelter their own assessable income. It remains

the case that it is not sufficient for the current business to

be of a similar “kind” or “type” to the former business.

The focus remains on the identity of the business.

While the new test is clearly wider than the existing

SaBT and is to be welcomed, it will continue to involve

much subjectivity and debate, and in some circum-

stances, a taxpayer’s only way to achieve certainty will

continue to be through application for private ruling.

This is because, as with the SaBT, in some instances,

one of the factors may suggest that the SiBT is satisfied,

whereas another factor suggests otherwise. This will

require the factors to be weighed up with the relative

importance of each factor depending on the facts of the

case.

It will be important to consider the effect of the new

legislation on the current tax ruling dealing with the

same business test: TR 1999/9.

Practical examples and issues

To illustrate the operation of the new provisions, we

have worked through some of the examples in the

Explanatory Memorandum.

Example 1: Company switches from manufacture to

retail

If a business ceases to manufacture its own product

and instead begins deriving income from purchasing and

reselling another brand of that same product, there will

have been a significant change in commercial operations

and activities of the former and current business. The

business no longer generates income from the same

assets (ie its processing plant, equipment and brand

name). The source of income has changed from manu-

facturing to reselling which goes to the heart of the

specific activities or operations from which the company

generates its income.

Even if it is assumed the third factor is satisfied (ie,

the changes are changes that would have been expected

of a similarly placed business), the business may not

satisfy the SiBT. Although it is still selling the same

product, this may be outweighed by the significance of

the change from the business producing its own unique

brand of product to reselling another brand. Because of

this, the company’s current business may not be a

similar business to the former business.

Example 2: Addition of new product line

For a successful application of the SiBT, consider the

following:

• A business changes ownership after making a tax

loss in its fifth year of operation.

• The business, which previously designed and sold

household furniture (not including mattresses) branches

into designing and selling mattresses.

• The business retains its brand name and logo but

moves into an online selling platform.

• The company then becomes profitable (20% of

sales are from mattresses and 80% is from the sale

of furniture) and seeks to recoup the tax losses

incurred prior to the ownership change.


Although a question of fact and degree, the company

would likely fail the SaBT but pass the SiBT. This is

because it uses the same assets, generates income from

the same sources (to the extent that it is generated from

the online reselling of furniture items) and arguably took

advantage of an opportunity that would reasonably be

expected to be made by a similarly placed business.

Although there has been a change, the change is one that

supplements the former business as a subsidiary or

ancillary business activity, rather than replacing it. This

indicates that the current identity of the business is

similar to its former identity.

Proposed start date

It is proposed that the SiBT will apply to tax losses

incurred on or after 1 July 2015.

If a company or listed widely held trust seeks to carry

forward tax losses from pre-1 July 2015 periods, it will

need to satisfy the SaBT for those losses (even though

the losses will be utilised in future years).

Andrew Clements

Partner

King & Wood Mallesons

Sylvester Urban

Solicitor


Anthony Mourginos

Solicitor


The authors would like to acknowledge the assistance of

Lara Moreton and Annabelle Paxton-Hall (Law Gradu-

ates, King & Wood Mallesons).

Footnotes1. Exposure draft inserts for Tax and Superannuation Laws

Amendment (2016 National Innovation and Science Agenda)

Bill 2016: Access to losses.

2. “Tax loss” generally refers to previous years’ revenue losses,

previous years’ net capital losses, trading stock losses, losses

from writing off bad debts and losses transferred from a

company joining a consolidated group, which has been incurred

prior to a change of ownership or control.

3. Income Tax Assessment Act 1997 (Cth), ss 165–12, 165–13

(companies); Income Tax Assessment Act 1936 (Cth), Sch 2F,

ss 269–55, 269–100 (listed widely held trusts).

4. ATO Taxation Ruling TR 1999/9 Income tax: the operation of

sections 165–13 and 165–210, paragraph 165–35(b), section

165–126 and section 165–132 (23 June 1999).

5. Avondale Motors (Parts) Pty Ltd v Federal Commissioner of

Taxation (1971) 124 CLR 97; 2 ATR 312; BC7100080.

6. Above n 4, at para 13.

7. Above n 4, at para 39.

8. Above n 5, at [13].

9. Exposure draft Explanatory Memorandum to Tax and Super-

annuation Laws 4 Amendment (2016 National Innovation 5

and Science Agenda) Bill 2016: Access to 6 losses.

10. Above n 9, at para 1.27.


ATO’s new individual professional practitioner(IPP) taxing measure: background, context andpolicy analysisDale Boccabella and Kathrin Bain SCHOOL OF TAXATION & BUSINESS LAW, UNIVERSITY OF

NEW SOUTH WALES

Introduction

On 30 June 2015, the Australian Taxation Office

(ATO) finalised its individual professional practitioner

(IPP) guidelines.1 The guidelines effectively amount to a

new taxing measure:2 practitioner principals in profes-

sional firms who have been alienating taxable income to

associated entities are likely to come under scrutiny

should they fail to include a minimum amount in their

assessable income from their firm’s activities. The main

basis supporting the guidelines is that the principal

practitioner’s personal efforts are largely responsible for

the generation of the taxable income.

Aside from this introduction and conclusion, the

article is in three parts. Part 2 briefly sets out how the

courts have approached attempts to alienate personal

exertion income in the past, and also contains an outline

of the personal services income (PSI) regime.3 Part 3

sets out the ATO’s IPP guidelines, and in particular,

when they apply, to whom they apply and the “safe

harbour” benchmarks within the guidelines. Part 4

analyses the merits and deficiencies of the IPP guide-

lines.

The article concludes that the guidelines represent a

sensible and equitable development in tax policy con-

cerning “personal exertion income” and “income from a

business structure” in the context of a professional

practice. However, there are considerable deficiencies in

and around this area of the tax law, and the guidelines

are not the best solution to address these deficiencies.

Tax law in this area aside from the IPPguidelines

Personal exertion income to be taxed to personthat provided the services

Putting aside for the moment the PSI regime, there

seems to be two bases that prevent the alienation of most

personal exertion income for income tax purposes.

Provider of exertions or services has no present property

interest to assign and is only assigning future income

This basis draws on property law and rules of equity,

rather than tax law principles, and reflects the idea that,

subject to a particular tax provision, the tax law operates

on the general law effect of transactions.4 The key idea

is that only assignments of presently existing property

are effective to alienate income from the property to an

assignee.5 If the purported assignor does not have a

presently existing property right to assign, it is likely the

assignor is merely assigning future income (only an

expectancy) when it arises.6 This is not sufficient to

prevent the assignor from becoming entitled to the

income under the general law when it arises. The tax law

adopts this, and therefore treats the assignor as the one

who has derived the income.

This analysis explains why attempted assignments

(diversions away from the employee) of salary or wages

or earnings from services is not effective for tax pur-

poses.7 It also explains why sole traders and a profes-

sional practising on his or her own cannot effectively

assign income from their activity so as to avoid deriva-

tion of the income for tax purposes.8

General anti-avoidance rule (GAAR)

If the provider of personal services has successfully

alienated the relevant income by interposing a legally

valid entity between themselves and the end user of the

natural person’s services or has assigned part of their

interest in a partnership, the relevant income is derived

by the interposed entity9 or assignee.10 From there, all

the usual rules that apply to that entity will apply.11

However, the ATO has consistently argued that if the

alienated income is personal exertion income, the GAAR

should apply to defeat the attempted alienation so that

the relevant income is included in the assessable income

of the person providing the personal services.12 In the

context of professional services firms, the ATO states

that if the firm has at least as many non-principal

practitioners as principal practitioners, the income of the


firm will be from the business structure, and not from the

personal services of the firm’s principals.13 Where there

are more principal practitioners than non-principal prac-

titioners, it is likely that the income will be personal

services income but all the circumstances need examin-

ing.14

The ATO argument has been put under the old

GAAR,15 and the new GAAR.16 The courts and the

Administrative Appeals Tribunal (AAT) have overwhelm-

ingly supported the ATO and applied the GAAR (both

old and new provisions) in alienation of personal exer-

tion income cases. Further, the courts and the AAT have

applied the GAAR both where the firm comprises arm’s

length parties,17 and where the firm comprises non-

arm’s length parties (closely held entity).18

PSI regime (Divs 84–87)The PSI regime was introduced with effect from July

2000 to largely replace the need for the GAAR in respect

of income alienation of personal services income. Apply-

ing the GAAR on a case by case basis was considered

“labour intensive and an inefficient use ofATO resources”.19

The PSI regime prevents individuals who provide per-

sonal services through an interposed entity from divert-

ing (alienating) their PSI to an associated entity.20

The PSI regime applies only to “personal services

income”, which is defined as income that is “mainly a

reward for your personal efforts or skills (or would

mainly be such a reward if it was your income)”.21

Income that is mainly generated by the sale of goods,

use of assets, or a business structure is not PSI. Income

from a medium or large professional practice would be

regarded as income from a business structure and not

PSI of the principals.22

Even where there is PSI, attribution of the PSI to the

individual will not occur under the PSI regime where the

interposed entity23 is conducting a personal services

business (PSB). A PSB exists if the interposed entity

satisfies at least one of the four tests set out in Subdiv 87–A:

• the results test;

• the unrelated clients test;

• the employment test;

• the business premises test.24

The GAAR can still apply to PSI income derived by

an interposed entity conducting a PSB, particularly if the

dominant purpose of the arrangement is income split-

ting.25

The IPP guidelines

Criteria for application of guidelines and thetarget of the guidelines

The guidelines will only apply if all three criteria set

out below are satisfied.26

IPP provides professional services to the firm or clients,

and IPP and/or associates have a legal or beneficial

interest in the firm

An IPP is an individual (natural person) professional

practitioner, and he or she, putting aside for the moment

legal structures, is a principal of the practice entity

(firm). The IPP must either provide services to clients of

the firm, or (less commonly) is actively involved in

management of the firm (eg managing partner).27

The IPP must provide “professional services”. Those

providing non-professional services are not within the

guidelines. The distinction between professional and

non-professional may be difficult to determine at times.

Some guidance may be obtained from the ATO’s com-

ment that the guidelines only apply to “thought related

professions”. In a non-exhaustive list, the guidelines

expressly mention accounting, architectural, engineer-

ing, financial services, legal and medical professions.28

The firm, in the sense of the “entity” that (outside)

clients are contracting with, could be a partnership or a

company. It is less likely to be a trust.29 The focus is on

whether the IPP, as a matter of practical reality, is

providing services to clients of the firm. The fact the IPP

may be an employee of the company-firm does not mean

the IPP is not providing services to clients.30

The IPP and/or the IPP’s associated entities must

have a legal or beneficial interest in the firm.31 It is

suggested that all of the entities in column two of the

table below will have a beneficial interest in the firm in

column one.32

Firm type Entities holding a legal or beneficial

interest in firm

Partnership • IPP is a partner in firm;

• spouse or relatives of IPP who has hadIPP’s interest in the partnership (or partof it) assigned to them;

• trustee of trust is a partner in firm,where the trust is owned and/or con-trolled by IPP and/or associates of IPP;

• beneficiaries in trust (trustee) that is apartner in firm; and

• company is partner in firm, where thecompany’s shares are owned by IPPand/or associates of IPP.

Company • IPP is a shareholder in firm;

• spouse or relatives of IPP are sharehold-ers in firm;

• trustee of trust is shareholder in firm,where the trust is owned and/or con-trolled by IPP and/or associates of IPP;

• beneficiaries in trust (trustee) that is ashareholder in firm; and

• company is a shareholder in firm, wherethe company’s shares are owned by IPPand/or associates of IPP.


It appears that the main focus of the guidelines is on

firms with arm’s length principals (IPPs), for example,

the medium-sized or large accounting firms. However,

there is nothing to indicate that criterion one and the

broader guidelines do not apply to firms that are closely

held.

Firm operates by way of legally effective entity

This criterion confirms that the guidelines can apply

no matter what legal structure (ie partnership, trust,

company) is used by the associated parties as their

practice entity (firm). Where the IPPs are arm’s length

parties, one would expect the practice entity would be

legally effective. Where the IPPs are not at arm’s length

(eg spouses are partners), it is more likely that the

practice entity may be seen as not being legally effective

or a sham. Consistent with the law, the ATO notes that

this will depend on contractual terms, and whether the

practice is conducted in accordance with the contractual

terms.33

Income of the firm is not personal services income

The ATO states that in determining whether income

earned by a firm is personal services income or income

from the business structure, it will apply guidelines in its

existing rulings.34 Accordingly, the outline at Sub-

Part 2.1.2 applies here.

ATO risk assessment benchmarks forremuneration of IPPs35

The ATO states:36

In some cases, practice income may be treated as beingderived from a business structure, even though the sourceof that income remains, to a significant extent, the provisionof professional services by one or more individuals. In thiscontext, we are concerned that Part IVA [the GAAR] mayhave application, despite the existence of a business struc-ture. … Where an IPP attempts to alienate amounts ofincome flowing from their personal exertion (as opposed toincome generated by the business structure), the ATO mayconsider cancelling relevant tax benefits under [the GAAR].

Despite this statement, the ATO acknowledges that

historically, the GAAR has not been applied to income

from a business structure of a professional firm.37

The ATO has created three risk assessment bench-

marks applicable to IPPs and/or associated entities.

Where the IPP satisfies one (or more) of the benchmarks,

the ATO will allocate a “low risk” rating, and the

taxpayer will not be subject to ATO compliance action in

respect of income alienation. Where none of the bench-

marks are met, the taxpayer will be allocated a “high

risk” rating, and is more likely to be subject to audit

action and potential application of the GAAR.38 The IPP

can use a different benchmark from year-to-year to

obtain a low risk rating.39 Each benchmark is discussed

immediately below.

Benchmark 1: equivalent or appropriate remuneration

returned as IPP’s assessable income

To meet this benchmark, the IPP must include in their

assessable income an amount at least equivalent to

remuneration40 paid by the firm to the lowest paid

employee in the upper quartile of professional employ-

ees who provide services to the firm that are equivalent

to the services provided by the IPP.41 If there is no

“equivalent employees” in the firm, which may be the

case in smaller practices, like employees in comparable

firms or industry benchmarks should be used.

Benchmark 2: 50% of IPP and/or associated entities’

entitlements returned as IPP’s assessable income

To meet this benchmark, the IPP must include in their

assessable income at least 50% of the sum of all

entitlements of the IPP and the IPP’s associated entities

(ie collective entitlement flowing from the firm).42 Even

where an associate entity’s entitlement accrues through a

chain of interposed trusts, that entitlement will still be

counted in the denominator of this benchmark.43

This also means that entitlements accruing to the IPP

and/or associated entities from a service entity that

services the firm will be counted in the denominator. An

IPP’s entitlement from a service entity will be counted in

the numerator under this benchmark.

Benchmark 3: effective tax rate of at least 30% on IPP

and/or associated entities’ entitlements

To meet this benchmark, the effective tax rate must be

30%44 or more on both:45

(i) the income entitlement of the IPP from the firm;

and

(ii) the income entitlement of the IPP and the income

entitlement of the IPP’s associated entities, from

the firm.

Arguably, if the IPP has no entitlements from the

firm, which is possible, the first requirement ((i) above)

would be satisfied rather than failed.46 In other words,

testing for the 30% tax rate for the IPP is only necessary

if the IPP has some entitlement. In regard to the second

requirement ((ii) above), it is the collective entitlement

of all parties that must bear at least 30% tax. There is no

need for each associate that is entitled to bear the 30%

minimum.

Where the IPP has no non-firm income, the IPP

would have to include approximately $172,500 of tax-

able income from the firm to meet his/her 30% effective


tax rate requirement.47 Where the IPP and/or associated

entities have non-firm income, the ATO states that in

determining the tax borne on income from the firm, the

entitlement from the firm forms the “top slice” of a

natural person’s taxable income.48 For example, for an

IPP with non-firm taxable income of $60,000 and firm

income of $80,000, the following result arises:

Taxable income, and compo-

nents of taxable income

Tax on column

one components

Taxable income: $140,000Non-firm taxable income: $60,000Firm taxable income: $80,000

$39,747$11,047$28,700

The effective tax rate on the IPP’s firm income is

35.87% ($28,700/$80,000), which meets the 30% require-

ment.

Policy analysis

Need for guidelinesThe ATO correctly asserts that a certain portion of an

IPP’s entitlement from the firm, until now viewed solely

as income from a business structure, is generated from

the IPP’s personal exertion.49 The rules prior to the IPP

guidelines (or the old view) of this area has been based

on an “all or nothing” characterisation of the income

(personal exertion or from business structure). The

established rules regarding personal exertion income

(PSI regime) cannot apply to an IPP’s return from the

business structure. The ATO has generally not applied

the GAAR to “alienations” of income from a profes-

sional firm’s business structure. This is the gap filled by

the IPP guidelines.

The damage to the integrity of the income tax from a

situation where an IPP could return zero taxable income

from their firm was most likely the key thing that moved

the ATO to [eventually] take this measure. Inter-taxpayer

fairness may also have contributed, as may the parlia-

ment’s failure to act. One could legitimately ask, why

did the ATO take so long to act?

Legal status of guidelines and use of guidelinesby ATO

The IPP guidelines and in particular, the three bench-

marks, are not specific legislation and they do not derive

from case law. However, they are ultimately grounded in

the GAAR. That is, if the ATO seeks to defend their

application to particular taxpayers, the ATO will need to

convince either the AAT or the appropriate court that all

elements of the GAAR are satisfied. It is also noted that

the IPP guidelines are not a binding public ruling.50 The

effect of this is that an IPP and associated entities cannot

obtain the “estoppel type benefit” that comes from a

binding public ruling.51

In terms of legal status then, the IPP guidelines are

merely ATO website content. However, the ATO is likely

to consider itself bound administratively to the guide-

lines. While a taxpayer may be protected from a false or

misleading statement penalty (and any shortfall interest),

they will not be protected from a tax shortfall if the

ATO’s guidelines are later found to be incorrect or

misleading and the ATO seeks to depart from them.52

One would also expect that changes to the guidelines

that are detrimental to taxpayers will only operate

prospectively.

In the first instance, the guidelines will act as a “risk

management” or “audit selection” tool for the ATO. If a

taxpayer complies with the guidelines, they will be rated

as low-risk and are unlikely to face audit action. Here,

the guidelines effectively act as a “safe harbour” for

IPPs. While this may provide those taxpayers with

increased certainty, it also means there would be no

incentive for such taxpayers to include any more “per-

sonal exertion income” in their assessable income than

is required by the benchmarks.

If a taxpayer does not comply with at least one of the

benchmarks, they will be rated as high-risk, thus increas-

ing the risk of audit action. However, a “high-risk”

rating will not necessarily result in the ATO attempting

to apply the GAAR to the arrangement; it simply means

that they are more likely to examine the arrangement in

order to determine whether the GAAR should apply.

Appropriateness of taxpayer coverage andbenchmarks

Taxpayer coverage

The guidelines are limited in their reach to “profes-

sional firm arrangements” (eg accounting, engineering,

legal, medical). This means that firms and businesses

that provide services or products to the consuming

public, for example, “blue collar” service providers (eg

electricians, plumbers) and traders (eg coffee shops) are

outside the guidelines. As with professional firms, part

of the income in both of these categories of business is

likely to be generated from the personal exertion of the

principal(s).

The ATO claims that the structure of professional

practices in certain “thought related” professions is

unique and has been driven by a combination of factors

(eg reforms to regulatory environments) which has led

to the adoption of a variety of structures. These factors

differ from the commercial drivers in other sectors, such

as those involving physical labour. And, in light of the

greater flexibility provided by regulators, there is greater

potential for the alienation of income.53

With respect, the ATO’s reasoning is not convincing.

If the key objective is not permitting the full alienation

of personal exertion income, it is very hard to see why

this objective should not be pursued in the case of a


“blue collar” business or other trading businesses. The

ATO may be working on separate guidelines (although

this is unknown), but at the moment, the absence from

the guidelines of other businesses where a principal’s

personal exertion contributes to the income offends

inter-taxpayer equity and seems wrong in principle.

Benchmarks

The benchmarks should be evaluated in accordance

with the overall purpose of the guidelines: to prevent the

full alienation of personal exertion income away from

the provider of the personal exertion. The presence of

three alternative benchmarks and allowing the IPP to

select a different benchmark each year, provides flex-

ibility in determining the appropriate amount to be

included in the assessable income of the IPP. However,

this flexibility means that the benchmark chosen each

year is likely to be the one that results in the smallest

amount of assessable income for the IPP. Further, even if

none of the benchmarks are satisfied, it does not neces-

sarily mean that the ATO will seek to apply the GAAR.

The guidelines provide an example where, due to valid

commercial reasons, the ATO will not apply the GAAR

even though none of the benchmarks are satisfied.54

The first benchmark is making an assumption that the

remuneration being paid to the lowest paid employee in

the upper quartile of employees providing equivalent

services to the firm is an appropriate reflection of the

IPP’s personal exertion. The IPP’s entitlement from the

firm could be substantially higher than this remuneration

figure. It is questionable whether any excess allocation

above this figure is an accurate reflection of income

from the business structure and compensation for busi-

ness risk.

The second benchmark, on the face of it, is not set by

reference to an objective industry criterion concerning

remuneration for personal exertion in the market place.

Instead, it requires a minimum of 50% of the IPP’s

overall income entitlement to be included in their

assessable income. This suggests that the remaining

50% is due to the IPP’s portion of the business structure.

The third benchmark makes no attempt to separate

the IPP’s overall income entitlement into a personal

exertion component and a business structure component.

It is merely ensuring that a minimum rate of tax is paid

on the IPP’s income allocation, even if a large portion of

the tax is paid by the IPP’s associated entities. Strangely,

the corporate tax rate, which is usually associated with

the production of business income, has been chosen as

the effective tax rate to apply.551 This may not be

appropriate considering the IPP guidelines are based

around the concept of appropriately taxing the IPP’s

personal exertion income component.

ConclusionWhile the guidelines are a sensible development, they

may be somewhat generous, with IPPs being able to

“pick and choose” between benchmarks each year. The

ATO’s view may be that taxing some income in the

hands of the IPP is better than nothing, which is what the

current position permits. The guidelines are also narrow

in taxpayer coverage in that they only apply to profes-

sional services firms. This means that principals of other

businesses where there is a contribution to business

income from the principal’s personal exertion are tax

advantaged.

From a tax system point of view, the GAAR with the

broad nature of its operative concepts, is not an appro-

priate mechanism for taxation of personal exertion

income. It is submitted that the enactment of the PSI

regime in 2000 provides considerable support for this.

Treasury and Parliament should therefore give serious

consideration to introducing a policy-based legislative

regime to appropriately tax IPP personal exertion income,

rather than relying on non-legally binding ATO guid-

ance.

Dale Boccabella

Associate Professor of Taxation Law

School of Taxation & Business Law

University of New South Wales

[email protected]

Kathrin Bain

Lecturer

School of Taxation & Business Law

University of New South Wales

[email protected]

This article has been reviewed by an independent

reviewer.

Footnotes1. Australian Taxation Office, Assessing the risk: allocation of

profits within professional firms, 18 March 2016, www.ato.gov.au.

The guidelines were modified on 18 March 2016.

2. There is some doubt about this though, because even where the

guidelines apply to a professional firm, the ATO has conceeded

that the general anti-avoidance rule (GAAR) will not neces-

sarily apply: see heading “The IPP Guidelines” below.

3. The PSI regime is contained in Divs 84–87 of the Income Tax

Assessment Act 1997 (Cth) (ITAA 97).

4. See for example, FCT v Whiting (1943) 7 ATD 179 at 184; FCT

v Ramsden 2005 ATC 4136 at 4150; Kiwi Brands Pty Ltd

v FCT 99 ATC 4001 at 4012, and the authorities there cited.


5. Norman v FCT (1963) 13 ATD 13 at 18–19 (per Menzies J) and

at 20–22 (per Windeyer J).

6. Booth v FCT (1987) 87 ATC 5100 at 5103 (per Mason CJ) and

5109 (per Toohey and Gaudron JJ); Howard v FCT (2014) 309

ALR 1; 2014 ATC 20–457; [2014] HCA 21; BC201404440 at

[40]–[41].

7. FCT v Everett (1980) 80 ATC 4076 at 4083; Liedig v FCT

(1994) 94 ATC 4269 at 4277.

8. FCT v Everett, above n 7, at 4083.

9. See for example: Tupicoff v FCT (1984) 56 ALR 151; 84 ATC

4851; FCT v Gulland; Watson v FCT; Pincus v FCT (1985) 62

ALR 545; 85 ATC 4765; BC8501057.

10. FCT v Galland (1984) 56 ALR 468; 84 ATC 4890.

11. For partnerships, it would be Pt III Div 5 of the Income Tax

Assessment Act 1936 (Cth) (ITAA 36). For trusts, it would be

Pt III Div 6 of the ITAA 36. For a company, the income would

become that of the company as a taxpayer.

12. See for example, Taxation Rulings IT 25 Incorporation of

medical practices (7 August 1981), IT 2121 Income tax: family

companies and trusts in relation to income from personal

exertion (12 December 1984), IT 2330 Income tax: Income

Splitting (30 June 1986), IT 2503 Income tax: Incorporation of

medical and other professional practices (3 November 1988)

and IT 2639 Income tax: personal services income (20 June 1991).

13. Paragraph 10(a) of Taxation Ruling IT 2639.

14. Paragraph 10(b) of Taxation Ruling IT 2639. A principal

practitioner is a practitioner with a share in the firm. Non-

principal practitioners are full-time professional and non-

professional staff (eg bookkeeper) that derives fees for the firm:

paragraph 11 of Taxation Ruling IT 2639.

15. ITAA 36, s 260.

16. ITAA 36, Part IVA: ss 177A–177G.

17. See for example: Peate v FCT (1966) 14 ATD 198; [1966] 2

All ER 766; BC6600690; FCT v Gulland; Watson v FCT;

Pincus v FCT, above n 9.

18. See for example: Tupicoff v FCT, above n 9; Daniels v FCT

(1989) 20 ATR 1120; 89 ATC 4830; Bunting v FCT (1989) 90

ALR 427; 89 ATC 5245; Egan v FCT 2001 ATC 2185; (2001)

47 ATR 1180; [2001] AATA 449.

19. Paragraphs 1.12–1.13 in the Explanatory Memorandum to the

New Business Tax System (Alienation of Personal Services

Income) Act 2000 (Cth).

20. If the regime applies, there are also limitations in relation to

deductions that can be claimed against PSI: see Div 85 and

Subdiv 86–B of the ITAA 97.

21. ITAA 97, s 84–5(1). Paragraph 25 of Taxation Ruling TR

2001/7 Income tax: the meaning of personal services income

(31 August 2001) states: “Implicit in the word ‘mainly’ is that

more than half of the relevant amount of the ordinary or

statutory income is a reward for the personal efforts or skills of

an individual.”

22. See Example 7 at para 94 in Taxation Ruling TR 2001/7. The

related ruling, Taxation Ruling IT 2639, also provides guidance

as to whether income from a professional practice is considered

personal services income or income from the business strucutre:

see sub-heading “General anti-avoidance rule (GAAR)” above.

23. The legislation refers to the interposed entity as a “personal

services entity” (PSE): ITAA 97, s 86–15.

24. If none of the tests are satisfied, a PSB determination must be

obtained from the Commissioner: Subdiv 87–B.

25. Paragraph 264 in Taxation Ruling TR 2001/8 Income tax: what

is a personal services business (31 August 2001). The ATO’s

position on the application of the GAAR to arrangements for

splitting personal exertion income are set out in Taxation

Rulings IT 2121, IT 2330 and IT 2639.

26. See under “Intent of the guidelines” at above n 1.

27. Although not expressly stated, there is good reason to think that

an IPP who only provides services “internally” should also

satisfy this aspect of the criterion (eg education role to

professional employees).

28. See third paragraph of document: above n 1.

29. It is not out of the question that the firm could be a fixed trust.

A discretionary trust would introduce too much uncertainty

where arm’s length IPPs are concerned. However, note the use

of the discretionary trust as the service entity to a major

accounting firm in Segelov v Ernst & Young Services Pty Ltd

(2015) 89 NSWLR 431; [2015] NSWCA 156; BC201504847.

30. If the firm is a partnership of IPPs, an IPP cannot be an

employee of the firm.

31. The term “associated entities” will generally reflect people and

entities coming within the definition of “associate” in the

income tax legislation: ITAA 36, s 318.

32. The table does not cover the situation where the firm (practice

entity or operating entity) is a trust. However, adapted for the

nature of a trust, the list of entities in column 2 in regard to the

partnership and company would also feature for a trust.

33. See under “Legally effective partnership, trust or company”:

above n 1.

34. Taxation Rulings IT 25, IT 2121, IT 2330, IT 2503 and IT

2639, above n 12. These rulings express the ATO’s views as to

the possible application of the GAAR to attempted alienations

of personal services income. One doubts that it would matter

much, but the ATO ruling on s 84–5(1) of the ITAA 97

(personal services income is income mainly from your personal

efforts and skills) is not strictly applicable here (TR 2001/7).

35. This heading roughly reflects a heading from the IPP guideline

document as it best captures the role of the guidelines.

36. See under “Our concerns”: above n 1.

37. See above n 36.

38. An arrangement that does not satisfy any of the benchmarks

may not be subject to compliance action. However, in such

cases, the lower the effective tax rate of the arrangement, the

higher the ATO will rate the compliance risk, which will

increase the chance of compliance action: See under “Addi-

tional information on the application of the benchmarks”:

above n 1.

39. All IPPs in the same firm are not obliged to use the same

benchmark.


40. The total remuneration package should be recognised. For

example, fringe benefits, any related fringe benefits tax and

superannuation have to be included. See Question 2 under

“Further information: Applying benchmark 1”: above n 1.

41. See under “ATO risk assessment factors for remuneration of

IPPs”: above n 1. A number of factors are taken into account in

determining whether services provided by an employee are

equivalent to IPP provided services.


IPPs”: above n 1.

43. For example, the child of an IPP obtains a trust allocation at the

end of a chain of three trusts.

44. Tax for these purposes does not include the Medicare levy,

Medicare levy surcharge and any other levies. See Question 2

under “Further information: Applying benchmark 3”: above n

1. This operates to the detriment of the taxpayer as more

taxable income is required to move the effective tax rate to

30%.


IPPs”: above n 1.

46. This will be the case where the IPP has completely or fully

alienated his/her firm income (eg firm partnership comprises of

discretionary trusts of each IPP, and the IPP is not allocated any

trust law income from the [family] discretionary trust for the

year). For the remainder of this article, it is assumed that the

IPP does have an entitlement.

47. Tax on $172,500 is $51,772, giving an effective tax rate of

30.01% ($51,772/$172,500).

48. See Questions 1 and 2 under “Further information: Applying

benchmark 3”: above n 1.

49. The benchmarks could also, in a broad way, be viewed as

deemed market value rules, similar to the numerous deemed

market value realisation rules throughout the income tax

legislation.

50. The key reason is that there is no statement saying the IPP

guidelines (or benchmarks) are a public ruling: s 358–5(3)(b)

in Sch 1 to the Taxation Administration Act 1953 (Cth).

51. Section 357–60(1) in Sch 1 to the Taxation Administration Act.

52. Australian Taxation Office, Levels of protection explained,

17 March 2016, www.ato.gov.au.

53. See Question 1 under “Further general guidance on the

Benchmarks”: above n 1.

54. See Question 3 under “Further general guidance on the

Benchmarks”: above n 1.

55. From 1 July 2015, the tax rate for “small business entities”

(businesses with annual aggregated turnover of less than $2

million) has been reduced to 28.5%. With the current pressure

to lower corporate tax rates for all companies, it will be

interesting to see whether this benchmark is kept in line with

corporate tax rates going forward, or whether it will remain

fixed at 30%.


For editorial enquiries and unsolicited article submissions please contact Laura Foss at [email protected]

or (02) 9422 2726.

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