Deductions for Tax Penalty Expenses

In Interpretative Decision (ID) ATO ID 2004/831, the Tax Office allows a taxpayer a deduction for expenses incurred in seeking legal advice regarding a tax penalty notice.

The ID considers a case where the taxpayer, a company director, is issued with a penalty notice from the Tax Office under section 220AOE of the Income Tax Assessment Act 1936 (ITAA 1936), regarding unpaid PAYG withholding debts of the company.

The taxpayer incurred expenses in seeking legal advice regarding the penalty notice. The nature of the legal advice related solely to the effect of the penalty notice and the required course of action.

Section 25-5 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for certain tax-related expenses. Specifically, paragraphs 25-5(1)(b) and (e) of ITAA 1997 allow a deduction for certain expenses incurred by a taxpayer in complying with an obligation imposed by Commonwealth law, where that obligation relates to the tax affairs of the entity. In addition, such advice must be provided by a recognised tax advisor such as a registered tax agent or a legal practitioner.

The Tax Office considers that the legal advice sought by the taxpayer in relation to the penalty notice, is an act of compliance with an obligation imposed by Commonwealth law.

In determining whether the term 'tax affairs' is broad enough to encompass matters relating to PAYG withholding, the Tax Office relied on the cases of Bartlett v. Federal Commissioner of Taxation and Falcetta v. Federal Commissioner of Taxation [2003] FCA 1125; 2003 ATC 4962; (2003) 54 ATR 261, where it was held that the expression 'tax affairs' used in section 69 of ITAA 1936 (the predecessor of section 25-5 of ITAA 1997) included ancillary taxes such as provisional tax, group tax and prescribed payments.

The Tax Office formed the view that it was not the intention of the legislature to narrow the meaning of the term 'tax affairs' by use of the new definition in section 995-1 of ITAA 1997. Accordingly, the term 'tax affairs' as used in section 25-5 was held to include ancillary taxes such as PAYG withholding.

In addition, the taxpayer engaged the services of a recognised tax advisor in the form of a legal practitioner. Consequently, the Tax Office declared the expenses incurred by the taxpayer in seeking legal advice to be an allowable deduction under section 25-5.

For further information please review ATO ID 2004/831 Deductions: expenses incurred by director in complying with penalty notice at:

http://law.ato.gov.au/atolaw/view.htm?docid=AID/AID2004831/00001

Tax Office Appeal Unsuccessful

In The Recoveries Trust and Commissioner of Taxation [2004] AATA 1075, the Administrative Appeals Tribunal (AAT) held that the taxpayer was entitled to full input tax credits on the cost of due diligence in line with GST Ruling GSTR 2002/2 despite the Tax Office's submission that its own ruling was not applicable.

The case involved a taxpayer, The Recoveries Trust (TRT), who acquired the debts of another entity (M Pty Ltd) with a view to collecting them. Before acquiring the debts of M Pty Ltd, TRT paid for due diligence services to be performed for the purpose of providing TRT with a recommendation as to whether TRT should acquire debts of M Pty Ltd. In addition to the due diligence services, TRT also obtained legal and debt recovery processes advice. TRT claimed full input tax credits for the GST paid on each of the pre-acquisition services.

After the acquisition, TRT took steps to recover the debts. This involved the engagement of legal services and other parties to manage the process. TRT claimed full input tax credits for the GST paid on each of these services.

The question at hand was whether TRT was entitled to claim full GST input tax credits in respect of the goods and services it acquired, both before the acquisition and during the collection of the debts.

The facts of the case presented a complex situation as the acquisition of financial debts is a financial supply. Again no GST is attracted, but the supply is input taxed. As the supply is input taxed, the question arose as to whether the debt collection services and the due diligence advice were acquired for creditable purposes.

Under section 11-5 of the A New Tax System (GST) Act 1999, a taxpayer is entitled to an input tax credit equal to the GST component paid on its creditable acquisitions. A creditable acquisition is the purchase of goods or services used in carrying on the taxpayer's enterprise.

With regard to the debt collection services, under paragraph 11-15(2) an acquisition cannot be a creditable acquisition to the extent that it relates to making supplies that would be input taxed. TRT argued there wasn't a sufficient relationship between the acquisitions and that the relevant supply occurred before the debt collection services were acquired. The AAT rejected this argument on the basis that a sufficient relationship did in fact exist and that debt collection services are listed under the GST Regulation 70-5.02 as reduced credit acquisitions. The AAT consequently affirmed the Tax Office's denial of the full input tax credits.

In regard to the due diligence advice, the GST Ruling GSTR 2002/2 states that such an acquisition would be for a creditable purpose and would accordingly give rise to full input tax credits. The GST Ruling contains an example that broadly states that services rendered prior to the forming of the intention to acquire shares will be for a creditable purpose while services after that date are not for a creditable purpose as they would relate to making supplies that are input taxed.

In an unusual move, the Tax Office argued that the Ruling was inapplicable and non-binding on the basis that it violated paragraph 11-15(2). The AAT acknowledged that differing views could be held on the matter, but was not persuaded that views in the Ruling were incorrect. Accordingly, the AAT set aside the Tax Office's original position and held that the due diligence advice was acquired for a creditable purpose and hence full input tax credits were available to the taxpayer.

You may review The Recoveries Trust and Commissioner of Taxation [2004] AATA 1075
(15 October 2004) case at:

http://www.austlii.edu.au/au/cases/cth/aat/2004/1075.html

For further information regarding GSTR 2002/2 Goods and services tax: GST treatment of financial supplies and related supplies and acquisitions, you may review the Ruling at:

http://law.ato.gov.au/atolaw/view.htm?locid='GST/GSTR20022/NAT/ATO'

Investigation of DIY Super Funds

See article in Australian Financial Review 'DIY funds under tax microscope' - Allesandra Fabro,
25 October 2004.

For further information please review the Tax Office's Media Release 04/054 - DIY Super: It's your money...but not yet! at:

http://www.ato.gov.au/corporate/content.asp?doc=/content/mr2004054.htm

R&D Claims under Review

For further information about the research and development tax concession, please review the Frequently Asked Questions at:

http://www.ato.gov.au/businesses/content.asp?doc=/content/34648.htm

Determining Residency Status

In Taxation Ruling TR 2004/15, the Tax Office offers guidelines for determining whether a company, not incorporated in Australia, is a tax resident of Australia. The residency status of a company assists in identifying how much of its income is taxable in Australia.

Broadly, section 6-5 of ITAA 1997 provides that the assessable income of an Australian tax resident includes both their Australian and foreign sourced income, whereas the assessable income of a non-resident includes only that income which has an Australian source.

The term 'resident' or 'resident of Australia' is defined in section 6(1) of ITAA 1936 as:

- a company which is incorporated in Australia or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.

The Taxation Ruling considers in detail whether:

         a company is carrying on business in Australia; and

         the company's central management and control (CM&C) is located in Australia.

Carrying on a business

It is worth noting that the Tax Office recognises that for the purposes of the section 6(1) definition of a resident company, the concept of carrying on a business may be considered to be wider than its ordinary meaning and consequently extends to all dealings conducted in a businesslike or commercial manner. As an example, the Tax Office suggests that a company may be carrying on business for the purposes of the section 6(1) definition of resident company even if its only activity is the management of its investment assets.

To determine which country a business is being carried on in, the Tax Office considers it appropriate to draw a distinction between a company with operational activities such as trading and manufacturing and one which is passive in its dealings such as a holder of investments.

Where a company has significant operational activities relative to its entire business, the Tax Office forms the view that it is carrying on a business in the country where those operational activities take place.

In the case of a company whose activities are passive in nature, the Tax Office will regard the company as carrying on a business in the place where the investment decisions are made. This is often where the company's CM&C is located.

Central management and control

A company's CM&C refers to the making of high-level decisions such as general policies, strategic directions, company performance and financial arrangements. Typically, such decisions are made by the board of directors.

The residence of the individual board members does not in itself determine where the company is resident, but may provide a good indication of where the company's CM&C is located. The Taxation Ruling provides, however, that the CM&C of the company will in most cases be the country in which board meetings are held, except where the circumstances indicate an artificial or contrived CM&C outcome.

Where the general affairs of the company are not controlled from one central location, it may be possible that a company has more than one location of CM&C.

For further information and detailed examples, please review TR 2004/15 Income tax: residence of companies not incorporated in Australia - carrying on a business in Australia and central management and control at:

http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR200415/NAT/ATO/00001

Important: This is not advice. Clients should not act solely on the basis of the material contained in this Bulletin. Items herein are general comments only and do not constitute or convey advice per se. Also changes in legislation may occur quickly. We therefore recommend that our formal advice be sought before acting in any of the areas. The Bulletin is issued as a helpful guide to clients and for their private information. Therefore it should be regarded as confidential and not be made available to any person without our prior approval.