THE DEVELOPMENT OF TAX ANTI-AVOIDANCE LAW IN AUSTRALIA AND THE UNITED STATES

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1 Preliminary Draft not for citation, distribution, quotation etc. THE DEVELOPMENT OF TAX ANTI-AVOIDANCE LAW IN AUSTRALIA AND THE UNITED STATES Susan C. Morse and Robert Deutsch * INTRODUCTION This Article uses a case study approach to describe and compare the development of tax anti-abuse law in Australia and the United States. Australian tax administrators turn more readily to statutory amendment to modify tax anti-abuse law, while in the United States efforts to amend the law are more substantially directed toward litigation and regulation. However, there is little evidence that institutional choice causes the substantive differences that exist in Australian compared to U.S. anti-abuse law. Governments attempt to address abusive taxpayer activity using legislative, judicial, and administrative action. Some countries, including Australia, have a general anti-abuse rule, or GAAR, crafted by the legislature, applied in the first instance to specific taxpayers by tax administrators, and adjudicated by courts. Other countries, including the United States, rely largely on the judiciary to both craft and adjudicate the law that limits taxpayer abuse. Under judicial anti-abuse law, tax administrators similarly propose, on audit and in litigation, the application of the law for a particular taxpayer and situation, while the legislature retains some power to influence anti-abuse law through general and specific provisions. A large literature compares and contrasts different experiences with GAARs and judicially-fashioned anti-tax-abuse doctrines such as business purpose, economic substance and the step transaction doctrine. For example, scholars have explored rule-of-law, 1 rules-versus-standards, 2 and * Susan Morse serves as Assistant Professor at the University of Texas School of Law, Austin, Texas. Robert Deutsch serves as Professor of Law at the School of Taxation and Business Law, University of New South Wales. 1 In many jurisdictions, rule-of-law concerns with respect to taxation have explicit constitutional roots. Australian courts have held that the Constitutional power to tax, see Australian Constitution 51(ii), requires, among other items, that the revenue provision is contestable. See MacCormick v. Commissioner 84 ATC 4230 ( ) (High Court). See, e.g., Graeme S. Cooper, Conflicts, Challenges and Choices the Rule of Law and Anti-Avoidance Rules 13, in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed. 1997) ( ). See generally Victor Thuronyi, Comparative Tax Law (2003) (describing the principle of legality applied to taxation law by many constitutions).

2 2 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 taxpayer certainty 3 approaches. concerns presented by different tax anti-abuse A substantial literature also focuses on the content of anti-abuse rules, in a way that is, for the most part, not uniquely applicable only to one approach to the exclusion of the other. For example, one important consideration for both a legislative and a judge-made rule is the extent to which the tax administrator may choose how to frame transactions in proposing the application of anti-abuse law, thus paving the way to an easier finding of tax avoidance. 4 Another relevant consideration for either a judge-made or a legislative rule is how to identify problematic tax avoidance behavior when many statutory provisions extend the carrot of lower taxes to encourage taxpayers to arrange their activities in a particular way. 5 Rebecca Prebble & John Prebble, Does the Use of General Anti-Avoidance Rules to Combat Tax Avoidance Breach Principles of the Rule of Law? A Comparative Study, 55 St. Louis L.J. 21, 45 (2010) ( General anti-avoidance rules demonstrate that the rule of law is not an unqualified good. ). U.S. scholars have also made rule-of-law arguments against judicial application of anti-abuse rules in the tax context, despite the absence of an explicit Constitutional basis for the position. See, e.g., Gunn, 76 Mich. L. Rev. 735; Isenbergh, 49 U. Chi. L. Rev See, e.g., David A. Weisbach, Formalism in the Tax Law, 66 U. Chi. L. Rev. 860, (1999) (arguing that a general anti-abuse law would constitute a standard that would allow for greater simplicity in the law; common transactions that are taxed inappropriately become common as a result of tax planning, so tax rules must anticipate uncommon situations, and the resulting complexity of rules leads to untenable interaction costs ). J. F. Avery Jones, Tax Law: Rules or Principles? (1996) BTR Compare J. Braithwaite, Making Tax Law More Certain: A Theory (2003) 31 Australian Business Law Review 72 with Judith Freedman, Defining Taxpayer Responsibility: In Support of a General Anti-Avoidance Principle, 2004 Brit. Tax Rev. 332, 346 (2004) (arguing that certainty is not the aim of the exercise of adopting an antiavoidance standard). See also Leigh Osofsky, The Case Against Strategic Tax Law Uncertainty, 64 Tax L. Rev. 489, (2011) (outlining difficulties for compliance strategies that rely on uncertainty, including tactical enforcement capacity and risk aversion diversity among taxpayers). 4 See, e.g., David P. Hariton, The Frame Game: How Defining the Transaction Decides the Case, see also Bevan (criticizing Hart). 5 See, e.g., R.W. PARSONS, INCOME TAXATION IN AUSTRALIA para. 2,420 (1985); Leandra Lederman, W(h)ither Economic Substance, 95 Iowa L. Rev. 389, 433 (2010) ( The question should be whether Congress intended the claimed result. ); C. John Taylor, Form and substance in tax law: Australia, 87a Cahiers de droit fiscal international 95, (arguing that Part IVA misses the key goal of evaluating what the policy behind legislative provisions is ) (citing Neil Brooks, The Responsibility of Judges in Interpreting Tax Legislation, 93, 99 in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed., 2007) (arguing that judges should not act as agents of the legislature and should rather decide what result would reflect the most sensible tax policy ). See also Shannon Weeks McCormack, Tax Shelters and Statutory Interpretation: A Much Needed Purposive

3 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 3 The ongoing interaction between, on the one hand, different branches of government, and, on the other hand, the structure and content of anti-abuse law, remains less explored. This interaction forms the focal point of this Article. This Article uses a case study approach to describe and compare the legislative, administrative and judicial paths available for changing the law under a statutory GAAR and under a judicial anti-abuse doctrine. The statutory GAAR description draws on the recent Australian experience with the counterfactual requirement of its GAAR statute. The judicial antiabuse doctrine description draws on the recent U.S. experience with challenges to foreign tax credit generator transactions. This Article attempts to capture the dynamic and interactive nature of ongoing adjustments to anti-abuse law. It makes three descriptive claims. First, tax administrators lead the course of development of anti-abuse law in both the Australian and United States systems. Second, the ease of enacting legislation in Australia relative to the United States prompts tax administrators to direct relatively more effort toward statutory change in Australia. However, this difference is one of degree, since both judicial and statutory avenues comprise important elements of the development of antiabuse law in both countries. Third, although substantive differences exist between Australian and U.S. tax anti-abuse law, there is little reason to think, based on these case studies, that institutional choice factors, rather than path dependence, had a dominant influence on the content of the law. Part I of this Article briefly traces the history of Australia s GAAR and the history of the U.S. economic substance and related case law doctrines. Consistent with the statutory nature of the Australian approach and the judicial nature of the U.S. approach, and as other scholars have observed, the legislature has produced important changes to the course of the antiabuse tax law in Australia; 6 while judicial decisions have resulted in such Approach, 2009 U. Ill. L. Rev. 697, (proposing an approach that identifies general structure, giveaway and administratively helpful provisions to identify legislative purpose in the case of tax shelters). 6 For example, the 1981 statutory change, and also numerous amendments. Perhaps the most accessible illustration consists of amendments to the definition of tax benefit, as capital loss, withholding tax and foreign tax credit provisions were added over the years. Cassidy footnote. The question of amending the definition of tax benefit arises under Australian law in part because of the schedular approach taken to drafting that section of the statute. See Robert Deutsch, Improving the operation of the anti-avoidance provisions in the income tax law government releases discussion paper, CCH Tax Week 1-2, 13 January In contrast, the Canadian GAAR broadly defines a tax benefit as a reduction, avoidance, or deferral of tax or other amount payable under this Act. Income

4 4 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 changes in the U.S. 7 But this leadership is not exclusive in either case. Australian courts have exercised discretion in a way that shaped the Australian GAAR into a powerful anti-abuse tool, 8 and the U.S. Congress has directed judicial discretion with specific anti-avoidance laws 9 as well as a recently enacted narrowly drafted rule of general application that will foreclose some taxpayer-friendly interpretations in future cases. 10 Part II of this Article presents two recent case studies that illustrate tax administrators approach to the process of adjusting tax anti-avoidance law in Australia and the U.S. Both stories begin with tax administrators dissatisfaction with government litigation losses. In Australia, the government lost several cases involving tax-motivated internal reorganization schemes. 11 The government responded by proposing a change in a statutory provision, known as the counterfactual requirement, 12 which some courts had interpreted to support some Tax Act (Canada) s.245(1). See Graeme S. Cooper, Conflicts, Challenges and Choices the Rule of Law and Anti-Avoidance Rules 13, 34 in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed. 1997) (contrasting Canadian and Australian approaches). Other sources include Taylor in Cahiers (2002) and general tax books: Gilders, Taylor, Walpole, Burton, Ciro; and Woellner, Barkocyz, Murphy, Evans, Pinto. 7 Lederman, Bankman articles provide views of chronology. E.g. Tiley s 4 BTR articles for overview of doctrines other than economic substance. 8 As evidence of judicial exercise of discretion to strengthen GAAR: High Court interpretation of exercising statutory option in Spotless Services; High Court interpretation of scheme requirement in Hart. Would prefer to give a nuanced understanding, though, e.g. acknowledge Peabody and interactions with trust law, though ideally should avoid too much diversion. 9 See, e.g., Charles H. Gustafson, The Politics and Practicalities of Checking Tax Avoidance in the United States, in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed. 1997) 349, (listing examples of specific anti-abuse rules in the U.S. Internal Revenue Code). 10 See I.R.C. 7701(o). Need a survey of 7701(o) literature. Osofsky has some commentary. 11 See Robert Deutsch, Part IVA and international transactions, 15(2) Tax Specialist 74, 83 (2011) (noting that the do nothing counterfactual is readily available in internal reconstructions more than in third-party transactions and citing News Australia and RCI as examples of cases where taxpayers raised a do-nothing counterfactual). 12 The revisions to the counterfactual requirement are apparently meant to counteract the possibility that taxpayers will successfully argue that no tax benefit was obtained because in the absence of the tax benefit, the transaction would not have occurred. See Explanatory Memorandum For example, the counterfactual must be a reasonable alternative to the scheme, disregarding possible adverse tax consequences of the alternative. See Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill Numerous uncertainties as to the application of the revised counterfactual requirement remain. See, e.g., Graeme S. Cooper, A Glimpse at Australia s GAAR Bill, 69 Tax Notes Int l 759 (Feb. 25, 3013).

5 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 5 taxpayers positions that no tax benefit resulted if a taxpayer would not have entered into any transaction at all if the tax benefits of the executed transaction were not available. 13 In the U.S., the government initially lost several cases relating to the generation of foreign tax credits by U.S. taxpayers through cross-border investment transactions. 14 (This contrasts with the experience in Australia, where a statutory change addressed similar foreign tax credit generation schemes effective 1998, 15 and a single 2010 case held that a foreign tax credit generator violated the GAAR. 16 ) In the U.S., tax administrators responded to their litigation losses by (1) promulgating guidance, 17 (2) seeking a limited general statutory rule to overturn specific elements of some courts reasoning 18 and a specific statutory provision aimed at splitter foreign tax credit generating transactions; 19 and (3) expanding future litigation strategy in order to improve the economic substance reasoning and add related substance-over-form, specific anti-abuse and other case law and regulatory-based claims to pleadings. Part III extrapolates from the case study descriptions presented in Part II to make several broader descriptive claims. First, tax administrators retain an important leadership role in the development of anti-abuse law whether the law stems from a statutory or judicial rule. This is because of their choices in audit, litigation and settlement 20 as well as the guidance they 13 See Graeme S. Cooper, Predicting the past the problem of finding a counterfactual in Part IVA, 40 Aus. Tax Rev. 185, 193, 194, 197 (2011) (noting that tax benefit is also the quantity that measures the increased tax due; that a tension exists because [t]here must [be] an alternative which would have triggered higher tax, but the very fact that it triggers higher tax could make the alternative unreasonable; and that the do nothing option was raised by the taxpayer but not resolved by the court in the News Australia case). 14 Compaq and IES. See Shaviro and Weisbach in Tax Notes. Also Guardian Industries. 15 Amendment No. 11 to Income Tax Assessment Act of 1936, The law had retrospective effect as of the date of the announcement, Australia solved the problem in 1999, with retroactive effect to the announcement date of the legislation, August 13, 1998, as is customary. See Richard Vann, Australia, at 1, 9, in Hugh J. Ault & Brian J. Arnold, COMPARATIVE INCOME TAXATION: A STRUCTURAL ANALYSIS (3d ed. 2010) ( [T]ax legislation is routinely made retrospective to its announcement date, a practice that does not create any constitutional issues in Australia. Initially this was confined to tax avoideance measures but not the same applies even where the legislation concerns systemic issues. ). 16 Citigroup Pty Ltd v Federal Commissioner of Taxation [2010] FCA Notice practice. 18 IRC 7701(o). 19 IRC Note settlement is more controversial in AUS; take care here.

6 6 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 might give to taxpayers. Second, different forums in each country the legislative branch in Australia and the judicial branch in the U.S. provide the leading avenue for the development or adjustment of the law. This is due in part to a pathdependent historical norm in each country; once anti-abuse law resides in a particular branch of government, it is most comfortable to contemplate amendments within the law of that branch. In addition, the prevalence of legislative solutions in Australia stems in part from the capacity of the legislature to pass anti-abuse laws quickly after such laws are proposed by the administration. For example, the counterfactual amendment under Australian law passed about 15 months after the first speech by the Australian Treasurer stating that a change would be proposed. This contrasts with a more-than-ten-year continuous process of studying and amending provisions introduced as draft legislation in Congress before the passage of I.RC. 7701(o). 21 Finally, there is more capacity to make statutes retrospective in Australia relative to the ability to make statutes retroactive in the U.S. In the U.S., the ability of courts to accomplish retroactivity where legislatures cannot provides more of an advantage to judicial solutions, from the perspective of the tax administrator, compared to Australia. However, the leadership of the administration and the emphasis on legislative solutions in Australia and judicial solutions in the U.S. does not exclude the participation of all branches of government. Instead, the difference is one of degree. Third, although substantive differences exist between U.S. and Australian anti-abuse law, the evidence drawn from the case study approach taken here does not support a conclusion that institutional choice issues produced the substantive differences. Instead, the evidence presented here suggests that path dependence strongly influences the substantive differences. In particular, when presented with early cases in which taxpayers modified their initial planning to obtain better tax results, the Australian law framed the issue as one of taxpayers deliberately choosing tax planning over a more normal way of approaching a transaction. The lasting concept of the counterfactual or alternative postulate has a logical structure that recalls this choice principle. The U.S. law framed the issue in early cases in a way that focused on business purpose and pre-tax profit. Even though these issues were tethered to the facts of the respective cases, they later became the building blocks for the subjective and objective prongs of the modern economic substance doctrine. These different rule 21 McMechan

7 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 7 structures do not appear to have emerged from institutional choice issues, but rather from the way in which early courts engaged with tax avoidance issues framed the cases before them. I. DIFFERENT TAX ANTI-ABUSE APPROACHES IN AUSTRALIA AND THE U.S. A. The Development of Australia s GAAR An earlier version of Australia s statutory general anti-avoidance rule, or GAAR, was incorporated into its tax statute in 1936 at section 260. Dissatisfaction with judicial interpretations of Section 260 prompted the passage of the existing GAAR in so-called Part IVA in The existing GAAR has been regularly amended since, in response to developments in taxpayer planning and also in response to tax litigation developments. Section 260 voided, as against the Commissioner, any contract (1) altering the incidence of any income tax; (2) relieving any person from liability to pay any income tax or make any return; (3) defeating, evading, or avoiding any duty or liability imposed on any person by [the tax] Act; or (4) preventing the operation of this Act in any respect. The language of Section 260 could have supported a broad interpretation. But instead, the case law developed under Section 260 narrowed the provision. The case law developed to include two doctrines that, as interpreted by courts, significantly limited its application. These were the choice principle and the antecedent transaction test. The choice principle permitted taxpayers to choose from different avenues available to them under the tax statute. For example, in the 1978 Slutzkin case, the Australian High Court (the final judicial arbiter in Australia) concluded that a taxpayer could choose between selling a company for a nontaxable gain or liquidating it and producing a taxable dividend. 22 British precedents that construed tax statutes in taxpayers favor by requiring specific explication of the tax liability supported decisions in Slutzkin and other cases Barwick CJ in Slutzkin (1978) 7 ATR 166, where the taxpayer s right to choose between selling the company for a nontaxable gain or liquidating it and producing a taxable dividend was upheld. (Note before the adoption of AUS CGT in.) See Julie Cassidy, To GAAR or Not to GAAR That is the Question: Canadian and Australian Attempts to Combat Tax Avoidance, 36 OTTAWA L. REV. 259 (2004); Jeffrey Waincymer, The Australian Tax Avoidance Experience and Responses: A Critical Review, in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed. 1997) 247, The Slutzkin court relied on the seminal British case Duke of Westminster v. IRC, 19

8 8 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 The antecedent transaction test made the application of Section 260 contingent on a fact pattern in which the taxpayer started down one road, and then changed plans for a tax reason. [More to come here.] Yet some narrow judicial applications of Section 260 that helped to prompt the enactment of the revised Australian GAAR were later reversed as to interpretations of Section 260 itself. After the 1981 passage of the GAAR, a resurrection of Section 260 occurred in cases in which courts concluded that a general anti-avoidance rule must in some cases be capable of reversing the effect of specific provisions of the statute, if the transactions referred to are not within the intended policy of the statute. 24 Frustration with anti-avoidance jurisprudence in the face of a wave of bottom of the harbor and other structured tax planning transactions in the 1970s prompted the Australian Treasury and ATO to propose a different general anti-avoidance, rule, or GAAR. 25 This revised version was enacted [effective] in It allows the Australian Commissioner of Taxation to challenge a transaction that (1) is a scheme, (2) provides a tax benefit that would not have arisen if the scheme had not been carried out and (3) involves the taxpayer s dominant purpose of obtaining the tax benefit. 27 [To come: discussion of AUS penalties.] Both the scheme requirement and the purpose requirement have been interpreted with some flexibility, while the tax benefit requirement has generally been defined in a less flexible way. The scheme requirement captures the issue of framing for tax avoidance transactions. 28 In other words, particularly for commercial TC 490 (1936) and the then-recent case Europa Oil (NZ) Ltd. (No. 2) v. IRC (NZ), 5 ATR 744). A similar taxpayer-favorable interpretation of the choice principle appeared in Cridland v. Commissioner of Taxation, 170 CLR 330 (1977) (holding for the taxpayer in connection with an income-averaging plan conducted through a trust). 24 See Jeffrey Waincymer, The Australian Tax Avoidance Experience and Responses: A Critical Review, in Tax Avoidance and the Rule of Law (Graeme S. Cooper ed. 1997) 247, (citing Gulland, Watson and Pincus, 15 ATR 422 (1984) and Gregrhon Investments Pty. Ltd. & Others v. FCT, 87 ACT 4988 (1987)). 25 [More to come here, including from ATO memoir material.] 26 A prior GAAR, part of Australia s statutory tax law from 1936 to 1981, was widely considered ineffective. [Choice principle, antecedent transactions? Cassidy. But need AUS source.] 27 ITAA Hariton, Burke

9 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 9 transactions tweaked to improve tax results, a narrowly framed transaction will prove easier to challenge as an abusive tax transaction. Under the Australian GAAR, the scheme requirement is not a significant obstacle to an effort by the Commissioner to challenge a transaction, under case law that sustains the Commissioner s ability to narrowly frame a scheme even if it is only part of a larger commercial transaction. 29 An eight-factor test [which has not been amended since the statute s initial passage in 1981] applies to the purpose element of the GAAR. Relevant factors include the manner in which the scheme was carried out; the form and substance of the scheme; the timing and duration of the scheme; the result achieved but for Part IVA; the change in the taxpayer s and/or connected persons financial position; any other consequence for the taxpayer and/or a person connected with the taxpayer; and the nature of any connection between the taxpayer and other persons whose financial position is affected by the scheme. The goal of the test is to ascertain the taxpayer s dominant purpose without necessarily slavishly tick[ing] off the factors. 30 There is no statutory carveout either in the purpose section or in the tax benefit section for ordinary business or family dealings, despite legislative history to the effect that the statute means to target blatant, artificial, or contrived planning. 31 The tax benefit requirement has been defined in a less flexible way, and has been subject to more amendments than either of the other two prongs of the Australian GAAR test, as the legislature responds to courts limited interpretation of the tax benefit definition. The schedular list of tax benefits has been expanded over time in Part IVA. 32 In addition, the alternative postulate or counterfactual element of the definition of tax benefit has been amended. Part II.A of this paper discusses recent changes to the counterfactual element in some detail. 29 See ROBIN WOELLNER, STEPHEN BARKOCZY, SHIRLEY MURPHY, CHRIS EVANS & DALE PINTO, AUSTRALIAN TAXATION LAW (noting that the High Court s endorsement of a narrow understanding of scheme in a split loan case appears to have considerably strengthened the Commissioner s ability to identify a scheme under Part IVA ) (citing Commissioner v. Hart, 206 ALR 207 (2004)); G.T. Pagone, Tax Avoidance in Australia (2010) (challenging notion that a scheme must have commercial or other coherence based in part on language in Hart). 30 Commissioner v. Consolidated Press Holdings Ltd. (no 1) 99 ATC 4945, See Woellner, Barkoczy, Murphy, Evans & Pinto, Australian Taxation Law (23d ed.) (citing and quoting Treasurer s Second Reading Speecn, Commonwealth Hansard, House of Representatives, 27 May ).A 32 See ITAA 177C(2).

10 10 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 The initial version of Part IVA as passed in 1981 listed two types of tax benefits: amounts not included in taxable income, and deductions allowed. 33 Withholding tax avoidance was added to the list effective 1996, 34 capital losses effective in 1997, 35 and foreign tax credits effective These expansions required analogous changes to the section of the tax benefit statute that carves out expressly provided benefits. [Each of] these statutory changes to the tax benefit definition in Part IVA was formulated and proposed by the Treasury in consultation with the Australian Taxation Office, or ATO, [and faced no opposition in Parliament, which is to say no opposition or minority parties raised objections in the Senate]. 37 This reflects the greater power of Australia s tax administrators with respect to tax legislation as compared with the power of the U.S. Treasury and Internal Revenue Service with respect to tax legislation in the United States. As in the United States, Australia s Constitution requires that tax bills originate in the popularly elected House of Representatives. However, because Australia has a Parliamentary system of democratic government, the Prime Minister s party by definition controls the House, as well as overseeing the administration of government, including the ATO. The Prime Minister s party often does not control the Australian Senate, but generally the government (or more accurately the bureaucracy) rather than the legislature is the driving force for tax policy and legislation in Australia. 38 The Australian tax statute is unusually long and detailed, and tries to anticipate a more comprehensive set of possible fact situations than does the United States tax statute. [L]ittle or nothing [is left] to [tax] regulations in Australia. 39 There is a tradeoff: Australian tax administrators may lack sweeping power to write regulations, but they possess a relatively large ability to influence the content of the statute ITAA 177C(1) and (2); Pagone at See ITAA 177CA; Pagone; Cassidy. 35 See ITAA 177C(1)(ba); Pagone; Cassidy. 36 See ITAA 177C(1)(bb); Pagone; Cassidy. 37 [Both bracketed items consistent with discussions but need to confirm/triple check.] 38 See Richard Vann, Australia 6.1, in Comparative Income Taxation (Hugh J. Ault & Brian J. Arnold eds. 3d ed. 2010). 39 See Richard Vann, Australia 6.2, in Comparative Income Taxation (Hugh J. Ault & Brian J. Arnold eds. 3d ed. 2010). 40 See, e.g., Malcolm Gammie, Tax Avoidance and the Rule of Law: A Perspective from the United Kingdom in TAX AVOIDANCE AND THE RULE OF LAW 181, 213 (Graeme S.

11 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 11 B. The Development of the United States Economic Substance Doctrine The development of the judicial economic substance doctrine in the U.S. is generally traced to a corporate reorganization case, Gregory v. Helvering. 41 Other benchmarks include Knetsch v. United States, 42 Frank Lyon v. United States, 43 and ACM Partnership v. Commissioner. 44 In an attempt to bring the economic substance story down to the present, the discussion here also covers the clarification of the doctrine in I.R.C. 7701(o), effective for transactions completed after March 30, 2010, and a recent Tax Court application of the doctrine in BNY Mellon. 45 Sometimes the economic substance doctrine is said to have a subjective and an objective prong. The subjective prong asks whether the taxpayer s purpose in entering the transaction was tax avoidance; it is sometimes explained as the requirement that a sufficient non-tax business purpose exists. The objective prong examines a transaction s bona fide, non-tax economic effect, and is sometimes translated as the requirement for a profit before taxes. 46 Gregory provides an early example of the application of a subjective business purpose test. 47 In Gregory, the taxpayer wholly owned a corporation that owned a block of stock. The taxpayer wanted to sell the block of stock, and she also wanted to avoid the corporate-level gain and dividend treatment that would result if the corporation sold the stock directly and distributed the proceeds to her. She used a second, transitory corporation to conduct a spin off transaction which, she argued, transferred ownership of the block of stock to her prior to the sale in a tax- Cooper ed IBFD Publications BV) (noting that the judiciary may confer on the administrator what traditional British constitutional and legal doctrine is supposed to deny discretion and that the different U.S. view ought to be considered with the different constitutional and legislative framework in mind ); John Tiley, Judicial Anti-Avoidance Doctrines: Corporations and Conclusions, 1988(4) Brit. Tax Rev. 108, (noting the greater detail of U.S. regulations and the broader drafting norms for U.S. statutes compared to British law and the fact that the United States tax legislation is not controlled by the IRS in the way that the United Kingdom legislation is ) U.S. 465 (1935) U.S. 361 (1961) U.S. 561 (1978) T.C.M. (CCH) 2189, aff d in part and rev d in part, 157 F.3d 231 (3d Cir. 1998). See, e.g., Joseph Bankman, SMU L Rev T.C. 15 (2013). 46 Shannon Weeks McCormack, Tax Shelters and Statutory Interpretation: A Much Needed Purposive Approach, 2009 U. Ill. L. Rev. 697, U.S. 361 (1960).

12 12 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 advantageous fashion, producing one level of capital gain tax and a much lower tax liability than the sale of the stock by the corporation would have. Gregory happened to be a case about a corporate transaction, and the Gregory court 48 found a business purpose requirement implicit in the relevant statute relating to tax-deferred corporate transactions like spin-offs. But this does not mean that business purpose is relevant for every tax statute. However, the genesis of the economic substance doctrine in the business transaction facts of Gregory shaped the doctrine in a way that was not necessarily relevant in all cases. Leandra Lederman and Shannon Weeks McCormack are among those who have persuasively argued that a more sophisticated subjective test, geared to the purpose of the particular statute at issue, would better apply Gregory s reasoning. 49 Knetsch 50 provides an early example of the application of an objective version of the economic substance doctrine. In Knetsch, the taxpayer borrowed at 3% interest to finance the purchase from the [lender] of savings bonds paying 2% interest. 51 As permitted by the contract, he paid the interest on the loan and claimed a deduction for it. The tax benefit of the deduction, if allowed, would exceed the 1% spread between the cost of financing and the investment return. But the Court concluded that the transaction was a sham involving no bona fide debt and no interest deduction. In reaching its conclusion, the Court considered the purpose of the provision of the Code permitting interest deductions. But it also emphasized the lack of pretax profit, and thus provided an example of an objective analysis of a tax planning transaction. Knetsch is an easy illustration of the objective view of economic substance, since the transaction could not have made any sense without the tax planning component, because the taxpayer had a pre-tax loss. But the existence of a pre-tax profit should not definitively show that a taxpayer has met an objective prong of the economic substance test. As Joe Bankman has explained, assuming the validity of the objective approach as a component of the test, a better approach though one still fraught with difficulties would compare the pre-tax profit achieved by the taxpayer under the tested transaction compared to the pre-tax market rate of return 48 Judge Learned Hand authored the seminal analysis in the Second Circuit opinion. Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934). 49 See Leandra Lederman, W(h)ither Economic Substance, 95 Iowa L. Rev. 389 (2010); Weeks McCormack U.S. 361 (1961). 51 Lederman at 406. See also Wolfman in Tax Notes.

13 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 13 that the taxpayer could otherwise have achieved. 52 Frank Lyon 53 involved a sale-leaseback transaction where the issue was whether the taxpayer would be treated as the owner of depreciable real estate, as the taxpayer argued, or as a lender. The Court s conclusion that the taxpayer owned the real estate for tax purposes has been roundly criticized for failing to give proper weight to the taxpayer s limited economic exposure to changes in the value of the real estate. For example, the Court did not conclude that the taxpayer s counterparty would exercise an option to purchase the building, even though the transaction would make sense for the counterparty only if it were exercised, as the counterparty was a bank whose business operations were located in the subject real estate and the option was priced below market value. But a bigger problem with Frank Lyon, as Professor Lederman has explained, is that it decontextualized the economic substance doctrine. Rather than considering the legislative purpose of the depreciation provisions of the Code, the Court made the economic substance inquiry more abstract. It suggested that a transaction would stand if it was compelled or encouraged by business or regulatory realities and imbued with tax-independent considerations. This abstract statement of the economic substance test, with its objective and subjective prongs, gave rise to the modern economic substance doctrine. 54 ACM Partnership, 55 a Third Circuit decision, is a case frequently cited as an example of the current version of the economic substance doctrine, as developed in the context of a wave of corporate basis-shifting and other tax shelters in the last years of the 20 th century. 56 ACM Partnership involved a partnership-based tax shelter that benefited the U.S. corporate taxpayer Colgate-Palmolive. In ACM, the partnership purchased corporate debt and then sold it for technically contingent payments taxed under the installment sale rules. The contingent payments were front-loaded, but under the rules then in effect, the basis in the installment notes was recovered ratably. This 52 See Bankman, 74 S. Cal. L. Rev. 5, (asking whether to compare a tax shelter return to a tax-favored asset or a taxable asset and noting that the pretax return of a taxfavored asset might well be negative though fully consistent with legislative intent and noting that there is no clear answer to this question because no tax shelter case has yet involved any positive return ) U.S. 561 (1978). 54 Lederman, Iowa L. Rev. at T.C.M. (CCH) 2189, aff d in part and rev d in part, 157 F.3d 231 (3d Cir. 1998). See, e.g., Joseph Bankman, SMU L Rev. 56 E.g. Bankman, Weeks McCormack.

14 14 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 produced front-loaded gain, which was allocated under the partnership rules not to Colgate-Palmolive, but to a zero-bracket taxpayer that was also a partner in the partnership. The partnership redeemed the zero-bracket taxpayer after most of the gain was recognized, leaving Colgate-Palmolive to reap the back-loaded tax losses. 57 The ACM court applied the related but distinct elements of objective economic substance and subjective business motivation to disallow the tax benefits claimed by Colgate-Palmolive in ACM Partnership. In ACM, the Third Circuit concluded that the transaction failed both prongs. But other cases have raised the question of whether a transaction can survive if it fails one, but meets the other, prong. Subsequent case law saw courts diverge on the question of whether a transaction required both objective and subjective economic substance to be respected (the conjunctive version of the test) or only one of the prongs (the disjunctive version of the test). Compaq, a case involving foreign tax credits discussed below, provides an example of a particularly brittle disjunctive version used there by the Fifth Circuit. 58 Compaq and other cases prompted some U.S. commentators to call for a statutory enactment of the economic substance doctrine to address shortcomings in the judicial application. 59 The result, eventually, was Section 7701(o), which was first proposed in at least somewhat similar form in [1999] but not enacted until March Section 7701(o) provides that if a court concludes that the economic substance doctrine applies, it must apply a conjunctive version. It also, for example, instructs the Secretary to promulgate regulations providing that foreign taxes will be treated as reducing pre-tax profit, in a response to the approach of the Fifth Circuit in Compaq and the Eleventh Circuit in IES. 60 Section 7701(o) applies to transactions entered into after March 30, 2010 and includes, as a result of interaction with other sections, a strict liability understatement penalty of 20 or 40 percent for transactions that lack economic substance. 61 It has not yet been tested or applied in courts, since the length of a typical audit cycle produces the result that 2010 cases have not yet been litigated See Bankman at F.3d 778 (5 th Cir. 2001), reversing 113 T.C. No. 17 (1999) 277 F.3d 778 (5 th Cir. 2001), reversing 113 T.C. No. 17 (1999) 59 See, e.g., Shaviro/Weisbach tax notes article. See generally Robert McMechan. Ecomomic Substance and Tax Avoidance: An Economic Perspective (2013) (cataloguing views of U.S. scholars on topic of economic substance) F.3d 350 (8 th Cir. 2001), reversing 1999 WL (N.D. Iowa 1999). 61 Charlene Luke article explains connection between 7701(o) and penalty provisions. 62 See, e.g., Historic Boardwalk Hall, 694 F.3d 425 (3d Cir. 2012).

15 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 15 A discussion of a recent Tax Court case, BNY Mellon, 63 will close this chronological sketch of U.S. economic substance doctrine. BNY Mellon involved a foreign tax credit generator case and thus belongs to a set of tax shelter cases that follows the set of basis-shifting and loss generation cases that includes ACM. 64 In BNY Mellon, the U.S. taxpayer ( BNY ) contributed $8 billion in portfolio investment assets and its British counterparty, Barclays, contributed $1.5 billion to a special-purpose entity (SPE). The SPE transferred $1.5 billion to BNY in redemption of some units it held in the SPE and paid Barclays an above-market interest rate on the $1.5 billion, thus in effect creating a loan from Barclays to BNY. Because both BNY and Barclays were considered under their respective countries laws to own the SPE, both claimed tax benefits, including foreign tax credits in the case of BNY for the payment of the British taxes on the investment income earned by the assets in the SPE. The payment of these taxes was accelerated through a stripping transaction. 65 The taxpayer in BNY Mellon had carefully structured the transaction to pass muster under the economic substance doctrine. First, the taxpayer wrapped the foreign tax credit generator structure around a bona fide business transaction borrowing money. Second, the taxpayer ensured that there was pre-tax profit. The Tax Court rejected the transaction nevertheless. It explained that even if the loan was a bona fide business transaction, the contrived use of a special-purpose entity lacked subjective business purpose. And it concluded that the existence of a pre-tax profit did not support a conclusion of objective economic substance where a market rate of investment return would materially exceed the profit obtained in the transaction at hand. The Tax Court in BNY Mellon even explicitly considered the question of legislative purpose, though at the behest of the taxpayer, and rejected the contention that the foreign tax credit provisions in the Code supported the taxpayer s claim of tax benefits. The Tax Court was able to adopt a flexible T.C. 15 (2013). 64 Also Son-of-Boss and other basis-shifting cases e.g. Black and Decker. Charlene Luke article in Tax Lawyer. 65 Bank of New York Mellon v. Comm r, 140 T.C. 15 (2013). See also T.C. Memo (holding on motion for reconsideration that interest on debt was deductible). See also See generally Lee Sheppard, Can the FTC Generator Transactions Be Reconciled? TNI Nov. 11, 2013.

16 16 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 interpretation of the economic substance doctrine in part because of the more flexible view adopted by the 2d Circuit, to which BNY Mellon would have been appealed. In other words, the Tax Court might been more constrained if the case had been appealable to, for example, the Fifth Circuit (especially assuming that Section 7701(o) did not apply). Nevertheless, the case illustrates the capacity of the judicial system to amend and flexibly apply the doctrine as cases evolve. For example, BNY Mellon demonstrates that the objective prong of the economic substance test can be interpreted in a way that compares pre-tax profit to other possible market rates of return. This differs from an approach that simply requires evidence of some positive pre-tax profit, however small. II. AN AUSTRALIAN CASE STUDY: THE COUNTERFACTUAL A. The Counterfactual Element of the Statutory GAAR Rule As described above, the Australian GAAR is contained in Part IVA, or Sections 177A to 177H of the Income Tax Assessment Act, or ITAA. 66 Section 177F allows the Commissioner to reverse the effect of a tax benefit obtained in connection with a scheme. 67 A scheme must support the conclusion that it was entered into for the purpose of obtain[ing] a tax benefit. 68 Often the GAAR requirements are described as a three-part test requiring (1) a tax benefit, (2) a scheme and (3) the purpose of obtaining a tax benefit. 69 The recent case law and statutory development examined below relates to the portion of the definition of tax benefit that relates to the alternative postulate or counterfactual requirement. Section 177C conceives of a tax benefit as an item of income, deduction, capital loss, or foreign income tax offset which might reasonably be expected to have been included (in the case of an income item) or not available (in the case of the other items) in the absence of scheme. In other words, it imagines that a taxpayer may pursue one of two courses of action. One course of action is the tax avoidance scheme option. The other course of action is the non-scheme option. The statute requires the comparison of the tax liability under the 66 See Woellner, Barkoczy, Murphy, Evans & Pinto, Australian Taxation Law (23d ed. [2013]). 67 ITAA 177F(1). 68 ITAA 177D. 69 See Woellner, Barkoczy, Murphy, Evans & Pinto, Australian Taxation Law (23d ed. [2013]).

17 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 17 two alternative courses of action. 70 This approach manages many kinds of tax avoidance transactions nicely. For example, an abusive structured transaction that produces a stand-alone loss to offset unrelated income generates a tax benefit compared to the alternative of not entering into the structured transaction. 71 The tax benefit description also covers a transaction that the taxpayer would certainly undertake in any case, but which the taxpayer alters to improve the tax benefits. 72 In this case, the alternative is entering into the transaction that the taxpayer would in any event undertake, but without the gloss of taxadvantageous structuring. But the tax benefit definition does not clearly encompass a business transaction that would only be undertaken in the presence of a certain tax advantage. As an example, consider the redemption of a shareholder s stock from a corporation. Assume that the shareholder would prefer the redemption to be treated as a dividend transaction rather than a capital gain transaction, because dividend treatment will produce less tax liability than capital gain treatment. Assume further that shareholder and corporation can only agree on a price if the redemption is treated as a dividend. In this example, if the parties engage in tax structuring to support the case that the redemption is treated as a dividend distribution, it is not clear that the tax savings from the dividend treatment constitutes a tax benefit within the meaning of the GAAR. The taxpayer would argue that there is no reasonably expected course of action that would produce the higher tax liability that would proceed from capital gain treatment of the redemption. In the absence of the tax advantage of dividend treatment, the parties would not have done the transaction. In other words, the alternative transaction, under this argument, would produce no tax; and there is no tax benefit within the meaning of the statute. This kind of counterfactual argument produced a taxpayer win in the 2011 case RCI Pty, as well as in a few other contemporaneous cases. 70 This conception of tax benefit has a logical structure that resembles the choice principle articulated in the case law under Section 260, the statutory anti-abuse provision that predated the 1981 adoption of the Part IVA GAAR. See, e.g. Cassidy note See, e.g. Calder v. FCT, 2005 ATC 5050 (holding Part IVA applicable to excessive deductions for advance fee and interest payments in tea tree oil plantation scheme). 72 See, e.g., FCT v. Hart & Anor, 2004 ATC 4599 (split loan scheme in which taxpayer accelerated interest deductions by allocating them to commercial loan rather than home residence loan to avoid capitalization requirement for interest on home residence loan).

18 18 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 B. RCI Pty Case RCI Pty illustrates the difficulty the Australian government has run into when using Part IVA to challenge a transaction that would not have occurred absent the claimed reduction in tax liability. 73 The case is one of several recent internal restructuring cases in which a counterfactual argument supported a taxpayer win. 74 The taxpayer in RCI Pty persuaded Australia s Full Federal Court one step below Australia s highest court, the High Court that the Part IVA GAAR rules did not apply because the taxpayer would not have undertaken the restructuring at all if the tax liability claimed by the Commissioner of about $172 million had applied. In RCI Pty, an Australian taxpayer corporation, RCI Pty Limited ( RCI ), wholly owned a U.S. subsidiary, James Hardie Holdings ( Holdings ). In March 1998, Holdings borrowed about $300 million from another group company and declared and paid a dividend of about $300 million to RCI. This reduced the value of the Holdings stock held by RCI. In October 1998, RCI transferred the Holdings shares to a different group member, RCI Malta, in exchange for shares in RCI Malta. 75 This transaction was taxable under Australian law to RCI Pty as a formal matter. But because of RCI s tax losses and the reduced value of Holdings, due to the March 1998 dividend, RCI reported no significant gain for Australian tax purposes as a result of the transfer of Holdings to RCI Malta. 76 These transactions took place as part of an internal restructuring intended, for example, to establish a central group finance company in the Netherlands. The Netherlands company would obtain financing from outside sources and on-lend to other group companies. This plan would locate interest income in the low-tax Netherlands and interest deductions in higher-tax jurisdictions such as Australia and the United States See RCI Pty Ltd. v. Commissioner, 2011 FCAFC 104 (Edmonds, Gilmour and Logan JJ), reversing 2010 FCA 939 (Stone, J.). 74 See Robert Deutsch, Part IVA and International Transactions, 15 Tax Specialist 74, 79 (2011) (distinguishing taxpayer-favorable outcomes in internal restructuring cases Noza Holdings, News Australia and RCI from government-favorable outcome in British American Tobacco Services, which involved a restructuring in connection with a thirdparty sale). 75 See RCI Pty, 90, See Robert Deutsch, Part IVA and International Transactions, 15 Tax Specialist 74, (2011). See also C. John Taylor, GAARs, Tax Avoidance and Tax Policy [date] unpublished manuscript on file with the author at 24 (noting that the result proceeded from the distinction between the treatment of dividend and capital gain transaction under Australian law). 77 See RCI Pty, 90, 103.

19 23-Feb-14] AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW 19 The Australian Commissioner contended that the capital gain that RCI would have paid on the October 1998 Holdings share transfer in the absence of the March 1998 Holdings dividend was a tax benefit within the meaning of Part IVA and so subject to government adjustment, producing an additional tax liability of about AUS $172 million. 78 But the taxpayer argued successfully that no tax benefit existed because if the taxpayer had faced a tax liability of AUS $172 million, it would not have entered into the internal restructuring transaction in the first place. 79 The court explained that although the government referred to the considerable long-term benefits of the group restructuring, including the more tax-efficient financing arrangements, the government provided no evidence in the way of a valuation of these benefits having regard to contingencies, and consequential uncertainties. 80 As a result of RCI Pty and other cases delivering taxpayer wins on the basis of counterfactual arguments, the Australian government found itself in a doctrinally difficult place. Because the GAAR statute was drafted to require a comparison between lower- and higher- tax liability alternatives, courts held that it would not apply to elements of internal restructurings where the larger transaction would only occur in the presence of tax savings. This stood in contrast to the logic in a transaction where tax planning steps preceded a sale to a third party. There, the third party sale might well be treated as a given, making it easier for the government to compare a tax-efficient intermediate planning step with the counterfactual of a tax-inefficient intermediate planning step. The government won such an argument in British American Tobacco. 81 But the Full Federal Court in the RCI Pty case also hinted at a blueprint 78 See RCI Pty, See RCI Pty, See RCI Pty, British American Tobacco involved an intercompany transfer of nine brands among the members of an Australian firm, the Rothmans Group ( Rothmans (, and then to a thirdparty buyer, Imperial Tobacco Group ( Imperial ). The intercompany transfer allowed Rothmans to use the losses of one group member to in effect shelter gain on sale to the third-party buyer. After the sale of the nine brands to Imperial, British American Tobacco Group and Rothmans merged. The disposal of the nine brands prior to the merger solved an unwanted assets problem, as it complied with an agreement struck with the Australian Competition and Consumer Commission. The tax decision favored the government and held that the group would be taxed as if it had transferred the brands directly to Imperial. See British American Tobacco Australia Services Ltd. v. FCT, 2009 FCA 939, aff d by 2010 FCAFC 130; See Robert Deutsch, Part IVA and International Transactions, 15 Tax Specialist 74, (2011). Compare Elkhorn Coal.

20 20 AUSTRALIAN AND U.S. TAX ANTI-ABUSE LAW [23-Feb-14 for the Commissioner to make a more successful argument in future Part IVA internal restructuring cases. In particular, it suggested that the Commissioner might provide better evidence to support the conclusion that the benefits of an internal restructuring were sufficiently significant that the taxpayer would have undertaken the restructuring even absent the alleged tax benefit. More broadly, the Australian government could have sought to persuade courts of a different meaning of the tax benefit requirement. For example, it might have formulated a litigation strategy to support the argument that the tax benefit provision simply requires a causal connection between the scheme and the tax benefit, or that the tax benefit would not have arisen in the absence of the scheme. 82 C. Amending Legislation Following government losses in RCI Pty and other cases on the counterfactual point, the Australian government undertook a project to amend the GAAR statute. Its success in proposing and enacting amendments to Part IVA in 2013 to address the litigation failures with respect to the counterfactual point, like other amendments to Part IVA discussed above in Part I.A., illustrates the Australian tax administration s power to achieve statutory change. It also gives an example of an administration s careful navigation around existing case law. In March 2012, Assistant Treasurer Mark Arbib announced that the government would act to address taxpayers counterfactual arguments. He explained: "In recent cases, some taxpayers have argued successfully that they did not get a 'tax benefit' because, without the scheme, they would not have entered into an arrangement that attracted tax.... Such an outcome can potentially undermine the overall effectiveness of Part IVA and so the Government will act to ensure such arguments will no longer be successful G.T. Pagone, Tax Avoidance in Australia 49 (2010). Pagone argues that prior GAAR case law supports the view that an investigation into other possibilities available to the taxpayer relates to the purpose of the transaction rather than to the existence of a tax benefit. See id. at 53 (citing and quoting High Court judgment of Gummow and Hayne JJ. in Federal Comissioner of Taxation v. Hart, 2004 CLR 216). [To double check and confirm that this was not argued on briefs. Any more to draw from fact that High Court denied appeal?] 83 Australian Government, The Treasury, Maintaining the Effectiveness of the General Anti-Avoidance Rule, Media Release of March 1, 2012.