Tough Tax Tactics for Tough Times

Tough Tax Tactics for Tough Times Mark Pizzacalla Managing Partner HLB Mann Judd Level 9, 575 Bourke Street Melbourne VIC 3000 Email: mpizzacalla@hlbvic.com.au Mobile: 0413-048-440

1 Abstract... 3 2 Overview... 4 3 Strategic Tax Matters... 5 3.1 Corporate Tax Governance... 5 3.2 Risk Differentiation Framework... 6 3.3 ATO Audit Readiness... 9 3.4 Prudential Tax Audits... 11 3.5 Director Penalty Regime... 12 4 Key tax issues in current economic times.. 15 4.1 Bad Debts... 15 4.2 Debt Forgiveness... 21 4.3 Trading Stock... 26 4.4 Depreciation... 29 4.5 Funding issues for hybrid trust structures. 34 5 Compliance tax matters... 37 5.1 Fixed assets and depreciation... 37 5.2 Company Tax losses... 38 5.3 Audit fees... 41 5.4 Directors fees and Employee Bonuses... 41 5.5 Superannuation Guarantee and remuneration... 42 5.6 Accruals versus provisions... 44 5.7 Amortisation versus depreciation... 45 5.8 Business Blackhole Expenses... 45 5.9 Travel... 46 5.10 To consolidate or not to consolidate... 46 6 About the Author... 49 7 Disclaimer... 50 8 References... 51 2

1 Abstract Tough economic times mean that as a CEO/CFO 1, you are expected to be aware of how you can maximise your company's after tax cash position. Businesses grappling with the current economic tightening can minimise exposures and exploit opportunities if they adopt appropriate tax planning strategies. In doing so, CEOs/CFOs may have to focus on tax provisions seldom used during boom times, identify tax strategies which ameliorate the impact of the downturn, and apply tax concessions which may be potentially available to them. This session is designed to help CEOs /CFOs decide which tax issues should be on the boardroom table during these tough economic times to help reduce the impact of the current business cycle. All references in this paper are to the Income Tax Assessment Act 1936 and Income Tax Assessment Act 1997, unless otherwise stated. 1 For the purpose of this paper, the terms CEO and CFO may be used interchangeably. 3

2 Overview The vast majority of CEOs/CFOs that I meet simply want to ensure that they are paying the right (legitimate) amount of tax. This represents a vast difference in taxpayer attitudes and a real cultural shift from the 1980s, and certainly bears no resemblance to taxpayer attitudes of the 1970s. 2 As a result of the Australian Taxation Office s (ATO) increased focus on tax governance, CEOs and CFOs prefer to have peace of mind when it comes to attending to the taxation affairs of the company that they are acting for. This makes good commercial sense as there is no upside for CEOs/CFOs to get involved in any grey tax matters for which they do not have an approved Private Ruling, or a Reasonably Arguable Position (RAP) Paper. However, during times of economic crisis, temptation can creep in, and CEOs and CFOs can take their eye "off the ball", or be a little bit more aggressive than they otherwise would be, in relation to their company's tax affairs. This may not necessarily be a conscious decision on their part, but just part of the commercial pragmatism that may kick in when company revenues are down, profits are being squeezed, and cash flow is under continuous pressure. All of these factors can culminate in a change of behavioural patterns that are aimed at trying to keep businesses in the black. The purpose of this session is to bring to the attention of CEOs/CFOs some of the salient tax considerations and issues that they should be addressing during these tough economic times. Whilst this list is not exhaustive, it does provide a high level view of the nature and types of tax matters that Boards should be focusing on. Tax Strategy Strategies need to be put into place which either makes the business money, saves the business money, or through improvements to processes and systems, will provide the business with significant benefits and synergies over time. Strategies need to be put into place which either makes the business money, saves the business money, or through improvements to processes and systems, will provide the business with significant benefits and synergies over time. With this in mind, this paper comprises three distinct parts. The first part deals with strategic tax matters that should be considered, the second part deals with key tax issues in current economic times, whilst the third part outlines salient tax compliance related matters. 2 Australian Taxation Office, 'Eyes on the commercial ball' (Paper presented at the International CFO Forum, The Mint, Sydney, 20 November 2009). 4

3 Strategic Tax Matters 3.1 Corporate Tax Governance At the top of the list is the issue of good corporate governance. From the ATO s perspective, this includes managing tax risk. 3 In the event of an audit, the business must be able to demonstrate to the ATO that it has the capacity to identify errors and mitigate tax risks. 4 It is also important to remember that if you are the CEO/CFO of a $100m turnover company, what is expected of you will be more than if you were responsible for a $10m turnover company (not that you should let this affect your thinking or approach!). Of course, simply because your business may be bigger does not necessarily mean that you are high risk from a tax perspective and vice versa. 5 The ATO expects to see that the company s corporate governance processes in relation to tax are functioning well on two levels: Strategic: at a macro level, what is the company s approach? Operational: what controls does the company have in place to meet its obligations? At a strategic level, 6 some of the governance questions include: Do you know how the ATO categorises your business under the Risk Differentiation Framework? What are the consequences of your risk rating? Do you have processes to present the approach to tax risk for review by the Board? Do you know your advisor s risk stance and does their approach to risk align with that of your business? Are the amounts of tax you are paying in line with your business results? At the operational level, 7 some of the key governance questions include: Are the roles and responsibilities associated with overall tax compliance clearly defined? Does your tax function have adequate resources to manage tax risks effectively and provide reasonable assistance when dealing with us? Can you ensure that tax information used for your internal accounting or provided to the ATO is accurate and reliable? Are you confident that your records and control systems enable you to meet your tax obligations properly? 3 Australian Taxation Office, Large business and tax compliance (2011), 8. 4 Australian Taxation Office, Large business and tax compliance (2011), 8. 5 Michael D Áscenzo, Two to Tango (Speech delivered at the G100, Sydney, Australia, 9 December 2009). 6 Australian Taxation Office, Large business and tax compliance (2011), 8. 7 Australian Taxation Office, Large business and tax compliance (2011), 8. 5

Are there material differences between your accounting profit and taxable income and, if so, are you comfortable with the reasons for those differences? A company s approach to these issues is significant, as the ATO has made it clear that the answers to these type of questions will affect how the ATO will engage with you. Mr Mark Konza, Deputy Commissioner (large business & tax compliance), has made it clear that: We differentiate our approach and engagement with taxpayers according to our assessment of their tax risk once we understand you and know how your governance systems work and we rely on them to identify issues we need to resolve, it is clear we have established trust. 8 3.2 Risk Differentiation Framework In July 2013, the ATO released a new version of its Large Business and tax compliance booklet which was co-designed with large businesses. The release indicates a significant change in the ATO s approach to assessing and managing tax risks and signifies a more proactive approach by the ATO; an approach which is driven by early engagements (between the ATO and large businesses) and enhancing relationships with large businesses. In its booklet, the ATO detailed that the value, volume and complexity of transactions undertaken by large businesses have inherent risks for tax compliance. That the ATO s overall approach is to closely examine significant transactions and business results that show inconsistencies between the tax and economic outcomes. 9 In particular, the compliance risks that the ATO are focusing on are: profit shifting through transfer pricing, thin capitalisation and debt generation; and material transactions such as mergers, acquisitions and business restructure that allows for opportunistic tax planning. The ATO detailed some examples of transactions which could potentially represent a tax risk from the ATO s perspective, as follows: related party cross-border and tax haven dealings where a tax deduction is made in Australia with no corresponding amount of assessable income; complex structures and intra-group transactions associated with generating tax benefits unrelated to the economic substance of your commercial activity; tax benefits from financial and other arrangements that are disproportionately high compared to the limited financial exposure, or where there is a divergence between the real and claimed economic substance of your business activity; using arrangements or products (such as tax rulings) to transfer or create tax benefits in circumstances not contemplated by the law; characterisation of transactions, for tax purposes, that is at odds with their economic substance; distortions and inconsistencies in market valuations; 8 Mr Mark Konza, A world without audits (Speech delivered at the Thomson Reuters Annual User Conference, Sydney, Australia, 17 October 2011). 9 Australian Taxation Office, Large business and tax compliance (2011), 22. 6

promotion of tax exploitation schemes; and implementation of a transaction in a materially different way to that described in a product ruling relevant to the transaction. 10 A fundamental change in the ATO s Large Business and tax compliance booklet was the introduction of the Risk Differentiation Framework (RDF). This framework was introduced to aid in the ATO s process of assessing tax risks (in relation to large businesses) and to govern how detailed the ATO s approach should be when responding to the nature and type of tax risk identified. The ATO indicated that their RDF is: based on the premise that our risk management stance will differ based on our perception of your estimated: likelihood of non-compliance (that is, having a tax outcome that we don t agree with), and the consequences (dollars, relativities, reputation, precedent) of that non-compliance. 11 The RDF consists of four broad risk quadrants as detailed below. Large taxpayers will be placed into one of the four quadrants for each tax type (income tax, GST, excise). 10 Australian Taxation Office, Large business and tax compliance (2011), 22. 11 Australian Taxation Office, Large business and tax compliance (2011), 23. 7

Quadrant 1 Higher risk taxpayers Taxpayers may be placed into this quadrant because of, for example, their relative size, the nature of the transactions they undertake, their apparent effective tax rate, or their compliance history. The Commissioner noted: 'Certainty for these taxpayers is not in relation to their tax position but rather a certainty that they will be reviewed by us. Such an experience will be fair and professional but may also be quite formal and intense.' 12 Accordingly, the ATO s approach is more likely to involve the use of formal powers of information gathering, and sufficient resources will be allocated to this. Quadrant 2 Key taxpayers Most of Australia's largest businesses fall into this category. That is, taxpayers categorised into this quadrant will be large businesses which have a significant influence on the health of the tax system, and are more likely to have applied for an ATO ruling in relation to contentious tax matters. The ATO s approach to such taxpayers is more likely to involve alternative dispute resolution approaches rather than formal powers of access and questioning. Quadrant 3 Medium risk taxpayers Taxpayer s placed into this quadrant may be involved in specific risk reviews, from time to time, in which the ATO will follow up on specific issues that are of concern. These reviews are likely to be part of a compliance project involving other businesses with similar issues. Quadrant 4 Lower risk taxpayers The ATO s approach in relation to lower risk taxpayers may involve gathering targeted information about specific issues identified in the market, visits to the taxpayer, and monitoring of the taxpayer s tax activities. The ATO notes that taxpayers in this category are less likely to be contacted for additional information or have significant issues of concern requiring follow-up. How is risk assessed? Broadly, the ATO will assess a business twice a year against the businesses previous results and other data (both domestic and international), and place the business in one of the four risk categories using the following risk filter items (this list is not exhaustive): 13 your past compliance behaviour your tax risk management governance your business performance over time compared to your tax outcomes and that of your peers 12 Michael D'Ascenzo, (Speech delivered at the 22nd Australasian Tax Teachers Association Conference 2010, University of New South Wales, 22 January 2010). 13 Australian Taxation Office, The Risk Differentiation Framework, Fact sheet for large business taxpayers. December 2011. 8

issues identified by our specialist areas and intelligence gathering, particularly in regard to significant transactions that allow for opportunistic tax planning, such as a material merger, acquisition or disposal intelligence from our industry segments on industry performance and its relationship to tax risks including patterns and trends in tax performance intelligence from overseas tax administrations and from the Joint International Tax Shelter Information Centre (JITSIC) intelligence from other government agencies such as the Australian Securities and Investments Commission (ASIC) and publicly available information risks arising out of the implementation of new tax law your level of international dealings and the tax outcomes derived from such dealings over time and compared to the functions performed, assets used and risks accepted The ATO has previously sent out written correspondence to the CEOs or public officers of large businesses about their risk categorisations. Accordingly, it is important for CEOs/ CFOs to not only consider and plan for their approach to the outcome of their risk ratings on the RDF, but also to implement and monitor internal process and systems so that they may be able to positively influence their risk rating for future years. 3.3 ATO Audit Readiness Therefore, the next question the Board should be asking is whether the company is audit ready? That is, if the ATO knocks on your door tomorrow morning, are you in a position to answer the strategic and operational questions that the ATO may pose. Is the Board aware of its hot spots? Has it done enough ground work and follow-through to mitigate its exposure in these areas? We know that the ATO s primary objective is to achieve high levels of voluntary compliance with Australia s tax and superannuation laws. Australia s tax framework is based on self-assessment, meaning it relies on the community self-regulating. This has been the case since 1990. The ATO then uses its compliance model to tailor its strategies. Accordingly, it is important for the Board to understand how the ATO s Compliance Model works and how this impacts the Board and wider organisational structure (refer below for a more detailed discussion). ATO Compliance Model The ATO s compliance program describes the tax and superannuation compliance risks that they are most concerned about and what they are doing to address them. So, you actually know this information up-front before the tax year commences. In this regard, there is, in my view, a high level of transparency by the ATO. The compliance program is then structured around the major market segments as follows: individuals; micro enterprises those with an annual turnover under $2m; small and medium enterprises those with an annual turnover of $2m to $250m; 9

large businesses corporate groups with an annual turnover above $250m; non-profit organisations; and government organisations (although this seems to have been excluded as a taxpayer category in the 2010-11 Compliance Program!) The compliance model provides a way for the ATO to better understand what motivates people to comply, or not comply (refer diagram below). It recognises that taxpayers are not a homogenous group, and that their circumstances can change over time. Importantly, it provides insights into factors that influence different compliance behaviours, and assists in deciding what interventions the ATO should make. ATO s Compliance Model The model reflects the different taxpayer attitudes to compliance and the corresponding compliance strategy that best responds to each particular attitude. The model advocates a deeper understanding of taxpayers motivation, circumstances and characteristics so that assistance and enforcement actions can be tailored to promote better compliance. The ultimate aim of the ATO is to influence as many taxpayers as possible to move down the pyramid into the willing to do the right thing zone! With the right responses and interventions (including a mix of alerts, audit, penalties, advice, guidance, education, procedural change, etc), the ATO can influence taxpayer behavior. Tax Office Compliance Program for 2012-2013 The Commissioner, in June 2012, launched the Tax Office Compliance Program for 2012-13. 14 Salient highlights from the Compliance Program include: Tax abuse: Focus includes secrecy jurisdictions, refund fraud, serious evasion of GST, organised crime, superannuation, fraudulent phoenix activity and tax avoidance arrangements. Large businesses: Focus includes amendments to taxation of financial arrangements (TOFA), profit shifting transfer pricing and thin capitalization, corporate restructures including mergers and acquisitions, consolidation inappropriate outcomes, research and development claims, 14 Australian Taxation Office, Compliance Program 2012-13 (2012). 10

integrity of business systems for GST, financial and GST supplies, taxation of alternative fuels and clean energy measure fuel tax amendments. SMEs: focuses include wealthy individuals in the tax and superannuation systems, use of trusts to inappropriately minimise tax, Division 7A treatment of private company profits, capital gains, non-disclosure and incorrect reporting, employer compliance with fringe benefits tax rules, integrity of business systems for GST and excise obligations, GST and property transactions. Micro enterprises: focus areas include unrecorded and unreported cash transactions, employer obligations, GST refund integrity and GST evasion, ensuring businesses are correctly registered in the tax system, supporting businesses in meeting their lodgment obligations and incorrect fuel tax credit claims following implementation of the clean energy measure. Individuals - priorities will include: incorrect or fraudulent refunds from over-claiming and deliberate fraud, review of work-related expenses for occupations with high levels of claims, people getting caught up in tax avoidance schemes, omitted income, including dividends and interest, capital gains and foreign source income. 3.4 Prudential Tax Audits In the early 1990 s with the introduction of the self-assessment regime, it became common place for corporate groups to undertake a prudential tax audit on the group s tax affairs for, say, the last three years. These exercises were done for a number of reasons, including: making a voluntary disclosure, thus negotiating reduced penalties and interest; know what the tax issues are ( peace of mind factor); and identify tax inefficiencies and introduce new processes and procedures. Having regard to the increased audit activity, over the last few years, we have seen a return to the 1990s approach of companies undertaking tax reviews to determine their exposure, if any, to hidden tax costs. The diagram below provides an example flowchart of how the prudential tax audit process would work in practice. Broadly, this involves: the Board determining the depth and breadth of scope that the prudential audit work should encompass (i.e. specific issues versus more general review); perform initial review to verify initial scope agreed is still appropriate; assessment of preliminary outcomes; preparation of draft report for Board consideration; and finalisation of prudential review and documentation of outcomes, including areas where further work may still be required. 11

Determine scoping Provision of relevant financial and group structure information Provide indicative fee estimate Determine Scope of Prudential Review Prudential tax audit process Initial Review Review records and other related documentation Discuss matters with appropriate staff/client accountants Identification of high level issues Prudential Review Process Assess Preliminary Outcomes Finalise Prudential Review Report Discuss potential options Consider restructuring alternatives Finalise Prudential Review Process and Report Prepare Draft Report Material tax issues identified Determine infomation gaps Agree timeline to finalisation Meet with staff/client accountant to discuss findings Issuance of draft Pruential Review Report 3.5 Director Penalty Regime Legislation to enact amendments to the director penalty regime ( DPR ) received Royal Assent on 29 June 2012. These amendments generally apply from 30 June 2012, with some transitional provisions, and: extend the DPR to make directors personally liable for their company s unpaid superannuation guarantee charge (SGC) liabilities; ensure that directors cannot discharge their director penalties by placing their company into administration or liquidation when an unpaid PAYG withholding or SGC liability remains unpaid 3 months after its due date; and ensure that directors (and their associates) are liable to PAYG withholding tax where the company has failed to pay amounts withheld to the Commissioner. The provisions apply to all companies (whether small or large, private or listed) and to all directors, regardless of their degree of culpability. The changes significantly increase directors risk of personal liability for the relevant tax liabilities of the company and, accordingly, directors need to exercise caution to ensure that the company is meeting its tax obligations and take prompt action if it appears the company is having difficulty paying these amounts. 12

Mistakes about super liability The SGC liability is deemed to arise at the end of the quarter and be payable when the company is required to lodge its superannuation guarantee statement for the quarter, regardless of whether it has been assessed. The legislation provides that a director will not be liable to a director penalty relating to SGC, if the director can establish that the penalty resulted from the company treating the Superannuation Guarantee (Administration) Act 1992 ( SGAA ) as applying to a matter (or identical matters) in a particular way that was reasonably arguable and if the company took reasonable care in connection with applying the SGAA to the matter (or matters). An example may be where a company reasonably thought that a worker was a contractor and not an employee. Director penalty liability and notices The directors are liable for a director penalty ( DP ) if the company has not paid the relevant liability and has not been put into administration or liquidation on or before the day on which the liability is due to be paid to the Commissioner ( due day ). While the DP liability arises on the due day, the Commissioner cannot commence proceedings to recover the penalty until 21 days after he gives the director a DP notice. The notice is deemed to be given when it is posted to, or left at, the director s residential or business address as shown in current ASIC records, regardless of whether or when the director receives it. The commissioner can also now give a copy of the DP notice to the director s registered tax agent, as notified to the Commissioner. Further, there is no time limit for the issuing of a DP notice. Directors can no longer avoid liability by putting the company into administration or liquidation after 3 months have elapsed from the company s due date (or, in the case of new directors, from when they became a director), to the extent that the amount remains unpaid and unreported to the Commissioner at the end of that 3 month period. New directors The legislation includes amendments to ensure that new directors have the time to familiarise themselves with corporate accounts before being held personally liable for corporate debts. The period of grace for new directors has been extended from 14 days to 30 days after their appointment. PAYG withholding non-compliance tax The PAYG withholding non-compliance tax ( PWNCT ) is new and applies to directors and associates of directors. The PWNCT effectively reverses the economic benefit of credits for the director or associate in respect of PAYG amounts withheld from payments by the company to them, where the company has an unpaid PAYG withholding liability in respect of the income year. PWNCT applies to an individual who: was a director of the company on the day by which the company was required to pay the withholding amounts to the Commissioner ( payment day ) and the company did not do so; or became a director of the company after the payment day, if they are still a director (and the company has not paid the amounts) at the end of 30 days after they became a director; or 13

was an associate of a director on the payment day; or was an associate of a new director when they became a director and throughout the 30 day period after that time. An associate of a natural person is broadly defined, extending beyond the director s immediate family. It is not necessary for the associate to be actively involved in the company s finances, but PWNCT is only relevant for associates who are employed by (or who receive other relevant entitlements from) the company. Defences The good reason and reasonable steps defences are still available, together with the reasonably arguable position and reasonable care defence mentioned earlier. A new limitation on the availability of the good reason and reasonable steps defences now applies. They can no longer be relied upon (outside court proceedings) unless the director provides all necessary information to the Commissioner within 60 days of receiving a relevant notice from the Commissioner. This places a very high onus on the director in non-court proceedings. Implications for directors Given the potential consequences for them (and possibly their associates) if the company does not comply with its obligations to pay PAYG withholding and SG amounts, the limited defences available and the short time frames allowed, directors will need to be increasingly vigilant to ensure that the company is meeting these obligations. 14

4 Key tax issues in current economic times 4.1 Bad Debts Background As the current economic tightening continues, it will be imperative that businesses ensure that they are entitled to fully claim income tax deductions for any bad debts that they are proposing to write off. However, there are a number of practical conditions that must be satisfied before a bad debt deduction can be claimed, as discussed below. Deductibility criteria A deduction is allowed for debts (or parts of debts) that have been written off in an income year. 15 Section 25-35(1) states that a taxpayer can deduct a debt (or part of a debt) that you write off as bad in the income year if: (a) (b) it was included in your assessable income for the income year or for an earlier income year; or it is in respect of money that you lent in the ordinary course of your business of lending money. 16 The above deduction is also subject to the following special rules: 17 a company must satisfy the continuity of ownership or same business test rules in Subdivisions 165-C and 166-C; in the case of certain trusts, the change of control or abnormal trading rules are met (refer Schedule 2F of the ITAA 1936); a company will not be able to deduct a bad debt in various cases that may involve trafficking in bad debts (subdivision 175-C and section 63D); if a debt which has been written off as bad is subsequently recovered, the amount will be assessable (subdivision 20-A); a bad debt deduction may be reduced if some parts of the debt forgiveness rules apply (section 245-90); and special rules apply to tax consolidated groups (Subdivisions 709-D and 709-I). Preliminary conditions A deduction is only allowable under s 25-35 if all of the following conditions are satisfied: there must be a debt; 15 Section 25-35 ITAA 1997. 16 This paper will not discuss the provisions as they relate to a money lending business. 17 Section 25-35(5). 15

the debt must be bad; the debt must have been written off as bad during the year of income in which the deduction is claimed; and the debt must have been brought to account as assessable income. Each of these requirements is separately discussed below. There must be a debt A debt must exist in law at the time of the write-off, and the taxpayer who writes-off the debt and seeks the deduction must have an equitable interest in the debt at that time. Taxation Ruling TR 92/18 provides the Commissioner s view on section 25-35. Although this ruling considers the application to the predecessor to section 25-35 of the 1997 Act (being section 63 ITAA 1936), it has not been withdrawn and its principles are still relevant in determining when a debt is a bad debt for the purposes of section 25-35. The Commissioner of Taxation defines a debt as a sum of money due from one person to another. This is similar to the definition of debt provided by Menzies J in GE Crane Sales Pty Ltd v FC of T (1971) 126 CLR 177 at 186, who held that debt means moneys which the taxpayer is presently entitled to receive. This does not imply there needs to be a physical provision of money from one party to the other to create the debt. Nor does the debt need to be enforceable under a contract or agreement, as an equitable entitlement to a debt will also qualify. The burden of proof is on the taxpayer to prove the existence of a debt. Mere accounting entries recording a debt are not sufficient, if in reality no debt is owed to a taxpayer (refer to Kratzmann v FC of T (1970) 1 ATR 827). The release or compromise of a debt constitutes the extinguishment of that debt. Accordingly there is no debt in existence which can be written off under section 25-35. Therefore, before a release or compromise is entered into, the debt should be written off. The debt must be bad This is a question of fact which can be difficult to apply in practice. The Commissioner states in Taxation Ruling TR92/18, that the debt does not have to be totally irrecoverable for it to be bad which would only arise where, say, the debtor has died without assets or has become insolvent. However, at the same time, the prospects of recovery must not be merely doubtful. The application of this test, therefore, invariably involves some level of subjectivity. In paragraph 31 of Taxation Ruling TR 92/18, the Commissioner outlines the following situations which suggest that a debt may be bad: the debt has become statute barred; the debtor has disappeared and has no assets; if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt; and 16

on an objective view of all the facts existing at the time, the debt is alleged to have become bad, there is little or no likelihood of the debt being recovered. In paragraph 32 of Taxation Ruling TR 92/18, the Commissioner outlines a number of steps that should be taken before writing off the debt as bad, including: following up the debtor with reminder notices including telephone and mail contact; a reasonable period of time must have elapsed since the original due date for the payment of debt (in which case regard should be given to the taxpayer s specific credit arrangements); taking action to ascertain the debtor s asset position; and issuing recovery proceedings (including service of a demand notice, the issue and service of a summons, any judgement entered against the delinquent debtor, and the execution of any proceeding to enforce judgement). Although the Commissioner acknowledges that a creditor will be limited in its resources to pursue the debt, the practical reality is that the above requirements have been effectively treated by the Commissioner as a checklist that the taxpayer is expected to have ticked off before claiming a bad debt deduction. Tax Strategy The creditor must be able to show positive steps have been taken in trying to recover the debt before it can be treated as being bad. Such steps could include telephone and mail reminders, undertaking title searches to determine the debtor s asset position and issuing recovery proceedings where appropriate. The debt must have been written off as bad during the year of income in which the deduction is claimed As discussed, the debt must be written off before year end. This involves a physical writing off of the debt, although it is not essential that the debt be written off in the creditor s books of account. For example, a company may be entitled to a bad debt deduction where its Board of Directors authorise the writing off of a debt and there is a physical recording of the written particulars of the debt and the Board minutes its decision before year end but the writing off of the debt in the taxpayer's books of account occurs subsequent to year end. Alternatively, a deduction will be written off where there is a written recommendation by a financial controller to write off a debt which is agreed to by management in writing prior to year end followed by a physical writing off of the debt in the books of account subsequent to year end. The consequences of failing to write off the debt before the financial year end can be fatal. In AAT Case 5543 (1989) 21 ATR 3111, a partnership was refused a bad debt deduction where it failed to write off the debt during the year ended 30 June 1976 even though it kept books of account. 17

Tax Strategy It will not be sufficient that the write off of a debt is merely provided for in the accounts in order for the debt to be regarded as being a bad debt. Nor will any deduction will be allowed if the debt is written off after year end at the time the books of account are being prepared. The creditor must physically write off the debt before the end of the tax year in which the deduction is claimed. The debt must have been brought to account as assessable income The Commissioner notes that this condition pre-supposes that the creditor is using an accruals basis in recognising income for tax purposes. Taxpayers on a cash basis would not have brought the income to account until it was actually received and, accordingly, are not entitled to claim a deduction for bad debts since the amount of the debt has not previously been included in assessable income. Section 8-1 deductions It should be noted that if a bad debt is not deductible under section 25-35, it may still be deductible as a loss or outgoing under the general deductibility provisions of section 8-1 ITAA 1997. It has been held that a bad debt incurred in the course of making loans to employees was a deductible loss incurred in the course of carrying on a business for the purpose of producing assessable income where such loans were a regular part of the taxpayer s business activities (see 14 CTBR(NS)). Similarly, a debt which could not be recovered was held to be deductible under the former section 51(1) of the ITAA (1936). This case involved a building contractor who frequently placed excess cash funds with a finance company on behalf of a group of contractors. The company subsequently lost a $500,000 deposit when the finance company collapsed. The Full Federal Court held that the loss sustained was an allowable deduction under section 51(1) as the periodic investment of monies in the short term money market was an integral part of the whole business carried on by the group. This amount could not have been deducted under section 25-35 because the amount was not previously returned as assessable income. If a loan has been made in a private capacity (i.e. it is not business related), a bad debt will not be deductible under section 8-1. To qualify for a deduction under section 8-1, a loan must be incurred in gaining or producing assessable income, or in carrying on a business for the purposes of gaining or producing assessable income. In addition, the loss must not be of a capital, private or domestic nature. Such a loan would not be regarded as an ordinary incident of the taxpayer's income earning activities, and would also be excluded from deductibility under the private and capital exclusionary provisions under paragraph 8-1(2)(a). 18 18 Refer to ATO Interpretative Decision ATO ID 2001/301 for further details. 18

Capital loss opportunities Section 108-20 ITAA 1997 provides that capital losses made from personal use assets are to be disregarded in working out the net capital gain or capital loss of the creditor. Subsection 108-20(2) (d) provides that personal use assets include, amongst other things, debts arising other than in the course of gaining or producing assessable income or from carrying on a business. Accordingly, if a debt has arisen other than in the course of gaining or producing the creditor s assessable income or carrying on the creditor s business, the capital loss arising upon cancelation of the debt will not be available to be offset against capital gains. This would also include, for instance, interest-free loans made for private or domestic purposes. It could also cover interest-free loans made to business or investment holding entities where the lender will not be receiving a dividend or distribution. In addition, due to the non-business nature of such loans, they can never be, by definition, capital expenditure incurred in relation to a past, current or future business, as required by subsection 40-880(2) ITAA 1997 and, therefore, cannot be amortised as black hole expenditure. Conversely, business related loans can be taken into account in working out the amount of a capital loss. This also automatically precludes the operation of section 40-880 for any business related bad debt, on the basis that you cannot deduct anything under Section 40-880 (i.e. the Blackhole provisions) for an amount of expenditure incurred to the extent that it could be taken into account in working out the amount of a capital loss. 4.2 Debt Forgiveness Background Prior to the introduction of the commercial debt forgiveness rules, 19 there was a lack of symmetry between the tax implications arising in relation to a debt forgiveness for a debtor and creditor respectively. In most cases, a debt forgiveness would have no tax consequences for the debtor as it merely relieved the debtor of a liability which would not be assessable income according to ordinary concepts. Conversely, the creditor could typically claim a deduction or capital loss in relation to the forgiveness of the debt. Broadly, the commercial debt forgiveness provisions in Division 245 of Schedule 2C ITAA 1936 were introduced to address this lack of symmetry. These provisions aim to tax the economic benefit of the debt forgiven. In these circumstances, the debtor will typically book an accounting entry debiting the debt liability and crediting the profit and loss account. Instead of treating such a book profit as assessable, the above provisions progressively strip the debtor of various tax attributes by reducing, in order, the debtor s prior year revenue losses, carried forward capital losses, various undeducted expenditures and the cost base of certain CGT assets. The end result is that tax will eventually be borne by the debtor as there will be less deductions and asset cost bases to reduce future assessable income or capital gains the debtor may derive. 19 The commercial debt forgiveness rules were introduced effective 27 June 1996. 19

To compound matters these provisions are also extremely complex, and are often inadvertently triggered by taxpayers especially small to medium sized entities. It is therefore crucial to identify their potential application, and any strategies which minimise their impact. Debt A debt is defined to be an enforceable obligation imposed by law on a person to pay an amount to another person, and expressly includes any accrued interest. Prima facie the definition is very wide and would apply to any scenario where a person is obligated to repay an amount. However, it does not apply to an amount which would be regarded as a debt waiver benefit under section 14 of the Fringe Benefits Tax Assessment Act 1986. Nor will it apply where the amount payable under the debt is included in the debtor s assessable income. Hence, any amount lent by a private company to a shareholder or an associate of a shareholder which is an assessable deemed dividend under section 109D of Division 7A ITAA1936 will not be treated as a debt under these provisions. Assuming neither exclusion applies, it is then necessary to determine whether the debt constitutes a commercial debt. Commercial Debt A debt is a commercial debt if any interest paid or payable on that debt would have been allowable under the general deductibility provisions of section 8-1 ITAA 1997. Moreover, interest free debt will also be regarded as being commercial debt if such interest would have been deductible had it been charged. In applying this test any other provision denying interest deductibility is ignored including, amongst others, the thin capitalisation and capital protected loan provisions. The above rules also apply to amounts in the nature of interest such as discounts on commercial bills, and to amounts paid on non equity shares such as a cumulative redeemable preference shares. However, commercial debt excludes private loans. Where an individual borrows funds to finance the purchase of a holiday home, there will not be a debt forgiveness if that private loan is subsequently forgiven as no interest charged on the loan would have been deductible. Similarly, borrowings which have been applied to generate exempt income or non-assessable non-exempt income will not be treated as commercial debt since any loan interest paid or payable would not be allowable. Where the commercial debt test has been met it will be necessary to determine whether there has been a debt forgiveness. Tax Strategy An UPE owed by a trust to a beneficiary will not be a debt where the amount is not a returnable amount under Taxation Ruling TR 2005/12, being an amount to repay trust capital or a beneficiary loan, or an amount that has been used by the trust to finance its income producing activities. 20

4.2.1 Debt forgiveness A debt will be forgiven if it is released, waived or extinguished. This will typically occur under a deed or agreement. However, Heerey J held in the recent Federal Court decision of Tasman Group Services Pty Ltd v FCT (2008) FTC 23, that a debt waiver can also be inferred from the creditor s conduct. Accordingly, a creditor may abandon a right of recovery where they act inconsistently with that right. Thus, if a debtor unilaterally books a debt forgiveness in its accounts and the creditor does not seek to collect that amount, then such conduct may constitute a debt waiver. A debt forgiveness may also occur where: the debt is irrecoverable due to the operation of a statute of limitations as a forgiveness will arise when the creditor s right of recovery expires at the end of the relevant period. The period of time over which such a debt may become statute barred is typically 6 years but can be as low as 3 years in certain jurisdictions; the debtor and creditor agree that the obligation to repay a debt will cease at a future time without the debtor incurring any financial obligation (other than for a token payment) in which case the debt is forgiven when the agreement is entered into and any later forgiveness is ignored; a creditor assigns its rights to receive repayment to a new creditor who is an associate of the debtor, or the debt is assigned under an agreement to which the new creditor and the debtor are both parties. In either case, the debt will be taken to have been forgiven at the time the debt was assigned except where the debt was acquired by the new creditor in the ordinary course of trading on the securities market; and a person subscribes for shares in a company to enable that company to repay a debt it owes to that person. The amount paid from the share capital subscribed will be taken to be the amount forgiven at the time it is so applied. Thus, a creditor cannot pump in additional capital to a related debtor company so that it can repay its debt and avoid the application of these provisions. However, there will not be a forgiveness if the wavier of the debt is effected under a will or a bankruptcy law, or occurs for reasons of natural love and affection. In practice, the latter exemption has been narrowly interpreted by the Commissioner of Taxation. Whilst ATO Interpretative Decision ATO ID 2003/589 found that a company can forgive a debt for reasons of the natural love and affection a director feels towards the debtor, it is not likely that it will be applied by the Commissioner other than in extraordinary circumstances (especially given the limited facts set out in the Interpretative Decision). Calculation of net forgiven amount The next step in applying the provisions is to calculate the net forgiven amount (if any) of the debt. Notional value The start point is to determine the debt s notional value. This will usually be the debt s face value at the time of the forgiveness assuming the debtor was able to pay its debts at the time the debt was both incurred and forgiven. This is because the provisions ordinarily assume the debtor was solvent at the time the debt was incurred and continues to be solvent at the forgiveness time. 21

However, where the parties are not acting at arms length when the debt is incurred there will be no assumption of solvency in which case the value may be for a lesser amount. Hence, if a loan is made to a wholly owned insolvent unit trust it will have a notional (and market) value which will likely be much less than its face value. This market value substitution rule dovetails with the CGT cost base provisions in section 112-20 ITAA 1997, which give the creditor a market value cost base in the debt where the parties have not acted at arm s length. The rationale for this treatment is that it should apply where the creditor has a cost base in its asset (being the debt) that has been reduced under the market value substitution rules, as the creditor will commensurately realise a lower capital loss. Tax Strategy Check whether the debtor and creditor were dealing with each other at arm s length when the debt was incurred. If they were not and if the debtor was not solvent when the debt was incurred, then the notional value of the debt could be limited, which will limit the application of the debt forgiveness rules. Consideration The debt s notional value will then be reduced by any consideration provided by the debtor at the time of the debt forgiveness being any cash paid and/or the market value of any property provided. It may also be reduced by deemed consideration equal to the debt s market value where there is no consideration in respect of the forgiveness, the consideration cannot be valued, or it is greater or less than its market value and the parties are not acting at arms length. In practical terms this means that where there is a non arms length forgiveness involving related parties (e.g. as between family businesses), the notional value may be reduced or extinguished under this deeming rule if the debt has significant market value. In order to ensure symmetry, section 116-30 1TAA 1997 contains a corresponding market value substitution rule which deems the creditor to have received market value consideration in each of the above three scenarios thereby reducing the creditor s capital loss. The market value substitution rule under the debt forgiveness provisions only applies where the creditor was a resident or the debt is taxable Australian property. Tax Strategy Check if the debtor and creditor were dealing at arm s length when the debt was forgiven. If they were not dealing at arm s length at the time of forgiveness, then the consideration could be deemed to be the market value of the debt. If the debtor was solvent at the time of forgiveness, this market value could be close to the face value of the debt, in which case the debt forgiveness rules will have limited application. 22

Finally, where the debt forgiveness has arisen due to a debt for equity swap involving a company, the consideration will be the market value of the shares subscribed for under the swap. After applying actual or deemed consideration against the debt s notional value the resulting balance in known as the gross forgiven amount of the debt. This in turn is reduced by any amount that is included in the debtor s assessable income or which reduces a deduction or the cost base of a CGT asset as a result of the debt forgiveness. For example, the forgiveness of a debt owed by a shareholder to a private company may result in the shareholder deriving an assessable deemed dividend under section 109F ITAA 1936, which will be applied to reduce the debt s gross forgiven amount. This gross amount will also be reduced where an intra group election is made between debtor and creditor group companies under common ownership, who agree that the creditor who will forego a capital loss or deduction in exchange for the gross value of the debt forgiveness being reduced by a corresponding amount. The agreement must be in writing and signed by the public officer of each company. It must be made by the earlier of the date of lodgement of the creditor or debtor s tax return for the year of forgiveness. Net Forgiven Amount After applying all the above steps, any remaining balance will be treated as the net forgiven amount of the debt which must be applied against the debtor s tax attributes. Application of the net forgiven amount After applying all the above steps any remaining balance will be treated as the net forgiven amount of the debt which must be applied against the debtor s tax attributes. Reduction of Tax Attributes A debtor must progressively offset the total net forgiven amount against the following tax attributes at the commencement of the income year in which the forgiveness takes place: prior year revenue losses; carried forward net capital losses; deductible expenditures including the opening adjustable value of depreciating assets, the balance of unclaimed borrowing costs, unclaimed prepaid expenditure and certain unclaimed expenditure on Australian films and research and development expenditure; and the cost base of certain CGT assets excluding pre CGT acquired assets, assets disposed of prior to 27 June 1996, personal use assets, main residence, trading stock, CGT assets which are subject to the deductible expenditure rules, rights relating to a superannuation fund or an approved deposit fund and goodwill. 20 Each category of tax attribute must be fully exhausted before the net forgiven amount is applied against a subsequent category of tax attribute. If there is a balance after applying the net forgiven amount against all of the above attributes, that amount expires and is not otherwise assessable. Debtors can also choose what items are reduced within each set of tax attributes. For example, debtors may choose which revenue losses are offset against the net forgiven amount and thus can 20 Section 245-175 to 245-190 ITAA 1997. 23

select items which may have less value than others. Similarly, taxpayers may choose which items of deductible expenditures are reduced and can therefore select items which have the slowest write off period. Tax planning is also required in reducing the cost base of CGT assets, as the debtor will not want to wipe out the cost base of an asset that is likely be disposed of in the near future and accelerate a capital gain. Thus, it may be preferable to reduce the value of assets whose value may diminish over time than debtors which will soon be realised. Broadly, special rules apply where the debtor company is a member of wholly owned group of companies in that the net forgiven amount may be applied against the revenue or capital losses of both the debtor and related group companies on a pro rata basis. If the debtor is a partnership, the debt forgiveness rules operate to apportion any residual net forgiven amount (after applying it against the tax attributes of the partnership) between the partners in proportion to their share of the net income or partnership loss for the forgiveness year. It should be noted that if there is no partnership net income or loss in the forgiveness year, the residual net forgiven amount is not attributed to the partners. Example: On 1 June 2006, the Great Guys Unit Trust made an interest bearing loan of $150,000 to a regional franchisee the Darcy Discretionary Trust, which was solvent at the time of the loan. The loan was made on arms length terms to help finance the franchisee s initial operations. The franchisee subsequently operated unprofitably and the Darcy Discretionary Trust was insolvent by the time the Great Guys Unit Trust waived a $200,000 loan (being the principal and accrued interest) for nil consideration on 1 June 2009. At that time, the Darcy Discretionary Trust had prior year carried forward tax losses of $80,000, an opening adjustable value of $40,000 for its depreciating assets, debtors of $50,000 and goodwill of $20,000. The debt waiver by the Great Guys Unit Trust constituted a debt forgiveness resulting in a net forgiven amount of $200,000 for the Darcy Discretionary Trust. The trust progressively applied its eligible tax attributes totalling $170,000 to reduce this amount being the carried forward losses of $80,000, the $40,000 adjustable value of depreciating assets and the cost base of debtors of $50,000. The resulting net forgiven amount of $30,000 expires after the above attributes is applied. It should be noted that the Darcy Discretionary Trust was not required to reduce its goodwill cost base of $20,000, as it not a tax attribute required to be reduced under the debt forgiveness provisions. 24

Tax Strategy Deferring the timing of when a debt is forgiven may create some tax planning opportunities. Deferring the forgiveness of a debt to a later income year may result in less tax attributes being foregone such as carried forward tax losses which may be recouped during the current period. 4.3 Trading Stock Background During economic downturns, and the impact this has on the values of shares, property and other assets, it becomes timely for taxpayers to consider whether they can use the trading stock provisions to crystallise losses, defer tax and generally improve cash flow. Taxpayers should consider: revaluing trading stock to the lesser of cost, market selling value and replacement value at year end to reduce their taxable income; and whether an asset that was previously held on capital account should be treated as trading stock. Tax Strategy Stock may be valued as being obsolete at year end which will generally result in an additional deduction where it can be established that the stock is in fact obsolete. Taxation Ruling TR93/23 provides relevant criteria which applies in evidencing such a claim. Tax treatment of trading stock The basic rules for the tax treatment of trading stock are as follows: sales are included in assessable income (section 6-5); purchases are a deduction (section 8-1); any excess of closing stock over opening stock is included in assessable income (section 70-35(2)); and any excess of opening stock over closing stock is an allowable deduction (section 70-35(3)). 25

Example: Lily starts a business in April 2013 and purchases $10,000 worth of trading stock. She does not sell any stock in the 2013 tax year and $10,000 worth of stock remains on hand at the end of the year. For tax purposes, the tax outcome for dealing with trading stock would be: Sales $0 Allowable deduction for purchases: ($10,000) Assessable amount (section 70-35(2)) $10,000 Taxable income: $0 Note: The assessable amount under section 70-35 is the excess of closing stock value over opening stock value (i.e. $10,000 - $0 = $10,000). Tax Strategy As the closing stock value is a key component in calculating the assessable amount or allowable deduction for a given tax year, reducing this value can allow taxpayers to reduce their taxable income for that year. Revaluing trading stock at year end Taxpayers should consider revaluing their trading stock at year end to the lower of cost, market selling value or replacement value to reduce their taxable income for the current year. A taxpayer can use any of the following three bases for determining the closing value of trading stock: Cost being the purchase price plus any other costs associated with the item; Market selling value being the current selling value of the item within the taxpayer s own selling market; or Replacement value being the amount the taxpayer would have to pay in its normal buying market on the last day of the income year to obtain an item which is substantially identical and available in the market. Taxpayers may use a different basis for each item of stock and may decide to adopt a different basis for the same item from year to year. However, the closing value of an item of trading stock at the end of the income year automatically becomes its opening value at the beginning of the following income year. Where a taxpayer is holding an item of trading stock that has dropped in value, the taxpayer should consider the options available in determining the closing value of the item. If the taxpayer is holding the item at cost and the market selling value of the stock falls below its cost value, the taxpayer may 26

be able to value the stock at market selling value at year end to reduce the closing value of trading stock for that year and, thereby, reduce its overall tax position. undertake Example: Eddie is a share trader who purchases 10,000 shares in Rio Tinto in June 2012 at $120 per share (his total cost $1.2 million). By June 2013, the share price has dropped to $60 per share. Eddie intends to continue holding the shares into the 2013 year in the hope that the share price will recover, however, due to poor performance of the market his cash flow is restricted. Eddie carried the shares at cost in his income tax return for the year ended 30 June 2012. For the 2013 tax year, Eddie calculates the closing value of his trading stock based on the market selling value of his shares. As the closing value of these shares is less than their opening value, he receives a deduction for the difference. Sales $0 Allowable deduction for purchases: $0 Assessable/(Deductible) amount: ($600,000) Taxable income/(loss): ($600,000) Note: Eddie receives a deduction under section 70-35(3) as the opening value of the shares of $1.2 million exceeds the closing value of $600,000 by $600,000. Eddie can apply this deduction to his other assessable income to improve his cash flow. It should be noted that if the share price does improve and Eddie subsequently sells the shares, he will pay more tax on the sale as the shares are carried at a lower value. Tax Strategy In some circumstances taxpayers may elect to value closing stock at its market selling value in lieu of cost where this value exceeds cost. This election will result in a timing adjustment where income is brought forward a year which would only typically occur where the taxpayer wishes to accelerate the recoupment of tax losses. This mechanism has been used by some companies to recoup losses prior to joining a tax consolidated group. Electing to treat an asset as trading stock Taxpayers may also consider whether there are potential benefits of electing to treat an asset that was held on capital account as trading stock provided this can be substituted from a tax perspective. Where a taxpayer holds an asset that was not previously held as trading stock and subsequently elects to treat the asset as trading stock, the taxpayer will be treated as having disposed of the asset and immediately reacquired it at the same price (section 70-30 ITAA 1997). Taxpayers can elect whether this deemed disposal and reacquisition takes place at cost or market value. This can be useful where a taxpayer is holding a capital asset that has decreased in value since it was acquired and genuinely wishes to hold this asset as trading stock. The taxpayer can elect to be treated as having disposed of the asset at market value and immediately repurchased it at the same 27

price which will crystallise a capital loss. Of course, this capital loss can only be utilised if the taxpayer has capital gains to offset against it. As the asset will now be held as trading stock, any future gains or losses on the asset will be taxed on revenue account, which means that any CGT discount and small business concessions which may have previously been available (depending on the taxpayer s investment structure) will be permanently foregone. If the taxpayer does not have any capital gains, they may prefer to elect to be treated as having disposed of and reacquired the asset at cost. Although there will be no capital loss in this instance, any change in the value of the asset that would have been taxed as a capital gain or loss will now be taxed on revenue account. This could be useful where the asset has decreased in value and the taxpayer has no capital gains against which to offset a capital loss. Example: Alan is a property developer. He buys a 3 bedroom house in Kew for $700,000 as an investment property which he rents out for 2 years. During that period, the market value of the property falls to approximately $600,000. At the end of the lease Alan decides that he will demolish the house and build several units on the property with the intention that he will sell each unit separately. Alan makes an election under section 70-30 to hold the property as trading stock. Alan will be treated as having disposed of the property and reacquired it at either its cost or market value (whichever he elects) and to have reacquired it for the same amount. Where Alan has capital gains from another CGT event against which he could offset a capital loss he may elect to be treated as having sold and reacquired the property at its market value of $600,000 which will crystallise a capital loss of $100,000. Alternatively, Alan may elect to be treated as disposing of and reacquiring the asset at cost. This will not trigger a capital gain or loss on the property becoming trading stock. However, if at the end of the following year Alan elects to recognise the trading stock at market selling value, he could realise an allowable deduction of $100,000 if the market selling value is still $600,000. Recharacterisation of the asset must be genuine It is important to note that a taxpayer cannot simply decide to begin accounting for an asset as trading stock if his or her intentions in relation to the asset have not changed. The taxpayer must genuinely decide to begin holding the asset for the purpose of sale as stock rather than on capital account. 28

4.4 Depreciation Background The depreciation regime allows taxpayers to claim income tax deductions for the decline in value of depreciating assets. Taxpayers should consider whether they can take advantage of the following options in order to maximise their income tax deductions and improve cash flow: self-assessing the effective life of depreciating assets rather than using the Commissioner s determination of effective life; using low value pools; and using concessional rules under the small business entity regime. Effective life of a depreciating asset A depreciating asset is an asset that is reasonably expected to decline in value over the time it is used under Section 40-30 ITAA 1997. This decline in value is calculated based on the effective life of the asset. Taxpayers have the option of either estimating the effective life of a depreciating asset themselves (self-assessing) or using the effective life determined by the Commissioner. Using the Commissioner s determination of effective life The Commissioner s recommended periods of effective life are now released in taxation rulings each income year (see Taxation Ruling TR 2008/4 which applies for the 2009 tax year). These rulings provide a safe-harbour estimate of the effective life of a depreciating asset that taxpayers can use with the confidence that the estimate cannot be questioned (section 40-95 ITAA 1997). The relevant determination of effective life for a depreciating asset is that which is in force: when the taxpayer entered into a contract to acquire the asset; when the taxpayer otherwise acquired the asset; or when the taxpayer started to construct the asset. provided the asset started to be used (or was installed ready for use) within 5 years of that time. If none of the above applies, the relevant ruling is the one in force when the asset starts being used (or is installed ready for use). Self-assessing effective life While the Commissioner s recommended period of effective life may be a useful tool for taxpayers, there are many cases where there is scope for depreciating assets more quickly as the particular asset s effective life is shorter than that specified in the Commissioner s ruling. 29

If a taxpayer estimates that the effective life of their depreciating asset is shorter than that published in the applicable tax ruling, the taxpayer can adopt their own effective life estimate. The taxpayer must estimate the period (in years) that the asset can be used by any entity for a taxable purpose having regard to the wear and tear you reasonably expect from your expected circumstances of use, assuming that the asset will be maintained in reasonably good order and condition. If the taxpayer concludes that the asset would be likely to be scrapped, sold for no more than scrap value or abandoned before the end of that period, its effective life ends at the earlier time. The effective life is estimated at the time when the asset is first used by the taxpayer or is installed ready for use and held in reserve. If the asset was acquired on or before 21 September 1999, the effective life estimate, once applied, cannot be varied if information later comes to light that would have affected the original estimate. However, if the asset was acquired after 21 September 1999 taxpayers can re-estimate the effective life where there is a change in circumstances that results in the effective life of the asset being recalculated (see Section 40-110(1) ITAA 1997). Some examples of changes in circumstances that may result in a taxpayer recalculating the effective life of a depreciating asset are: the taxpayer s use of the asset turns out to be more or less rigorous than expected; there is a downturn in demand for the goods or services the asset is used to produce that will result in the asset being scrapped; legislation prevents the asset s continued use; changes in technology make the asset redundant; or there is an unexpected demand, or lack of success, for a film. Example: Tony owns a manufacturing business which is the sole Australian manufacturer of the photographic material that is used in Polar instant cameras. In 2004, Tony purchased a new machine that is designed specifically for producing instant film for Polaroid cameras. He used the Commissioner s determination of effective life of 20 years as set out in the tax depreciation ruling which depreciated the asset at a rate of 5% each year. In 2008, Polar announces that it will stop making instant cameras. Now that Tony is aware that the machine will be obsolete in the near future, he can recalculate its effective life and claim a tax deduction for its adjustable value. Using low value pools Taxpayers should consider whether to use low value pools for assets that cost less than $1,000 or have declined in value to less than $1,000. By placing low-cost assets and assets depreciated to a low value into a low value pool, these assets are treated as a single depreciating asset with concessional rates of depreciation applying. Taxpayers, other than small business entity taxpayers, may choose to allocate the following assets to a low-value pool: low-cost assets - assets costing less than $1,000; and 30

low-value assets - assets that have declined in value under the diminishing value method to less than $1,000. The decline in value for assets in the low-value pool is worked out on a diminishing value basis as if all the pooled assets had an effective life of four years (i.e. 37.5%). Low-cost assets added to the pool during the year are depreciated at half the pool rate (18.75%), while low value assets allocated to the pool during the year are depreciated at the full pool rate (37.5%). Tax Strategy If taxpayers are planning to acquire low cost assets next year, consider bringing the acquisition forward to this year to obtain a 18.75% deduction this year (provided the asset is used or installed ready for use this year). If taxpayers pool low-cost assets, they must pool all low-cost assets of that income year and in subsequent income years. Once allocated to a low-value pool, the asset must stay in the pool. Assets that cost less than $1,000 each but are identical and, therefore, not immediately deductible may be allocated to a low-value pool even if their overall cost exceeds $1,000 (see ATO Interpretative Decision ATO ID 2003/496). Taxpayers can also pool in-house software expenditure in a software development pool. Before allocating a depreciating asset to a low-value pool, a taxpayer must estimate the percentage of the asset s usage (including past use) for a non-taxable purpose being any purpose other than that of producing assessable income. In making this estimate the taxpayer must consider the use of the asset over its effective life (for a low-cost asset) or its remaining effective life (for a low-value asset). The taxpayer must reduce the cost allocated to the low-value pool by the percentage of the asset s use for non-taxable purposes. Small business entity taxpayers Small business entity taxpayers can elect to use simpler depreciation rules which provide an alternative way of calculating deductions for most depreciating assets. Broadly, a small business entity taxpayer is an individual, partnership, trust or company with aggregated annual turnover of less than A$2 million. If a taxpayer elects to use this method, they must use all of the simpler depreciation rules for calculating deductions on their depreciating assets. They cannot pick and choose between the rules. The simpler depreciation rules can be summarised as follows: Assets costing less than $6,500 can be written off immediately. Taxpayers can immediately write off assets which each cost less than $6,500 in the tax year in which those assets are first used, or installed ready for use. A deduction is only allowed to 31

the extent that the asset is used for an income producing purpose. This means that taxpayers will need to apportion their deduction to exclude a non-allowable portion if the asset is not used 100% of the time for income producing purposes. Small business pools Assets with an effective life of less than 25 years are pooled in a general small business pool and depreciated at a rate of 30% per year. Most depreciating assets costing $1,000 or more must be allocated to a small business pool. The exceptions to this are: assets specifically excluded from the simpler depreciation rules; certain assets that relate to primary production for which you have no choice; assets with an effective life of 25 years or more that were held before 1 July 2001; and assets that are pooled in a small business pool may include assets such as motor vehicles and computers. Assets with an effective life of 25 years or more are pooled in a long life small business pool and depreciated at a rate of 5% per year. Such assets include generators and insulation panels for freezer rooms. The general small business pool and the long life small business pool are each treated as single assets. Deductions are calculated by multiplying the pool balance by the relevant pool rate. Where a taxpayer acquires a depreciating asset part way through an income year, they can claim a deduction at half the pool rate in that income year. This applies regardless of when during the year they acquired the asset. Tax Strategy If a business is planning to acquire an asset next year, consider bringing forward the acquisition to this year to qualify for half rate depreciation this year and the full rate depreciation next year. Changes to income producing percentage Taxpayers must monitor the income producing use of their depreciating assets if they are not solely used for income producing purposes. If the income producing purpose changes by more than 10%, the opening pool balance must be adjusted to reflect the change. Taxpayers will also need to account for changes in income producing use when they dispose of assets from the pools. 32

Certain assets are excluded from the simpler depreciation rules. Deductions for these assets must be calculated using the usual depreciation rules (as discussed above). These assets include: assets that the taxpayer leases out more than 50% of the time; horticultural plants (including grapevines); and buildings and structural improvements to buildings. Tax Strategy Business capital expenditure which is not deductible, depreciable or eligible to be included in the cost base of an asset may be eligible blackhole expenditure deductible at 20% pa over 5 years. Eligible expenditure would include expenditure incurred in establishing, restructuring or ceasing your business. Blackhole deductions are not required to be apportioned in the year the costs are incurred. 33

4.5 Funding issues for hybrid trust structures Interest on debt often represents a large cost to businesses. In these tough economic times, it has become increasingly important to ensure that funding arrangements are structured appropriately with regard to claiming interest deductions. Whilst trusts have been in use in Australia by small and medium enterprises (SME s) for many decades, the use of hybrid trusts has been under ATO scrutiny in recent times. Deductibility of Interest Interest is deductible to the extent to which it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, provided that it is not of a capital, private or domestic nature. 21 Courts have traditionally looked towards the purpose of any borrowing and the use of the borrowed funds in determining the deductibility of interest. The nexus between expenditure incurred and assessable income also applies to other expenditures incurred in obtaining funding, such as bank guarantee and loan establishment fees. 22 Taxation Determination 2009/17 In 2009, the Commissioner published Taxation Determination 2009/17 (TD 2009/17) in which he expressed his views on the deductibility of interest on funds borrowed to invest in trusts where beneficiaries have fixed and discretionary entitlements to income or capital. These arrangements are effectively describing what are commonly known as hybrid trusts. TD 2009/17 examines the case when interest on borrowings is used to settle money on a trust to benefit both the borrower and other beneficiaries. The Commissioner s view is that interest expense is only deductible to the borrower to the extent that it relates to the gaining or producing assessable income of the borrower. The Commissioner further states that, where the terms of the trust deed indicate that the borrowed money has been used to benefit both the borrower and other beneficiaries, an apportionment calculation will be required to be completed to determine the extent of the borrower s interest deduction. Forrest Case A deduction for interest used to borrow funds to invest in units in a hybrid trust was allowed by the Full Federal Court in Forrest v FC of T. 23 Broadly, the background facts of the case are as follows: the taxpayer borrowed $4.5m to acquire units in a hybrid trust and claimed interest expenses in relation to this loan; the trust deed specified that income was to be distributed to unit holders and that capital gains were to be distributed to the discretionary beneficiaries at the discretion of the trustee; and clause 12 of the trust deed specified that the trustee had discretion to determine whether an amount was income or capital for the purpose of the trust. 21 Section 8-1 ITAA 1997. 22 Section 25-25 ITAA 1997. 23 [2010] FCAFC 6. 34

In Forrest s case, the terms of the deed were found by the Court to demonstrate that the trust was a fixed trust of income other than capital gains. It was not, in that respect a discretionary trust in relation to income. In addition, the ATO stated in a decision impact statement issued in May 2010, 24 that: Clause 12 which appeared to confer upon the trustee an unfettered discretion to determine whether a receipt was income or capital was no more than an administrative penalty to honestly classify receipts according to law. It followed that as the taxpayer had a fixed entitlement to the income of the trust, interest payments claimed by the taxpayer in relation to interest were deductible in full. The issue of apportionment was not considered by the Court in this case. Lambert Case In contrast to Forrest, the taxpayer in Lambert v FCT 25 of T was denied deductions for interest on funds used to purchase investment properties. The key facts in the case as are follows: the taxpayer established a discretionary trust and appointed himself as trustee of the trust; properties were purchased in the name of the Trust and loans were obtained by the taxpayer in his capacity as trustee of the trust to fund these property purchases; interest on these loans were claimed by the taxpayer in his personal income tax returns; and the taxpayer executed a variation to the trust deed, which specified that the taxpayer received the entire income of the trust until further notice was given to the trustee. The two key issues considered by the Court in arriving at its decision were: firstly, whether the loans were obtained by the taxpayer as trustee of the trust or in his personal capacity and secondly, whether the variation to the trust deed effectively entitled the taxpayer to a fixed entitlement of income from the trust. The taxpayer claimed that although the initial loan applications were made by the taxpayer in his capacity as the trustee of the trust, the intent was to borrow in his personal capacity and on lend the funds to the trust on an interest free basis. Accordingly, the taxpayer requested for the applications to be amended within months of the initial loan applications. The Court held that although it was accepted that the taxpayer requested for the applications to be corrected, he had failed to ensure they were corrected by the bank until notice of amended assessments were issued by the Commissioner. 26 Therefore, the liability for interest payments fell on the taxpayer in his capacity of trustee of the trust and not in his personal capacity. In reference to the second issue, it was held that the variation to the deed of settlement was void due to flaws in the execution of the deed of variation. In addition, the Court held that the deed of 24 Australian Taxation Office, Decision Impact Statement, 4 May 2010. 25 [2013] AATA 442. 26 In addition, the Court referred to s960-100, which provides that, a legal person can have a number of different capabilities in which the person does things. In each of those capabilities, the person is taken to be a different entity. 35

variation appeared to be executed solely for the benefit of the taxpayer, which does not conform to the fiduciary duty of a trustee to vary a deed to benefit beneficiaries as a whole. In summary, the taxpayer had no more than an expectancy to receive income and was not presently entitled to income from the trust. Accordingly, the taxpayer was not entitled to deductions for the interest expenditure because there was insufficient nexus between the outgoings incurred and the derivation of assessable income. ATO s focus In recent times, the ATO s focus has been on uncommercial trust arrangements involving hybrid trusts. In particular, the focus in taxpayer alert TA 2008/3 has been on the use of hybrid trusts which are set up predominately to achieve negative gearing for high tax rate taxpayers while protecting the assets in the trust and are used to push profits to beneficiaries with a lower tax rate. This is achieved by providing the beneficiaries of these trusts with discretionary entitlements to income and/or capital gains. The trustees of these trusts are also effectively controlled by the taxpayer and/ or their associates. The ATO has warned that there may be a denial of interest deductions for arrangements which possess the features highlighted in TA 2008/3, as these arrangements do not provide a sufficient connection between interest expenditure and the production of future income and / or capital gains. The abovementioned cases and determination make certain that the issue of deductibility of interest will fundamentally depend on the facts of the case, and in particular, the terms of the trust deed. It is imperative that existing funding terms and trust deeds be reviewed by taxpayers and their advisors. Careful consideration should also be taken in the drafting of new funding arrangements and trust deeds. 36

5 Compliance tax matters 5.1 Fixed assets and depreciation One of the first areas the ATO will focus on, in the event of an audit, is your fixed asset schedule and your depreciation claim. This is because it is usually subject to numerous errors and so is a focus area that is capable of providing the ATO with some quick early wins. Why? Well, no-one likes to maintain fixed asset registers. As a result, human error is not uncommon and this shows up in a variety of ways including: incorrect recording of acquisition dates for new additions; use of incorrect depreciation rates or methods; and calculation errors in relation to asset disposals. If you haven t already done so, go back and review your fixed assets! You will end up either saving tax or discovering problems that you should fix now rather than wait for an ATO auditor to find out about them. A review of your fixed assets will also reveal to you strategies that may result in immediate tax savings, including: writing off of obsolete fixed assets (this does not mean you have to physically scrap your assets to obtain a tax deduction) and transfer some of your fixed assets to a low value pool thus increasing your tax deductions. 27 Small Business Concession In November 2011, a Bill was introduced in the House of Representatives containing amendments in relation to the depreciation rules for small businesses. These amendments include: increasing the small business instant write-off for depreciating assets, from $1,000 to $6,500; 28 combining the current two pools (i.e. the long life small business pool which is depreciated at a rate of 5% per year, and the general small business pool which is depreciated at a rate of 30% per year) into one single pool to be depreciated at a single rate of 30% per year; and an immediate deduction may be claimed for additions to existing assets provided the addition costs less than $6,500. 29 It is noted that the above amendments are still subject to the taxable purpose rules, that is, the amount claimed must be for income producing purposes. The above amendments have applied from the 30 June 2013 income year (and subsequent years). 27 Section 40-425 ITAA 1997 28 It was originally proposed that this threshold would be increased to only $5,000, however, the threshold was subsequently increased to $6,500 as part of the carbon pricing scheme. 29 The Liberal party has signalled its intention to scrap this measure upon winning government. 37

5.2 Company Tax losses Availability and utilisation of carried forward tax losses Broadly, a company is only permitted to offset its carried forward income tax losses against any future assessable income (and capital losses against any future capital gains), subject to certain limitations. Such losses cannot be utilised interchangeably and are utilised on a first-in, first-out basis (i.e. with respect to the income year that the loss was first incurred). Generally, a company is not entitled to deduct a loss unless it meets either: the Continuity of Ownership test (COT) (which is about the company maintaining the same owners); or the Same Business test (SBT) (which is about the company carrying on the same business). If a company has not passed the COT test for particular periods during the relevant test period, it may then rely on the SBT in order to carry forward and utilise previous year s tax losses. However, before you do this, you should conduct a detailed SBT analysis in respect of the carried forward tax losses, and develop a process of compiling a reasonably arguable position tax paper in this regard. It is not unusual to trip yourself up in the company s annual accounts. For example, the Chairman s Report, or the Director s Report, may indicate that certain changes have occurred in relation to the company s operations, which may be interpreted as resulting in the company failing the SBT. Treasury Consultation Paper Update When the 2011-12 Federal Budget was announced in May 2011, one of the proposed amendments included changes to the company tax loss recoupment rules, with the aim of making it easier for companies to satisfy the COT, in particular circumstances. In July 2011, a Treasury Consultation Paper was released detailing these proposed changes as follows: 30 modifying the ordinary COT, so that tracing ownership is not required where shares are held by a complying superannuation fund, a complying approved deposit fund, a first home savers account trust, a special company or a managed investment scheme amending the modified COT (i.e. broadly, the modified COT is applicable to widely held companies only and contains concessional tracing rules whereby, the COT only needs to be satisfied at the start of the loss year, at the end of the income year in which the loss is claimed, at the end of any intervening year, and at the end of a corporate change such as a takeover bid) so that where direct and indirect stakeholders have less than a 10 per cent stake in the loss company, the concessional tracing rules apply where: an entity is interposed between the direct stakeholders and the loss company; an entity that is interposed between the stakeholders and the loss company, demerges the shares that it has in the loss company, or its interests in another entity which is interposed between itself and the loss company; and 30 Treasury, Improvements to the company loss recoupment rules Consultation Paper (2011); Huynh, Myloan, Company loss recoupment rules: Proposed outlook for 2012, Taxation in Australia, Volume 46(8) March 2012. 38

a foreign listed company that is interposed between a stakeholder and the loss company issues bearer depository receipts. extending the concessional tracing rules under the modified COT so that they apply where an entity is interposed between the loss company and a relevant stakeholder that is a complying superannuation fund, a foreign superannuation fund regulated under a foreign law, a complying approved deposit fund, a first home savers account trusts, a special company or a managed investment scheme clarifying that, for the purpose of applying the modified COT when a corporate change happens because new shares have been issued in a company, the corporate change ends when all of the new shares are issued treating all membership interests in an entity (which is owned by the test company at the relevant times), as a single asset, for the purposes of applying the low value asset exclusions. Broadly, the low value asset exclusions are applied so that if the market value of each individual asset is less than $10,000, any unrealised losses on these assets will not be taken into account in calculating the company s unrealised net loss, and the losses in relation to these low value assets can be utilised without the need for the company to pass the SBT. In a scenario whereby a company owns CGT assets that are membership interests in another company (such as shares in another company), there will no longer be uncertainty as to whether each of these membership interests is treated as a separate asset or a single asset The Business Tax Working Group s Interim Report On the 5 October 2011, the Business Tax Working Group (the Working Group) was formed, with the purpose of looking at improving the Australian business tax system. In December 2011, the Working Group completed its interim report on the overall tax treatment of losses which detailed four different possible reforms, as follows: 31 Replacing the COT and SBT with an alternative integrity test - the report detailed that the removal of the COT and SBT would increase the company s ability to utilise its carry forward losses regardless of any changes to its ownership or business structure. As a result, companies would be able to restructure their ownership structure, seek new equity partners, pursue new business ventures and terminate unprofitable business components and still be able to utilise its carry forward losses. However, the report notes that the removal of the COT and SBT could undermine the integrity of the tax system if it results in businesses having access to benefits arising from artificial tax losses. A potential alternative to partially negate this risk is to apply the current rules applicable to tax losses brought into a tax consolidated group (for example, the application of the available fraction), in a more broader sense. Allow losses to be refunded immediately - as detailed in the report, this would create a more symmetrical tax treatment of profits and losses however, this would not be a viable option, from a Government revenue collection perspective. Introduce a loss carry back system with time limits - this reform would allow companies to carry back current year tax losses and offset these against previous year s profits, resulting in a refund 31 Treasury, Business Tax Working Group Interim Report on the tax treatment of losses, (2011). 39

of tax previously paid. The ability to carry back current year tax losses would be limited to a carry back period and also be restricted by a company s franking account balance. Apply an uplift factor to losses - the report details that the real value of carry forward tax losses can erode over time, therefore an uplift factor could be applied to tax losses as they are carried forward, with a suggestion that the uplift factor could be the long term (10 year) Government bond rate. The Business Tax Working Group s Final Report Final report on the tax treatment of losses was subsequently released in April 2012 32, which recommended the following: Recommendation 2: The Working Group considers that loss carry back would be a worthwhile reform in the near term and could be implemented consistent with a model that: is limited to companies; provides a two-year loss carry back period on an ongoing basis; limits the amount of losses that can be carried back by applying a cap of not less than $1 million; limits the amount of refunds to a company s franking account balance; and is phased in from 2013-14 with an initial one year carry back period. Recommendation 3: The Working Group recommends that the Government, as a matter of priority, undertake further analysis with a view to developing a model for reforming the same business test. One model for improving the existing loss integrity rules could involve a combination of: modifying the existing SBT so that it better aligns with the modern business environment; and introducing an alternative statutory drip-feed mechanism calculated on a straight line basis. 33 Post the April 2012 Final report on the tax treatment of losses May 2012 Budget announcement of loss carry-back reforms the Government announced that it would introduce a limited loss carry-back to the income tax law for corporate tax entities. June 2012 Focus on longer term reform of the business tax system the Government asked the Working Group to prioritise consideration of a cut to the company tax rate accompanied by measures which fully offset the cost by broadening the business tax base. 32 Treasury, Business Tax Working Group Final Report on the tax treatment of losses, (2012). 33 Treasury, Business Tax Working Group Final Report on the tax treatment of losses, (2012), ix. 40

the Working Group released a consultation guide setting out how the Working Group planned to involve the community in its consideration of business tax reform. August 2012 Discussion paper on longer term reform of the business tax system released The Working Group released a discussion paper in August 2012 that sought views from stakeholders about whether a lower company tax rate funded by some specific base broadening options could deliver net benefits to the Australian economy. September 2012 Discussion paper on longer term reform of the business tax system consultation Consultation meetings were held between Working Group members and interested stakeholders throughout September. Submissions in response to the interim report closed in September. October 2012 Discussion paper on longer term reform of the business tax system consultation The Working Group released the draft final report on longer term reform of the business tax system. November 2012 Final report on longer term reform of the business tax system The Working Group released the final report on longer term reform of the business tax system. The final report remain unchanged from the draft final report released by the Working Group on 24 October 2012. The findings of the Working Group included: Finding 1: Finding 2: Finding 3: Finding 4: Finding 5: The Working Group believed there could be economic benefits associated with a cut in the company tax rate. A reduced rate would lead to greater investment in Australia in the longer term, which would contribute to improved productivity and higher wages for Australians. The Working Group considered that a cut in the company tax rate of two to three percentage points would be needed to drive a significant investment response. The Working Group had found that the business tax base is broader than it was in the 1980s and 1990s and significant savings are now more difficult to identify and reach consensus on. The Working Group notes that there is considerable debate and uncertainty around the magnitude of the distortion associated with the remaining concessions in the business tax base, including concessions that promote important activity like investment in infrastructure and research and development. The Working Group received feedback from many individual businesses asserting that they would be worse off as a result of the trade-offs canvassed in the Discussion Paper. Further, some submissions questioned whether there would be a net benefit for the economy as a whole from a combination of some of the base broadening measures canvassed and a cut in the company tax rate of between one and three 41

percentage points. Overall, the Working Group had found there is a lack of agreement in the business community to make such a trade-off. Finding 6: Finding 7: Finding 8: The Working Group considers that Australia should have an ambition to reduce its company tax rate as economic and fiscal circumstances permit. This would need to be considered against other budget priorities and should take into account the overall mix of business taxation. The Working Group commends the principles for business tax reform it has identified as a useful framework that articulates the range of relevant considerations. The Working Group also supports the continuation of a consultative approach to business tax reform. The Working Group considers that an allowance for corporate equity (ACE) should not be pursued in the short to medium term but may be worthy of further consideration and public debate in the longer term. 5.3 Audit fees Generally, a provision for audit fees for work yet to be undertaken at balance date is not deductible for tax purposes. A deduction is only allowable in the year the fees are actually incurred. However, in Taxation Ruling IT 2625 Income tax: deductibility of audit fees (IT 2625), the Commissioner indicates that, depending on the contract terms with the auditor, an accrual for audit fees may be deductible for tax purposes. For example, the contract may provide that the full amount of the audit fee is due upon entering into the contract, but that the auditor may accept the payment of the fee by instalments. It is accepted that in such cases, the liability for the total audit fee becomes due on the entering into of the contract and the subsequent instalments are payments in settlement of the original debt incurred. In such cases, the full amount is deductible in the year in which the contract is entered into. Whilst this represents a timing difference between one year and the next, bringing tax deductions forward through uncomplicated tax planning, by being organised, makes for good common sense. 5.4 Directors fees and Employee Bonuses Quite often, there are accrued directors fees and/or employee bonuses (in the balance sheet) as at year end. In Taxation Ruling IT 2534 Income tax: taxation treatment of directors fees, bonuses, etc. (IT 2534), the Commissioner discusses when such fees are deductible for tax purposes in the following way: 34 to qualify for a deduction a company must, before the end of the year of income, become definitively committed to the payment of a quantified amount of directors fees, bonuses or other such payments, (e.g., by passing a properly authorised resolution). 34 At paragraph 3 of IT 2534. 42

It is not unusual for Boards to not have agreed Directors fees until after year end and, consequently, the company not being entitled for a tax deduction in relation to such fees, notwithstanding that the Board was always going to approve the Directors fees. In these circumstances, a favourable tax outcome can be achieved by ensuring that such directors fees are agreed to by the Board every year in, or around, a certain month (e.g. December), and paid on a quarterly basis in arrears. On this basis, the accrued directors fees can be treated as being deductible, for tax purposes, in the income year in which the Board resolution is passed. Similarly, employee bonuses will also be deductible as at year end provided the company is definitely committed to making the payment of a quantified amount. 35 5.5 Superannuation Guarantee and remuneration Under the Superannuation Guarantee (Administration) Act 1992 (the SGAA), employers are required to make superannuation contributions into a complying superannuation fund (or Retirement Savings Account) for the benefit of their eligible employees in accordance with minimum prescribed levels. For these purposes, Directors are employees under the extended definition of employee in the SGAA. The SG scheme is administered on a self assessment basis. The required minimum rate of superannuation contributions from 1 July 2013 is 9.25% of ordinary time earnings. Directors fees are included in ordinary time earnings. The actual level of superannuation support provided in respect of each employee is measured on a quarterly basis (i.e. over each three month period commencing 1 July, 1 October, 1 January and 1 April each year). The required contributions for a quarter must be made by the 28 th day after the end of the quarter. Employers must also pay the contributions to the superannuation fund chosen by the employee under superannuation fund choice. Employers who do not make the minimum level of support, or make the payment late, incur a liability for the SG charge. Employers who pay the contributions to the wrong superannuation fund also incur additional penalties under the SGAA. The SG charge is calculated as the sum of: 1. The total of the employer s individual SG shortfalls for the quarter. 2. The employer s nominal interest component for the quarter. 3. The employer s administration component for the quarter. The employer s SG shortfalls are calculated using employees salary and wages, rather than the generally lower ordinary time earnings. The employer s nominal interest component is calculated on the total individual shortfalls at an interest rate of 10% per annum. Interest is imposed for the period from the beginning of the relevant quarter to the date on which the SG charge is paid. 35 Merrill Lynch International (Australia) Ltd v FCT 47 ATR 611. 43

The employer s administration component is $20 for each employee for whom there is an SG shortfall. In addition, the SG charge is not deductible for tax purposes. 36 If the contribution is made at the correct level, but is paid after the 28 th day after the end of the quarter, the contribution made can be offset against the employer s SG charge. However, contributions that are offset against the SG charge are not tax deductible. Example 37 An employer has an employee who has ordinary time earnings of $15,000 for the quarter commencing 1 January 2013. The employee s salary and wages are $17,500, including $2,500 of overtime. The employer was required to contribute an amount of $15,000 at 9% = $1,350 by 28 April 2013. If the employer made the contribution on 1 May 2013, and assuming that the SG charge was paid on 28 May 2013, the SG charge was calculated as follows: SG shortfall $1,575 ($17,500 at 9%) Interest component $63.86 (10% p.a. from 1 January 2013 to 28 May 2013) Administration component $20 SG charge $1,658.86 The employer was able to offset the contribution made ($1,350) against the SG charge, meaning that an amount of $308.86 was required to be remitted to the ATO. However, no part of the amount of $1,658.86 was tax deductible to the employer in 2012/13. By making the contribution 3 days late, the cost to the employer is $308.86 (the additional payment to the ATO) plus $497.66 (30% of $1,658.86, due to the non-deductibility), totaling $806.52. This is almost equal to 60% of the original contribution! Superannuation Mistakes Superannuation is becoming a focus area for the ATO and it is not surprising, given the increased likelihood for taxpayers to make mistakes in complying with their superannuation obligations in a continuously changing superannuation environment. The ATO has noted that the mistakes most commonly made by employers in relation to their superannuation obligations include: paying insufficient super contributions; missing the quarterly cut-off dates (i.e. 28 October, 28 January, 28 April, 28 July); incorrectly complying with super obligations in relation to contractors; not keeping accurate records; 36 Section 26-95 ITAA97. 37 Section 290-95 ITAA97. 44

not passing on an employee s TFN to their super fund; and not lodging a superannuation guarantee charge statement. The ATO plans to undertake audits of employers who continue to fail to meet their superannuation obligations in respect of their employees. In this respect, it is essential that taxpayers keep records to show: the amount of superannuation paid for each employee and how it was calculated; the date on which the contributions were paid; eligible employees have been offered a choice of super fund; and how any reportable employer superannuation contributions were calculated. 5.6 Accruals versus provisions When reviewing year end financial accounts, companies usually record various accrued expenses and provisions across a multitude of different expense categories. However, the confusion that reigns over determining the difference between a provision vis-à-vis accrual is alive and well. What I inevitably find is that certain of these accrued expenses and provisions are not deductible on the basis that they represent accrued expenses or provisions that are, in substance, estimates of expenses that have not yet been incurred for tax purposes. Broadly, to be deductible, in a particular tax year, the expenditure must have been incurred in that year. 38 Whether or not this is the case will depend on various factors including, inter-alia, whether: the taxpayer was definitely committed to the expenditure; the liability was defeasible ; the expenditure was properly referable to the tax year in question; and the taxpayer returns assessable income under the accruals or cash basis. Of course, there are always exceptions to the general rule resulting from ATO administrative practice (e.g. the deductibility of audit fees, as previously discussed). Some common examples of accruals taken up at year end for which a tax deduction is not necessarily available include, inter-alia, the following: Audit fees (refer 5.3); Directors fees and employee bonuses (refer 5.4); and Superannuation (refer 5.5). 38 Section 8-1 ITAA97. 45

Some common examples of provisions for which a tax deduction cannot be claimed include, interalia, the following: Annual Leave and long service leave; Provision for doubtful debts; and Unreliable (guess) estimates of provisions for expenses. 5.7 Amortisation versus depreciation It is important to keep separate in your financial accounts amortisation expenses from depreciation expenses. This can be a real sleeper particularly where depreciation and amortisation amounts are lumped into the same expense category for management reporting purposes. Usually, amortisation expenses are recorded in the company s financial accounts in relation to intangibles, which have been expensed in the profit and loss statement. Such amounts are generally not deductible and are required to be added back in the company s tax reconciliation. Further it is not uncommon that the accounting depreciation is not equal to tax depreciation. Accordingly, you will be required to add back the accounting depreciation amount and subtract the tax depreciation amount in the company s tax reconciliation. Special rules apply in relation to IT/software which provide for an accelerated rate of tax depreciation. A detailed review of the company s tax depreciation schedule should be performed, if this has not been undertaken in recent years (refer 5.1). 5.8 Business Blackhole Expenses Broadly, taxpayers may deduct capital expenditure incurred that is not otherwise deductible and that relates to a business that was, or is proposed to be, carried on for a taxable purpose. 39 The deduction is claimed over a period of five years on a straight line basis (i.e. 20% per annum) starting in the year in which the expenditure is incurred and in the next four years. In addition, in order to qualify for a deduction, the expenditure must not be deductible nor denied a deduction elsewhere in the income tax law, or form part of the cost base of a depreciating or capital asset. Common examples of blackhole expenditure include, inter-alia, the following: Establishing a business structure (e.g. a company); Conversion or winding up of an existing business structure; Equity raising costs; and Takeover defence costs. On 30 November 2011, the ATO released Taxation Ruling TR 2011/6 Income Tax: business related capital expenditure section 40-880 of the Income Tax Assessment Act 1997 core issues, 39 Section 40-880 ITAA 1997 (in Sub-division 40-I), effective from 1 July 2005. 46

as a final version of the previously issued Draft Taxation Ruling TR 2010/D7. This ATO Ruling specifically considers: the type of expenditure to which section 40-880 applies; the nexus required for capital expenditure to be in relation to a current, former or proposed business; the requirement that the business be carried on for a taxable purpose; and limitations and exceptions to a deduction. 5.9 Travel Domestic and overseas travel and accommodation expenses can amount to a significant dollar value. It should be ensured that (i) such expenses are all business related and (ii) that the relevant travel records have all been kept, in order to secure the deductibility of the expenses for tax purposes. It should be noted that for certain domestic travel and overseas travel, travel records must be kept. 40 The rationale behind the documentation requirements is to show which of the taxpayer s activities were business related versus personal and, therefore, deductible versus non-deductible. As a general rule, record keeping requirements dictate the following when travelling away from home: 1-5 nights - written evidence 6 + nights - written evidence plus travel diary Substantiation rules in relation to travel must also be able to be satisfied by the company, for both deductibility and FBT purposes. Upon ATO audit, these records will be requested by the ATO. 5.10 To consolidate or not to consolidate Related companies that are not part of a consolidated group, for tax purposes, will be affected by the: Removal of the inter-corporate dividend rebate on the unfranked portion of dividends flowing between resident group companies (meaning that the unfranked dividends will be taxed). Where dividends flow between members of a consolidated group, the dividends will be ignored for tax purposes; Removal of the ability to transfer Australian tax losses between Australian companies that are members of a wholly-owned group; Removal of intra-group asset roll-overs currently available for CGT (and other purposes) for companies that are members of a wholly-owned group; Removal of the ability to transfer excess foreign tax credits (FTCs); and Withdrawal of grouping rules for thin capitalisation purposes. 40 Refer Sections 900-1 to 900-250 ITAA 1997. 47

Accordingly, there are sufficient commercial and / or tax reasons for a company group to consolidate. Further, by consolidating, a company group could potentially obtain a step up in the cost base of the asset goodwill as part of the preparation of a future sale of some of the business assets of that group. It is important that the key advantages and disadvantages are carefully weighed up when considering whether to tax consolidate a corporate group. The following table provides a summary of the key issues that should be considered. Tax Consolidation - Key Issues Benefits Disadvantages Increase goodwill cost base Lost (or reduced) tax depreciation Facilities restructuring Lost (or reduced) tax losses Compliance benefits Potential upfront capital gains Access to former tax concessions Cost / resource requirements Trust entities Valuations 48

6 About the Author Mark Pizzacalla is Managing Partner of HLB Mann Judd Melbourne, and Head of the firm s tax practice. Mark is a regular speaker on taxation issues, and a prolific writer having contributed significant tax commentary through his numerous articles, publications, and conference papers, and has also had his work cited in Australia s Parliament. Mark is regularly interviewed on Lateline Business in relation to current SME taxation issues, and is the current Chair of the Taxation Institute of Australia s National SME Sub-Committee. 49

7 Disclaimer The content of this paper is of a general nature only and should not be used or treated as professional advice. This paper does not take into account your particular circumstances, or those of your client or your employer. You should rely on your own enquiries, together with tailored professional advice, in making any decisions concerning your own interests or those of your client or your employer. This paper (and accompanying slides) represents the opinion of the author and not necessarily those of HLB Mann Judd. 50

8 References Australian Taxation Office, Compliance Program 2011-12 (2011). Australian Taxation Office, 'Eyes on the commercial ball' (Paper presented at the International CFO Forum, The Mint, Sydney, 20 November 2009). Australian Taxation Office, Large business and tax compliance (2011). Mr Mark Konza, A world without audits (Speech delivered at the Thomson Reuters Annual User Conference, Sydney, Australia, 17 October 2011). Merrill Lynch International (Australia) Ltd v FCT 47 ATR 611. Michael D'Ascenzo, (Speech delivered at the 22nd Australasian Tax Teachers Association Conference 2010, University of New South Wales, 22 January 2010). Michael D'Ascenzo, 'Two to tango' (Speech delivered at the G100, Sydney, Australia, 9 December 2009). Ms Katie Walsh, We can work it out, tax man tells CEOs, The Australian Financial Review, 17 January 2012. The Institute of Chartered Accountants, Reportable Tax Positions and the Risk Differentiation Framework, (2012). Thomson Reuters, Weekly Tax Bulletin, Issue 16, 20 April 2012; The Hon David Bradbury MP, Protecting worker s entitlements and strengthening director obligations, (Media Release No.016, 18 April 2012). Thomson Reuters, Weekly Tax Bulletin, Issue 024, 10 June 2011; Bruce Quigley, We can see clearly now: growing transparency with large businesses, (Speech delivered at the Corporate Tax Association Convention, Melbourne, 7 June 2011). Treasury, Improvements to the company loss recoupment rules Consultation Paper (2011); Huynh, Myloan, Company loss recoupment rules: Proposed outlook for 2012, Taxation in Australia, Volume 46(8) March 2012. Treasury, Business Tax Working Group Interim Report on the tax treatment of losses, (2011). Treasury, Business Tax Working Group Final Report on the tax treatment of losses, (2012). 51