Discuss deductibility under S 8-1. Relevant Case-brown ‘s Case and Steele Case.
In the given case Taite Moneybags and his business colleague Aramis Lotsamoney were planning to start a business. Both these people are resident of UK for tax purposes. Both these people have plans of starting a business relating to land development activities. They are planning to set up a company who will borrow money as per the company structure and they will send the money with hundred percent owned subsidiary at commercial rates. The subsidiary company will use the money to buy land and we’ll subdivide those and will sell the subdivided land to the general public. They are planning to invest the initial 2 years of planning and the next coming 5 years for carrying out the company’s business operation. The subsidiary company in return will pay interest to the parent company for the loan that the parent company has given them for carrying out the business operations along with dividend for the 100% shareholding held by the parent company. As per the business model of a company, the parent company will sell the subsidiary company to a least competent tender applicant and has a plan of the purchasing the same in 2 to 3 years at a lower price. The business model that has been put in place by the management required huge initial investment. Further, the subsidiary that has been sold will let to losses as the interest amount have to be paid and the loans will not be paid off letting to only the necessary loan commitment will be paid. These losses will be carried out till the repurchased subsidiary will turn out to be profitable. (Gov.UK, 2017)
If a person who is a resident of some other country is operating in Australia and at the same time any person who is a resident in Australia and is operating a business in overseas is impacted by the double taxation treaty which has been taken place among the government of both the countries. If a person resident in some other country is doing business in Australia and is working in Australia and his country in which he is resident has a tax treaty with Australia, then, in that case, he is required to get himself registered with the tax authorities of the country. As per the provision of Australian tax laws, the permanent establishment plays a vital role in determining the taxability of a company. A permanent resident refers to a place from where the business has been wholly or partially being carried out by the business house. Further, a permanent residence includes sales outlet, branches, factories, place of management etc. If a person is a resident of a country who has a tax treaty with Australia then any income that has been generated from a business which has a permanent establishment in Australia will be taxed as per the provision of Australian tax act. In this case, it is important that the income that has been generated from the business is carried out through the help of permanent establishment in Australia itself. Any other type of business income will not be taxable in Australia. In the given case, UK and Australia has an income tax treaty and a double taxation avoidance agreement among themselves as a result of which any income that has been generated through the help of permanent establishment will be taxed in Australia considering the provision of the Australian tax laws. As per the provision of the Australian tax laws any asset that has been owned by the tax payer in relation to the above business will be subject to the Australian capital gain tax that will be levied on the tax assessee at times when the asset is sold or disposed of. (Anon, 2008)
Thus, considering the above facts, it is evident that the establishment of permanent establishment is important in determining the tax liability of the tax payer especially a company in Australia. Thus, Taite Moneybags and his business colleague Aramis Lotsamoney were a resident of UK but any income that has been earned by them in Australia via carrying out of business will be taxable as per the income tax laws of the country.
In the given case, as per the business model of the company, the parent company was planning to give a loan to its subsidiary company at commercial rates. The amount of interest that has been paid by the subsidiary company to the parent company will be treated as interest expense in the books of the subsidiary company. From the perspective of the income tax, as per section 8-1 of the income tax assessment act 1997, an expense that has been incurred by the assessee in producing or gaining the assessable income will be allowed as deduction or further the same has been incurred for the purpose of the carrying out the business which in return will be used for generating income. (ATO, 2017)
As per the case law “FC of TV Total holding (Australia) PTY LTD”, the tax payer was a wholly owned subsidiary company of Compgnie Francaise Des Petroles (CFP) which is a French company. The tax payer holds all the shares in Total Australia Limited (TAL). Later in the year 1968, the taxpayer transferred 50% of the shares in TAL to Total Boral Ltd which is also 50% owned by the tax payer. Further, in the year 1972, the taxpayer purchased the balance 50% stake in the TAL limited. TAL was engaged in carrying out the business of selling and marketing of petroleum products. The taxpayer in order to carry out the above operations has borrowed $23 million from its parent company. This amount was borrowed at an interest rate of 3% and further lent the same to Tal at an interest rate of 7% and with a note that the interest amount has been charged by the parent company (taxpayer) only at times when TAL was not fully owned by the taxpayer, else the same was interest free. The income tax commission n this case has denied the carry forward of the losses by stating that there has been no direct nexus that exists between the income producing activities and the making interest-free loans to TAL. The commission was of the opinion that the interest-free loan has been made by the taxpayer with an intention to make the company profitable and then sell the shares of the company at a higher price. The federal court, in this case, decided that the taxpayer is entitled to claim a deduction for the interest amount that it has paid to his parent company which it has further let out to TAL interest-free. It has further been guided by the notion that the interest-free loan has been provided by the taxpayer to TAL with an intention to make TAL profitable and make it commercially feasible to pay a dividend to the taxpayer. (Northrop and Fisher JJ concurring). Thus, in this case, it was later on decided that the amount of interest that has been paid by the taxpayer to its parent company was important for the derivation of the company and thus meet out all the tests of section 51 of the Act. Thus, in this case, the commissioner contention for the interest-free loan relation to the business activities was put aside by the court. (ATO, 2017)
Further for the purpose of determining the deductibility of the interest expenses, there is certain ruling in place. In case law (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele)), it was determined that the deductibility of the interest expense is determined based on the examination of the purpose of the borrowing and the use for which these funds are been put. Further, in the above case law, it has been decided that interest paid prior to generation of the assessable income will be considered as spending in relation to the producing the assessable income in the following circumstances:
On the other hand, in the above case law, it was provided that in case any interest expense has been incurred after the income earning activities are ceased, it is evident that the same has not been incurred in relation to producing the assessable income of that period or any future period, then, in that case, the interest expenses will not be allowed as a deduction. Further, if by any means, the taxpayer is able to justify that the even after the cessation of the earning activities will arise again and will let to an extension for which the debt was originally being incurred. In this case, the refinancing of the loan will have no impact in determining the taxability of the interest expense.
In the given case, Taite Moneybags and his business colleague Aramis Lotsamoney were planning set up a company. The company will borrow money as per the company structure and they will grant a loan to its 100% owned subsidiary company at commercial rates. The subsidiary company is engaged in carrying out the business of land development activities. After a period of 7 years, the subsidiary company will be sold and through refinancing the same will be purchased again after 2-3 years. In the initial 2 years, the subsidiary company was operating in the planning phase. This planning phase was important considering the nature of business the subsidiary company was engaged in. Further, in light of the above case laws, the planning phase before commencing the actual operation is not too long considering the nature of business the company is engaged with. Considering the provision of the case law, in this case, it is evident that the interest expenses that have been incurred prior to commencing of the operations are relevant and the period of 2 years is also not too long considering the land development business of the company.
The interest expense that has been incurred by the subsidiary during the life of the land development activities will be allowed as normal deduction being the same is related to the income earning activities of the company.
On the other hand the interest expense that has been incurred by the company after the sale of the business will also be allowed as deduction considering the fact that the taxpayer is able to justify that the even after the ceastion of the earning activities will arise again and will let to an extension for which the debt was originally being incurred. Thus, considering the fact, that the business of the subsidiary company will be taken over again in the next 2-3 years as per the agreed business model, thus the interest expense during the period will also be allowed as deduction. As discussed above, the refinancing does not have any impact on the interest deductibility.
In the given case, the subsidiary company is expected to repurchase the shares that have been sold at the lower price at which the same has been sold. Further, the losses in relation to the interest expense that has been borne by the company during the period of sale and repurchase of the business will be allowed as deduction. Considering the fact, that the business of the subsidiary company will be taken over again in the next 2-3 years as per the agreed business model, thus the interest expense during the period will also be allowed as deduction.
Capital gain arises when the capital asset is sold at a price higher than its purchase cost. There may be capital loss sometimes when the capital asset is sold at a lower price than the purchase price. This form of income is totally different from the ordinary income. The tax payer cannot set off capital losses from the ordinary income. For the purpose of calculating the capital gain/loss, the cost that has been incurred in making necessary improvements in the capital asset and further cost that has been incurred for making the sale will become part of the purchase cost.
In the given case the subsidiary company has been engaged in the business of land development activities. Thus, considering the nature of business of the company the land will be considered as a trading stock. As per the provision of Australian tax laws, the land, in this case, will not be considered as a Capital Asset. Thus, in this case, the sale of land by the subsidiary will be exempt from the purview of capital gain tax.
The business model that has been presented by Taite Moneybags and his business colleague Aramis Lotsamoney are subject to some business risk. The first and foremost is the change in the tax ruling that in greater terms may impact the taxability of the company. Currently, the tax ruling is in favor of the company but the same might get impacted by any law which in long run is not beneficial for the company. The management strategies will help the company in managing the risk. Further, from the perspective of the management, they are required to document the sale and purchase price of the land effectively. Further, all the documents that are required to be maintained in relation to the sale and purchase of the business/shares should be in place and should be duly verified by some professional expert.
Anon., 2008. Northrop v Thorsen. [Online] Available at: https://www.courts.state.ny.us/Reporter/3dseries/2007/2007_10124.htm [Accessed 4 Aug 2017].
ATO, 2016. Foreign residents doing business in Australia. [Online] Available at: https://www.ato.gov.au/business/international-tax-for-business/foreign-residents-doing-business-in-australia/ [Accessed 4 Aug 2017].
ATO, 2016. Tax on income and capital gains. [Online] Available at: https://www.ato.gov.au/Business/International-tax-for-business/Foreign-residents-doing-business-in-Australia/Tax-on-income-and-capital-gains/#permanentestablishment [Accessed 5 aug 2017].
ATO, 2017. Taxation Ruling TR 2004/4. [Online] Available at: https://www.ato.gov.au/law/view/document?DocID=TXR/TR20044/NAT/ATO/00001 [Accessed 4 Aug 2017].
ATO, n.d. INCOME TAX ASSESSMENT ACT 1997. [Online] Available at: https://www.ato.gov.au/law/view/document?docid=PAC/19970038/8-1 [Accessed 4 Aug 2017].
ATO, n.d. TR 2002/5, Income tax: Permanent establishment – What is ‘a place at or through which [a] person carries on any business’ in the definition of permanent establishment in subsection 6(1) of the Income Tax Assessment Act 1936?. [Online] Available at: https://law.ato.gov.au/atolaw/print.htm?DocID=TXR%2FTR20025%2FNAT%2FATO%2F00001&PiT=99991231235958&Life=20161207000001-99991231235959 [Accessed 4 Aug 2017].
EY, 2014. Doing business in Australia. [Online] Available at: https://www.ey.com/Publication/vwLUAssets/Doing_Business_in_Australia_and_Australian_tax_landscape/$FILE/EY-doing-business-guide-australia.pdf [Accessed 4 Aug 2017].
GOV.UK, 2012. Australia: tax treaties. [Online] Available at: https://www.gov.uk/government/publications/australia-tax-treaties [Accessed 4 Aug 2017].
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