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11. Chapter 11 Income-Splitting

note

11.1. The phrase ‘tax evasion’ describes an act in contravention of the law whereby a person who derives a taxable income either pays no tax or pays less tax than he would otherwise be bound to pay. Tax evasion includes the failure to make a return of taxable income or the failure to disclose in a return the true amount of income derived. Leaving aside the cases where a person parts with some portion of his income under the dictate of some particular legal or moral obligation, ‘tax avoidance’, on the other hand, usually connotes an act within the law whereby income, which would otherwise be taxed at a rate applicable to the taxpayer who but for that act would have derived it, is distributed to another person or between a number of other persons who do not provide a bona fide and fully adequate consideration; in the result the total tax payable in respect of that income is less than it would have been had no part of the income been distributed and the whole been taxed as the income of that taxpayer. The act which distributes an amount of income for the purpose of achieving that result is usually described as ‘income-splitting’.

11.2. Generally speaking, as salaries and wages cannot be made the subject of income-splitting, the opportunity by that means to order one's affairs so as to reduce the amount of tax otherwise payable is not equally available to all taxpayers. This is inequitable to the taxpayers who do not have that opportunity. A progressive taxation system that seeks to bring to charge the income of each individual upon an ascending scale of tax rates should operate fairly as between all taxpayers and should tax each person upon the amount of income that was truly and realistically his to receive. Fairness to the whole body of taxpayers demands that this principle should have a full application, for the loss to the Revenue in the reduction of taxation effected by income-splitting must be recouped from those who are unable to practise it. Therefore, it behoves the revenue laws to correct the inequity and restore the efficiency and balance of the taxation system.

11.3. Income-splitting is almost universally confined to family relatives: husband and wife, father and child, grandfather and grandchild and so forth. When the word ‘relative’ is mentioned in this chapter, it is intended that it should bear the meaning ascribed to ‘relative’ in section 6 (1) of the Income Tax Assessment Act. The means by which it is accomplished are most frequently to be seen in partnerships, alienation of income, trusts, private company arrangements, loans, gifts and employer and employee relationships. The current legislation contains a number of sections designed to inhibit some forms of income-splitting; but these have proved to be ineffective in the sense that they leave large areas untouched, and it is necessary that the use of other measures be explored.

11.4. One suggestion to this end has been the adoption, in place of the individual as the unit of taxation, of a family unit which could be comprised of a husband and wife or husband, wife and children. For the reasons given in Chapter 10, the Committee has rejected the compulsory aggregation of family incomes; and in the present context it would not attain its objective where children had reached a given age and in circumstances where the income distribution was effected to children who had ceased to reside in the household of their parents. This chapter proceeds on the footing that any proposal for a family unit basis of taxing income is not being implemented.




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11.5. In some other countries, legislation has been enacted for the purpose, amongst other things, of preventing income-splitting. These are sections framed in such extremely wide and general terms and in language so vague and imprecise that interpretation becomes very difficult. This inevitably leads to inconsistency in their application, with the consequence that liability to taxation becomes to a great degree uncertain and causes dissatisfaction to both the taxpayers and the administration. It has been well said that in fiscal legislation, when the choice lies between general provisions and provisions identifying with precision the kind of transaction which is to be struck at and prescribing with corresponding precision the consequences which are to follow, the second course ought to be chosen. The Committee rejects the adoption of general legislation of the type referred to. In so far as it is possible to do so, it prefers to deal with the different areas in which income-splitting is practised by less sweeping means.

11.6. It is, however, not always possible to enact legislation to cope with tax avoidance in language that fulfils the ideals of simplicity and precision. Firstly, most provisions of a taxation statute have an application to so many sets of circumstances of infinite variety that to attain an adequate coverage of all of them necessitates the employment of wording that is correspondingly extensive. Secondly, the ingenuity and complexity of the procedures to be found in the many and varied schemes of tax avoidance compel the use of measures that are sufficiently wide to counter them, and precision usually sits uncomfortably with width of expression. Thirdly, it must also be recognised that in framing legislation sufficiently all-embracing to deter tax avoidance, there is always the danger of penalising those who have a genuine reason for entering into a bona fide transaction which, if carried out by others, has the objective that ought to be prevented. There is frequently such a very fine line to be drawn between the transaction which offends and the one which merits no condemnation that clear definition in statutory terms cannot always be satisfactorily achieved. In some instances recourse must be had to an administrative discretion as the only practical instrument available to obviate an unjust result. To set forth in detail in the statute all the circumstances and factors that would regulate the discretion's exercise is clearly out of the question. Some guidelines there may be but, as with a judicial discretion, to confine it within rigid limits is in effect to destroy the discretion and to legislate in its place for a number of particular cases the full complement of which could never possibly be foreseen. The safeguard against error in the exercise of the discretion lies in the availability of a satisfactory procedure for its review.

11.7. Before proceeding to discuss the various procedures by which income-splitting may be effected, it is convenient to point out that all transactions between family relatives do not fall within that description. Some may be voluntarily and reasonably entered into in response to a legal or moral obligation and others may be executed in compliance with a Court order. Others again may result from the desire to carry into effect a mutual enterprise or dealing which by its very terms is stamped as genuine and free from criticism as an income-splitting device. The last-mentioned serves to emphasise the importance of what the law describes as ‘valuable consideration’, which for present purposes may be said to be the value received by a person in return for parting with some part of his income to another. Valuable consideration may consist of money or money's worth. For example, if a husband were to take his wife into partnership and the income she receives from the partnership is truly commensurate with the services she renders, or if one relative purchases from another some income-producing asset at a price reflecting its true value, no question of income-splitting arises, since such transactions or others like them are entered into on the same basis as


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strangers, acting at arm's length, would do. On the other hand, there are those arrangements between relatives under which income arising from the employment of assets owned by one person, or from the exercise by that person of personal skills or business ability, is established wholly or in part as the income of a relative: in reality there is a gift of this income. There are also those cases—inter-family gifts of capital—where assets producing income are the subject of transfer between relatives without adequate valuable consideration.

11.8. In general the Committee has approached this question in terms of three principles. Firstly, minor children are in a special category and tax advantages that might otherwise flow from diversion of income to them should be denied, by taxing their income at a rate based on parental income. Secondly, husband and wife are a category of relatives requiring special consideration separately from other relatives. But while income arising from arrangements resulting in gifts of income, as referred to in the preceding paragraph, should be assessed at a rate of tax based on notionally aggregated incomes, the Committee, on balance, considers that income arising from gifts of capital between spouses should be assessed in the normal way to the spouse actually deriving the income. And thirdly, there should be denial of income-splitting advantages under arrangements resulting in gifts of income in the case of other relatives; in these cases, however, as with husbands and wives, there should be no assessment on a notionally aggregated basis of income arising from gifts of capital. These matters are considered in more detail in the following paragraphs. The position in relation to minors is first examined; various means of income-splitting between spouses and with other relatives are then dealt with under several headings.

Income-splitting and Minor Children

11.9. It would be possible to deal with income-splitting between parents and minor children, i.e. children under 18 years of age, in much the same fashion as is being proposed in relation to income-splitting between other relatives. In the Committee's view, however, it is appropriate that their incomes should in general be taxed at rates that take account of the amount of income of their parents. It is proposed therefore that the unearned income of a minor child be taxed at a rate determined by notionally adding his income to the income of the parent with the higher income. The income thus notionally added would, for the purpose of ascertaining the tax on it, be regarded as the top slice of the parent's income with the amount added. Where there is more than one child involved, the total income of the children would be added for this purpose and the resulting additional tax then spread amongst the respective children on the basis of their incomes.

11.10. As a method of dealing with income-splitting, the proposal would have a wider application than measures specifically directed to that end would be likely to have. Thus unearned income of a minor child derived under a trust established by the will of a deceased grandfather would be taxed by reference to the amount of his parent's income.

11.11. The existing provisions of the Act (section 102 (1) (b)) relating to a trust created by a parent for his minor children would be unnecessary. Those provisions have, in any event, been shown to be defective in a number of respects. It seems that they have no application where the trust is created by some person other than the parent and the parent later vests assets in the trust. They are defective, too, in not requiring that amounts under all such trusts for the same minor child, and incomes under trusts for several minor children, be added in one calculation to the income of the parent in order to determine the rate of tax to be applied to the amounts.




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11.12. A number of detailed aspects of the Committee's proposal require consideration. The Committee has, in framing what follows, derived assistance from the model of the provisions of the United Kingdom Income Tax Act relating to ‘Aggregation of Income—Parent and Child’.

11.13. The system should apply only to income of a minor child who is unmarried and is not working in some occupation in an arm's length arrangement. The system is based on a view that it is appropriate to determine the ability of a child to pay tax on his income, by reference to the ability to pay tax of those on whom he normally depends for support.

11.14. The system will not apply to arm's length earned income derived by a minor child, since this would operate as a disincentive to work effort. But it should apply to earned income from transactions not at arm's length. For the purposes of the operation of the system, the latter income should be treated as income from property (or investment income). A minimum amount of such income might be specified which would not be taxed under the system. The purpose of this exclusion would be to limit compliance and administrative costs.

11.15. The United Kingdom legislation makes an exception of income derived from the investment of compensation for personal injuries and some similar amounts. The Committee considers that a similar exception should be adopted in Australia. There should also be provisions excluding the operation of the system when the child has a disability and is resident in an institution. There may be a case for other exclusions, for example where some grave and permanent incapacity is involved calling for special care for the child. The Committee would propose a general provision giving the Commissioner a discretion to relieve income from the operation of the system where he is of opinion that to tax the income at the parent's rate would cause unreasonable hardship.

Income from Gifts of Capital

11.16. There are difficulties in the way of dealing with income-splitting in the area of gifts. Where one person becomes the legal owner of an asset as the result of a gift from another, that asset may be income producing, may be incapable of producing income, or may not have been producing income when given but is capable of producing income when put to another use. Subject to such exemption or reliefs as the gift duty legislation may allow, gift duty will be payable on the capital value of the asset. Its value may be reflected in the income it produces or is capable of producing. If the subject-matter of the gift is cash, its value for gift duty purposes will be the amount given. But a gift of cash may not have effected any split of the donor's income: it may have been paid out of a credit balance in the donor's bank account. On the other hand, the donor may have sold an income-producing asset (a parcel of shares) or an asset not producing income (his own residence) or one not capable of producing income (jewellery) in order to obtain the cash to give. Ordinarily, in the latter two cases, there would again be no split of the donor's income. These are some only of the aspects of a gift when looked at in the hands of the donor and before he parts with it to a donee.

11.17. The asset when transferred into the possession and ownership of the donee may in turn be given to a third party, sold for a price above or below its value, mortgaged, exchanged, consumed, rendered non-income yielding or made to yield an income greater or less than that obtained by the donor when it was his property. The form and character of the asset may be materially changed by the labor of the donee


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himself or by the expenditure of his own moneys. By that expenditure the donee may have effected a reduction of his own income. It is unnecessary to list further illustrations. Enough has been said to indicate that the form, character and value of the subject-matter of the gift in the ownership of the donee in a great many instances will be markedly different to the features it exhibited in the ownership of the donor. More importantly, there is no necessary correspondence between either the income-producing qualities of the asset or the income it in fact produces in the ownership of the donor and donee.

11.18. If the donor owns a valuable work of art from which he derives only his own personal enjoyment and makes it the subject of a gift, it would not be a practical course to impute an income to the donor or the donee for the purpose of exacting an income tax from the donee, as the pleasure obtained from its ownership will vary with the personality of the owner and the use to which he puts it. In the genuine case of a gift of non-income-producing assets there is no income splitting by the donor. If the donee converts such assets into income-producing investments or sells them and invests the proceeds so as to produce an income, in either case the net income proceeds will normally be taxed in the usual way by taking into account the deductions allowable in respect of the production of that income.

11.19. The outright gift of income-producing property which confers upon the donee as its absolute owner the unfettered right to do with it as he wishes presents problems which are difficult to resolve in a manner that is both practical and equitable. If the donor splits his income by giving to the donee an income-producing asset, its income proceeds, whilst the asset remains intact in the donee's hands in the form given to him, could be identified and taxed at a rate equal to the rate of tax that would have been payable by the donor had those proceeds been included in his assessable income. The same objective of income-splitting could be achieved if the donor were to realise an income-producing asset and give the cash proceeds, or a non-income-producing asset aquired with those proceeds, to the donee who thereupon invested the cash proceeds, or the proceeds of the realisation of the asset gifted, in an asset that produced income for him. Whatever course be pursued, the subject-matter of the gift—the asset in specie or the cash—will have borne its appropriate gift duty. Difficulties for income taxation are to be met with in each case. For example, the donee may realise the income-producing or the non-income-producing asset given to him in specie and out of the net proceeds now mixed with his own funds in his bank account may take another investment, or by his own exertions or expenditures the donee may alter the income characteristics of the asset he has retained. Similar problems can be envisaged where the gift takes the form of the cash proceeds.

11.20. In those circumstances the onus should, perhaps, rest on the donee to satisfy the Commissioner either that there is no income derived by him which is attributable to the subject-matter of the gift or that, of the income he does derive from an investment constituted in part by his own funds and in part either by the proceeds of the realisation of the asset originally given or the gift in the form of the cash proceeds, so much is attributable to the subject-matter of the gift to be taxed as if it were the income of the donor, and so much is attributable to his own labours or expenditures.

11.21. A statutory alternative would be to adopt as the income of the donee attributable to the gift an amount determined by applying a rate per cent, say a rate equal to the ruling bank overdraft rate, to the amount of the gift or to some part of it that could reasonably be regarded as producing income. This alternative would be available for adoption by the donee where he found major difficulties in determining the income


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actually attributable to the gift or by the Commissioner where he is not satisfied with the basis of determination of a lower figure put forward by the donee.

11.22. The view might be taken that, despite the difficulties outlined above, there should be a notional aggregation of the income, arising to a donee from capital transferred by way of gift, with the income of the donor for assessment of tax. This view could enlist greater support where the donor and donee are husband and wife, because such transfers commonly have saving of income tax as their objective and because in practice some married couples pool their incomes for joint spending. These aspects are considered in more detail in Chapter 10 dealing with the taxing of family units.

11.23. An alternative view is that where a gift of capital has been made by one person to another, including a gift between married couples, the Revenue should be satisfied by payment of any gift duty liability; and income arising from the gift, in the hands of the donee, should be taxed to the donee in the normal way. This view is supported on the grounds of the major difficulties, to both taxpayers and the Commissioner, in satisfactorily identifying, in the hands of the donee, the capital constituting the gift and the income flowing from it, referred to earlier in paragraph 11.19. These difficulties would increase with the passing of time subsequent to the making of the gift and the need to identify further income arising from the investment of earlier income produced by the capital the subject of the gift.

11.24. The Committee, on balance, favours the latter view and accordingly recommends that income derived by a donee from capital received as a gift should in all cases be assessed to income tax in the hands of the donee in the normal manner.

Partnerships, Inter Vivos Trusts and Arrangements Achieving Similar Income-sharing Results

11.25. Under this heading the Committee considers in some detail income-sharing between relatives by means of a partnership, puts forward proposals for denial of tax advantages from income-splitting by this means, and then goes on to apply the principle of those proposals to trusts and other arrangements achieving generally similar income-sharing results. The other arrangements include those under which a business may be in the ownership of one or more persons but the operational skills, work effort and capital are supplied or in part supplied by a relative of the owner or owners in a manner which is not at arm's length; the ownership of income-producing assets is vested in one or more persons and the financing of the purchase has been by interest-free loans by a relative; and substantial property is leased to a relative, at a token rent, to enable the relative to derive the substantial rents from the sub-lessees.

11.26. In considering these income-sharing arrangements, it is necessary to have in mind that the Committee in Chapter 15 recommends a basis of assessment of income of an inter vivos trust to which no beneficiary is presently entitled. Attention here can thus be confined to the taxation treatment of income flowing from such a trust to a beneficiary in circumstances where the beneficiary is assessable on that income. It is also necessary to have in mind the recommendation earlier in this chapter that income of unmarried minors should be assessed at a rate based on parental income, and the recommendation that income arising from assets transferred between married couples, and others, by way of gift should be taxed to the donee in the normal manner.

11.27. As in most taxation systems, the partnership in Australia, though required to make a return, is not taxed as a single entity (section 91). As set out in more detail in


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Chapter 15, the partners themselves are taxed in separate assessments and their assessable incomes include their individual interests in the net income of the partnership (section 92). The only measure directed against income-splitting by the use of a partnership is section 94. That section provides that a partner who does not have the real and effective control and disposal of his share of the partnership income is taxed, unless the Commissioner by reason of special circumstances is of the opinion that it would be unreasonable, at a rate of not less than 50 per cent on that share of income (section 94). For this purpose a direct or indirect share of partnership income of a taxpayer under 16 years of age, as reduced by any amount genuinely attributable to remuneration for services rendered, is uncontrolled partnership income.

11.28. The Ferguson Commission (1932-34) recommended that the administration should not be concerned with the purpose for which a partnership is formed or with the relationship of the partners. The only test to be applied ought to be whether the partnership is bona fide or fictitious, and the partnership should be regarded as bona fide if each partner is the real owner of his share of the capital and profits of the partnership. In many instances, the result in practice of such a test is that the mere production of a partnership agreement meets the test and in almost any occupation provides a partner, frequently a wife or child, regardless of qualifications and despite the performance of services of a very minor nature, with a legal entitlement to a substantial share of the partnership profits. The test propounded by the Ferguson Commission is satisfied and the partners are taxed in accordance with section 92, but the reality of the situation is that the income of the effective owner and operator of the business or profession is split.

11.29. With the greatest respect to the Ferguson Commission, the Committee is unable to agree with its recommendation. The taxation treatment of a family partnership should not depend simply on the existence of a document which, as a matter of form, satisfies the requirements of the law of partnership but which readily presents itself as a vehicle for income-splitting by distributing the profits in arbitrarily determined proportions to relatives whose services (if any) in the partnership activities and/or whose capital or property contributions are not commensurate with the remuneration or share of profits received. The privacy attaching to an inter-familial contract is of itself sufficient to cast an onus upon relatives of displacing the possibility that the transaction they have entered upon is the product of a tax avoidance scheme. This is in keeping with the well-established principle that, where the relevant facts are solely within the keeping of one party, very little is required to change the onus relating to their disclosure. The fact that the partnership comprises family members requires that disclosure. The Commissioner is entitled to be made aware of the whole of the facts surrounding the formation of the partnership.

11.30. The whole of these facts are not necessarily established by the partnership agreement itself. Also relevant are the facts relating to the operation and control of the business, the manner in which its capital and property have been provided, and the relationship between the services performed and the capital and property provided by each of the partners and the remuneration each receives by way of salary and profit-sharing. Neither section 161 (1) of the Act nor Regulations 13 and 14 are sufficient in this regard. The Commissioner should be supplied, in a form accompanying the return of partnership income for the relevant year, with the appropriate information to enable him to be satisfied that the partnership is bona fide and that the individual interests of each partner in the partnership income, when measured in relation to his business or professional activities in the partnership and his provision of


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capital and property, are such as would reasonably be determined upon in all the circumstances by parties acting at arm's length. If the Commissioner was not so satisfied as to the share of any partner or some part thereof, that share or that part of the share should be taxed at a deterrent rate. Where an assessment was objected to, the issue for determination on appeal would not simply be, as it is at present, whether a partnership existed but whether the distribution of its income to each of its members was genuinely commensurate with their contributions of capital and property and their services to the partnership or whether the partnership agreement was merely a cloak for tax avoidance. The bona fide partnership would have no difficulty in resolving this issue in its favour. However, if the reality of the situation were otherwise, it should be apparent that the partners would be faced with the difficulty of proving the truth of the statements accompanying the return of income as to their respective roles and activities and their provision of capital and property in order to discharge the onus that lies upon them to displace the assessment. For this purpose the provision of capital and property to a partnership would not only include funds and assets overtly contributed as partnership capital. It would also extend to property, including loan moneys made available for use in the partnership business without recompense or on favourable terms, and any other benefit given or granted to the partnership by one or more partners but not by all partners according to their shares, such as land, livestock, plant, goodwill, etc. owned by one partner but used by the partnership without realistic recompense.

11.31. The determination of the amount of any share of partnership income to be taxed at a deterrent rate in accordance with what is set out above should also apply as the base figure for determining any liability to gift duty. Paragraphs 24.A54-24.A64 and 24.A67 deal with these questions for gift duty purposes. Thus, where in an equal partnership between a husband and his wife deriving income of $15,000 the Commissioner determines that $5,000 of the $7,500 allocated share of the wife is to be subject to a deterrent rate, that figure of $5,000 would be the base figure for gift duty purposes. As stated in paragraph 24.A105, that amount less the income tax payable on it would be treated as a gift.

11.32. Inter vivos trusts—trusts created by the creator or settlor of the trust during his lifetime—are frequently resorted to by a taxpayer to bring about a sharing of income with those of his relatives who are beneficiaries. In fact it is true to say that an inter vivos trust, where the income of the trust is distributed to the beneficiaries and becomes assessable to tax in their hands, can achieve the same purpose and result as the family partnership considered above. In the view of the Committee, distributions of income from trusts of this kind should be accorded the same tax treatment as distributions from family partnerships. Thus the Commissioner would be required to examine the whole of the facts surrounding the setting up of the trust and its operation and control. This examination would disclose whether the shares of income as allocated to beneficiaries, when measured in relation to their beneficial interest in capital and property of the trust and their business and/or professional contributions to the production of the trust income, are such as would reasonably be determined upon in all the circumstances by parties acting at arm's length. To the extent that the Commissioner could not be so satisfied, income or a part of income distributed would be subject to a deterrent rate of tax.

11.33. In relation to the other arrangements achieving income-sharing mentioned in paragraph 11.25, the Committee recommends the same treatment as for partnerships and inter vivos trusts. Thus, in the case of a business owned by one person and conducted and financed by a relative, including a spouse, the Commissioner would be


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enabled, in effect, to treat the business as a partnership between the relatives involved. Where the incomes derived by each relative could not be supported on the arm's length tests set out previously, the deterrent rate of assessment would apply. The same results would follow where the ownership of assets or property and certain leasing arrangements have been established and operated on bases not in accord with the arm's length test.

Excessive Payments for Services or Benefits

11.34. A common method of income-splitting is the payment by one relative to another of sums for services rendered or in respect of some benefit received and the amount of the payment exceeds what would normally, in an arm's length transaction, be expected to be paid for those services or that benefit. Payments of this kind are encountered in the relationship of employer and employee, hire of equipment, rent of premises and interest on money lent. Partnerships and private companies are areas frequently used for this purpose. The relationship of the person performing the services or affording the benefit to the person making the payment would, if the quantum of the payment were reasonably commensurate with the nature of the services or benefit, be an irrelevant consideration and the payment would be an allowable deduction under section 51 of the Act as an outgoing in gaining or producing the assessable income of the relative making the payment. Section 65 of the Act provides that a payment to an ‘associated person’ or a liability incurred to make such a payment shall be allowable as a deduction only to the extent to which, in the opinion of the Commissioner, it is reasonable. Section 65, broadly speaking, defines an ‘associated person’ as including relatives (as defined in section 6 (1)) of a taxpayer, partnerships in which relatives are involved, and relatives of partners in a partnership making a payment, as well as members of a company and beneficiaries in a trust, and relatives of these people, where a company or a trust is a partner. Provisions are included in the section to cover the position of the recipient of a disallowed payment and also to cover an amount not allowable as a deduction in a partnership in which a private company is a partner. These are of some unavoidable complexity.

11.35. Section 109 of the Act is designed to prevent income-splitting by a private company where excessive payments are made or credited to persons who are or have been its shareholders or directors or their relatives for services rendered or by way of an allowance, gratuity or compensation upon retirement from or termination of office or employment. The amount allowable as a deduction shall not exceed an amount which, in the opinion of the Commissioner, is reasonable.

11.36. The Committee is of the opinion that the principles of sections 65 and 109 are to be supported but that, as they now stand, these sections are not sufficiently wide in their coverage. There are basically four types of taxation entities that need to be considered in the context of income-splitting by the means envisaged in sections 65 and 109: an individual taxpayer, a partnership, a trust estate and a private company. The Committee recommends that the principles of sections 65 and 109 should apply to all payments flowing from any one of these entities to another entity in such circumstances that the payment, or part of the payment, can enure directly or indirectly for the benefit of the payer or a member or director of the payer or for the benefit of a relative of such a payer or member or director of a payer. For this purpose a settlor or deemed settlor and a beneficiary of a trust estate are to be included in the term ‘member’ in relation to a trust estate of which they are a settlor, deemed settlor or beneficiary.




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Alienation of Income

11.37. Alienation of income for short periods is dealt with in Division 6A of Part III of the Act. Generally speaking, a taxpayer is legally entitled to transfer to another, through an inter vivos transaction, the right to receive income from assets owned by the taxpayer without transferring the property in those assets to that other person. Where a taxpayer makes such a transfer for a period of less than seven years, by section 102B, the income transferred will be included in his assessable income from other sources. Sections 434 to 436 of the United Kingdom Income and Corporation Taxes Act 1970 contain provisions with the same objective as Division 6A of the Act, but the period is six years in place of seven. Where family income-splitting is to be prohibited, there appears to be no reason why a much longer period could not be selected—indeed, any period which by the form of the alienation did not transgress the provisions of the general law.

Family Companies

11.38. The private company when it is controlled by relatives is one of the most fruitful fields for income-splitting. For the purposes of the Act, a private company is defined as a company that is not a public company (see sections 6 (1), 103A), and it is the company that falls into one of the various categories set forth in the statute which for income taxation purposes constitutes a public company. Not every company classified for income taxation purposes as a private company is used as a medium for tax avoidance. The private company of the ‘family company’ kind is the usual vehicle employed to attain that objective. Private companies that are not family companies may attract the provisions of section 109 (see paragraphs 11.35–11.36 above), but most frequently it is the private company controlled by relatives in which income-splitting is practised. A family company, in the present context, is a private company controlled directly or indirectly by relatives either by means of a preponderance of its shares or the voting rights attached to them or to classes of them or by means of any other rights conferred by the Articles of Association, whether the person to exercise those rights be a shareholder or simply the holder of some office in the company, or by agreement or covenant. The number of relatives who possess that control is irrelevant: the relevant fact is the control.

11.39. One type of transaction which may constitute an income-splitting device by means of a family company can be seen in the acquisition of shares by a relative of the family which (i) entitle the holder to a share in the distribution of the company's profits disproportionate to the amount of capital subscribed by him, or (ii) enable those in control of the company to declare dividends in respect of his shares without distributing dividends to other shareholders, or (iii) enable those in control to declare differential dividends to selected shareholders. By these means it becomes possible to regulate the income levels of the various relatives associated with the company in addition to those activities struck at by section 109. It is not necessary, of course, for shareholders in a family company to subscribe substantial sums by way of capital in order to be capable of exercising the contemplated control or to be in a position to benefit from its exercise. It is not uncommon for the proprietor of a prosperous unincorporated business to sell his business to a family company in exchange for shares of a class which, however numerous they may be, will not necessarily return to their owner a share of the company's profits bearing any realistic relation to the amount of capital represented by them. The bulk of the profits will be divided amongst relatives whose shareholdings are nominal, so that the moneys required to take up those shares can be provided by them out of their own funds or by some friend of the family. The variations in the schemes that have been adopted to secure the income-splitting objective


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are multiple and further description of them would serve no useful purpose. But they all have one characteristic feature. The transactions carried out between the relatives themselves and between them and the company, in conjunction with the structure of the company itself, constitute a ‘settlement’ or an ‘arrangement’ of their affairs which it would be impossible to say that business people acting at arm's length in the investment of their own funds and contemplating for that purpose a bona fide commercial transaction would enter upon.

11.40. Apart from definitions of the word for some special statutory purpose, generally speaking a ‘settlement’ may be said to be created by or consist of any transaction operating or contributing to effect a disposition of property, whether real or personal, by means of one or a number of instruments with the intention that the property, whatever its form, may be enjoyed by others. Where other persons join in the transaction at some point in order to benefit or to be capable of benefiting from the property, either in pursuance of some legally enforceable agreement or of some informal understanding with others (including a family company) engaged in the transaction the scheme regarded as a whole may be termed an ‘arrangement’ whereby the income to be derived from the property can be parcelled out amongst those designed to be its putative beneficiaries.

11.41. In the Committee's view, income-splitting by means of settlements or arrangements of this nature effected through the medium of family companies should be prevented. Where the Commissioner is of the opinion that any such settlement or arrangement was effected by means and created rights or obligations that business people acting at arm's length in a bona fide commercial transaction of that nature would not be likely to adopt, he should be enabled at his discretion to tax the dividend income paid or credited to any shareholder at a deterrent rate: for example, at a rate that would have been payable had such shareholder been paid or credited with all the profits distributed by way of dividend in the relevant year of income. Gift duty could also be involved in these cases. The amount determined as subject to the deterrent income tax rate would be the base for the levy of gift duty (see paragraphs 24.A70–24.A90).

Section 260

11.42. The parent of section 260 appears to be section 82 of the New Zealand Land and Income Tax Assessment Act 1900 which, apart from the addition in 1936 to the Australian section of the words ‘as against the Commissioner’ and certain other immaterial differences in wording, is the pattern of the Australian section. The counterpart of section 260 was section 108 of the New Zealand Land and Income Tax Act 1954 as amended by section 16 of the Land and Income Tax Amendment (No. 2) Act 1968. The New Zealand section 108 has been recently repealed and replaced by a section in very wide-reaching terms but is itself now intended to be the subject of further amendment. The present New Zealand section 108 would be susceptible to the type of criticism referred to in paragraph 11.5. Although in a shortened form to section 260, both that section and the former New Zealand section 108 have the same objective and both have been the subject of considerable judicial criticism and frequent differences of judicial opinion as to their application. As with the New Zealand section, the Revenue has endeavoured to apply section 260, sometimes successfully and sometimes unsuccessfully, to transactions where it has been contended that the feature of income-splitting is involved. The section has been interpreted as meaning that not every transaction having as one of its ingredients some tax-saving feature is caught by its provisions and that, if a bona fide business transaction can be carried


  ― 154 ―
through in one of two ways, one involving less liability to tax than the other, the section is not to be applied merely because the way involving less tax is chosen. For the section to have an application, it has been held, it must be able to be shown that it was implemented in that particular way so as to avoid tax; if the transaction is capable of explanation as an ordinary business or family dealing without necessarily being labelled as a means of avoiding tax, the section cannot be applied to the transaction. If tax avoidance is an inessential or incidential feature of the arrangements that may well serve to indicate that the arrangement cannot necessarily be described as a means of avoiding tax (see the various observations collected in Hollyock's Case note).

11.43. It cannot be denied that this test for the section's operation lacks precision and that in many instances there will be strongly opposing points of view as to the necessity of applying the label. Further, as it has been held that section 260 is an annihilating provision—that it operates to destroy but not to supply and contains no power to rectify a transaction or to substitute something new in its place—the consequences which may follow from its application also create many difficulties. A number of these problems are referred to in the dissenting judgments of Lord Donovan in Peate's Case note and Mangin's Case note. The section provides ample room for uncertainty and for dissatisfaction on the part of the Revenue and the taxpayer alike and has been said to be long overdue for reform.note

11.44. The Committee is of the opinion that the criticisms of section 260 to which reference has been made should be heeded and the section be amended to reflect the following principles. If any arrangement had or was calculated to result directly or indirectly in the type of tax advantage described in the lettered sub-clauses of the section, the Commissioner should have the right to disregard it for taxation purposes, unless the arrangement was an ordinary business transaction creating rights or obligations that would normally be created between business people dealing at arm's length in a transaction of the nature in question and effected by means normally employed in such a transaction, or was made in the ordinary course of making or changing an investment, or was a bona fide arrangement of a person's or a family's affairs, and the Commissioner was satisfied that the arrangement was not entered into solely or primarily for the purpose of obtaining the tax advantage or that one of its main objectives was to obtain the tax advantage. If the Commissioner did disregard the transaction, he should be empowered to assess any person deriving income under or consequent upon the arrangement to income tax at a deterrent rate: for example, at a rate equal to the maximum marginal rate or at a rate declared by Parliament for the purposes of the section. Where the Commissioner acted upon this section, he should supply any persons affected with his reasons for doing so. It should be made possible to obtain the Commissioner's ruling upon proposals for any such arrangement in order to prevent a transaction being irrevocably entered into with the consequences, amongst others, of expensive litigation. For this purpose the system of advance rulings by the Commissioner, proposed by the Committee in Chapter 22, would be available to taxpayers and their advisers.

Distributions of Income under a Legal Obligation

11.45. A husband has an obligation imposed under the general law to maintain his wife, and a father has a similar obligation in respect of his infant children. Such obligations are presently the subject of certain relief in the nature of concessional deductions from assessable income (see section 82B) and are discussed elsewhere in this report. No question of income-splitting arises in connection with payments made in discharge of these obligations. In certain circumstances a husband may transfer a right to receive income from property or income-producing property itself to his wife or to his former wife pursuant to the order of a Court, in which case the income would be taxable in the hands of the wife and would not be exempt income under section 23 (1). Section 102B (4) exempts the transfer by a husband or former husband of a right to receive income from property for the purpose of alimony or maintenance from the alienation of income provisions of section 102B, whether made in compliance with a Court order or not, and the income in question is not taxable as income of the husband. The Committee is of the opinion that, where the right to receive income or income-producing property is, by virtue of a Court order, transferred to a wife or former wife or to the children or to a trustee for her or the children, by the husband or father, the measures against income-splitting in this chapter should not apply.




  ― 155 ―

Distributions of Income under a Moral Obligation

11.46. Distributions of income under a moral obligation fall into two classes. Firstly, there are cases in which, without the intervention of a Court, the impact of a strong moral obligation will induce a person to make some enduring provision for a relative by the creation of a trust of some part of his income-producing property or by some kindred means. It is impossible to catalogue all the types of instances where particular circumstances may raise the need for the implementation of a transaction of this nature. It will for the present suffice to be reminded of those cases in which grave and permanent incapacity calls for some special institutional care upon a stable income basis. In the Committee's view, the Commissioner should have a discretion to relieve transactions of this class from the provisions of the Act which otherwise would be attracted to them where he is of the opinion that to impose them would create unreasonable hardship. Secondly, there are the transfers of income-producing property to charitable institutions. Such transfers to selected charitable institutions should not be categorised as income-splitting.

Retrospectivity

11.47. The provisions that have been suggested to overcome the problems for the Revenue of income-splitting have, of necessity, a wide application. If they are adopted, the consequences of their infringement will be, in many cases, to impose a heavy burden of taxation upon those who fall within their purview. For a long period of years there has been no legislation in the Australian taxation system comparable to what is now being proposed. Accordingly, taxpayers have been lawfully enabled and entitled to order their affairs so that the tax for which they become liable was less than it otherwise would have been. The arrangements they made and the documents they executed breached no provision of the law. A great many of these transactions have been long acted upon and the rights and obligations of third parties, who were not the instigators of these schemes, have been regulated and affected by them, and it would not be unreasonable to suppose that in a great many cases what has been done is irrevocable.

11.48. There is a well-established, fundamental and sound principle that legislation, especially fiscal legislation, should not have a retrospective operation. That which was


  ― 156 ―
lawfully done should not, after the completion of the act by which it was done, be made unlawful and subjected to a penalty. There is a strong presumption against retrospectivity because it manifestly shocks one's sense of justice.note It is, for example, because of this principle that section 437 (2) of the United Kingdom Income and Corporation Taxes Act 1970 is framed not to affect an irrevocable settlement made before 22 April 1936, which was the date when section 21 of the Finance Act 1936 came into operation and introduced for the first time provisions similar to those now appearing in the current legislation. In the opinion of the Committee, it will be proper, therefore, to safeguard any legislation that may be introduced on the lines discussed in this chapter from the vice of retrospectivity penalising any bona fide transaction where the rights and obligations of the parties are involved irrevocable.




  ― 157 ―

Reservation to Chapter 11: Income-Splitting

My reservations relate, in the first place, to the chapter's explanation of the principle that measures directed against transfers of income should serve. The descriptions given in the chapter of unacceptable ‘income-splitting’ transactions fail to identify any such principle except a notion that a course of action is ‘tax avoidance’, and therefore unacceptable, if it is undertaken solely or primarily for the purpose of reducing income tax liability. In my view such a notion is not a satisfactory explanation nor, where it is adopted as such, is it a workable test of the operation of measures intended to deal with transfers of income.

It is true that this notion is at the basis of the interpretation of section 260 of the Act. But, in that context, it has led to the development of a question-begging distinction between cases where a taxpayer is said to have a ‘choice’ to pursue a course of action which will reduce his tax and cases where he has not. And the drawing of an inference of purpose to reduce tax is unpredictable. A gift of property by a husband to his wife is as much open to the construction that he has moved by love for her as it is open to the construction that it was done to reduce tax on the income produced by the property given.

A principle requiring the defeat of a transfer of income to a person, most likely a spouse, who may be expected to share the enjoyment of the income with the transferor may have some merit as the basis of measures directed against transfers of income, though the appropriate measures would, of course, have a significantly narrower operation than those proposed by the Committee. This principle might be seen as some expression of the philosophy of family unit taxation discussed in Chapter 10. It would be said that the transferor's ability to pay tax should be determined not only by reference to income he himself has derived, but also by reference to income derived by others who may be expected to share that income with him. The income transferred should be taxed to him or taxed at a rate determined by reference to his income.

Clearly the expression given to the family unit philosophy by the principle would be very limited. That philosophy assumes that the ability of an individual to pay tax should reflect not only the benefits he may expect from the expenditure of income by others, but also the benefits he confers on others by sharing his income with them. It requires an aggregation of the incomes of those who share expenditures, and the taxing of that aggregated income at a rate which reflects the fact that the aggregated income supports more than one individual. And the principle would apply only when the shared income had been the subject of transfer. The principle cannot give effect to the philosophy where the shared income enjoyed by one spouse is income derived from property which the other has inherited from a third party.

Moreover, there are very significant practical limitations on how far measures giving effect to the principle can go. Any attempt, otherwise than by the most arbitrary rules, to identify as income transferred income which flows from the investment of money transferred or from property transferred is clearly an impossible undertaking. There may have been movements of money and other property, sometimes in both directions, between husband and wife over a period of years and dealings with that money or other property.




  ― 158 ―

The imperfections and inadequacies of measures against transfers of income as an expression of family unit philosophy suggest that what is really called for is the explicit application of family unit taxation. The Committee has rejected compulsory family unit taxation. I appreciate that it is unlikely to be politically acceptable, though those who would reject it on the ground that it denigrates the status of women curiously assert, at the same time, that a widow should be treated as having been an equal partner in the acquisition of assets which her husband owned at his death. An elective system of family unit taxation could not, however, be said to denigrate the status of women, and it ought to be politically feasible. It should not be too costly to Revenue, nor would it be unfair to unmarried individuals, if the rate structure were carefully framed to offer a limited advantage, over a lifetime, to most married couples, compared with the lifetime operation of individual unit taxation.

An elective system of family unit taxation would not make measures against transfers of income between husband and wife wholly inappropriate, but it would then be possible to give a satisfactory explanation of the limited measures which practical considerations would allow. Husband and wife who did not elect would be taken to have asserted that family unit philosophy had no application to them because the financial affairs of each were wholly separate from the other's. Transfers of current income made without consideration between husband and wife contradict the assertion of separateness and those who have not elected family unit taxation should not be allowed by such transfers to gain a tax advantage over those who have. The possible tax advantage that they could gain would, in any event, be significantly less than they could gain under an exclusively individual unit system. Put in another way, elective family unit taxation gives some of the advantages to be gained by transfers of income but gives it to all those who elect, whether or not there are techniques of transfer of income open to them.

I accept that, so long as family unit taxation is not applied, or is not available on an elective basis, what can be done should be done to prevent an individual gaining a tax advantage by transferring income in whose enjoyment he continues to share. The opportunities to transfer income which property law and the tests of derivation in tax law afford are unevenly distributed between taxpayers. They are readily available to taxpayers in business and to taxpayers who have substantial property incomes but not to wage and salary earners. Nonetheless, my acceptance of measures to defeat transfers is tempered by the fact that the divisions of income between husband and wife which occur as a result of the good fortune of inheritance or gifts from third parties continue to give tax advantages. It is tempered too by the fact that defeat of the principal technique of transfer of income—outright gift of capital—is beyond the limits of effective legal action.

Having regard to my understanding of their function and what I consider to be administratively feasible, the measures against transfers of income which I think appropriate will have a narrower operation than those proposed by the Committee. The measures would be limited to transfers of income between husband and wife. There are other cases, it is true, where a person who transfers income may be expected to share in the expenditure of the income transferred: a son may transfer income to his aged parent who lives with him. But these other cases are not a serious threat to the equity of the tax system. The measures would not attempt to deal with the income flowing from the investment of money or from other property which has been the subject of an outright transfer. The problems involved are quite unmanageable even if the attempt is confined to income flowing from capital transfers. And there is no


  ― 159 ―
reason in logic why the attempt should not extend to income flowing from the investment of income currently transferred, for example, through a partnership.

The measures should be limited to transfers of income made without full consideration. Where full consideration is given for a transfer there will be an offsetting transfer of income which cannot fairly be ignored, though, in the interests of administrative feasibility, an offsetting transfer involved in a less than full consideration will have to be ignored. Division 6A of Part III, referred to in paragraph 11.37, in its present terms, applies to transfers of income whether or not consideration has been given. I think that its operation should be qualified so that it applies only when there is a transfer for less than full consideration. I would, in any case, limit its operation to transfers of income between husband and wife. The principle expressed in Division 6A is not easily discovered. It applies notwithstanding that there has been a transfer for full consideration, whether or not the transfer was between persons who share the enjoyment of income and whatever might be thought to have been the purpose of the transfer.

I have a number of reservations in regard to the detail of the measures proposed by the Committee. The proposals are not fully integrated, as I think they should be, with the proposals in Appendix A to Chapter 24 as to the operation of gift duty in relation to gifts of income. The references to taxing income transferred at ‘a deterrent rate’, for example in paragraph 11.30, seem to me to be inappropriate. The income transferred should either be taxed to the transferor as if it were his income, or, preferably, be taxed to the transferee at a rate determined by reference to a notional addition to the income of the transferor.

The assumption in paragraphs 11.34–11.36 that sections 65 and 109 are designed to prevent ‘income-splitting’ seems to me to be open to question. While they will in some circumstances defeat transfers of income, their basic purpose is to deny deductions in respect of payments which are not in fact made in the deriving of income. Without such measures tax might be imposed on an amount less than the true net income of a business and, to this extent, income might escape tax altogether. I agree that there is need for such measures and that they should have a wider operation than they have at present.

The proposals made in paragraphs 11.42–11.44 in regard to section 260 do not have my support. I do not agree that they will overcome the uncertainty and dissatisfaction associated with the operation of the section. The proposed express exclusions of ordinary business transactions and bona fide arrangements of a family's affairs have already been written into the section by judicial interpretation. And the Commissioner's proposed powers to tax any person deriving income consequent upon the arrangement at ‘a deterrent rate’, are too wide. In any case it is my view that section 260 has no place in the Act. Any general provision directed against courses of action described only as ‘tax avoidance’ involves an abdication of Parliament's responsibility to formulate and inform the taxpayer of the principles intended to be expressed in the tax law.

I concur in the proposal to tax the unearned income of a minor child at a rate determined by reference to his parent's incomes. I think it should be made explicit that this is an adoption of the philosophy of family unit taxation. The child's ability to pay tax on his income reflects the fact that he shares in the expenditure of the income of those on whom he is dependent for support. However, as an expression of that philosophy, the proposal in paragraph 11.9, in my opinion, goes too far. It is not appropriate to tax the income of a minor child at a rate which takes account not only of


  ― 160 ―
the incomes of his parents but also the incomes of other minor children of the same parents.

R. W. Parsons




  ― 161 ―

Reservation to Chapter 11: Income Splitting

While I am in full agreement with the need to strengthen the income tax law to reduce the loss of revenue from income splitting, I have a number of reservations on the proposals set out in Chapter 11.

I concur with the view of Professor Parsons that the proposals in this chapter are not adequately integrated with the proposals in appendix A to Chapter 24 as to the operation of gift duty in relation to gifts of income. As paragraph 11.1 states, income splitting devices invariably involve the distribution of income to a person who has not provided an adequate consideration for the amount received. The appendix to Chapter 24 contains detailed procedures for identifying and quantifying gifts of this type together with proposals that such gifts should be brought within the ambit of the proposed integrated estate and gift duty. The principal objective of Chapter 11 should be to suggest clear and certain provisions for the method to be followed in taxing income which has been identified as a gift by the operation of provisions which match those proposed in relation to the estate and gift duty.

I support the proposal in paragraph 11.9 that the unearned income of a minor child should be taxed at a rate determined by reference to his parents’ income. However I concur with the reservation of Professor Parsons that it is not appropriate to tax such income of a minor child at a rate which takes to account not only the income of his parents but also the incomes of other minor children of the same parents.

I do not support the proposal made in various paragraphs of the chapter, that income identified as having been unreasonably diverted to others should be taxed at ‘a deterrent rate’. I concur with the view expressed by Professor Parsons that it is only income diverted to a spouse which need be subject to special taxing measures. In these cases, the tax payable should be such as would have been paid had the income in fact been received by the spouse who has made or is deemed to have made the gift. In cases of other than minor children and a spouse the diverted income should be taxed in the normal way and the sole deterrent to income splitting procedures should be the imposition of gift duty as proposed in Chapter 24.

I reject as impracticable the proposal in paragraph 11.32 that the allocation of income between the beneficiaries of a trust, other than a trust established by will, should fall to be reviewed by the Commissioner in the same way as is proposed in the chapter in respect of allocations of income by a family partnership. The tests proposed in paragraph 11.32 that the Commissioner should apply, such as beneficial interest in capital and property of the trust, business and professional contributions to the production of trust income and the arm's length concept have no place in a review of the distribution of trust income made by a trustee in accordance with the provisions of the trust document, particularly in the case of a discretionary trust. There may well be grounds for empowering the Commissioner to identify partnership income or income of a company flowing through a trust to a spouse to determine tax payable on this income but such a provision should be limited to these instances only. The Committee's proposals in relation to taxing of income of minor children, the imposition of tax at maximum marginal rates on income accumulated by a trustee and the widening of the base of estate and gift duty should adequately protect the Revenue in cases where trusts are used to spread or divert income.




  ― 162 ―

Finally, I do not support the proposed amendment to section 260 of the Act as proposed in paragraph 11.44. I believe it will increase the present uncertainty of the application of this section and is contrary to the Committee's view expressed in paragraph 11.5 of the chapter. I make no suggestion as to the action which should be taken to heed criticisms of this section of the Act as no acceptable proposal, in my view, has emerged from the Committee's researches and discussions in this area.

K. Wood

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