3.1 This chapter starts by setting out the background to the review. It then describes what R&D syndicate arrangements were and how they operated in simple terms. A brief history is given, outlining key events. The Inspector-General then sets out his conclusions and recommendation. The chapter concludes by signalling issues for review in the fourth report.
3.2 The Tax Office has taken a very long time to deal with this issue. There were many factors that contributed to the long timeframes. The Inspector-General's report does not aim to cover every contributing factor. It does not reproduce every issue that was raised with him, that was considered by him or that concerned him. Rather, the report focuses on key issues with the most potential for future tax administration improvements.
3.3 This case study is one part of a broader review. That broader review examines how the Tax Office handles major, complex issues. The reasons for the case studies arose from the Inspector-General's Review into the Length of Time to Complete Tax Office Active Compliance Activities. In that review the Inspector-General generally concluded that overall the Tax Office finalises audits within reasonable timeframes. However, the review also found that in some instances the Tax Office took far too long to finalise certain major, complex matters.
3.4 The aim is to identify systemic issues common to three case studies. These are the Tax Office's handling of living away from home allowances, service entities and R&D syndicate arrangements. A report will issue for each case study. A fourth report will bring together common issues and recommended action to address these common issues.
3.5 This case study identifies why the Tax Office took too long to come to grips with and satisfactorily resolve a major, complex issue — the Tax Office's compliance approach to syndicated R&D core technology claims. Many aspects of these audits have their roots in the early to mid-1990s. The Inspector-General acknowledges that we are applying today's standards with the benefit of hindsight. Although not obvious at the time, we can now assess the effect of certain approaches and decisions. This can be used to improve future tax administration approaches in major, complex issues.
What is the R&D tax concession and an R&D syndicate arrangement and how do they work?
R&D tax concession
3.6 The R&D tax concession was a major part of the then Government's late 1980s package of measures to encourage innovation in Australian companies. The aim of the concession was to attract investment into early-stage, high-risk R&D — an area where no market previously existed. Researchers were largely unsuccessful in accessing external funding for costly R&D projects. Financiers were discouraged by the significant technical and commercial risks. The tax concession offered a substantial tax benefit to investors to attract private funding of these projects.
3.7 From November 1987 to July 1996 syndicates could register to claim the R&D tax concession. Syndicates comprised two or more eligible companies jointly registered for the tax concession. They contracted out or undertook eligible R&D project(s). They claimed their proportion of R&D expenditures.
3.8 The concession was designed to encourage investment in R&D where it was either too big or too risky for one company. Initially, syndicates were required to expend a minimum of $1 million on the R&D project. This threshold was lowered to $500,000 in May 1994. Initially syndicates were required to involve financial institutions but this requirement was removed in mid-1991.
3.9 The tax concession provided a 150 per cent tax deduction for investments in 'fully at risk' syndicates. In these syndicates investors accepted the full balance sheet risks associated with the project. A 100 per cent deduction was given for investments in 'guaranteed syndicates'. In these syndicates investors could guarantee themselves a rate of return regardless of the technical or commercial success of the R&D work. This was done through the exercise of a 'put option'. Researchers would effectively 'buy the investor out' of the syndicate at a pre-agreed amount. A 1994 report of the Bureau of Industry Economics' (a predecessor to the Productivity Commission) review of R&D syndication commented that:
Notwithstanding its complex guise, the program is an officially sanctioned mechanism for financing new R&D through the sale of tax losses. (BIE report, 1994, page 8.)
3.10 The main form of syndication was the guaranteed syndicate. The Government accepted that financial institutions would not participate without a guaranteed return.
3.11 There were three phases in the life of a syndicate.
3.12 The first phase was the establishment phase. It comprised formation of the syndicate. A researcher with an R&D proposal and investor with start-up capital were brought together. The R&D and finance scheme was scrutinised by the Industry Research & Development Board (IRDB). The IRDB was assisted by the Tax Concession Committee (TCC) and AusIndustry in the Department of Industry, Tourism and Resources (and its predecessors). If all requirements were met, the syndicate was registered and eligible to claim the tax concession.
3.13 The second phase was the research phase. During this phase, R&D work was carried out over a period of 2-3 years. If the work was a technical success, a marketing company could be formed by the syndicate that would oversee the marketing of the product. The marketing of the product was the final phase.
3.14 The investor was obliged to consider whether to continue the arrangement. Where the investor decided to discontinue the arrangement it exercised a 'put option'. This resulted in the researcher buying the syndicate from the investors at a pre-agreed price. This usually occurred within 2-7 years.
3.15 Syndicates operated by effectively 'trading' researchers' tax losses in exchange for investors financing early-stage R&D work. The following is an extract from a Government report. It sets out a simple example of how a guaranteed syndicate works. It excludes the complications of interest payments, profit margins and other accretions. The ratios used in actual syndicates varied. Although this is an overly simplistic example it does give the sense of how R&D syndicates operated.
A research company wishes to conduct $2 million of R&D. A syndicate [comprising, in part, of a special purpose company] is formed with an investor (who effectively has a 100 per cent share in the syndicate). The investor injects $12 million of funds into the syndicate. $2 million is passed onto the researcher to undertake R&D, while a further $10 million is … paid to the researcher as a core technology licence fee. The terms of the agreement with the researcher stipulates that [if the investor exercises the put option] the researcher must … purchase the [special purpose company] at an agreed price at the end of a specific period. The agreed price, in this case, is the core technology value. The investor receives total deductions of $12 million x 0.33 (the tax rate [at the time]) = $3.96 million. Assuming that the investor [exercises the put option resulting in the researcher buying the special purpose company], then the investor receives back the $10 million originally injected, so that their overall return is $3.96 + $10 – $12 = $1.96 million.
The researcher receives $2 million of R&D, and gives up tax losses. The researcher has tax losses of more than $10 million. The core technology fee is assessable as income — and accordingly the researcher gives up $10 million of these losses, which, if immediately realisable, are worth $10 x 0.33 (the tax rate) = $3.3 million. No actual taxes are paid. (BIE 1994, pp 34-35) …
The 'price' of the core technology licence, and to a lesser extent, profit on the contracted R&D, are the major vehicles for enabling the [special purpose company] to transfer tax loss to the major financial investor [by virtue of section 80G of the ITAA 1936] and at the same time provide guaranteed returns on gross funds invested. The researcher … agreed to completely set aside the proceeds from the core technology licence and the R&D profit margin in a deposit account which accumulates interest and is ultimately used to provide security on funds invested by the [special purpose company] in the syndicate.
The researcher draws down the R&D funds provided by the syndicate in accordance with a predetermined schedule. These funds then meet the costs associated with the new R&D. Any interim interest earned on this account is also generally allocated to the deposit account to help meet the POP (put option). (BIE 1994, pages 37-38.)
3.16 One of the key factors in 'trading' tax losses is the core technology value. The following simplistic example assumes that the put option is exercised:
A 20 per cent increase in the core technology valuation, without a compensating increase in R&D funding, reduces the research firm's terms of trade and raises the rate of return to the investor. In order to buy the same amount of R&D, the researcher must give up more [tax] losses relative to the base case….
The research company depletes its tax losses as the core technology valuations increase because the core technology licence fees are taxable. The core technology income is set aside as security on the start up project finance, and is not available to the research firm for its own use. In this sense the core technology licence fees and the concomitant depletion of accumulated tax losses can be visualised as a way of financing new R&D … Viewed in this light [and assuming the amount paid in relation to the core technology is taxable in the researcher's hands], it is clear that the researcher has an interest in keeping the core technology valuation as low as possible (for a given amount of new R&D) so long as the investor is still willing to supply finance at the level of the core technology value that is chosen.
In contrast, the financial investor is able to [effectively] buy more tax deductions as a percentage of total capital outlay and augment the rate of return on funds invested if the value of core technology increases (for a given amount of new R&D). There is clearly a tension in valuation of core technology [assuming the core technology licence fees are taxable in the hands of the researcher] …
… in the case of tax exempt bodies the pressure to constrain core technology valuations vanishes as they are not relinquishing valuable tax losses when the core technology value rises. Such researchers may have an incentive to 'load' the core technology valuation to attract an investor. It is certainly true that core technology to R&D ratios are much higher for such tax exempt bodies. The concern that such exempt bodies could inflate core technologies to attract investors and crowd out private sector firms was, in part, the basis for which their eligibility for syndication was revoked. (BIE, 1994 pages 45 and 49.)
3.17 If a project was a technical success it could enter a marketing phase. A major proportion of proceeds would accrue to the researcher with a royalty paid to the syndicate. Investors would be paid royalties in proportion to their interests. These royalties reduced the price of the put option.
3.18 According to the Tax Office, all syndicates failed to be commercially successful. This was because no syndicate made returns which exceeded the total outlays on the core technology, associated interest and contracted R&D spend. There were some cases where the developed technology was commercially successful. But this was after investors had exercised the put option and the syndicate terminated.
3.19 Most syndicates were registered in the early to mid-1990s.
Registration process and scrutiny
3.20 Syndicates needed to be registered by the IRDB to claim the concession. There were three main stages.
3.21 Firstly, the IRDB decided whether the proposed activities were eligible. This included assessing whether the proposed activities would be 'R&D activities' under the law, whether the company claiming the concession was undertaking the proposed R&D activity on its own behalf and whether the proposed R&D activities contained an adequate level of Australian content. Syndicates could also request an optional determination of eligibility of the 'core technology'.
3.22 Secondly, the IRDB assessed whether the syndicate's proposed financial arrangements (the finance scheme) were 'not ineligible'. The IRDB accepted financial arrangements that included an attractive risk free-return to investors. This return flowed from the tax benefit and put option exercise. The put option exercise gave investors a minimum 'guaranteed' return. This was irrespective of the technical or commercial success of the project. Where the put option was not exercised, the concession required the results of the R&D activity to be exploited on normal commercial terms and in a manner that was to benefit the Australian economy.
3.23 Thirdly, syndicates submitted the final syndicate registration details so that the IRDB could register the syndicate. Parties could claim the tax concession after the IRDB accepted the proposed syndicate and officially registered it.
3.24 The IRDB relied on the TCC's advice regarding syndicates' eligibility. The TCC scrutinised applications. It required full disclosure of all relevant information. This included the financial arrangements and their tax effect.
3.25 The IRDB made it clear that the Tax Office had sole power to make determinations in relation to tax law matters. This included determining compliance with the specific anti-avoidance provision, subsection 73B(31) of the Income Tax Assessment Act 1936 (ITAA 1936). However, core technology valuations were still considered in the context of registration. The IRDB sometimes rejected valuations.
3.26 All investors obtained advance opinions and private binding rulings from the Tax Office before entering syndicates. Many applications asked for binding advice on the core technology valuation and the anti-avoidance provisions. The Tax Office refused in almost all cases to give this advice. The Tax Office considers that the law prevented it from giving private binding rulings on matters of fact, such as valuations (please note: the law has since been amended to allow the Tax Office to provide private binding rulings on matters of fact). It also did not rule on the anti-avoidance provisions. The Tax Office claimed it depended on the future implementation of the arrangement.
3.27 The IRDB could de-register syndicates in certain cases. This included cases where the syndicate did not implement the arrangements as set out in the registration application.
3.28 Over the life of the concession 246 syndicates were registered. Their investors claimed a total of around $3.7 billion in tax deductions. This included around $2.1 billion of claimed core technology expenditure.
Core technology and valuations
3.29 'Core technology' was essentially novel and unique intellectual property. It was not sufficiently developed to be commercially valuable. There was no established market for that technology. Therefore valuations or prices paid could not be easily compared.
3.30 During the early 1990s, the Australian valuation profession was in its infancy in dealing with unique and novel intellectual property. Accountants and valuers were used to estimate values. However, valuations were a time consuming and costly process. In some cases, costs ranged from $60,000 to $100,000. Expertise was difficult to locate as knowledge was needed of the relevant markets. It also took time to give an opinion of the reasonable value, particularly from overseas experts. Due to the short lead times for R&D work, that time was not always available. In any event, expert opinion did not prove the price that should be paid. Often, highly qualified experts gave significantly different values for the same core technology.
3.31 Generally, promoters and researchers arranged the core technology valuations. The valuations considered the researcher's assumptions and forecasts. Generally, investors relied on those valuations. In a few rare cases, investors also obtained their own valuation of the core technology.
3.32 At the time there were many different valuation methodologies to use.
3.33 The discounted cash flow methodology estimated the future cash flows of a project. It then applied discount rates reflecting, among other things, the level of risk, inflation and time value of money. It was based on a series of assumptions that could not be precisely verified. This gave an estimated range of values. Many experts considered the discounted cash flow methodology as the most appropriate for valuing core technologies.
3.34 Essentially, the discounted cash flow method valued the inherent value of the core technology itself. It ignored any contractual features particular to the contract, for example, the value of special negotiation rights, advance royalties and taxes payable. It also ignored any idiosyncratic factors that influenced the parties' bargaining position or special value the particular vendor or purchaser placed on the technology. Depending on the discount rates applied, the discounted cash flow method could result in negative values.
3.35 The historic cost method used the previous expenditure incurred by the researcher as a starting point.
3.36 A comparables analysis method considered the value of other similar products or enterprises in the market. It had regard to their operations and stage of development.
3.37 Other methodologies were used also.
The specific anti-avoidance provision, subsection 73B(31)
3.38 Subsection 73B(31) of the ITAA 1936 aims, among other matters, to address the risk of core technology overvaluation. It provides the Commissioner with the power to adjust claimed core technology expenditure.
3.39 Before the power can be exercised, the Commissioner must be satisfied of two things. Firstly, the Commissioner must be satisfied that the parties to the core technology were not dealing at arm's length in relation to the core technology expenditure. Secondly, the Commissioner must be satisfied that the amount of core technology expenditure would have been less if the parties had dealt with each other at arm's length in relation to the incurring of that expenditure.
3.40 If the Commissioner is satisfied of these two issues, he can adjust the claim to a reasonable amount, having regard to:
- the connection between the parties;
- the amount of the expenditure that would, in the opinion of the Commissioner, have been incurred if the parties had dealt with each other at arm's length in relation to the incurring of that expenditure; and
- such other matters as the Commissioner considered relevant.
Tax laws providing unlimited periods for review
3.41 Syndicates involved the transfer of losses from the special purpose company to the investor group. The core technology deduction, amongst other things, was claimed by the special purpose company. It returned a 'nil' assessment. The resulting losses were transferred under section 80G of the ITAA 1936 to other investor group members (loss transferee companies).
3.42 Most loss companies transferred the core technology loss in the same year as incurring that expense. All transferred it within two years. No syndicate incurred a core technology expense after 1996.
3.43 Under tax law, 'nil' assessments were not assessments for the purpose of determining time limits for periods of Tax Office review. Effectively, the Tax Office had no time limit to amend these assessments. The Tax Office relied upon these laws to deny loss companies' core technology deductions. The Tax Office then adjusted the losses transferred to the loss transferee companies. Subsection 80G(15) also permits adjustments at any time.
3.44 Treasury considered the unlimited periods for review in its 2004 Review of Aspects of Self Assessment (ROSA). Among other things it recommended that time limits be imposed for 'nil' assessments. The Tax Laws Amendment (Improvements to Self Assessment) Act 2005 gave effect, amongst others, to this recommendation.
3.45 In November 1987, law was enacted to permit syndicates to register and claim the R&D tax concession. This concession had a sunset clause and was due to expire in 1993. The first syndicate was registered in December 1989.
3.46 In May 1991, the Tax Office published a public ruling, IT 2635. It set out the Tax Office view on different R&D tax concession issues. The ruling accepted guaranteed returns where a syndicate was set up according to the structure set out in the ruling. In relation to core technology values, the ruling asked the reader to assume that there was no guaranteed return, that the price was not simply equated with an expert's valuation and that it reflected 'market realities'.
3.47 In December 1991, a specific anti-avoidance provision was inserted into the tax law — subsection 73B(31) of the ITAA 1936. Among other things, it effectively allowed the Commissioner to substitute a reasonable amount for claimed core technology expenditure. However, the Commissioner first needed to be satisfied that the parties were not dealing with each other at arm's length in relation to the core technology expenditure. He also needed to be satisfied that the expenditure would have been less if they had dealt with each other at arm's length.
3.48 In mid-July 1992, the Tax Office commenced its first audits of investments in syndicated R&D. These audits not only looked at potential core technology overvaluation but also included other syndication issues. By late 1992, the Tax Office's National Taxpayer Audit area considered syndicated R&D a substantial compliance issue. It recommended a national project.
3.49 In late 1992, the tax concession's sunset clause was removed. It could now operate indefinitely. Around this time, concerns with core technology overvaluation were raised by the TCC. The concession was changed to exclude public sector tax exempt researchers who had little commercial motivation to contain core technology values. In March 1993, the law introduced guidelines for determining finance schemes' eligibility. It gave the IRDB greater discretion.
3.50 From March 1993, the Government was:
concerned to exclude those schemes whose arrangements [were] primarily intended to achieve a guaranteed return for investors as opposed to returns generated as a result of commercialisation of R&D results.
3.51 In 1993, the Australian National Audit Office (ANAO) reviewed the concession's administration. In late 1993, it recommended that a sample of R&D syndicates involving suspected inflated core technology valuations be examined. By September 1994, the Tax Office started a project to audit R&D syndicates.
3.52 Also in late 1993, the TCC sought to cap core technology values. It changed the finance scheme requirements to limit core technology expenditure to around two-thirds of the syndicate's total expenditure.
3.53 The Tax Office had an observer on the TCC. From March 1994, this was the Tax Office's R&D syndication project manager. Part of his role was to manage the Tax Office's audits of R&D syndicates.
3.54 During 1994, the Bureau of Industry Economics (BIE) (a predecessor to the Productivity Commission) evaluated the syndicated R&D programme. It published its report in October 1994 (the BIE report). The report said that notwithstanding the problems with syndication, the programme should continue. This was because it generated 'significant net social benefits'. The report recommended that private tax exempt researchers be barred from the programme. This was because of concerns with inflated core technology values.
3.55 The BIE report discussed many issues. It questioned whether core technology valuations were a reliable means to ensure an arm's length value. It observed that many syndicates considered their valuations 'artificial'. Some 'simply estimated the most defensible valuation … treating it as a genuine valuation exercise'. The report asked the Tax Office and others to reduce uncertainty. Its first recommendation was that the Tax Office and others should clarify the treatment of core technology and financial structures. The Tax Office has never publicly responded to this report.
3.56 By this time the Tax Office had obtained an Australian Valuation Office (AVO) critique of a particular syndicate's valuation. It indicated that the values were inflated. It indicated further lines of inquiry to determine what parties dealing at arm's length would have paid for the core technology.
3.57 In early 1995, a senior tax counsel officer gave a speech at an R&D industry conference. The notes indicate a general talk on core technology pricing and that the Tax Office was still considering its response to the BIE report.
3.58 In late 1995, a former Commissioner of Taxation was appointed Chairman of the TCC. Following public consultation, the TCC issued new guidelines on the registration requirements for syndicates. The Guidelines imposed more stringent conditions. It was intended to 'eliminate potential syndicates using artificial structures'. The TCC began to scrutinise core technology valuations more closely.
3.59 In March 1996, the TCC Chairman gave a public speech at an industry conference. He said that core technology valuations provided a raft of issues. He referred to a widespread perception that valuations were 'substantially on the too high side'. He indicated the TCC had received 'unsustainable' valuations. He outlined five criteria by which the TCC would assess core technology valuations. He also said that the TCC was prepared to commission its own valuations if necessary. A Tax Office senior tax counsel also gave a speech at this conference. He referred to 'early indications of questionable valuations of core technology'.
3.60 At this time also the Government had changed. The Department of Industry, Technology and Regional Development commissioned the author of the BIE report to review syndication again. A report of that review was published in July 1996. It commented that 'like a chameleon, the program has continually changed in ways which favour the easy extraction of large tax deductions'. It recommended that the programme be terminated. The Government acted on this recommendation by closing off the concession to new applicants. Those applicants that had already received advance approvals were still able to access the concession. No case pursued by the Tax Office involved core technology claims made after 1997.
3.61 In one key audit that started in 1995, the Tax Office told the investor in mid-1996 that it had finished its inquiries. It was waiting on an AVO valuation and would then finalise the audit. That investor did not hear from the Tax Office again on this matter until mid-1999.
3.62 In September 1996, a Tax Office senior tax counsel gave a speech at an R&D industry conference. He said that notwithstanding the Government's decision, the Tax Office was continuing its audits of syndicates. He commented that Tax Office-engaged valuers supported the earlier views of serious overvaluation of core technology in the cases under review. He said that the Tax Office was close to issuing position papers in those cases. They would likely flag amendments based on non-arm's length transactions and possibly Part IVA.
3.63 In late 1997, the TCC Chairman gave a speech at an industry conference. He outlined the TCC's forward compliance approach. He commented that he suspected that quite of number of registered syndicates would not get approval from the TCC if they applied for registration today. He said that the TCC was working in close collaboration with the Tax Office. He referred to the Tax Office's 'review responsibilities' in connection with core technology valuations and Part IVA. He also said that a possible outcome of TCC and Tax Office reviews would be to disallow deductions. However, in early 1998, the TCC Chair announced that the TCC would not revoke registrations merely because the estimated projections did not come to fruition. However, it would seek to revoke registration for those cases where investors impeded the commercialisation of the developed technology.
3.64 In April 1998, the Tax Office obtained an external legal opinion in a syndicate case under audit. In relation to the specific anti-avoidance provision it advised the following:
- There was no one test to determine an arm's length dealing. The closest thing to a test was a judicial suggestion that the outcome of the dealing must be 'a matter of real bargaining'.
- The position paper in the audit did not identify matters supporting the Tax Office's conclusion of no arm's length dealing but the Case Manager's earlier internal report did. The Case Manager's reasons were that:
- there was documentation that suggested the investor was seeking to achieve deductions of an amount near that outlaid for the core technology licence before the researcher was even chosen;
- there was documentation to show that the core technology fee was pre-determined — the investor and packager had agreed on the core technology outlay and also applied for IRDB registration before the licensor had completed its valuation of the core technology;
- there was documentation to show that there was an absence of any real bargaining — the researcher had accepted an increase to the core technology licence by about a million dollars so as to incorporate the packager's fee;
- there was documentation to indicate that the researcher was
aware that [the investor's] primary concern was its high tax liability and not the commercialisation of research results. This could provide a basis for concluding that [the researcher] and [the investor] were not dealing at arm's length in relation to the core technology fee but were acting in collusion to achieve a reduction in [the investor's] tax liability. 'We are aware that the high profitability of the group of [the financial year in question] has given rise to a considerable taxable income and that this is the primary reason for the company considering entering research and development agreements with [the researcher].
- The 'matter of greatest significance' was the value of core technology opined in the AVO valuation:
The marked discrepancy between the two valuations seems to us to be at the centre of the issue as to whether the parties were dealing with each other at arm's length.
- It was surprising, in a commercial context, to find that a company outlaid millions of dollars for a licensing arrangement on reliance of a valuation provided by the licensor. However,
the preparedness of [the investors] to do so in the present circumstances is probably explained by the existence of the put option, which effectively eliminated any commercial risk on the part of [the investor] should the valuation prove inaccurate.
- Based on the assumption that the AVO valuation was correct, the Commissioner was entitled to be satisfied both that there was no arm's length dealing and that the value opined by the AVO was reasonable to be allowed as the amount incurred as core technology expenditure for the purposes of paragraph 73B(31)(d) of the ITAA 1936 on the basis of the matters referred to in the Case Manager's internal report above and the following conclusions:
- The investor outlaid tens of millions to acquire core technology rights which had a value of less than half a percent of the claimed amount.
- The investor never obtained a 'truly independent valuation'.
- The investor was assured of recovering the outlay for the core technology through the put option mechanism, which insulated the investor against any adverse commercial consequence flowing from the inaccuracy of the licensor's valuation.
- The legal advice stressed that it was assumed that the AVO valuations were correct. It noted that the AVO had no expertise in that field of technology and that there was need for further input from independent expert valuers before concluding a view in relation to subsection 73B(31). This was because the Commissioner needed to have a 'high degree of confidence' in the valuations relied upon to amend the assessments.
3.65 In April 1999, the Tax Office issued its first position papers to investors in one syndicate. Those papers did not provide adequate reasons for decisions to enable auditees to understand the Tax Office's case against them. They were also based on AVO valuations.
3.66 In August 1999, the Part IVA Panel considered one investor's core technology claim. It advised that the claim should be reduced to zero. This was on the basis of the specific anti-avoidance provision (subsection 73B(31)). It concluded that the core technology was grossly overvalued when compared to the AVO valuation (zero) and that both parties were aware of that fact. However, the Panel concluded that the case would not be so strong if the investor was not aware of the overvaluation.
3.67 Around this time, the Tax Office had also engaged expert valuers. Those experts opined that investors' valuations contained errors which would substantially inflate core technology values. Examples of these errors included no independent assessment of sales forecasts and inappropriate use of maximum royalty rates. They also advised that the valuations incorrectly had regard to the contractual features of the syndicate which were idiosyncratic to the way in which the syndicate was structured. They opined that core technology valuations should ignore the contractual features and any special value the particular vendor or purchaser placed on the technology. They opined that the valuation should value the core technology itself. Other matters which were generally thought not have a material effect on the value of the core technology licences were the historical costs and background of investors. This approach to valuing core technology led the experts to conclude that zero or negative values were appropriate.
3.68 In early 2000, the R&D syndication issue was escalated to one of the most senior tax officials. A 'hands on' approach was taken. A litigation strategy for the R&D syndication issue was developed. During this time, mediation was also discussed with an investor. File notes of that discussion record that senior tax officials did not see the point of mediating a case that did not establish principles that could be applied to other cases.
3.69 The Part IVA Panel met again in June 2000 to consider another three R&D syndicates involving the same investor. These syndicates involved tax exempt researchers. The syndicates were established before legislation excluded tax exempt researchers from registering for the programme. The Panel decided that Part IVA applied. This was because the 'excessive valuation was the primary indicator of non-arm's length dealing' and the arrangements had been entered before the valuation was done. The Panel said it had seen enough 'representative R&D schemes'.
3.70 By July 2000, there was significant internal Tax Office discussion at senior levels on designing an overarching resolution to the R&D syndication issue. At this time position papers in only two audits had issued. Investors repeatedly requested reasons for the Tax Office's decision. It was not until mid-2001 that the Tax Office first released a position paper that provided reasoning for its decision.
3.71 In late 2000, the Tax Office sent a report to the TCC. It said that 'there were limited options available to the Tax Office to compel termination of syndicates'. The report also said that the Tax Office was considering the option of legislative amendment.
3.72 In March 2001, senior tax officials met to decide the Tax Office's forward strategy. They decided to run a lead case litigation strategy to 'maximise leverage' for settlement. Many audits would be put on hold. Two of the more advanced cases were to be progressed to litigation. Mediation was not to be pursued at that point. A record of the discussions at this meeting shows that the Tax Office wanted a favourable court decision. This was so the Tax Office could:
be in a stronger position to achieve resolution on other cases on an acceptable basis to the Tax Office … A settlement basis acceptable to the Tax Office is unlikely to be able to be achieved until we strengthen our hand in this matter.
3.73 In March 2002, the Tax Office received external legal advice on a syndicate. It said that the Tax Office and the investors were 'misdirected' in their technical arguments. This was because the arguments were based on 'arm's length values' rather than the questions posed by the specific anti-avoidance provision, subsection 73B(31). It commented that the valuations the Tax Office had commissioned proceeded on a 'misconceived and erroneous basis'. This was because the valuations did not use an appropriate method to value experimental technology. Assessing the potential returns from the commercial exploitation of technology and applying reasonable risk-based discount rates would 'inevitably produce a present value of a negligible amount'. The adviser said that subsection 73B(31) required the Commissioner to have regard to 'what the actual syndicate members would, if dealing at arm's length, have paid'.
3.74 The advice also recommended valuation on a basis analogous to a comparables basis — an expert in venture capital investment would be in a better position to give an opinion 'rather than an accountant or a person with narrow expertise in intellectual property evaluation'.
3.75 It also opined that if the investors relied on expert advice, 'properly sought and reasonably assessed,' in determining the market value, then the Tax Office should not conclude that the price paid was excessive merely because the Tax Office had a valuation which differed in value to the investor's claim.
3.76 The Tax Office discounted this advice because large parts of it were contrary to the advice it had received to date that indicated close to zero or negative values. This included using a comparables method to value the contractual rights to the core technology (rather than a discounted cash flow method that valued the intrinsic value of the core technology itself) and focusing the arm's length dealing inquiry on the legal entity of the special purpose vehicle rather than the economic entity of the investor's group of companies. It also said that later that year the QC gave similar advice to another investor in another syndicate.
3.77 In August 2002, the Administrative Appeals Tribunal (the Tribunal) heard the case of Zoffanies Pty Ltd and Commissioner of Taxation  AATA Tribunal 758 (4 September 2002) (Zoffanies). The taxpayer applied to the Tribunal. It sought a merits review of the Commissioner's decision to apply the specific and general anti-avoidance provisions to deny its core technology and associated claims.
3.78 The Tribunal decided in the taxpayer's favour in relation to both the specific and general anti-avoidance provisions. It rejected the Tax Office's 'zero' valuations which were supported by overseas experts. It concluded that the parties' dealing over the relevant expenditure was at arm's length; they had applied their separate minds and wills in forming a bargain. It also found that the investor's valuer acted independently in preparing his valuation.
3.79 The Tribunal rejected the Tax Office's submission that there was persuasion and cooperation amounting to collusion between the parties. It also rejected the Tax Office's submission that indifference to the price indicated a lack of bargaining. The Tribunal also concluded that obtaining a tax benefit in connection with the scheme was undoubtedly an important purpose of the scheme. However, it concluded that it was not the dominant purpose. The dominant purpose was investment.
3.80 Although the outcome of the case did not turn on it, the Tribunal considered the approach to take in determining the amount under subparagraph 73B(31)(b)(ii) — the amount that parties would have expended if they were dealing at arm's length. It considered that with the benefit of hindsight:
it is easy to be critical after the event when what was then unknown is now known. In the context of what was no more than an estimate of value, care needs to be taken when substituting one valuer's opinion for another without good reason.  With regard to s 73B(31)(b)(ii), it should be noted that the relevant question is what would the expenditure have been if these parties had been dealing with each other at arm's length? Would a competent and independent valuer other than Dr Venning have made a different valuation which the parties would have relied on in concluding the terms of transaction so that the amount of the relevant expenditure would have been less?
3.81 The Tribunal concluded that another competent and independent valuer might have made a similar valuation. It was not satisfied that the valuation was flawed such that the Tribunal should substitute a different valuation. There was insufficient evidence that the relevant expenditure would have been any less had the valuation been made by a different valuer.
3.82 A little after this time the Tax Office settled the other lead case prior to it being heard in court.
3.83 The Tax Office appealed to the Full Federal Court against the Tribunal's decisions on the specific anti-avoidance provision and the general anti-avoidance provision. In July 2003, the Tax Office withdrew its appeal against the Tribunal's decision on the specific anti-avoidance provision. This happened four days before the Federal Court hearing. One day before the appeal hearing the Tax Office entered a mediation agreement with another investor. The purpose was to determine 'guidelines for reviewing R&D arrangements, thereby potentially removing the need for detailed syndicate audits and/or litigation'. The mediator was a former High Court Chief Justice and also a former Solicitor-General.
3.84 In September 2003, the Tax Office agreed to settle with another taxpayer. This was on the basis of 'economic neutrality'. Effectively, the taxpayer paid back to the Tax Office the tax benefit it received through the claims it made. No interest or penalties were applied.
3.85 In October 2003, the Full Federal Court (Federal Commissioner of Taxation v Zoffanies Pty Ltd 2003 ATC 4942) decided in the Tax Office's favour in respect of the approach to be taken in considering the general anti-avoidance provision. The Court found the Tribunal had erred in law. It ignored the additional tax benefits relied upon in the Commissioner's alternative case. It also applied the wrong test in stating its conclusions as to purpose. However, it did not overturn the Tribunal's findings on arm's length dealings or the independence of the valuer. This was because those findings were not before the Court for reconsideration as the Tax Office had withdrawn this ground of appeal. The Court also declined to apply Part IVA to the arrangement itself. The Court ordered that the Tribunal's decision should be set aside only insofar as it related to the Part IVA issue. It ordered that the Part IVA issue should be remitted to the Tribunal for re-determination. In May 2004, the Tax Office withdrew its case and the Tribunal issued consent orders in the taxpayer's favour. The Tax Office says that this case was 'wrongly decided' and is confined to the facts of this case.
3.86 In March 2004, the mediator gave his evaluation of the issues in the case under mediation (refer paragraph 3.83). Amongst other views, he rejected the Tax Office's submission that the core technology had a nil or negative value. He also rejected both the investor's and the Tax Office's approaches to determining whether dealings are at arm's length. The question to be answered was:
whether the parties in relation to the particular matter — here the incurring of the expenditure on core technology — have dealt with each other as arms' length parties would be expected to do.
3.87 The Commissioner gave a speech in April 2004. He announced that he would not apply Part IVA to core technology values where the specific anti-avoidance provision did not apply. This was a change to the Tax Office's previous approach.
3.88 In July 2004, the mediator gave an addendum to his March evaluation. He gave draft guidelines which dealt with the application of private binding rulings and the question of arm's length dealing. He also set out his approach to determining an arm's length amount.
3.89 This approach was significantly different to the Tax Office's previous approach. It would significantly change the values arrived at by the Tax Office's experts, although it did not endorse the investor's approach or that of the Tribunal. The outcome of the mediation was to arrive at a range of values that was different to the range of values relied on by both the Tax Office and the investor. The range of values was significantly more than the Tax Office's previous negative or zero value. It was also significantly less than the investor's value.
3.90 In September 2004, the Tax Office published guidelines which would be used to determine whether core technology deductions were properly allowable. Those guidelines gave practical guidance on when the Tax Office would be bound by a private binding ruling. They also gave practical guidance on what factors should be considered in assessing whether there was an arm's length dealing. They gave general guidance on determining an amount where there was no arm's length dealing. This guidance was contained in Part C of those guidelines.
3.91 However, the published guidelines did not disclose the factors that the mediator considered relevant in determining the arm's length amount. In particular, they did not indicate the mediator's rejection of the Tax Office's previous approach of relying on a valuation methodology that led to close to zero or negative values. The following is distilled from the mediator's reasons and compares with the guidance published in Part C of the Tax Office's published guidelines:
- In determining subparagraph 73B(31)(b)(ii), it is open to the Commissioner to demonstrate that the arm's length value is less than the amount paid by showing the arm's length value is within a range of values, the highest of which is lower than the amount paid. [Covered by Tax Office guidelines in point 2 and 6(ii)]
- The Commissioner may have regard to expert valuations to provide guidance on the arm's length value, including opinions on the appropriate values for sales projections and royalty rates. [Covered by Tax Office guidelines in point 4(i) — the Tax Office guidelines also suggest that other material indicating overinflation may also be used]
- Subparagraph 73B(31)(b)(ii) does not permit the substitution of a value determined by an independent valuer for an arm's length amount. This is because factors external to the valuation may influence the investors to pay more than the amount of the value independently ascertained. However, an arm's length value can be ascertained by reference to expert valuations so long as: [NOT covered by Tax Office guidelines]
- those valuations adopt the test in Spencer v Commonwealth (1907) 5 CLR 418 — what is the price that a willing purchaser would have had to pay a vendor not unwilling but not anxious to sell?; and
- those valuations are adjusted to take account of any special characteristics of the parties to the particular transaction.
- In taking account of any special characteristics of the parties, relevant factors include: [NOT covered by Tax Office guidelines]
- The availability of the tax benefits would have inclined investors to agree to the high end of a range of permissible values. In determining a 'permissible value', the discounted cash flow methodology of itself will not provide an arm's length amount. However, it does provide guidance in what parties would have expended had they been dealing with each other at arm's length.
- It would be unrealistic to suggest that the researcher would dispose of core technologies for derisory amounts where significant sums had been spent in developing that technology. The amount that the researcher spent in developing the technology up to the point at which the syndicate was entered was relevant.
- The timeframes for successful development of the technology.
- The constraints on the researcher's ability to fund further development, including the researchers' access to alternative finance for developing the core technology and whether the research could have been undertaken without the funds.
- The timing of the tax benefits and whether there was income against which the tax deductions could be immediately offset.
- Any factors which would suggest that the technology was developed to a point where its value exceeded the amount expended by the researcher on it.
- However, taking account of the special characteristics of the parties does not require the Commissioner to engage in an elaborate exercise, seeking to reconstruct what the parties would have done had they been dealing with each other at arm's length, by reference to the investors' actual attributes, knowledge, expertise and risk profile, through administrative and contemporaneous observation and record. [NOT covered by Tax Office guidelines]
- Although not an exhaustive list and otherwise relevant to the degree of comfort investors derived, the following factors are to be ignored in determining an arm's length value: [NOT covered by Tax Office guidelines — although can be inferred from the Tax Office's previous approach]
- the value of the guaranteed return — for example, through the exercise of a put option or a non-recourse loan;
- the registration process; and
- the reputation of the researcher.
- Where the inherent risks in the project were drawn to the registering bodies' attention before registration, it is irrelevant to determining an arm's length value that the project was risky, ambitious or in too short a timeframe. The very purpose of the tax concession was to encourage investment in short-term R&D projects which were risky and ambitious. [NOT covered by Tax Office guidelines]
- Reconstruction of an arm's length value as at the relevant date must not be made with reference to what was not known or knowable by the parties at that time — for example, considering the market influence of a competitor where it is questionable whether that influence was apparent at that time. However, that does not mean that it is necessary for the Commissioner to identify a contemporaneous valuation ignored by the investors, or letters or file notes which establish an inflated price. [NOT covered by Tax Office guidelines]
- The arm's length value will not be nil or negative. This is because the taxation benefits which the investment attracted gave it a higher value than that. [Covered by Tax Office guidelines at point 6(i)]
- The Commissioner need not precisely quantify the arm's length value under subparagraph 73B(31)(b)(ii). But in determining a reasonable amount under paragraph 73B(31)(d) a precise amount must be quantified. [Inferred by Tax Office guidelines at point 5]
- An arm's length value under subparagraph 73B(31)(b)(ii) may be different to the amount the Commissioner determines as reasonable to allow as a deduction under paragraph 73B(31)(d). [Covered by Tax Office guidelines at point 6(iii) — the Tax Office goes further to say reasonable amount will not be less than arm's length amount]
- In determining a reasonable amount under paragraph 73B(31)(d), the Commissioner may, in addition to the approach and factors outlined above:
- take other factors into account — such as the relationship between the parties; and
- determine an amount to allow as a deduction in excess of the maximum permissible value, so long as he considers it reasonable. [Covered by Tax Office guidelines at point 6(iv)].
3.92 The mediator also provided the Tax Office with draft guidelines for reviewing R&D arrangements, thereby potentially removing the need for detailed syndicate audits and/or litigation.
3.93 The Tax Office then looked at different settlement options. It concluded that there was a maximum amount of around $3.4 billion of revenue involved. This was based on the Tax Office's approach before the mediation. It included 50 per cent penalty and full general interest charge (GIC) over a number of years.
3.94 The Tax Office decided to offer settlement terms of denying half of the core technology claims and half of six years of GIC. Under this offer, the Tax Office stood to recover a maximum amount of around $580 million.
3.95 The Tax Office also decided to target only the largest core technology deduction claims. The claims of the 40 investors with the largest claims were targeted. These investors had each claimed more than $3 million for core technology expenditure in syndicates that involved a total amount of core technology of $10 million or more. Their claims comprised a little over half of all the claimed core technology expenditure and associated interest. The remaining investors were excluded from compliance review. Under this approach, the Tax Office stood to recover a maximum amount of around $280 million. This figure excludes those investors that had already settled with the Tax Office.
3.96 In late 2004, the Tax Office offered a settlement to those 40 investors. The Tax Office offered two options. Investors could settle for half of their core technology claimed and half GIC over six years with no questions asked. Or, investors could choose to prove to the Tax Office's satisfaction their compliance with the recently issued guidelines.
3.97 For 19 of these investors it was the first time that the Tax Office advised them that they had to prove that they were compliant and had to evidence that compliance in order to retain their claims that were made 8 to 12 years ago.
3.98 Over three-quarters of investors were excluded from potential review. This was essentially because the Tax Office believed that, given the smaller amounts (under $3 million), there was less scope for large core technology overvaluation in these smaller claims than in the larger claims. However, the costs and time for assessing these claims would be the same as for the larger claims. These investors were not contacted. Most, if not all, were unaware of the Tax Office's potential concerns with their investments.
3.99 The Tax Office limited the period in which the settlement could be accepted to six months. However, this was extended after strong lobbying. As long as investors continued to work actively with the Tax Office towards resolution, the offer would remain open.
3.100 Most investors subjected themselves to the review to prove compliance with the guidelines. The Tax Office was surprised that so many investors sought this option and did not settle on the 'no questions asked' basis. The Tax Office kept investors informed of the progress of their review if investors initiated contact with the Tax Office.
3.101 In late 2004, Treasury reviewed aspects of the income tax self assessment system. Amongst other matters, it recommended: that the law be changed to allow private binding rulings to be made on matters of fact; that market valuation guidelines be developed with the industry; and, that limits be imposed on the effective unlimited periods for review arising from 'nil' assessments. It also flagged further review of other unlimited periods for review.
3.102 In late 2005, another Tribunal decision was handed down. Its conclusions and findings of fact were adverse to the Tax Office's position on subsection 73B(31). Although this case posed different legal questions, the facts considered were materially similar. In this case the Tax Office had amended a syndicate researcher's assessment to include the undeclared receipt of money for a core technology licence. The researcher argued the investor's valuations were a sham. It argued the valuation was not independent. The researcher had relied on a Tax Office-engaged valuation which the Tax Office had used against the investor in the syndicate to deny their core technology deduction. The researcher argued that the Tax Office-engaged valuer's evidence should be preferred and therefore the value of the core technology should be zero. The Deputy President rejected that evidence and found that the investor's valuation was independent and open to the contracting parties to accept.
Current administrative approach and situation
3.103 Of the 246 syndicates originally registered, the Tax Office has finalised compliance action in most cases. It has also decided that over three-quarters of investors, those with relatively smaller claims, will not be reviewed. One case was litigated, resulting in the deductions being allowed in full. During the recent Tax Office reviews of the top 40 investors, a little over one-third of claims were accepted by the Tax Office in full. Most of the remainder were settled.
3.104 There are nine cases (9 investors in 11 syndicates) still being reviewed. Three investors (four syndicates) have been told that their claims do not satisfy the guidelines. The Tax Office is seeking valuation advice in these cases. In the remaining cases the Tax Office is in the process of determining whether there was an arm's length dealing. Either the Tax Office has indicated a preliminary view and is awaiting the investor's response or investors are collating more material on the matter.
3.105 The total revenue recovered to date by Tax Office action is about $110 million and $33 million in notional tax (losses recouped). This figure includes GIC and penalties. A further $73 million of potential revenue relates to the nine cases still under review.
3.106 Based on information provided to the Inspector-General and on a conservative estimate, the overall compliance costs to the community are thought to be in the range of $35 to $55 million. Taxpayers' direct compliance costs (expenses paid to external advisers and in-house personnel in response to Tax Office compliance action on the issue) are estimated to be about $20 to $35 million. The Tax Office's direct costs and salary costs are estimated to be about $15 to $20 million.
3.107 The Tax Office has taken a very long time to deal with this issue. There were many factors that contributed to the long timeframes. The Inspector-General's conclusions do not aim to cover every contributing factor. They do not reproduce every issue that was raised with him, that was considered by him or that concerned him. Rather, the following conclusions focus on key issues with the most potential for future tax administration improvements.
1. Aspects of the concession's design and its administration created a high risk of inflated core technology values
C1.1. Both investors and researchers could benefit from overvaluing core technologies. Researchers obtained more R&D financing the higher the core technology value. Investors were assured a guaranteed return on exercise of a put option. This was irrespective of any technical or commercial success. The IRDB and the Tax Office both approved the use of put options. The concession effectively removed the usual commercial tension between purchasers and vendors in striking bargains.
C1.2. There were certain measures that 'capped' core technology values. The availability of tax losses pressured taxable researchers to limit values. In 1993, the IRDB imposed maximum ratios of these values as a proportion of total R&D expenditure. However, the concession effectively relied on the tax law's specific anti-avoidance provision to contain core technology overvaluation. That provision aimed to address the risk of non-arm's length core technology values. However, the technologies had no established market by which their price could be easily compared. The technologies were novel and unique. Different experts advised different values for the same technology. That expertise was costly and time consuming to obtain.
C1.3. The R&D tax concession was jointly administered by the IRDB and the Tax Office. The IRDB checked compliance on a range of matters before syndicates were registered. The IRDB made it clear that compliance with the tax anti-avoidance provisions was solely within the Tax Office's power to determine.
2. The Tax Office had good reason to be concerned
C2.1. The investors were major organisations knowledgeable and experienced in taxation matters. There were strong signals that many core technology values were inflated. The Tax Office had good reason to be concerned about the behaviours it observed. By the time the issue was publicly raised in late 1993, the Tax Office had to act.
C2.2. The Tax Office considered that many investors took advantage of the concession. It generally claims the following:
C2.2.1. Some investors derived unintended benefits. The financial arrangements extracted large tax deductions for investors and fees for the promoters on the basis of overvalued core technology. They were tax effective financing transactions with little concern for the commercialisation of the developed technology.
C2.2.2. Investors may have done what was required to get syndicates registered. But they did not do all that could have been done to comply with tax law anti-avoidance provisions. In many cases, extra steps were not taken to ensure that their dealings were consistent with those that they would normally adopt in an arm's length transaction.
C2.2.3. In 1989, the Government of the day intended to attract private equity investment in high-risk, early-stage R&D. But it did not permit the overvaluation of core technology. This is why the specific anti-avoidance provision was enacted. This is also why the Government of the day chose to 'shut syndication down' in 1996.
C2.2.4. Many core technology values were 'back solved' — generated by first determining the required return on investment rather than the potential future profits in the event of successful commercialisation of the R&D results. In some cases these values were subsequently confirmed by valuations that were not independent. They were provided by a select group of valuers who did not test vendors' assumptions, the optimistic market shares and the optimistic sales forecasts.
C2.2.5. Many investors did not carry out the prudential measures in testing the core technology values and bases for valuations. A financially sophisticated, well-advised, large corporate would be expected to carry out these measures when entering a large financial transaction.
C2.3. Investors dispute these claims. They generally claim the following:
C2.3.1. Two Administrative Appeals Tribunal cases rejected the Tax Office's approach.
C2.3.2. Carrying out costly and lengthy testing on valuations in the circumstances was not a commercially realistic option. This was because of the minimal commercial risk to the investment capital and the short lead times to enter the investments. If there was an administrative requirement to conduct these measures and that was communicated to investors at the time, they would have complied. However, no such requirements were communicated to investors at the time of investment.
C2.3.3. The Government induced private investment by offering attractive tax benefits. At the relevant time, published material made it clear that the Tax Office was responsible for addressing matters relating to the tax laws. All investors had to comply with an involved registration process. The IRDB specifically advised registrants of the need to comply with the tax anti-avoidance provisions. Investors sought, but did not obtain, Tax Office private binding rulings on the application of the anti-avoidance provisions to their particular investments. They provided detailed factual material to the Tax Office, including the valuations, financial arrangements and their tax effect. The tax laws prevented private rulings on matters of fact. But the Tax Office did not express any concerns. The Tax Office did not rule on the anti-avoidance provisions because it depended on the future implementation of the arrangements. But, the arrangements were required to be implemented as stated or else the IRDB would de-register the syndicate. There was a great deal of uncertainty surrounding core technology values. This was publicly known. The Tax Office and others were asked to reduce this uncertainty. They did not.
C2.4. The Tax Office should not have relied on the mere existence of the tax anti-avoidance provisions to prevent overvaluation. One purpose of an anti-avoidance provision is to act as a deterrent. In a self assessment environment it is up to the taxpayer to comply with the law. However, the Tax Office should not have expected taxpayers to act conservatively in these circumstances just because the anti-avoidance provisions were there. The existence of these provisions increased the Tax Office's obligation to provide certainty rather than replaced or reduced it.
C2.5. Given the uncertainty around the effect of the provision and the number of requests to clarify the Tax Office position, there was an obligation on the Tax Office to state what it would expect to see as compliant arrangements. The anti-avoidance provision had a diminished value as a deterrent without further certainty being provided.
3. The Tax Office took far too long to give practical guidance and this caused significant unnecessary compliance costs and extended the resolution's timeframes
C3.1. The Tax Office took far too long to give practical guidance on the specific anti-avoidance provision. The Tax Office knew the risks arising from the concession's design and the way syndicates were marketed. It was also involved in the concession's administration. In this environment the Tax Office should have provided practical guidance on its compliance expectations at the outset. It did not. If it had done so, many of the problems of this case study would have been averted.
C3.2. The Tax Office gave general guidance on core technology values in mid-1991. This was through a public ruling. That ruling drew attention to key considerations on 'arm's length market values' for core technology. It said core technology prices should not be merely equated to a valuation, should not ignore the guaranteed returns and should reflect market realities. The specific anti-avoidance provision was enacted in late 1991. It dealt with the risk of core technology overvaluation, amongst others. At the time the Tax Office was responsible for giving instructions on amendments to tax law provisions. Therefore, the Tax Office was well aware of the risk of inflated core technology values before this anti-avoidance provision was drafted, introduced into Parliament and enacted into law. However, the public ruling was not updated to consider that provision. The Tax Office did not give practical guidance on that provision until September 2004.
C3.3. The Tax Office received several signals to reduce the uncertainty in relation to core technology values. However, it was the TCC that took steps to reduce uncertainty. In early 1996, the TCC Chairman publicly announced the framework by which it would assess the reliability of core technology valuations. Prior signals that should have alerted the Tax Office to act sooner include the following:
C3.3.1. The Tax Office gave advance opinions and private binding rulings in relation to around 245 syndicates. Although it could not rule on matters of fact, it did not raise concerns with the industry or in the rulings themselves.
C3.3.2. The specific anti-avoidance provision was enacted in December 1991. The then Government removed the sunset clause for tax concessions for R & D syndicates in 1992, signalling an intention to allow the concession to operate indefinitely. However, public Tax Office guidance on the concession was not updated before the concession was closed to new entrants.
C3.3.3. The 1993 ANAO report recommended that the Tax Office should examine a sample of syndicate arrangements with suspected inflated core technology values.
C3.3.4. In December 1993, the IRDB introduced ratios to cap the amount of core technology claimed.
C3.3.5. By March 1994 concerns over potentially inflated core technology values were well known. The Tax Office R&D syndicate project manager joined the TCC as an observer. His role included the management of the Tax Office's audits of R&D syndicates.
C3.3.6. By November 1995, some core technology values were rejected by the TCC. They were subsequently accepted when values were reduced.
C3.3.7. The 1994 BIE report of its inquiry into syndicates specifically recommended that the Tax Office clarify issues for taxpayers on the treatment of core technology and financial structures. The Tax Office never responded to this recommendation or to the BIE report generally. This was despite the report observing taxpayer behaviour that appeared to be contrary to the Tax Office's 1991 Public Ruling IT 2635.
C3.3.8. In October 1994, the Tax Office had expert advice that suggested further lines of inquiry to better determine what parties dealing at arm's length would have paid for the core technology.
C3.3.9. In early 1996 the Tax Office first made its general concerns known publicly — in a speech by a senior officer to an industry conference.
C3.3.10. In late 1995 and early 1996, the TCC signalled it would be expecting to see 'arm's length market values' as part of its registration process. It also pointed to specific issues that a valuation should address. The Tax Office acknowledges that this approach led to improved compliance with the tax laws. It has accepted that the core technology expenditure deductions were validly claimed in all cases where the TCC scrutinised valuations after this date.
C3.4. In September 2004, the Tax Office issued practical guidelines on the application of the specific anti-avoidance provision (subsection 73B(31) of the ITAA 1936). These guidelines were developed during mediation with a key investor. They were developed for the purpose of:
reviewing R&D arrangements, thereby potentially removing the need for detailed syndicate audits and/or litigation.
C3.5. The Tax Office could have provided practical guidance before arrangements were entered into. The Tax Office knew the details of the financial arrangements and their tax effect before arrangements were entered into. Investors sought advance opinions and private binding rulings from the Tax Office. But the then tax laws prevented private binding rulings on matters of fact, including valuations. The Tax Office also refused to rule on the anti-avoidance provisions, which was common practice at the time. The Tax Office had an observer on the TCC. However, the Tax Office was ill-equipped to check compliance at that time and Tax Office auditors were initially ill-supported to deal with the technical and strategic issues.
C3.6. But none of these constraints would have prevented the Tax Office from providing investors with practical guidance on what it would expect to see in a tax compliant syndicate before arrangements were entered into.
C3.7. Initially, the Tax Office relied on the TCC to identify inflated core technology values. The TCC comprised of subject experts. The valuations appeared credible on the surface. The TCC also questioned and rejected some valuations during the registration process from November 1995. Before November 1995, the TCC looked at matters associated with core technology values but did not assess those values. Before this time the Tax Office had a growing awareness that some values were inflated. The Tax Office had no expertise itself in valuing novel and unique intellectual property. Its expertise in engaging experts was in its infancy. Staff were not skilled in instructing valuers or testing their opinions. Staff were also unaware of the relative reliability of different experts. They did not know which experts had an in-depth knowledge of the relevant markets, including the competition, take up of the market and likelihood of technical success of the technology. That advice was costly and time consuming. It could not be applied to other cases because it valued novel and unique intellectual property. In any event, that advice was not conclusive proof of the value the relevant parties would have struck had they been dealing at arm's length.
C3.8. The Tax Office's reliance on the TCC changed following public comments, escalating claimed both core technology values and concerns about their reasonableness of core technology values. By the time the Tax Office commenced audits to check compliance many syndicates had already been registered. The Tax Office considers the TCC did not perform its role in relation to scrutinising core technology valuations.
C3.9. Many legislative and administrative changes were made by the IRDB during the life of the concession. Some of these aimed to address overvaluation concerns. However, the power to make determinations in relation to core technology expenditure remained solely with the Tax Office.
C3.10. Investors had an impression of acceptance of the arrangements. The Government accepted that without the concession, financial institutions would not invest in the core technologies. The tax benefits were more generous than those offered in other tax shelter arrangements. Investors saw a pattern of registrations that extracted very large tax benefits. Changes were made to the concession. Investors changed arrangements to comply with these changes. The Tax Office did not raise any specific concerns until after all syndicates were entered.
C3.11. Because of the above factors there was a significant need for the Tax Office to give early practical guidance. If the Tax Office had given practical guidance earlier, significant compliance costs, extended timeframes and the uncertain scope of this problem would have been significantly reduced, if not prevented. Had practical guidance been given before arrangements were entered, up to 12 years and $30 to 40 million of direct compliance costs could have been avoided. At the very least, investors would have been better equipped to demonstrate compliance. It may have also led to more conservative core technology values in some cases. This may have led to the Tax Office considering the issue a low priority for its compliance focus. The Tax Office also would not have placed itself in a position of denying deductions claimed by many investors 8 to 14 years ago.
4. Investors could have done more to be able to demonstrate compliance, but this was unrealistic in the circumstances especially in the absence of practical guidance from the Tax Office
C4.1. In the absence of practical guidance from the Tax Office, investors could not anticipate what evidence would satisfy it of compliance. Most investors could have done more to ensure that their claim was unassailable in any Tax Office audit, but this was disproportionate to the risks at the time.
C4.2. Before arrangements were entered into, investors tried to obtain Tax Office private rulings on the anti-avoidance provisions. The private rulings gave little comfort and the Tax Office did not provide practical guidance to assist investors with their compliance. Through the Tax Office's public ruling, IT 2635, investors were aware in general terms that an 'arm's length market value' was expected. However, this ruling was not updated when the specific anti-avoidance provision was enacted. Had the Tax Office given guidance on what its compliance expectations were, investors would almost certainly have followed that guidance.
C4.3. Investors were experienced, well resourced and 'tax savvy'. They could have done more ground work to ensure that their claims would be unassailable in any Tax Office audit. They could also have ensured that they could evidence that they had undertaken additional valuations, obtained marketing advice about key sales projections and considered at the Board level core technology qualities, price negotiations and transaction risks.
C4.4. However, taking steps to ensure that their claims were unassailable was disproportionate to the risks at the time.
C4.5. At the time there was no specific administrative need to take these steps to evidence compliance. The Tax Office did not publicly express any general concerns with core technology values until early 1996. It did not give practical guidance until September 2004.
C4.6. There was little commercial need to engage costly and lengthy expertise to address a perceived low risk. Lead times for syndicates were short and pressing. The technology was needed to be developed quickly to maintain any potential competitive advantage. Researchers indemnified the investors of any risk that the deductions would not be allowed by the Tax Office. Investors relied on the impressions of administrative acceptance of the risk free returns flowing from the tax benefits and put options exercise. The effect of relying on these impressions was that there was little commercial reason to be concerned about the price paid for core technologies.
C4.7. In any event, had such preparation equipped taxpayers to demonstrate their compliance when required, it would have done no more than to reduce the timeframes from that point forward and potentially provide them individually with a satisfactory resolution. It would have done nothing to reduce the protracted delays in the Tax Office finalising its compliance action.
5. The Tax Office took far too long to finalise its compliance action; it displayed no material sense of urgency for a major period of the timeframe
C5.1. The Tax Office took far too long to finalise its compliance action. The Tax Office started its audit project in September 1994. It was not until 2004 that the Tax Office took a strategic decision not to pursue most of the investors. The Tax Office issued practical guidance and offered a practical settlement from September 2004. By late 2006, the Tax Office had settled or excluded from compliance review almost all investors in the 246 syndicates.
C5.2. The tax laws allowed the Tax Office legally to amend deductions claimed by investors 8 to 14 years ago. But for these laws, the Tax Office would have been pressured to resolve its concerns within four years. This was the standard period of review (six years if the tax avoidance provisions were applied). Together with the sunset provisions (that were removed in 1992) these laws reduced any material sense of urgency within the Tax Office.
C5.3. The Tax Office initially considered R&D syndicates a relatively low compliance priority until 1994. The life of the concession was limited. It was extended and then from August 1992 allowed to operate indefinitely.
C5.4. Investor resistance in initial audits contributed some months to the extended timeframes. This included taking time to coordinate Tax Office visits through to refusal to meet and defending legal professional privilege claims on requested documents. In one case, a syndicate delayed the start of an audit by eight months. This was because it insisted all parties be present at the opening meeting. However, these timeframes were not long when compared to other factors that materially contributed to the timeframes of the issue.
C5.5. Eliminating investor and promoter delays would not have sped up the finalisation of any audit before late 1999. This is because before this time the Tax Office did not settle its initial technical view of the specific anti-avoidance provision to a point where it could be communicated to investors. Nor would it have sped up the resolution of any case after early 2000 unless it was treated as one of the few lead cases. Other cases were put on hold pending the outcome of these cases.
C5.6. The following factors materially contributed to the compliance action timeframes.
C5.6.1. Obtaining valuations and developing an initial Tax Office technical view added around four years to the timeframes. The Tax Office had started reviewing R&D syndicates as early as mid-1992. It started an audit project by September 1994. It was aware of the core technology valuation issue in October 1994. However, the Tax Office did not issue its first position paper until April 1999. Soon after in late 1999, the Tax Office first settled its position on the general anti-avoidance provision. This was four years after the audit was commenced. This position was, effectively, that where the Tax Office-engaged valuer gave a valuation of close to zero or a negative value, it was 'best evidence' on non-arm's length dealing. Adjustments to investors' claims would be made to reflect that Tax Office-obtained valuation. No amended assessments were issued until October 2000. In one case, the Tax Office advised an auditee it was awaiting a valuation to finalise the audit. The Tax Office next contacted the auditee over three years later.
C5.6.2. The TCC announced its forward compliance approach to syndicates in early 1998. It decided that it would not cancel registration on the basis of overvalued core technology. This approach was based on legal advice.
C5.6.3. The Tax Office took until 2000, to escalate the issue for it to be managed at a very senior level. Prior to this time, senior management was 'monitoring' the progress of this issue. The Inspector-General questions the adequacy of Tax Office bottom-up escalation processes as a mechanism for ensuring that complex issues that are subject to delays receive appropriate and timely management of senior tax officials. It should not take at least six years for a hotly contested complex matter involving significant costs and revenue to begin to be managed at an appropriately senior level.
C5.6.4. From 1999 until September 2004, the Tax Office maintained its reliance on expert valuation and legal advice as the basis for adjusting core technology claims where the Tax Office-obtained valuation opined the core technology's value was close to zero or negative. The Tax Office considered this was the best evidence of non-arm's length dealing. This view was held notwithstanding the Tax Office's views on valuations being an inexact means to value core technology and the eventual adverse Tribunal decision on critical findings of fact. Investors and promoters considered the Tax Office's approach unreliable.
C5.6.5. Tax Office resourcing also posed a problem. Auditors needed to examine and analyse a considerable amount of documentation. Auditors needed to travel extensively because documentation was typically held in different States. Also, high-level well-qualified auditors were in short supply because of their demand within the Tax Office.
C5.6.6. Each case needed to be dealt with on its merits. Many investors did not accept the Tax Office's approach to determining the issues. Without generally accepted practical guidance, the Tax Office effectively needed either that the relevant investors acquiesce to denial of their claims, or part thereof, in settlement, or, itself to undertake costly and resource-intensive audits that involved obtaining time consuming and costly valuation advice.
C5.6.7. The Tax Office's lead case litigation strategy contributed around two years to the timeframes. In March 2001, the Tax Office decided to litigate two of the most advanced cases. Having lost its key lead case in the Tribunal, the Tax Office settled one case and withdrew one critical ground of appeal in the other by July 2003. It then commenced a mediation to determine guidelines to resolve R&D syndicate cases.
C5.6.8. The Tax Office's mediation strategy contributed around one year to the timeframes. In mid-2003 parties formally agreed to mediate. In mid-2004 the mediator gave his final advice. The timeframes were mainly attributable to the complexity of the issues. A considerable period of time was taken to agree on a set of facts and guidelines.
C5.6.9. The Tax Office's post-September 2004 reviews have contributed more than two years to the timeframes. By early 2007, most investors had either settled with the Tax Office or satisfied the Tax Office that claims were validly made. Some investors took many months collating the requested material for the Tax Office. Much evidence relied on people's recollections of events, the continuing existence of documents and availability of key people. This took time to collate. The Tax Office took many months considering the information provided. It did not have the resources to deal quickly with the 'surprising' number of investors that sought to satisfy the Tax Office of their claims. There were disagreements between some investors and the Tax Office on the application of the guidelines to the facts of their case. A key issue was whether the valuations investors relied upon were 'independent'. Two cases are obtaining further information from the Tax Office after the Tax Office advised the investor's representative in November 2006 of a 'determinative' factor that would lead to satisfying the Tax Office of reliance on the valuation, namely TCC additional scrutiny of the valuation where the finance scheme was assessed after November 1995.
C5.7. From September 2004, the Tax Office offered a practical settlement to 40 of the largest investors. These investors were offered an alternative. They could accept 'base level' terms of settlement on a 'no questions asked' basis. Or, they could seek to satisfy the Tax Office that their claims complied with the guidelines (or convince the Tax Office of better terms of settlement) by subjecting their claims to lengthy and costly review. The remaining investors were excluded from review. By early 2007, most investors had either settled with the Tax Office or satisfied the Tax Office that their claims were validly made.
C5.8. The Tax Office accepts that it took far too long to finalise its compliance action.
C5.9. The extended timeframes led to accrued GIC. The terms of the settlement offers from September 2004 included a 50 per cent remission of six years of GIC. This was, in part, recognition of the Tax Office delays involved. However, in some cases this remission was not an accurate reflection of the delays involved. For example, in one case taking more than six years to complete, four years were spent awaiting a Tax Office-commissioned valuation and the Tax Office's position paper. Also, for those audits commenced in 2005, the Tax Office's offer of GIC remission does not reflect the Tax Office current GIC remission policy. However, this policy was released after the settlement was first offered to taxpayers.
C5.10. The Inspector-General finds this approach to GIC remission to be sloppy administration. It fails to differentiate compliance approaches sufficiently. It fuels public perceptions that the Tax Office takes 'one size fits all' approaches for administrative ease at the expense of proportionate and fair treatment.
6. Only when very senior Tax Office executives directly managed the issue did the Tax Office take positive action to speed up its resolution
C6.1. By 2000, the Tax Office recognised the difficulties of dealing with matters of complexity within a mainstream 'audit and litigate on a case by case' approach. From early 2000, very senior Tax officials directly managed the issue. From this time the Tax Office sped up its compliance action by a combination of positive factors.
C6.1.1. It removed the issue out of the Tax Office's mainstream 'audit and litigate on a case by case' process. By early 2001, a strategy was devised to use lead cases to resolve the issue and minimise costs.
C6.1.2. It engaged a key investor in mediation with the intention of developing practical guidance to resolve the uncertainty surrounding the application of the specific anti-avoidance provisions.
C6.1.3. It published that practical guidance, albeit with material exclusions on the approach the mediator took to determine the amount parties would have agreed to if they had dealt with each other at arm's length.
C6.1.4. It offered a practical settlement that allowed taxpayers either to pay and walk away or convince the Tax Office of better settlement terms based on stronger claims than those who could walk away.
7. An unchecked cultural influence of 'hitting tax abuse hard' has been a major contributing factor to why the R&D syndication issue has taken well over a decade to near resolution
C7.1. Despite considerable uncertainty which accommodated a variety of reasonable views, the Tax Office tenaciously believed that views contrary to its own were wrong. It took far too long to reassess its position objectively. Eventually it was forced to do so. In some cases it also ignored a major part of that reassessment and applied a flawed resolution approach as a result. This was because it believed the arrangements amounted to tax abuse.
C7.2. The Inspector-General believes that to be a fair administrator, the Tax Office has an obligation to maintain its objectivity in all circumstances. Processes are required to ensure that the cultural influences that are part of any organisation, including the Tax Office, do not get in the way of administrative objectivity. To achieve administrative objectivity also requires the Tax Office to rise above any prevailing community, political or media views about the issue in question.
C7.3. The Tax Office did not objectively reassess its view earlier because it tenaciously believed that views contrary to its own were wrong and that the arrangements were 'tax rorts'. The Inspector-General considers that the Tax Office belief that arrangements were tax rorts triggered a cultural response that the Tax Office's view was correct both in the desired outcome and the path to reach that outcome. This culture led the Tax Office to assess selectively and subjectively the weight of external signals and the perspectives of investors. Those signals that supported its view were correct. Those that did not were wrong.
C7.4. The Tax Office claims that this conclusion is fundamentally flawed because it misunderstands the Tax Office's approach. The Tax Office asks what more it could have done. It says that:
- it was responsive to industry suggestions to mediate the issue in April 2002;
- in July 2002, it agreed to mediate;
- the Zoffanies case was being litigated at the time so it had to await the result of that case before mediating; and
- a formal agreement to mediate was entered into in July 2003.
C7.5. The Inspector-General considers that this claim ignores the previous decade of continuing uncertainty both outside of and within the Tax Office on how these arrangements should be treated under the specific anti-avoidance provision. Because the Tax Office disputes this conclusion, the Inspector-General goes to some lengths to set out the background leading to it. Key points supporting this conclusion are organised under the following headings:
- The Tax Office believed that the arrangements were 'tax abuse'.
- The Tax Office stuck to an approach that led to zero or negative core technology values that would effectively wipe out syndicates.
- The Tax Office was aware of a range of other valid views.
- The Tax Office discounted views that were contrary to its position.
- The Tax Office was eventually forced to reassess its view objectively.
- The Tax Office's view was changed significantly by objective reassessment by an independent mediator.
- The Tax Office should have checks and balances over its culture of 'hitting tax abuse hard'.
The Tax Office believed that the arrangements were 'tax abuse'
C7.6. The Tax Office strongly believed that the behaviours it observed amounted to 'tax abuse'. It tenaciously believed and overtly stated that the behaviours it observed amounted to 'tax abuse'. This view continued to be expressed during the course of this review.
C7.7. For example, during the course of the review, the Inspector-General asked the Tax Office to comment on investors' observations of Tax Office behaviour. One of these observations was that in the press release announcing the Government's 1996 decision to close syndication off to new registrants, there were four examples of 'tax abuse'. However, investors observed that these were examples of syndicates rejected by the IRDB and refused registration and they therefore never came into existence. The Tax Office's written response to the Inspector-General was that:
Examples given were to illustrate a point. This comment is old copy and reflects unwillingness by promoters etc at the time of closure, and apparently even now, to accept that syndication represented tax abuse.
C7.8. The Tax Office has also indicated a willingness to disregard a major part of the mediator's advice and the questions posed by the specific anti-avoidance provision where it holds this strong belief.
C7.8.1. For example, in one particular case in applying the guidelines to a key investor's claim, tax officers involved in the review ignored the advice of Sir Anthony Mason in determining section 73B(31)(b)(ii) and 73B(31)(d) issues and continued to recommend that the Tax Office apply the approach that merely substituted a zero value for the investor's claimed core technology expenditure.
It is the ATO's contention that [the investor] … and [the researcher] were not dealing with each other at arm's length … It is the ATO's contention that [the researcher] merely acquiesced to the Core Technology Licence Fee of $ … millions which was determined by [the investor]. The ATO relies on [its commissioned] valuation report to refute [the syndicate's] valuation of the Core Technology Licence Fee in the range of $[just below the claimed Licence Fee] million to $[15 per cent above the claimed Licence Fee] million and to satisfy the Commissioner that the Core Technology Licence Fee would have been less than $[the claimed Licence Fee] million if [the investor] … and [the researcher] had dealt with each other at arm's length and that the Core Technology Licence Fee would have been nil had [the investor] … and [the researcher] dealt with each other at arm's length.
C7.8.2. This document evidences a particular culture within an area of the Tax Office. It is consistent with other comments made by officials that inferred the entity engaged in tax abuse.1
C7.8.3. The Tax Office says this recommendation was never adopted as the Tax Office position nor accepted by senior officers. This view of maintaining a 'nil' core technology value is adopted elsewhere in the internal report also. Further, the Tax Office has not produced contemporaneous evidence to support its assertion. Despite this willingness to adopt a 'nil' core technology value approach in this case (contrary to the mediator's advice), the tenor of settlement negotiations in this case did not require the Tax Office to pursue this particular approach with the taxpayer. As flagged in Chapter 3 at paragraph 114, The Inspector-General will further examine R&D syndicate settlements in the context of my future review of settlements generally.2
C7.8.4. The Tax Office also says it accepted the advice of the mediator in finalising its position in respect of this case. However, the Tax Office did not follow the mediator's advice in how to determine the core technology price that parties should have reached. This is because it merely used the non-arm's length 'indicative proposal price, which was assumed to equal the market value' (set before valuations were obtained) as a basis for the arm's length price. It did not consider the factors the mediator considered relevant to determine what the price would have been if those parties had dealt with each other at arm's length. This approach also appears inconsistent with the Tax Office's view on subparagraph 73B(31)(b)(i) — that the parties were not dealing with each other at arm's length in relation to the core technology price. It is incongruous that the Tax Office genuinely believed that the parties were not dealing with each other at arm's length and then used the indicative proposal pre-valuation price (the price the Tax Office rejected as evidence of an arm's length dealing) as the basis for an arm's length price. However, following the Zoffanies case, the Tax Office was hampered in merely asserting a 'nil' core technology value to the investor without expending considerable amounts of money and resources in prosecuting such a view. A pragmatic resolution was reached. The tenor of settlement negotiations in this case also did not require the Tax Office to pursue this particular view with the taxpayer and therefore it was never communicated to the taxpayer.3
C7.8.5. While applying the guidelines the Tax Office repeatedly stated and inferred during the review that this investor, and others, had engaged in tax abuse. Also, during discussions tax officials told Inspector-General staff that it was unrealistic to expect the Tax Office to follow the mediator's guidance on section 73B(31)(b)(ii) and (d) issues because it was 'not practical' to follow that advice, the cases amounted to 'tax abuse' and the legislative provision did not adequately enable the Tax Office to address that abuse.4 General comments were also made that the arrangements amounted to tax abuse and that was why the Government 'wanted syndicates closed down'.
C7.9.1. The TCC publicly commented that some arrangements were 'rorts' relying on 'unsustainable valuations'. The TCC however, decided in early 1998 that it could not rescind registration on the basis of overvaluation of core technology.
C7.9.2. The Department of Industry, Science and Resources (DIST) recommended in mid-1996 that the concession be terminated. It reported that:
like a chameleon, the program has continually changed in ways which favour the easy extraction of large tax deductions.
C7.9.3. In July 1996, the Government closed off syndication to new registrations but allowed existing syndicates to continue to access the concession. This was because 'the [then] current arrangements with regard to syndication have become focussed on tax minimisation rather than the provision of genuine R&D'.
C7.9.4. No syndicate was commercially successful. However, some technologies did go on to be successfully commercialised after the syndicate's put option was exercised.
C7.9.5. The Tax Office adjusted the core technology claims in many cases.
The Tax Office stuck to an approach that led to zero or negative core technology values that would effectively wipe out syndicates
C7.10. The Tax Office's expert advice led to zero or negative outcomes in valuations. These outcomes were a significant part of the way the Tax Office had considered the issue up to this point. From investors' perspective, the approach that led to zero or negative values amounted to 'zero tolerance' of syndication. It was seen as a means to 'wind syndicates up'. Effectively, it characterised the arrangements as 'tax rorts'. This entrenched investors' resistance to the Tax Office's approach to the issue.
The Tax Office was aware of a range of other valid views
C7.11. There was considerable uncertainty around the application of the anti-avoidance provisions. This gave enough scope for many contrary views to be validly held. The Tax Office itself received various, and sometimes conflicting, advice on how to apply the specific anti-avoidance provision and how to quantify the amount that should be allowed as a deduction. (The Tax Office also says that it received a number of oral advices before the mediation, including advice given in the Zoffanies matter, in addition to the legal advices referred to below. It has not provided a written summary of these advices.)
C7.11.1. In early 1998, the Tax Office obtained external legal advice in a case that advised:
- there was no one test to determine an arm's length dealing;
- the 'matter of greatest significance' as to whether the parties were dealing with each other at arm's length was the marked discrepancy between the value of core technology opined in the AVO valuation and the syndicate's valuations;
- it was assumed that the AVO valuations were correct, however, because the AVO had no expertise in that field of technology there was need for further input from independent expert valuers before concluding a view in relation to subsection 73B(31); and
- if the AVO valuations were correct, the value opined by the AVO was reasonable to be allowed as the amount incurred as core technology expenditure for the purposes of paragraph 73B(31)(d).
C7.11.2. In late 1999 and mid-2000, the Tax Office's Part IVA Panel, in relying on AVO valuations, gave an opinion that:
- the application of the specific and general anti-provisions depended on the syndicate's valuation of the core technology being excessive — it was 'the primary indicator of non-arm's length dealing';
- core technology expenditure claimed by the investor ought to be reduced to zero on the basis of subsection 73B(31) where the syndicate's valuation was excessive in comparison to the AVO's negative valuation — 'A valuation based on a discounted cash flow could yield a theoretically negative valuation, indicating that the investor would want to be paid to develop the core technology';
- the correct methodology for the core technology was likely to be a significant point — the Panel noted that the investor 'purported that the valuation methodology used by the AVO was flawed'; and
- the non-arm's length argument might not be so strong if the purchaser was in fact not aware of the overvaluation of the core technology.
C7.11.3. In a case in early 2002, the Tax Office obtained external legal advice that:
- both the Tax Office's and investor's arguments were 'misdirected' because they did not answer the questions posed by subsection 73B(31);
- the question of arm's length dealing should be directed towards the investor group's special purpose subsidiary company rather than the investor group (the advice concluded that there was no arm's length dealing in this case);
- the Tax Office's case was unlikely to succeed if it found that the valuations obtained were genuinely relied upon in the dealings relating to the core technology;
- the Commissioner cannot conclude that investors paid a price in excess of what they would have paid on an arm's length dealing merely because a different valuer now considers an arm's length value to have been greater;
- the allowable arm's length expenditure is to be assessed by what the actual parties, with their knowledge at the time (without the benefit of hindsight), would have paid if they were dealing with each other at arm's length;
- what the Commissioner is required to have regard to is what the actual syndicate members would, if dealing at arm's length, have paid, which requires the 'circumstances peculiar to the parties to be taken into account'; and
- all valuations, the Tax Office's and the investor's, proceeded on a 'misconceived and erroneous basis' because the appropriate method of valuation should have been one analogous to a comparables basis — an expert in venture capital investment would be in a better position to opine on core technology prices than an accountant or a person with narrow expertise in intellectual property evaluation.
C7.11.4. In 2002, the Administrative Appeals Tribunal, among other things, held that:
- persuasion is part of the normal process of negotiation and that cooperation does not, of itself, indicate that parties fail to exercise their separate minds and wills in reaching a bargain;
- in the context of what was no more than an estimate of value, care needs to be taken when substituting one valuer's opinion for another without good reason as it is easy to be critical with the benefit of hindsight when what was then unknown is now known; and
- with regard to subparagraph 73B(31)(b)(ii), it should be noted that the relevant question is what would the expenditure have been if these parties had been dealing with each other at arm's length — would a competent and independent valuer other than the one relied upon have made a different valuation which the parties would have relied on in concluding the terms of transaction so that the amount of the relevant expenditure would have been less?
C7.11.5. In 2004 in another case, the mediator evaluated the Tax Office's and an investor's position during the course of a mediation. The substance of his advice on the arm's length dealing issue is set out in the guidelines that the Tax Office published in September 2004. His evaluation also gave the following advice:
- Subparagraph 73B(31)(b)(ii) does not permit the substitution of a value determined by an independent valuer for an arm's length amount. This is because factors external to the valuation may influence the investors to pay more than the amount of the value independently ascertained. However, an arm's length value can be ascertained by reference to expert valuations so long as those valuations are adjusted to take account of any special characteristics of the parties to the particular transaction.
- The arm's length value will not be nil or negative. This is because the taxation benefits which the investment attracted gave it a higher value than that.
- It would be unrealistic to suggest that the researcher would dispose of core technologies for derisory amounts where significant sums had been spent in developing that technology. The amount that the researcher spent in developing the technology up to the point at which the syndicate was entered was relevant.
- Reconstruction of an arm's length value as at the relevant date must not be made with reference to what was not known or knowable by the parties at that time — for example, considering the market influence of a competitor where it is questionable whether that influence was apparent at that time.
- The availability of the tax benefits would have inclined investors to agree to the high end of a range of permissible values. In determining a 'permissible value', the discounted cash flow methodology of itself will not provide an arm's length amount. However, it does provide guidance in what parties would have expended had they been dealing with each other at arm's length.
C7.11.6. The Tax Office also relied on valuations about which it had doubts. In addition to the concerns expressed in the legal advices above, one very senior tax official thought that some of the values returned in valuations were 'not intuitive' and 'did not sound right'. The Tax Office also recognised that valuation was 'more of an art form than a science'. It gave the Inspector-General examples of 'blatant cases' showing 'obvious rorting'. However, it conceded that it was not obvious on the face of it or picked up during the registration process because of the complexities of valuations. What was needed was experience in dealing with valuers and valuations to identify the problems.
C7.11.7. From 1999, the Tax Office applied the general anti-avoidance provisions in an attempt to deny the core technology deductions. This was notwithstanding the existence of a specific anti-avoidance provision aimed, amongst other mischiefs, at core technology overvaluation. This was also despite the concession being designed to induce investment by offering a tax benefit to investors and the acceptance by the IRDB and the Tax Office of the operation of the put option to guarantee investor returns. In early 2004, the Tax Office retracted its view of Part IVA's application to core technology claims.
The Tax Office discounted views that were contrary to its position
C7.12. However, in spite of these independent views that were contrary to the Tax Office's view, the Tax Office tenaciously believed that its view of how to apply the law was correct and that its approach to valuations was also correct. For example:
C7.12.1. The Tax Office considers that the 1998 legal advice above supported its approach. The adviser concluded that the Tax Office was entitled to be satisfied that there was no arm's length dealing in that case. However, on a reading of this advice, it should have been clear to the Tax Office that there was significant uncertainty in which legal test to adopt and the evidentiary material needed to prosecute its case. The advice specifically alerted the Tax Office to the lack of experience underlying the AVO valuations and therefore their unreliability on which to base the exercise of the specific anti-avoidance provisions. However, the Tax Office went on to use AVO valuations in other cases to issue Part IVA determinations and amended assessments. It also engaged other expert valuers. However, the Tax Office considered it would have been a waste of money to get further valuations unless the AVO valuations were challenged by investors.
C7.12.2. The Tax Office discounted the 2002 legal advice. The Tax Office says that the 2002 advice 'ran against all the advice the Tax Office had received up to that time'. Also, it says that some time later the same QC advised investors in another case. However, key parts of this advice were later echoed in the evaluation given by the mediator.
C7.12.3. The Tax Office discounted the Tribunal's 2002 decision. The Tax Office took the view that it was 'wrong' and had no precedential value.
C7.13. The Tax Office also says that there is no evidence to show that it did not appropriately consider its view or did not consider it objectively. The Tax Office argues that oral advice also strongly supported its approach. However, it has not provided a written summary of this advice. The Tax Office says that it saw conduct which concerned it, and so did the Government, in 1996.
C7.14. However, one of the legal advices above commented that both the Tax Office's and investor's approaches were 'misdirected'. The other written legal advice expresses uncertainty about which test to apply and the reliability of the Tax Office-engaged valuations. These points at least should have triggered the Tax Office to reassess its position objectively and further test its views. The Tax Office did not.
C7.15. Further, the Inspector-General notes that these advices came relatively recently. A decade of difficulty preceded this and was, of itself, a clear signal that the issue needed to be objectively reassessed. The Tax Office did not objectively reassess its position before then because there was no Tax Office check or balance to trigger a requirement to do so.
C7.16. Because it did not objectively reassess its view earlier the Tax Office did not understand the strengths and weaknesses of each party's case. The Tax Office also hampered investors from understanding the strengths and weaknesses of each party's case. Until mid-2001, the Tax Office issued 10 position papers without giving sufficient reasons for its view. By mid-2001 the Tax Office was pursuing litigation to strengthen its settlement position. It only issued amended assessments in specific cases. This was either where the investor agreed to settle or the case was selected as a lead case. Before this time the Tax Office was unresponsive to requests to provide reasons. However, it did give detailed reasons to the Tribunal while litigating the Zoffanies matter.
The Tax Office was eventually forced to reassess its view objectively
C7.17. The Tax Office says that it was not forced but merely accepted a proposal from industry to mediate the issue. The Inspector-General concludes that this view is the Tax Office making a virtue of necessity. It was effectively forced to reassess its position objectively because of the considerable pressure brought to bear. Both of the two lead cases failed to achieve their aim of strengthening the Tax Office's position. One was settled on the steps of the Federal Court under confidential terms. The other damaged the Tax Office's position. The Tribunal's decision was publicly available. Key investors were well resourced and prepared to litigate more cases. These investors also tenaciously believed that their view was the correct view, relying on expert valuer and legal advice that supported their position. Litigation required costly and time consuming expert opinions that could not be applied to other cases. These opinions varied significantly and created significant litigation risks for the Tax Office.
C7.18. The Tax Office acknowledges that it could not ignore the effect that the outcome of the Zoffanies decision had on its resolution of its review of core technology claims. Views were polarised for 10 years and this decision forced the Tax Office to enter into a process that ultimately led to the objective reassessment of its position.
The Tax Office's view was changed significantly by objective reassessment by an independent mediator
C7.19. The Tax Office's and a key investor's views were objectively reassessed in 2003-04 by a well-respected lawyer. This was for the purpose of determining guidelines for reviewing R&D arrangements. The effectiveness of this reassessment primarily relied on two features. Firstly, it was critical that both parties had a high degree of confidence in the objectivity and skill of the lawyer. Among other roles, Sir Anthony Mason had performed the roles of Chief Justice of the High Court and Solicitor-General (the Government's principal legal adviser). In both roles he was well known to be 'concerned to diminish the possibility of abuse of power in what were once the opaque processes of government' (Brennan, G, 'A tribute to the Hon. Sir Anthony Mason, AC KBE', speech at The Mason Court & Beyond Conference, Melbourne, 8 September 1995). Secondly, the Tax Office intended to use the process to determine practical guidance that could be used to review other R&D syndicate cases.
C7.20. The published guidelines coming from the mediation gave clear practical guidance on the 'arm's length dealing' issue. This issue is effectively the threshold for the exercise of the Commissioner's power to adjust core technology expenditure claims. The guidelines also gave four general propositions that were relevant to how the Tax Office would determine the reasonable value of the core technology where it concluded that the parties were not dealing with each other at arm's length:
- the core technology licence fee is likely to have a positive value (as distinct from a negative or nil value);
- the arm's length amount may be within, and is likely to be within, a range of estimated amounts;
- subsection 73B(31) contemplates that the amount that the Commissioner considers reasonable will not necessarily coincide with the arm's length amount, but will not be less than the arm's length amount; and
- section 73B(31) enables the Commissioner to reach a conclusion in a given case that a part of the expenditure on the core technology licence fee is reasonable even though it does not correspond to the arm's length amount and may exceed that amount.
C7.21. However, the Tax Office did not publish the practical guidance the mediator gave on the factors to take into account in determining reasonable values for core technologies.
C7.22. It was not until the mediator objectively reassessed the Tax Office's approach leading to zero and negative core technology values that the Tax Office started to reconsider its approach and steps were taken on the path towards resolution.
C7.23. The mediator rejected the approach that led to zero or negative outcomes. He discounted the Tax Office's reliance on a discounted cash flow methodology that ignored the contractual features and the special value that the parties may have placed on the technology and the influence on price of the tax benefits themselves. He considered that the Tax Office must consider what price that particular investor and researcher would have struck if they had dealt with each other at arm's length. This was because the specific anti-avoidance provision required this to be considered. Values were not to be determined with the benefit of hindsight. Parties were likely to agree on a price in the upper range of values if they had dealt with each other at arm's length. This was because the concession created a demand, if not a market, for the core technology. This approach would have the effect of substantially increasing the core technology values from those the Tax Office-engaged valuers previously gave. However, it may not have increased the values to the extent claimed by investors. This was because the mediator also highlighted key deficiencies in the investor's position.
C7.24. The importance of objectively reassessing the Tax Office's longstanding prior approach that led to zero or negative values cannot be overemphasised. From investors' perspective, the approach that led to zero or negative values amounted to 'zero tolerance' of syndication. It was seen as a means to 'wind syndicates up'. Effectively, it characterised the arrangements as 'tax rorts'. This entrenched investors' resistance to the Tax Office's approach to the issue.
C7.25. The Tax Office should have been more transparent about how the mediation changed that approach. The Tax Office says it could not have put more into the guidelines because they were a product of the mediation and agreed by the parties, including the mediator. The Inspector-General rejects the proposition that the Tax Office could not have transparently provided full information on how the mediation had changed its position. A full disclosure of the relevant factors that it would now take into account, would have created a more open and constructive environment for final resolution of this issue. It would have enabled investors to understand fully the Tax Office's basis for compliance action. It would have demonstrated that the Tax Office had objectively reassessed and changed its position on what had been a critical point of difference. It would have reduced investors' resistance, especially where the Tax Office concluded that the core technology expenditure was not incurred in relation to an arm's length dealing.
C7.26. The Inspector-General notes that by not publishing this guidance the Tax Office avoided weakening its' settlement position. This does not mean that the Tax Office intended its inaction to achieve this result. It was merely the result of such inaction. The Tax Office says that it did not try to hide anything. The guidelines were settled by the mediator and the Tax Office 'did not want to tamper with' those guidelines. This was because it thought that it would weaken the credibility of the guidelines. In final discussions, the Tax Office further claimed that the material in the mediator's report had a different purpose to the guidelines. However, the specifics of the mediator's report provided a line of thought of general application to other R&D syndication cases. But notwithstanding who was responsible for settling the guidelines or the purpose of the advice the mediator gave, the Tax Office remained responsible for clearly articulating its forward compliance approach. This approach included how the Commissioner would exercise the power under paragraph 73B(31)(d) in determining an amount allowable as a deduction, to indicate (as it had in relation to the question of arm's length dealing in subparagraph 73B(31)(b)(i)) what factors were relevant and to indicate what weight those factors might be given. There was also nothing preventing the Tax Office from publishing this further guidance in addition to the guidelines settled by the mediator.
C7.27. It was wrong not to publish this guidance fully. The guidelines did note that core technology values were likely to be positive rather than nil or negative as they had previously been. However, without publishing that full guidance investors were left with the impression that the Tax Office would continue to value core technologies in accordance with its previous approach. In its final submission to this report (see appendix 3), the Tax Office says that it 'finds it difficult to understand how investors would have been left with the impression that the Tax Office would continue to value core technology in accordance with our previous approach.' As previously pointed out to the Tax Office, there is evidence that senior officials were well aware of this impression. The following is an extract from a 13 October 2004 email sent from one senior official to four others that documented a telephone conversation between the senior official and an investor's representative on the guidelines:
[The investor's representative] also queried why the guidelines revealed that the core technology price is likely to have a positive value. He well understood the evidence of the Commissioner in Zoffanies that the status quo valuation and methodology would reveals a zero value or negative value for most syndicates if not all syndicates. It was explained that this point arose out of the mediation …
As to the guidelines arrived at by Sir Anthony Mason [the investor's representative] was of the view that they 'were not clear …'
[the Guidelines] should set more explicitly, what is required …
[The investor's representative] observed 'we get nothing' if we go to Part C.
C7.28. Since the outcome of the mediation, there was a substantial change in the Tax Office's approach. This has substantially changed the quantum of revenue involved. The overall compliance outcome is now only a small proportion of the total originally thought to be involved — about 5 per cent or $143 million including GIC and penalties plus a potential further $73 million subject to review.
The Tax Office needs checks and balances over its culture of 'hitting tax abuse hard'
C7.29. The points above support the Inspector-General's view that a Tax Office compliance culture of 'hitting tax abuse hard' exists within the organisation. This culture is expected and, in circumstances where tax abuse clearly exists, is justified.
C7.30. However, if there are insufficient checks and balances to prevent this culture from denying a fair process then Tax Office processes are likely to be flawed and the resolution highly problematic. Unchecked, this culture could impede the objective assessment of whether tax abuse actually exists. It could also impede the correct resolution of cases regardless of whether tax abuse, in fact, exists. Processes are needed to trigger the objective reassessment of Tax Office positions in order to prevent the adverse impact of this culture in matters of uncertainty and complexity.
C7.31. The Inspector-General concludes that this unchecked cultural influence has been a major contributing factor to why the R&D syndication issue has taken well over a decade to approach resolution. Further, notwithstanding recent changes to the tax system, the culture exhibiting these behaviours continues to be demonstrated.
C7.32. It could be argued that such conduct promotes future voluntary compliance by 'tax abusers'. However, based on discussions the Inspector-General has had with investors, the Tax Office's conduct in these matters has only served further to entrench future resistance to Tax Office views in areas of uncertainty. Further, such conduct is contrary to the Tax Office's Compliance Model and the Taxpayers' Charter. It also does not sit easily with the Commissioner's recent statement to large business taxpayers:
Given the significance of large businesses to the efficient and effective operation of Australia's tax system, and the inherent uncertainty in the application of the tax law to complex arrangements, it is critical that we develop a close and constructive working relationship with the large business sector, including the efficient and proper resolution of disputes. [Commissioner's foreword, Large business and tax compliance 2006, 29 August 2006]
C7.33. The Tax Office is entitled to come to a view of the law that it believes is the correct view. It is entitled to believe that other views of the law are 'not the better view'. It is entitled to believe what the right outcome should be in any particular case. However, it must also ensure that the process by which it arrives at that outcome is fair and appropriate. It must also be open to objectively reassessing its view where it receives signals that its view may not be the correct one.
C7.34. The Tax Office did not objectively reassess its view earlier because it tenaciously believed that views contrary to its own were wrong and that the arrangements were 'tax rorts'. The Inspector-General considers that the Tax Office belief that arrangements were tax rorts triggered a cultural response that the Tax Office's view was correct both in the desired outcome and the path to reach that outcome. This culture led the Tax Office to assess selectively and subjectively the weight of external signals and the perspectives of investors. Those signals that supported its view were correct. Those that did not were wrong.
C7.35. The Tax Office's tenacity was fuelled, in part, by the suspected amount of revenue at risk. This amount kept increasing. Until investors exercised the put option, they continued to claim large interest deductions. One Tax Office report to the TCC forecast claims in the hundreds of millions for three syndicates 'unless they were closed down'. In the Tax Office's view at the time, R&D syndicates involved about $3.4 billion of revenue. The size of this figure contributed to the Tax Office's belief that the issue required firm treatment. It also engendered concern with others, including Government.
C7.36. If the Tax Office had objectively reassessed both its and investors' views earlier, long time periods and significant costs would have been avoided. Had these views been objectively re-assessed before the initial audits were concluded in 2000, up to three years and more than $11 million of direct compliance costs could have been saved. Additionally, significant erosion of investors' confidence in the Tax Office would have been avoided, particularly that relating to the Tax Office's ability to reassess its technical views objectively.
8. The Tax Office used litigation purely to strengthen its settlement position rather than to test the issues objectively
C8.1. The Tax Office used litigation purely to strengthen its settlement position rather than to test the issues objectively. It intended to use litigation to resolve other R&D cases 'on an acceptable basis to the Tax Office'. At the time the Tax Office saw mediation as an option but 'highly problematic' without a case successfully litigated. The Tax Office did not have extensive experience in using mediation to resolve highly complex matters, involving polarised views. The Tax Office saw litigating high-profile cases would lead to other investors viewing the Tax Office-obtained valuations more favourably. The aim was to obtain outcomes capable of applying across the syndicate population.
C8.2. However, applying the outcome to the other cases was problematic. This was because the issues in dispute were essentially factual and therefore easy to distinguish. Strictly speaking, all judicial decisions in common law jurisdictions are distinguishable on the facts of their case. Existence of an arm's length dealing is essentially a finding of fact. What amount should be substituted for the claimed deduction essentially relies on the facts of the case. However, parties can obtain great guidance from the reasoning given by a court or tribunal. Parties can see how the issues in dispute are resolved, including the questions that the law poses, the process through which those questions are answered, what facts are considered relevant and irrelevant, how much weight the differing facts are given, what is needed to evidence those facts and how they influence the outcome.
C8.3. The Tax Office's intended approach hindered it from properly assessing whether it might lose in litigation or what it would do if it did lose. When it did lose, the Tax Office sought to confine the adverse impact that the Tribunal's decision in Zoffanies had on its position. The Tax Office said that the Tribunal 'got it wrong' and was not precedential. This was contrary to the Tax Office's initial thinking on its reasons for litigating this case — that it obtain 'outcomes which are capable of application across the syndicate population'. (The issue is also further evidence of the issue discussed at page 167 of the Inspector-General's report on his review of the Tax Office's management of litigation.)
C8.4. The Tax Office could have used the Tribunal's reasoning as a guide in determining facts in other cases. The Tribunal is not a judicial body. It 'stands in the shoes' of the decision maker. It 'remakes' the decision as if it were the decision maker. Therefore, the reasoning adopted by a body reviewing the merits of the Commissioner's decisions is an important and significant indicator of the reasoning approach that should be applied by the Tax Office in assessing the merits of other like cases. However, the Tax Office disagrees that in these circumstances it could have done this. It says that it was in mediation at the time the Full Federal Court decision in the Zoffanies case was published. Although the Tax Office agrees that the Tribunal decision gave guidance on how to approach the application of the law to the facts, it says that the mediation process was a better process through which to achieve this, especially as it did not agree with the approach taken by the Tribunal.
C8.5. If the Tax Office disagreed with the decision it should have alerted investors to its view, how it intended to challenged the decision and how it would administer the provisions in the interim. It did not. Nor did it widely inform the community that it was taking an alternative course in mediating a case to clarify the issue.
C8.6. Had the Tax Office used the litigated case to give practical guidance in how the Commissioner would approach the anti-avoidance provisions, then up to a year and around $5 million in direct compliance costs could have been saved. However, the sole intention of using litigation to strengthen its settlement position drove the Tax Office into an alternative strategy, the mediation, instead of using the decision immediately to move forward to resolve the issue.
9. The Tax Office failed to communicate effectively
C9.1. The Tax Office failed to communicate effectively. This contributed to investors' resistance. It also undermined confidence in the Tax Office as a fair administrator. In spite of the syndicate investors being a small population and known to the Tax Office, at no time over the 15-year period did the Tax Office communicate directly with all of them to provide practical guidance or convey its concerns. If practical guidance were communicated directly and earlier it would have likely led to a different compliance outcome.
C9.2. The following are examples of ineffective communication.
C9.2.1. In the absence of clearly communicated concerns, investors considered they were reasonably entitled to assume that there was administrative acceptance of their investment once it was registered. People were reasonably aware of the overvaluation of core technology (especially by October 1994 when the BIE pointed out widespread perception of artificial core technology valuations — although the basis for this perception was not explored). Full disclosure of the financial arrangements and valuations, including their tax effect, was made during the registration process. However, the Tax Office did not indicate tax law concerns until after the TCC publicly specified its concerns with valuations in 1996.
C9.2.2. Investors considered that they met the letter of the law as understood at the time of their investments. The laws and administrative requirements were progressively changed to address compliance concerns. Investors relied on promoters' experience and material in obtaining registrations. The TCC scrutinised arrangements during the registration process. Investors were unable to change the arrangements once registered. The Tax Office had an observer in the TCC registration process. This observer had no voting power but did advise the TCC on tax matters. Investors' perceptions in this context are important and the significance of the observer's status is lost on them. Some applications were rejected but later approved when lower core technology values were tendered. From November 1995, the TCC considered the valuations more closely.
C9.2.3. The Tax Office did not tell investors before they entered arrangements that core technology overvaluation was a significant compliance risk. The Tax Office refused to give binding advice on core technology values or the anti-avoidance provisions. At the time, this was typical of the Tax Office's approach towards giving advice on the anti-avoidance provisions. The Tax Office started audits from 1992. Tax Office officers gave speeches at industry conferences from early 1996 saying that there 'were early indications of questionable valuation of core technology'. However, these are insufficient and unrealistic means to communicate compliance concerns to others. They did not give sufficient information to enable people to assess the merits of their own claims.
C9.2.4. The Tax Office took far too long to communicate that it had objectively reassessed its view. Investors saw the Tax Office discounting earlier signals that its view might not be the correct view. The Tax Office maintained that its view was correct because it relied on expert valuer advice and that it was reasonable to rely on this advice. Investors perceived a double standard. The Tax Office used the same argument that investors had used to defend their reliance on their valuations. However, investors comment that although the Tax Office used this argument to support its own case, it rejected the argument when it was used by investors.
C9.2.5. The Tax Office refused to acknowledge to investors that it contributed to the behaviours it was observing. It refused to accept it allowed uncertainty to continue. It refused to accept that its inaction towards the continuing uncertainty influenced the taxpayer behaviours. Investors considered the Tax Office was trying to 'rewrite history' by retrospectively applying a view that was not known at the time. Investors believe that if the Tax Office had given that guidance before arrangements were entered, they would have followed it.
C9.2.6. The Tax Office litigated the Zoffanies case. Once the Tax Office lost on the grounds of the specific anti-avoidance provision, it distinguished the case on its facts. Investors heard the Tax Office say that the Zoffanies case was the most expensive case it had ever litigated. Investors asked why the Tax Office would litigate a case for a relatively low amount of revenue if it had no precedential value.
C9.2.7. The Tax Office did not inform auditees that it was executing lead case strategies. Auditees perceived Tax Office inaction. Others that were not audited were surprised to receive later a choice of accepting an offer of settlement or subjecting their claim to review.
C9.2.8. The Tax Office excluded from review investors with investments of under $3 million. This was because the Tax Office considered the largest investments represent the greatest risk — there being greater scope for inflation in a larger amount than a small one. The Tax Office did not publicly provide its reasons for this decision. By not publicly providing its reasons for differentiating its compliance treatments the Tax Office left itself exposed to allegations that the decision was merely based on an arbitrary revenue figure and not on compliance behaviours or attitudes. This was especially where the smaller investments were thought to be less likely to have as strong claims as the larger investments in having conducted due diligence which evidenced an arm's length dealing.
C9.2.9. Some investors found the way in which the Tax Office offered its September 2004 settlements to be threatening. They had claimed the deductions 8 to 12 years earlier. For 19 of the 40 investors selected for Tax Office compliance review from September 2004, they heard nothing on the matter from the Tax Office until late 2004. They were forced into either 'admitting guilt' and paying half of the core technology claimed with half of six years back interest, or, submitting to an expensive review process to prove the innocence of their claims.
C9.2.10. Investors initially considered that the Tax Office was applying a 'double standard' in response times to its settlement offer. For some the Tax Office took over 10 years to notify them of the issue. It expected investors to provide a response to the settlement offer within 6 months. This issue was resolved by the Tax Office later writing to investors to offer extensions of time, without accruing GIC during those periods, where investors actively worked with the Tax Office to resolve the issue.
C9.3. The Tax Office did not effectively communicate its review and resolution strategies. It did not alert relevant taxpayers that their claims might be reviewed in the future (in many cases more than eight years later). This allowed GIC to accrue and investors to be ill prepared when the time came for review. The Tax Office did not tell taxpayers that it was focusing its resources on resolving lead cases to establish guidance for the resolution of other cases. In one case this allowed an investor to settle on substantially more detrimental terms than would have awaited the outcome of the mediation. It did not communicate the change to its long held approach to quantifying an arm's length amount following the mediation. This would have allayed investors' concerns that the Tax Office would merely continue to substitute investors' valuations with the Tax Office-commissioned 'close to zero' valuations. It would have promoted transparent administration and reduced investors' resistance. The Tax Office disputes the conclusion that it did not communicate the change to its long-held approach to quantifying an arm's length amount following the mediation. However, the Inspector-General maintains his view that the Tax Office did not provide as much information as it could have done on this point. What was communicated did not adequately convey the change in the Tax Office's approach or the factors that should be considered in quantifying these amounts.
C9.4. The Tax Office relied on indirect communication of the issue (speeches at industry conferences and other auditees telling the investors). It argues that all investors would reasonably be aware of the Tax Office's scrutiny of this issue by reason of its audits of key investors and general public statements. The Tax Office states that the vast majority of syndicates were managed by four merchant banks, which had ongoing roles in conjunction with the investors in relation to the R&D programme for each syndicate. They were the subject of intense Tax Office audit action. The Tax Office finds it difficult to conceive that the ongoing issue of core technology values, of which promoter banks were well aware, was not raised at these meetings.
C9.5. This view is unrealistic. The investors were in competition with each other. They would not discuss such sensitive information with anyone unless it was a threat to their syndicate and then only with other syndicate members. This information would cause market concern and depress the share price.
C9.6. Further general statements in a public forum are not enough to alert taxpayers to the Tax Office's concerns. Specific information about the concerns was needed. The first time the Tax Office provided specific information was in its position papers to some auditees from mid-2001.
C9.7. Further, the arrangements and their tax effects were examined before arrangements were entered. Investors complied with a Government registration process in which the Tax Office was involved.
C9.8. The Tax Office could have engaged industry much earlier. It did discuss mediation with a key investor three years earlier. However, the investor withdrew from these discussions when the Tax Office insisted that amended assessments should issue in parallel to the mediation and the Tax Office did not respond to the investor's requests to give reasons for its decision.
C9.9. The Tax Office could have arrived at an understanding of the strengths and weaknesses of each party's case much earlier. The Tax Office could have struck a compliance framework that showed it appropriately considered industry's views. Had it done so when the specific anti-avoidance provision was enacted, up to 12 years and $30 to $40 million of direct compliance costs would have been saved. Also, with more effective communication the Tax Office would have avoided the erosion of investors' confidence in its administration of the tax laws.
C9.10. The Tax Office accepts that with the benefit of hindsight it should have had greater communication with investors to advise them of emerging concerns and the Tax Office's audit programme.
10. In some specific cases the Tax Office acted unfairly
C10.1. There were also instances where the taxpayers were treated unfairly. This was not only through the excessive timeframes in resolving disputes. It was also in the Tax Office's handling of various aspects of the disputes. This included the following:
C10.1.1. It was not until mid-2001 that the Tax Office gave reasons for decision to auditees in its position papers, and then not in all cases. The Tax Office says that it relied on 'explicit' legal advice not to disclose its reasons. However, the legal advices provided to the Inspector-General do not indicate this. One advice merely comments that the position paper did not disclose reasons for the decision. Before this time auditees were unable to understand the case made against them. This impeded an adequate understanding of the strengths and weaknesses of each party's case. This in turn hindered an objective assessment of the issue early on.
C10.1.2. Investors thought it 'incredible' that core technologies would have close to zero or negative values. This was especially the case where the researcher had a history of successfully developing technologies and had spent significant time and money (in the millions of dollars) in developing the core technology before entering the syndicates. The approach leading to close to zero or negative values had been rejected by the Administrative Appeals Tribunal in the Zoffanies case (as well as by the mediator). Submissions also pointed to a 2005 Administrative Appeals Tribunal case (The Taxpayer and The Commissioner of Taxation  AATA 1039, 20 October 2005, Sydney) which also rejected that approach. Investors had their own contemporaneous valuations that supported their position. Investors perceived that the Tax Office was applying a view retrospectively with the purpose of 'winding syndicates up'. This was despite a Government policy decision in July 1996 that allowed existing syndicates to continue to claim the concession.
C10.1.3. Part IVA Panel decisions relied on untested auditors' submissions. This is because investors were not afforded adequate opportunity to be heard in relation to these submissions.
C10.1.4. The Tax Office also effectively denied taxpayers the right to have its' view reviewed by an independent body. Non-lead and less advanced cases were to be put on hold. This meant that it was unlikely that other cases would progress to amended assessments. This would deny the taxpayer the right to exercise their right to challenge the Tax Office view under Part IVC prior to the lead cases being finalised. In only two cases did the Tax Office issue amended assessments without first settling the matter. All other investors were unable to exercise choice in pursuing any merits review through Part IVC of the Taxation Administration Act 1953. Access to review under Part IVC depends on the Tax Office issuing amended assessments. Taxpayers are able to seek merits review of assessments of tax liabilities through Part IVC. Unless an 'unlimited period of review' provision applies, as was the case here, the Tax Office is limited to a time period in which it may amend a taxpayer's assessment. The Tax Office argues that although it effectively may be a denial of a right, it is a right that the taxpayers did not want to exercise. It may be true that many investors did not want amended assessments before settling the matter because it would adversely affect their market value and financing. They did, however, want the matter to be independently reviewed. The Part IVC dispute resolution process did not enable independent review of the matter without exposure to adverse market responses.
C10.1.5. The Tax Office also denied four requests for internal review in one case. The Tax Office says that the requests did not satisfy its criteria for internal review. It saw these requests as a delaying tactic. This case was ultimately resolved in the taxpayer's favour four years later.
C10.1.6. One potential effect of the Tax Office's September 2004 settlement strategy was to impose greater costs on those more compliant taxpayers. Investors could settle on a 'no questions asked' basis without review. Taxpayers that had potentially made excessive claims could settle without review and without compliance costs. However, investors that believed they had made valid claims were required to incur greater compliance costs in undergoing a review to prove compliance. Some investors who have settled state that minimising ongoing compliance costs was seen as a better outcome than seeking to prove their belief of eligibility. Serious consideration was given to settlement even though they considered their claims validly made. They point to the prohibitive financial costs in disputing any Tax Office amendment or submitting to an audit on this issue. They also perceive considerable loss of productive time that senior executives would incur if involved in negotiations or disputes on the issue.
C10.1.7. In the absence of full disclosure by the Tax Office, investors assumed that the Tax Office would continue to apply its previous approach to determining quantum — that was thought to be to substitute the core technology deduction that the investors claimed for the negligible value in the Tax Office-commissioned valuation. This placed greater pressure on taxpayers to settle without review.
C10.1.8. In late 2004, the Tax Office unnecessarily selected a number of cases for review. Syndicates that were registered and had their valuations scrutinised by the TCC from November 1995 had the right to assume that they were compliant on this issue when they were registered. This was because the TCC made it clear in 1996 that it had been examining core technology valuations to determine if they evidenced arm's length market values as part of registration since November 1995. The Tax Office acknowledges this and found those cases compliant. However, the Tax Office did not exclude these cases from review. It required the investors to provide detailed submissions. This unnecessarily increased the compliance costs for those cases. The Tax Office considers that it is 'up to the investor' to prove that the TCC scrutinised their valuation. However, the Tax Office could access that information from the TCC directly as part of its case selection and should have done so.
C10.1.9. The Tax Office hindered quick and fair resolution of some cases reviewed after September 2004. The Tax Office perceived the cases amounted to 'tax abuse'. It considered 'it was up to the investor' to make a claim for a better basis for settlement. The Tax Office questions the need to discuss cases in detail. However, as the Tax Office disagrees with this conclusion, the Inspector-General considers it necessary to recount the following relevant matters in some detail.
C10.1.10. In late 2004, three investors in different syndicates were offered a choice to settle on a 50 per cent basis or subject themselves to review according to the published guidelines. Over the next two years there was correspondence between the Tax Office and the investors on whether there was an arm's length dealing in relation to the core technology price.
C10.1.11. In early November 2006, the Tax Office wrote to one investor advising that the Tax Office would take no further action. The taxpayer was not given any reasons in the letter. However, the Tax Office told the Inspector-General that it took this decision because the TCC registered the syndicate after it announced that it had been scrutinising core technology values as part of its registration process since November 1995. The Tax Office decided to take no further action after meeting with Inspector-General staff in October 2006. At this meeting the Inspector-General discussed the key issues identified in the course of the review and expressed the view that the Tax Office should have taken account of the strengthened TCC scrutiny in its risk assessment and compliance strategy. The Tax Office agreed and commented that it had seven cases falling into this category. It was only uncertain in relation to one. This was because although the syndicate was registered after November 1995, it was unclear whether the TCC had approved the finance scheme before that date. There was usually a time delay between assessing the finance scheme and the date of registration. In its final submission to this report (see appendix 3), the Tax Office now says that 'additional TCC scrutiny was one of the factors taken into account'. This latest response is contrary to advice the Tax Office gave the Inspector-General in October 2006 and confirmed in February 2007. It is also contrary to advice it gave to an investor's representative in February 2007, that the factor was 'determinative'.
C10.1.12. For the second investor the Tax Office advised in late November 2006 that, in its view, there was no arm's length dealing. It also gave an indication of the likely amount it would allow as a deduction by enclosing a copy of the Tax Office-commissioned valuer report. The Tax Office gave the second investor until mid-February 2007 to make submissions on the value of the core technology.
C10.1.13. The second and third investors were made aware of the issue of additional TCC scrutiny by their adviser. In late November 2006, the second investor asked for more time to collate relevant information going back more than 10 years to demonstrate additional TCC scrutiny. This was because the TCC had initially rejected the registration because of the financial arrangements. The Tax Office advised that it would not give this extra time and that it had already determined the issue of arm's length dealing (on the basis of material in the investor's submission given many months before the Tax Office decided that the factor was determinative). However, it said that it would consider anything the investor provided before mid-February.
C10.1.14. However, for the second investor the Tax Office had evidence that indicated the TCC may have scrutinised the initial valuation. This was because auditors had previously obtained an IRDB letter declining to register the syndicate on the ground that its financial arrangements did not comply with the finance scheme guidelines. The Tax Office could have provided this information to the investors. The Tax Office could have satisfied itself of the scrutiny and either excluded the investors from its compliance actions or informed the investor why it was not satisfied that the scrutiny given was enough. This would thereby have avoided the investor having to incur costs in preparing submissions. The Tax Office did not provide this information.
C10.1.15. It is also unfair administration to receive a submission, later decide a factor is determinative of the issue, not communicate that factor and then refuse investors reasonable time to reconsider their submission in light of that additional factor. The Tax Office must keep compliance activity moving. However, this should not be at the expense of appropriate procedural fairness.
C10.1.16. The third investor was involved in another syndicate which was registered six months after the TCC commenced additional scrutiny of core technology valuations. Its finance scheme was scrutinised during the period from which the TCC Chairman said that the TCC was scrutinising core technology values as part of its registration process. However, the Tax Office did not advise that third investor that additional TCC scrutiny was a significant factor in determining the issue. Also, the Tax Office assumed that the TCC did not scrutinise the syndicate's core technology value because that syndicate's finance scheme was examined by the TCC shortly before the issue of the new finance scheme guidelines. This was notwithstanding the fact that the syndicate's finance scheme was considered during the period in which the TCC was scrutinising core technology values. This was also notwithstanding the fact that even though the announcement of the new finance scheme guidelines was made in late November, the TCC Chairman stated that applications under the old finance scheme guidelines for advance approval of the finance scheme leading up to the announcement of the new guidelines were subject to the TCC's 'close administrative scrutiny'.
C10.1.17. The Tax Office then said in final discussions with the Inspector-General's office that if investors did not refer to additional TCC scrutiny of their valuation in their submission (given to the Tax Office some time before the Tax Office decided that additional TCC scrutiny was a 'determinative factor') it would not consider that the investor relied on that scrutiny. The Tax Office considers that there must be evidence of additional scrutiny as well as reliance on that additional scrutiny.
C10.1.18. The Inspector-General considers this an ill-considered approach. Whether or not investors claimed reliance on additional scrutiny became irrelevant once core technology valuations were scrutinised before the syndicates were registered. The specific reason for the TCC's additional scrutiny was to address the risk of inflated core technology values before syndicates were registered. Inflated core technology values were a significant concern for government bodies by late 1995. The Tax Office had observer status on the TCC and provided the TCC with advice on tax matters. In August 1995, the TCC's newly appointed Chairman (a former Commissioner of Taxation) immediately embarked on public consultation on new draft guidelines by which syndicates' financial arrangements would be assessed. During this period he gave speeches stating that he thought core technology valuations were on 'the too high side'. One speech clearly and unambiguously set out five factors of concern that the TCC would consider when looking at core technology valuations. The Chairman indicated that the TCC would not recommend registration of syndicates with valuations it considered excessive and, further, the TCC would be prepared to commission its own valuations 'if necessary'. However, most of the syndicates, that were the subject of this review, had been processed by the TCC prior to this time.
C10.1.19. The Tax Office did not tell investors that additional TCC scrutiny was a 'determinative' factor because it was likely that all investors would claim they relied on registration regardless of whether they in fact did. However, arguing that arm's length values depended on investors claiming reliance would likely lead to inequitable outcomes. In the absence of knowing that the additional scrutiny was a determinative factor the taxpayer may have relied on the additional scrutiny but simply not mentioned it in their submission. A better approach was to use an objective measure: whether the TCC assessed the financial arrangements after the date on which the TCC began to address the risk of inflated core technology prices.
C10.1.20. In spite of accepting that the TCC's additional scrutiny was a determinative factor, the Tax Office's strong belief that these cases amounted to 'tax abuse' continued to impede its ability to demonstrate a fair and quick review of these cases.
C10.1.21. In its final submission to this report (see Appendix 3), the Tax Office appears to have now accessed the TCC records. The Tax Office now says that the TCC did not scrutinise the valuation and the core technology valuation was not obtained at the time the TCC scrutinised the finance scheme. However, it also appears from the Tax Office's submission that it has now finalised this case without adjustment.
C10.1.22. In another matter, two investors settled with the Tax Office while the Tax Office was involved in the mediation. The mediation was conducted for the purpose of providing guidelines for the resolution of other R&D cases. The Tax Office did not inform the investors of the mediation or its purpose. The investors found out through a Commissioner's speech given in April 2004. For the investor who settled before the Commissioner's speech, the terms of settlement were far less concessional than those offered to the other investor who delayed settlement until after the Commissioner's speech. All facts were materially similar. The Tax Office considers the earlier settlement a 'commercial decision to settle'. At that time the investor would have been aware of the Zoffanies Full Federal Court decision and considered the risks. Further, the Tax Office says it could not tell investors it was involved in a mediation to provide guidance 'because of the terms of confidentiality'. This is not supported by the terms themselves. Further, these terms did not prevent the Commissioner from publicly announcing the Tax Office's involvement in the mediation three months before its completion.
C10.1.23. In its final submission to this report, the Tax Office argues that the earlier case was settled at a time when the Tax Office had not contemplated making a general settlement offer. Although the Tax Office may not have contemplated a general settlement at the time this does not mean that the mediation would not affect terms of settlement being negotiated in individual cases. It is clear that the output of the mediation was intended to have wide application to other R&D syndication cases and would therefore likely affect the terms of any settlements being negotiated on the issue, even though the extent that the mediation would affect those terms was uncertain until the end of the mediation. The Tax Office continued negotiations with the first taxpayer and entered into a settlement with them at the same time it was developing a global policy to deal with all matters of that kind, without notice to that taxpayer.5
C10.1.24. The Inspector-General considers this unfair and inconsistent administration. Such conduct erodes public confidence in the Tax Office's ability to administer the tax laws objectively. It gives the perception that the Tax Office took advantage of the prevailing uncertainty solely to obtain a better revenue outcome. The Tax Office was aware of the mediation. It was aware that the mediation was aimed at producing 'guidelines for reviewing R&D arrangements'. It should have been aware that this would affect the position taken in relation to the taxpayer. It knew that the investor was not aware of this. It therefore settled on an unfair basis. This conduct is inconsistent with the Taxpayers' Charter. It is also inconsistent with community expectations that the Tax Office will be fair and transparent in its dealings.
C10.1.25. For 19 of the 40 investors targeted in late 2004, the settlement offer was the first time that the Tax Office told them that the claims they made 8 to 12 years ago would likely be reviewed. Other investors were already told many years earlier that their claims would be reviewed. At the time there was significant uncertainty and the Tax Office was aware of the detail of the arrangements and their tax effect before arrangements were entered.
C10.2. The Inspector-General considers it unconscionable for the Tax Office to have allowed one investor to hold off concluding a settlement because of the mediation but not the other investor it was in settlement negotiations with when all the time the Tax Office was aware that there was a process being undertaken to provide guidelines for reviewing R&D arrangements.
C10.3. In relation to the 19 investors that were not formally notified of the likely Tax Office review of their claim at all until late 2004, the Inspector-General concludes that the Tax Office acted unfairly, albeit legally. It retrospectively applied a compliance view to claims made 8 to 12 years previously without prior notice to those taxpayers that it might do so.
C10.3.1. The tax laws allow the Tax Office unlimited time to amend a 'nil' assessment.
C10.3.2. The Government recently placed limits (with prospective effect) on the amendment of 'nil' assessments. It considered the general issue during the ROSA review.
C10.3.3. However, the facts of this case are materially dissimilar to those of other 'nil' assessment cases. All investors sought Tax Office binding advice, the Tax Office was aware of the compliance issue yet did not provide practical guidance despite many adequate opportunities to do so over 13 years, it was aware of the facts and their tax effect before arrangements were entered, all losses were utilised more than eight years ago and the Tax Office did not alert those 19 investors that it might review their claims at any point in the future. It waited more than eight years to do so.
C10.3.4. The Tax Office argues that it must take action where it has formed a view that there is a significant compliance problem. However, it agrees that there was no fraud or evasion in these cases. It also, in 2004, pragmatically chose not to pursue over three-quarters of the investors.
C10.3.5. The Tax Office could have reviewed all claims many years earlier but it failed to do so. Despite familiarity with all the investors, the Tax Office inappropriately relied on indirect communication to alert taxpayers to the probability of reviews. It gave private binding rulings to investors in the 246 syndicates. Through AusIndustry it had access to the details of all investors.
There have been a number of changes to tax administration
3.108 During the period from 1991 to 2007 there have been a number of changes to tax administration. These include the following.
3.109 Since 2002, the Tax Office has aimed to improve awareness of the effects that policy and law design will have on tax administration (the Integrated Tax Design). The aim is to address tax administration issues during the policy development and drafting of tax laws.
3.110 There have been recent law and administrative changes aimed at improving practical guidance.
- The law was recently changed to allow the Tax Office to provide private binding rulings on matters of fact, including valuations.
- The Tax Office has agreed to implement Treasury's recommendations flowing from its Review of Aspects of Self Assessment (ROSA) report. This includes indicating in private binding rulings whether the Tax Office considered the general anti-avoidance provisions. Treasury recommended that where Part IVA has been substantively addressed and there has been a full and true disclosure of all material facts, the Tax Office should be prevented from reopening an assessment.
- The Tax Office has also implemented Treasury's recommendations to develop Market Valuation Guidelines. These guidelines were published after discussions with business, accountants and valuers. Generally, the guidelines set out detailed criteria that the Tax Office will apply when assessing the quality of market valuations. They also provide a framework for the Tax Office to give binding advice on valuations.
- The Tax Office is beginning to extend its practice of entering pre-assessment agreements in complex matters — for example, advanced pricing agreements in transfer pricing cases.
- Since 2003, the Tax Office has sought to raise awareness at the corporate board level of tax risks.
- Since late 2005, the Tax Office has had the benefit of the joint advice of the Solicitor-General and Australian Government Solicitor (sought by the Tax Office in connection with the Inspector-General's review of the Tax Office's management of litigation) This advice gives practical guidance in how to administer the tax laws in circumstances where the Tax Office disagrees with case law. In particular, this advice provides guidance to the Tax Office on how it should inform taxpayers of how it will administer the law following adverse decisions.
3.111 There have also been law and administrative changes aimed at reducing the timeframes for periods of review and the adverse effects of extended review periods.
- The Tax Office amended its GIC remission policy (Practice Statement 2006/8) as a result of the Inspector-General's audit timeframes review to give GIC and SIC remission where delays are not caused by the auditee.
- Since 2004, the Tax Office has implemented improved case management of large case audits, including reporting of 'aged cases' directly to senior management on an ongoing basis and having two of its most senior officials involved in the case management of the most difficult cases.
- As a result of the Inspector-General review of audit timeframes and Tax Office discussions with the Corporate Tax Association, the Tax Office currently aspires to complete large complex audits within five years.
- The law was recently changed to place time limits on the effective unlimited time periods for review of 'nil' assessments. This gave effect to Treasury's recommendations in its ROSA review. Treasury also flagged for more detailed review other unlimited periods for review in the tax laws.
- The tax laws were changed to reduce the rate of interest accruing before amended assessments are issued. However, they will not impact on the R&D syndicate core technology audits. The changes operate prospectively.
3.112 The Tax Office has also implemented mechanisms aimed at improving its communication with taxpayers.
- Since the early 1990s the Tax Office has further refined its internal processes to identify, prioritise and communicate to the public compliance risks. For example, the Tax Office publishes its compliance programme annually which sets out its compliance focus for the coming year. It has also refined its processes for the escalation of technical issues for resolution.
- The Tax Office has improved its public communication on compliance issues. Since 2000, the Tax Office has used 'Taxpayer Alerts' to advise taxpayers of potential Tax Office concerns with certain tax arrangements and the reasons for those concerns. It also uses media releases, industry meetings and professional forums to draw public attention to high compliance risks.
- As a result of the Inspector-General's review of the Tax Office's management of litigation, a number of changes were recommended that would go some way to improving the Tax Office's use of litigation — for example, introducing a standard communication product to communicate the application of finalised court and tribunal decisions.
- In 2005, the Tax Office changed its procedures to provide taxpayers with the opportunity to be heard at Part IVA Panel meetings. This is set out in Practice Statement 2005/24.
1.113 The Inspector-General makes the following recommendation.
The Inspector-General recommends that the Tax Office fully reconsider whether it has fairly struck settlements with:
- the 19 investors that the Tax Office did not formally advise that their investments made more than 8 years previously would be subject to review; and
- those investors with whom the Tax Office negotiated settlements without telling them that at the same time it was mediating a case to develop guidelines for the resolution of R&D syndicate cases.
3.114 In making this recommendation, the Inspector-General notes that he will be further examining R&D syndicate settlements in the context of his future review of settlements generally.
Tax Office response
3.115 The Tax Office provided the following response to the above recommendation.
In relation to the 19 investors mentioned in paragraph (a), it should be noted that settlements have been made in respect of only 6 cases with another 3 cases yet to be finalised. In the remaining cases, adjustments have not been made to claimed deductions.
The Tax Office accepts that it would have been better if direct contact was made with these investors earlier. However, it is our view that most, if not all, of those investors and their advisers would have been aware of the Tax Office's ongoing review of R&D syndication arrangements.
In the small number of these cases where adjustments have been made, the settlements were entered into in good faith and were based on the fact that the deductions claimed by investors were not fully allowable under the law. To unwind these settlements for the reasons suggested in the report would raise questions of fairness to other taxpayers who have complied with their tax obligations under the law. It would also raise questions of fairness to other taxpayers who have settled or otherwise finalised assessments in circumstances where the Tax Office has reviewed old issues, for example loss company cases.
It should also be noted that in reviewing these cases the Tax Office did take into account the length of time since the transactions took place in considering our position and the terms of settlement in each case.
In response to the cases settled during the course of the mediation mentioned in paragraph (b), each case was settled at a time when the Tax Office had not contemplated making a general settlement offer. This offer was considered towards the end of the mediation and was announced following the mediation. The cases were also settled before the Commissioner announced in April 2004 that the general anti-avoidance provisions in Part IVA of the Act would not be applied to deny deductions for core technology expenditure. The timing of the events relating to the two cases referred to in the report is set out in the attachment.
While not raised in the report, the overall complex and special circumstances of the R&D syndication issue may warrant that consideration should be given to reviewing any case settled on less favourable terms than the general settlement offer made towards the end of 2004. Although these cases would have been settled in good faith, there is an issue whether such investors have been unfairly disadvantaged compared to other investors simply because they chose to finalise their case in a more timely way. We will review this matter further taking into account all of the circumstances relating to these cases.
Inspector-General's comments on Tax Office response
3.116 I am pleased that in the last paragraph above the Tax Office has accepted my recommendation to reconsider the fairness of some of its settlements, albeit not on the basis set out in the recommendation.
3.117 In relation to the 19 investors mentioned in recommendation (a), the Tax Office accepts that it should have directly contacted these investors earlier. But, the Tax Office fails to acknowledge as unfair the fact that it did not. It also fails to acknowledge that it was aware of all the relevant facts (including the details of the syndication arrangements and their tax effect) and the utilisation of the tax losses at least eight years before it sent them a settlement offer out of the blue (see paragraphs C10.3 to C10.3.5 in Chapter 3).
3.118 Further dialogue on these recommendations will be undertaken as part of the process leading up to the finalisation of my final and overall report on the Tax Office's ability to deal with major complex issues within reasonable timeframes.
Issues signalled for fourth report
3.119 This report also signals issues arising from this review that may be the subject of recommendations to be made in the Inspector-General's fourth report or the subject of other reviews. These issues will be assessed and discussed with the Tax Office before drafting the fourth report. The focus of these issues is on matters of administrative objectivity, timely resolution and provision of certainty that have been identified in this review of R&D syndicates.
- Providing early practical compliance guidance in matters of complexity and uncertainty. This includes the early publication of guidance and the early communication to relevant taxpayers that their claims may be reviewed in the future.
- Improving the mechanisms to trigger management at an appropriate senior level of those complex issues experiencing delays, without relying on bottom-up escalation processes.
- Providing sufficient reasoning on technical issues to enable an informed understanding of the strengths and weaknesses of each party's case. This could include developing and applying a set of guidelines as to the form, content and purpose of a position paper.
- Introducing circuit-breakers to require independent and objective reassessment of the Tax Office's view and compliance approach where significant technical or compliance issues are not being resolved in a timely way.
- Introducing processes to minimise any risk of potential cultural, or other extraneous, influences getting in the way of administrative objectivity (noting that all organisations, not only the Tax Office, are subject to unconscious influence by their culture).
- Using lead cases to reduce compliance costs of the majority of potential auditees in areas of uncertainty. These lead cases could be representative of the class of cases against which the outcome will be applied. They could be used to reduce uncertainty and provide practical guidance. These cases could be clearly identified as lead cases at the outset.
- Ensuring that there is no basis for allegations of bias in review processes by either implementing sufficient transparency and external assurance in those processes, or engaging tax officers without a prior history in the matter.
- Ensuring that there is no basis for criticism of settlement offers by ensuring that the alternative action to settlement was not arbitrary or overstated. This could include obtaining appropriate external counsel opinion on the litigation risks (both in terms of the view of the law and an assessment of the evidentiary basis to sustain that view for that case) and likelihood of success. Greater clarity around the weight of factors for adjusting settlement terms could also be given.
1 This paragraph was inserted subsequent to receiving the Tax Office submission in Appendix 3 in order further to substantiate points raised in that submission.
4 This sentence was altered subsequent to receiving the Tax Office submission in Appendix 3 in order further to substantiate points raised in that submission.