Overview

2.1 From a simplistic, number-driven perspective, tax litigation is only a small part of the overall operation of the tax system, numerically overshadowed by the large volumes of transactions and compliance actions that do not result in litigation. Based on Tax Office figures, over the last two years, fewer than 0.3 per cent of Tax Office compliance adjustments have led to appeals and disputes, a total of some 3,200 cases. Importantly, this review has noted that the majority of these cases are appropriately concluded by the Tax Office.

2.2 However, the importance of tax litigation is greatly leveraged in the overall system for a number of reasons:

  • Litigation is part of the operation of the broader system of government at a higher level than the tax system itself. As both the practical and symbolic interface between the administrators of the laws and the judiciary in its role of determining how the laws apply, it brings into sharper focus foundational concepts of the broader system such as the right of those affected by government administrative decisions to have those decisions reviewed by a body which is independent of the original decision maker and other principles of the rule of law.
  • As well as resolving particular disputes, litigation contributes directly to the basis of ongoing administration of the laws, and may lead to the shaping (or re-shaping) of the laws in Parliament.
  • Litigation often involves the more contentious, higher profile issues and engages significant players in adversarial positions. Some cases may be, or have been perceived as having flow-on financial impact to large numbers of people in the community.

2.3 These factors also leverage the negative impact of the relatively few but significant cases which the community thinks have been inappropriately handled by the Tax Office. They often leverage the influence that perceptions of litigation processes and administrative outcomes may have on the community's broader view of the integrity of tax administration.

2.4 In this context, it is a matter of concern that many submissions to this review, often from significant and representational quarters in the community, have surfaced strong negative perceptions of the Tax Office's management of its litigation program. Most submissions also provided details of the reasons why these perceptions are held.

2.5 A strong focus of this review has therefore been to establish if these perceptions were valid by testing for systemic issues behind them beyond mere 'sour grapes' or assertions of differing legal interpretations in particular cases.

2.6 The review has evidenced and concluded that a composite set of systemic deficiencies in the Tax Office's management of its litigation program is providing fertile ground for these negative perceptions to arise. Uncorrected, these deficiencies will continue to grow perceptions that will further undermine community confidence in the Tax Office as a fair administrator, and in the tax system itself. The review puts forward recommendations which, when implemented, would correct these deficiencies and improve both the actuality and perceptions of administration in this area.

2.7 Diagram 2.1 presents a summary of these major deficiencies, how they lead to specific and broad negative perceptions, and what major changes are necessary to correct them. (Care should be taken, however, to examine the body of this report to obtain a full picture of the review's findings and recommendations that support this summary level diagram.)

2.8 The challenge for the Tax Office is not to defend against perceptions that it disagrees with by arguing specific cases or by dismissing perceptions on the grounds that they are based on unrepresentative exceptions. The Tax Office must acknowledge that these damaging perceptions are a reality evidenced by the many submissions to this review. It should objectively consider the underlying systemic problems which give rise to these perceptions and shift its focus to implementing the recommended changes that will overcome them.

2.9 This review has also raised issues which, subject to community consultation, are likely to be the subject of future Inspector-General reviews and may also be explored further in the course of reviews currently under way. One of these issues is the possibility that inadequate quality of Tax Office processes upstream of litigation, such as audit or resolving objections, may be driving unnecessary litigation and having other negative impacts for taxpayers.

Diagram 2.1: Summary of systemic deficiencies, consequential perceptions and major changes required

This diagram presents a summary of the major deficiencies referred to in this review, how they lead to specific and broad negative perceptions, and what major changes are necessary to correct them. (Care should be taken, however to examine the body of this report to obtain a full picture of the review's findings and recommendations that support this summary level diagram.)

Diagram 2.1: Summary of systemic deficiencies, consequential perceptions and major changes required

Summary of report

2.10 Tax litigation is the process which begins when a taxpayer seeks a review of a Tax Office decision on the amount of a tax liability or on the terms of private ruling by appealing the relevant decision to either the Administrative Appeals Tribunal (AAT) or the Federal Court. Tax litigation generally ends when the appeal is withdrawn or settled or when the AAT or Federal Court (or a court of higher appeal status) finally determines the matter or matters in dispute.

2.11 The number of tax cases which have been litigated over the last few years has remained relatively constant. However, in the 2000/01 year the number of litigated tax cases surged, primarily as a result of an influx of cases which related to the Tax Office's crackdown on various mass marketed tax effective investments (MMTEIs) in the late 1990s.

2.12 Only a minority of litigated cases are finalised by a court or AAT decision (12 per cent in respect of cases referred to the AAT). The Tax Office keeps statistics which show that it wins the majority of court or tribunal cases that are finalised by a hearing. These figures represent a positive achievement for the Tax Office, but do not give an accurate picture of the Tax Office's success in all litigated cases.

2.13 AAT statistics indicate that the overwhelming majority of litigated disputes which are referred to the AAT — around 88 per cent (85 per cent once two years affected by mass marketed tax effective investments are excluded) — are resolved without any hearing by the AAT and that, of these cases, 70 per cent are finalised by the Tax Office's decision being set aside or varied. These figures indicate that the majority (61 per cent) of all Tax Office decisions which enter the litigation phase and are referred to the AAT are varied in some way.

2.14 The AAT does not keep statistics to show which of these 70 per cent of Tax Office decisions which are set aside or varied prior to a hearing are resolved wholly or in part in favour of the taxpayer. An examination by staff of the Inspector-General of a sample of these cases that were resolved by way of a settlement between the parties indicated that a significant proportion of these cases were settled wholly in favour of taxpayers by the objection being allowed in full. This indicates that a significant percentage of the tax cases which reach the litigation stage could have been resolved at an earlier stage. In the Inspector-General's view this could be due to a number of reasons. It could be due to information relevant to the dispute not being sought by the Tax Office earlier in the dispute resolution process or a taxpayer not providing the Tax Office with requested information until the dispute proceeds to litigation. It could also be due to the wrong technical issues being raised by taxpayers' advisers or the Tax Office. It suggests that the earlier stages of the tax dispute process may not be wholly effective in the timely resolution of disputes and may warrant further review.

2.15 These figures have led the Inspector-General to recommend that the Tax Office report its litigation performance to the public and the Parliament more fully in the future than it has in the past. As well, the Inspector-General has placed on his forward work program future reviews to consider settlements and finalising disputes by the Tax Office with taxpayers.

2.16 Normally, taxpayers engage in litigation to resolve their particular tax dispute. However, they are generally unwilling to do so because it is a costly and lengthy process whose outcome is uncertain. Also, if tax litigation reaches the stage of a court or tribunal hearing it can result in adverse publicity for a taxpayer. However, sometimes litigation can be deliberately used by a taxpayer to delay the payment of tax that is rightfully due.

2.17 The principles (or philosophy) which guide the Tax Office's involvement in litigation are less clear. These principles are not set out in any single Tax Office document. They need to be gleaned from a number of different Tax Office documents and from the Tax Office's actual conduct in litigation.

2.18 These principles have been created in an environment where the Tax Office acts as a litigant in all tax cases and is not in control of all aspects of tax litigation, and where litigation is an adversarial process.

2.19 Tax Office statements on litigation indicate that it regards litigation as an important part of its overall compliance program. The Tax Office therefore sees litigation as an important means to ensure that taxpayers both individually and collectively act in accordance with the tax law.

2.20 Tax Office statements on litigation also indicate that the Tax Office sees litigation as having a role in clarifying the law. The Tax Office considers that this clarification purpose is to be carried out in accordance with the Tax Office's view of the underlying policy of the law, which may not be the same as the actual terms of the law. The Tax Office states that it supports this law clarification aim for litigation by running a test case program. Under this program the Tax Office will agree to fund a taxpayer's costs in cases which it considers will clarify an area of the law, in the sense of establishing new legal principles.

2.21 The Tax Office's actual conduct in litigation indicates that, in reality, its principal philosophy on litigation is that it is a means of validating the Tax Office view and ensuring that taxpayers comply with its view of the law. This compliance aim for litigation is also, in certain circumstances, overriding its involvement in activities which may lead to law clarification through objectively testing what the legislation means.

2.22 The Inspector-General has observed that the Tax Office's aspiration to be seen as a fair administrator is at risk because its objectivity and fairness in litigation is compromised by a perceived over-emphasis on achieving compliance with its views.

2.23 This over-emphasis is most evident in the Tax Office's behaviour in relation to its administration of the test case litigation program and the application of finalised court decisions.

2.24 The Inspector-General considers that the test case litigation program is important, is generally achieving its purpose and should be continued to provide public funding for litigating major disputes and grey areas of the tax law. An analysis of the cases that have been selected by the Tax Office for funding under the program up to the stage of a final court or tribunal decision showed that most were meeting this objective.

2.25 However, the Tax Office is currently not administering the test case litigation program in a way that ensures that it meets its objective of clarifying the law by establishing new legal principles in all appropriate cases. Test case funds have been $20 million over the ten year life of the program ($2 million per year), but only $5.97 million of these funds has been spent. Of this $5.97 million, a significant percentage (38 per cent) has been used to fund two cases where the primary purpose of funding was to achieve a compliance outcome, that is, to assist the Tax Office to enforce the existing law, rather than to clarify the law by establishing new legal principles.

2.26 The Inspector-General does not question the right or the validity of the Commissioner deciding to fund cases to assist in achieving compliance outcomes.

2.27 However, in addition to using the formal test case program for funding compliance-based cases, the Tax Office has not adequately communicated to the public the overall operations of the program and has not internally managed this program well. Although there have recently been improvements in the Tax Office's internal management of the program, this review finds that new arrangements for the management of the test case program are needed to overcome community confusion about the operations of the program, to improve its administration and overcome perceptions that the program is overly subject to Tax Office influence.

2.28 In some significant cases, such as Essenbourne, the Tax Office is also not giving effect to the results of a litigated case to taxpayers other than the particular taxpayer who has initiated the relevant case. These types of cases have not achieved clarification of the law for the benefit of the community as a whole because the Tax Office has refused to follow relevant legal principles which have been established by the case to any other similar case.

2.29 The Inspector-General considers that any Tax Office behaviour of not following the legal principles set by court decisions can be perceived to be in breach of the principles of the rule of law. Under these principles the Parliament's role is to enact the tax laws, the courts' role is to interpret these laws and the Tax Office's role is to administer the tax laws in all cases in accordance with finalised court decisions. Although cases where the Tax Office is not following court decisions are few in number, and the Inspector-General believes that the Tax Office follows rule of law principles in the majority of litigated tax cases, the existence of any such cases causes the community to doubt the Tax Office's commitment to rule of law principles. This is undermining the community's confidence in the tax litigation process and the Tax Office's administration generally.

2.30 There are differing views in the community on the extent to which the Tax Office should follow finalised court decisions in all situations and whether a failure to do so amounts to a breach of the principles of the rule of law.

2.31 Just prior to the finalisation of this review, when giving its response to this report, the Tax Office provided the Inspector-General with an opinion from the Solicitor-General and Australian Government Solicitor's Chief General Counsel on this issue. This opinion is an opinion on what constitutes good administration, rather than a matter of strict law. The opinion refers to the rules of precedent and notes that it would usually be inappropriate and unwise for an administrative decision maker to depart from decisions of single judges or of higher courts. Subject to following the rules of precedent, the opinion appears to confirm that there is no legal impediment to the Tax Office resisting a finalised court decision in rare and exceptional circumstances.

2.32 The opinion states that, if the Tax Office considers that a finalised court decision is wrong, it may challenge that decision in a subsequent case provided certain conditions are met. These conditions are:

  • that the Tax Office has credible and robust legal advice (which will withstand public scrutiny) that the court's interpretation is wrong in law;
  • that the challenge is made as soon as possible;
  • that those affected by the challenge are advised of the Tax Office's proposed course of action;
  • that the Tax Office must take steps to avoid any suggestion that the challenge will unduly burden or prejudice individual taxpayers and must therefore fund or organise suitable assistance to bring a test case on the issue; and
  • that the challenge must not be made just because, as matter of policy, the Tax Office considers that the decision in the case is wrong or undesirable.

2.33 The Inspector-General has not sought to resolve the debate on whether the Commissioner, who aspires to be seen as a good administrator, should challenge finalised court decisions and, if he does so, the circumstances in which this can be done. The Inspector-General considers that this matter is worthy of further debate, including in a broader context than the tax system and this review. However, the Inspector-General has found during this review that the Tax Office's conduct in this area has not, in relevant cases, met all the conditions for making such a challenge that have currently been formulated by the Solicitor-General and Chief General Counsel. The Tax Office's conduct in this area has therefore amounted to poor administration and has led to legitimate negative community perceptions of its behaviour.

2.34 The Tax Office also refuses to follow the results of certain finalised court decisions that have altered a previous Tax Office view as set out in a ruling or other statement until that view has been formally changed by the Tax Office. This process can take many months or even years. In addition, the Tax Office also has no process for undertaking an urgent review of any rulings during any earlier stage of the litigation process where doubts arise as to the correctness of a ruling.

2.35 The Tax Office's conduct of litigation has also generated community perceptions that the Tax Office is not managing its litigation in accordance with the rules which have been formulated by the Attorney-General to guide Australian Government departments on how they should act in all litigation matters to which they are a party ('the Model Litigant Rules'). The Tax Office's conduct which has led to these perceptions includes its conduct in certain specific litigated cases, a possible failure to ensure that all cases that should not be litigated are identified and dealt with early in the dispute resolution process, and its refusal to follow aspects of finalised decisions.

2.36 The Inspector-General considers that the Tax Office should issue a formal consolidated public statement to guide its conduct in litigation. This statement should say that the purpose of tax litigation is to resolve a dispute in a fair, timely and cost effective manner consistent with the rule of law. Principles of ensuring compliance with or clarification of the law should be subject to the overriding purpose of ensuring that a just and fair result is achieved for taxpayers engaged in litigation with the Tax Office.

2.37 The Tax Office's overriding compliance approach to litigation is also evident in the way in which it internally manages tax litigation. The Tax Office's compliance areas — its business lines — have the primary decision making roles in most litigated cases. There is no area of the Tax Office which conducts an internal review of litigated cases which is free of the influence of the Tax Office's compliance areas. Processes for handling high priority cases that involve what the Tax Office terms Priority Technical Issues (PTIs) are more robust, in that decisions are made by senior tax officers from the Tax Counsel Network outside the business lines and external counsel is often involved.

2.38 Unlike the Tax Office's other activities which are wholly or partly directed towards compliance, the Tax Office has not implemented a risk management approach to its internal management of litigation. As a result, the Tax Office does not identify, assess, analyse, prioritise, treat and monitor its risks that are associated with tax litigation.

2.39 The Tax Office's overall compliance approach to litigation when coupled with the absence of risk management approaches to litigation means that community perceptions that at times the Tax Office has a 'win at all costs' approach to litigation are justified.

2.40 Unlike certain other compliance activities, the Tax Office has no formal, structured internal quality control processes for litigation. Other internal management policies and procedures for litigation also require improvement. For example, the Tax Office has inadequate internal reporting of litigation and test case matters to its senior management. There are also no reporting and review systems for evaluating the effectiveness of the Tax Office's in-house legal area and there is a lack of national support structures for staff who work in that area. Some areas of the Tax Office with key roles in the litigation process (including the Aggressive Tax Planning area which has the largest number of litigated cases) have no documented internal policies for their involvement in litigation. Most areas of the Tax Office which are involved in litigation have inadequate processes for the internal review of their litigation decisions.

2.41 The Tax Office does not communicate the status of its litigation program (including the revenue results and/or costs incurred) to the public. As a result the public is unable to assess whether the Tax Office's overall litigation program is being conducted effectively, fairly and with minimum cost.

2.42 The Tax Office has internal policies in place for funding taxpayer's costs in some litigated cases where a taxpayer wins their case but the Tax Office appeals against that decision to a higher court. These cases are not part of the formal test case litigation program. These funding policies are commendable and recognise to some degree that some taxpayers do not have access to the same resources for pursuing a case to finality through the appeal courts that may be available to the Tax Office. They help avoid the possibility that a taxpayer will withdraw because they cannot meet the costs. However, these policies do not cover all cases where the Tax Office has been unsuccessful at any stage of litigation and decides to appeal the relevant decision, and where funding might be in the public interest.

2.43 The Inspector-General makes the following major recommendations which he considers must be implemented to overcome the systemic deficiencies identified in this review. Subsidiary recommendations of this review are set out in the remaining chapters of this report.

Key recommendation 1

The Tax Office should clearly articulate its corporate philosophy and approach to litigation in a formal and consolidated published policy or guidelines on tax litigation, such as a Litigation Charter.

The Inspector-General considers that this document should state that the primary aim of litigation for the Tax Office is to resolve disputes in a fair, timely and cost effective manner, consistent with the rule of law.

There should also be community consultation in the development of a published policy or guidelines on tax litigation.

In this document the Tax Office should also affirm its commitment to administer the tax laws as enacted by Parliament and interpreted by the courts in an impartial and transparent manner. The Tax Office should also affirm that it will follow the results of finalised court decisions in other similar cases.

There should be wide community consultation in the development of any policy by the Tax Office on whether it should challenge finalised court decisions in certain circumstances. If the result of this process is that the Tax Office still considers that it will challenge finalised court decisions in certain circumstances then the Tax Office should clearly and fully articulate those circumstances and its associated processes in its formal published policy or guidelines on litigation.

Pending the development of any such policy regarding challenging finalised court decisions, and its publication in a formal consolidated set of guidelines on litigation, the Tax Office should publicly affirm that it will follow the results of finalised court decisions in accordance with the criteria which have been formulated by the Commonwealth Solicitor-General and Chief General Counsel.

Tax Office response

2.44 We will issue a practice statement on the Tax Office's approach to, and conduct of litigation, ensuring that it is consistent with Attorney-General directions relating to the conduct of litigation by the Commonwealth. We will consult with professional bodies in the development of the practice statement.

2.45 In relation to the question of whether the Commissioner should challenge finalised court decisions in certain circumstances, we have the benefit of the advice of the Solicitor-General and the Attorney-General's Chief General Counsel. That advice indicated that it may be appropriate in exceptional circumstances for the Tax Office to challenge an earlier decision which it considers to be wrong, where there is credible legal advice (including internal advice) to that effect. The advice also stated that the Tax Office should put those affected on notice of its view and it would normally be appropriate for the Tax Office to fund any further challenge.

2.46 The guidance provided by the advice will be set out in a proposed litigation practice statement.

Inspector-General's comments on Tax Office response

2.47 The Inspector-General considers that the Tax Office should accept and implement Key Recommendation 1 in full.

2.48 While the Tax Office's proposal to develop a practice statement on litigation is a positive step, the Inspector-General's recommendation actually refers to a document being developed which is in a form similar to the existing Taxpayers' Charter. A litigation practice statement of the kind referred to in the Tax Office's response could supplement but should not be a substitute for a Charter-like document.

2.49 The Inspector-General considers that a document of higher status than a practice statement is needed to promote community confidence in the Tax Office's philosophy on litigation. The Inspector-General also believes that this document needs to contain a formal affirmation of the Tax Office's role in relation to litigation as distinct from the roles of Government, Parliament and the Judiciary. Consultation processes for this document (and any accompanying practice statement) also need to embrace the views of the wider community as well as those of the professional bodies.

Key recommendation 2

The Tax Office should establish management arrangements which give a single area of the Tax Office overall responsibility and authority for the management of all aspects of litigated cases.

Tax Office response

2.50 Agreed

2.51 We are reviewing our end-to-end processes for litigation to find efficiency and quality improvements. We will establish arrangements so that all decisions regarding litigated cases will be managed by the Office of the Chief Tax Counsel (OCTC) or the Tax Counsel Network.

2.52 In cases involving a Priority Technical Issue (PTI), the Tax Counsel Network will continue to decide the Tax Office's position.

2.53 In other cases, the Legal Services Branch (LSB) will be responsible for deciding the Tax Office's position. However, we will retain the existing processes through the Law Sub-plan whereby any differences of views on such matters can be quickly resolved through escalation.

2.54 In all cases, the Tax Office business lines will continue to be responsible for the risk ownership and mitigation strategies.

Key recommendation 3

The Tax Office should introduce risk management techniques to its management of tax litigation issues. It should start this process by defining the scope of the Commissioner's and the Tax Office's legal risk in collaboration with the Australian Government Solicitor (AGS) and counsel engaged by the Tax Office.

Tax Office response

2.55 We will review our current practices with this recommendation in mind.

2.56 All litigation cases are risk assessed at the commencement of litigation and risks are reviewed throughout the course of litigation. The Tax Office has a practice statement that outlines the process for risk assessment in litigation — see PSLA 2005/22. Although that practice statement focuses on priority technical issues (PTI) it makes it clear that, whether or not a case is linked to a priority technical issue, business lines must adhere to their own governance practices to ensure decision making is made at the appropriate level. Moreover, the Tax Office's Code of Settlement Practice provides guidance for Tax Office staff considering settlement of disputes, which also encapsulates risk management concepts. Where counsel and the AGS are involved in litigation, they assist in identifying legal risks to the Commissioner throughout the course of litigation.

2.57 Nevertheless we will review our current practices to ensure that the proposed litigation practice statement clearly articulates how we approach litigation in cases which do not involve PTIs, including a better articulation of the factors that underlie our risk management approach.

Key recommendation 4

The formal test case program (defined as the program under which a taxpayer makes a formal application for test case funding in accordance with funding criteria that have been publicised by the Tax Office) which is designed to fund cases which will clarify the law by establishing new legal principles should remain but new arrangements for the management of the test case program are needed. Precedents for an appropriate structure which deliver independence without being overly bureaucratic could be the existing Tax Agents' Boards or the Board of Taxation.

Tax Office response

2.58 The establishment of a panel independent of the Tax Office to decide applications for test case funding is a matter for government.

2.59 The existing Test Case Panel comprises seven members, five of whom are external to the Tax Office, including a former judge of the NSW Court of Appeal, a barrister, a solicitor and two accountants.

Inspector-General's comments on Tax Office response

2.60 The Inspector-General notes that the Tax Office's response does not address the suggestion made in the recommendation that possible precedents for an appropriate structure for the formal test case program which deliver independence without being overly bureaucratic could be the existing Tax Agents' Boards or the Board of Taxation.

2.61 The Inspector-General also believes that the detailed findings contained in this report on the manner in which the Tax Office has managed the program speak for themselves.

Key recommendation 5

The Tax Office should fund taxpayers' expenses in defending the case in all cases where the Tax Office has been unsuccessful at any stage of litigation, a decision is made to appeal the relevant decision and it is fair and in the public interest for the Tax Office to fund the taxpayer's expenses. The Tax Office should develop and publicise appropriate guidelines for the funding of such cases.

Tax Office response

2.62 Agreed in principle where it is fair and in the public interest to do so, and the test case program does this.

2.63 At present, the Tax Office funds the costs of taxpayers in small claims where the Tax Office appeals a decision of the Administrative Appeals Tribunal or Small Taxation Claims Tribunal to protect small taxpayers from the costs of court litigation. Considerations of capacity to pay are relevant to this practice.

2.64 The Tax Office has also established the Test Case Funding Program to fund cases where it is fair and in the public interest to do so. We will review the Test Case funding criteria in consultation with others to determine whether the capacity to pay should remain a factor, and whether the other factors clearly reflect the requirements of fairness and the public interest.

Inspector-General's comments on Tax Office response

2.65 The Inspector-General welcomes the Tax Office's acceptance of this recommendation. However, the Tax Office's response also refers to the test case funding program when this recommendation and the report's findings leading up to this recommendation indicate that the recommendation is dealing with cases funded under the Tax Office's other funding practices.

Key recommendation 6

The Tax Office should introduce a standard communication product to communicate the application of finalised court and tribunal decisions. The content of any Tax Office communication should be consistent with its role of administering the tax laws in a fair and objective manner and could include, for example:

  • the issues to be decided by the tribunal or court;
  • the implications of the decision on each of those issues;
  • the implications of the decision on the Tax Office view;
  • how the Tax Office will apply and follow the finalised decision;
  • the reasons why the Tax Office will apply and follow the finalised decision in that manner; and
  • whether the Tax Office will be seeking legislative amendments.

Tax Office response

2.66 Agreed in principle.

2.67 We will communicate to taxpayers the implications of adverse court and AAT decisions and significant court decisions. This will include impacts on any published views of the Tax Office, except where this is likely to mislead taxpayers.

2.68 While it would generally be inappropriate for the Tax Office to make its advice to Government public, we will further consult with Treasury as to whether it would generally be appropriate to advise that a matter has been referred to Treasury.

Inspector-General's comments

2.69 The Inspector-General notes that where Government is considering legislative amendments the Tax Office should nevertheless communicate to the community that it is seeking legislative change or that the matter is with Government. This is important in promoting transparency in tax administration by providing guidance to taxpayers operating in a self assessing environment on the implications of a finalised court or tribunal decision.