Tax avoidance/Reconstruction of transactions
In the history of Australian tax law, the former section 260 of the Income Tax Assessment Act 1936 (Cth) is remembered as a failed general anti-avoidance rule. It suffered from two keys problems, being the 'choice principle' and the 'annihilation problem'. This page focuses on the annihilation problem in order to illustrate the need to 'reconstruct' transactions in an anti-avoidance provision.
Section 260 provided that any transaction entered into for the purpose of avoiding tax was 'void' as against the Commissioner of Taxation. This meant that the transaction was 'annihilated' -- the Commissioner was entitled to pretend it never happened.
However, what if, after annihilating the transaction, there was nothing left to tax? (TODO: Find case on this, to illustrate the kind of scheme against which section 260 is ineffective.)
In contrast, Part IVA, which replaced section 260, allows reconstruction. Part IVA authorises the Commissioner of Taxation to make up a 'counterfactual' (the term does not appear in the legislation but is the commonly-used term for the concept which appears implicitly in the legislation) representing the transaction that the taxpayer would have entered into had they wished to pursue the same non-tax objectives as the actual transaction but without pursuing any purpose of obtaining a tax benefit. The comparison of the tax consequences of the actual transaction and the counterfactual yields a quantification of the tax benefit. The Commissioner is authorised, under Part IVA, to impose additional taxation to bring the taxpayer's liability up to the liability that would had applied had the counterfactual been reality.
Reconstruction gives the tax authority great discretion. The only limits on this discretion are provided by whatever facts the legislature specifies that must remain the same between the actual transaction and the counterfactual. For example, Part IVA requires that the counterfactual have broadly the same non-tax purposes or effects as the actual transaction. A previous version of Part IVA prohibited the Commissioner from imposing a counterfactual which the taxpayer would never have willingly entered into (e.g. because the tax cost associated with it made it uncommercial, that is, the taxpayer would have preferred to simply do nothing: TODO find case), but this limitation has since been removed by amending legislation.