Five ways that tax litigation is different

In this article, the authors compare an income tax appeal by a company in the Federal Court of Australia (FCA) under Pt IVC of the Taxation Administration Act 1953 (Cth) (TAA53) with a claim for breach of contract, highlighting five key differences. These differences are important because they can inform how tax disputes are managed and explain why the parties might behave in a particular way, even where the relevant rules may not bite until a later time.

Significant information exchange occurs well before litigation

Tax context

Most tax disputes which reach litigation follow an ATO audit, the first stage of which is information-gathering. In an audit, the ATO often issues multiple requests for information so that it can form its view about the level of risk posed by a taxpayer’s positions. The ATO sometimes supplements this with interviews to ensure that it has what it considers to be an appropriate level of factual detail to inform its views.

The ATO has a very broad statutory power to require the production of information for the administration or operation of a taxation law. The ATO’s normal practice is to seek information without using formal powers, but cooperation is encouraged by the fact that the formal powers exist and carry significant penalties for non-compliance. The ATO can also gather information from third parties, such as a taxpayer’s banks, suppliers and investors. Although not standard, broad-ranging fishing requests are allowed.

These information requests allow the ATO to build on the enormous amount of data gathered through tax returns, other lodgment requirements (including country-by-country reports and reportable tax position schedules), and standardised compliance programs such as the justified trust assurance reviews.

Once a contentious issue has crystallised, taxpayers and the ATO spend considerable effort exchanging submissions about the application of the law to the facts. This generally occurs during the position paper stage of an audit, in any independent review or general anti-avoidance rule panel process towards the end of an audit, and also throughout the objections process.

All of these processes mean that the parties are typically well aware of the other side’s arguments and potential evidence prior to any litigation being commenced. Arguments for both the taxpayer and the Commissioner are, of course, refined and can evolve during litigation. When evidence is finalised in admissible form, and with the fresh eyes of any additional counsel involved in the litigation phase, new perspectives are brought to the dispute. These shifts in arguments are almost inevitable. However, the long and information-heavy lead up to the litigation reduces the possibility of ambush or surprise.

Once litigation commences, the ATO will generally need to rely on the more limited discovery provisions of the court rules rather than its broad information-gathering powers.

Other contexts

In contrast, parties to contractual disputes do not generally have access to broad, pre-litigation statutory mechanisms to obtain information about another party’s case. Unless the parties have contractually agreed to a dispute resolution procedure which involves some degree of information-sharing or a court orders pre-action discovery (which provides only for limited discovery and in limited circumstances), they are generally left to the discovery, subpoena or summons mechanisms in litigation to require their opponent to provide information.

Implications

There are a number of implications of this early information exchange, including:

• ATO audits can be extraordinarily cost-intensive, particularly to conduct the burdensome tasks of looking for supportive documents or responding to notices demanding documents which may harm the taxpayer’s case. Although much of this exercise now occurs electronically, digitisation has resulted in significantly more information being created and therefore needing to be reviewed. Further resource intensity also arises if there are complexities concerning legal professional privilege claims, an area of intense ATO interest;
• the process of case review does enable self-reflection by a taxpayer, identifying gaps in its position and developing evidence (lay or expert) to fill these as far as possible;
• the parties to tax litigation are encouraged to assume that discovery will not be necessary or that only limited, targeted discovery will occur. The pre-trial steps in tax litigation are normally focused on preparing and filing submissions and evidence. Although discovery, subpoenas and notices to produce can arise in tax litigation, they are used far less frequently; and
• the parties can be more informed about the strengths and weaknesses of each other’s position much earlier in the process, conceivably making successful alternative dispute resolution more likely before proceedings are commenced. Over 90% of the disputes settled by the ATO in the 2021 financial year had not reached litigation.

The “pay now, argue later” regime

Tax context

Where the Commissioner disagrees with a taxpayer’s position, he normally concludes an audit by issuing an original or amended assessment to the taxpayer. The tax liability becomes due and payable no later than 21 days after receipt of the assessment. The due date invariably falls prior to a taxpayer exercising its right to object against the assessment, and certainly well in advance of any Pt IVC litigation commencing.

Despite the tax liability being due and payable, the ATO has a policy of entering into 50/50 payment arrangements with taxpayers in certain circumstances where the assessment is disputed. Subject to the ATO’s risk assessment in accordance with its own guidelines, and the taxpayer paying half of the primary tax in dispute, the ATO often agrees to not seek to recover the rest of the debt while the dispute continues. Other mechanisms which can satisfy the ATO that it need not take debt recovery action for the full tax liability include the taxpayer entering into a payment plan or providing security.

In a Pt IVC dispute, a taxpayer can commence litigation even if it has not yet paid the tax liability. However, if the taxpayer does not pay the liability or reach agreement with the ATO about management of the debt, the ATO can seek to recover the debt in parallel to objection and litigation processes being pursued by a taxpayer despite the substantive litigation continuing. The ATO can recover the debt by initiating legal proceedings, or the use of its powers to:

• issue a garnishee notice requiring a third party to pay the funds (eg. the taxpayer’s bank);
• apply to a court for a freezing order preventing the taxpayer’s assets from being disposed of, dealt with or diminished in value; and
• issue a creditor’s statutory demand for the debt and apply to the FCA to have the taxpayer company wound up if it is insolvent.

Engaging with the ATO can mitigate the chances of any of these steps being taken without advance warning from the ATO to the taxpayer.

Other contexts

Payment of a disputed amount prior to litigation for breach of contract is not required unless this has been agreed in the contract. Rather, an immediate concern regarding payment includes whether the parties continue to make any contracted payments despite the alleged breach. While parties can also use freezing orders and other interlocutory measures to preserve a position while litigation continues, that would rarely extend to payment of disputed funds to one party. Further, it is rarely open for a party to serve a statutory demand on another once litigation has commenced as there would usually be a genuine dispute as to the debt.

Implications

There are a number of implications of the tax debt arising prior to any litigation, including:

• the tax legislation provides the ATO with a powerful position in relation to tax debts. These strong statutory powers typically come to the fore in any hostile disputes where the taxpayer is not being communicative with the ATO or where the ATO considers there is a risk that a tax liability might ultimately remain uncovered; and
• taxpayers need to make arrangements promptly to pay any assessments, negotiate a 50/50 arrangement or reach some other agreed terms so that the ATO does not take recovery action in parallel to the substantive dispute proceedings.

Short filing deadline requires a quick, important decision

Tax context

Where the ATO delivers an adverse objection decision, the taxpayer only has 60 days to commence proceedings in the FCA. The FCA has no power to extend the filing deadline.

As discussed, this short filing deadline is preceded by many interactions with the ATO, normally including an audit and an objection process. However, the short filing deadline means that taxpayers in the objections phase need to be prepared to decide quickly whether proceedings should be commenced. Once a taxpayer has lodged an objection, the ATO can decide it at any time, starting the 60-day clock. The ATO ordinarily communicates with the taxpayer about a forthcoming objection decision and the likely outcome, but even where this occurs, the actual decision generally results in a flurry of activity for the taxpayer in formally deciding how it should proceed.

The short filing deadline does not mean that a hearing will necessarily occur quickly. Both parties may need to prepare and file evidence and submissions, and procedural issues can arise. However, there is an increasing desire of the FCA to actively manage tax litigation as efficiently as possible, including with early identification of key issues in dispute and in relation to managing the amount of witness evidence.

Other contexts

In other commercial matters, the statutes of limitation vary between Australian States and Territories, but provide a period of several years to bring civil proceedings. In Victoria, simple contracts generally have a six-year time frame for proceedings to be commenced once an action accrues. Tardy suits for breach of contract may also face defences or counterclaims of misleading and deceptive conduct or various estoppels, but those defences and counterclaims are not an absolute bar to claims.

Implications

There are a number of implications of the short filing deadline following receipt of an adverse objection decision, including:

• during the objection process, taxpayers need to plan as far as possible for the need to make a well-informed decision regarding the commencement of litigation if it becomes necessary. The size and nature of the tax dispute and the taxpayer’s business will influence its risk appetite, governance processes and the degree to which other management personnel need to be involved in any decision-making about litigation (eg. the CEO, CFO, the general counsel, and the head of public relations). Closely held groups also need to manage the involvement of investors in decision-making. So that a decision about whether to litigate can be made promptly, it is important that these stakeholders are actively engaged before any adverse objection decision is made by the ATO; and
• once proceedings are initiated, certain information filed with the FCA can be accessed by the public and media. It is prudent to be ready to respond to questions or to issue a proactive statement with the taxpayer’s comments on the proceedings. Some taxpayers that the authors have worked with have engaged PR firms to assist them with this.

The ATO’s broader strategic considerations

Tax context

As the federal government’s principal revenue collector, the ATO has strategic considerations which go well beyond any single dispute. Factors that the ATO needs to balance include encouraging voluntary compliance with the law, acting against non-compliance, having the law clarified where necessary, acting fairly between taxpayers, and managing litigation costs.

In deciding whether or not it should settle a dispute, the ATO balances:

• the relative strength of the parties’ position;
• the cost versus the benefits of continuing the dispute (eg. law clarification, acting against bad taxpayer behaviour); and
• the impact on future compliance for the taxpayer and the broader community.

Taxpayers can only form a view about how the ATO may approach some of these issues. For example, the ATO’s willingness to litigate a specific issue often depends on what the ATO is seeing across the taxpayer’s industry or in relation to a specific tax issue more broadly, which is based on information held by the ATO and not the taxpayer. The ATO frequently implements programs or taskforces which are targeted at specific issues or industries.

When weighing up these factors, the ATO may determine priorities for cases it would prefer to litigate. Some of these cases may receive test case litigation funding from the ATO where the law is unclear and where the outcome of the dispute will be significant for a substantial section of the public or for an industry. However, the ATO’s preferred cases for litigation can be derailed by those taxpayers agreeing to the ATO view or proposing acceptable settlement offers.

Other contexts

Commercial organisations do not have the same responsibilities to encourage compliance within an area they regulate, and do not consider the public interest in the same way as regulators do. Whether they litigate a matter may also be impacted by strategic concerns beyond the litigation itself (eg. seeking to discourage other customers or suppliers from breaching their contracts), but these reasons differ in nature to the strategic concerns of a regulator.

Implications

There are a number of implications of the ATO’s broader strategic considerations in tax disputes, including:

• the ATO’s strategic objectives can have clear implications for how a taxpayer’s specific dispute is managed, and this commonly flows into the viability of settlement negotiations;
• how a taxpayer’s dispute is managed can change over time due to actions outside the control of both the taxpayer and even the ATO officers managing the audit or objection on a day-to-day basis. For example, a taxpayer might become the ATO’s preferred case for litigation if another taxpayer that was at the head of the queue concedes or settles with the ATO; and
• the ATO’s views on the value of law clarification for a particular issue can also change over time, such as if the ATO has an unfavourable court decision and wants to prevent taxpayers from seeking to applying the decision in a widespread manner.

Taxpayers bear a heavy burden

Tax context

Taxpayers bear the burden of proof in tax matters, with the standard of proof being the balance of probabilities. There are two statutory requirements which make the taxpayer’s burden decidedly heavy in practice.

First, the taxpayer must prove not just that the ATO’s assessment is excessive, but also the specific amount that the assessment should have been. This brings the scope of the dispute into focus, and highlights the benefit to taxpayers from agreeing to the scope of the dispute with the ATO. Often this occurs through the parties’ submissions to the FCA prior to trial, but there can be great benefit in this occurring earlier. If the scope of a dispute remains relatively wide, the burden on the taxpayer can be more onerous.

In FCT v Dalco, Brennan J explained:

“If the Commissioner and a taxpayer agree to confine an appeal to a specific point of law or fact on which the amount of the assessment depends, it will suffice for the taxpayer to show that he is entitled to succeed on that point. Absent such a confining of the issues for determination, the Commissioner is entitled to rely upon any deficiency in proof of the excessiveness of the amount assessed to uphold the assessment …”

In the process of seeking to confine the scope of the dispute, taxpayers might be facilitated by the Commissioner’s obligations as a model litigant, which includes “endeavouring to avoid, prevent and limit the scope of legal proceedings wherever possible”.

Second, the taxpayer is confined to its grounds of objection unless the FCA orders otherwise. In contrast, the Commissioner can defend the assessment on any basis, which enables new arguments that have not been raised at an earlier stage of the dispute. The Commissioner introducing a new basis for defending an assessment will bear favourably on the court allowing the taxpayer to amend its grounds of objection.

The recent FCA decision in SingTel provides an example of the Commissioner refining his arguments in defence of an assessment, where the Commissioner was permitted to change the basis on which he had calculated the transfer pricing benefit. The court determined that although the Commissioner’s calculations had changed since the assessment was issued, that was permissible because the Commissioner had (in a more general sense) made his determinations on the basis that a transfer pricing benefit arose, which was still the case.

Other contexts

The burden of proof typically requires the claimant to prove, on the balance of probabilities, that each element of a breach of contract is established. Defendants will generally bear the onus of proving any defences or counterclaims such as estoppels or exclusion clauses. However, the burden operates without the additional statutory provisions discussed above in a tax context.

Implications

There are a number of implications of the taxpayer’s heavy burden, including:

• because the Commissioner has a more flexible statutory position than taxpayers, little comfort can be drawn from any concessions by the Commissioner outside of litigation, such as in an objection decision. Surprises in tax litigation do happen from time to time; and
• taxpayers should consider trying to satisfy the Commissioner of as many matters possible, confining the dispute, in order to avoid needing to satisfy a court of those matters with admissible evidence at a later time. The lengths that taxpayers may need to go to in order to discharge the burden of proof are significant, particular given that it is not uncommon for tax disputes to be litigated more than 10 years after the relevant events took place.