Economic Entitlement Rules – practical insights after 2 years
The Economic Entitlement Rules (EER) in Part 4B of Chapter 2 of the Duties Act 2000 (Vic) were enacted on 19 June 2019 in conjunction with State Revenue Office (SRO) website guidelines (Guidelines). With the second anniversary of the rules approaching we thought it might be timely to reflect on what we know, or think we know, about the practical operation of the rules.
1. Disconnect between legislation and administration
The first (and perhaps most important) thing to appreciate is the disconnect between the EER legislative regime and how that regime is currently being administered by the SRO. Under the legislation every arrangement made in relation to relevant land that has an unencumbered value in excess of $1 000 000 and which entitles a person directly or indirectly to any one or more of the value criteria listed in section 32XC gives rise to an economic entitlement (EE). It is then only by means of the Guidelines that some arrangements that would otherwise give rise to an EE are currently being administered out of the legislation. This unusual outcome is a direct result of government reluctance to amend the Bill enacting the EERs after being warned by industry bodies such as UDIA and PCA that the legislation would apply more broadly than what was originally intended. The resulting “consultation process” led to the hasty release of the Guidelines in an attempt to limit the practical reach of the new legislation.
2. Evolving guidelines
As has already occurred since their first release in June 2019, the Guidelines will be added to, refined, augmented and possibly clarified as the Commissioner acquires a better understanding of the structures and agreements that are routinely used by developers to procure and deliver Victorian development sites. The Guidelines will therefore evolve over time. The outcome of any change will be the subject of usual SRO public notification. However, the process leading to that change will in all likelihood be initiated and managed with the same secrecy with which the legislation and the Guidelines themselves were first prepared and released. Change may be in response to private ruling requests or investigations that highlight deficiencies in the Guidelines. It may also occur at the request of industry bodies seeking to encourage the Commissioner to clarify the practical application of the rules in certain circumstances.
3. Not confined to Development Agreements
Although Development Agreements (DAs) are the main casualty of the new rules, they are not alone. The new rules apply to any arrangement involving Victorian land that has an unencumbered value of more than $1 million under which a person is or will be entitled (directly or through another person) to an economic entitlement in relation to the land. Most notably:
- the rules only require an arrangement not necessarily an agreement;
- the arrangement merely needs to ‘relate’ to the land. So it could be quite an indirect, disconnected, or ancillary entitlement at issue;
- ‘is or will be entitled’ means current or future entitlements are caught;
- the entitlement can be direct, or arise indirectly via another party.
4. Not confined to service-based arrangements
Service-based arrangements such as Development Management, Project Management and Sales Management Agreements clearly fall within the legislation and the Guidelines. However, debt funding arrangements, land co-ownership agreements, joint venture agreements, and share/unit subscription/sale agreements are also all potentially caught if they evidence anything approximating an EE. The Commissioner has left himself ample room in the Guidelines to apply or not apply the legislation beyond service based arrangements.
5. Not just anti-avoidance rules
The EERs were originally embedded in the Landholder Rules in Chapter 3 of the Act and were integrity rules. Possibly at the time the Commissioner saw Development Agreements as a model to avoid Landholder duty. Although aspects of the first generation EERs have been retained in the Landholder Rules, the new EERs have been inserted into Part 4B of Chapter 2 of the Act. The EERs therefore now operate as a separate new head of duty. In so far as the EERs impose duty on mere economic interests in land, they are however unique. No other Australian jurisdiction has them, and the imposition of duty on a mere economic interest (in the absence of some other more traditional legal or beneficial interest in land), is a conceptual first for Victoria.
6. Not confined to companies and unit trusts
Because the first generation EERs were housed in the Landholder Rules and the Landholder Rules only apply to companies and unit trusts, the original EERs only operated in respect of land held in a company or unit trust. That remains the case for those parts of the original EERs left in the Landholder Rules. The new EERs in Chapter 3 are, however, not so limited. Any arrangement struck with a landowning company, unit trust, discretionary trust, fixed trust, person or other landholding vehicle is potentially caught. The $1 million threshold is in place to exclude small value domestic transactions. However, given that most residential properties within 5 km of Melbourne CBD now sell for at least $1m, query how effective that de minimus rule really is. A residential property sale commission payable to an REIV registered estate agent is therefore caught by the legislation. It is only by virtue of the Guidelines that such commission arrangements are currently being administered out of the rules by the Commissioner.
7. Cost plus Developer Agreements not caught
For the EERs to operate the entitlement must arise as a function of one or more of the value criteria listed in section 32XC (i.e. gross revenue, profit, rent, capital growth etc). If a fee is payable in a Development Agreement purely as a margin on cost, that fee should not give rise to an economic entitlement. However the downside with a cost plus Development Agreement is that some proportion of gross revenue or profit will be left with the landowner. Such Agreements therefore have limitations when being used in relation to third party landowners.
8. Duty based on hypothesised outcome
Although EE duty is calculated based on land value, the calculation of the economic entitlement itself is based on the economic model used by a developer to engineer the financial outcomes for a landowner and the developer in respect of the land. Expressed as a percentage, the EE therefore relies on a developer’s own forward projections of the revenue or profit it expects to receive in connection with the development of land. The fact those projections may not end up reflecting actual outcomes will not affect the application of the EERs and the upfront EE duty that will be paid. Similarly, if a project does not proceed because a feasible planning permit is not obtained, there is no mechanism in the legislation or Guidelines for a refund of EE duty already paid. The EE is therefore as hypothesised as the project at its inception stage. EE duty is however still taken by government at a time when the EE only really exists as a theoretical construct.
9. Duty on land value not project value
If land has an unencumbered value of $10 million but agreed project value of $15 million, EE duty should be paid on the former. The fact the parties hypothesize a land value for purposes of determining who will receive what, and what the percentage of economic entitlement will be, should not lead to duty on the higher project value. Moreover duty is payable on the percentage of EE as it relates to land value. So, if an EE of 70% is acquired, ad valorem duty of 5.5% is payable on only 70% of the unencumbered land value at the time the EE is acquired. While economic metrics such as profit and revenue are therefore used to calculate the EE, duty is not payable on profit or revenue. Similarly, the value of the EE itself (in dollar terms) is not important. The EE as a percentage must always be translated back to the unencumbered land value to determine the ‘economic interest’ that has been acquired and on which duty is payable.
10. Highest indicia determinative
Although an EE can be calculated as a function of several different variables in section 32XE, it will invariably be the highest EE that the Commissioner will start with in determining the EE duty that is payable. This is confirmed in Example 2 of the Guidelines in which the Commissioner only falls back on the 50% profit indicia once the gross proceeds indicia has been discounted to below 50% on account of third party construction costs.
11. Retrospective application
Despite what the Guidelines say about the EERs not applying retrospectively, they will make a company or unit trust a ‘landholder’ (for the purposes of the Landholder Rules in Chapter 3) if it holds a pre June 2019 economic entitlement. Indirectly therefore, the Commissioner believes the EERs can apply to earlier arrangements. Care should also be exercised in assigning or novating after 19 June 2019 an agreement executed before 19 June 2019. Although the Guidelines are silent on the matter, there seems ample room for the Commissioner to treat a novated pre 19 June 19 Development Agreement as a new arrangement (and EE) for purposes of the new EERs. Also keep in mind that the former EERs, with all their limitations, still operated up until 19 June 2019. Accordingly, whilst there is scope to sidestep the current (new) EERs on the basis that a Development Agreement was entered into via a Heads of Agreement executed before 19 June 2019, if the landowning entity in that Heads is a company or unit trust, the former ERRs could easily still apply to the Heads of Agreement.
12. Ownership interest vs economic interest
Statements in the Guidelines that a transferee of property also obtains an EE but the Entitlement is not subject to the EERs because the rules are displaced by the normal transfer duty rules are confusing to say the least. Under the wording of the legislation it is difficult to understand how a transferee of property can also be said to have acquired a separate EE. Duty will be payable on the new ownership interest and that should be the end of the matter under the Act. This distinction is important because Service Providers only need to self-report their DMAs, PMAs etc if they enter into an agreement with an associated party that holds an EE. If an owner of land also has an EE under the legislation (which is highly disputable), then potentially a lot more DMAs, PMAs and other service agreements that would otherwise not be caught by the EERs, will be caught.
13. Commissioner not bound by Guidelines
The Guidelines are mere website guidance and do not administratively bind the Commissioner in his interpretation and application of the legislation in the same way as a public or private ruling. Although reliance on website guidance was understandable when the EERs were first introduced (as the government clearly needed to publish something quickly to address the deficiencies in the Bill), there has since been ample time for government to consult on the scope of the new rules and encourage the Commissioner to convert the Guidelines to a public ruling. Only the government can explain why this hasn’t occurred, but it has left the development industry with a set of rules that operate legislatively on one level and administratively on another.
14. Litigation uncertainty
In the ordinary course of events a taxpayer will argue with the Commissioner in VCAT or the Supreme Court over the application of the legislation to its circumstances. However, when the legislation does not reflect the original intention of parliament, where does that leave the taxpayer? If the dispute concerns the application of the Guidelines to a taxpayer’s circumstances, what standing, if any, do the Guidelines have in a court of law? They are after all just website guidance. If a taxpayer seeks to argue that its circumstances are not covered by the principles set out in the Guidelines, doesn’t that just leave it with the legislation? Knowing that the legislation is far broader in scope than what was originally intended, rejection of the Guidelines could mean that a taxpayer’s arrangement will be taxed when it was never originally intended to be taxed.
We know from past outcomes that VCAT and the Supreme Court pay little regard to SRO public rulings. So if a taxpayer maintains its transaction is not dutiable under the Guidelines (or dutiable in a different way or to a different extent) and the Commissioner maintains it is, couldn’t or wouldn’t VCAT or the Supreme Court just ignore the Guidelines and head straight to the legislation? If it does that, wouldn’t that mean considerably more transactions are subject to duty than was originally intended by parliament?
Seeking to recalibrate mis-calibrated legislation using administrative guidance could thereby lead to the imposition of duty on far more commercial arrangements than was originally intended. Moreover, the balance of interests between government and taxpayers in litigation is weighted in favour of the government because rejection of the administrative guidance will mean the taxpayer has to deal with legislation which it knows is more likely to lead to a dutiable outcome than under the Guidelines.
Serious consideration should therefore be given by government to the continued reliance on website guidance to achieve intended outcomes under the EER legislation. Industry does not dispute the right of government to impose duty on whatever transactions it likes. However, industry is entitled to take issue when the legislation being used to impose duty is so badly targeted that it requires website guidance to achieve the original policy intention.
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