The principles are listed below
Principle 1 –The Pre-emptivity Principle (P)
This principle states that a tax strategy must be pre-emptive to succeed. To be pre-emptive, the followin1g rules must be obeyed:
Principle 2: The Inflow Principle (I)
This principle states that to be valuable, a tax strategy must result in an increase either in actual net income and/or asset or expected income and/or assets.
Principle 3: The Economic Principle (E)
This principle states that to be valuable, a tax strategy must have a very strong probability of producing an immediate and/or expected economic benefit, ordinarily via an increase in net worth and that this increase, must exceed the cost of the strategy.
Case Study
| Name | Peter Smith |
| Income | $160,000 |
| Annual tax bill | $47, 467 (medicare excluded in all examples below) |
Current financial picture
Up to 30% of Peter’s current income goes into tax. Peter spends 31% of his income on living and other expenses and saves the remaining 39% into his bank account. If he works for 10 years, he will pay approximately $470,000 in tax ignoring the impact of inflation. Peter’s current strategy violates the cardinal principle of tax planning since is merely earning the income and putting it into his bank account.
An apparent good solution that violates the cardinal principles of tax planning
Peter’s adviser tells him to borrow $100,000 and put it into a complying forestry managed investment scheme. Interest and other charges amount to 15%. This product is not expected to pay income for 10 years and lacks independent research. The tax situation is summarised as follow:
| Before | Year 1 | Year 2 | |
| Income | $160,000.00 | $160,000.00 | $160,000.00 |
| Less: deductions | $- | $115,000.00 | $15,000.00 |
| Taxable income | $160,000.00 | $45,000.00 | $145,000.00 |
| Tax payable | $47,467.00 | $5,992.00 | $41,717.00 |
| Tax saving over year 1 | $41,475.00 | $5,750.00 |
Even though the strategy results in tax savings of $41,475 in year 1, net addition to capital is only $5,750 the 2nd year and beyond year two, higher and higher capital growth would be required to make the strategy worthwhile. As the product will not pay any income for about 10 years and the quantum of any future cannot reasonably be ascertained now, the inflow principle is violated. Unless there is a strong probability that the future returns will be significantly more than the cumulative value of outflows to third parties (principle three), the strategy is not worthwhile.
Often you find that mistakes of this nature are likely to occur unless professionals you engage to help you are tax specialists.
As an alternative to the above, Peter could have considered hybrid gearing strategy. This is a strategy that has the following characteristics:
Epic Tax and Financial Services, along with its related entities Epic Property Marketing and R2M Home Loans have developed the cardinal principles tax planning after years of experience dealing with a wide range of clientele. Implicit in these rules is the ability to link the tax plan to an investment or business activity that produces income and adds to immediate and/or future wealth. Our team includes Chartered Tax Advisers™, banking and lending specialists and real estate specialists who work together to ensure you execute a complying and wealth producing tax strategy.