Division 7A continues to be a minefield for taxpayers. Even relatively “settled” positions regarding unpaid present entitlements are now being disputed in litigation, with at least some initial success.1
Companies being partners in partnerships, and what if any impacts Division 7A has on that structure has not been considered at length outside of specific limited partnership schemes (which is not the topic of this article). However there are some signs that the there may be Division 7A issues associated with common occurrences with corporate partners.
While the ATO formerly maintained a “FAQ” regarding Division 7A, which contained some non-binding view of the ATO in respect of how Division 7A interacts with partnerships,2 it appears this document has been withdrawn, and some private rulings suggest that the ATO’s position may have shifted.3
Discussing these issues will be assisted by the use of a case study. Consider the following scenario:
Ms Bloggs and Bloggs Trading Pty Ltd (BT Co) are partners in a general law partnership that operates a successful business;
Ms Bloggs is the sole shareholder in BT Co;
BT Co has made no loans or payments to Ms Bloggs, except by way of a properly declared dividend;
the profits from the partnership have generally been retained by the partnership to fund future working capital, such that each of the partners have a partnership account owing to the partner; and
due to a brief period of financial instability following Ms Bloggs’ separation from her spouse, the partnership loaned funds at a nominal interest rate to Ms Bloggs, and that loan is still outstanding.
A partnership comprising of one or more private companies and one or more individuals is not an uncommon structure. It is also not uncommon for the individuals to be either shareholders in the company partner or be associates of those shareholders via a trust or other entity.
Does Division 7A apply to any part of this structure? The answer is frustratingly unclear and has been made more unclear by recent ATO rulings.
The starting point
There are a few key legal points to understand before delving into this structure. The first is that for most tax purposes a partnership is treated as an entity. This is the case whether it is a “general law partnership” and carries on a business or is a “tax law partnership” and the partners merely receive income jointly.
The second key point is that a loan for Division 7A purposes is specifically defined in the legislation to include, among other things, a “financial accommodation” or a “transaction (whatever its terms or form) which in substance effects a loan of money”.4
The ATO takes a broad interpretation of financial accommodation in Taxation Determination TD 2022/11 (TD 2022/11), which replaced the ATO’s earlier rulings on this point. The ATO considers that “the phrase ‘financial accommodation’ in paragraph 109D(3)(b) has a wide meaning. It extends to cases where an entity with a trust entitlement has knowledge of an amount that it can demand and does not call for payment.”5
This is the basis on which the ATO considers unpaid present entitlements owing to company beneficiaries of trusts to be loans for Division 7A purposes.
Loans from partnerships
Turning back to our case study, is there a risk that Division 7A could apply to the loan from the partnership to Ms Bloggs?
There are potential issues here: whether the company, by virtue of being a partner in a partnership, is owed money by its shareholders, or whether the interposed entity rules in Subdivision E of Division 7A could apply (where the partnership is the interposed entity).
Has the company made a loan?
Under general law, a partnership is not an entity. Each partner holds an interest in the assets of the partnership, which can include loan assets. In our case study, BT Co holds an interest in a loan to its shareholder by virtue of being a partner in the partnership that has made a loan.
There is a reasonable argument that, because the tax entity rules apply to Division 7A,6 meaning the partnership is treated as a separate entity for these tax purposes, the only entity which has made a loan for the purposes of Division 7A is the partnership, not BT Co, meaning Division 7A would not apply to the loan from the partnership to Ms Bloggs. It may still apply for other reasons, discussed below.
The interposed entity rules in Subdivision E of Division 7A apply only where a company makes a payment or loan to the interposed entity.7
In our case study, BT Co has not made a traditional loan or payment to the partnership. But it has an entitlement to an amount by the partnership because BT Co has not fully drawn down its partnership account.
Under the ATO’s expansive view of financial accommodation, does BT Co make a loan to the partnership (meaning the first step in applying the interposed entity rules is satisfied) when it chooses not to draw on its partnership account? This takes us to our key issue, and one where we are concerned the ATO may take an aggressive approach.
Can an undrawn partnership account be a loan for Division 7A?
The ATO has, in private binding ruling PBR 105219530678 made in 2023, set out its view that a deemed dividend arises in circumstances where a company underdraws on its partnership account, while related individuals overdraw their partnership accounts. This is because the ATO considered it to be a financial accommodation between the company and the individuals.
Further, the ATO considers that a loan made by the partnership to the individual partners represents a financial accommodation from the company to the individuals.
The ATO’s logic is that by acquiescing to the arrangement (either the unequal drawings, or the loan), and by not calling on the profits owed to it, the company has made a financial accommodation (within the ATO’s broad interpretation of that expression as set out in TD 2022/11) to the other partners.
There is no particular reason this logic would not equally apply to undrawn partnership accounts even where those partnership drawings are equal between company and non-company partners. In that case, there is still a company that, in its capacity as a partner, is choosing not to demand payment of an amount owing to it. Another entity is then getting the benefit of that money – either the partnership, or the other partners indirectly.
This would seemingly run contrary to the now withdrawn non-binding “FAQ” the ATO previously published.
It would seem an absurd outcome that if a company chooses to not call on payment of its partnership profit as to allow the partnership to retain working capital, Division 7A is triggered and a deemed dividend arises. But where the partnership pays out all its profits and concurrently demands working capital contributions from its partners, then Division 7A would not apply because the resulting capital contribution is a discharge of a pecuniary liability and exempt.
However, that is the necessary conclusion from the line of logic that starts with a position that “a failure to call upon moneys owing is financial accommodation” – which is the ATO’s position in respect of unpaid present entitlements from trusts and appears to be the ATO’s position in respect of partnership accounts, at least where those partnership accounts are uneven.
It may be that the ATO adopts a position that unpaid partnership accounts are only a Division 7A issue where the accounts are not even, and the company partner has underdrawn its partnership account, and the individual partners have overdrawn their partnership account.
But this position is not logically consistent with the view that, if a company chooses not to demand payment of an amount owing to it, it has made a financial accommodation (either to the partnership, or to the other partners) – as expressed in PBR 105219530678.
If the company partner has made a financial accommodation to the partnership by not drawing all its partnership profits, then that financial accommodation can presumably be the first ‘step’ in applying the interposed entity rules for Division 7A to any payment or loan from the partnership.
To return to our case study to illustrate the result of the ATO’s apparent position:
BT Co may have made a financial accommodation to Ms Bloggs (its shareholder) by choosing not to demand payment of its partnership profits – which would be a deemed dividend; and
BT Co may have made a financial accommodation to the partnership, which may have allowed the partnership (being a separate entity for tax) to make a loan to Ms Bloggs – which would be a deemed dividend to Ms Bloggs under the interposed entity rules for Division 7A.
What are the arguments against this interpretation?
It may be possible to argue that because partnership accounts may lack the fundamental component of a loan – the absolute obligation to repay – then having an undrawn partnership account is not a financial accommodation from the company.
Another approach would be to recognise that a partnership (despite any tax deeming as an entity for certain tax purposes) is not separate from its partners at general law. It, therefore, seems to follow that there can be no debt/no financial accommodation owed for undrawn partnership accounts where, at general law, a partner is dealing with itself regarding that entitlement in the normal course.
There is precedent for the ATO recognising limits to the effect of a partnership being a deemed entity for tax purposes in the GST position that deemed tax law partnerships cannot have partnership capital8. (But note, this reasoning differs from the ATO views noted below from PBR 1051393604802, about capital contributions being payments to the partnership entity.)
On this basis, only to the extent partnership funds have been lent/draw disproportionately, are there dealings are with other parties – which may then be characterised as loans/financial accommodation by a partner, to that extent.
We would expect the ATO would contest this interpretation because if it is correct, it could call into question the ATO’s position on unpaid present entitlements. Similarly to partnership accounts, it is possible for an unpaid present entitlement to exist almost perpetually (although a trust may end after 80 years, the trustee could still hold those entitlements for the benefit of the company after vesting).
This feeds into a broader argument as to whether the ATO’s interpretation of “loan” in the context of Division 7A is correct – a position currently being tested in Bendel and Commissioner of Taxation (Taxation) [2023] AATA 3074 where the taxpayer was successful in the Tribunal but (at the date of this publication) the ATO had appealed that Tribunal decision to the Federal Court.
Due to the particular arguments in Bendel its impact may be limited to whether unpaid present entitlements are financial accommodation – so even a favourable decision on this matter may not provide certainty on the treatment of undrawn partnership accounts.
But it is submitted that partnership circumstances can/should be recognised as materially different from that of unpaid present entitlements owed from trusts/trustees, regardless of the outcome in Bendel. With unpaid present entitlements, there is typically a legal person (the trustee) separate from the beneficiary. As noted above, this is not the case for partners. Arguably, only to the extent partnership funds have been lent/draw disproportionately should potential Division 7A issues arise.
How can this risk be managed?
Given the lack of clarity from the ATO as to how Division 7A interacts with partnerships the remaining question is how best to manage these risks where they operate a partnership that includes at least one company.
First, taxpayers should test the ownership structure of the company to confirm whether the partnership or the non-company partners are shareholders or associates of shareholders in the company. If they are not (for example, because the partners are all unrelated parties), then Division 7A may not have any operation.
It is open to a taxpayer to adopt a position that undrawn partnership accounts are not financial accommodation and Division 7A does not apply. But taxpayers should be made aware of the risks associated with adopting this position – while they may ultimately be proven true, it may involve a costly audit, objection and litigation process to arrive at that conclusion.
Otherwise, as a starting point, it would appear that the partners in a partnership should draw down their partnership accounts at equal rates. If this approach is adopted, then the ATO would not be able to argue that non-company partners had benefitted from the company choosing not to drawdown its partnership account, or that the company has indirectly funded the over-payments to the individuals.
Where a partnership is intending to make a loan to a partner, you may wish to consider putting it on Division 7A complying terms – that is with a maximum term with interest and minimum principal repayments calculated in accordance with Division 7A. This would resolve any concern that the individuals are somehow “getting access” to company money without that company receiving compensation. Alternatively, the company could make the loan directly to the individuals.
A genuine contribution of capital is not subject to Division 7A
Finally we note that the ATO has seemingly kept to its position that a genuine contribution of capital to a partnership by a company partner is not a payment that is a deemed dividend.
The ATO see the contribution as a payment (to an entity) but accepts it does not cause a deemed dividend because it is s merely the discharge of a pecuniary liability and not more than what an arm’s length party would pay (under the terms of the partnership).9 This has been confirmed in one private ruling made in 2018 of which we are aware PBR 1051393604802.
That PBR also reasons that the capital contribution is not a loan for Division 7A purposes, because it “is made in accordance with the Partnership Agreement and for purposes which are consistent with the purpose of the Partnership”.
Annexure – ATO FAQ on Division 7A
This copy was extracted from Alex Kokkinos and Leo Gouzenfiter’s Tax Institute paper, “Division 7A – Everything old is new again”:
Footnotes
Bendel and Commissioner of Taxation (Taxation) [2023] AATA 3074 ↩︎
The relevant part has been extracted and replicated in the Annexure to this article ↩︎
Since 1 July 2019, Queensland has recognised a 1% discount on the applicable payroll tax rate for regional employers (Discount). The Discount was originally enacted to end on 30 June 2023 but it was extended for a further seven years, until 30 June 2030.
Employers intending to claim the Discount need to be cognisant of the technical requirements to access the Discount, to ensure the concession is properly being claimed. The Queensland Revenue Office (QRO) can (and often does) conduct reviews and audits of taxpayers to verify claims for exemptions and concessions, including the Discount.
Regarding the Discount, there are two key eligibility conditions:
the employer has a ‘principal place of employment’ in ‘regional Queensland’;
the employer pays at least 85% of taxable wages to ‘regional employees’.
Earlier this year, a further condition was inserted to exempt large employers. For the 2025 and later financial years, employers with annual Queensland taxable wages of more than $350 million are not eligible.
Principal place of employment
For employers with an Australian Business Number (ABN), this first condition hinges entirely on whether the employer’s registered ABN business address is located within the ABS statistical areas for Cairns, Townsville, Mackay, Central Queensland, Darling Downs Maranoa, Isaac, Whitsunday, Wide Bay or Queensland – Outback.
Accordingly, it is critical that employers regularly update their ABN records (which often is not a priority), in addition to any addresses listed with ASIC. If ABN records are inaccurate, issues can arise in seeking to make retroactive amendments to ensure that eligibility for the discount is maintained.
This can be an issue if an employer’s ABN address has been inputted as their head office or accountant’s address in South-East Queensland rather than their principal place of business in regional Queensland. In this regard, the ATO and ABR websites both acknowledge it is not uncommon for addresses listed for ABN purposes to be out of date, and that these need to be current places of business.
The second condition is that 85% of payments are paid to employees whose principal place of residence is located in regional Queensland (i.e. the areas set out above).
The requirement should apply on an entity-by-entity basis notwithstanding that entities may otherwise be grouped for payroll tax purposes.
Employers should implement systems to ensure this 85% requirement is satisfied each year. Payments to employees each year must be cross-checked to postcodes of employees, to ensure at least 85% of payments are to regional employees.
Whether this criterion is satisfied may be impacted where:
business operations have changed, involving more employees in South-East Queensland;
workers are engaged on a fly-in fly-out (FIFO) basis;
a workplace may be in regional Queensland, but workers travel from an ineligible area to work in the workplace
Assistance
We can assist you with undertaking an independent review to ensure the regional employer discount is properly being claimed. Alternatively we can also assist in making voluntary disclosures of any potential shortfalls and/or liaising with the QRO as part of a QRO review or investigation, to help ensure any QRO concerns are satisfactorily answered.
For more information contact Lyndon Garbutt or DJ Alexander, on the contact details listed above.
Presented at the Trusts Intensive on 6 – 7 June 2024
In recent years there has been a renewed push for the application of anti-avoidance provisions to the operation of trusts – including what would historically be regarded as typical family discretionary trust distributions.
Specifically, the application of Part IVA and section 100A of the Income Tax Assessment Act 1936 to trusts has been the focus of Australian Taxation Office (ATO) audit activity, public rulings (and other statements) and litigation.
This paper reviews the recent developments and, particularly the recent case law, in these areas.
Particularly, the paper considers the following aspects of tax integrity provisions being applied to trusts.
The possible direct application of Part IVA to trust distribution choices. This was the subject of the recent Minerva Financial Group litigation, and those cases (the original Federal Court and the later Full Federal Court decisions) will be considered in some detail. As the Full Federal Court decision has not been appealed, it stands as an important statement of the current law. Part of the decision in the Guardian litigation also involved a direct application of Part IVA to trust distribution choices and will be, more briefly, considered.
How trusts have featured in the application of the dividend stripping provisions within Part IVA (section 177E) and for denial of franking credits. While dividend stripping, by its nature, relates to corporates, particular features of trusts have been utilised in various arrangements to which those dividend stripping provisions have been sought to be applied. The relevant aspects of recent cases will be considered.
Where things stand on section 100A, as an integrity provision directly applicable to trusts. The current ATO position and the current state of the case law will be considered.
Part IVA – trust distributions generally
Recent cases
The manner in which distributions of the income or gains from small business, investment or other activities are made from a typical family discretionary trust has not, historically, been an area to which Part IVA of the Income Tax Assessment Act 1936 has been (at least directly) applied.
Some recent cases, however, have involved scenarios in which the manner of the distributions have been directly challenged under Part IVA.
It is helpful that those cases have turned on the dominant purpose aspect of Part IVA (after resolution of questions relating to tax benefit). The dominant purpose issue can be expected to be the critical issue going forward.
It is relevant and important to understand the facts and reasoning from these cases, to be able to manage the (heightened) risk of Part IVA applying to typical family discretionary trust distribution scenarios.
The section of the paper will consider:
Minerva Financial Group Pty Ltd v FCT [2022] FCA 1092;
the subsequent Full Federal Court appeal decision in Minerva Financial Group Pty Ltd v Commissioner of Taxation [2024] FCAFC] 28; and
the aspects of the Full Federal Court appeal decision in Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 relevant to the potential application of Part IVA to trust distributions (the section 100A aspects are considered separately below).
Minerva decision(s)
Minerva facts
The facts in Minerva were as follows.
The Liberty Group (Group) carried on a financial services business that involved lending for profit. Originally, the Group carried on its business in a corporate silo where earnings from its lending and securitisation activities were taxed at the 30% corporate tax rate. The Group was owned by non-resident entities that were residents of a lower tax jurisdiction.
The Group had, for an extended period, wanted to conduct an initial public offering (IPO) of “stapled securities” in the holding company, Minerva Financial Group Ltd (from 2008 a Pty Ltd company) (MFG) and a trust, Minerva Financial Group Trust (MFGT). It ultimately took the Group until 2020 to achieve this restructure, , with delays caused by various reasons, including the GFC.
The Group sought external advice on the best way to IPO and all the advice suggested that the Group restructure into a stapled structure with:
a corporate silo which did the loan origination, underwriting and servicing of financial assets and business; and
a trust silo which held the group’s wholesale and securitisation trusts and received interest income and fee income from borrowers.
To address a concern that the yields on stapled securities should not exceed 4 to 5%, which would have caused yield fluctuation and valuation issues, and to ensure that the corporate silo had funds to meet its cashflow requirements to carry on its business, two companies in the corporate silo were each issued with a discretionary unit from the Minerva Holding Trust (MHT). The MHT owned all the securitisation trusts in the trust silo. The discretionary unit provided the trustee of the MHT with the discretion to distribute a discretionary amount of trust income to the corporate unitholders from year to year.
The following diagram (extracted from the full Federal Court judgment and a little more detailed than that included in O’Callaghan J’s judgment), outlines the structure of the Group in 2007 and 2008, after the restructure (note the shares and units in the Group were not stapled until 2020 – after the relevant income years in dispute, being the 2012 to 2015 income years):
The tax effect of the restructure was that if the MHT trustee:
did not exercise its discretion to distribute income on the discretionary units, then the interest income it earned would flow to a non-resident (Jupiter and later Vesta) and be subject to 10% interest withholding tax; and
exercised its discretion to distribute income on the discretionary units, then such income would be taxed to the corporate silo at 30% – as it had prior to the restructure.
In the income years of concern, the MHT trustee only distributed 2% of its trust income to the corporate silo.
The ATO argued that Part IVA applied to the arrangements and that the corporate silo should be taxed on the MHT’s trust income. A particular concern of the ATO was that the restructure adversely affected the corporate silo’s capital adequacy ratios and resulted in the need for the MHT to make loans to the corporate silo so that it had sufficient working capital to carry on its business activities.
The ATO identified three Part IVA schemes arising from the arrangements:
first scheme:the restructure into the corporate and trust silos, and the nominating of MHT as the residual unitholder entitled to residual income from the securitisation trusts under MHT;
second scheme: the transfer of ownership of MFGT to Jupiter from MFG, the decision by MHT trustee to only distribute 2% of trust income to the corporate silo in the relevant income years and lending of funds by MHT to the corporate silo for its business activities;
third scheme: this scheme had the same steps as the second scheme, except that it did not contain the transfer of ownership of MFGT to Jupiter.
The taxpayer conceded that it had obtained a tax benefit under each of the schemes and so the focus of the case was on whether the schemes outlined by the ATO objectively displayed a dominant purpose of tax avoidance.
Federal Court (single judge) reasoning
O’Callaghan J decided that the first scheme did not evince a dominant purpose of tax avoidance, since the restructure reflected consistent external advice provided to the taxpayer that the best way to IPO was to use a stapled structure. The corporate silo was profitable after the restructure and delaying the restructure would have led to more costs at the IPO time when the Group’s asset holding would have to be restructured to get to the stapled structure. These additional costs included the CGT and duty that would have to be incurred to move the securitisation trusts under the MHT.
With respect to the second and third schemes, O’Callaghan J ruled that both were entered into for the dominant purpose of tax avoidance.
O’Callaghan J stepped through the eight factors in section 177D of Part IVA and decided the first and third factors supported the dominant purpose.
In particular, his Honour found the MHT trustee’s choice not to exercise its discretion to distribute more than the nominal 2% of income to the corporate silos in the income years in question objectively displayed a dominant purpose of tax avoidance.1 O’Callaghan J noted that the taxpayer could not provide any commercial reasons why only a nominal amount of income was distributed, apart from an obscure unexplained comment that only nominal amounts were distributed as it would have been undesirable for a return on equity metric.
Because they are focused on the precise act of a trustee deciding how to distribute, and can be contrasted with the subsequent Full Federal Court’s reasoning, it is worth extracting the following critical paragraphs in the decision (when considering the first factor in section 177D):
“563 The applicant could only proffer one reason why a greater distribution of income from MHT to LF would not be desirable, that is, the so called return on equity “metric”. As I also explained, the applicant was unable to provide any evidence as to how the metric was calculated, what assumptions underpinned it, whether or why a lower return on equity metric would not be desirable or how that consideration outweighed the negative consequences of LF not receiving the income. See [502] [507].
564 The applicant was unable to provide any cogent reason, other than the tax benefit, why the decision was taken in each of the relevant years to direct no more than 2% of MHT’s net income to the special unitholders. The applicant submitted that neither LF nor Secure Credit had an “entitlement” to the income from the RIUs and that the power of the trustee of MHT to distribute income to the special unitholders was discretionary. So much, unsurprisingly, was accepted by the Commissioner. But neither factor goes to the relevant question of dominant purpose, objectively viewed.
565 In those circumstances, I agree with the Commissioner’s submission that, viewed objectively, the exercise of the choice in each of the relevant years (the manner in which the second part of the second scheme was carried out) was driven by the tax benefit of directing income away from LF. Having found that this factor is neutral insofar as it relates to the first part of the second scheme, I agree with the Commissioner’s submission that, objectively, the manner in which the second scheme was entered into is indicative of a dominant purpose of obtaining that tax benefit.”2
The fact that the MHT had to make loans to the corporate silo after the restructure was not seen by O’Callaghan J as relevant to assessing dominant purpose, his Honour determining that inter group loans are normal and there was no evidence showing that the corporate silos’ capital adequacy ratio was actually affected. On this basis, it was the non-exercise of a discretionary income power that provided the dominant purpose of tax avoidance.
The Minerva decision suggests that a trustee income distribution based solely on a lower marginal tax rate may be problematic for Part IVA purposes. It may be that this case is confined to its very particular facts where a corporate taxpayer restructures into two entities which are in substance held 100% by the one entity (Jupiter and then Vesta later on). This fact scenario is very different from a situation where a family discretionary trust is established from the outset as a discretionary trust and it has been operated on a discretionary basis from the outset. The main concern raised by Minerva is the lack of detailed analysis on ruling that the lack of exercise of a discretion in favour of a higher tax rate taxpayer translates generally to the wider taxpaying community.
Full Court reasoning
On appeal, the decision on the first scheme was not raised by the ATO, but a fourth scheme – consisting only of the non-exercise of the discretion of the trustee of MHT to make distributions to the special unitholders3 – was added to the second and third schemes.
That this fourth – and most narrow – scheme was raised is helpful. Taxpayers must grapple with the possible application of Part IVA in circumstances where there is the risk that, the more narrowly the ATO formulates the scheme to focus only on parts that directly have taxation effects (e.g. here, a trustee’s decision on distributions, but such simple matters as the act writing off bad debts or acts that otherwise realise tax losses) the more likely a dominant tax purpose may be found.
While the Full Court did not separately say a lot about this fourth scheme, it did expressly mention the fourth scheme in its consideration of the first and second factors of section 177D – in arriving at its rejection that those factors supported a dominant tax purpose (as discussed below).4
The Full Court by a joint decision allowed the appeal, finding that Part IVA did not apply to any of the schemes identified by the Commissioner. This included the fourth scheme.
Prior to considering the eight factors in section 177D the Full Court:
made comments on the ATO’s approach;
restated a number of principles in relation to the operation of Part IVA; and
explained where it disagreed with the earlier single judge decision.
These comments are a very helpful guide, and partly a correction, to the thinking that often arises around Part IVA.
The difficulties with the ATO’s approach, the Full Court highlighted, related to the ATO’s tendency to treat the Group’s underlying business activities as if they were static from before the reorganisation in 2007 – despite the rejection of that reorganisation as subject to Part IVA as the first scheme and despite very material changes since 2007. This was relevant to the objective facts to be considered in applying Part IVA.5
The Full Court restated 12 principles to be followed when applying Part IVA and in considering the eight factors in section 177D. They are worth extracting in full (bold emphasis added):
For Part IVA to apply it must be shown that having regard to the eight matters “it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme” or enabling the relevant taxpayer and one or more other taxpayers to obtain a tax benefit in connection with the scheme: s 177D; Commissioner of Taxation (Cth) v Hart [2004] HCA 26; (2004) 217 CLR 216 at [44].
The inquiry mandated by s 177D is directed at a conclusion to be drawn in respect of the dominant purpose of a person who entered into or carried out the scheme or any part of the scheme. It is not an enquiry about the purpose of a scheme or part of a scheme: Hart at [63].
The inquiry required by Part IVA is an objective, not subjective inquiry: Hart at [37].
The fact that a particular commercial transaction is chosen from a number of possible alternative courses of action because of tax benefits associated with its adoption does not of itself mean that there must be an affirmative answer to the question posed by s 177D: Hart at [15]. The bare fact that a taxpayer pays less tax, if one form of transaction rather than another is made, does not demonstrate that Part IVA applies: Hart at [53].
Even if a particular form of transaction carries a tax benefit, it does not follow that obtaining the tax benefit is the dominant purpose of the taxpayer in entering into the transaction: Hart at [15]. Simply to show that a taxpayer has obtained a tax benefit does not show that Part IVA applies: Hart [53].
Merely because a taxpayer chooses between two forms of transaction based on taxation considerations does not mean that it is to be concluded, having regard to the factors listed in s 177D, that the dominant purpose of the taxpayer was to obtain a tax benefit: Hart at [15]. Part IVA does not apply merely because the Commissioner can identify another means of achieving the same or similar outcome which would have resulted in more tax being payable.
However, a transaction may take such a form that a conclusion of the kind described in s 177D is required even though the transaction also advances a wider commercial objective. There is a false dichotomy between rational commercial decisions and obtaining a tax benefit: Hart at [51]. The presence of a discernible commercial end does not determine the answer to the question posed by s 177D: Hart at [64]. The terms of Part IVA do not reference “bona fide commercial reasons” or any equivalent expression: Hart at [47].
There is a distinction between a taxpayer adopting a form of transaction that is influenced by taxation considerations (where the presence of a fiscal objective does not mean that it is to be concluded, having regard to the factors listed in s 177D, that the dominant purpose of the taxpayer was to obtain a tax benefit) and a taxpayer taking steps to maximise after-tax returns in a manner objectively indicating the presence of a dominant purpose to obtain a tax benefit: Hart at [16]–[18]; Commissioner of Taxation v Spotless Services Ltd [1996] HCA 34; (1996) 186 CLR 404 at 416, 423.
Although the conclusion as to purpose may be a conclusion to be drawn in respect of a person who only entered into or carried out part of the scheme, the factors are to be applied having regard to the scheme as a whole and not to part of the scheme: Commissioner of Taxation v Macquarie Bank Limited [2013] FCAFC 13; (2013) 210 FCR 164 at [199] (Middleton and Robertson JJ).
Although all of the eight factors must be considered, not all the factors in s 177D(2) will have the same relevance or the same importance in every case.
Statements about why the taxpayer acted as they did or about why a party to the transaction structured the transaction the way they did are not statements which are an answer to the question posed by s 177D(2). That section requires a conclusion about purpose to be drawn from the eight objective matters; it does not require or even permit any inquiry into the subjective motives of the taxpayer or others who entered into or carried out the scheme or any part of it: Hart at [65].
The inquiry directed by Part IVA requires comparison between the scheme in question and an alternative postulate. To draw a conclusion about purpose from the eight matters identified in s 177D will require consideration of what other possibilities existed to achieve the same commercial end: Hart at [66].
In following paragraphs, the Full Court made some concise summary statements:
Part IVA and in particular the conclusion to be drawn under s 177D is not drawn by looking only at the consequences of what was done or by comparing the tax consequences of what was done with the tax consequences of another possible transaction that achieved different commercial outcomes. It is a conclusion to be drawn by reference to the eight factors applied to the totality of the scheme considered in its wider context.6 (bold emphasis added)
That Part IVA does not pose a “but for” test and does not require that a taxpayer choose a form of transaction which results in the most tax or more tax being payable.7
The Explanatory Memorandum to the Bill which originally enacted Part IVA is set out extensively in the reasons of Callinan J in Hart at [86]. As the EM makes apparent, and consistent with the statutory text, it is the features of the scheme and its surrounding circumstances which are objectively examined through the s 177D factors. It is not an examination of the subjective purpose or subjective motive of any party to the scheme8. (bold emphasis added)
Purpose directs attention to object or aim. It is concerned with the reason why something has occurred or been allowed to occur. The objective dominant purpose of a party to a scheme (such as an action or course of action) that has enabled a person to obtain a tax benefit is determined by regard to what has happened and evaluating why it has happened. Obtaining the tax benefit is not enough. Desiring the tax benefit is not enough. The obtaining of the tax benefit must have been the main object or aim of what is said to be the scheme when viewed objectively in its surrounding context.9 (bold emphasis added)
In disagreeing with the earlier single judge decision, the Full Court focused on – and disagreed with – the reasoning of O’Callaghan J in paragraphs 563 and 564 as extracted above. The Court observed that:
O’Callaghan J’s reasoning elides the question posited by s 177D with an inquiry as to whether the trustee’s discretion would have been exercised differently but for the tax benefit10 – the Full Court rejecting the suggestion of a “but for” approach;
the relevant question posed by section 177D is not addressed by consideration of any subjective purpose – but rather the statutory question is to determine purpose by an objective assessment of objective facts.11
On observing that the essence of each of the schemes on appeal focussed on the exercise of the discretion by the trustee of MHT to make distributions12, the Full Court proceeded to consider the factors in section 177D together for all the schemes.
The Full Court did not find any factors that supported a dominant tax purpose conclusion (some were neutral). It particularly set out detailed reasoning for the first (manner carried out) and second (form and substance) factors.
Regarding the first factor, the difficulties with the ATO’s approach noted earlier – whereby the ATO tended to treat the Group’s underlying business activities as if they were static from before the reorganisation in 2007 (despite the rejection of that reorganisation as subject to Part IVA as the first scheme and despite very material changes since 2007) – led the Full Court to conclude on this first factor:
The trustee paid distributions in accordance with the terms of issue of the ordinary notes and the trust constitution. None of the contextual matters relied upon by the Commissioner cast any different light on the manner in which the scheme was entered into.13
It is worth noting a timing aspect to this reasoning. While the Full Court stressed the need to consider the wider context, that context was based on the (post 2007 reorganisation) commercial structure that existed at the time the discretion was exercised to pay the distributions.
Regarding the second factor, the form and substance were considered the same, so not supporting a dominant tax purpose. The ATO’s attempt (by a contention) to ignore the intervening financial dealings and structures and, essentially, argue that the cash flows ultimately flowed back to the same ultimate owners (but with less tax) was rejected – as conflating the concept of cash or funds with the concept of income.14
ATO Decision Impact Statement
The ATO issued a Decision Impact Statement (DIS) on the Full Court decision on 29 May 2024, which did not consider the decision to ‘disturb the Commissioner’s long-held view that schemes which include a trustee’s exercise of discretion to distribute income can attract the operation of Part IVA’ – but acknowledged each scheme will turn on the objective facts.
The ATO’s acknowledgment of the objective facts found by the Full Court, under the ‘Dominant purpose’ heading include:
The default position under the terms of the MHT constitution was for distributable income to be distributed to the ordinary unitholders such that there was nothing extraordinary about distributions flowing in accordance with the terms of the trust constitution. The objective facts were that special unitholders had no entitlement to the income of MHT absent the exercise of the discretion available under the trust constitution. This conclusion was also supported by the commercial context of the restructured business, and in particular the changes to LF’s role in that business.
The Full Court found that the same commercial outcome for the parties would not have been achieved had distributions been made instead to LF. The distribution of income to Jupiter and Vesta had real economic and financial consequences to them that would not have flowed had the income been distributed to LF. The Full Court relied upon these facts in finding that the fourth factor was neutral and that the sixth factor pointed away from a party having the requisite dominant purpose.
Guardian Full Court appeal
Guardian concerned two taxpayers: Guardian AIT Pty Ltd (Guardian), which acted as trustee of the Australian Investment Trust (AIT), and Mr Springer. Mr Spinger owned all the shares in Guardian AIT and was principal and a beneficiary of AIT.
AIT was an Australian-resident trust. Its income in the 2012, 2013 and 2014 income years was derived in Australia.
Mr Springer was a Vanuatu resident in each of the 2012, 2013 and 2014 income years.
As principal of AIT, Mr Springer had the power to appoint any person or corporation as a beneficiary. On 27 June 2012, AIT Corporate Services Pty Ltd (AITCS) was incorporated as part of a strategy recommended to Mr Spinger by his accountant. The shareholder of AITCS was AIT. On 29 June 2012, Mr Springer appointed AITCS as a beneficiary of AIT.
In 2012, the following steps were taken by Guardian, AIT and AITCS:
On 28 June 2012, Guardian resolved to distribute AIT’s income for the 2012 income year, of approximately $2.6 million, to AITCS.
Guardian did not pay the distribution to AITCS, creating an unpaid present entitlement.
In April 2013, around the time that AITCS was due to pay tax on its distribution from AIT, approximately $792k was drawn down by AITCS from its UPE – an amount equal to the tax payable on its distribution from AIT.
In May 2013, AITCS declared a fully-franked dividend of approximately $1.8 million. This dividend reduced the balance of AITCS’s UPE to nil.
On 23 June 2013, Guardian resolved that the net income of AIT attributable to franked dividends be set aside and held on trust absolutely for Mr Springer.
Similar steps were repeated by Guardian, AIT and AITCS in the 2013 and 2014 income years.
At audit, the ATO identified a primary scheme and three secondary schemes.
The primary scheme identified by the ATO consisted of each step taken by Mr Springer, Guardian, AIT and AITCS in relation to the 2012, 2013 and 2014 income years.
The three secondary schemes identified by the ATO consisted of the relevant steps taken by Mr Springer, Guardian, AIT and AITCS in relation to the 2012 distribution, the 2013 distribution and 2014 distributions each as a separate scheme.
Guardian decisions
At first instance, Logan J held that the section 177D did not apply to either the primary scheme or any of the secondary schemes.
On appeal to the Full Federal Court:
“145 The Commissioner’s case on appeal was thus focussed on the narrower 2012 related scheme and the 2013 related scheme. In relation to the 2012 related scheme, the Commissioner’s emphasis was on the steps involving the appointment of income to AITCS [the company beneficiary] and the subsequent dividend paid by AITCS to the AIT [the trust], rather than on the reasons for the incorporation of AITCS and its inclusion in the class of eligible beneficiaries.”15
Further:
“152 The 2012 related scheme and 2013 related scheme were each a “scheme” as defined in s 177A. The particular form of the 2012 related scheme as identified was not limited to the formation of AITCS or the inclusion of AITCS as an eligible beneficiary of the AIT, or even to the creation of the present entitlement of AITCS to net income of the AIT. The 2012 related scheme included the declaration and payment of the franked dividend by AITCS to AIT following the creation of AITCS’s unpaid present entitlement and the distribution by the AIT of that franked income to Mr Springer. The 2013 related scheme was likewise not limited to the creation of the present entitlement of AITCS to net income of the AIT but also included the declaration and payment of the franked dividend by AITCS to the AIT following the creation of AITCS’s unpaid present entitlement and the distribution by the AIT of that franked income to Mr Springer.”16
A tax benefit was identified by the Full Court:
“171 Accordingly, it is considered that Mr Springer obtained a tax benefit in each of the years ended 30 June 2012 and 30 June 2013 in the form of the non-inclusion of an amount in Mr Springer’s assessable income in those years.”17
If the income had been included in Mr Springer’s assessable income, Mr Springer would have paid Australian tax at the non-resident marginal rates, rather than the Australian tax being effectively capped at the company tax rate of AITCS, with no later dividend withholding tax applying.
The role the trust distributions by AIT played was:
firstly, that AIT distributed to AITCS; and
secondly, when AITCS paid a franked dividend to AIT (to offset/satisfy the unpaid entitlement created by the earlier distribution to AITCS), that franked distribution was distributed to Mr Springer who, as a non-resident, then did not pay any additional Australian tax.
The Full Court undertook the exercise of considering the dominant purpose question in a similar manner as the (later) Full Court in Minerva appeal. For example:
“179 As was made clear in Hart 217 CLR at 242–3 [63] (Gummow and Hayne JJ), the inquiry mandated by s 177D is directed at the dominant purpose of a party who enters into or carries out the scheme and not at ascertaining the purpose of the scheme itself.”18
Also:
“181 In considering the s 177D matters, it may be appropriate and necessary to have regard to the possibilities that existed outside of the scheme entered into or carried out. The various alternatives that were in fact considered may cast light on the conclusion to be drawn from the application of a particular s 177D matter …”19
The dominant purpose was found for the 2013 related scheme but not the 2012 related scheme.
The reasoning can be summarised from the following comments of the Full Court when considering the first factor under section 177D (manner scheme carried out):
“195 The essential difference between the 2012 related scheme and the 2013 related scheme was that objective circumstances would support a conclusion that, at the time AITCS’s present entitlement to the AIT income was created for the year ended 30 June 2013, Mr Springer (or those advising him) would procure the payment of a dividend by AITCS to clear out the present entitlement and, following the payment of tax by AITCS, flow the franked dividend income back to Mr Springer, giving him direct ownership and control of the value of that present entitlement. Far from the payment of a dividend by AITCS to clear out that present entitlement being wholly conjectural, it would be the most likely course of action.”20
The Full Court concluded after considering all the factors under section 177D that, for the 2013 related scheme (only), Mr Springer, Guardian AIT (i.e. the trust) or AITCS (or those advising them) entered into or carried out the scheme for the dominant purpose.21
The Full Court decision did not rely on a narrow “but for” reasoning. The fact that funds flowed through to Mr Springer, rather than funds being substantively accumulated in AITCS for retention/investment, was a significant surrounding circumstance supporting the finding of the relevant dominant purpose.
Conclusions – Part IVA and trust distributions
It is suggested that the central point(s) to take from the Full Court decision in Minerva (which are consistent with the Full Court decision in Guardian) regarding dominant tax purpose is that the text of Part IVA requires a qualitative assessment (conclusion), having regard to the eight factors in section 177D:
of the objective, not subjective purpose
of a person (who is a party to the scheme), not of the scheme
in entering into the scheme as a whole and just a part of the scheme
made from the objective facts – including the actions taken, the objectives/aims of those actions and the consequences – relevant to the totality of the scheme considered in its wider context (to which the eight factors are applied)
The above leaves room for tax considerations to be part of decisions on how trustees may distribute trust income – even if the subject scheme is just the distribution choices (like the fourth scheme in Minerva) – without there being a dominant tax purpose.
For example, the distributions within a family may be part of a wider context – in which it can be objectively supported that the (albeit tax effective) distributions were part of a purpose of genuinely sharing of income within the family over the short and long-term.
In Minerva, the distributions (albeit tax effective) were accepted as being made within, and as part of, a wider commercial structure. There was a timing dimension in that the commercial structure as it already existed (without Part IVA applying to the changes that brought it into existence by the 2007 reorganisation) represented some limit on the wider context the Full Court considered relevant.
In Guardian also there was a timing dimension limiting the wider context, that caused the 2012 related scheme to be regarded differently to the 2013 related scheme.
This timing dimension/limitation for the context may assist either the ATO or the taxpayer but should be expressly considered.
The ATO’s DIS on the Minerva Full Court decision is not considered inconsistent with this thinking, with its confirmation of the objective facts as the determinative – and its acknowledgement of the commercial context found in that case.
Part IVA – trusts and dividend stripping
Recent cases
While dividend stripping (primarily dealt with under section 177E of Part IVA – and, in respect of denial of franking credits, by sections 207-145, 207-150 and 207-155 in the Income Tax Assessment Act 1997), by its nature involves companies, there have been recent instances where trusts have been an integral part of the arrangements.
Section 177E has the effect, where it applies, of deeming a tax benefit (so that a benefit cannot by denied or disproven) in the hands of the relevant taxpayer. Perhaps because of the 2012 changes to Part IVA making the identification of a tax benefit easier for the ATO, the use of section 177E to access this deeming of tax benefit may not now be as important as in prior years. In the decisions we consider below, the franking credit provisions relating to dividend stripping have been sought to be applied.
In this section, the paper will consider:
BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112 and the subsequent full court appeal decision in B&F Investments Pty Ltd as trustee for the Illuka Park Trust v Commissioner of Taxation [2023] FCAFC 89 – referenced as the BBlood Federal Courtsingle judge and Full Federal Court decisionsfor convenience
Michael John Hayes Trading Pty Ltd as trustee for MJH Trading Trust v FCT [2023] AATA 3005
Brief comment is made on Merchant v Commissioner of Taxation [2024] FCA 498 – but it is not considered to substantively relate to trusts.
BBlood
BBlood facts
This section of the paper is concerned with the dividend stripping aspects of the BBlood decisions. (Section 100A aspects are considered separately below.)
The trust (Illuka Park Trust) played a central role in the arrangement for which an assessment was made that denied franking credits to a company (BBlood Enterprises Pty Ltd) – on the basis of section 207-150(1)(g) applying, because the subject distribution that flow indirectly to the company was part of a “dividend stripping scheme” per section 207-150(1)(e).
It is sufficient for present purposes to note the arrangement as one in which:
the terms of the trust, through which a share buy-back was later passed, were amended;
the amendment caused the share buy-back amount, treated as an assessable dividend for tax purposes but which was treated as capital for trust law purposes, to be retained in the trust as capital;
the tax liability for the assessable dividend amount passed to a company beneficiary as part of the net income of the trust, so that franking credits limited the tax (i.e. no “top-up” tax over the company rate was paid); and
the capital amount was later passed out of the trust to individuals without further tax.
Federal Court (single judge) reasoning
Thawley J held that (if he was wrong about section 100A applying) the company,
has not discharged its onus of establishing that the notice of amended assessment of income tax in respect of the 2014 year was excessive. It has not shown that s 207-150(1)(e) does not apply. The Share Buy-Back Dividend was made as part of a scheme which was “in the nature of” dividend stripping within the meaning of s 207-155(a) and was one which “had substantially the effect of a scheme by way of, or in the nature of, dividend stripping” within the meaning of s 207-155(b).22
The Full Court later disagreed that this company assessment could/should have been affirmed (even in this conditional manner) when the subject income was held as assessed to the trust (a different taxpayer) under section 100A.
But Thawley J’s reasoning on dividend stripping (and the Full Court’s later comments) is helpful to consider.
Thawley J provided the context of the legislation as:
295 Subsection 207-150(1) of the ITAA 1997 relevantly includes:
270-150 Distribution that flows indirectly to an entity
Whole of share of distribution manipulated
(1) If a *franked distribution *flows indirectly to an entity in an income year in one or more of the following circumstances:
…
(e) the distribution is made as part of a *dividend stripping operation;
…
then, for the purposes of this Act:
…
(g) the entity is not entitled to a *tax offset under this Division because of the distribution; and …
296 Section 207-155 provides:
207-155 When is a distribution made as part of a dividend stripping operation?
A distribution made to a *member of a *corporate tax entity is taken to be made as part of a dividend stripping operation if, and only if, the making of the distribution arose out of, or was made in the course of, a *scheme that:
(a) was by way of, or in the nature of, dividend stripping; or
(b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping.23
The scheme was identified as:
“298 The “scheme” relied upon by the Commissioner as one falling within s 207-55 was constituted by the Illuka Park steps set out at [19] to [28] above. The scheme involved a distribution (the Share Buy-Back Dividend) made to a member (the IP Trust) of a corporate tax entity (IP Co). The making of the Share Buy-Back Dividend and its subsequent treatment were central features of the scheme. The critical question is whether the scheme falls within either the first or second limb of s 207-155.””24
The history of the meaning of “dividend stripping” was considered in a level of detail not possible or relevant to repeat fully here.
The traditional view of a dividend strip is captured by the following extract from Thawley J’s judgment, from the explanatory memorandum to the Income Tax Assessment Bill 1972 (Cth) by which section 46A originally introduced the term into Australian legislation:
“In its simplest form, a dividend-stripping operation involves the purchase by a share trading company of shares in another company which has accumulated profits. A payment of a dividend is then made to the share-trading company which, in effect, wholly or substantially recoups its outlay on purchase of the shares that are then resold for a reduced price or are retained at a reduced value for income tax purposes.
Although, in a commercial sense, the share-trading company may make an overall profit on the transaction, no part of the deduction allowable for the cost price of the shares can be set off against dividend income to determine the part of the dividends included in taxable income on which the rebate is allowable. The result is that, while the dividends are effectively freed from tax by the rebate, the deduction allowed for the cost of acquiring the shares is applied against non-dividend income which thereby escapes full tax.”25
An arrangement involving the purchase/sale of shares is not what occurred in BBlood. Much of Thawley J’s consideration is directed to determining the limits of the meaning of “dividend stripping” – or substantially the effect of a scheme by way of, or in the nature of, dividend stripping (the second limb of section 207-155) – in respect of the BBlood arrangements.
Thawley J:
did not read the authorities as excluding evidence from a taxpayer about the taxpayer’s subjective reasons for doing what the taxpayer did26
regarded the meaning of “dividend stripping” as “protean” (i.e. tending or able to change frequently or easily), so as to encompass what was done in BBlood27
appeared to see a high emphasis on purpose from the authorities, in considering whether a course of action was a dividend strip28
He concluded on the first limb of section 207-155:
“356 Assessing the circumstances and events objectively, but also taking into account the evidence of subjective purpose, the predominant purpose of entering into the scheme was to move the profits of IP Co to its shareholder (IP Trustee) in capital form and without subjecting any person to tax beyond the level of corporate tax already paid on the profits, as reflected in the Franking Credits. Absent the scheme, dividends would have been declared and paid to the IP Trust and additional tax would have been paid. BE Co has not discharged the onus of establishing that the scheme was not undertaken for a tax avoidance purpose. The hallmark feature of tax avoidance necessary for both limbs of s 207-155 permeates the scheme.”29
And, placing an emphasis on the statutory context of a “manipulation” of the imputation system, took a wide view of the second limb:
“365 Like former s 160APP(6), s 207-155 is directed to “manipulation” of the imputation system – see: the heading to s 207-150(1). A conclusion that the second limb of s 207-155 would apply only to a scheme that would be within the first limb, except for the fact that the distribution by the target company is not by way of a dividend or deemed dividend, would leave s 207-155(b) without much of the operation it was evidently intended to have: its principal purpose, read with s 207-150(1)(e) and (g), lies in denying an offset in relation to franking credits attached to distributions such as dividends.
366 BE Co has not discharged the onus of establishing that the scheme did not have “substantially the effect” of a scheme in the nature of dividend stripping falling within the ‘second limb’ of s 207-155.”30
Full Court reasoning
The Full Court held that the company’s appeal against its assessment (as dividend stripping) should be allowed, essentially, because the orders of the primary judge incorrectly maintained two inconsistent assessments.
When section 100A was held to tax the trust, the assessment of the company based on section 207-150, which required that the franked distribution flow indirectly to the company, should not have been affirmed.31
Despite this conclusion, the Full Court proceeded to make some observations about section 207-155, which are relevant to consider. The expressed differences in reasoning from that followed by Thawley J are instructive.
The Full Court also reviewed the history of the meaning of “dividend stripping”. It is convenient to extract its summary from paragraphs 101 to 103:
“101 In Consolidated Press Holdings (No 1), the Full Court observed that the four cases referred to by Gibbs J in Patcorp had the following five characteristics in common (at 561 [136]):
a target company, which had substantial undistributed profits creating a potential tax liability either for the company or its shareholders;
the sale or allotment of shares in the target company to another party (a company in three cases and individuals resident in the then Territory of New Guinea in Bell);
the payment of a dividend to the purchaser or allottee of the shares out of the target company’s profits;
the purchaser escaping Australian income tax on the dividend so declared (whether by reason of a s 46 rebate, an offsetting loss on the sale of the shares, or the fact that the shareholders were resident outside Australia); and
the vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers (there being no capital gains tax at the relevant times).
102 The Full Court added that a further common characteristic was a predominant or sole purpose of the vendor shareholders avoiding tax on a distribution of dividends by the target company: Consolidated Press Holdings (No 1) at 561 [137].
103 Together, these six characteristics were said by the Full Court to be the “central characteristics of a dividend stripping scheme”: at 566 [157]. A dividend stripping scheme takes its character from the content of the scheme and its purpose: see 571–2 [183].”32
The Full Court seemed to place more importance on the purchase/sale aspects of a dividend strip, including when it noted:
“None of the cases involved a payment out of retained earnings to an entity that was an existing shareholder of the company.”33
The Full Court noted the following matters, which included some differences from the reasoning adopted by Thawley J (as the primary judge).
Firstly:
“… determining whether a scheme is by way of or in the nature of dividend stripping did not involve an inquiry into the subjective purpose of any participant in the scheme. The purpose of the scheme was to be assessed objectively: Consolidated Press Holdings (No 1) at 570 [174]”34
Regarding the first limb:
“In characterising a scheme as being by way of or in the nature of dividend stripping, it is necessary to look at the content, purpose and effect of the scheme. A scheme is not characterised as being by way of or in the nature of dividend stripping by looking only at the purpose of the scheme. Whilst the purpose of avoiding tax on a dividend is the typical characteristic of a dividend stripping scheme, perhaps an essential characteristic, it is not the only characteristic.”35(bold emphasis added)
“As for content of the scheme – In so far as the content of the scheme is concerned, whilst it may be accepted that the term “in the nature of dividend stripping” is capable of encompassing schemes that depart from the paradigm of a dividend stripping operation, the term cannot be so protean as to be meaningless. It may be doubted that a scheme can be by way of dividend stripping without a participant in the scheme acting as a dividend stripper. Although it is not necessary to express a concluded view, there is room to doubt whether a scheme can be in the nature of dividend stripping where the scheme involves a payment of a deemed dividend between a company and long-standing shareholder.”36(bold emphasis added)
“As for effect of the scheme – such schemes historically resulted in the receipt by the vendor shareholder of a sum that was not income for tax purposes. The receipt by the vendor shareholder was described as a “capital sum” in contradistinction to an income receipt for income tax purposes. In this context, “capital” was not used in a trust law sense but in the tax law sense. It is observed that the Illuka Park Steps resulted in the existing vendor shareholder receiving a tax law deemed dividend that was taxable as a dividend. The retained earnings of IP Co were not moved from IP Co to the shareholder in a form that was recognised for tax law purposes as capital.”37
The Full Court considered that the second limb raised difficult issues, but it did not make a determination of those issues, regarding them as best addressed in circumstances where any tax liability depends upon their resolution.38 But the issues included:
“…It is an open question as to whether a scheme can have substantially the same effect as a scheme by way of or in the nature of dividend stripping if the scheme involves an existing shareholder receiving a payment in the form of a tax law dividend or deemed dividend.”39
“…If s 207-155(1)(b) has the meaning ascribed to it by the primary judge, it would never be necessary to look past the effect of the scheme.”40 This is in the context that the Full Court had doubted, in terms of the content (vs effect) of a scheme, that a dividend strip could exist where a payment is made to a long-standing shareholder (as that shareholder would not be a “dividend stripper” as historically understood).
The sense from the Full Court decision is that there must be a limit to the meaning of a “dividend strip”, which could mean that the involvement of trusts (such as in BBlood) may mean that certain
arrangements fall outside that meaning. Of course, other provisions could then apply. Section 100A was the main focus of the ATO in BBlood.
Also, the Full Court (consistent with the way the Minerva was decided by the Full Court) sought to look at all of the content, purpose and effect of the subject scheme – not just purpose, and certainly not subjective purpose.
Hayes
Hayes facts
The subject assessments were issued to four trusts that were public trading trusts treated as companies for some but not all tax purposes. The assessments were made under section 207-155, applying the dividend franking provisions in respect of “dividend strips” to deny the franking credits to those trusts.
The facts are complex, including because of the multiple entities brought into existence as part of the major restructure. Given the focus of this paper is on integrity provisions relevant to trusts, it is sufficient, for present purposes, to note the arrangements from the AAT’s background comments:
“1. The present applications concern whether fully franked dividends paid in May 2010 by each of four Hayes Group Operating Companies to the Applicants constituted distributions ‘made as part of a dividend stripping operation’ within the meaning of s 207-155 of the 1997 Assessment Act.
2. Each of the four Hayes Group Operating Companies had profits available for distribution to shareholders. Each of them also had franking account balances to enable the dividends that were paid to be franked, and each of them paid significant dividends to new shareholders (the Applicants) in respect of newly created and issued shares.
3. The Applicants are companies who act as trustees of four trusts that are treated as companies by the Assessment Acts for some tax purposes. [This comment noting the public trading trusts status of the trusts.] The four (trustee) companies were acquired in February 2010 by members of the Hayes family and shortly thereafter became trustees of trusts that were formed with particular features or attributes (so as to attract the Trading Trust rules) to participate as Trading Trusts in a reorganisation of the Hayes Group late in the 2010 Year.
4. Shortly after the Applicants were formed, in different combinations two of the Applicants each acquired 10 Z Class shares (shares with special rights) for $1 per share in three of thefour Hayes Group Operating Companies, and the other two Applicants each acquired 10 Z Class shares for $1 per share in each of the four Hayes Group Operating Companies. The Z Class shares acquired ‘proved to be a good bargain’. Later, on the day the Applicants acquired those shares, the four Hayes Group Operating Companies declared and paid fully franked dividends totalling $8,008,459.72 to the holders of the Z Class shares.
5. In their 2010 Year income tax returns, each Applicant included the franked dividend amounts and the associated franking credit amounts in its assessable income and claimed tax offsets on account of those franking credits. The effect of the tax offset was to shelter the franked dividends from tax: in cash flow and economic terms the franked dividends were received free of any tax burden. Each Applicant contends it was entitled to the tax offsets claimed.
6. The Commissioner disagrees. He says that all of the dividends that were paid to the Applicants were distributions made as part of a dividend stripping operation because those dividends were paid pursuant to a scheme that:
(a) was by way of, or in the nature of, dividend stripping; or
(b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping,
with the effect that the amounts of the franking credits associated with the dividends are not included in the Applicants’ assessable income, and the Applicants are not entitled to tax offsets for these amounts, while the dividends received remain included in the Applicants’ assessable incomes.
7. At the core of the dispute is whether the relevant purpose in carrying out the 2010 Hayes Group reorganisation was tax avoidance. The Applicants contend that it was not, and that the purpose was to secure better asset protection features of the asset ownership arrangements within a group of family entities, and to streamline those arrangements. The Commissioner contends the purpose was to avoid tax.
8. The Commissioner does not allege that the transactions were shams. He accepts that the transactions entered into produced the legal and or equitable effect they purport to have produced. Further, the Commissioner has not sought to apply Part IVA of the 1936 Assessment Act to a tax benefit comprising an assumed payment of a dividend to any alternative recipient, or to any amount of tax benefit that may otherwise have arisen for Hayes family members or entities, or to arrangements that allowed loans to be made by entities that were treated as companies for some purposes but not Division 7A purposes.”41
The public trading trust status allowed income of those trusts to be taxed at the company rate (nil when franking credits were offset) but for loans made by those trusts not to be subject to Division 7A. So, the trusts played that critical role in the arrangements.
AAT decision
The AAT held that the distribution of fully franked dividends following the group restructure was not a part of a dividend stripping scheme because the shareholders did not receive a capital sum as a substitute for taxable dividends paid and there was no tax avoidance purpose.
The AAT summarised the three elements of a dividend stripping scheme that were in dispute:
“… only three elements of a dividend stripping operation that are disputed, namely whether:
(a) the dividends in the Applicants’ hands were taxed;
(b) the original shareholders (as represented by the Hayes brothers) received any, and if so what, capital sum as a substitute for taxable dividends; and
(c) the schemes had the requisite tax avoidance purpose.”42
On the first point, it was rejected that the dividends had been taxed. The “net of franking credits” position – of no tax payable – was considered to be required by the authorities and to sensibly apply the dividend stripping rules.
On the second point (of a capital sum as a substitute for taxable dividends):
The AAT noted that only 30.46% of value made its way to the original shareholders (the Hayes brothers, even if the loan could be seen as a capital sum – considerably less than needed to constitute a dividend stripping operation.43
The majority of the funds paid out by the subject dividends was seen as being returned to source (the operating companies) and, even that minority paid to the Hayes brothers was seen as a refinancing (only) by them of their obligations – neither the “receipt” of capital by the original shareholders.
This analysis did not directly address whether the change of the nature of the loans owed by the Hayes brothers, from being loans subject to Division 7A, to loans which were outside of those rules (because of the public trading trust status of the trusts that received the subject dividends), could amount to a capital sum.
That change of status provided an open-end nature to the funds provided to the Hayes brothers, albeit still subject to ultimate repayment.
On the third point (tax purpose):
The AAT acknowledged the Full Federal Court comments in BBlood, endorsing earlier authority, that the purpose was to be ascertained by an objective assessment of the transactions.44
Motivation and factors such as asset protection, non-transformation into non-taxable amounts and non-movement of value beyond the Hayes family, were considered to exclude a conclusion that the sole or dominant purpose was to avoid tax.45
Having already defined the three matters in dispute as noted previously – of which purpose was the last – the AAT did not widen its consideration to include the content and effect of the scheme on which the Full Court in BBlood had commented. This seems a function of how the case was run before the AAT and what had been agreed between the parties.
Also, there was no wider discussion of how the issue of the Z class shares (with their dividend rights), related to the first or second limbs of the meaning of a “dividend strip”, including the relevance of the dividends being paid to trusts with the special characteristics of public trading trusts and whether those trusts were to be identified as being the same as the long-standing shareholders (the Hayes brothers).
The long-term advantage (in terms of Division 7A – the advantage that loans could remain outstanding without repayment) of the public trading trusts seemed not to be within contextual time span the AAT considered relevant.
Merchant
The decision by Thawley J, handed down on 14 May 2024, in Merchant v Commissioner of Taxation [2024] FCA 498 is not outside its appeal period.
The decision did not particularly involve trust distributions or particular features of a trust – such as the characterisation of a buy-back dividend as capital in BBlood or the use of public trading trust status in Hayes.
For these reasons, in the context of this paper on trust tax integrity measures, Merchant will only be commented on briefly.
A trust was involved but only as the entity that happened to make the tax loss under the scheme, which Thawley J held was disallowed under Part IVA (generally, not as a dividend strip).
A dividend strip under section 177E was also held to arise, in respect of certain loan forgiveness schemes that, on their implementation, redirected value to that loss trust and out of the creditor companies, when the trust sold shares in the debtor company (its value having been increased by the debt forgiveness).
Conclusion – trusts and dividend stripping
From the recent cases examined, the use of particular features of trusts in arrangements that result in the movement of value out of companies, may not always fall within the scope of a “dividend strip”.
The Full Court in BBlood – but importantly as observations and not part of its decision – has expressed the need to consider:
all of the content, purpose and effect of the subject scheme – not just purpose, and certainly not subjective purpose
a possible limit to any expanded meaning of “dividend strip” – such as, whether a dividend strip could exist where a payment is made to a long-standing shareholder that could be a trust, where the passing of the payment/dividend through the trust could change its character in a tax advantageous way (as in BBlood)
If the AAT is correct in Hayes, certain unique features of trusts – the non-application of the Division 7A rules to public trading trusts in Hayes – may not be sufficient to cause a capital sum to be taken to be paid to which would enliven the dividend stripping rules. We will need to see if the Full Federal Court expresses different views in the appeal.
Of course, anti-avoidance rules other than the dividend stripping rules could still apply (section 100A, Part IVA generally) to circumstances involving trusts.
100A – current state of play
In seeking to summarise the current state of play, this section will comment on46:
The ATO position – the history and current guidance in Taxation Ruling TR 2022/4
Because the Full Federal Court appeal, which was limited to the application of section 100A(8) relating to tax purpose, many aspects of the Federal Courtsingle judge decision of Thawley J remain the current statement of the law – including importantly, for current purposes, the meaning of ordinary family dealing
The aspects of the Full Federal Court appeal decision in Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 relevant to section 100A – relating to an agreement.
ATO History
The history of the current ATO guidance on section 100A starts with the administrative position published on the ATO website in July 2014, titled “Trust taxation – reimbursement agreement” (https://www.ato.gov.au/law/view/document?DocID=SGM/trusttaxation) – still referred to at paragraph 54 of PCG 2022/2 (under Date of effect), on the basis that the ATO will “stand by” that 2014 administrative position if more favourable to a taxpayer’s circumstances for entitlements arising before 1 July 2022.
This a fairly meaningless concession. The July 2014 ATO guidance made general statements and did not state a reasoned legal basis for the ATO’s views. It was more in the nature of an “ambit claim”.
Example 1 of that July 2014 guidance includes the following (bold emphasis added):
“Example 1 – trust estate
The trustee of a trust estate makes a beneficiary entitled to trust income.
Instead of paying the amount of trust income to the beneficiary, the trustee gives, or lends on interest-free terms, the money to another person. The other person benefits from the trust income but is not assessed on any part of it.
The arrangement does not constitute ordinary commercial or family dealing.
This arrangement would generally constitute a reimbursement agreement if it was intended that the beneficiary who was made presently entitled to the trust income pays a lower amount of tax than would have been payable by the person who actually enjoyed the economic benefits of that income.”
Consistent with the sense of this example, from 2014 the ATO’s focus has been to seek to interpret section 100A by reference to tax purpose. (The other family dealing examples offered in 2014 were uncontroversial, being related to a trust established under will and to family lending at commercial terms.)
The ATO commenced audits on this basis, some of which are still ongoing or are at objection stage.
But taxpayers had to wait until 23 February 2022 before the ATO was prepared to provide a public statement of the claimed legal basis for its views, by way of draft Taxation Ruling TR 2022/D1 and accompanying draft Practical Compliance Guideline PCG 2022/D1. This is despite the ATO promising since October 2018 to provide such a draft ruling. The long history of the repeatedly deferred estimated dates for delivery of the draft ruling has since been (unhelpfully, for taxpayers) deleted from the ATO website.
During this time, taxpayers under audit also experienced delays with the issue of ATO position papers. When ultimately provided, such position papers were described as the “TCN approved view”, in advance of the issue of TR 2022/D1.
Some such audit position papers were being issued in December 2020, a very long time after the July 2014 ATO guidance and numerous earlier promised dates for the draft ruling.
The long delay in the public issue of TR 2022/D1 is difficult to understand, when audits had already been commenced.
When finally issued, TR 2022/D1 sought to accommodate the ATO’s views on the decision of Logan J in Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021] FCA 1619 (handed down on 21 December 2021) – but noted the decision was on appeal and, in parts, maintained alternative views.
TR 2022/4 and PCG 2022/2, as issued on 8 December 2022, include material differences from TR 2022/D1 and PCG 2022/D1 – largely due to the ATO seeking to accommodate the decision of Thawley J in BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112 (handed down 19 September 2022).
Not long after the issue of TR 2022/4, the Full Federal Court appeal in Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 (Guardian Full Court) was handed down (on 24 January 2023).
The ATO issued a Decision Impact Statement (DIS) on the Guardian Full Court appeal decision (on 24 April 2023). In terms of section 100A, some changes to TR 2022/4 (as issued on 8 December 2022) were made by an Addendum on 27 September 2023, to take account of the Full Court’s observations on the existence of an agreement (particularly, consensus and adoption, as noted below) – including whether a beneficiary must be a party to the agreement and the adoption of plans or recommendations from advisers. The ATO changes still seek to maintain the widest possible meaning of agreement.
All this history has been difficult for taxpayers under audit.
Where exactly do the ATO views sit now, per (the last updated September 2023) TR 2022/4?
TR 2022/4 – general approach
Paragraph 5 of TR 2022/4 sets out the ATO approach at the highest level. Fully extracted, that paragraph states (bold emphasis added);
“5. This Ruling provides the Commissioner’s view about these arrangements and the 4 basic requirements for section 100A to apply, namely that:
• The following 3 requirements are satisfied:
− ‘Connection requirement’ – broadly stated, the present entitlement (or amount paid or applied for the benefit of the beneficiary) must have arisen out of, as a result of or in connection with a reimbursement agreement (being an agreement, understanding or arrangement that has the 3 qualities described in the following points in this paragraph).
− ‘Benefit to another requirement’ – the agreement must provide for the payment of money or transfer of property to, or provision of services or other benefits for, a person other than that beneficiary.
− ‘Tax reduction purpose requirement’ – a purpose of one or more of the parties to the agreement must be that a person would be liable to pay less income tax for a year of income.
• The ‘ordinary dealing exception’ is not satisfied – the agreement must not be one that has been ‘entered into in the course of ordinary family or commercial dealing’.”
More comment is made below (under ”Issues with ATO guidance”) but, at this point and as already foreshadowed above, it can be noted that stating the structure of section 100A this way – particularly the characterisation by the ATO of tax purpose matters as relating to a requirement rather than acknowledging the absence of tax purpose as an exception (just like the ordinary dealing exception) – does not accord with the words of section 100A.
The grouping in TR 2022/4 of the meaning of “agreement” with the “arose out of” requirement also tends to distract from the primacy, and starting point, of the existence of a “reimbursement agreement” under the structure of section 100A – before any consideration of the exceptions for no tax purpose and for ordinary dealing.
It is reasonable to expect that adherence to the exact structure and the exact words of section 100A would provide the most reliable guidance.
As already noted, such departure from the exact words and exact structure of section 100A in TR 2022/4 appears to be an attempt to promote a focus on tax purpose.
Agreement
In paragraphs 66 to 70D (paragraphs 70A to 70D added in September 2023) of the Appendix 1 – Explanation part of TR 2022/4, the widest possible approach to the existence of an agreement is taken, relying sometimes on case law from former section 260 and other provisions. There appears to be an intention to regard repeated cooperation, such as occurs within families, as constituting an agreement.
This is particularly evident from comments in paragraphs 70 to 70D about such matters as tacit adoption, concerted action, an understanding over a period of time (footnotes omitted, bold emphasis added):
“70. An agreement could be:
• informal concerted action by which 2 or more parties may arrange their affairs towards a purpose; an example in the particular context of section 100A would be an ‘arrangement or understanding’ that the beneficiary would act in accordance with the wishes of another person or group, or
• an understanding that the parties will implement a series of steps undertaken individually or collectively by those parties over a period of time, or
• the actual implementation of such a series of steps.
70A. The parties to the agreement may include advisers who formulate the documentation and implement the agreement with the knowledge and assent of one or more parties to the transactions (or the party’s controllers, where relevant).
70B. A person can be made a party to an agreement without knowing its terms where another person is authorised to act on their behalf or where they have agreed to follow the decisions of another person in relation to the management of certain affairs. Whether these conclusions can be reached in a specific case is a question of fact, which may turn on the documentary and other evidence relevant to determining whether an agreement, arrangement or understanding exists. The Courts have not prescribed what being authorised to act means, but have observed that authorisation would not be established simply by showing a general practice of following advice.
70C. Section 100A applies according to its terms, which do not require a presently entitled beneficiary to be a party to the agreement. However the Courts have recognised in some cases that it cannot be concluded that there is an agreement that meets the conditions of being a reimbursement agreement unless the presently entitled beneficiary, or at least their controller or representative, is a party to that agreement. For example, where an alleged reimbursement agreement requires a presently entitled corporate beneficiary to declare and pay a franked dividend in favour of the trustee to achieve the intended taxation outcome of that dividend being appointed to another beneficiary, the beneficiary or their controller would ordinarily have to be a party to that agreement. For other cases, whether abeneficiary will be required to be a party to the agreement for it to be a reimbursement agreement will depend on the particular circumstances and documentation.
70D. Consistent with the approaches of the Courts where the meaning of the words ‘agreement’, ‘arrangement’ or ‘understanding’ have been otherwise considered:
Where, as provided by subsection 100A(13), an agreement can be implied, it is open to infer that an agreement exists from the surrounding circumstances or the conduct of the parties. In the particular context of section 100A, examples of where it is possible that this inference may be drawn include
-where the conduct of the trustee and others is inconsistent with the rights and duties imposed by the trust deed and the general law
-where parties act in accordance with the advice of a professional adviser (or rely on the professional adviser) in undertaking a series of steps or taking concerted action, and it is open to infer that the parties had knowledge of, and had assented to a relevant plan formulated by the adviser.
While an ‘arrangement or understanding’ must have been entered into consensually, the parties’ acceptance or adoption may be tacit and it is not essential that they be committed or bound to support it. The arrangement may be both informal and unenforceable, and the parties may be free to withdraw from it or to act inconsistently with it, notwithstanding their adoption of it. An arrangement or understanding may lack formality and precision.”
Further, at paragraph 74, it is acknowledged that an expectation is not an agreement, but an emphasis on conduct before and after the time an entitlement arises seeks to extend what will constitute an agreement (footnotes omitted):
“74. Where a present entitlement arises from an agreement or a payment or application of trust income results from an agreement, naturally, the relevant agreement must be in existence at the time when the present entitlement arises or the payment is made or funds applied. An expectation that some arrangement will be entered into after the creation of the present entitlement is not sufficient for the purposes of section 100A. The existence of an agreement might be established by evidence of the conduct of the parties before and after the time the present entitlement is created.”
The ATO modified some of its prior paragraph 74 comments to allow for the Guardian appeal decision to add the second sentence acknowledging that an expectation is not sufficient.
Connection requirement
The breadth of the ATO’s view about a present entitlement arising from a reimbursement agreement is probably best summarised in paragraph 73 (footnotes omitted) (bold emphasis added):
“73. It is sufficient for there to be a connection between the reimbursement agreement and some other act, transaction or circumstance from which the entitlement has arisen. If the beneficiary’s present entitlement or the payment or application of income to or for them was one of the consequences of any act, transaction or circumstance that occurred in ‘connection with’ or ‘as a result of’ the reimbursement agreement, this aspect of subsections100A(1) or (2) would be satisfied. The existence of such a connection will depend on the facts of a particular case.”
Taxpayers should take care about the evidence they should retain and be able to present, in addressing the onus the ATO will demand be satisfied in respect of claims about what would have been distributed to the beneficiary absent any reimbursement agreement – per paragraph 76 (footnotes omitted):
“76. The taxpayer has the onus of establishing a reasonable expectation that the beneficiary would have been presently entitled to the original amount if the reimbursement agreement had not been entered into. A ‘reasonable expectation’ requires more than a possibility. It involves a prediction as to events which would have taken place if the reimbursement agreement had not been entered into. The prediction must be sufficiently reliable for it to be regarded as ‘reasonable’.”
Benefits to another
The wide scope of how a benefit may arise to someone other than the beneficiary is set out in paragraphs 79 and 80.
This includes (consistent with the BBlood decision, commented on below) that a reimbursement agreement does not need to involve a payment to – and so a “reimbursement” back from – a beneficiary.
“79. Subsection 100A(7) does not limit who can be the provider of the money, property, services or other benefits. It also does not require that a benefit be provided directly.
80. Similarly, it is not a requirement of subsection 100A(7) that the ‘relevant trust income’, to which the beneficiary is presently entitled or has paid or applied for their benefit, also be the precise form or amount of the benefits that are provided to another person under the agreement. It is sufficient that someone other than the beneficiary benefits, such as by the provision of money, property, services or other benefits, whether directly or indirectly procured by (or in connection to or as result of) the beneficiary’s present entitlement (or the income paid or applied for the beneficiary).”
Tax reduction purpose
The ATO adopts from the words of section 100A(8) (and from the BBlood decision commented on below) a view that it is the tax “purpose of one or more parties to the agreement”47 that is relevant – not the tax purpose or effect of the agreement.
Paragraphs 84, 84A (both replaced or added in September 2023) and 85 summarise the narrowness of the bases on which a tax purpose may be taken not to exist (footnotes omitted):
“84. An agreement is entered into for a tax reduction purpose if any of the parties to the agreement entered into the agreement for that purpose. For there to be a tax reduction purpose, ‘[i]t is not part of the statutory task to establish what the parties would have done if the agreement had not been entered into.
84A. In BBlood FCFCA, the Court observed that:
An inquiry as to the purpose of a party (as required by s 100A(8)) is, on the other hand, an historical inquiry of why [a] party entered into the agreement in fact entered into. The inquiry is not a prediction. Nor is it an examination of a comparative position or comparative outcomes for a particular taxpayer requiring you to remove from the proposed future what was done and positing what might have been done: Ludekens at 192.
85. To meet the tax reduction purpose requirement:
the person whose tax liability is to be reduced or eliminated need not be a party to the reimbursement agreement
the income tax liability to be reduced can be in relation to any year of income, meaning that a purpose of deferring tax to a later year would be sufficient to demonstrate the tax reduction purpose
a person can have a purpose of securing a reduction in tax for subsection 100A(8) even where that purpose is not achieved or ceases to be held at some time following the entry into the agreement
there is also no requirement that the tax reduction purpose be the sole or dominant purpose of the party or parties for entering into the agreement. It need only be one of the purposes of the relevant party or parties for entering into the agreement”
Ordinary dealing
As for TR 2022/D1 before, the ATO’s views on the ordinary dealing exception are likely to remain the most contested parts of TR 2022/4 – especially about what is in the course of ordinary family dealing.
(The author found particularly surprising the prior ATO statement at paragraph 163 of TR 2022/D1 presuming to identify the “contemporary meaning” adopted by Parliament, without any reference to the principles of statutory interpretation. That statement has been removed in TR 2022/4 without explanation, or acknowledgement of its error.)
The ATO has had to adapt its views previously expressed in TR 2022/D1, as a consequence of the BBlood decision by Thawley J.
In TR 2022/D1 the ATO sought to directly apply the predication test from Newton v Federal Commissioner of Taxation (1958) 98 CLR 1 as the meaning of “entered into in the course of ordinary family or commercial dealing” in section 100A.48
Because Thawley J in BBlood did not mention Newton in his reasoning on the ordinary family or commercial dealing exclusion, the ATO has in TR 2022/4 altered its reasoning to be about a supposed “core test” of family and commercial objectives:
“98. The core test is that ordinary family or commercial dealing is explained by the family or commercial objectives that the dealing will achieve…”
The ATO still seeks, albeit less directly, to rely on the Newton reasoning by making those objectives primarily about tax purpose, as illustrated by paragraphs 99 and 100 (footnotes omitted) (bold emphasis added):
“99. The method for applying the core test is to ask whether a dealing can be explained by, or is founded in, the achievement of family or commercial objectives. In one sense, this closely parallels the predication test in former section 260, first expressed in Newton and applied in later High Court authorities on that section. Under the predication test, as originally formulated by Lord Denning on behalf of the Judicial Committee of the Privy Council, for the Commissioner to establish that an arrangement had the purpose or effect of avoiding tax, that purpose had to appear on the face of the arrangement. If having regard to the overt acts by which an arrangement was implemented, it was ‘capable of explanation by reference to ordinary business of family dealing, without necessarily being labelled as a means to avoid tax’, section 260 would not apply.
100. The Courts that have considered section 100A and observed that the wording of the ordinary family or commercial dealing test derives from the decision in Newton have also cautioned that there are differences in the statutory tests as between sections 100A and 260. Notwithstanding these differences, the principles drawn from the authorities on former section 260 can be helpful in demonstrating whether family or commercial objectives explain, found or (to adapt the language of the section 260 cases) are the predicate of the dealing to which the core test is being applied.”
In expounding these (new) views about family or commercial objectives:
the core test is stated to involve “an inquiry into what the objectives of the dealing are, whether the transactions achieve that objective and whether they are better explained by achieving some other objective”;49
it is maintained that lack of artificiality does not make a dealing ordinary;50 but
contrivance, artificiality, (excessive) complexity and being tax-driven are advanced as pointing against ordinariness.51
In essence, the dichotomy (from Newton) that a dealing cannot be both tax-driven and be ordinary is sought to be maintained.52
Paragraph 106 sets out instances (of an arrangement) which call for close examination of whether the contrivance, artificiality, (excessive) complexity and tax-driven factors – that indicate non-ordinariness – exist:
the manner in which an arrangement is carried out has contrived or artificial features
family or commercial objectives could have been achieved more directly; for example, could the arrangement instead have simply or directly provided the benefit to the person who actually benefited, such as by making that person presently entitled to trust income
the complexity of the arrangement and the presence of additional steps that achieve no commercial purpose
the conduct of the arrangement is inconsistent with the legal and economic consequences of the beneficiary’s entitlement (such as an asset or funds representing the entitlement are purportedly lent to others without any intention of being repaid), and
income entitlements have actually been remitted to the beneficiary, amounts were subsequently returned or other benefits or services were provided, by way of gift or otherwise to another person (such as the trustee, another beneficiary or an associate, whether by the beneficiary or by the trustee either independently or under a power of attorney).”
The ATO repeats from TR 2022/D1, and elevates to an example in TR 2022/4 at paragraph 96, a family member’s medical costs as a contextual fact for family objectives accepted as not extraordinary:
Example 1 – identifying family objectives
“96. In an income year, family members agree to gift their trust distributions to one family member, Paul, who has significant medical bills. The arrangement is implemented via trust distributions to the family members and a gift by each of them to Paul. That Paul has significant medical bills is not a part of the agreement; however, it is a highly relevant contextual fact which demonstrates the content of the family objectives
The ATO introduces in paragraphs 109 to 113 of TR 2022/4 the idea (and examples) of cultural factors that may explain gifting between family members:
“109. The test is objective. Cultural factors inform the question whether a dealing is to achieve family or commercial objectives.
Example 2 – cultural practice of gifting
110. Azra is a member of an extended family whose members’ cultural values include grandparents gifting money or goods to younger members of the family during the festive season. This cultural practice is relevant in considering whether transactions that involve Azra gifting money to her grandchildren out of funds from a trust distribution she has received have been entered into in the course of ordinary family or commercial dealing.
Example 3 – cultural practice to support older relatives
111. Jack lives by the practices that have been common for centuries in the culture that he draws his heritage from. One of those practices is that children will meet the needs for shelter and living of their parents and other older relatives when they are no longer participating in the workforce. This is founded in notions of respect for elders and is practiced irrespective of what means those relatives would have to fund their own needs from available resources. This cultural practice is relevant in considering whether Jack’s direction to the trustee of a trust to apply his entitlements to meet mortgage repayments for his aunt, who has retired from her employment working in a factory, is in the course of ordinary family or commercial dealing.
112. Cultural factors refer to the distinct and observable ideas, customs or practices of people or certain groups within a society. The existence of a cultural factor which is not widely understood in the broader community can be demonstrated by evidence. As the core test is applied to the whole of the agreement, rather than the individual steps, whether the presenceof a cultural factor determines if a dealing is entered into in the course of ordinary family or commercial dealing will depend on the facts of the case.
Example 4 – cultural practice of not accepting entitlement
113. Max and the trustee of a trust he controls agree to distribute certain income of the trust to Asher, a non-resident who for religious reasons will not accept the entitlement. While Asher’s beliefs are a cultural factor that explains why the entitlement will not be called for, in these circumstances they do not, without more, explain the objectives for making the resolution to distribute in the first place.”
These cultural examples are the closest the ATO comes to directly addressing whether “simple” family sharing or joint consumption of income/assets is ordinary. Even then, the favourable examples53 are heavily limited by:
gifting during a festive season; and
the gift being made irrespective of what means the giftee relative would have to fund their own needs – and described as based on a practice that has been “common for centuries”!
BBlood
Full Court appeal – tax purpose
The Full Court appeal only dealt with the limited matter of tax purpose under section 100A(8) combined with the effect of section 100A(9).
The Full Court found such a purpose existed and dismissed the taxpayer’s appeal.
While the Full Court did not find the relevant purpose was a person’s subjective purpose, it did note the following points in its reasoning:
The purpose to be identified is not an objective purpose of an agreement but the purpose of a person who is a party to the agreement54
Section 100A(8) will be satisfied if the proscribed purpose is one of the purposes of a party. There is no requirement that the proscribed purpose be the sole or dominant purpose55
The advisers formulating the documentation and implementing the arrangement with the knowledge and assent of the controllers of the entities who were parties to the transactions are themselves parties to the reimbursement agreement56
An inquiry as to the purpose of a party (as required by s 100A(8)) is, on the other hand, an historical inquiry of why party entered into the agreement in fact entered into. The inquiry is not a prediction57
The relevant purpose is that a party intends that, by entering into the agreement, someone — “a person” — is liable to pay “less tax” or no tax in a year of income. Whether that intention would in fact be realised is not to the point. It is not part of the statutory task to establish what a particular person’s hypothesised tax position would necessarily have been in a particular income year in coming to a view about the purpose of a person58
The conclusion as to purpose is to be drawn in light of the established facts59
An investigation as to the purpose of a party in entering into an arrangement may include a consideration of the circumstances leading up to and surrounding that entry60
It is suggested that it will be very difficult to exclude a finding of tax purpose under section 100A(8), even in the simple scenario of distributing income from a trust across family members. The typical calculations made of the income of each family member and resulting matching of distributions to the tax thresholds for margin tax rates, will themselves provide evidence of that tax purpose.
But the other aspects of section 100A, may still exclude its application.
Federal Court (single judge) reasoning – excluding tax purpose
Example 11 in TR 2022/4 appears to relate to the type of arrangement dealt with in BBlood.
While the taxpayer in this case was unsuccessful, in the author’s view the reasoning adopted by Thawley J in his decision is very helpful to taxpayers in general – particularly by providing some clear guidance in respect of the exclusion from an agreement under s 100A(13) of “an agreement, arrangement or understanding entered into in the course of ordinary family or commercial dealing”. The following comments focus on what was held regarding that ordinary dealing exception.
As already summarised under the dividend stripping section, the arrangement as one in which:
the terms of a trust through which a share buy-back was later passed was amended;
that amendment caused the share buy-back amount to be treated as an assessable dividend for tax purposes, but which was capital for general trust purposes, to be retained in the trust as capital;
the tax liability for the assessable dividend amount passed to a company beneficiary as part of the net income of the trust, so that with franking credits tax was limited (i.e. no “top-up” tax over the company rate was paid); and
the capital amount was later passed out to individuals without further tax.
After stating the provisions of section 100A, Thawley J identified the issues raised for the potential application of section 100A as follows:
“The issues raised by s 100A in its potential application to the present case include:
(1) Issue 2(1): whether there was an agreement, arrangement or understanding and, if so, whether it included the “initiation of” and “planning for” the Illuka Park steps as opposed to the agreement to implement, and implementation, of the transaction;
(2) Issue 2(2): whether the agreement, arrangement or understanding was entered into in the course of ordinary family or commercial dealing;
(3) Issue 2(3): whether a “reimbursement agreement” for the purposes of s 100A requires that the “payment” referred to in s 100A(7) be, in substance, a reimbursement for the relevant beneficiary being made presently entitled to the income of the trust;
(4) Issue 2(4): whether, in the terms of s 100A(8) and (9), any party to the “agreement” entered into the agreement for the purpose, or for purposes that included the purpose, of securing that a person who, if the agreement had not been entered into, would have been liable to pay income tax in respect of a year of income would not be liable to pay income tax in respect of that year of income or would be liable to pay less income tax in respect of that year of income than that person would have been liable to pay if the agreement had not been entered into;
(5) Issue 2(5): whether, in the terms of s 100A(1)(b), any or all of BE Co’s present entitlement to income of the IP Trust arose out of the “reimbursement agreement” (if there was one) or arose by reason of any act transaction or circumstance that occurred in connection with, or as a result of the reimbursement agreement.”61
Thawley J did not mix the questions of:
agreement
arose out of
as the ATO does in TR 2022/4 and, in his following analysis, treated both the matters of:
ordinary dealing
tax purpose
as separate exceptions, in accordance with the words of section 100A.
Agreement
Regarding an agreement, it was held62 that the “Iluka steps”63 were an agreement within section 100A(13).
But Thawley J rejected ATO submissions that initiation and planning were part of the agreement64, stating at paragraph 90:“90. There either is or is not an “agreement” (which can include a non-legally binding “understanding”) within the meaning of s 100A(13). If the Commissioner contends that there is one, he should identify it. A statement that the “agreement” includes “initiation” and “planning” says nothing about what the contended “agreement” is.”65
Ordinary family or commercial dealing
Regarding the ordinary dealing exception, Thawley J firstly directs attention66 to the relevant statutory question as being whether:
the agreement was entered into in the course of ordinary family or commercial dealing. He stresses that it is not whether individual steps carried out in implementing the agreement, viewed in isolation, could be characterised as steps entered into in the course of ordinary family or commercial dealing; and
the agreement was entered into in the course of ordinary family or commercial dealing, not whether the agreement was an ordinary family or commercial dealing.
It is made clear67 that individual steps might be considered – but the statutory question is different.
Secondly, Thawley J acknowledges68 that this statutory question “is distinct to the inquiry about purpose required by s 100A(8) and (9)” and then explains69some matters that may be looked at in determining the statutory question.
Those matters include:
what is “said to be” the object to be achieved by a dealing – in the course of which the relevant agreement was entered into;
the relevance, to the claimed object, of particular steps under the agreement;
whether particular steps might be explained by objectives different to the objectives “said to be” behind the ordinary or commercial dealing;
that a dealing might not be an ordinary family or commercial dealing if it is overly contrived, or artificial; and
that a dealing might not be an ordinary family or commercial dealing if it involves more than is required to achieve the relevant objective – such as additional steps not necessary to achieving the (claimed) objective.
It is noteworthy that no mention of the decision in Newton v FCT (1958) 98 CLR 1 is made by Thawley J in relation to section 100A(13).
Thirdly, consistent with these observations about tax purpose, in explaining70 the relevance of the decision in FCT v Prestige Motors Pty Ltd (1998) 82 FCR 195 to determining the relevant statutory question under s 100A(13), Thawley J is careful not to refer to tax purpose as the determining factor but to instead cite the references made in Prestige Motors to an absence of:
• “commercial justification”, leaving “the only explanation for the entry into the agreement as the elimination or reduction of tax liabilities”72; and
• “commercial necessity or justification for the transaction” or “commercial reason to raise capital from outside the group“73.
Ultimately, Thawley J held the arrangements were not entered into in the course of ordinary family or commercial dealing after he considered the various attributes of the arrangement as a whole – which included but was not limited to its objectives.
It is worth extracting the relevant paragraphs in full, given their importance as direct authority on the ordinary dealing question (bold emphasis added):
“100 The agreement comprising the Illuka Park steps as a whole was not an agreement “entered into in the course of ordinary family or commercial dealing”. Nor was the agreement to implement the Illuka Park steps. Whether the agreement is viewed as the agreement to enter into the steps, or the steps as a whole, the agreement was unusual. Its complexity was not shown to be necessary to achieving a specific outcome sought to be achieved by a dealing aptly described as “an ordinary family or commercial dealing”. It was not explicable, for example, as having been entered into for family succession purposes. Nor was it explicable as having been entered into as part of an ordinary commercial dealing.
101 As I have said, whilst it may be relevant to the statutory inquiry, it is not necessarily persuasive that an individual step can be seen to be “ordinary”. Viewed in isolation, the generation of income in IP Co of about $300,000 might be something done in the course of an ordinary family or commercial dealing. Even that is doubtful because this was the first time this had occurred and was accordingly not consistent with the historical behaviour of the parties. Moreover, this component of the Illuka Park steps does not suggest that the agreement to implement the Illuka Park steps or the agreement comprising all of the Illuka Park steps were “ordinary”.
102 It might be said that a buy-back is an ordinary commercial transaction. The statutory question, however, is whether the agreement as a whole was entered into in the course of an “ordinary family or commercial dealing”. In any event, even viewed in isolation, the applicants did not establish a sensible commercial or family rationale for adopting the buy-back procedure. As is explained further below, the explanations given for the buy-back component of the agreement are unlikely. The buy-back was not conducted for the purpose of simplifying the corporate structure as suggested. Nor was it done for succession planning purposes as suggested.
103 It might be said that the variations to the IP Trust Deed were, viewed in isolation, an ordinary family or commercial transaction. Although relevant, that is not the issue. The issue is whether the agreement as a whole was entered into in the course of a family or commercial dealing. 104 Having examined the agreement as a whole, I am not satisfied that the agreement to implement the Illuka Park steps was an agreement which was entered into in the course ofordinary family or commercial dealing. I am also not satisfied that the agreement comprised of the Illuka Park steps as a whole was an agreement which was entered into in the course of ordinary family or commercial dealing.”74
Guardian Appeal
Regarding section 100A, the most important reasoning the Full Court appeal decision in Guardian has added to that of the earlier (single judge) Guardian decision by Logan J, is that supporting there being no agreement within the meaning of section 100A(13) – and accordingly that there could not be any “reimbursement agreement” for the purposes of section 100A(7)75.
An interesting part of the Full Court’s reasoning was a rejection of the ATO’s arguments seeking to draw on Part IVA case law, about attributing the purpose of an adviser to a client, to support the client being a party to an agreement76. This point is acknowledged in the ATO’s DIS on the decision.
The reasoning incidentally highlighted the important difference between Part IVA and section 100A – that the focus of section 100A is on the existence of a relevant agreement, not on purpose (bold emphasis added)77:
“123 … the entire object of s 177D is to require a conclusion be drawn in respect of the purpose of a party based on the factors specified in s 177D. That purpose is not the party’s actual subjective purpose but an attributed purpose …
124 The inquiry in relation to the existence of a reimbursement agreement in s 100A is different. It requires the existence of an “agreement” (as defined in s 100A(10)[sic]) invoking, as it does, a requirement of consensus and adoption. The scope for attribution in that context is far more limited.”
“111 … By contrast, an expectation that an arrangement will be entered into after the creation of the present entitlement is not sufficient for the purposes of s 100A.”
Unresolved issues with ATO guidance – risks
In considering the issues raised below regarding TR 2022/4, the Compendium to TR 2022/4 (providing ATO responses to comments received on Draft Taxation Ruling TR 2022/D1) can be a useful source of additional insight into the ATO reasoning underlying TR 2022/4:
This is particularly so because some of the issues raised are matters that were also raised in respect of TR 2022/D1, but which the ATO has not accepted or to which the ATO has not fully responded.
Approach in TR 2022/4 – versus the words and structure of section 100A
As already previewed above in section 3.2, there is a reason to question the ATO’s overall approach as set out in paragraph 5 of TR 2022/4, of:
“The following 3 requirements are satisfied:
‘Connection requirement’;
‘Benefit to another requirement’;
‘Tax reduction purpose requirement’; and
The ‘ordinary dealing exception’ is not satisfied”
It is true that these four dots points also appeared, but as equal points, in TR 2022/D1 (and, with hindsight, did not get the attention deserved at that time). But, in TR 2022/4, the ATO has sought to exaggerate the incorrect distinction between tax purpose as a requirement and the ordinary dealing as an exception, by the grouping the three requirements together separately from what is represented as a sole exception.
By doing so, paragraph 5 of ATO 2022/4 incorrectly represents both the words of section 100A and the approach taken in the case law.
It:
distracts from the primacy, and starting point, of the existence of “reimbursement agreement” in applying section 100A; and
misrepresents the role of the tax purpose (in misstating it as a requirement) by both:
taking tax purpose to be part of the positive process of determining what arrangements are included in a “reimbursement agreement” – rather than correctly reflecting the absence of tax purpose as solely a basis for exclusion from what is the correct primary focus – of whether there a “reimbursement agreement”; and
by that incorrect statement of the role of tax purpose – also failing to adhere to the limitation of the relevance of questions of tax purpose to consideration of the entirely separate and equally important second exception of ordinary dealing.
It is difficult to understand why the words of section 100A are not more faithfully reflected in TR 2022/4. After all, it has been eight years since the ATO first commenced agitating section 100A matters, with its 2014 examples.
It invites the conclusion that it is a deliberate decision, made to advance (continue) the ATO’s preferred views about tax purpose being more central to the operation of section 100A than the actual words of the section (and the case law) allow.
Scope of agreement
The approach adopted in TR 2022/4 of claiming the existence of an agreement:
based on tacit adoption, concerted action, an understanding over a period of time79: and
from conduct before and after the time an entitlement arises80,
goes too far.
It is inconsistent with the reasoning from the Guardian Full Court appeal – it does not adequately reflect the need for consensus and adoption.
It is noteworthy that:
the ATO seeks to adopt the widest possible views of “agreement” so as to find a “reimbursement agreement” from informal understandings; and
in contrast, when addressing what is an ordinary family dealing, the ATO does not seek to recognise/discuss the many and long-term understandings that exist in any typical family (regardless of culture) – including about the sharing of financial, physical, emotional, etc. resources – that make up the course of ordinary family dealing.
Ordinary dealing – “core test” concept
TR 2022/4 introduces the new concept of the “core test” relating to, and seeking to limit, the ordinary family or commercial dealing exceptions. Such a core test, as framed by the ATO, has no direct case law basis.
While in BBlood Thawley J had reference to objectives in applying the ordinary family dealing exception, objectives were not (and were not stated to be) the core test. Objectives were part (only) of the overall consideration (of the full wider context) undertaken by Thawley J.
In TR 2022/4, the ATO has “repackaged” its prior references to and focus on tax purpose, as drawn from Newton, to instead be “family objectives” as part of this claimed core test – while still retaining the same “predication test” reasoning from Newton.
There is nothing in BBlood that prioritises objectives as a “core test”, much less tax-related objectives. Only (what will be referred to here as) a “whole of dealing” approach – considering all of the actual steps taken, complexity, artificiality, objectives, etc. – as undertaken by Thawley J in BBlood is authorised by that decision.
The comment is made in TR 2022/4 (at paragraph 28) – “If the objective of a dealing can properly be explained as the payment of less tax to maximise group wealth, rather than some other objective which is a family or commercial objective, it is not an ordinary family or commercial dealing.”
This comment is an express continuation (re-packaged) of the ATO’s prior tax purpose-based reasoning from Newton.
The ATO’s refusal to depart from its Newton derived approach is also indirectly evident from the ATO’s persistence in equating “tax avoidance” with having a “tax purpose” when considering the ordinary dealing exception. This labelling (in advance) of certain behaviour as tax avoidance flags the preconceived conclusion the ATO wishes to see realised from section 100A – that the section applies to confirm having a tax purpose as being tax avoidance – regardless of the actual words of section 100A.
Under the “whole of dealing” approach undertaken in BBlood, ordinariness is not excluded by having a tax purpose/objective. Ordinariness is instead judged by reference to (all) the types of matters noted in TR 2022/4 at paragraph 27 – whether artificial or contrived, overly complex, the objectives, the actual steps, extra steps (but without some overriding tax purpose related exclusion).
In that context, there is usually no conflict between what is ordinary and what is commonplace in family dealings – which includes the “simple” and frequent decisions by adult family members (based on the whole complexity of family relationships, values, etc.) to share resources within the family.
The distinction that the ATO has sought/still seeks to maintain from Newton – to exclude tax influenced family cooperation from being ordinary – does not apply, on a proper reading of section 100A and the case law.
Simple family sharing – what medical conditions justify sharing?
This ATO refusal to acknowledge “simple” family sharing as ordinary in the context of reimbursement agreements reflects in the ATO’s Example 1 in TR 2022/4, regarding Paul’s medical expenses being funded by gifts from family members (noted under section 3.7 above).
The ATO acknowledgement that Paul’s medical costs are a relevant contextual fact or circumstance suggests that there must be some such “special” reason for family sharing of resources, for it to be ordinary.
This approach is both unnecessary on the words and structure of section 100A and naturally leads to challenges – does the ATO intend to publish guidance on what medical conditions qualify as sufficiently “special” to justify family sharing being ordinary?
In its refusal to engage with simple family sharing as being objectively ordinary, the ATO is reserving to itself the right to make what will necessarily amount to value judgements, when it seeks to undertake a more in-depth assessment of a family’s interactions. Such a more in-depth assessment of simple sharing within a family is not required (or authorised) by the words and structure of section 100A.
Simple family sharing – not so different between cultures
Rather than introducing new concepts that are not supported by the words of section 100A, such as cultural issues, TR 2022/4 should have directly addressed the simple and commonplace acts of sharing and of collective use/consumption within families.
The words of section 100A refer to “family”, not culture as now introduced in TR 2022/4.
That simple family sharing (including to maximise wealth) may be regarded as non-ordinary, can only be a sustainable argument under the tax purpose-based reasoning from Newton – by which ordinary family dealing is mutually exclusive with a tax purpose-based arrangement.
TR 2022/4 acknowledges81 that BBlood did not contain a reference to Newton in Thawley J’s reasoning on the ordinary dealing exception – which is in conflict with TR 2022/4’s claim of BBlood as legal authority for the ATO’s Newton based reasoning in respect of the ordinary dealing exception.
Agreement and reimbursement agreement
So, where are we on the questions of agreement and reimbursement agreement?
The meaning of the complete phrase “reimbursement agreement” is drawn from two provisions within section 100A:
section 100A(13), which provides a definition for “agreement”; and
section 100A(7) which sets out when an agreement becomes a reimbursement agreement.
Those sections, when considered together, set out when a set of arrangements will be a reimbursement agreement.
What is an “agreement” in section 100A(13)?
Section 100A(13) defines “agreement” as follows (bold emphasis added):
“any agreement, arrangement or understanding, whether formal or informal, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings, but does not include an agreement, arrangement or understanding entered into in the course of ordinary family or commercial dealing.”
There are three features to note in the definition:
“agreement, arrangement or understanding” is very broad drafting which is likely to capture most if not all arrangements;
whether or not there is an enforceable arrangement is irrelevant – this means informal arrangements such as non-binding discussions between parties are potentially an agreement for the purposes of section 100A; and
finally, an arrangement is not an agreement where it is entered into in the course of ordinary family or commercial dealings – which is considered under its own heading below.
The phrase “agreement, arrangement or understanding” is drafted very broadly.
But, despite this breadth, there must still be an actual agreement – the Guardian Full Court decision tells us that there must be consensus and adoption82. And it must occur before the present entitlement arises83. The ATO may wish to point to a pattern of behaviour between trustees and beneficiaries within a family as evidence of an agreement – such as repeated occurrences over years of distributions to beneficiaries who then allow the value of the distribution to be used for the benefit of/controlled by other family members.
The ATO can be expected to claim that an agreement exists from circumstances of tacit adoption, concerted action, an understanding over a period of time and/or conduct of before and after the time an entitlement arises.
But if each of the trustee and the beneficiary act unilaterally in each of their decisions to distribute and to not call upon payment, respectively, such a pattern of conduct does not constitute an agreement, arrangement or understanding – whether formal or informal, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings.
While the correspondence of (genuine voluntary cooperation evidenced by) such unilateral behaviour for mutual benefit would not be credible in non-family (commercial) situations, it is entirely to be expected in family situations.
But, to resist ATO claims, families will need to be attentive to establishing evidence of such genuine unilateral (even if cooperative) actions. The practical suggestions at the end of the paper are partly directed to that evidence.
Reimbursement agreements under section 100A(7)
A “reimbursement agreement” involves:
an agreement that provides for certain actions or outcomes; and
those actions or outcomes being a payment of money, transfer of property, provision of services or other benefit to pass to a person other than the beneficiary that is presently entitled.
The act of making the beneficiary presently entitled (usually the unilateral act of the trustee) does not “provide for” the actions or outcomes noted in the second dot point.
This fits with the view that it is not the distribution itself with which section 100A is concerned, regardless of the tax planning that may be behind the distribution. Something more – the relevant “agreement” – is needed to cause (to provide for) the actions or outcomes.
As for the actions/outcomes, they will often be the everyday ways a person will always consume or use their assets or choose to pass value to another person.
When a person:
buys something in a shop – they “pay money” to another person.
pays a bill for themselves or a relative – they “pay money” and/or “provide benefits” to another person.
donates money – they “pay money” to another person.
gives a gift of property – they “transfer property”.
helps in the family business – they “provide services”.
The scope of these actions/outcomes is vast. As the BBlood facts show, the actions/outcomes can even arise (by a benefit arising to another) without the beneficiary receiving and passing on any value.
But section 100A does not apply to most of such actions/outcomes because:
they will not have been provided for under any agreement – before the person became presently entitled to a trust distribution; and
even if so provided for, either:
no person will have entered into the relevant agreement with the required tax purpose; or
the relevant agreement will have been entered into in the course of ordinary dealing.
The attention of section 100A is always focussed on the agreement that provides for these actions/outcomes – as the essence of what defines a “reimbursement agreement”.
On the words of the section, questions of tax purpose do not cause anything to be included in section 100A, only for certain agreements to be excluded. This is as one of the two separate and independently operating exceptions. The other, of course, is the ordinary dealing exception discussed following.
Ordinary family or commercial dealings
Where are we on the meaning of “entered into in the course of ordinary family or commercial dealing”?
As will be apparent from the earlier comments, the ATO has sought (still seeks) to interpret the ordinary dealing exception in section 100A(13) as limited by tax purpose in the manner of the reasoning from Newton.
It is submitted that this has never been the correct law:
from the words of the section and principles of statutory interpretation; and
from the (albeit limited) direct case law.
In TR 2022/D1 the ATO failed to fully cite the comments made by Hill and Sackville JJ in FCT v Prestige Motors Pty Ltd as trustee of the Prestige Toyota Trust 98 ATC 4241 at 4262 (bold emphasis added):“There is a danger that, when words used in a judgment are translated into the legislation, the change of context may alter the meaning of the words from that which they originally bore. It is clear from both the judgment of the Privy Council and from the language of the High Court on the same case (FCT v Newton (1957) 96 CLR 578 ) that s 260 was regarded as involving a dichotomy. A transaction was either stamped as one entered into to avoid tax or as one about which it could be predicted that it was entered into in the course of ordinary family or commercial dealing. In the former case the transaction was caught by s 260 ; in the latter case it was outside the section. We do not need to decide in the present case whether s 100A imports a similar dichotomy. In particular we do not
need to decide whether if an agreement is shown to have been “entered into the course of ordinary commercial dealing”, the operation of s 100A is spent, regardless of whether the commercial purpose was subsidiary to the purpose of tax avoidance. In our view, none of the transactions was entered into in the course of ordinary commercial dealing.”
Thawley J in BBlood applied Prestige Motors and did not adopt the Newton dichotomy – so the ATO has adjusted its comments in TR 2022/4. But, in TR 2022/4, the ATO has still sought to retain that dichotomy – recall84.
“28. If the objective of a dealing can properly be explained as the payment of less tax to maximise group wealth, rather than some other objective which is a family or commercial objective, it is not an ordinary family or commercial dealing.”
Against these current ATO views (which may need to be dealt with in an audit), it is submitted the correct approach, supported by the case law, is to determine whether an agreement has been ”entered onto in the course of ordinary family or commercial dealing” on the basis of the “whole of dealing” approach undertaken in BBlood.
The cases on section 100A to date have involved arrangements with some special element. This is unsurprising, in that those special elements are what have led to the dispute. This is not to say that any special elements necessarily mean that the ordinary dealing exception cannot apply to family or commercial matters.
But because commercial dealings can generally be expected to be conducted on a basis of self-interest, a strong tax reduction purpose – even though that is not itself the test – tends to result in commercial dealings that are “non-ordinary” in objective ways, even ignoring tax purpose. This has been the story of the historical case law dealing with section 100A (e.g. Prestige Motors).
While BBlood related to a family, there were special elements – such as the change of trust deed and the resulting separation of the tax liability from the benefit of the capital part of the share buy-back.
The simplest scenario – of sharing and collective use/consumption within families (by family members gifting and lending to each other) – has not been the subject of direct judicial consideration. But (from direct experience) ATO auditors have been regarding such family sharing and collective use/consumption as “non-ordinary” and subject to section 100A in audits since 2014.
Applying the “whole of dealing” approach undertaken in BBlood to the simple family sharing scenario, should include a recognition that the relevant ordinary family dealing in the course of which such simple family sharing occurs, is inseparable from the wider family relations.
Such family relations are complex. They are relationship based, not transactional. Consequently, they are long-term and, by their nature, are not self-interested in the same way as commercial dealings. It is submitted that some tax purpose can very well co-exist with other family purposes and actions that do not follow self-interest, and which may seem “non-ordinary” if (as the ATO seeks to maintain) tax purpose is the primary measure.
It is submitted as being in the course of ordinary family dealing, in a modern context:
for the “caretakers” of family wealth (typically parents) to be trusted to manage the family wealth for best possible return and use – conduct which is undertaken based on the very natural goal of seeking to maximise family wealth through prudent management to, among other things, ensure sufficient finances for future emergencies, care for family members who cannot finance their own care (due to age, illness or mental incapacity) or preserve value for successive generations of the family.
for all family members to contribute to the family wealth, as they choose/are able – not just parents to children, also adult children to parents/wider family.
for “unexpended” family wealth to be returned to/concentrated in a family trust, including possibly the family trust from which the trust entitlements originally flowed – as that trust structure, by which no one family member owns that wealth, may best provide (non-tax based) protection against the risks of claims against any one family member.
Family members, including beneficiaries of family trusts, can naturally be expected to co-operate in these endeavours for the simple reason that families have long term emotional connections. If a more mercenary view is required, family members do so because, by participating in this management, the family member can expect benefits to return to them if they require them in the future, due to illness or incapacity, or through intergenerational wealth transfer. Either way, joint management and consumption of their assets and income it is what families do, in the ordinary course.
If a family cooperating to prudently preserve and deploy its wealth is ordinary, then the scenario where a trustee makes a beneficiary presently entitled to income, that beneficiary then not calling on that entitlement to be paid but instead allowing the value that entitlement represents to be used for family purposes, should be taken to be an ordinary family dealing.
It is also part of this family co-operation that family members often do not require a detailed accounting of their entitlements – as long as there is trust in the “caretakers” of the family wealth (typically parents).
In terms of the types of matters noted in TR 2022/4 at paragraph 27, such simple sharing and collective use/consumption within families is not artificial or contrived, is not overly complex, achieves family objectives (of funding whatever is the object of the sharing or collective use/consumption) and does not involve any extra steps.
Any suggestion that the trust distributions “should have” gone direct to the persons with whom the family member chooses to share, ignores that it is not an extra step for a family member beneficiary to be genuinely made entitled to trust income, so that they may choose to share (or not to share) that entitlement at their discretion.
Entitlement arose out of
Even if an agreement exists, does the “arose out of” nexus exist?
The subject present entitlement must be one that “arose out of” or “arose by reason of” the reimbursement agreement (or any act, transaction or circumstance that occurred in connection with, or as a result of the agreement).
Where the family member would be entirely free to use their entitlement at their sole discretion, can it correctly be said that the entitlement (the distribution decision) arose out of the reimbursement agreement?
If the trustee would have distributed the same way – for family reasons – regardless of what the beneficiary chose to do with their entitlement, the distribution would have been made and the entitlement would have arisen even if the reimbursement agreement had not existed.
It is suggested that acceptance – for personal reasons of family affection, family obligation, etc – of the “risk” of the family member not complying with any prior expectation, breaks the “arose out of” nexus between any reimbursement agreement and the creation of the entitlement.
In such circumstances, it could not be said that – but for the transactions which form part of the reimbursement agreement – the present entitlement would not have arisen.
These are important issues that need addressing in family situations in determining whether a present entitlement is one that “arose out of” or “arose by reason of” any claimed reimbursement agreement.
Even if the meaning of “agreement” may be wide enough to extend to unenforceable and implied understandings of which a trustee may be party, the very loose nature of such an “agreement” is consistent with a trustee – who still chooses to make a distribution in family situations (based only on such an “understanding”) – having made that distribution independently of any such “agreement” and instead because of reasons of family affection, obligation, etc.
Practical suggestions to avoid and manage the risks
From all of the above, there are steps that can be suggested for taxpayers to take, to help avoid/manage section 100A risks. The following comments focus on family situations, being seen as the area most in need of guidance.
As a first step, taxpayers should avoid poor trust administration matters by:
advising all beneficiaries of their entitlements each year – in writing; and
obtaining the written authority of beneficiaries for the non-payment of their entitlements, or for the payment (as satisfaction) of their entitlements to other persons or as loans/goods/services for other persons. Such authority could be by way of a general confirmation after the relevant payments, loans etc. have been made.
It is important that this advising, and obtaining of confirmations from beneficiaries does not become a “paper exercise” (i.e. “sign here”). Care should be taken to create an environment in which the beneficiary is genuinely made aware that they may call for direct payment of their entitlement and that they alone may authorise or not authorise its satisfaction by being otherwise used/directed.
Ensuring the trust can demonstrate a financial position (from available funds or from borrowings against trust assets) to make payment of a beneficiary’s entitlement (if called to do so) would be helpful (adding credibility).
It can be seen that the above matters are directed to supporting that any sharing of their entitlement will be a unilateral act of the beneficiary.
Remember that, in an audit or dispute, beneficiaries may be called upon in formal interviews with the ATO or, ultimately, to give evidence in court, to confirm these matters.
So that there is no agreement when the trust distribution is made, it would seem to be better for trustees not to discuss intended distributions with potential beneficiaries – only advise them afterwards.
From the ATO’s insistent in TR2022/4 (even after the September 2023 changes) on the widest possible meaning of an agreement, taxpayers may well still find themselves in dispute with the ATO – and so need to be prepared to argue the ‘ordinary family dealing’ exception.
To enhance access to the ordinary dealing exception, bearing in mind the onus of proof rests on taxpayers, attention should be given to maintaining some records evidencing what is “ordinary family dealing” for the particular family. This may involve keeping a record of the (or summarising, now, the past) pattern/history of substantive sharing of the family resources across the family.
This is not to suggest that families need to track all of their collective expenditure – though the more that can be proven the better.
But it will assist to be able to demonstrate/prove a pattern of substantial and material family sharing – such as, funds shared/collectively deployed to fund family houses, as family loans, as support provided for family members in illness, misfortune, etc.
But, given the ATO’s insistence in TR2022/4 about the narrowness of what is ‘ordinary’ in terms of this exception (in contrast to the ATO’s insistence on the widest views for agreement), taxpayers may, again, still find themselves in dispute with the ATO about the exception.
To support that the trust distribution did not arise out of any reimbursement agreement, the trustee should be prepared to confirm and evidence that they distributed to the beneficiary in the full expectation of paying the beneficiary their entitlement in cash if called upon by the beneficiary to do so – accepting that any other outcome would be entirely the unilateral choice of the beneficiary.
Also, a trustee should be prepared to confirm that their distribution decision is not related to any services the beneficiary may have provided/will provide to any party (e.g. to a family business) – but only flows from their status as a beneficiary.
Concluding comments
Whether seeking to determine an objective dominant purpose for Part IVA, assessing if an agreement was entered into in the course of ordinary family or commercial dealing for Section 100A or some other statutory task, the author sees some common threads being reinforced in the recent decisions considered in this paper.
The Federal Court is stressing adherence to the statutory text. First, correctly identify the statutory task from the text. Is it to determine objective dominant purpose? Is it to determine objectively if an agreement has been entered into in the course of an ordinary family dealing?
While the focus of what is being objectively determined may differ (e.g. dominant purpose, whether in the course of ordinary family dealing, etc) one should look to all the relevant context/surrounding circumstances that relate to the statutory task.
The overall context of an arrangement, agreement, scheme, etc will involve matters such as the objectives of those involved, the steps taken, the outcomes achieved. One does not narrow the consideration and exclude aspects of the relevant context/surrounding circumstances, except for reasons to be found in the statutory text about the statutory task (e.g. a purpose is distinct from an outcome, an ordinary family dealing is not limited by purpose).
There does seem to be a timing dimension/limitation that can apply to the relevant context/surrounding circumstances. If a particular commercial and legal structure already exists (as in Minerva), that structure provides the limits of the wider context in which the existence of a dominant tax purpose is determined (as long as the creation of the structure is not part of the scheme). The commercial, investment or family use of that pre-existing structure may then weigh against any finding of a dominant tax purpose.
This timing dimension also arises in relation to identifying the course of ordinary family dealings. Those family dealings can be argued to arise/persist over long periods (even over generations), but the ATO seems to seek only to consider periods of/around single income years.
But taxpayers and their advisers must also be mindful of the recurring importance of discharging the onus of proof in respect of the relevant context/surrounding circumstances to be relied upon – in the event of a dispute involving the tax integrity provisions.
Repeatedly in decisions (including in the cases considered in this paper) taxpayers are described as having failed to satisfy the onus of proof.
Nothing should be assumed to be obvious and accepted. Rather, a consistent approach is needed to record and retain evidence of the facts relating to context/surrounding circumstances – and a realistic view should be taken of what those facts will objectively support when completing the relevant statutory task, before embarking on an arrangement/scheme.
Footnotes
Minerva Financial Group Pty Ltd v FCT [2022] FCA 1092 at paragraphs 562 to 565 and 572. ↩︎
The comments in this section of the paper are largely drawn (and updated) from earlier articles M West and A Whitney, “Trusts — 100A reimbursement agreements; identifying and reducing taxpayer risks”, a paper presented at The Tax Institute’s Queensland Tax Forum in May 2021; M West, “Section 100A and tax purpose”, (2022) 56(11) Taxation in Australia 701: and M West, “Section 100A and trust reimbursement agreements”, (2023) 57(11) Taxation in Australia 674. ↩︎
Paragraph 28 of TR 2022/4 – “If the objective of a dealing can properly be explained as the payment of less tax to maximise group wealth, rather than some other objective which is a family or commercial objective, it is not an ordinary family or commercial dealing.”↩︎
Presented at the QLD Tax Forum on 29 – 30 May 2024
At its broadest level, funding private groups and investments involves:
the ‘funding’ itself – which is most often cash but can, alternatively, be the services of key people (‘human capital’) or the contribution of existing assets (e.g. premises or existing intellectual property) by immediate transfer or by allowing the use of assets (e.g. by lease or licence);
the chosen entity (company, trust of partnership) as the vehicle for the relevant business or investment activity being funded – here, the focus is on funding companies;
contribution of the funding into the chosen entity in a manner that results in acquiring a particular ‘interest’ in the entity – which can be such interests as shares, options, loans or other contractual rights; and
receipt of a return for the funding from the interest acquired – which can be a fixed or variable return and be in the nature of dividends, loan interest, salary or bonus or other contractual returns, depending on the form of interest acquired.
Because private groups often source their funding from related parties (often family members) or from amongst a small group of ‘closely co-ordinating’ owners/investors, there are often greater opportunities to implement more flexible funding arrangements – e.g. recognising variable contributions for variable returns, making non-monetary contributions for no immediate payment, making at-call loans.
These types of funding arrangements often seek to provide the ‘funding’ in a manner that provides flexibility around matters such as (not exhaustively):
timing or certainty of repayment – e.g. at call loans with nil or a variable/profit-based interest rate;
the ability to both be repaid funds provided and to share in future ‘super’ profits and capital gains – e.g. loans with an attached ability to take up equity (such as convertible notes, options to take up equity), redeemable shares, contractual loan terms with variable/profit-based returns; and
matching returns payable to different initial or ongoing contributions made – e.g. different share classes with variable dividend and capital entitlements based on agreed formulas (per the constitution, a shareholders’ agreement or otherwise).
In pursuing flexibility, these funding arrangements often seek to blend the usual legal characteristics of debt, equity or contractual ‘interests’ and their associated ‘returns’.
But, in doing so, these flexible arrangements require an awareness of, and careful management under, various taxation provisions to avoid potentially unfavourable tax outcomes.
This paper seeks to provide an overview of the typical taxation complexities and issues that need to be navigated when private groups seek to implement funding arrangements for their business or investment activities, especially flexible and innovative arrangements between related or closely co-ordinating parties.
The paper proceeds by examining the types of issues that typically require attention under the following headings/provisions:
Capital gain tax (CGT) and income tax basics (including deemed market value, cost base and alienation of income issues)
Value shifting rules (including on the issue of variable return interests)
Debt/equity rules (including related party financing, at-call loans)
Employee share schemes
Franking credit issues that can affect equity raisings
Thin capitalisation considerations for SMEs
Anti-avoidance matters
References to sections in this paper are generally to the Income Tax Assessment Act 1997 (ITAA97), unless otherwise stated. Other legislation referred to includes the Income Tax Assessment Act 1936 (ITAA36).
The Taxation of Financial Arrangement (TOFA) rules in Division 230 are beyond the scope of this paper – but, in any case, would not be applicable to most private groups due to the size and turnover thresholds (e.g. $100 million turnover, $300 million assets) below which the TOFA rules do not apply (except for the qualifying security rules mentioned below).
Capital gains (and some income) tax basics
It is relevant to first recall some ‘basics’ when it comes to flexible funding arrangements, before moving onto some applicable specialist provisions.
Shares for nil/normal/discounted price or for a premium
When creating interests (shares or loans) in a company or creating contractual rights (e.g. profit share arrangements, rights for payment for leased/licenced assets) as part of funding (by cash, labour or assets) of the company, the analysis should include the general CGT and income tax effects before moving onto the more specialised tax provisions that may apply.
In particular, the operation of section 112-20 is relevant:
112-20 Market value substitution rule
(1) The first element of your *cost base and *reduced cost base of a *CGT asset you *acquire from another entity is its *market value (at the time of acquisition) if:
(a) you did not incur expenditure to acquire it, except where your acquisition of the asset resulted from:
i. *CGT event D1 happening; or
ii. another entity doing something that did not constitute a CGT event happening; or
(b) some or all of the expenditure you incurred to acquire it cannot be valued; or
(c) you did not deal at arm’s length with the other entity in connection with the acquisition. The expenditure can include giving property: see section 103-5.
(2) Despite paragraph (1)(c), if:
(a) you did not deal at arm’s length with the other entity; and
(b) your *acquisition of the *CGT asset resulted from another entity doing something that did not constitute a CGT event happening;
the *market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition). The payment can include giving property: see section 103-5. [Emphasis added]
Issuing shares for nil or nominal consideration may occur where the incoming shareholder is providing input/funding that does not have an immediate or proven value, but where a company with existing cash or other tangible assets sees that input/funding as valuable. The company may then, quite reasonably, be prepared to secure that funding by issuing shares at a low cost that provided access to the existing company value and future profits/gains of the company.
The incoming shareholder may, for example, be providing:
certain credibility that may attract other investors, by being known to be on the share register;
ideas or intellectual property (IP) that is currently very uncertain in value – so there is no current market and its range of possible values is meaningless until further work is done (and the incoming shareholder does not want to formally recognise, by agreement, a current value on which they would be taxed); or
access to desired personal skills.
The basic CGT deemed cost base rules work in a way that any discount provided on the issue of shares, does not provide an adjustment upwards to a market value cost base
If there is no consideration, the table in section 112-20(3) – by items 4 and 5 – excludes the application of section 112-20(1) and any deemed market value cost base, for the grant of rights to acquire shares, or options to acquire shares, in a company (item 4) and the acquisition of shares in a company (item 5) where nothing is paid
Section 112-20(2), as bolded above, then has the effect of excluding any deemed market value cost base where less than market value is paid under a non-arm’s length dealing – because the issue of a share does not represent a CGT event (disposal ) by the company (see exclusion from CGT event D1 under section 104-35(5)(c)) and the market value substitution only applies where more than market value is paid
For example, if company X is worth $100 and an incoming shareholder is allowed to only give $1 for 50% equity, then the incoming shareholder has received a discount. But the cost base of that transaction is not adjusted up for the incoming shareholder if not dealing at arm’s length
That ‘non-adjustment’ does not cause an immediate disadvantage to the incoming shareholder – but does mean the shareholder should remain aware they will be subject to future tax on the basis of their nil/nominal cost base
The other shareholders do not retain the advantage of a higher cost base as these circumstances will fall within the value shifting rules discussed below – so that their CGT cost bases will be adjusted downwards.
In summary, in these ‘issued at a discount’ circumstances the tax rules remove any advantage.
Alternatively, shares may be issued for a premium where the situation is reversed – e.g. where the incoming shareholder is providing the cash for a company which already holds ideas or IP of uncertain value.
In these circumstances, the basic CGT deemed cost base rules work in a way that any premium provided on the issue of shares, does cause an adjustment downwards to a market value cost base.
Specifically, section 112-20(2) as bolded above, has this effect because the issue of a share does not represent a CGT event (disposal ) by the company (again, see exclusion from CGT event D1 under section 104-35(5)(c)) and the market value substitution does apply where more than market value is paid – to reduce the cost base.
For example, if company X requires capital and an incoming shareholder is willing to give $100 for 50% equity, then commercially speaking, company X could be expected to be worth $200 in total and $100 before the extra $100 share subscription. If instead, company X is in fact worth only $50 based on the market value but with a potential future value for which the incoming shareholder is prepared to still pay the $100 for 50%, then the cost base of that transaction is adjusted down for the incoming shareholder if not dealing at arm’s length because they invested more than the market value of the equity received.
That ‘non-adjustment’ does cause an immediate disadvantage – as it means:
the incoming shareholder will have their cost base reduced and may pay tax in future on their share of the actual value they contributed; and
the other shareholder may also pay tax in the future on their share of the actual value contributed by the incoming shareholder, as their cost bases are not increased under the value shifting rules discussed below.
In summary, taxpayers must look after themselves and are left to suffer the disadvantage when they pay more than they should in a non-arm’s length situation.
Giving of property – market value
Section 103-5 causes property given to be valued at market value and for that value to be counted as proceeds or costs for CGT purposes:
103-5 Giving property as part of a transaction
There are a number of provisions in this Part and Part 3-3 that say that a payment, cost or expenditure can include giving property.
To the extent that such a provision does say that a payment, cost or expenditure can include giving property, use the *market value of the property in working out the amount of the payment, cost or expenditure
Accordingly, IP or other assets given to acquire shares or other rights must be valued and counted at that value.
The ATO’s guidelines on market value will need to be considered where non-cash consideration is provided:
But, as already mentioned above, valuing some assets can be very difficult – especially when those assets are unproven (e.g. unproven IP) so that there is no existing market. A valuation exercise seeking to predict possible future cash flows and incorporate weightings for uncertainty can result in a meaningless ‘average’ value, between binary outcomes of success (high value) or failure (no value).
These difficulties can drive the different forms of funding arrangements, by seeking to preserve access to future success (through future access to profits/gains) without payment of some ‘standard’ up-front and uncertainly valued contribution.
Even where it may be possible to come to some sensible range of possible market values, there will often be a tension between the desire to recognise/maximise an up-front value financially – on which value the percentage of shares or other interests may be based – versus the tax/CGT on contribution/transfer of the asset to the company as the funding.
Each situation will need to be considered on its own facts.
Granting of rights
Where funding is provided through the use of an asset (e.g. by lease, licence), rather than by transfer to the company, the tax implications of granting the lease, licence or other rights will need consideration.
Section 104-35 and CGT event D1 is relevant:
104-35 Creating contractual or other rights: CGT event D1
(1) CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity.
Example: You enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this. You have created a contractual right in favour of the purchaser. If you breach the contract, the purchaser can enforce that right.
(2) The time of the event is when you enter into the contract or create the other right.
(3) You make a capital gain if the *capital proceeds from creating the right are more than the *incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.
(4) The costs can include giving property: see section 103-5. However, they do not include an amount you have received as *recoupment of them and that is not included in your assessable income, or an amount to the extent that you have deducted or can deduct it.
Exceptions
(5) CGT event D1 does not happen if:
(a) you created the right by borrowing money or obtaining credit from another entity; or
(b) the right requires you to do something that is another *CGT event that happens to you; or
(c) a company issues or allots *equity interests or *non-equity shares in the company; or
(d) the trustee of a unit trust issues units in the trust; or
(e) a company grants an option to acquire equity interests, non-equity shares or *debentures in the company; or
(f) the trustee of a unit trust grants an option to acquire units or debentures in the trust.
Example: You agree to sell land. You have created a contractual right in the buyer to enforce completion of the transaction. The sale results in you disposing of the land, an example of CGT event A1. This means that CGT event D1 does not happen. [Emphasis added]
There is no deemed market value capital proceeds for CGT event D1 where there are no actual capital proceeds per section 116-30(3)(b) – but, equally, there is no deemed market value cost base in these circumstances per the table in section 112-20(3) item 3.
There can be both an increased or decreased deemed market value for capital proceeds and deemed market value for the cost base for CGT event D1 in a non-arm’s length dealing, where some payment is made.
There are also the specific provisions dealing with the grant/variation of leases (e.g. CGT event F1 for grant).
The point is that, for funding arrangements that take the form of contractual rights other than shares or loans, CGT implications arise – and that there are some special rules about deemed market value cost bases or proceeds to take into account when structuring those arrangements.
Alienation of income
Remember there are also specific provisions in Division 6A ITAA36 relating to the alienation of income.
Though we tend not to have to look at those provisions these days, that is because the provisions have essentially rendered ineffective most attempts to alienate income separately from selling the underlying asset. Also, there is the effect of the ‘second strand’ of reasoning in the High Court’s reasoning in FC of T v Myer Emporium Ltd 87 ATC 4363 – that a lump sum received in substitution for the value of future income (interest in Myer Emporium) is assessable income.
These provisions and Myer Emporium are mentioned here because they may need to be considered in respect of possible profit-sharing arrangements proposed to be entered into as part of funding arrangements outside of shares or loans. Funding provided by way of a payment for acquiring those rights will typically be assessable.
It is important to bear in mind the distinction between such assignment of the income stream (e.g. interest, royalties, dividends) and the assignment of the underlying asset itself – such as happens, under Australian law, when an Everett assignment is done. But, of course, assigning the asset itself has its own tax consequences.
Section 102B causes the transfer of rights to income to be ignored for tax when the transfer is to an associate of the transferor, for less than 7 years and not for arm’s length consideration.
Section 102CA causes any (actual) consideration received for the transfer of rights to income to be assessable income when (generally, section 102B does not apply and) the transfer is to any person for any term.
(There are certain exceptions to the specific provisions not relevant here, including for transfers under a will, maintenance payments and if Division 230, TOFA, applies.)
An example where these issues were considered is SP investments Pty Limited (as Trustee of the LM Brennan Trust) v FCT 93 ATC 4170, where an assignment of part of a royalties stream for longer than 7 years was made for a lump sum held assessable, under the reasoning in Myer Emporium.
While such alienation of income is obviously a form of disposal of an asset (which taxpayers would pre Myer Emporium seek to be of a capital nature), it is also a form of funding in that, in substance, a share of an income stream from a business is being provided for a payment.
An example of an arrangement of this type encountered in practice is funding provided by an ‘employee’ of a franchised business, under a document purporting to be in the legal form of a loan but where the (any) return is an agreed share of the borrower’s profit and a share of the proceeds on later sale of the borrower’s business. (In the particular example in mind, the borrower was a trust. The debt equity rules, discussed below, would also need to be considered for a company.)
Qualifying (deferred interest) securities
It is not intended to discuss in detail the rules for qualifying securities in Division 16E of the ITAA36 – but it is important to remember that these rules will apply to private groups regardless of the TOFA thresholds.
There may be forms of funding by way of loans (alone or combined with other contractual arrangements) on which a return is structured other than by way of traditional periodic interest – by deferral or variability (maybe profit based?) of the return – for which these rules need to be considered.
The scope of ‘security’ to which these rules can apply is very wide. Per section 159GP(1) of the ITAA36 security is defined to include:
(a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;
(b) a deposit at bank or other financial institution;
(c) a secured or unsecured loan; or
(d) any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.
But the ATO accepts (see TD 2008/21 paragraph 20) that:
… having regard to paragraphs (a), (b) and (c) of the definition of ‘security’, in subsection 159GP(1) of the ITAA 1936 only those contracts that have debt like obligations will usually fall under paragraph (d) of the definition of ‘security’.
A profit-based return will likely not be within the rules, as it would give rise to issues around whether:
the arrangements are a debt like obligation – so as to be a ‘security’ subject to the rules; and
whether the profit-based return could be an ‘eligible return’ necessary for the rules to operate – as the ‘reasonably likely’ threshold for such a return could not be satisfied (see comments in ATO ID 2008/42 – though now withdrawn)
The possibility of these provisions applying would need to, at least, be considered in respect of variations of the type of arrangement referred to at the end of section 2.4 above; i.e. funding provided under a document purporting to be in the legal form of a long term loan and where the (any) return is variable – but which may be sufficiently certain to be an ‘eligible return’. For example, if the profit sharing from the borrower had some base accumulating ‘interest’ rate plus the variable upside, and that return is deferred (to seek to match in effect the position of an owner) to not be payable until actual cash profits of a certain amount had been received by the borrower.
Value shifting rules
Overview
Before launching into relevant specifics of the general value shifting (GVS) regime/rules, it is useful to remember the overall scope of the rules.
The ATO’s Guide to General Value Shifting Regime (NAT 8366-2006 – dated 2006) (ATO Guide) is a detailed and useful guide to the rules – and some of that ATO Guide’s materials and examples are referred to below.
The GVS rules apply to three types of value shifts:
Direct value shifts from created rights (DVS Rights) – Division 723
Direct value shifts from entity interests (DVS) – Division 725
Indirect value shifts (IVS) – Division 727
The following flowchart from the ATO Guide provides a (highest level) summary of when the GVS rules need to be considered, including their applicable thresholds:
[ATO’s Guide to General Value Shifting Regime NAT 8366-2006]
This paper will not consider the IVS rules and the DVS Rights, although the (longer term) effects of those rules may need to also be considered in some funding situations because:
the IVS rules do not trigger immediate capital gains – they are directed to adjusting cost bases; and
the DVS Rights rules operate by reducing a loss that would otherwise be made upon (later) realisation of an underlying asset as a result of value having been shifted out of the asset through the creation of a right out of, or over, the asset. No reductions are made to the extent the value shifted has been taxed on the creation of the right (e.g. CGT event D1).
This paper focuses on the DVS rules, being the rules most likely to have immediate implications for proposed types of funding arrangements – as they will most directly address funding arrangements involving the issue or variation of shares with special rights or of loans with special rates of return.
The current DVS rules have been in place since 1 July 2002. Broadly:
DVS applies to debt (loan) interests as well as equity (share) interests – relevant for possible types of funding arrangements involving debt; and
DVS applies to ‘active participants’ holding interests in closely held entities, not just the controllers and their associates – relevant for possible types of funding arrangements between co-operating but not associated parties.
The following statement from the ATO Guide advises the steps by which taxpayers can ensure the GVS (including DVS) rules do not apply to them:
‘You can make sure the regime doesn’t apply by ensuring:
equity and loan interests in entities are issued at market value
rights over any underlying asset are granted for full market value consideration, and
entities provide economic benefits to each other at market value or otherwise deal at arm’s length.’
While seemingly simple enough guidance, the demands of the providers of funding and different factual/valuation circumstances still commonly give rise to many circumstances when the GVS, including the DVS, rules need to be considered and managed.
Obviously, determining market values is a part of assessing any value shifts, so that issues and decisions around values for difficult or uncertain (e.g. unproven) assets arise here also, and reference to the ATO’s guidelines on market value will be appropriate (per the link above at section 2.2).
DVS rules
Key issue
There cannot be an (entity interest) DVS unless both of these ‘limbs’ arise:
there is a decrease in the market value of one or more equity or loan interests in a target entity (called down interests), and
there is an increase in the market value of one or more equity or loan interests, or the issue at a discount of one or more equity or loan interests in the same target entity (called up interests).
Diagrammatically, per the ATO Guide:
It is significant, however, that the decrease in value of the down interest does not include the issue of the interest at a premium – paying more than the interest’s value, so that the holder makes an immediate loss.
That loss of value is picked up by the general CGT rules to cause a reduction of cost base. But, as there is no DVS (the first limb is not satisfied), no upwards adjustment occurs for any up interest.
General DVS rules
For there to be a DVS, four conditions need to exist in respect of a relevant ‘target entity’ (per mainly section 725-50):
the control test is satisfied (section 725-55);
the participants in the scheme (cause of the value shift) test is satisfied (sections 725-65);
there are affected owners of interests in the target entity (sections 725-80 and 725-85); and
no exception applies (sections 725-70, 725-90 and 725-95).
The control test
The control test will be satisfied if an entity controls the target entity at some time during the period beginning when the scheme is entered into and ending when the scheme has been carried out.
The existence of just one controller during this period is sufficient to satisfy the control test, but there may be more than one controller during the period.
The participants in the scheme test
The participants in the scheme test looks at whether one or more of the following persons did the things under the scheme that the decreases or increases in value of interests, or issues at a discount, were reasonably attributable to:
the target entity itself;
a controller of the target entity;
an entity that is an associate of the controller at or after the time when the scheme was entered into; and
an active participant in the scheme.
Active participant
A participant can only be an active participant if:
at some time while the scheme was being carried out, the target entity was a closely held entity; and
the active participant owned either a down interest or an up interest in the target entity or had an up interest issued to it at a discount in the target entity.
Affected owners of interests in the target entity
As flagged at the start of this section, for there to be consequences for DVS there must be an affected owner or owners of:
at least one down interest in the target entity; and
at least one up interest in the target entity.
Affected owners of down interests
There will be an affected owner of a down interest in the target entity if one of the following entities owned the interest at the time it decreased in value under the scheme:
the controller of the target entity;
an entity that was an associate of the controller at or after the time when the scheme was entered into; and
an active participant in the scheme.
Affected owners of up interests
There will not be affected owners of up interests in a target entity unless there is at least one affected owner of a down interest.
There will then be an affected owner of an up interest in the target entity if one of the following entities owned the interest at the time it increased in value under the scheme or alternatively had an interest issued to it at a discount under the scheme:
the controller of the target entity;
an entity that was an associate of the controller at or after the time when the scheme was entered into;
an entity that was, at or after the time when the scheme was entered into, an associate of an entity that is an affected owner of a down interest because it was an associate of the controller; and
an active participant in the scheme.
The de minimis exception
Under the de minimis exception, there are no consequences for an entity interest direct value shift under a scheme if the sum of the decreases in market value of all equity and loan interests in the target entity because of DVSs under the scheme is less than $150,000 (section 725-70).
Where two or more DVSs happen under different schemes they may be considered together if it is reasonable to conclude that the sole or main reason for this was to access the benefit of the exception.
The reversal exception
Under the reversal exception, there are usually no consequences for an entity interest direct value shift under a scheme if it is more likely than not that, at the time the first of the things done under the scheme happens, the cause of the value shift will reverse within four years under the terms of the same scheme (sections 725-90 and 725-95).
Effect of DVS
Broadly, a direct value shift under a scheme between equity or loan interests in a company or trust gives rise to the following consequences for affected owners:
entities with equity or loan interests that decrease in value will be required to decrease the tax values (cost bases, carrying costs) of their interests and, in some cases, may make gains that are included in assessable income in the year in which the value shift happens, and
entities with equity or loan interests that increase in value, or that are issued at a discount, in relation to the same scheme will be required to increase the tax values of their interests.
Loans – at above or below market interest rates
Even something as seemingly simple as the interest rate on a loan to a company being set below or above market rates will require consideration of the DVS rules.
If a loan is provided at a below market (including nil) interest rate, the loan is being provided at a premium. The correct market (present) value of the loan will be less than its face value (the principal loan funds lent) because those loan funds will be repaid in the future without any/with less than market interest.
As already noted above, such a loan will be not be a down interest. Issue at a premium does not fall within the first limb for a DVS – even though there will be up interests because the equity interests in the company will be increased from the savings in interest that would apply as compared to the market rate.
For a loan, the CGT cost base reduction discussed above as arising under the general CGT rules, would not apply as the loan will not have been ‘acquired from another entity’ in the sense of the words at the start of section 112-20. (Also, the making of the loan itself is not a CGT event D1 per the exclusion in section 104-35(5)(a).)
But if a loan is provided at an above market interest rate, the loan is being provided at a discount. The correct market (present) value of the loan will be more than its face value (the principal loan funds lent) because those loan funds will be repaid in the future with above market interest.
Such a loan will be an up interest. Issue at a discount does fall within the second limb for a DVS – and there will be down interests because the equity interests in the company will be decreased from the extra interest that would apply as compared to the market rate. Accordingly, cost base adjustments may arise under the DVS rules if the other conditions are met.
Varying the rate of interest on an already existing loan can also give rise to DVS consequences – both where the interest rate is decreased or increased. There will be a decrease in market value of the (already existing) loan as a down interest under the first limb of a DVS where the interest rate is decreased versus the initial premium paid being ignored if the initial interest rate is below market (or nil).
Determining these potential DVS implications of loans can become increasingly difficult where funding arrangements seek to include a form of return linked to some non-standard measure such as a profit share, rather than ‘standard’ interest. That return may be difficult to analyse as being above or below the market interest rates.
The concept of ‘equity or loan interest’ is a ‘primary interest’ or ‘secondary interest’ – which are, in turn, defined as:
‘primary equity interests’/’secondary equity interests’ – actual shares (not the debt/equity concepts);
’primary loan interests’/’secondary loan interests’ – actual legal loans (not the debt/equity concepts).
Accordingly, where the funding arrangements remove some of the essential characteristics of a loan (primarily, an absolute obligation to be repaid at the end of the loan term), but do not constitute a legal share, the DVS – on issue or later variation – would not apply.
Shares
Of course, the issue, or variation of the rights, of shares with/to ordinary or special rights are a regular area for potential value shifts.
They are a regular way of structuring funding arrangements to provide the funding parties with an unequal but agreed access to future returns.
Per the above analysis for loans and the earlier discussion of the CGT basics, care should be exercised when shares are being issued at a premium when not at arm’s length. Double taxation can ultimately result.
Otherwise, each share related dealing needs to be assessed on its own facts.
Active Participant issue
Private groups may involve more than just one family. The owners may be a smaller group of ‘closely co-ordinating’ owners/investors, but who still deal at arm’s length with each other.
It is worth stressing that that arm’s length dealing may not be enough to prevent application of the DVS rules, given the wide meaning of ‘active participant’.
Practical planning
Because of the potential application of the DVS rules when changes are made to pre-existing lending terms or shareholdings, after value has already accrued in a company, there is an obvious preference to get the planning right from the beginning – so that changes that involve value shifts do not occur.
If changes are needed, a strategy is to ensure the changes do not result in both the down interest and up interest, as needed to trigger the DVS rules.
As noted already, this happens by virtue of the provisions themselves when an interest is issued at a premium (excluded as a down interest), but to the possible later detriment of taxpayers.
But circumstances may arise where taxpayers can ensure that changes only result in all down interests or all up interests.
The ‘all down interests’ scenario is what commonly happens when discretionary entitlement share (‘dividend access shares’) are issued.
If properly structured, such discretionary shares do not have any value themselves, as they do not have any certainty of distributions. As such, they are not an up interest or a down interest. But, note, this will be subject to any related arrangements (e.g. profit share agreements – per the company constitution or contractually) that may govern how the discretionary distributions on the shares will be made.
The issue of such discretionary shares will usually have the effect of reducing the value of pre-existing ordinary shares, so those shares will be a down interest.
As there are only down interests, the DVS rules would not apply.
Conversely, if a private group was wishing to eliminate pre-existing discretionary shares – e.g. so as to revert to fixed entitlements when new shareholders are providing new funding for a fixed ownership interest – there may only be all up interests. All shares may move to a position of certainty of a fixed share of distributions, from a previously uncertain position.
Debt/equity rules
Overview and why debt/equity rules are important
The debt/equity rules in Division 974 apply to ‘schemes’ (arrangements) to determine what is equity in a company and what is debt in an entity for taxation purposes.
From the company’s tax (as well as other) perspective(s), whether the character of the return to those parties providing funding is deductible interest (a debt deduction) or a dividend (non-deductible distribution – potentially franked) will be of critical importance.
From the point of view of the provider of the funding (investor) the character of the return is important – but so too is whether repayment of the ‘principal’ funds provided to the company will be treated as a (mere) loan repayment or as some form of distribution that could be partly assessable.
These are questions (among other tax treatments not immediately relevant here) the debt/equity rules will determine.
Broadly, in determining what is a debt interest, the test is whether this is an effective obligation of an issuer (borrower) to return to the holder (lender) an amount at least equal to the amount invested. The rules look to the substance of the arrangement. The classification is not necessarily determined by the legal form of the arrangement.
As for equity interests in a company, the rules contain a table (discussed below) that lists four categories of arrangements which give rise to equity interests.
There is a tiebreaker test that applies to interests that pass both the debt and equity tests. Where both the debt and equity tests are satisfied, the tiebreaker test provides that the interest is a debt interest.
The debt and equity tests usually only need to be applied to classify the relevant scheme when ‘it comes into existence’ but, where there are material changes, a new scheme may be taken to arise and the test will need to be re-applied (section 974-100 and, for example, ATO ID 2004/611).
Determining whether an interest is a debt interest
The following summarises the basic test for working out if an interest is treated as debt at the time it is issued.
Five elements are required to satisfy the debt test:
• there must be a scheme;
• the scheme must be a financing arrangement;
• there must be a financial benefit received by the issuing entity;
• the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit; and
• there must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received.
First Element – there must be a scheme
The first element of the debt test is the existence of a scheme (section 974-15).
Scheme means any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.
Second element – the scheme must be a financing arrangement
The second element is the existence of a financing arrangement (section 974-20(1)(a)).
A financing arrangement is an arrangement entered into by the issuer to raise finance – or to fund another scheme that is a financing arrangement, or to fund the return on another scheme that is a financing arrangement.
A financing arrangement generally involves the contribution to an entity of capital in some form – for example, the provision of loan capital to an entity in return for the issue of a debt interest.
Certain arrangements, such as ordinary employment contracts, are generally not undertaken to raise finance. Such arrangements are not debt (nor equity) interests. Some things are specifically excluded from being financing arrangements, for example, life insurance and general insurance contracts undertaken as part of the issuer’s ordinary course of business.
Third element – there must be a financial benefit received
The third element is the receipt of a financial benefit by the issuing entity under the financing arrangement (section 974-20(1)(b)).
A financial benefit anything of economic value. It includes property and services.
Generally, the financial benefit received will be the issue price specified in the terms of the financing arrangement. It is the amount paid to acquire the financial interest and amounts to be receivable in the future.
Fourth element – the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit
For an interest to be regarded as a debt interest, there must also exist an effectively non-contingent obligation for the issuer to provide a financial benefit to the holder of the interest (section 974-20(1)(c)). The financial benefit to be provided could be a single amount or a number of instalments over time.
To determine whether an effectively non-contingent obligation exists, regard is to be had to the terms, conditions and pricing of the financing arrangement.
The concept is of an obligation that is non-contingent in substance – as opposed to an obligation that is non-contingent only in form.
Where a creditor has a right that becomes due and payable, the debtor’s inability or unwillingness to meet the obligation does not make the obligation contingent.
In some cases involving obligations owed by a number of entities under a scheme, the Commissioner of Taxation has the power to determine who issued the debt interest.
In considering whether there is an effectively non-contingent obligation, artificial and immaterially remote contingencies are to be ignored.
Subordination clauses that preserve the obligation but operate to (merely) postpone enforcement of that obligation to a time that other creditors are paid, do not prevent there being a non-contingent obligation.
When meeting the obligation is dependent only on the debtor’s ability to pay, this is not enough to make the obligation contingent.
But where the creditor’s right to repayment is subordinated to the level of ordinary equity interests, such that the obligation, in a winding up, to repay the creditor is contingent on paying the ordinary equity interest holders, the obligation will be contingent.
In a limited recourse loan arrangement, if the borrower does not repay the amount due at maturity, the lender’s only recourse is to a specified security or asset. This limitation of recourse will also, not of itself, prevent the debtor having an effectively non-contingent obligation to provide a financial benefit.
Where there is an effectively non-contingent obligation, whether the interest passes the debt test will fall to be determined by whether it is substantially more likely than not that the value of the security or asset to be provided will be at least equal to, or exceed, the amount borrowed (i.e. satisfaction of the fifth element discussed below).
Fifth element – it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received
The fifth element of the debt test is that it be substantially more likely than not that the financial benefit to be provided by the issuer will be at least equal to the value of the financial benefit received (section 974-20(1)(d) and (e)).
The financial benefit to be provided is what the issuer has an effectively non-contingent obligation to provide to the investor and this can include the return of the initial investment amount.
The method of calculating the value of the financial benefit depends on the performance period of the arrangement. If the term is 10 years or less, the value will be calculated in nominal terms. If the term is more or may be more than 10 years, the value of the benefit will be calculated in present value terms (sections 974-35 and 974-50).
The performance period is the period within which, under the terms on which the interest is issued, the issuer has to meet its effectively non-contingent obligations in relation to the interest.
The present value of a benefit is the nominal value of the benefit, discounted using an ‘adjusted benchmark rate of return’.
The adjusted benchmark rate of return is defined as 75% of the ‘benchmark rate of return’ on the test interest.
The benchmark rate of return is defined as the internal rate of return on an investment if the investment were ‘ordinary debt’ of the issuer or an equivalent entity, compounded annually and otherwise comparable with the interest under consideration.
Determining whether an interest is an equity interest
The equity test identifies schemes that will be classified as equity.
As equity, returns under the scheme may have frankable distributions (like dividends) rather than having returns that may be deductible (like interest).
There is a table in section 974-75(1) that lists schemes that are equity interests. A scheme satisfies the equity test if it gives rise to an interest listed at items 1 to 4 of this table. In relation to items 2 to 4 of the table (other than legal membership/share interests), the interest must also be a financing arrangement.
A scheme gives rise to an equity interest if the scheme satisfies the equity test when it comes into existence, subject to it also satisfying the debt test. Under a tiebreaker rule, if a scheme satisfies both the debt test and the equity test, it will be a debt interest (section 974-5(4), also per section 974-70(1)(b)).
Unless an interest satisfies the debt test at the time of issue, entities will issue an equity interest when they issue:
a membership interest (such as a share) – item 1;
an interest providing returns that depend on the issuer’s economic performance – item 2;
an interest providing returns at the discretion of the issuer – item 3; or
an interest that may or will convert into such an interest or share – item 4.
In this context ‘returns’ include the return of an amount invested in the interest (i.e. return of capital). An equity interest that is not an actual share is a ‘non-share equity interest’.
Item 1 – an interest as member or stockholder of the company
Unless it satisfies the debt test, any membership interest in a company is an equity interest in that company, whether an ordinary share or a preference share, and whether in a company limited by shares or a company limited by guarantee.
Item 2 – an interest that carries a right to a return that is effectively contingent on economic performance
Item 2 of the table recognises an equity interest where the holder of such an interest has a right to a return that is dependent on the economic performance of the company or certain activities of the company. An example of this would be an interest where the returns are dependent on the company’s profits.
As for the debt test, an equity interest does not generally arise in cases where an employee’s remuneration (e.g. a bonus arrangement) is partly or wholly contingent on the economic performance of a company. This is because a contract for personal services entered into in the ordinary course of the business of an entity is generally not entered into to raise finance.
Item 3 – an interest that carries a right to a return that is at the discretion of the company
Under item 3 of the table, an equity interest exists where the holder of such an interest has a right to a return that is made at the discretion of the company. An investor may, for example, have an interest in an entity that provides a return of a set amount unless the directors determine otherwise. Such an interest is an equity interest.
Item 4 – an interest issued by the company that will or may convert to, or provides a right to be issued with, an equity interest in the company
A holder of an interest issued by the company that carries a right to be issued with an equity interest in the company holds an equity interest in the company under item 4. Similarly, an investor holds an equity interest under item 4, if the interest they hold is issued by the company, and it will or may convert into an equity interest in the company.
Notwithstanding the rights to be issued with, or to convert into, equity interests, there is a general exclusion under section 974-30(1) of the value of that possible (future) equity interest from being counted as a financial benefit to be taken onto account for the debt test. This means that these types of interests may still be equity under the tie breaker rule. Examples are discussed further below in section 4.4.3, including the exception to this general rule in section 974-30(1).
Particular debt/equity interests
Loans with contingent or discretionary returns
Where a loan carries a right to a return that is effectively contingent on aspects of the economic performance of the company or certain activities of the company, it will generally qualify as an equity interest. A right to a return will generally be considered ‘contingent on the economic performance of the company’ where:
the payment of returns is dependent on the availability of the company’s profits;
the repayment of the original investment amount is dependent on the availability of the company’s profits;
the interest gives its holder the right to a percentage of the profits made by the company; or
the interest gives its holder a right to set an annual repayment/ return amount if a related company makes a profit.
An example of such an interest could be a loan, where payment of any non-cumulative interest/return is dependent on profits existing each year.
Because, where the loan satisfies both debt and equity interests, the interest will be deemed to be a debt interest as a result of the tie breaker test in section 974-5(4), the way to manage that a loan with such ‘contingent on the economic performance of the company’ terms remains a debt interest could be to:
retain the absolute obligation to repay the loan by 10 years – so that the (undiscounted) face value repayment is enough to satisfy the debt test; or
(likely more difficult commercially) retain a sufficient base level of return (interest) payable on a loan with a term that exceeds the 10 years, to cause the present value of the loan to satisfy the debt test.
There is also the specific ‘at call’ loan exception discussed below.
‘At call’ loans
Funding may be provided by family or associates by way of ‘at call’ loans.
Such ‘at call’ loans, because they do not have a definite 10 year repayment term and because any interest (return) is at the discretion of the company, may not satisfy the debt test – and so could be treated as equity.
Such an equity treatment would mean that repayments of the loan principal would be treated as an effective return of capital (non-share capital returns) to which the anti-avoidance capital benefit rules in section 45B could apply per section 45B(7) (and see PSLA 2008/10). In summary, the repayment of the ‘at call’ loan principal could be determined to be partly an assessable unfranked dividend – unlikely to be a welcome treatment.
But there is a specific small business turnover carveout for ‘at call’ loans between connected entities, if a company has a turnover of less than $20 million. The carve-out means that a related party ‘at call’ loan will be treated as being a debt interest rather than an equity interest.
A company’s annual turnover (worked out at the end of an income year) is to be determined in accordance with the GST rules.
Private companies with related party ‘at call’ loans that do not qualify for the special carveout would otherwise need to consider whether to change their loan terms, so they are debt interests under the general debt/equity rules.
The company may elect (under section 974-110(1A)) to treat such a change of terms as if it occurred at the beginning of the previous income year. This election must be made before the earlier of the due date for the company’s tax return or the date of actual lodgement for that year. Practically, this timing allows companies to manage (fix) a change of characterisation of an ‘at call’ loan for an earlier income year where that change can only be identified after year end (because of the turnover test), by deeming the changed terms to apply for that earlier year.
Because the turnover test applies on an annual basis, a company may qualify for deemed debt treatment under the debt/equity rules for one year but not the next. This means that related party ‘at call’ loans to the company could change from being debt interests to being equity interests if their turnover exceeds $20 million.
Loans that become equity-convertible notes/interests
Where the providers of funds wish to protect their downside risks by retaining loan characteristics, but also allow for the upside of taking up equity, some form of convertible interest may be proposed.
Such convertible interests, the equity character of which arises from the ability of their holder to possibly become an equity holder in the future, will generally satisfy the equity test – item 4.
Section 974-165 provides an interest is a converting or convertible interest if the interest, or a component part of it, may (or must) be converted into an equity interest in the company or a connected entity. This is equally applicable where the relevant financial arrangement comprises a number of rights or interests, only one of which converts into an equity interest.
But, as noted in the earlier comments on item 4 in the equity test table, the general exclusion under section 974-30(1) of the value of that possible converted equity interest from being counted as a financial benefit for the debt test, means that these types of interests may still be equity under the tie breaker rule.
Section 974-135(4) provides an exemption to this general principle where the holder of a convertible interest has a right to convert the interest into an equity interest in a company. In these circumstances, the issuer’s obligations to repay the issue price will not be considered to be effectively contingent because of the mere existence of the holder’s right to convert. In other words, the convertible interest can still be debt.
Section 974-135 does not contain a similar exception that applies where the issuer (the company) holds the right to convert the note into an equity interest in the issuer. This means the issuer’s right to convert the convertible note would still be considered a relevant contingency for the purposes of the debt test. The discretion that an issuer has about converting the note into an equity interest in the issuer to end any obligations of the issuer, is a contingency that could of itself preclude a finding that there is an effectively non-contingent obligation after the time the conversion choice could be made.
In summary – and depending on the exact wider terms, conditions and pricing of the arrangement – it is likely a convertible interest at the right of the issuer (the company, only) would be considered an equity interest.
Paragraph 25 of TR 2008/3 confirms this:
‘A convertible note that can be converted into an equity interest in the issuer at any time at the issuer’s discretion will satisfy the equity test in subsection 974-75(1). Item 3 in the table in subsection 974-75(1) will be satisfied because the amount of the return on or of the amount invested in the note will be at the discretion of the issuer: the amount of the return will depend on whether and when the issuer exercises its discretion to convert the note. The amount of any interest payable on the note will depend on the issuer’s discretion to convert. Item 4 in the table will also be satisfied because the note is an interest that may convert into an equity interest in the issuing company’.
Accordingly, careful planning, or review, of the terms of any convertible notes/interests is required – to ensure the intended debt/equity treatment will arise.
Equity with preferential returns – redeemable preference shares
Alternatively, providers of funding may be prepared to take up equity with preferential access to profit distributions and later return of capital, including by redemption.
Section 974-135(5) provides that an obligation to redeem a preference share is not contingent merely because there is a legislative requirement, such as section 254K of the Corporations Act 2001, for the redemption amount to be funded out of profits or a fresh issue of equity. Therefore, in applying the debt test to the redeemable preference shares, those company law restrictions can be disregarded.
Where the terms of the redeemable preference shares only specify that they must be redeemed after a specific period of time (subject to the company law requirements), the issuer’s obligation is only to redeem for the redemption price.
In these circumstances, an equity raising by the company to comply with the company law requirements, about funding the redemption, would be a separate arrangement – and not create any convertibility rights in connection with the redeemable preference shares.
The general exclusion under section 974-30(1) of the value of a possible converted equity interest from being counted as a financial benefit for the debt test should therefore have no application to the redemption of the redeemable preference shares in determining the value of the financial benefits to be provided by the issuer under the redeemable preference share arrangement.
In summary, the redemption price (as the ‘simple’ obligation stated for redemption) is not prevented from being included in the value of the financial benefit to be provided by the issuer when applying the debt test. Depending on the exact wider terms, conditions and pricing of the arrangement the redeemable preference shares could be made a debt interest.
Discretionary shares plus agreements
The financial effects of a funding arrangement may be sought to be achieved by a combination of different classes of shares and contractual obligations (in or outside the company constitution, including by shareholder agreements) around how distributions will be made on those different classes of shares.
For example, a group of professionals may see this as a way to calibrate returns to the contributions of the different owners of the business/company.
The overall arrangement is unlikely to give rise to debt interests. It is really a type of structure being used to provide variable profit shares – here by way of a governance structure imposed over the operation of the discretionary share rights.
lssues are more likely to arise under the value shifting rules, if the structure has not been put in place from commencement – or when interests are varied without market value consideration being paid. Otherwise, when owners exit or enter, it would be expected the usual CGT and other tax consequences would be dealt with – even if the structure involves more than a ‘simple’ share.
Employee share schemes
To access funding by way of the ‘human capital’ – the particular personal skills – of key personnel a private group may wish to provide the incentive of equity ownership in the group, in addition to other periodic financial (cash and benefit) remuneration.
This is not usually a major element in a private group’s funding. Ownership of such groups is held by related parties (often family members) or by a small group of ‘closely co-ordinating’ owners/investors. The introduction of owners outside this group may be consciously refused, or be severely limited so as not to introduce additional complexity to how the group is managed and returns shared.
But there will be a place for the provision of equity in order to access key skills and key personnel in some circumstances.
This section is to provide a very broad overview the Employee Share Scheme (ESS) provisions to be found in Division 83A. Generally, the provisions are directed at ensuring that tax applies to benefits provided by way of ESSs, however there are some concessions.
The discussion will mainly focus on particular aspects/concessions of the ESS that may be of benefit or interest to private groups.
Overview
The ESS provisions apply to include in assessable income the discounts provided by employer companies to employees on ESS interests – being shares or the right to acquire a beneficial interest in a share (e.g. options) – because of their employment with the company.
So there is a threshold issue of determining whether the discount is provided in respect of employment versus because of family or pre-existing shareholder status. (The GVS rules may of course apply even if the ESS rules do not.)
To determine if a discount exists obviously involves comparison to a market value. Where rights exist to acquire shares in a company (e.g. an option), its market value is to be calculated in accordance with relevant Regulations. Those Regulations broadly require companies to calculate the value of an unlisted right based on its terms (exercise period, price, etc) in comparison to the existing market value of an ordinary share in the company.
The value and timing of tax under the ESS rules of amounts to be included in an employee’s assessable income is dependent on whether the scheme is considered an:
deferred scheme – Subdivision 83A-C
upfront scheme – Subdivision 83A-B
Deferred schemes
The deferral concessions will apply if the conditions in section 83A-105 are satisfied. It is not a choice made by the company or the employees.
Also note that the deferral mechanism operates in a way that defers the time the taxable discount is calculated – versus deferring when the time when a discount, calculated at the time of grant of the ESS interest, is taxable.
For this reason, deferral may not be seen as a concession and may not be desired – and the company and the employees may prefer to structure for the ESS interests to be taxed up-front.
Whether planning to be in or out of the deferral treatment, for a grant of ESS interests to be eligible for deferred treatment, the following general conditions must be satisfied:
the ESS interest is acquired by an employee of the company or a subsidiary of the company;
all of the ESS interest acquired under the scheme relate to ordinary shares;
the company for which the ESS interest is acquired must not be predominantly in the business of acquiring, selling or holding shares, securities or other investments; and
the ESS interest must not result in the employee holding more than 10% of the shares in the ESS company or controlling more than 10% of the votes at a general meeting.
Additional conditions in section 83A-105 will also apply depending on whether the relevant ESS interests are either shares or rights.
If the ESS interest is a share:
under the scheme, shares must be available for at least 75% of the permanent employees with at least three years of service; and
either:
there must be a real risk that under the conditions of the scheme, you will forfeit or lose the share (other than by disposing it); or
the share must have been acquired under a salary sacrifice arrangement and the total discount received on the interests acquired during the year (including any other schemes) does not exceed $5,000.
If the ESS interest is a right:
there must be a real risk that under the conditions of the scheme, you will forfeit or lose the right (other than by disposing of it, exercising the right or letting the right lapse) or if you exercise the right you will forfeit or lose the share (other than by disposing of it); or
the scheme rules must genuinely restrict immediate disposal of the right and the governing rules expressly state Subdivision 83A-105(6) applies to the scheme.
If the general and additional conditions in section 83A-105 are met, timing of taxation is the earliest of the following.
For shares:
when there ceases to be a real risk that the recipient will forfeit or lose the shares (other than by disposal) and there are no genuine restrictions preventing disposal;
on cessation of the employment to which the interests relate; or
15 years after the share was acquired.
For rights:
if the right has not been exercised – when there is no real risk of forfeiture or loss of the right and any genuine scheme restrictions on disposing of the right imposed at the acquisition time have ceased to apply;
when the employee ceases employment;
15 years after the right was acquired; or
when the right is exercised, provided there is no real risk under the conditions of the scheme, after the right is exercised, that the beneficial interest in the share will be forfeited or lost (other than by disposing of it) and any genuine scheme restrictions on disposing of the right imposed at the acquisition time have ceased to apply.
Upfront schemes
Broadly, an ESS will be considered an ‘upfront’ scheme where it not considered a deferred scheme.
The relevant taxing point under an upfront scheme is the time at which the employee acquired their beneficial interests in the share or right – typically on acceptance of the offer made by the company.
In some circumstances, the assessable discount for ESS interests granted to employees under an upfront scheme may be reduced by $1,000 per employee.
Concessions for start-up companies
A more favourable tax treatment for employees acquiring ESS interests is available for employees of certain small start-up companies. The concession means that the employees do not need to include certain discounts on ESS interests acquired in their assessable income. As such, access to this concession can make the use of an ESS as part of a private group’s funding much more attractive.
In relation to shares, the discount is not subject to income tax and the share, once acquired, is then subject to the capital gains tax system with a cost base reset at market value.
In relation to rights, the discount is not subject to upfront taxation and the right is then subject to capital gains tax with a cost base equal to the employee’s cost of acquiring the right. This may seem less of a benefit than the deemed market value for shares under the concession – but the capital gains tax discount rules (in Subdivision 115-A of the ITAA97) have been modified in relation to ESS interests that are rights to acquire shares and that benefited from the small start-up concession. When determining the acquisition time for a share that has been acquired by way of exercising a right that was an ESS interest subject to the small start-up concession, the time of acquisition for capital gains tax discount purposes is the time at which the right was acquired, and not the time at which the share was acquired. This allows the capital gains tax discount to be available so long as the right and underlying share are sequentially held for 12 months or more.
The small start-up concession applies to the exclusion of all other ESS taxation rules – so that, where eligible for the small start-up concession, the $1,000 up-front concession or the deferred taxation concession cannot apply.
General conditions
The general conditions that apply to all ESS concessions – as noted above – must still be met, namely that:
the ESS interest is acquired by an employee of the company or a subsidiary of the company;
all of the ESS interest acquired under the scheme relate to ordinary shares;
the company for which the ESS interest is acquired must not be predominantly in the business of acquiring, selling or holding shares, securities or other investments; and
the ESS interest must not result in the employee holding more than 10% of the shares in the ESS company or controlling more than 10% of the votes at a general meeting.
Extra scheme conditions
The following extra conditions apply to the scheme:
the scheme must meet the existing minimum holding period condition (operation of the ESS so that employee hold for three years or until employment ceases); and
if the scheme relates to shares, the scheme must meet the existing broad availability condition (entitlement to acquire under the ESS of 75% of Australian-resident permanent employees with at least three years’ service).
Extra employer conditions
To access the concession:
no equity interests in the company in which the ESS interest is in, can be listed on an approved stock or securities exchange;
the ESS interests need to be in a company that was (and all companies in the corporate group were) incorporated less than 10 years at the end of the most recent income year before the ESS interest was acquired. (It is the company’s income year that is the relevant income year);
the ESS interests need to be in a company that has an aggregated turnover (per the concept within the ITAA 1997, section 328-115) not exceeding $50 million for the income year prior to the income year in which the ESS was acquired;
the employing company (which may or may not be the company issuing the ESS interest) must be an Australian resident taxpayer. If the ESS interests are not in the employing company, only the employing company needs be an Australia resident taxpayer.
ESS interest conditions
To access the concession, the ESS interest must:
in the case of a share – be acquired with a discount of not more than 15 per cent of the market value of the share when acquired; and
in the case of a right – have an exercise price (or strike price) that is greater than or equal to the market value of an ordinary share in the issuing company at the time the right is acquired.
The Explanatory Memorandum introducing the concession for small start-up companies (Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015) states that this condition ensures the concession only applies in situations in which the ESS interest is issued at a small discount to the employee – and mentions possible abuse through salary packaging arrangements.
The following examples are extracted extracted from the Explanatory Memorandum (paragraph 1.92):
Example 1.1: Shares
Tracy is issued with 10,000 shares in a small Australian start-up entity under an ESS. The shares at issue have a market value of $1 per share. Tracy contributes 85¢ per share under the scheme.
Tracy and the ESS meet all the rules for her 10,000 shares to be covered by the small start-up ESS tax concession.
After 5 years, the Australian start-up entity is sold under a trade sale where Tracy receives $1.50 per share for each of shares.
On acquisition, Tracy receives a discount of $1,500 which is not included in her assessable income (i.e., not subject to income tax). Her shares will then have a cost base for capital gains tax purposes of $10,000.
When Tracy sells her shares she has a discount capital gain of $2,500 this is included in her net capital gain or loss for the income year. If she has no other capital gains or losses for that year, and no capital losses carried forward from a previous year, the $2,500 is then included in her assessable income.
Example 1.2: Rights
Tim is issued with 10,000 ‘out of the money’ options under an ESS operated by his small Australian start-up employer for no consideration. The options allow Tim to acquire 10,000 ordinary shares in his employer after paying an exercise price of $1.50 per right (which is more than the current market value of each share – $1 per share).
Tim and the ESS meet all the rules for his 10,000 rights to be covered by the small start-up ESS tax concession.
After 5 years, Tim exercises each right by paying $15,000. Tim then immediately sells each share for $2.00 with his total proceeds being $20,000.
On acquisition, Tim does not include any amount in his assessable income in relation to the discount received on his options. His options will have a nil cost base for capital gains tax purposes.
There will be no capital gains tax on exercise of his rights and receipt of his shares (due to the availability of a capital gains tax rollover). However, on exercise, the cost base of his shares will be $1.50 per share.
On sale of his shares Tim will have a discount capital gain of $2,500 that is included in his net capital gain or loss for the income year. If he has no other capital gains or losses for that year, and no capital losses carried forward from a previous year, the $2,500 is then included in his assessable income.
Appropriate pricing – plus funding by company
To trigger up-front taxation of a known and acceptable (potentially nil) amount while still structuring ESS arrangements to provide incentive to key employees to commit their special skills (their form of funding), options may be issued (for no consideration) at an exercise price greater than the market value of the company’s shares (i.e. ‘out of the money’).
This can be effective because the taxable discount in respect of unlisted rights is required to be determined in accordance with the valuation tables detailed in the Regulations.
Under these tables, a value is still being attributed to the ‘upside’ represented by the option, even if ‘out of the money’ at grant – but depending on the extent to which the option exercise price exceeds the current share market value, the incentive effect for the employee may still be effective, while providing taxation certainty.
At the extreme, where the exercise price is more than double the market value of the shares at the date of grant and the exercise period does not exceed 15 years, the market value of the option for the purposes of Division 83A will always be nil.
The management of the up-front taxation for the employee may be assisted by the company providing loan funds to pay that tax. This can also apply when/if the options are exercised. Such loan arrangements are common and necessary as any incentive arising for employees from ESS arrangements can be sharply curtailed if the employees find themselves with cash outflow demands from the taxation of their ESS interests, while not being able to realise the ESS interests to pay that tax. Further, even if employees could sell their ESS interests to fund the up-front tax, it acts against the whole intended incentive effect of the ESS arrangements if employees cannot hold onto those ESS interests.
An alternative is to structure the grant of options or shares to the key employees for a price that will reduce or fully eliminate any discount subject to up-front tax. In these situations, the company may still provide loan funds to pay that price, when due on grant and when/if any options are exercised. This approach may be more useful in a more mature business – where there is not expected to be a significant increase in the value of the company’s shares as the company moves from a ‘start-up’ with unproven but potentially valuable IP and other assets to a more established and profitable business.
Points to consider in respect of company loans to support ESS (funding) arrangements:
dividends paid on purchased shares can be used to reduce the outstanding loan balance;
typically such loans are provided on the basis that any security provided to the company is on a limited recourse basis – limited to the underlying options/shares – so that the incentive effect for employees is not diluted by the borrowing risk;
Division 7A (shareholder loan) issues arise where the loan is made to an employee (or their associate) who is already a shareholder of the company – so that loan arrangements are most simple when supporting the initial recruitment of key personnel;
fringe benefits tax issues can be managed via the ‘otherwise deductible’ rule where the employee is the holder of the options/shares and the borrower – but not where an associate is the holder/borrower;
Corporations Act issues need to be considered around companies lending to fund an acquisition of its own shares; and
it will be necessary to consider how an outstanding loan balance will be dealt with if an employee leaves employment – immediate recovery may be required, as the incentive effect will no longer be relevant.
Shadow plans
A shadow equity plan is essentially a bonus scheme, albeit one under which the amounts payable to a key employee are linked to the value of notional ‘shares’ in the company under a contractual arrangement versus the employee acquiring ‘real’ options/shares.
The tax effects are not as potentially favourable as a ESS arrangement – the bonus amounts will be ordinary assessable income and not capital gains, as no actual options/shares are acquired.
But use of shadow equity plans may be preferred to prevent minority interest holders appearing on the share registry of private groups, while still providing a mechanism to reward key employees in a way aligned to how the contribution of their skills improves the value of the group.
Franking credit issues that can affect equity raisings
The Tax Laws Amendment (2023 Measures No. 1) Act 2023 enacted integrity provisions in sections 202-45(e) and 207-159 of the ITAA97 which broadly make certain company distributions funded by capital raisings unfrankable.
These integrity provisions apply from 28 November 2023 and address concerns that companies with excess franking credits were using capital raisings to fund fully franked distributions1– where there was no substantive change to a company’s economic circumstances but the distribution had the result of releasing franking credits from the company (see Taxpayer Alert 2015/2).
Section 177EA of the ITAA36 could potentially apply to such a situation but relies on the Commissioner making a determination, whilst these integrity provisions operate automatically.
As with much recent tax legislation, the drafting of these integrity provisions goes much wider than the problem they seek to cure and, as such, the provisions will need to be considered each time a company carries out an equity raising, where franked distributions are paid either before or after the raise.
To understand the potential impact of these integrity provisions it is relevant to review their terms. Section 202-45(e) deems a distribution to be unfrankable where all of the following conditions of section 207-159(1) of the ITAA97 apply to the distribution:
either:
the entity has a practice of making distributions of that kind on a regular basis and the relevant distribution is not made in accordance with that practice; or
the entity does not have practice of making distributions of that kind on a regular basis;
there is an issue of equity interests in the entity or any other entity (whether before, at or after the time at which the relevant distribution was made);
it is reasonable to conclude, having regard to all relevant circumstances, that:
the principal effect of the issue of any of the equity interest was the direct or indirect fundingof a substantial part of the relevant distribution or the relevant part; and
any entity that issued, or facilitated the issue of, any of the equity interests did so for a purpose (other than an incidental purpose) of funding a substantial part of the relevant distribution or the relevant part; and
the issue of equity interests was not a direct response in order to meet a requirement, direction or recommendation from APRA or ASIC.
Section 207-159(2) outlines relevant matters which should be taken into account in considering whether a company has a distribution practice including the nature of previous distributions before the relevant distribution, the timing and amount of the distribution, extent of franking and any explanation provided by the company for the distribution.
Section 207-159(4) outlines matters which should be taken into account in determining whether the issue of equity interests was for the purpose of funding the subject distribution. This includes the timing of the equity issue/s and the subject distribution, the amount of the equity issue versus the amount of the subject distribution, the extent of change of financial position of the entity which made the subject distribution and the entity which issued the equity, the use of the funds from the equity issue, the reasons for the equity issue, and the company’s franking history (i.e. deficit or surplus) as compared to history of profits and share capital.
Where a distribution is made unfrankable under section 202-45(e), there are flow on effects in that the recipient’s assessable income will not include a franking credit gross up and such a distribution will not be exempt from dividend withholding tax in the case of a non-resident shareholder.
Common transactions in the SME environment which may be potentially affected by these integrity provisions include:
the franked pay out of profits to existing shareholders prior to entry of new third party shareholders or an initial public offering;
a selective buyback of an exiting shareholders, where it is intended that the buyback dividend be fully franked, and the buyback is funded by an equity raise amongst remaining shareholders; and
restructures using capital gains tax rollovers which may involve the issue of shares (such as the transfer to a wholly owned company in Subdivision 122-A of the ITAA97, the scrip for scrip rollover in Subdivision 124-M and the company interposition rollover in Division 615 of the ITAA97) – where, prior to such rollovers, there may be a pay out of retained profits to existing shareholders.
These common transactions are generally not aimed at releasing franking credits inappropriately, but rather their main purpose is to either pay out retained profits to existing shareholders who were shareholders during the time when the profits were made, or to facilitate the exit of a shareholder.
Due to concerns raised about the broadness of the wording of section 207-159 and their impact on such common SME transactions, the Federal Government included the following further commentary in a Supplementary Explanatory Memorandum to the Tax Laws Amendment (2023 Measures No. 1) Act 2023:
‘5.45B Also, while it is intended that contrived arrangements undertaken by closely held companies to release franking credits to their shareholders are captured by these amendments, family or commercial dealings of private companies where the capital raising and distribution are initiated to facilitate the departure of one or more shareholders from the company are not intended to be affected by the operation of the measure. This would include, for example, unless the facts and circumstances indicate another (other than incidental) purpose:
• where, as part of a succession plan, a new generation of family members funds and acquires equity in the company and the funds are applied to pay a franked dividend to the exiting generation of shareholders; or
• to allow a particular shareholder to exit the company (e.g., due to a falling-out between family members), where the departing shareholder is paid a franked dividend funded by capital raised from those shareholders who remain.
The company directors may need to consider whether, in the particular facts and circumstances, existing anti-avoidance provisions in the tax law that deal with, among other things, the streaming of franking credits, would apply.’
No changes were made to the actual terms of section 207-159 and so the potential for the section to apply to these situations still remains, from the words of the statute.
The Supplementary Explanatory Memorandum takes the position that there is a link between the equity raise and the franked distribution, but section 207-159 does not apply because the purpose of the equity raise is to facilitate the exit of a shareholder, as opposed to having a non-incidental purpose of funding the franked distribution. The weight to which one can rely on the Supplementary Explanatory Memorandum’s comments is unclear.
Section 207-159(1) contains many uncertain terms and concepts including what a ‘substantial part’ of the relevant franked distribution means and the assessment of a non-incidental purpose of funding the relevant franked distribution.
The ATO conducted public consultations on section 207-159 between December 2023 and February 2024 with a view to issuing public guidance on the section. Without such guidance, it is likely that a private ruling may need to be obtained from the ATO in common SME transactions (as outlined above) to obtain certainty in relation to the section’s non-operation.
Practical steps that a company may undertake to try to navigate through section 207-159 include:
documenting the company’s prior distribution practice with the aim of showing that the subject distribution is within the scope of such a practice – this will be no help if the company is a start up and has not previously paid dividends;
managing future dividends so that it they do not otherwise upset this distribution practice;
documenting contemporaneously the reasons for a franked distribution (being non-related to any equity issue) and why it may be in keeping with the company’s distribution practice;
documenting the source of the funding of a franked distribution and how the funds raised by an equity issue are used; and
considering whether an equity issue both from the company or an related entity in the group may affect the company’s ability to pay franked dividends.
Thin Capitalisation – SME considerations
$2 million threshold – but be aware
The thin capitalisation rules are generally not an issue for most SMEs because of the $2 million de minimis threshold. This threshold means that the thin capitalisation rules do not apply to disallow debt deductions if the total debt deductions of the entity and all its ‘associate entities’ for the year are $2 million or less (s 820-35 ITAA97).
Although, care always needs to be taken to ensure that the threshold does apply.
First, the definition of ‘debt deduction’ in s 820-40 ITAA97 needs to be considered. This definition can extend beyond what is ordinarily understood as debt deductions. For example, under amendments passed this year (explained at 7.2 below), the definition has been broadened to include amounts ‘economically equivalent to interest’.2 The explanatory memorandum to the introductory bill explains that this is intended to capture interest related costs under swaps, such as interest rate swaps.3
Further, the definition has been broadened to include costs not in relation to debt interests issued by the entity being tested.4 That is, debt deductions could now include costs in relation to debt interests issued by another entity.
Secondly, the required analysis of ‘associated entities’ is not the same as for other parts of the ITAA97 and ITAA36. Section 820-905 of the ITAA97 provides a special definition of ‘associate entities’ that effectively narrows the definition of associate under s 318 of the ITAA36 for the purposes of the thin capitalisation rules.
Recent changes
On 8 April 2024, substantial amendments to the thin capitalisation rules received assent with effect from 1 July 2023 (except for new debt deduction creation rules (discussed at 7.3 below), which commence from 1 July 2024).
Of assistance to SMEs, the $2 million de minimis threshold (discussed at 7.1 above) applies to the new rules (including the new debt creation rules discussed at 7.3 below).
If the $2 million threshold is exceeded, it is necessary to consider whether the taxpayer falls within the categories of entities to which the thin capitalisation rules apply.
Broadly, the previous rules apply to outward-investing entities (broadly being Australian entities that carry on a business in a foreign country at or through a permanent establishment or through an entity that it controls), inward-investing entities (broadly being Australian entities that are controlled by foreign residents or foreign entities having investments in Australia). The previous rules then apply differently depending on whether the outward or inward investing entity is categorised as a general or financial entity, whether it is a subsidiary or branch and whether it is an authorised-deposit taking institution (ADI).
The new rules introduce a new concept of a ‘general class investor’, which, broadly, encapsulates outward and inward investing entities (as defined in the previous rules) that are not classified as financial entities or ADIs.
General class investors apply the new thin capitalisation debt tests, whereas financial entities and ADIs continue to use the previous rules.
The following three new debt tests apply to general class investors:
Fixed ratio test – 30% tax EBITDA: This is the default test if the other two tests are not chosen by the taxpayer. Under the fixed ratio test, an entity is denied net debt deductions that exceed 30% of its tax EBITDA (broadly, the entity’s taxable income adding back deductions for interest, decline in value and capital works). Importantly, denied deductions can be carried forward and claimed in the next 15 income years when the entity’s net debt deductions are under the 30% tax EBITDA threshold.
Group ratio test: The group ratio test applies similarly to the fixed ratio test except that the maximum permitted percentage of net debt deductions of tax EBITA is not 30% but rather is the ratio of the group’s net third party interest expense to the group’s EBITDA for an income year.
Third party debt test: This test denies debt deductions which are not attributable to third party debt (and that satisfy certain other conditions).
The new fixed and group ratio tests are a radical change to the existing asset-based tests. Taxpayers that previously relied on the 60% safe harbour debt amount may need to implement substantial changes to their debt structures to ensure compliance with the new tests.
New debt creation rules
In addition to the above tests, new debt creation rules have been enacted with the new thin capitalisation amendments, which can also operate to deny debt deductions. The debt creation rules will apply from 1 July 2024 and to general class investors (as explained above) and certain outward and inward investing financial entities. Importantly, there is no grandfathering of pre -1 July 2024 arrangements, so that the rules will require the analysis of prior year arrangements.
Again, of assistance to SMEs, the $2 million de minimis threshold also applies to the debt creation rules.
There are two scenarios where the debt creation rules can apply.
First, where an entity acquires an asset or obligation from an associate and the entity (or one of its associates) incurs debt deductions in relation to the acquisition. Debt deductions are denied to the extent they are incurred in relation to the acquisition or subsequent holding of the asset.
Second, where an entity borrows from its associate to fund a paymentor distribution (including dividend, trust distribution, return of capital, etc) to that, or another, associate and incurs debt deductions in relation to the borrowing. Debt deductions are disallowed to the extent that they are incurred in relation to the borrowing.
Anti-avoidance matters
General Comments
While consideration of the anti-avoidance provisions in any detail is outside the scope of the paper, this section seeks to highlight that, aside from the specific rules already discussed, the potential for complications to arise under anti-avoidance provisions should also be borne in mind. Ideally, time should be taken for a wide ranging reflection on possible risks, if (unfavourable) surprises are to (hopefully) be avoided.
Possible application of anti-avoidance provisions to funding arrangements is most likely when there are changes to pre-exiting arrangements – versus initial set-up.
When changes are made, there are both:
tax costs/benefits to be actively considered; and
the tax benefits will typically be more discretely identifiable (in comparison to initial set-up) – because there will be ‘before’ and ‘after’ positions from which the tax benefits may be distilled.
In any case, it is practically more common for issues to arise on restructuring than on set-up. So it is important to take the time to seek to ensure the funding structures (any structures) are as fully considered as possible when initially implemented – with a view to the arrangements being flexible enough to accommodate foreseeable circumstances – so that future changes are minimised.
In pursuing flexibility, funding arrangements often seek to blend the usual legal characteristics of debt, equity or contractual ‘interests’ and their associated ‘returns’ (for example, implementation/use of special/variable shares or loan rights). Those ‘hybrid’ features may attract special interest when the ATO is considering the various anti-avoidance provisions – e.g. in considering the eight factors listed in section 177D ITAA36 to which regard must be had for Part IVA, or the ‘relevant circumstances’ listed in section 45B(8) ITAA36.
Risks can be enlivened from the very nature of the ‘hybrid’ features, not just when there are changes introduced. Above, in the discussion about ‘at call’ loans at section 4.4.2, it was noted that section 45B can apply to cause the repayments of (what might be thought to otherwise be simply) loan principal to be treated as an effective return of capital (non-share capital returns) – so that application of the testing under section 45B necessarily follows for any repayment.
Accordingly, initial implementation must be alert to any such exposure to anti-avoidance provisions inherent in the arrangements by their very nature.
But the risks generally and mostly increase when changes are made.
It is not possible to exhaustively list possible scenarios but some examples, to encourage awareness, are:
implementation of new special/variable shares – carrying risks of application of the dividend strip rules in section 177E where value is redirected between shareholders;
buy-back, redemption or cancellation of shares as investors/providers of funding exit/enter – possible section 45B concerns;
sale of equity with favourable tax outcomes (e.g. small business CGT concessions) with the new owner being funding by vendor finance – whether such funding may be taken to be indicative of the sale itself being ‘contrived’; and
streamed franked dividend distributions being loaned back – whether such funding may be questioned as having facilitated the provision franking credit benefits that may be disallowed under section 177EA.
Family trusts
There may be concerns where funds are sourced from associated trusts.
If the trust has made a family trust election, by use of trust monies (loans) or use of trust assets (leases/licences) by a company outside the family group, on anything other than clear supportable arm’s length terms, the ATO may seek argue there to be a distribution under Division 270 and section 272-60, that is subject to family trust distribution tax. See the ATO views and examples in TD 2017/20 such as Example 3.
Example 3 – interest-free loans by a business
33. The Phantom Family Trust has made an FTE and Kit Walker is the specified individual. The trust carries on a commercial retail business which sells goods to customers at market value. At no extra cost, a customer can request the business’s ‘no repayment for 12 months’ deal. This results in an interest-free loan from the trust to a customer for a year.
34. The benefit of the interest-free loan is a distribution transaction. However, in the circumstances it will be inferred that the amount or value of the interest-free loan does not exceed the amount or value of consideration given in return. The interest-free loan is on arm’s length terms and is an ordinary incident of a retail business carried on by the trust.
The ‘distribution transaction’ in this Example 3 is accepted by the ATO as matched by arm’s length consideration received in return, because it is part of a wider arm’s length dealing with an arm’s length customer.
But where such an interest free (or otherwise non-arm’s length on its own terms) loan is made as part of funding arrangements of an entity, closely held but outside the family group, that wider arm’s length context may not exist. Whether family trust distribution tax can apply will depend on that wider context – and it could be expected that issues will arise around whether the funding supports shares held by the trust itself or held by beneficiaries within the family group.
Example 2 from TD 2017/20, while about circumstances quite separate from questions of funding, gives a sense of the ATO’s thinking – that use of trust monies or assets by persons outside the family group should trigger family trust distribution tax.
Example 2 – use of holiday home, not an incident of a business
31. The Wonder Family Trust has made an FTE and Diana Prince is the specified individual. The trust owns a holiday home. The holiday home is used by Diana’s friends, for no consideration, for four weeks in the year.
32. This transaction is not on arm’s length terms nor an ordinary incident of a business being carried on by the trust. As no consideration is given in return for the use of the property, the full value of that use is a distribution within the extended meaning of ‘distributes’. But note the article by John Balazs in the Thompson Reuters Weekly Tax Bulletin for 21 June 2019 paragraph 862, about an unreported Federal Court case Mashed Potato Pty Limited v FCT, NSD1757/2018, with facts similar to this Example 2. In that case, the relevant objection to an ATO assessment imposing family trust distribution tax was allowed in full but – as the ATO reversed its position, at the invitation of the court – there were no reasons for decision published.
The article notes that the taxpayer’s submissions were:
1. First, as a matter of construction, FTDT could only be imposed if the (deemed) distribution was made to a beneficiary. In other words, while s 272-60 extended what was a distribution to include the use of the property by someone outside of the family group, that person still needed to be a beneficiary for the tax to be triggered.
2. Secondly, if the Commissioner’s construction of the section was correct, the distribution was made to Mrs H and not to her friends.
3. Thirdly, as MPPL had passed a resolution resolving to distribute all the income for the income year to Mrs H and there had been no diminution in the capital of the trust, no amount could be taxed.
No change to TD 2017/20 has yet been made to reflect whatever basis the ATO adopted to reverse its position in this unreported case.
Section 100A?
There may be issues where there is a use of trust monies (loans), or use of trust assets (leases/licences), by a company (even one within the family group) on anything other than clear supportable arm’s length terms, when the underlying trust income represented by those loan funds or the value of that asset has previously been distributed to beneficiaries with lower tax rates (but the entitlement is typically left unpaid, with the value to be retained in the trust).
The ATO might seek to argue that, by the use of the trust assets for funding the company in this manner, the elements of section 100A (regarding trust reimbursement agreements) are satisfied, so as to seek to tax the prior income distributions (effectively the funding value) to the trustee.
Footnotes
Such distributions may be via a special dividend or a selective buyback. ↩︎
Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Act 2024 (Cth) Sch 2 Pt 1 s 24. ↩︎
Explanatory memorandum to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity And Transparency) Bill 2023 (Cth) [2.159]. ↩︎
Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Act 2024 (Cth) Sch 2 Pt 1 s 23. ↩︎
On 13 December 2023, the NSW Court of Appeal (comprised of Ward P, Payne JA and Basten AJA) handed down the decision Chief Commissioner of State Revenue v Integrated Trolley Management Pty Ltd [2023] NSWCA 302. The decision focuses on the application of the employment agent provisions in the Payroll Tax Act 2007 (NSW).
As the first Court of Appeal decision to consider the application of the UNSW Global ‘in and for’ test in detail, it is an important case for payroll tax practitioners to be familiar with.
Background
This article follows from our article published on 15 December 2023 about the key developments in 2023 in relation to the payroll tax treatment of payments to contractors. In that article we provide some background to the employment agent provisions, the UNSW Global ‘in and for’ test and the first instance decision, Integrated Trolley Management Pty Ltd v Chief Commissioner of State Revenue [2023] NSWSC 557.
Before turning to the Integrated Trolley Management appealdecision, below we briefly repeat the critical background points.
The employment agent provisions are engaged where there is an ‘employment agency contract’
as defined. This requires there to be a contract under which a person procures the services of
another person ‘for a client’. In 2016, in UNSW Global Pty Ltd v Chief Commissioner of State Revenue (2016) 104 ATR 577, White J concluded that the words ‘for a client’ should be read as ‘in and for the conduct of the business of the client’ (at [62]) (often called the ‘in and for’ test).
The Integrated Trolley Management decisions concern payments from Integrated Trolley Management Pty Ltd (ITM) to contractors to perform trolley collection and cleaning services under contracts it has with Woolworths, ALDI and IGA. At first instance, Parker J found that those payments were not captured by the employment agent provisions (and therefore, not subject to payroll tax). The NSW Court of Appeal has allowed the Chief Commissioner’s appeal to Parker J’s decision.
The appeal decision
Basten AJA gave the leading judgment with Ward P and Payne JA each agreeing with his Honour’s reasoning (and providing their own additional reasons).
The following key points can be gleaned from Basten AJA’s judgment regarding the definition of employment agency contract and the ‘in and for’ test:
The contract to examine in identifying an employment agency contract is the one between the putative employment agent and the client (rather than the contract between the putative employment agent and the service provider) (see [27]-[39]). Basten AJA rejected Parker J’s position that the subject contract is that with the service provider.
The focus is on an objective analysis of the contract. The actual operation of the agreement provides little guidance as to its characterisation (see [111]). In most cases, a fact-sensitive analysis, going beyond an analysis of the contractual arrangements and the nature of the client’s business, is not necessary (see [112]).
The ‘in and for’ test requires the identification of: (i) the work to be done by persons who provide the services to a client; and (ii) the nature and ordinary conduct of the client’s business (see [49]). It is the relationship between these two matters which determines the application of the definition of employment agency contract.
In considering this relationship, a potentially valuable inquiry is whether the client might conduct its business by directly employing the individuals and whether those individuals work in much the same way as they would if they were employees of the client. This involves a comparison to a hypothetical scenario where the client directly employs the individuals including consideration of the degree of control which would be exercised, whether employees would be maintained on a regular and continuous basis and whether the nature of the services would be different (see [86]-[91]). Below we refer to this analysis as the Hypothetical Employee Comparison.
Indicia considered in previous cases will rarely be of assistance to the analysis and the language used by judges in applying the test ‘cannot, and should not, be relied upon as establishing a legal principle’ (see [40]-[54] and [113]).
Basten AJA and Payne JA each separately considered several indicia raised by the parties regarding the ‘in and for’ test (see [63]-[85] and [96]-[101] (Basten AJA) and [14] (Payne JA)). Ward P did the same by reference to the factors listed by Payne JA (see [5]).
Below we comment on three of the more contentious indicia considered.
Control
Payne JA found that Woolworths, via its contract with ITM, exercises reasonably close control over the activities of trolley collection workers. His Honour said that this pointed to the services being supplied in and for the conduct of the business of Woolworths (see [12] and [14(6)-(7)]).
Basten AJA mentioned that the contract ‘made ITM liable for compliance by service providers with … directions given by Woolworths’ representatives’(at [85]). His Honour then considered the Hypothetical Employee Comparison and concluded that ‘[h]ad such a test been applied in the present case, a high level of similarity between the situations should have been accepted, given the proper construction of the agreement between ITM and its clients’ (at [91]). Notwithstanding the warnings that indicia used in previous cases will rarely assist future applications of the ‘in and for’ test, it appears that a contractual right of control by a client over service providers (under the contract between the client and putative employment agent) may often be a strong indicator that the service providers are working in and for the conduct of the client’s business in the context of the Hypothetical Employee Comparison. This is because a contractual right of control is a hallmark of an employer-employee relationship and therefore, a client’s contractual right of control over service providers suggests that the service providers are working in much the same way as employees would be.
Working for multiple stores simultaneously
There was evidence given that some of the trolley collectors simultaneously worked for more than one store at the same shopping centre.
Payne JA rejected this factor as being persuasive to his consideration given the limited evidence (at [14(9)]). Basten AJA also took issue with the lack of detail in the evidence and any finding based on it (see [63]-[68]).
Significantly, Ward P hesitated in reaching her conclusion principally because of this factor (without explaining the basis of her Honour’s hesitation), although, her Honour accepted that there was limited evidence on the issue (see [5]).
When this factor is considered under the Hypothetical Employee Comparison, it can be seen how it might have supported ITM’s contentions (if better evidence was given). If Woolworths employed trolley collectors directly, would it permit the trolley collectors to simultaneously work for its competitors? If not, this might demonstrate that the trolley collectors (at least those that simultaneously work for other stores at the same location) do not work in much the same way as they would if they were employees of Woolworths.
Uniforms
The trolley collectors wear ITM branded uniforms or in some cases a sticker saying ‘visitor’.
Contrary to previous cases that have found uniform branding to be important to this analysis (e.g. Bayton Cleaning Company Pty Ltd v Chief Commissioner of State Revenue (2019) 109 ATR 879), Basten AJA and Payne JA both found that this factor is not relevant (at [14(2)] and [97]-[98]). Both their Honours’ reasoning focuses on their findings that customer perceptions about the identity of an employer is unlikely to cast light on the statutory question.
However, it can again be seen how this factor may be relevant (in some circumstances) in the Hypothetical Employee Comparison. If, in the hypothetical scenario where the client directly employs the service providers, the client would require the service providers to wear uniforms with its own branding (but under the actual arrangements, the service provider does not wear client-branded uniforms), this may assist in demonstrating that the service providers do not work in the same way as they would if they were employees.
Concluding remarks
As at the time of writing, ITM has not appealed the decision to the High Court and the ordinary 28 day appeal time limit has elapsed (on 10 January 2024). Accordingly, this decision should stand as the leading authority on the application of the ‘in and for’ test for the immediate future (unless the High Court dispenses with the 28 day time limit).
The decision will be useful to practitioners by providing authoritative guidelines regarding the application of the ‘in and for’ test (refer to the bullet points above). However, the test remains complex to apply and the case law will no doubt continue to evolve as further cases consider the ‘in and for’ test in light of this appeal decision.