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A recent AAT case serves as a useful reminder of several very basic, but also very important, propositions relevant to tax law and practice. The taxpayer, together with 2 other individuals, had acquired 6 mining tenements between 2004 and 2006. They purported to transfer the tenements to a company associated with 2 of them, although there was no change in the formal ownership of the tenements and a subsequent sale of some of them to an unrelated company described the individuals (rather than that associated company) as the owners of the tenements. The other tenements were also subsequently sold to unrelated companies.
The taxpayer argued that he did not receive any sales proceeds – they were received by the associated company and one of the co-owners of the tenements. The Tribunal nevertheless held that the taxpayer was properly assessed on the profits from all sales and the Commissioner's amended assessments, including substantial penalties, were upheld. The several important propositions that are reinforced by this case are:
Tax applies on the basis established by the legal position according to the application of the general law. The purported sale of mining tenements to the associated company in this case was ineffective under basic contract law – there was no consideration. So the taxpayer and his partners retained ownership of the tenements until the sale to unrelated parties.
The profits on sale of the mining tenements were of a revenue nature and liable to be taxed as ordinary income. The tenements were also no doubt CGT assets and subject to the CGT regime, but that is of no help if the profits constitute ordinary income in any case (typically, any capital gains will be reduced to the extent of any amount included in assessable income).
Ordinary income will still be assessable to the taxpayer, despite non-receipt, if non-receipt is because the income ‘is applied or dealt with in any way on [the taxpayer's] behalf or as [the taxpayer] direct[s]’ (s6-5(4)).
Unless there is specific provision otherwise, an agreement cannot have retrospective effect for taxation purposes (even though having retrospective effect under the general law in some cases) – an agreement in this case between the taxpayer and his partners with the associated company, made after the commencement of ATO audit activity, was described by the Tribunal as ‘an attempt to rewrite history.’(Kirkby v C of T [2014] AATA 759)
The Federal Court has recently sanctioned an agreement between the ATO and the directors (husband and wife) of a corporate trustee of an SMSF, for substantial penalties and costs – $40,000 and $10,000 respectively, in aggregate. The Commissioner had already disqualified each of the directors from acting as a trustee, investment manager or custodian of a superannuation entity under s126A(2) of SIS.
The trustee bought a residence in which the directors’ son lived without paying rent, spend money on a number of things from which no income was produced (a caravan, cattle, 2 cars that were garaged with the directors’ 2 sons, etc) and some expenditure could not be explained. Apart from the cost of the residence, the costs paid (including further costs after the SMSF auditor had filed a Contravention Report) were debited to loan accounts in the names of the directors, amounting to over $250,000.
Despite the penalties, the directors got off lightly – the amounts were paid back to the SMSF by the directors from other funds and the Commissioner did not make the fund non-complying. The other thing of note is that the penalties in this case were under the civil penalty rules. Under the new administrative penalty regime that started on 1 July 2014, the Commissioner can apply penalties for breaches without seeking any order of the Court. (DC of T v Graham Family Superannuation Pty Ltd [2014] FCA 1101)
Practitioners commonly look to the trust deed of a trust as the source of its terms and powers of the trustee. The trust deed is a very important source, but it is complemented by a vast body of Judge-made law and the Trusts Act 1973 (Qld) (and its counterparts in other States) and other legislation.
In this case, the trustees of 2 separate discretionary trusts (though both relating to the same family) successfully applied to the Court under s94 of the Trusts Act 1973 for the vesting dates to be extended to a maximum of 80 years. The Judge held, largely by reference to cases decided on the equivalent NSW provision, that he was authorised to grant the orders and that indeed he should.
Apart from support for the applications from the family members who could benefit from the trusts, the main evidence relied upon and upon which the Court granted the applications, was the substantial capital gains tax and duty liabilities that would result upon vesting of the trusts. Under the trust deeds, vesting was to occur no later than 16 February 2017.
In this context, I note that (subject to the drafting of the trust deed) the rule against perpetuities only requires that interests in the trust property be fully vested within the requisite time, not that the trust be wound up. And vesting without winding up can be done without triggering a CGT event or incurring duty (Qld duty, at least) – but that's another story. (Re Arthur Brady Family Trust; Re Trekmore Trading Trust [2014] QSC 244)
I referred in our Tax Facts of 24 September to the release by the Commissioner of draft guidelines on how the ATO will assess the risk of Part IVA potentially applying to the allocation of profits from a professional firm carried on through a partnership, trusts or companies. In correspondence to Chartered Accountants Australia New Zealand, the ATO has sought to clarify the third alternative criterion that will reduce the risk of ATO audit – that the principal and their associated entities have an effective tax rate of at least 30% on the income from the firm.
The ATO says that its intention is that each principal of the firm, and also each associated entity that receives practice income, has an effective tax rate of at least 30%. Further, that measure is to be applied to taxable income, after deductions such as super contributions and prior year losses. Although it is still not clear, the 30% threshold seems to imply an average tax rate of at least 30% – coincidentally, a taxable income of $180,000 will result in an average tax rate (apart from Medicare) of just over 30%.
The Commissioner has released a Decision Impact Statement regarding the decision of the Full Family Court in C of T v Darling [2014] FamCAFC 59. In that case, the Commissioner was successful in obtaining access to parts of the court file for the purposes of a tax audit, although not a party to the case.
The Court in that decision made specific reference to its practice to refer matters to the relevant authorities where it becomes apparent in the course of a case that there has been tax evasion. My understanding is that the Federal Court has a similar practice, although it is less common in State Supreme Courts.
Indeed, in a recent Federal Court matter where I was engaged as an expert witness relating to tax issues, there was an expectation that one of the reasons that the other side may want to settle was that those parties would come to the realisation that the Court would be likely to refer the matter to the ATO if it proceeded to hearing. It seemed very likely that those parties had wrongly claimed the small business CGT concessions in respect of substantial capital gains on the business sale to which the Court action related.
It was also very interesting in that matter to see how much incriminating evidence relating to the doubtful tax claims, in e-mail correspondence between various parties both before and after the time of the sale, had been uncovered through the court discovery process.
The ATO intends to resume its consultation process in October in order to finalise its view on whether unpaid trust entitlements may be deducted for the purposes of the $6M net asset value test. Consultation had been suspended pending the outcome of the AAT decision in Pope v FC of T (referred to in our Tax Fax of 27 August). In that case, the Commissioner successfully argued that no bad debt deduction was allowable to a trust beneficiary under s25-35 in relation to a UPE that the trustee could not pay, although the basis of that decision rested on the terms of the particular trust deed involved.
Of course, whether a UPE may be deducted for the $6M net asset value test may be academic if the beneficiary is the relevant taxpayer or one that is an affiliate of or connected to the relevant taxpayer, and the UPE must be counted as a CGT asset in any case.
We should have no doubts about the Commissioner's interest in whether claims for the small business CGT concessions are legitimate, both as to compliance with all relevant requirements and matters of valuation relating to the $6M net asset value test. In an AAT case handed down last week, it was held that a husband and wife did not satisfy the (at the time) $5M net asset value test and additional assessments by the ATO on capital gains of approximately $2.15M and $1.6M were upheld by the AAT. The capital gains related to the sale by the taxpayers of their shares in a family company that conducted a successful business.
Many of the taxpayers’ problems related to termination payments of $1.925M and $0.825M that the husband, as sole director of the company, resolved should be paid to them on termination as a result of the sale. That resolution was made on advice from their accountants – before execution of a formal contract, but after acceptance by the taxpayers of a written offer from the purchaser. The taxpayers argued that their acceptance of the offer was not the time of the CGT event and that, by the time when the CGT event did occur, the company had liabilities for the termination payments to be paid to the taxpayers. This argument was rejected on a number of different bases, the AAT concluding that the termination payments of $1.925M and $0.825M were not to be deducted in computing the $5M net asset value test and that, consequently, the taxpayers failed that test and were not entitled to access any of the small business CGT concessions.
The AAT decided that there was no liability at all for the termination payments – in terms of contract and corporations’ law, the company director's resolution to pay the termination payments was unenforceable. Even if the Tribunal was wrong about that, it held in any case that the obligation arose after the CGT event when the purchaser's offer was accepted. And, for good measure, the Tribunal also held that, even if it was also wrong about that, the termination payments were not assets being used for the personal use and enjoyment of the taxpayers (contrary to what they had argued), so had to be counted for the purposes of the $5M net asset value test as their CGT assets anyway.
Note the first point decided by the Tribunal, that the termination payments were unenforceable. That same logic applies to a company's decision to pay a bonus or some other additional remuneration to a director or employee, which is then claimed as a deduction by the company although not paid until the following year of income. If you have ever asked me about that point, you will recall that I have warned that there is usually no legal basis for the company's deduction (subject, of course, to any specific agreements in a particular case), even though the ATO as a matter of practice seems to regard ‘a properly authorised resolution’ (refer to IT 2534) as sufficiently committing the company to payment. (Scanlon v C of T [2014] AATA 725)
Tax planning arrangements can fail for a number of reasons. One of those reasons has little to do with technical tax rules. With a real-life example, this episode of Tax Solutions illustrates how tax planning can go wrong because of a fatal legal flaw in the underlying transactions or circumstances on which the tax plan is based. With the result that the practitioner involved is highly exposed.
The small business CGT concessions provide very substantial benefits in situations where they apply. And given the policy intent to direct the concessions to business assets, one of the central conditions that must normally be satisfied is the ‘active asset test’.
This episode of Tax Solutions emphasises a class of CGT assets that achieve a special status for the purposes of the small business CGT concessions. Those assets continue as active assets indefinitely – retaining that status even long after they have ceased being used in any business controlled by the owners!
Widely drafted beneficiary classes in discretionary trusts can create headaches in dealing with various State taxes. A recent example is Victoria’s new 3% additional duty on foreign buyers of residential property – where a trustee is the buyer and a family beneficiary lives overseas. A starker example that applies in all States and Territories is payroll tax grouping of businesses controlled by family relatives, where at least one of the businesses is operated by a discretionary trust.
Having extraordinarily wide beneficiary classes is an outdated practice that creates problems, rather than serving any useful purpose. There is really no point in including a whole range of relatives who are never intended to benefit. A narrow class of beneficiaries is required, with a simple and practical mechanism to add others to whom it is desired to distribute.
Frustrations with ATO views about UPEs of corporate beneficiaries have led to companies more frequently being used to acquire and operate small and medium sized businesses. But the problem is not discretionary trusts owning businesses, it is Division 7A. And there will usually be ways to deal with Division 7A anyway.
Some advisers believe that a business owner can still access the small business CGT concessions on a future business sale, by selling shares in the company that owns the business. But how realistic is it to hope that that is the way things will turn out. This edition of Tax Solutions emphasises 2 reasons why clients with a business owned by a company may not actually benefit from the CGT concessions.
One of the best things you will ever do for some of your small business clients is to deliberately trigger a CGT event and capture the small business CGT concessions. In the right client circumstances, this strategy can produce several very substantial benefits. That will particularly be so if 100% CGT exemptions can be achieved without duty applying to the transaction.
A restructure for this purpose should always be kept in mind, particularly for clients who may grow to the point where they can no longer satisfy either the $2M turnover test or $6M net asset value test. But it warrants greater consideration at the moment, given the apparent increased political risk of changes to CGT concessions.
