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In a recent Federal Court case the ATO has been dealt a bitter blow on its views as to how important anti-avoidance provisions operate.
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Commissioner’s anti-avoidance arguments found wanting
05 January 2022
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Introduction
Beginning with a quotation from Dr Carl Jung regarding the term “synchronicity”, Logan J of the Federal Court has systematically abolished the arguments of the Commissioner of Taxation (“the Commissioner”) in Guardian AIT Pty Ltd as trustee for the Australian Investment Trust v the Commissioner and the related proceedings of Alexander Springer v the Commissioner [2021] FCA 1619.
For accountants and tax agents serving the SME market, this is probably the most important tax case in 2021. Decided on 21 December 2021, it is somewhat of a Christmas present for the industry. The case is important because it deals with section 100A and part IVA, both found in the Income Tax Assessment Act 1936.
The ATO has indicated in various forums that it may be moving towards a much broader view of the types of transactions to which s.100A can apply. Also, a long-awaited draft ruling on this provision is due to be released early in 2022. I suspect that this decision may delay the release of this draft ruling (again).
Facts
Here are the players in this matter.
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Guardian AIT Pty Ltd (“Guardian AIT”) is the trustee of Australian Investment Trust (“AIT”). AIT is a discretionary trust. Alexander Springer (“Mr Springer”) is the sole shareholder of Guardian AIT, but not a director. AIT is an Australian resident trust and Mr Springer, in the years in question, was an (undisputed) non-resident of Australia for tax purposes.
A new company was incorporated in June 2012, AIT Corporate Services Pty Ltd (AITCS). All of the shares in this company were owned by Guardian AIT as trustee for AIT. AITCS was made a beneficiary of AIT. So, the trustee owned all the shares in a company that was also a beneficiary of the trust.
Understanding the facts is important. This is what happened:
28 June 2012 – Guardian AIT distributed $2,640,209 to AITCS. The distribution was recorded as an unpaid present entitlement.
17 April 2013 – AITCS paid its income tax liability by drawing on the unpaid present entitlement in the amount of $792,062.
1 May 2013 – AITCS declared a fully franked dividend to its shareholder (Guardian AIT as trustee of AIT) in the amount of $1,848,145.
23 June 2013 – Guardian AIT resolved to distribute all of the fully franked dividends it received to Mr Springer. No withholding tax would have been paid on this distribution. Further, no further tax was paid by Mr Springer due to the operation of the withholding tax provisions.
23 June 2013 – Guardian AIT distributed $2,646,166 to AITCS. This was recorded as an unpaid present entitlement.
14 February 2014 – AITCS paid its income tax liability by drawing on the unpaid present entitlement in the amount of $595,845.30.
27 February 2014 – AITCS declared a fully franked dividend in the amount of $1,780,453 to the trust. Again, that dividend was paid by reducing the balance of the 2013 unpaid present entitlement of AITCS to nil.
23 June 2014 – Guardian AIT resolved to distribute all of the fully franked dividends it received to Mr Springer.
23 June 2014 – Guardian AIT distributed $2,670,117 to AITCS. This was recorded as an unpaid present entitlement.
20 March 2015 – AIT paid AITCS’ 2014 tax liability, thereby reducing the 2014 unpaid present entitlement to $1,869,083.
Around June 2015 (by implication) – Guardian AIT made a further distribution to AITCS of $1,471,775.
18 March 2016 – AITCS and AIT entered into a division 7A loan agreement for the balance of the 2014 unpaid present entitlement.
31 March 2016 – The tax liability of AITCS in relation to the 2015 income year was paid by the trustee (it is assumed).
2 May 2016 – The trust repaid the balance of the loan owed to AITCS.
The result
From the above it will be seen that a total of $7,956,492 (relevant to this case) was distributed by Guardian AIT as the trustee of AIT to AITCS. AITCS paid tax on those distributions at the prevailing corporate rate of 30 per cent. The after-tax amounts were paid as fully franked dividends back to the trust and the trustee distributed these dividends to Mr Springer. No tax was paid on the distributions by Mr Springer. Accordingly, the tax on the profits was capped at the corporate tax rate.
The ATO did not like this outcome. It thought this was a “reimbursement agreement” or a “scheme” to stop Mr Springer from paying tax on the amounts he received at non-resident tax rates.
It thought that a “reimbursement agreement” had been entered into under s.100A or, in the alternative, part IVA applied. The ATO raised assessments against Guardian AIT under s.99A Income Tax Assessment Act 1936 on the view (as per s.100A) that no beneficiary was presently entitled to the fully franked dividends received by the trust from AITCS. This meant assessment at the top marginal tax rate on the trustee. Also, the ATO applied a 50 per cent penalty. This resulted in assessments totalling $5,549,653.10 to the trustee under s.100A.
Alternatively, the Commissioner raised assessments to Mr Springer under part IVA. These assessments totalled $5,324,555.10.
The taxpayer wasn’t happy. Eventually, Logan J of the Federal Court was asked to preside over the dispute.
The decision
Logan J decided neither s.100A nor part IVA applied to these events.
An important background fact was that Mr Springer was in the process of permanently retiring. Although originally from Canada, Mr Springer had migrated to Australia and had a number of business interests, most of which were quite successful. Mr Springer was a wealthy man, according to the Federal Court.
As part of his retirement planning, Mr Springer wanted to set up a “clean skin” entity in which he could accumulate wealth without there being risks from his former business activities. This is why AITCS was incorporated. Logan J made it very clear that he thought this was the reason for the creation of the company and that there was not a tax avoidance motive involved. This was supported by Mr Springer’s evidence and the evidence of a partner of Pitcher Partners, Mr Nigel Fischer. Logan J was very impressed by both of these witnesses, which, no doubt, added believability concerning the motives behind the events set out above.
The court found that, on his own initiative, Mr Springer caused AITCS to be incorporated with Guardian AIT (as trustee) holding 100 per cent of the shares. He did not take advice from Pitcher Partners in respect of this.
There is a long explanation in the case as to the reasons for the decision of Logan J. I will summarise his decision on the two main provisions. Why these decisions were made are instructive when considering the operation of the problematic provisions of s.100A and part IVA.
Section 100A
Logan J reinforced the view, decided in prior cases, that the reimbursement agreement must precede making a beneficiary presently entitled and the payment of benefits to the (in substance) beneficiary. On the facts, Logan J held that there was no such agreement that preceded these events. The payment of the dividends to AIT and then their subsequent distribution to Mr Springer were not in contemplation at the time AITCS became presently entitled to the distribution from AIT.
Very broadly, s.100A attacks what is known as “trust stripping”. This is where a beneficiary (in form) receives a distribution from a trust but (in substance) another person or entity benefits from that distribution. When it operates, it deems no beneficiary to be presently entitled to the income to which the section relates. This results in the trustee being assessed at the top marginal rate.
Reimbursement agreement
For s.100A to operate, there must be a “reimbursement agreement”. This term is rather awkwardly defined in the law, but the two key things that are required are:
- Someone pays no tax, or less tax due to the reimbursement agreement.
- The reimbursement agreement cannot be one that has been entered into in the course of ordinary family or commercial dealing.
The section requires that an alternative to what actually happened is postulated. This alternative postulate must posit that someone would have paid more tax had the reimbursement agreement not been entered into. The taxpayer has the onus of showing that this alternate postulate would not have occurred.
The ATO posited that absent the “reimbursement agreement” (as defined by the ATO), Mr Springer would have been the beneficiary assessed on the distributable income of AIT. At non-resident tax rates, this would have resulted in a good deal more tax than had been collected from AITCS.
However, the court held: “The documents contemporaneous to June 2012 reveal a complete absence of contemplation by anyone in Pitcher Partners or Mr Springer personally that AITCS be used as a vehicle for streaming via dividend payments. Axiomatically, in law that was possible but that was never a feature of any prior plan” (paragraph 150).
The taxpayer submitted that the only two rational and reasonable counterfactuals as to what would have occurred in the 2012 income year, absent the Commissioner’s posited reimbursement agreement, were either that AITCS would have received and retained in full its unpaid present entitlement in cash, as it in fact did in respect of the 2014 unpaid present entitlement, or it would have invested it with Guardian AIT in accordance with a division 7A compliant loan agreement, as it did on 12 April 2013, before the dividend was paid in that income year. The court agreed with these submissions. It did not agree that the distribution of the franked dividends to Mr Springer by the trust was a valid counterfactual.
Ordinary family or commercial dealing
Logan J also held that what occurred was entered into in the course of ordinary family or commercial dealing. The creation of AITCS as a corporate beneficiary was part of the risk minimisation strategy required by Mr Springer as part of his retirement plans. The creation of a “clean skin” corporate beneficiary was an unremarkable part of that process. This had nothing to do with a tax avoidance motive. Mr Springer wanted to accumulate wealth in a risk-free environment and the court held, despite the protestations of the Commissioner, that this is exactly what happened.
S.100A requires the reimbursement agreement to provide for “the payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary or the beneficiary and another person or other persons”. The court held that there was only an agreement to pay money to the beneficiary, being AITCS and not any other party (e.g. Mr Springer). Accordingly, the agreement could not be a reimbursement agreement.
Part IVA
The court also needed to deal with the alternative assessments raised on Mr Springer. These were raised pursuant to Part IVA, the general anti-avoidance provision of the Australian income tax law.
For Part IVA to have operation, among other things, there must be a scheme that has the sole or dominant purpose of achieving a tax benefit (as defined in s.177C). This provision also requires the positing of an alternative postulate, as discussed above. Logan J held that the dominant purpose of the primary scheme defined by the Commissioner was the minimisation of risk. According to the court, this was always the “ruling, prevailing, or most influential purpose”.
Logan J also held that the Commissioner’s posited counterfactual was not just something that might not reasonably be expected to have occurred but for the primary scheme. It was “against all reason” (paragraph 188). Putting it plainly, the court held that the raising of the assessments on Mr Springer was unreasonable. “The Commissioner’s postulated distribution to Mr Springer would never, ever have occurred” (paragraph 189).
Synchronicity
Returning to Dr Jung – synchronicity – “events which coincide in time and appear meaningfully related but have no discoverable causal connection” (paragraph 1 of the decision). According to Logan J the Commissioner saw a meaningful relationship between particular events attended with adverse fiscal consequences, whereas the taxpayers contended that, in terms of adverse fiscal consequence, no such meaningful relationship existed – only synchronicity. That is, the Commissioner looked at the events, with the benefit of hindsight, and saw clear tax avoidance to be punished by a 50 per cent penalty. The court looked at the events and saw no such thing. It only saw synchronicity.
Is this commencement of the “synchronicity” defence in anti-avoidance cases?
What now?
Due to the importance of this case to what is believed to be the ATO’s approach to s.100A, I think it likely will appeal to the Full Federal Court to overturn this decision. I also expect that the long-awaited draft ruling on the operation of s.100A will be further delayed.
If this decision stands, the ATO will need to undertake some serious reconsideration of its views about s.100A.
John Jeffreys CA CTA is an experienced tax professional who specialises in providing tax consulting advice and tax training to accountants and tax agents in public practice.
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