Involved “associate” issues come up frequently on this blog. For instance:
- Minority SMSF investors and related unit trusts
- Why setting up offshore companies for Australians is a tricky business
In this piece I am looking at some core associate rules concerning income tax deductions: how the Income Tax Assessment Acts (ITAA) can restrict income tax deductions for payments, including salary and wages, where the person in receipt is a relative or associate.
Example – mischief to which s26-35 of the ITAA 1997 is directed
Let us say X owns a business which employs X’s son Y and daughter-in-law Z. The business is profitable and X pays tax on income from the business at a high marginal rate. Y and Z only have assessable income from their salary from working in the business and both pay income tax at a lower rate than X. To give Y and Z a helping hand and so X, Y and Z pay less income tax overall X pays Y and Z overly generous salaries taking into account the age, experience, extent and profitability of the work that Y and Z do in the business.
How s26-35 applies
Section 26-35, which operates together with section 65 of the ITAA 1936, to cover off on payments to individuals including payments routed through partnerships, trusts and companies, reduces the deduction for salary and wages X is allowed to the amount the Commissioner of Taxation (Commissioner) considers reasonable based on the nature of the duties performed by, the hours worked by and the total remuneration of the relative. The excess is not deductible.
The section is not punitive: sub-section 26-35(4) operates to treat the non-deductible part of the payment the relative receives as non-taxable (NANE income) to the relative. So in the example assessments of income of X, Y and Z are all in the frame for adjustment by the Commissioner so the reduction in the tax deduction for salary and wages to X can be effected.
Income tax return requirements
The onerous part of section 26-35 is that X must keep sufficient records to substantiate that the payments to relatives claimed as deductions are reasonable. As usual a taxpayer needs to self assess and the burden of proving a payment, such as of salary, is reasonable is on the taxpayer: see our blog The burden of proof in a tax objection
In support of a claim of a reasonable deduction for a payment paid to relative a taxpayer such as X must also return the total of all payments made to associates in their income tax return. This is a flag to the Commissioner that deductions have been claimed for payments to relatives and, for a safe harbour to support the total associate payments deducted, the Commissioner states that a taxpayer needs to keep:
- full name of relative or other related entity
- age, if under 18 years of age
- nature of duties performed
- hours worked
- total remuneration
- salaries or wages claimed as deductions
- other amounts paid – for example, retiring gratuities, bonuses and commissions.
for the Commissioner’s inspection. In the 2022 income tax return X might complete this item is:
with amounts comprising total associate payments deducted returned at item G item P15, These records need to be kept even if, in the view of the taxpayer and his or her advisers, the payments made by the taxpayer to relatives are reasonable and say even align with award entitlements.
The regime catches payments to partnerships where a partner is a relative however a payment by a partnership to a partner (of the same partnership) who is a relative of another partner (of that partnership) is not caught: proviso in sub-section 26-35(3). Hence the above records are not required in the context of deductible payments made to say a wife partner by a husband and wife partnership. (Not of partnership [agreement] “salary” which is not deductible in any case.)
A payment of a deductible superannuation contribution by X as an employer for Y or Z is also not necessarily caught by this regime where the payment is not to a relative either directly or indirectly via a company, trust or partnership within the section 26-35 of the ITAA 1997 and section 65 of the ITAA 1936 regime. The relative is less likely to become entangled in this regime where the relative is not an individual trustee of the superannuation fund contributed to by X.