Changing the trustee of a trust – some elements for success

It is sometimes wrongly assumed that a minute of the current trustee is sufficient to change the trustee of:

  • a family discretionary trust (FDT); or
  • a self managed superannuation fund (SMSF) (which must be a trust with a trustee too – see sub-section 19(2) of the Superannuation Industry (Superannuation) Act (C’th) 1993 (SIS Act));

and that a change of trustee will have no serious tax consequences. The second proposition is more likely to be true, but not always.

FDTs and SMSFs invariably commence with a deed which contains the terms (the trust terms or governing rules – TTOGRs) on which the trust commences. That, in itself, is a reason why I contended in 2009 in Redoing the deed that an instrument or resolution less than a deed to change the trustee is prone to be ineffective even where change by less than or other than a deed is stated to be permitted by the TTOGRs in the trust deed.

Changing trustee relying on ability to change in the trust deed

It is thus to the trust deed that one needs to look to find:

  1. whether there is a power in the TTOGRs to appoint a new trustee or to otherwise change the trustee; and
  2. if, so, what the procedure or formalities are for doing so.

Changing trustee relying on the Trustee Acts

If ability to change trustee is not present, or is derelict, in the TTOGRs then the Trustee Acts in states (and territories) provide options for appointing a new or additional trustee which vary state to state.

Trustee Act – New South Wales

In New South Wales: section 6 of the Trustee Act (NSW) 1925 allows a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state.

However an appointment of a new trustee in these situations must be effected by registered deed: sub-section 6(1) That is the deed of appointment must be registered with the general registry kept by the NSW Registrar-General, which is publicly searchable, and the applicable fee to so register the deed must be paid to NSW Land Registry Services for the appointment to take effect.

It is apparent from sub-section 6(13) that registration of a deed of appointment is not required where ability to appoint a new trustee is in the TTOGRs where the TTOGRs express a contrary intention; that is: where the TTOGRs expressly and effectively allow an appointment to be effected without a registered deed.

Trustee Act – Victoria

In Victoria there is a comparable capability for a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in writing in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state;

under section 41 of the Trustee Act (Vic.) 1958. However this Victorian law does not impose any requirement that the required instrument of appointment in writing must be registered.

Changing trustee by obtaining a court order

The supreme courts of the states and territories are also given a residual statutory capability to appoint trustees under the respective Trustee Acts. However applying to a supreme court for an order to change a trustee of a FDT or a SMSF with sufficient supporting grounds is an option of last resort given likely significant costs and uncertainties of obtaining the order.

Changing trustee by deed

The TTOGRs in a trust deed of a FDT or a SMSF will frequently require that an appointment of a new trustee may or must be effected by a deed. It is desirable that it should do so to ensure the appointment of a new trustee does not become of a matter of uncertainty and difficulty for the reasons I have described in Redoing the deed.

Tax consequences of a change of trustee

As a change of trustee without more generally does not change beneficial entitlements under a trust, the tax consequences are usually benign:

For capital gains tax (CGT), assurance that changing trustee does not give rise to a CGT event for all of the CGT assets held in a trust is diffuse under the Income Tax Assessment Act (C’th) (ITAA) 1997:

Sub-section 104-10(2) concerning CGT event A1 states:

(2) You dispose of a * CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee.

Sub-section 960-100(2) with the Notes below it in fact say:

(2) The trustee of a trust, of a superannuation fund or of an approved deposit fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.

Note 1: This is because a right or obligation cannot be conferred or imposed on an entity that is not a legal person.

Note 2: The entity that is the trustee of a trust or fund does not change merely because of a change in the person who is the trustee of the trust or fund, or persons who are the trustees of the trust or fund.

Similarly sections 104-55 and 104-60 of the ITAA 1997 which concern:

• Creating a trust over a CGT asset: CGT event E1

• Transferring a CGT asset to a trust: CGT event E2

each restate the above Note: viz.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event E… will not happen merely because of a change in the trustee.

Stamp duty

A change of trustee can have stamp duty consequences where the trust holds dutiable property such as real estate.

Duty – NSW

Concessional stamp duty on the transfer of the dutiable property of the trust to the new trustee can be denied in NSW to a FDT unless the trust deed of the trust limits who can be a beneficiary, for anti-avoidance reasons: see sub-section 54(3) of the Duties Act (NSW) 1997.

Indeed Revenue NSW withholds the requisite satisfaction in sub-section 54(3) unless the TTOGRs provide or have been varied in such a way so that an appointed new trustee or a continuing trustee irrevocably cannot participate as a beneficiary of the trust. Contentiously satisfaction is withheld by Revenue NSW unless a variation to a FDT to so limit the beneficiaries is “irrevocable“ : see paragraph 6 of Revenue Ruling DUT 037, even though that variation may not be plausible or permissible under the TTOGRs of the FDT.

This hard line is taken by Revenue NSW to defeat schemes where someone, who might otherwise be a purchaser of dutiable property who would pay full duty on purchase of the property from the trust, becomes both a trustee and beneficiary able to control and beneficially own the property who is thus able to contrive liability only for concessional duty and avoid full duty,

Duty – Victoria

Although the Duties Act (Vic.) 2000 contains anti-avoidance provisions addressed at this kind of anti-avoidance arrangement, there is no comparable hard line to that in NSW in sub-section 33(3) of the Duties Act (Vic.) 2000 so that the transfer of dutiable property, including real estate, on changing trustee is more readily exempt from stamp duty.

Other requirements

A prominent requirement on changing trustee of a SMSF is notification to the Australian Taxation Office, as the regulator of SMSFs, within twenty-eight days of the change: see Changes to your SMSF at the ATO website.

Where changing trustee involves a corporate trustee then there may also be an obligation to inform the Australian Securities and Investments Commission of changes to details of directors of the corporate trustee, if any. There may be further matters to be addressed if any new or continuing directors are or will become non-residents of Australia and, with SMSFs, the general requirement in section 17A of the SIS Act that the parity between members of the fund on the one hand and trustees, or directors of the corporate trustee on the other, needs to borne in mind and, if need be, addressed.

Taking out tax when superannuation death benefits are paid to deceased estates and testamentary trusts

Confusion-Blue

Who pays tax and how much when a superannuation fund pays out death benefits to a deceased estate or to a testamentary trust is not intuitive. The two technical concepts of “dependant” and “taxable component” in particular are a source of confusion.

Dependant

There are two relevant kinds of dependant. The SIS Act kind of dependant (a spouse of the person, any child of the person and any person with whom the person has an interdependency relationship – section 10 of the Superannuation Industry (Supervision) Act 1993) notably differs from a death benefits dependant under section 302-195 of the Income Tax Assessment 1997 , a subset of (SIS Act) dependant, as a death benefits dependant excludes adult children who are not disabled or in an interdependency relationship. Such an independent adult child can be a (SIS Act) dependant in receipt of a death benefit from a superannuation fund but is not a (section 302-195 of the ITAA 1997) death benefits dependant.

Taxable component

For tax purposes a death benefit is split into a taxable component and a tax fee component. The tax free component is tax free to any dependant but the taxable component is a misnomer when paid to a death benefits dependant (DBD): it’s tax free too! So of the four permutations (tax free to DBD, tax free to Non-DBD, taxable to DBD, taxable to Non-DBD) it is when a death benefits dependant receives a death benefit comprising taxable component that the benefit becomes taxable.

Re-contribution

Superannuation benefits can be paid prior to death if a member has satisfied a condition of release such as reaching the age of 65 years. This can be a way of reducing the taxable component of a death benefit that might be taxable to a dependant when paid after the member’s death. Member benefits, viz. benefits withdrawn by a member during his or her lifetime, are generally not taxable to the member where the member has reached aged 60.  It is permissible to re-contribute withdrawn benefits as non-concessional contributions back into superannuation, which become tax free component, when later paid out by the superannuation fund as death benefits.

Non-concessional limits and caps on re-contribution

However the member must be within non-concessional contribution limits to re-contribute back into superannuation in this way. At over age 65 that involves meeting the work test and being within the non-concessional caps. That is being under:

  • annual non-concessional contributions of $100,000 p.a. (no bring forward allowed for over age 65s); and
  • a total superannuation balance of $1.6m.
A look at how a taxable death benefit is taxed

A payment of death benefit that flows to a beneficiary of a deceased estate is something of a three stage event. The tax system looks through to the ultimate dependant in receipt of the death benefit (the third stage) even though the trustee of the superannuation fund may simply be paying death benefits to the legal personal representative of the deceased member who is an allowable (SIS Act) dependant (the first stage).

Non-death benefits dependants only get lump sum death benefits

Only lump sum death benefits can be paid to a dependant who is not a death benefits dependant, such as an independent adult child, so ordinarily we are looking at tax at 15% on a “taxed element” (the usual source [element] of benefits from a SMSF) but other rates can apply: see this table of rates at the ATO website https://www.ato.gov.au/rates/key-superannuation-rates-and-thresholds/?page=12

A curiosity is that taxable lump sum death benefits received by the trustee of a deceased estate are not subject to the medicare levy. Taxable lump sum death benefits viz. taxable component received directly by a non-death benefits dependant from the trustee of a superannuation fund, that is, not indirectly from the fund via a legal personal representative deceased estate dependant, is subject to medicare levy and PAYG withholding.

No PAYG withholding on lump sum death benefit paid by the trustee of the superannuation fund

The ATO also confirms that a lump sum death benefit is not subject to PAYG withholding where it is paid to:

  • a death benefit dependant (tax free); or
  • the trustee of a deceased estate – this amount is taxed within the deceased estate broadly in the same way it would be taxed if it was paid directly to the beneficiary.

https://www.ato.gov.au/super/apra-regulated-funds/paying-benefits/taxation-of-super-benefits/?default

The trustee of the superannuation fund is obliged to provide a PAYG payment summary – superannuation lump sum form (NAT 70947) to the trustee of the deceased estate within fourteen days of the payment though.

Obligations of the trustee of the deceased estate

According to the 2018 trust tax return instructions at the ATO website https://www.ato.gov.au/forms/trust-tax-return-instructions-2018/?page=43

A superannuation death benefit paid to a trustee is taxed in the hands of the trustee in the same way that it would be taxed if paid directly to a beneficiary, that is, the portions of the payment are subject to tax to the extent the beneficiary is a dependant or a non-dependant of the deceased. There is no tax payable to the extent that the payment is made to dependants or eligible non-dependants of the deceased.

At stage two, the trustee returns the taxable portions applicable to the non death benefits dependants in the trust return so that the ATO can assess the tax payable by the trustee as if the estate beneficiary/non-death benefits dependant was being directly taxed (with the taxed element generally capped to 15%).

This tax is a final tax paid at the trustee of the deceased estate level so no tax at stage three! A trustee of deceased estate should not include taxable elements of a superannuation death benefit lump sum, otherwise returned and directly and finally taxed, in income in its tax return. Then these amounts will not be further taxed at stage three as income say of a resident adult beneficiary.

Declarations of trust and stamp duty on disguised conveyances

declare

Each of the state and territory duty jurisdictions include declarations of trust over dutiable property (typically real estate) as dutiable transactions in one form or another. Without a declaration of trust head of duty, or an apt anti-avoidance provision, conveyancing duties that would by paid on a transfer of the dutiable property to B can be avoided by A declaring that property is held on trust for B though still held legally (on title) by A. Duty on a declaration of trust generally applies at full rates chargeable against the value of the dutiable property and differs from the head of duty which applies to declarations of trust which are not made over dutiable property to which a concessional duty or, in some states and territories, no duty will apply.

Duty eagerly assessed on the mention of a trust

So the Commissioners of State Revenues Australia wide are eager to assess any document to duty which purports to contain a declaration of trust over dutiable property which could be viewed as either:

  • a transfer of beneficial interest in the property in substance; or
  • a disguised transfer.

Integrity of the state revenues

That zeal can be understood in the context of the integrity of state revenues. In New South Wales, where a “declaration of trust” is a dutiable transaction under section 8 of the Duties Act 1997, Revenue NSW will treat documents which foreshadow or even just mention a trust over dutiable property as dutiable. Hence those who have an eye to the duty implications of deeds and documents that impact dutiable property are justifiably cautious about using the expression “on trust” in a deed or document where dutiable conveyance of the beneficial ownership of dutiable property by that document is not intended.

Ambit declaration duty rejected in W.A.

A recent case in Western Australia shows that duty on documents that state that dutiable property is held on trust can be too readily assessed as a declaration of trust by state revenue. The W.A. Court of Appeal in In Rojoda Pty Ltd v. Commissioner of State Revenue (WA) [2018] WASCA 224 decided against the Commissioner where two deeds of dissolution of partnership in that case explicitly stated that a partner, the surviving registered owner of land, held dutiable property on trust for other surviving partners of the partnerships. The Court of Appeal found that the dissolution of two partnerships involving family members, whose business included property ownership and investment, were not declarations of trust and were not dutiable as declarations of trust over dutiable property.

It was determinative in Rojoda that the trusts recited in the deeds were confirmatory of trusts that already existed. It was significant that the Court of Appeal, in overturning a decision by the State Administrative Tribunal, was prepared to examine the equitable implications and the relevant legal and beneficial interests of the partners just before and on the execution of the deeds of dissolution of the partnerships. The Court of Appeal found that the legal and beneficial interests of the partners, just before the deeds were executed, were sufficiently comparable to the interests set out to be on trust in the deeds and thus held the deeds established no new trusts and thus did not declarations of trust in the context of the W.A. head of duty.

Identifiable new trust needed for a dutiable declaration of trust

The land had been used as partnership property of the partnerships. The Court of Appeal found that the wife, who was the surviving registered proprietor of the land, already held the land for the partners, which included the children of the wife and the husband, or their representatives. They thus had specific and fixed beneficial or equitable interests in the partnership properties before the deeds prepared for the dissolution of the partnerships were executed. These interests, reflecting their respective proportionate share of partnership property, were comparable interests to those said to be held on trust in the deeds. Thus the Court of Appeal found the trusts set out in the deeds were not new trusts declared over property dutiable in W.A.

The High Court has granted the Commissioner of State Revenue special leave to appeal in Rojoda. This case will likely inform what amounts to a declaration of trust dutiable in state and territory stamp jury jurisdictions.

Aggregating for dual $6m MNAV tests following 2018 small business CGT concession integrity changes – with the aid of chess!

ChessPieces

Those seeking the small business capital gains tax (CGT) concessions in the 2018 and later income years need to be wary of modified small business CGT concession integrity rules which apply from 8 February 2018 by virtue of Schedule 2 of the Treasury Laws Amendment (Tax Integrity and Other Measures) Act 2018 (TIOMA).

The small business CGT concessions in Division 152 of the Income Tax Assessment Act (ITAA) 1997 may look straight forward but there are subtle complications within the misnamed “basic” conditions for the relief which can be matrixlike. The small business CGT concessions are generous so perhaps it is right that rules to protect their integrity, as ramped up by the TIOMA, are more complicated than the rules that ordinarily impose a CGT liability on sales of small business related CGT assets.

Share or interest sales need to meet additional basic conditions

For CGT events involving sales of shares in companies or interests in trusts “additional” basic conditions have commenced with the TIOMA. The additional basic conditions go further than what I describe here. In this post I wish to focus on the significance of the dual $6m maximum net asset value tests that the TIOMA initiates. So in the below considerations I am going to assume that the other basic conditions for the small business CGT concessions, including the additional basic conditions, such as the dual active asset test, which also needs to be considered following the introduction of the TIOMA, will be met.

The dual MNAV and SBE tests

The dual $6m maximum net asset value (MNAV) tests are alternative tests with the similarly dual small business entity ($2m aggregated turnover) (SBE) tests which apply where the small business CGT relief is sought on a sale of shares in a company or an interest in a trust. The dual MNAV tests and SBE tests separately test both the taxpayer (“you”) and the object entity which is the relevant company or trust in which the shares are or interest is held by the taxpayer as the case may be. To obtain relief under the basic conditions, and under the additional basic conditions set out in sub-section 152-10 as revised by the TIOMA, the dual tests must be separately satisfied to obtain any small business CGT concession relief:

Taxpayer must satisfy AND Object entity must satisfy
MNAV test or SBE test   Modified MNAV test or SBE test and carried on business up to day of sale

When the object entity MNAV test becomes vital

In practice, there is a significant slew of sales of shares or trust interests where the object entity won’t satisfy the SBE test because of:

  • an aggregated annual turnover of the object entity of more than $2 million; or
  • alternatively, the object entity may satisfy that SBE test but paragraph 152-10(2)(a) may apply because the object entity ceased to carry on its business some time before the sale.

In those cases the object entity also needs to satisfy the MNAV test even where the taxpayer has separately satisfied either of the MNAV test or the SBE test or both.

Satisfaction of the MNAV test by the object entity may thus be vital to the availability of the small business CGT concessions to a taxpayer selling shares or a trust interest. Where the object entity, let us say a private company with multiple owners, is worth more than $6m overall, this may well be a problem for minority owners who otherwise are:

  • on or over the 20% significant individual/CGT stakeholder threshold; or
  • with net asset value (NAV) under $6m who sell their shares looking for the small business CGT concessions.

The Explanatory Memorandum with the TIOMA gives the following example:

Example 2.4: Investment in large business

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year. Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019 CGT assets exceeds $100 million throughout this period. On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

MNAV test complexities

Like the SBE test with aggregated turnover of the taxpayer, affiliates and their connected entities, compliance with the MNAV test relies on, or more specifically NAV (net asset value) must stay under the relevant $6m limit after, aggregation.

Before aggregation is considered there is a flip side: the exclusions from the MNAV test: The substantial exclusions are confined to individual taxpayers viz. interests in an individual’s main residence, personal use assets, superannuation and insurance: section 152-20 of the ITAA 1997. The other exclusions in this section are largely to prevent accounting anomalies with:

  • accounting provisions; and
  • the double counting of the value of an asset indirectly held in an entity and the value of the stake in the entity including the asset, representing the same value, in NAV.

Liabilities are also excluded from NAV where they relate to assets so the MNAV test can be a maximum net asset value test.

The value of assets that are not excluded are tallied in NAV when applying the MNAV test. Then aggregation must be done. Just like with the complexity of small business CGT concessions integrity more generally, MNAV tests and sometimes qualification for the concessions, involve a hierarchy of constructs which, for the purposes of illustration, can be loosely compared to the pieces on a chessboard one’s opponent in chess may hold:


Chess piece: King

Div 152 construct: The taxpayer

Comment: If the King falls, it’s game over. If either NAV of the taxpayer or (modified) NAV of the object entity exceeds $6m in each required MNAV test the basic condition is failed unless there is a pathway to compliance through the SBE test as described above.

Chess piece: Queen

Div 152 construct: An affiliate

Comment: Although an affiliate is not the taxpayer (or object entity), the NAV of the affiliate also counts/aggregates to the taxpayer (or object entity) when applying the MNAV test to the taxpayer (or object entity), in all directions including NAV aggregated from connected (and Oconnected in the case of an object entity – see below) entities of the affiliate.

Chess piece: Bishop

Div 152 construct: Connected entities

Comment: The whole of the NAV of the connected entity (excluding the exclusions described above) counts in the MNAV test. So if a taxpayer, or an affiliate, has a stake of 50% in a connected entity X, all (100%) of X’s net value is aggregated to the taxpayer’s NAV (including NAV relating to the stake in X of minority stakeholders unrelated to the taxpayer or affiliate). If Y is a connected entity of X then aggregate all (100%) of Y’s net value to the taxpayer’s NAV too.

Chess piece: Knight

Div 152 construct: Oconnected entities

Comment: The Oconnected entity (my terminology – I thought of using “controlled entity” which is in contrast to a connected entity which can either control or be controlled by the other entity it is connected to. But controlled entity is misleading for, as we shall see, only a 20% stake, hardly control in any sense, is needed to trigger this link) is a new construct introduced with the additional basic conditions in the TIOMA relating to the object entity.

The NAV of a Oconnected entity is aggregated to the NAV of the object entity but it is look through forward to aggregate and not look through back too (unlike “controlled by the other entity” which can connect too to a connected entity). An example is needed to explain constructs here: So if O, an object entity controls Q an Oconnected entity, due to a 20% or greater stake in Q, and P is another unrelated stakeholder in Q; the value of Q owned by P is included in the NAV of Q aggregated to O (see the outcome of that in the below Example 2.5 drawn from the Explanatory Memorandum) but the NAV of P and its connected entities is excluded from the NAV of O (if they are not separately affiliated/connected to O).

In chess the Knight moves in a weird way so the Knight is the allegory chosen here!

Chess piece: Pawn

Div 152 construct: Asset or investment of the above

Comment: A pawn generally moves one space in chess. $1 in value of an asset or investment owned by a taxpayer or object entity, which is not excluded, counts $1 to the NAV of the taxpayer or an object entity.  $1 in value of an asset or investment owned by affiliates, connected entities and Oconnected entities, which are not excluded, count $1 to the affiliate, connected entity and Oconnected entity, as the case may be, but if that NAV is in an affiliate, a connected entity or a Oconnected entity of the taxpayer or object entity in applying the dual tests, the whole NAV of the relevant entity is aggregated to the taxpayer/object entity, not its proportionate NAV based on percentage stake. i.e. A percentage stake is only used for an interest in an entity where the entity the interest is held in is not an affiliate, connected entity or, in the case of the object entity MNAV test, an Oconnected entity.

I don’t play chess and I accept my chess analogy with the workings of the MNAV tests is far from perfect. My endeavour is to make this consideration of the hierarchical workings of the MNAV tests a little more comprehendible and so, perhaps, if you are still reading by this point I have succeeded? If the comparison with chess conveys:

  • that counts of over $6m by either of the taxpayer NAV or the object entity NAV will generally mean failure of a basic condition for the Division 152 CGT relief so can lead to loss of the game; and
  • that high value pieces accelerate aggregation of NAV to the $6m limit. That is they can move more than one space: every $1 of a stake a taxpayer (or object entity) in a connected entity (or Oconnected entity), and affiliates and their connected entities without needing any stake in the affiliate of the taxpayer (or object entity) will generally aggregate more than $1 to NAV as the value of others’ stakes in these entities will count to the NAV attributed to the taxpayer (or object entity) too.

The modified MNAV test of the object entity & the modified Oconnected entity

The NAV for controlled entities of an object entity is different due to sub-paras 152-10(2)(c)(iii), (iv) & (v) in the TIOMA:

The threshold between unrelated entity, counted simply as an asset or investment (pawn) to NAV and connected entity (bishop) consistent with other tests of control in the ITAA 1936 and the ITAA 1997 is 40% with a discretion given to the Commissioner where:

  • there is 40% or over and under a 50% stake; and
  • it can be established to the Commissioner that some other entity controls the entity that would otherwise be the connected entity.

In practice this means expect the Commissioner to de-connect A from connection with X if A owned 48% of X and B (unconnected to A) owned 52% of X.

When applying the object entity MNAV test, sub-paras 152-10(2)(c)(iii), (iv) & (v) have operation so that the threshold is lowered to a 20% stake in the other entity. That is enough “control” to make the other entity, otherwise an asset or investment, an Oconnected entity (knight). This is apparent from another example in the Explanatory Memorandum with the TIOMA:

Example 2.5: Indirect investment in large business

Tien owns 20 per cent of the shares in Investment Co, a company that carries on an investment business. Investment Co is a CGT small business entity (according to the general rules) for the 2020-21 income year. Investment Co holds 20 per cent of Van Co, a transport company. Van’s assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year. On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition. For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van.

As stated in the table above there is no look through back so in a case where an object entity has a stake of 21% of X, the NAV in entities connected to X by virtue of the remaining 79% stakes in X are excluded from the object entity NAV although the NAV of the assets of  X, including that relating to the other stakeholders, counts to the object entity NAV.

The odd way disputes over PAYG deducted from salary are resolved

payday

A recent Federal Court case Price v. Commissioner of Taxation [2019] FCA 543 demonstrates the divergent way a taxpayer must go about contesting a dispute with the Commissioner of Taxation over pay as you go (PAYG) tax withholding amounts taken from salary or wages received by the taxpayer.

Right to object about PAYG credits not available

Although the credit for PAYG withholding amounts is notified on a notice of assessment of income tax the PAYG credit is not one of the matters that can be disputed by objection, or more specifically, an objection under Part IVC of the Taxation Administration Act (C’th) 1953 (“TAA”) as discussed on this blog in: Is an objection needed to amend a tax assessment? https://wp.me/p6T4vg-k.

To formally dispute a PAYG credit, especially where the salary and wages from which the withholding is made are not disputed, court action may need to be taken instead. The proceeding that can be taken by a taxpayer is further limited as the Commissioner’s refusal to allow PAYG credits cannot be challenged under the Administrative Decisions (Judicial Review) Act (C’th) 1977: Perdikaris v Deputy Commissioner of Taxation [2008] FCAFC 186. So in Price, the taxpayer (Robert) sought a declaration from the Federal Court of his entitlement to credit for PAYG withheld by his employers under section 39B of the Judiciary Act (C’th) 1903.

Price v. Commissioner of Taxation

In paragraphs 6 to 8 of the Federal Court decision in Price, Thawley J. outlined the legislative basis of the PAYG withholding regime including in the context of the predecessor PAYE (pay as you earn) regime which operated until 2000. In paragraph 2 Thawley J. confirmed that the taxpayer’s proceeding under section 39B of the Judiciary Act, rather than under Part IVC of the TAA, was correctly instigated.

Why the taxpayer risked heavy costs in the Federal Court

Action in the Federal Court is expensive, and an unsuccessful litigant in the court is generally liable for the legal costs of the successful litigant. Those legal costs are significantly more than the costs of lodging an objection or appealing against an objection decision with which the objector is dissatisfied in the Administrative Appeals Tribunal (AAT) which are costs risked in Part IVC of the TAA disputes. The AAT does not award legal costs.

It follows that considerable PAYG credits need to be in dispute before action against the Commissioner in the Federal Court is worth the risk of legal costs at stake.

In Price, Robert was employed as a truck driver by four entities controlled by his brother Jim from the 2001 to the 2016 income years. Robert claimed PAYG credits for the entire period so considerable PAYG credit entitlements were at stake. Robert hadn’t lodged tax returns returning his salary and wages income until 26 September 2016 when all sixteen income tax returns were lodged together. Robert sought all sixteen years’ worth of tax credits then.

The employer and not the Commissioner is tested

One would think that the Commissioner could easily ascertain PAYG credit from amounts remitted by an employer for a recipient of salary and wages. If amounts withheld from salary and wages haven’t been remitted to the Australian Taxation Office (ATO) then that would seemingly be conclusive or near conclusive.

But the point of remittance of PAYG credits to the ATO is not the point at which the TAA operates to confer a PAYG credit entitlement to a taxpayer. Sub-section 18-15(1) of Schedule 1 of the TAA allows PAYG credit to a taxpayer where there has been withholding by the party with the withholding obligation, viz. the employer in the case of an employer who pays salary and wages, of the amount withheld. Sub-section 18-15(1) necessitates an enquiry into whether or not the amounts claimed for PAYG credit were “withheld” by the employer whether or not the amounts “withheld” were ever remitted to the Commissioner. In the Federal Court, in its original (non-appellate) jurisdiction, whether amounts have been withheld is a matter of fact to be established to the court on the balance of probabilities.

In another Federal Court decision cited with approval in Price, David Cassaniti v Commissioner of Taxation [2010] FCA 641 at paragraphs 163 to 165 Edmonds J. thus focussed on the actions of the employer. Edmonds J. explained and contrasted the evidential value of an employer’s apparent withholding to a (its own) bank account which, on the one hand, “clearly demonstrates” a withholding and an employer’s apparent withholding by book entry, which may be insufficient to demonstrate withholding by the employer depending on the surrounding circumstances, on the other. It was also relevant in David Cassaniti, as it was in Price, that the employer had been a company enabling Edmonds J to accept the books of account of the company as first instance evidence of what the books of account contained in accordance with section 1305 of the Corporations Act 2001.

Employers were wound up companies

In the Cassaniti line of cases, which also included the Full Federal Court decision in Commissioner of Taxation v Cassaniti [2018] FCAFC 212, relevant company records of the employers were thus sufficient to establish to the Federal Court that amounts had been withheld by the party with the withholding obligation. As in Price, in which the Cassanitis were also involved, the relevant employer companies had been wound up but nevertheless, by virtue of section 1305 of the Corporations Act 2001, the financial records of these companies in the (earlier) Cassaniti cases were sufficient evidence to show that the companies had made the relevant withholdings despite no record of remittance to the ATO. Robert’s case in Price relied on PAYG payment summaries produced from accounting records of the employer companies being accepted as financial records of the companies.

Robert was unsuccessful. The tax returns and PAYG payment summaries were produced from MYOB in September 2016 after the employers were wound up so the court refused to accept the PAYG payment summaries as financial records of the wound up companies. Thus the PAYG payment summaries were not first instance evidence of the PAYG withholdings asserted in them. In paragraph 87 Thawley J. listed findings showing that withholdings were not made for Robert:

  • the absence of any records from the ATO to that effect or supporting inferences of withholding;
  • the absence of any contemporaneous record of any person or entity who paid Robert evidencing withholding;
  • the fact that every year or thereabouts Robert asked for but was not provided any PAYG payment summary;
  • the fact that no superannuation was paid by any of the employer companies for Robert;
  • the fact that Allyma Transport Services did prepare PAYG payment summaries for other employees; and
  • the fact that the bank records suggest a number of different entities paid the weekly amounts into Robert’s account (including NT TPT Pty Ltd, PMG Transport, CJN Transport) and that at least one of those entities (PMG Transport) probably treated the payments to Robert on the basis that he (or a partnership of which he was a partner) was a subcontractor rather than an employee.

The unremitted PAYG no man’s land

Cases such as the Cassaniti cases and Price are relatively rare.  In that context we can observe that it is precarious to be in the position of an employer, or of a director of an employer, obligated to withhold PAYG amounts from employees’ salary and wages where those amounts have not been remitted to the ATO. The employer and, in the case of a company, its directors personally where director penalty notices issue to the directors and trigger personal liability under Division 269 of Schedule 1 of the TAA, are liable to the Commissioner for these amounts. Further failure to remit PAYG withholding on salary and wages is a strict liability offence under Division 16 of Schedule 1 of the TAA.

The pursuit of unremitted salary and wage PAYG withholdings from the Commissioner can potentially be a fraud against the revenue where employers and their directors have overtly arranged their affairs so that they are not exposed to the above liabilities and prosecution for failure to remit. Confinement of salary and wage earner remedy to proceedings under section 39B of the Judiciary Act does operate as a bulwark against that type of fraud.

It is to be hoped that reporting of and liability for PAYG withholding on salary and wages can be reformed and streamlined so that employees can better monitor withholding for them in real time and opportunities for “phoenix” PAYG credit frauds on the revenue can be reduced.

Small business now has its own dedicated taxation division of the AAT

To give effect to a bi-partisan initiative, changes aimed at making it easier, cheaper and quicker for small businesses to appeal to the Administrative Appeals Tribunal (AAT) against decisions by the Australian Taxation Office (ATO) commenced on 1 March 2019. Small business taxpayers contemplating a tax appeal to the AAT with scant legal knowledge or representation will benefit most from the changes. Represented small business taxpayers too can benefit from the easier, cheaper and quicker AAT tax appeals and may improve their prospects of obtaining funding by the ATO of legal representation costs of their appeal.

Under the changes small business taxpayers can appeal adverse tax objection decisions to the new Small Business Taxation Division (SBTD) of the AAT. The Small Business Concierge Service (SBCS) within the office of the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) also commenced on 1 March 2019 to assist small business taxpayers with appeals to the SBTD.

Tax and related review by the AAT

The AAT can review decisions on objections against tax assessments and other specified decisions made by the Australian Taxation Office (ATO) in the ATO domain on appeal under the Taxation Administration Act (C’th) 1953 viz decisions on:

  1. Commonwealth taxes: income tax, goods and services tax, excise, fringe benefits tax, luxury car tax, resource rent taxes (petroleum and minerals) and wine equalisation tax;
  2. Australian Business Numbers, fuel schemes, fuel tax credits, the ATO’s superannuation administration; and
  3. penalties and interest relating to a. and b.

The SBTD can review these decisions where the taxpayer/applicant is a small business entity under section 328-110 of the Income Tax Assessment Act (C’th) 1997.  A small business entity is an entity carrying on business with an aggregated turnover of less than $10 million in the current income year.

Cheaper – fees for AAT review

The ordinary filing fee for review of (appeal against) a reviewable decision by the ATO in the Taxation & Commercial Division of the AAT is $920 as at 1 March 2019. A single fee can apply if there are related multiple decisions in relation to the same appellant. A concessional fee of $91 applies for disadvantaged appellants: https://is.gd/1s5Vtt

The ordinary filing fee for review by the SBTD is a reduced $500. AAT regulations apply so that a SBTD taxpayer/applicant who the AAT finds is not a small business entity must pay an uplift to the ordinary $920 fee and their appeal will transfer to the Taxation & Commercial Division of the AAT.

Easier – Small Business Concierge Service

The SBCS of the ASBFEO assists a small business taxpayer with the SBTD appeal process and with advice about the appeal or prospective appeal to the SBTD the small business taxpayer plans. Although the SBCS is within the office of the ASBFEO and does not itself give legal advice, the SBCS:

  • offers a one hour consultation with an experienced small business tax lawyer to an unrepresented small business taxpayer prior to the appeal so the lawyer can review the facts pertaining to the ATO decision and provide advice on prospects of success of the appeal. In arranging a pre-appeal consultation the taxpayer needs to be aware of the 60 day time limit that generally applies for making appeals to the AAT on these decisions. A co-payment of $100 for the consultation is required from the small business taxpayer and the balance of the small business tax lawyer’s fee for the consultation is paid by ASBFEO;
  • assigns an ASBFEO case manager (not to be confused with the AAT case manager who will manage the appeals for the AAT) to help the small business to compile the relevant documents to maximise the benefit of the one hour pre-appeal legal consultation;
  • assists with the appeal to the SBTD if the small business chooses to go ahead with the appeal. The ASBFEO case manager assists with the applications and submissions to the SBTD and with engagement by the small business taxpayer with the AAT process; and
  • offers a second one hour consultation with an experienced small business tax lawyer to an unrepresented small business taxpayer after the appeal commences with the cost of the second consultation met by the ASBFEO without a co-payment.

Even if an unrepresented small business taxpayer utilises both hours of consultation with the assistance of the ASBFEO case manager it is still cheaper for the small business taxpayer to commence their appeal to the AAT for $600 in the SBTD, including the $100 co-payment, than to commence for $920 in the Taxation & Commercial Division.

Quicker – 28 day turnaround of reasons for decision

Decisions of the SBTD are to be “fast tracked” so that reasons for decisions will be given to the small business taxpayer usually within twenty-eight days of the hearing where the appeal goes that far. Where practicable an oral decision is to be given at the end of SBTD hearings.

Cheaper – further support for legal costs for SBTD appellants

Although the AAT, and the SBTD and the Taxation & Commercial Division in particular:

  • is not a court;
  • does not make cost orders;
  • isn’t bound by the legal rules of evidence; and
  • of itself, imposes no imperative to have legal representation;

the reality is that, where significant tax is in dispute in an appeal to the AAT, most informed appellants are legally represented and present their case in conformity with rules of evidence as if the AAT was a court. The ATO, too, selectively attends the AAT with external legal representation and, if not, ATO officers who conduct cases and appear at the AAT for the ATO are likely to have legal skills and experience. AAT decisions are reported/published and are used as legal precedent. Appellants can, though, more readily request and obtain anonymity from the AAT in tax cases than they can in courts which operate on the principle that justice is to be done in public.

The SBTD initiative partly synchronises the legal representation choice of a small business taxpayer and the ATO in a SBTD case. The ATO has transparent policy positions on when the ATO will use external legal representation in the AAT. The ATO’s position generally is that the ATO will use external legal representation where the case has high legal or factual complexity or where the case has implications for other taxpayers. Where the ATO is to engage legal representation in the SBTD then the ATO:

  • must inform the appellant that it proposes to engage external legal representation; and;
  • may meet the legal costs of the legal representation of the small business appellant that do not exceed the ATO’s legal costs of its own external legal representation. That is a possibly contentious integer as the ATO has and uses its leverage, which a small business doesn’t have, to negotiate lower fees from legal counsel with expectation of more ATO briefs.

Cheaper – greater opportunity for ATO litigation funding

This opportunity for a small business taxpayer to obtain the assistance of the ATO with their costs of legal representation in the SBTD dovetails with the test case funding policy of the ATO. Like under that policy the decision to assist a small business taxpayer with its legal costs of a SBTD appeal is with the ATO. Where the case has implications for other taxpayers then it is more likely that the ATO will both seek its own external representation and will fund the small business taxpayer’s legal costs up to the same level. Although time will tell, a small business taxpayer appears to be in an enhanced position to obtain ATO assistance with their legal representation costs in the SBTD as compared to taxpayers generally who appeal to the Taxation & Commercial Division of the AAT or who appeal directly to the Federal Court which involves significantly greater costs.

Unlike the Federal Court, the AAT does not order costs. That means that the legal fees and costs of a small business taxpayer running an appeal in the SBTD will only come from the ATO SBDT case funding or ATO test case funding, if not self funded, as legal costs won’t be awarded by the AAT even where the small business taxpayer is successful in a tax appeal case.

ASBFEO already acts as a gateway and assists small businesses to access funding for small business disputes. It is understood that the SBCS will be similarly resourced to act as a gateway to assist small businesses to obtain legal representation funding under both SBTD or ATO test case funding guidelines.

$3,000 deduction cap for managing personal tax affairs – non-millionaires caught in the cross-fire?

Labor’s Fairer Tax System plan

The ALP’s Andrew Leigh and Chris Bowen announced their A Fairer Tax System for Millions, Not Millionaires plan on 13 May 2017. The plan is comprised of a number of laudable and progressive policy announcements including transparency improvements that will impede tax avoidance by wealthy taxpayers and multinationals.

These policies are:

  1. $3,000 cap on deductions for managing their tax affairs for individuals.
  2. Public reporting of country-by-country reports.
  3. Whistleblower protection and rewards.
  4. Mandatory shareholder reporting of tax haven exposure.
  5. Public reporting of Australian Transaction Reports and Analysis Centre (AUSTRAC) data.
  6. Government tenderers must disclose their country of tax domicile.
  7. Develop guidelines for tax haven investment by superannuation funds.
  8. Publicly accessible registry of the beneficial ownership of Australian listed companies.
  9. Australian Taxation Office disclosure of settlements and reporting of aggressive tax minimisation.

The first measure, which this blog post concerns, is a proposed cap of $3,000 on the income tax deduction for managing personal tax affairs. There is no doubt this cap will restrict tax deductibility, which is substantially the funding by other taxpayers, of wealthy taxpayers’ tax professional costs of devising ways to avoid paying Australian tax.

Why an arbitrary $3,000 cap?

Still the $3,000 cap is arbitrary and there is, somehow, a disconnect in the announcement between the proposed cap and the millionaires against whom it is targeted. Why is the cap $3,000 rather than $30,000? My point is that it is not so unusual for ordinary taxpayers, particularly property owners who are not millionaires at whom the Fairer Tax System proposals are directed, to rack up tax professional costs of more than $3,000 for managing their tax affairs in an income year. The $3,000 cap includes tax agent costs for annual tax return preparation and lodgment so the remaining cap to deal with remaining tax difficulties or obligations will be something less than $3,000. So, although the measure will achieve its aim to curb deductibility of these costs to millionaires, there will be taxpayers who are not millionaires who will be collaterally caught with non-deductible tax professional costs in excess of the cap.

It is not so clear that the cap has been designed by someone who has real experience of seriously high individual tax professional costs and of situations where they may happen. Sure, all being well, a salary earner who owns real estate and who engages a tax agent, who charges moderately, will have tax professional costs in an income year comfortably under the cap. However, the salary earner with tax difficulties out of the ordinary may find himself or herself with a need to take a considered custom professional tax advice or to have his or her tax advisor non-prejudicially apply for a binding private ruling to protect himself or herself under the self assessment system.

The self assessment system

Out of the ordinary doesn’t mean tax avoidance is going on. Under the self assessment system a taxpayer is responsible for correct reporting and filing of tax information and severe penalties and interest apply if the taxpayer makes an error and a tax shortfall is assessed. If the taxpayer has an activity or activities where the tax treatment is unclear then it is the taxpayer who must ensure his or her return or other statements to the Australian Taxation Office (ATO) complies with tax law adopting, in the least, a reasonably arguable position on items in the return or statements that are contentious.

Something over $2,000 is not a big budget for obtaining a tax advice letter or a position paper or for professional preparation of an application for a private binding ruling or a complex objection. Often issues an individual can face can take a tax professional a couple of days or more to do thoroughly.

It can be costly just to understand obligations imposed by government

Not so long ago I was briefed to give tax advice to an owner of a heritage building about to enter into a sale of “transferable floor space” in compliance with local government heritage laws. The interaction of the relevant capital gains tax (CGT) and goods and service tax (GST) laws with property, environment and local government laws, cases and public rulings took considerable time to work through even in the absence of any live dispute about these matters with the ATO. $2,000 would have been a fraction of fees for the time needed to give advice so that the client understood the client’s CGT and GST obligations on the sale . The correct application of CGT events and tax rules that apply in this client’s situation are notably unclear and difficult and, in its rulings, the ATO takes positions which some may view as confused and ambiguous. A withering array of laws applied to this heritage building owner.

Each of these laws, considered separately, benefit or aim to benefit government, society and thus other taxpayers by the contribution of taxes, the stimulation of commerce and the preservation of heritage buildings. But is it fair for society to impose such a multitude of obligations on a not necessarily wealthy building owner yet severely reduce society’s contribution to the owner’s costs of compliance with them?

You see much of my work, and the work of many other tax advisors who act for clients who are not necessarily wealthy, is just to advise or explain how the tax law applies to them and what their position is. Generally, as the tax laws have been tweaked and greatly expanded over time, the tax laws do not present exploitative opportunities to ordinary taxpayers for avoidance. There are, of course, exceptions.

The CGT provisions are a good example of tax laws that are necessarily intricate and complex. $2,000 in professional advice costs just to understand a CGT position in an advice from a CGT expert won’t go far. The CGT rules can apply, and severely, to taxpayers who own property, securities and other valuables. If the owner dies or is a non-resident the complexity can ratchet up. Not all of the aforementioned are millionaires.

It can be costly to get a ruling or guidance from the Australian Taxation Office

It is frequently the case that an ordinary taxpayer is unable to articulate, or would be disadvantaged having to personally articulate, a technical capital gains tax problem to the ATO without professional assistance in order to obtain guidance or a binding private ruling from the ATO. So an ordinary taxpayer can be justified in seeking substantial tax professional help applying for a private binding ruling from the ATO. If a binding private ruling adverse to the taxpayer is issued by the ATO the taxpayer may seek to dispute the ruling and still further tax professional help is needed. The taxpayer’s professional tax advisor may need to attend the ATO or prepare an objection or appeal.

The intractability of many tax problems, notably capital gains tax problems, is usually not the fault of the taxpayer but is a feature of complex tax law seeking to impose tax obligations in a wide diversity of situations fairly on the tax paying community.

Costly tax problems not of concern to wealthy taxpayers

A taxpayer of modest means suffers an injury at work and receives an ongoing insurance payout. This taxpayer is the opposite of a millionaire. Still the taxation of the insurance payout gives rise to the income versus capital conundrum on which the Australian income tax system continues to rely. The payouts fall through the cracks of types of insurance payout that are afforded tax exempt status under the Income Assessment Acts 1936 and 1997. If the payouts are capital then capital gains on personal injury payouts are exempt from CGT so there is a lot of tax at stake if the payouts should be treated as capital rather than as assessable income.

Pursuing capital treatment of the payouts is not tax avoidance by the wealthy. Inevitably ruling, objection and appeal costs of disputing that the payouts are not assessable income are likely to be way in excess of $3,000.

These kinds of cases appear often enough in published Administrative Appeals Tribunal reports, and there are plenty below the visible tip of that iceberg to show that they still remain a frequent and expensive kind of tax dispute for injury victims. To deprive injury victims of tax deductibility for costs of their tax dispute to target other less deserving taxpayers is tough indeed on taxpayers affected. It is of no consolation to an ordinary taxpayer who can’t claim most of their seriously high tax professional costs that he or she is one of a number of less than 90,000 taxpayers who incur more than $3,000 in tax professional costs each income year.

Australia’s tax system abounds in these kinds of structural challenges. Whether or not an activity of a taxpayer amounts to “an adventure in the nature of trade” and consequently an enterprise carried on by a taxpayer attracting a GST obligation, is another good example of a tax uncertainty a taxpayer who is not a millionaire may find costly to solve in their case and may not solve without taking valuable professional assistance.

The cap binary and alternatives to better target the cap

So if $3,000 might not be enough of a cap to ensure fair operation of the cap, why impose a binary limitation with such a confidence in the announcement that its impact will be on millionaires?

The small business capital gains tax measures themselves show that the demarcation between “small” and bigger business is not necessarily easily achieved as shown by the unwieldy $6 million net asset test. A demarcation between ordinary and “millionaire” taxpayers to qualify for exemption under the cap may be similarly difficult. But might it be possible to devise a targeted cap which looks at the character of the professional tax costs of a taxpayer of managing their personal tax affairs so that the cap operates more equitably?

For instance could costs of professional tax work just directed at establishing the position of a taxpayer under certain tax laws on non-contrived circumstances be exempted from the cap? Most capital gains tax rules could be within that exemption. If the professional work addressed specific anti-avoidance measures, the general anti-avoidance provisions or exploitative tax planning the professional work could be “tainted” by that consideration and so fall outside of the exemption. One difficulty is that some sort of “chinese wall” solution may be needed so privileged thus confidential tax advice could be considered to verify whether the costs of the professional tax law assistance is exempt from a targeted cap on costs of managing tax affairs.

It may be possible to conveniently go through all of the (many) tax laws and classify those where issues and disputes arising from them are benign, in an avoidance context, as exempt from the cap. Often wealthy taxpayers and their advisers have little interaction with these laws and so exempting them would not give wealthy taxpayers any advantage. That would better achieve the aim of the Fairer Tax System plan.

Getting tax advice to take the 50% recklessness penalty out of play

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Self-assessment

Under Australia’s self-assessment system taxes including, notably, income tax and the goods and services tax, are based on returns by each taxpayer where responsibility is on the taxpayer to ensure statements and representations made to the Australian Taxation Office (ATO) reflected in those returns are true and correct.

Penalties when returns are not true and correct

When a taxpayer departs from true and correct disclosure to the ATO, penalties, including base penalties, for false and misleading statements to the ATO, unarguable tax positions and tax schemes are imposed by Division 284 of Schedule 1 of the Taxation Administration Act (C’th) 1953.

To understand the base penalty regime in Division 284 it is helpful to consider simplified categories of a taxpayer’s disclosures relevant to their return viz:

  1. those items that are straight forward where the taxpayer understands how the item should be returned and its impact on the taxpayer’s tax liability, and
  2. those items which are more complex or difficult where the taxpayer does not fully understand how the item should be returned and its impact on the taxpayer’s tax liability.

It is expected, or at least hoped, that matters in the first category will greatly outnumber matters in the second category. Still an item in the second category may involve a large liability and there may be a need for the taxpayer to resolve the complexity or difficulty, by taking tax advice or perhaps by obtaining a binding private ruling from the Commissioner of Taxation about that item to ensure the item is correctly returned.

As a general proposition it can be said that, unless other mitigating factors apply, failure to correctly return an item in the first category attracts the 75% “intentional disregard” base penalty and that failure to correctly return an item in the second category attracts the 50% “recklessness” base penalty based on the reasoning below:  

Deceptively understating assessable income or overstating allowable deductions etc.

If a taxpayer omits an item in the first category from an income tax return which understates true and correct taxable income then the highest base penalty of 75% for intentional disregard of a taxation law under the table in section 284-90 can be imposed. This isn’t the only liability that follows from a tax review, audit or investigation of a tax return. In addition to section 284-90 base penalties, the taxpayer will be held separately liable for the tax on the taxable income that should have been returned, medicare levy, and, to reflect the time value of taxes outstanding to the ATO, the shortfall interest charge and the general interest charge, etc when an amended assessment is raised to amend the original assessment which was not true and correct.

Base penalties, including the 75% intentional disregard base penalty, are imposed on a case by case basis. Thus the ATO will infer from the way the return was completed and surrounding facts whether there was intentional disregard of taxation law justifying imposition of a 75% intentional disregard base penalty. Similar considerations as arise as to whether there was fraud or evasion (which impacts on when an amended assessment can be raised) including whether the conduct giving rise to the omission of assessable income or the overstatement of allowable deductions or offsets etc. was deceptive or calculated, or whether the conduct could be explained as some sort of mistake, which attracts a lesser penalty, are relevant.

50% “recklessness” base penalty applied in PSI cases

The recent personal services income (PSI) cases of Douglass v. Commissioner of Taxation [2018] AATA 3729 (3 October 2018) and Fortunatow v. Commissioner of Taxation [2018] AATA 4621 (14 December 2018) illustrate how the 50% “recklessness” base penalty under the table in section 284-90, one rung down from the highest 75% intentional disregard base penalty, can be applied to a taxpayer who fails to correctly apply taxation law to matters in the second category.

Both cases involved the application of the personal services income measures in Part 2-42 of Income Tax Assessment Act (ITAA) 1997 to the income of professionals (an engineer and a business analyst respectively) which was alienated from the respective individual professionals by arrangements using related companies reducing their overall income tax liabilities.

Complex or difficult?

The personal services income measures in Part 2-42 are relatively complex involving multi-tiered considerations of various tests even though the Commissioner of Taxation expressed this view in the objection decision in Douglass (from para 110 of the AAT decision):

The attribution rule of the PSI is not an overly complex area of the relevant law. There was readily available information on the operation of the PSI rules set out on the ATO website. It was also explained in the Partnership tax return instruction and in the Personal Services income schedule instruction that accompanied the tax return guide for company, partnerships and trusts. You did not make further enquiries to check the correct tax treatment of your PSI.

In both cases, the taxpayers primarily relied on the “results test” in section 87-18 of the Income Tax Assessment Act 1997 to establish that, in each case, a personal service business was being carried on so that alienated income for the personal services of the individuals would not be attributed to the individuals under Part 2-42. On the facts of each case, each AAT found that the individual was not engaged to produce a result in accord with section 87-18 and so could not satisfy the “results test”.

Recklessness

Also, in both cases, the AAT was critical of the way in which each taxpayer tried to ascertain their respective liabilities under the personal services income measures. In Douglass the taxpayer did not take a cogent advice on how the PSI measures can apply. In Fortunatow the taxpayer had received an advice on asset protection considerations from a tax lawyer which inferred that PSI advice should be taken. But that PSI tax advice was not taken by the taxpayer in Fortunatow.

In each case the AAT referred to BRK (Bris) Pty Ltd v Commissioner of Taxation (2001) ATC 4111 where Cooper J. at p.4129 considered “recklessness”:

Recklessness in this context means to include in a tax statement material upon which the Act or regulations are to operate, knowing that there is a real, as opposed to a fanciful risk, that the material may be incorrect, or be grossly indifferent as to whether or not the material is true and correct, and that a reasonable person in the position of the statement-maker would see there was a real risk that the Act and regulations may not operate correctly to lead to the assessment of the proper tax payable because of the content of the tax statement. So understood, the proscribed conduct is more than mere negligence and must amount to gross carelessness.

It was unhelpful to the case of the taxpayer in Fortunatow that the taxpayer had been made aware by his tax advice that the PSI measures had potential application to him and that there was a real risk that he was not correctly complying with tax laws. The tax advice he received went no further than saying that income would not be attributed under the PSI measures if there was a personal services business but the taxpayer could not show that he had been advised that he had been carrying on a personal services business.

Obligation on the taxpayer to be correct

These AAT decisions leave little doubt that the responsibility on a taxpayer to correctly address and resolve complex or difficult tax questions in completing their tax returns is serious and far reaching. Ordinarily this means that a taxpayer will need a cogent tax advice or will need to take other steps to demonstrate that the taxpayer has adequately addressed each question to mitigate the “real risk” that the taxpayer’s position on a complex question in a tax return is incorrect to avoid “recklessness”.

Interaction with other base penalties and where taking cogent tax advice is desirable

This removes the opportunity to shirk a complex question or issue in a tax return and to rely on the difficulty or character of the question or issue to assert that some lesser base penalty, such as the 25% base penalties under Division 284 either for failure:

  1. to take reasonable care; or
  2. to take a reasonably arguable position;

is applicable.

Base penalties under Division 284 of Schedule 1 of the Taxation Administration Act (C’th) 1953 apply on the basis that the highest base penalty applies to the exclusion of the other applicable base penalties.

Complex PSI cases demonstrate how self-assessment works

The above personal service income cases provide good case studies of how base penalties under Division 284 are likely to apply in cases where a category 2 complex issue arises and a taxpayer fails to adequately address the issue in their return to the ATO.

Although the ATO cannot apply a 75% intentional disregard base penalty where the taxpayer was without intent to disregard taxation law which was or may have been too complex for the taxpayer to appreciate; the 50% recklessness base penalty, on the next rung down, can nevertheless be applied because of the taxpayer’s failure to deal with that complexity. Complexity is dealt with by taking cogent tax advice from a professional tax adviser for example. It can be seen that the 50% recklessness base penalty is thus integral to taxpayers taking responsibility for true and correct disclosure to the ATO under the self-assessment system.

Rights to object to a tax assessment lost when waived under a deed to settle a tax dispute

separateIn EE&C Pty Ltd as Trustee for the Tarcisio Cremasco Family Trust v. Commissioner of Taxation (Taxation) [2018] AATA 4093 (30 October 2018) the taxpayer, after concluding a minute of terms of agreement with the Commissioner of Taxation (the Commissioner) on 18 January 2011, entered into a deed to settle a tax dispute with the Commissioner for the 1999 to 2005 years of income on 23 March 2011 (the Deed of Settlement).

Assessments in line with settlement

On 2 June 2011 the Commissioner issued a series of assessments for those years primarily increasing, and in some income years reducing, the taxable income of the taxpayer in line with the Deed of Settlement.

Under the contractual terms of the Deed of Settlement the taxpayer was precluded from objecting against the assessments which issued as negotiated and set out in the terms.

Despite that the taxpayer had its lawyers prepare and lodge “objections” against the 2 June 2011 assessments on 4 June 2014.

Right conferred by statute overrides the terms to settle?

Apparently the lawyer had explained to the taxpayer that the taxpayer’s right to object against a taxation assessment, or more precisely a “taxation decision” under Part IVC of the Taxation Administration Act (C’th) 1953 (the TAA), is a statutory right which had lead the taxpayer to understand that their right to object persisted despite the apparent waiver of their right to object against the assessments in the Deed of Settlement.

Commissioner relied on the taxpayer’s waiver in the Deed of Settlement

The Commissioner took a contrary view and refused to treat the 4 June 2014 “objections” as valid objections.

Waiver did impact the statutory right to object

The AAT found that the Commissioner was correct in his approach. Deputy President Forgie of the AAT concluded that, as the 4 June 2014 “objections” were invalid, the AAT had no jurisdiction to review how the Commissioner dealt with them under the TAA and the Administration Appeals Tribunal Act (C’th) 1975.

Capability to waive right to object/appeal an imperative in settling tax disputes

At paragraph 89 of the AAT decision, Deputy President Forgie described a functional imperative that a taxpayer can waive their statutory right to object or appeal to settle Part IVC review and appeal proceedings:

The authorities of Cox, Grofam, Fowles and Precision Pools all support the Commissioner’s reaching a settlement with the taxpayer.  The taxpayer must be permitted to forego his rights of objection and review or appeal just as the Commissioner may fulfil his obligation to decide the objection and respond to the review or appeal in terms that do so but are reached by way of agreement with the taxpayer rather than by, for example, imposition of a decision of the Tribunal or judgment of the Court.  Agreement may be reached before a taxpayer engages in the formal processes of taxation objection leading to an objection decision and on to review or appeal or at some point during the process.

Why a Part IVC right to object or appeal is a type of right that can be waived

The AAT drew a distinction between a statutory right that can be waived under a contract and a statutory right that cannot. At paragraph 90, Deputy President Forgie referred to the general rule, expressed by Higgins J. in Davies v. Davies [1919] HCA 17; (1919) 26 CLR 348, at p 362:

Anyone is at liberty to renounce a right conferred by law for his own sole benefit; but he cannot renounce a right conferred for the benefit of society.

and gave examples of other statutory rights where the recipient of the right may abandon the right or not pursue the right. It follows that as a taxpayer is the sole recipient of the legal right to object under Part IVC, the taxpayer is able to renounce that right in the course of settlement of a Part IVC dispute.

Should more than one family share a family discretionary trust?

pointatdeedFrom time to time a family discretionary trust is set up for the benefit of two or more families who may be pursuing a business or a venture in common.

Risk of unequal returns from the discretionary trust!

A double (or more) -throated family discretionary trust is unwise on a number of levels and often reflects misunderstanding of the tax and civil dispute realities that can apply to trusts.

If there is a dispute between the business/venture principals then backing out of this kind of structure it can lead to complications where there are assets in the discretionary trust still to be divided and distributed to beneficiaries. One of the principals controlling the trustee may die or become incapacitated and the other principal may take the opportunity to distribute the assets of the trust solely to his or family! The other family may claim, say, that they should get 50% of the assets of the trust, or the value of the work contributed by them to the trust, but the trust document, being based solely on discretion, will disavow that any family has a 50% or other set interest in the trust.

A family discretionary trust is often funded by gift from the beneficiary family or by the unrewarded work of a member of the beneficiary family. That may be but there is no obligation on the trustee to return the capital or the income of the discretionary trust in proportion to those contributions to that family. The families are highly reliant on the arrangements for control of the trustee, who holds the discretion to distribute the income and capital of the trust, to ensure members of each family will participate in the income and capital of the trust on any equal basis.

A hybrid trust is an alternative to a multi family family discretionary trust which addresses such problems but hybrid trusts have their own separate set of commercial and tax difficulties.

Reimbursement agreements

Multi-family family discretionary trusts can be at high risk of audit under the “reimbursement agreement” provisions in s100A of the Income Tax Assessment Act 1936. Income distributions by the trust could be used to shift value between the families tax effectively however, if section 100A is applied, the distributions are void for tax purposes. The principals and their families, as beneficiaries, can’t resist a section 100A assessment with the usual defence based on the definition of “agreement’ in sub-section 100A(13) viz. that the distribution reflects an ordinary dealing within the family, because it does not. They are dealing between families.

Sometimes these structures are used to save establishment costs notably stamp duty which in NSW is as much as $500 to establish a trust where the trust holds no dutiable property. Such savings may prove inadvisable due to later considerable cost.