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Only a loan? Impugnable loans, proving them for tax and shams

 

Is a loan just a sum advanced to be repaid by a borrower to a lender? Accountants understand that a loan can be a nimble device to explain and show why money and value is elsewhere even when the relationship between the borrower and the lender is not arms length or clear.

Necessary elements of a loan

So a loan is recognised. It is clearly recorded in the books of account and appears as a liability in the financial statements of the “borrower”, the “lender” or frequently both. The individual, who is the controlling mind of the borrower, says yes, it is a loan, and the apparent lender, who has an established relationship with that individual, doesn’t say it is not. Will that apparent loan be accepted as a loan by all persons interested?

A number of recent tax cases in the aggressive tax planning space show that, in those kinds of cases, the Commissioner of Taxation is prepared to commit significant resource and effort into:

  1. disabusing courts that arrangements with the appearance of loans are loans in fact; and
  2. pursuing high profile tax scheme promoters and their clients using arrangements based on inpugnable loans.

A wide but demarcated construct

There is no doubt that a loan is a wide concept. In Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements, the Commissioner took a wide view of what amounts to a loan, or to what amounts to at least one or more of:

(a) an advance of money; and

(b) a provision of credit or any other form of financial accommodation; and

(c) a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and

(d) a transaction (whatever its terms or form) which in substance effects a loan of money.

being a loan under section 109D of the Income Tax Assessment Act (“ITAA”) 1936 which triggers a deemed dividend to a shareholder or an associate under Division 7A of that Act. The “loan” regime in Division 7A is an exception though. Generally, if a taxpayer can establish that a sum received is received as an advance of a loan, that receipt can explain why that money or value is not in the nature of income that may be assessable to the taxpayer. That is a vital capability when the schema of Australian income tax recovery is “asset betterment” allowing the Commissioner to assert that money or value received is income unless the taxpayer can prove that it is otherwise.

Hart v Commissioner of Taxation (No 4)

So it was in Hart v Commissioner of Taxation (No 4) [2017] FCA 572, a decision of Bromwich J. of the Federal Court, concerning the personal tax affairs of the senior tax partner of Brisbane-based law firm and tax planning and tax scheme services provider Cleary Hoare. Mr Hart asserted that the amount in dispute in that case was a loan to him by an associated trust clearly recorded as a credit loan in the books of the trust.

The firm of Cleary Hoare was operated by a practice trust (“the Practice Trust”) in which discretionary trusts of the partners owned units in the Practice Trust which, it transpired, was not structured in accord with Queensland legal professional practice rules. The discretionary trust of Mr Hart owning units in the Practice Trust was referred to in the decision as the Outlook Trust.

Loan or benefit or both to the taxpayer (“borrower”)?

During the 1997 income year, the Outlook Trust included $220,398 in its assessable income as a distribution to it as a unitholder in the Practice Trust under section 97 of the ITAA 1936. The distribution was routed by a series of on-distributions through a network of interposed trust entities associated with Cleary Hoare, or its associates, to a company carrying significant tax losses, Retail Technology Pty. Ltd. and by the making of gifts by way of promissory notes to and through entities that were associated with Cleary Hoare or its associates, including Mr Hart. The Commissioner took issue with the last flow of the money through the arrangement back to Mr Hart. The Commissioner viewed that last flow as a distribution to Mr Hart for the benefit of Mr Hart. For his part, Mr Hart contended that the payment was a loan to him from the Outlook Trust, or alternatively from the Practice Trust, and that the payment was so recorded in the books of account of the Outlook Trust.

The Commissioner also pressed a number of alternative cases including a case that, even if the payments were not trust distributions, the application of general anti-avoidance provision in Part IVA of the ITAA 1936 meant that, in the absence of the scheme, the money would still have been paid to Mr Hart and instead been taxable, to which Mr Hart, for his part, contended that such payments would not have taken place in the absence of the scheme.

Present entitlement by benefiting trust beneficiaries

One of the alternative cases run by the Commissioner was that payments benefiting Mr Hart of at least $84,615.52 of the $220,398 were assessable directly to Mr Hart who was also a special unitholder, as trust distributions to him by the Practice Trust. In the absence of a sustainable case that the $220,398 or any part of it was a loan, the court could find that sections 95A and 101 of the ITAA 1936, which have the effect of deeming payments to or for the benefit of a beneficiary to be payments to which the beneficiary is presently entitled, applied to bring the $84,615.52 into the special unitholder’s assessable income for the 1997 income year.

Although this finding did not directly inform the character of the remaining $135,782, this application of sections 97, 95A and 101 of the ITAA 1936 to at least $84,615.52 of the amount in dispute, which the court accepted, did not assist Mr Hart to prove that the assessment of the greater $220,398 was excessive.

How Mr Hart’s loan contention failed

The court deduced from the submissions of the parties that whether the 1997 assessments of Mr. Hart were excessive or not turned on whether Mr Hart received the $220,398 as a loan. Mr Hart’s counsel contended that the evidence of Mr Hart, including the accounts of the Outlook Trust which showed the borrowing to Mr Hart, was sufficient to show that the funds had been loaned to Mr Hart. However other evidence caused this contention to unravel, viz.:

  1. there was nothing in writing to record or otherwise evidence a loan;
  2. there was no interest paid or payable under the purported loan;
  3. there were no repayments required or made under the purported loan, despite more than 19 years having elapsed since the advance of money under the purported loan (and the “creditor” trust had not traded for 15 years); and
  4. there were records of contemporaneous bank statements showing “pay” or “sol[icitor] pay” which were made on a fortnightly basis to a bank account of Mr and Mrs Hart between at least 5 July 1996 and 23 April 1997.

In addition to this evidence, which the court found, of itself, compelling, was the coup de grâce of a credit approval request by Mr. Hart to Suncorp Bank for two loans in 1999 in which Mr Hart, as an applicant providing personal details, appeared to state he had income of precisely $220,398 in 1997. The court observed that stating this, if it was nothing more than antecedent indebtedness, was hardly going to assist in securing a further loan, so it didn’t make sense as a loan.

Was the loan a sham?

Mr Hart’s counsel asserted that, as the Commissioner had not demonstrated that the purported loan was a sham, the court was obliged to accept the evidence lead by Mr Hart viz. his testimony and the accounts of the Outlook Trust, that there had been a loan. The court observed that a sham requires there to be a purported transaction which is falsely presented as being genuine. The court agreed with the Commissioner that, in this case, there was thus no sham loan, but that no loan had been proven to exist with the burden of proving that there was a loan on the taxpayer.

Loan terms in writing?

In Hart v Commissioner of Taxation (No 4), the taxpayer relied on an undocumented related party loan recorded only in the accounts of a related trust which gave the Commissioner leeway to run a case based on there being no loan at all. That leeway is reduced, of course, if the loan is reduced to writing in a loan agreement. However if that writing does not present the real arrangement then the loan can still be impugned by the Commissioner and the issue of sham will more likely arise with that false presentation.

Commissioner of Taxation v Normandy Finance and Investments Asia Pty Ltd

The taxpayer in Commissioner of Taxation v Normandy Finance and Investments Asia Pty Ltd [2016] FCAFC 180 faced that predicament.

Mr. Townsing was a client of Vanda Gould, a Sydney accountant and offshore tax scheme promoter. The taxpayer and two other companies were controlled by Mr Townsing. The taxpayer asserted that these companies were borrowers under loans from three companies controlled by Mr Gould recorded in written loan arrangements with those companies.

The Townsing controlled companies received substantial advances from the Gould controlled companies. The Commissioner asserted that payments to the Townsing controlled companies were sham borrowings used by Mr Townsing to bring assets held for his benefit into Australia and that they were thus assessable income of the companies.

The judges in this case noted the excessive length of the submissions of more than 1000 pages of submission material, ostensibly in support of oral argument at trial, to the primary judge by the taxpayer and the Commissioner.

Edmonds J. of the Federal Court, (Normandy Finance Pty Ltd v FCT [2015] FCA 1420) found for the taxpayer at first instance but did so on what was to prove a precarious basis. Edmonds J. found that the loans were not shams, even though the loan documents revealed disguises and pretences directed to demonstrating that the loans were at arms length, when the evidence was that the advances under the purported loans happened differently, and not at arm’s length. Still Edmonds J. found that, despite these irregularities, elements of the loans, including commitments to repay the loans, could be indentified in the evidence and so the loans were allowed to stand.

Appeals

The Commissioner appealed to the Full Federal Court. All three judges of the Full Federal Court closely considered the evidence that was before Edmonds J., and the majority, Jagot and Davies JJ., found that the basis on which Edmonds J. had recognised the loan arrangements as loans, distinct from the impugned purported written loan agreements, was expressly negated by the evidence of Mr Townsing under cross-examination by senior counsel for the Commissioner. The majority concluded that, in his evidence, Mr Townsing had rebuffed the facts upon which Edmonds J. had relied to find that there were loans not shams. Logan J., in the minority, disagreed with the majority and agreed with the trial judge’s approach to the evidence.

The taxpayer sought special leave to appeal from the Full Federal Court to the High Court but leave was refused by the High Court on the basis that the taxpayer did not have sufficient prospects of success of reversing the Full Federal Court majority’s findings.

Take-outs

Documenting a loan in writing reduces the scope of the Commissioner to assert there is no loan leaving the taxpayer, carrying the burden of the onus of proof, to prove the loan.

However documenting the loan may be a two-edged sword in contentious situations. Forcing the Commissioner to assert a sham will not necessarily give a taxpayer, who must disprove a sham in Part IVC of the Taxation Administration Act 1953 tax appeal proceedings, an advantage. Costs in litigation with the Commissioner to redress the consequences of a loan inadequately documented, can be significant. Poor documenting may have the adverse effect of revealing aspects of the arrangement that are not real or genuine. In other words, the pretences in the document and later compromising admissions by a taxpayer asserting the loan may irretrievably taint the believable in an asserted loan document and cause a loan to fail as a construct for a payment.

Loans not at arms length are the most likely to be challenged by the Commissioner. Trust beneficiary loan accounts may be held up to particular scrutiny. If a purported trust beneficiary loan is impugned sections 95A and 101 can trigger present entitlement to payments/advances to the beneficiary under the “loan” as assessable income.

These cases and the earlier Full Federal Court case of Millar v FCT [2016] FCAFC 94:

  1. which again involved an impugned loan devised by the Sydney accountant Vanda Gould for other clients; and
  2. where the taxpayers opted not to admit evidence from Mr Gould but relied on evidence of the relevant loan only from the lay taxpayer parties to the purported loan;

show that the Federal Court will not readily allow an appeal based on such restricted evidence as sufficient to prove the existence of a loan or to disprove a sham in the process of determining whether an assessment is excessive and that the High Court is reluctant to allow appeals to disturb these Federal Court decisions.

SMSFs getting practical to invest in land with others

The force of the superannuation law is that investment in land by a SMSF needs to be prudent. An investment needs to be considered in a business-like way.

Limited recourse borrowing is one way to fund investment in real estate. SMSF principals may prefer to arrange equity investment from private connections outside of the SMSF.

Investment as a tenant-in-common?

I am frequently asked about SMSFs participating in land investments as a tenant-in-common with related and unrelated entities of the principals of the SMSF. It is apparent from the NTLG Superannuation sub-committee technical minutes of June 2011, released by the Australian Taxation Office, that tenants in common arrangements for SMSFs are not going to be prudent for the SMSF without careful and restrictive implementation. Wherever other tenants in common could borrow, or use or risk their interest as security, the SMSF tenant-in-common is exposed to uncontrolled risks which would bring into question, for instance, whether the SMSF:

1.    has acted prudently pursuing the investment for members for whom it is bound to provide;

2.    has breached regulations which prevent charges, or the potential for them, being taken over SMSF property; or

3.    has satisfied the sole purpose test.

Investment through a trust?

The tenant-in-common option is frequently turned to because of the restrictive regime that has applied in relation to the investment by SMSFs in related trusts since 1999. Shortly stated, a post 1999 investment by a SMSF in a trust, which is related to the principals of the SMSF, a “related trust”, is treated as an “in-house asset” and more than 5% of the assets of a SMSF in in-house assets can leave the SMSF non-complying.

Non-geared unit trust – expressly relieved from being a related trust

The SIS Regulations provide an express exception. A superannuation fund can invest in a non-geared unit trust (NGUT) to which Regulation 13.22C applies without the NGUT being taken to be a “related trust” and thus the investment isn’t taken to be an investment in an “in-house asset”.

This express exception is especially limited and, aside from relief from “related trust” treatment causing in-house asset difficulty, offers no expansion in the kind of investment that can be pursued with superannuation money. In other words, the investment still needs to address 1 to 3 above, for instance.

The Regulation 13.22C and 13.22D requirements and restrictions on NGUTs essentially mirror the restrictions on regulated superannuation funds. NGUTs cannot borrow and they can only “lend” to operate a bank account. They cannot secure or charge their assets. (A non-SMSF unit holder in a NGUT could give a security over his, her or its units but security could not be given over the assets of the NGUT.) A NGUT cannot run a business – unlike with superannuation funds, this is a direct requirement. Loss of NGUT status, so that the NGUT becomes a related trust triggering in-house asset difficulties follows the merest breach under Regulation 13.22D which can put complying status of a SMSF investor at the mercy of the ATO.

Practicalities

1.    Nevertheless a carefully implemented NGUT can be the most practical way to pursue unitised investment in land by related parties and unrelated parties of a SMSF with the SMSF.

2.    Compliance with the regulations needs to be closely monitored as stated. Any debtor or creditor, aside from a bank for the (credit only) trust bank account, potentially causes loss of protection from related trust status. Funding of, and money flow to and from, the NGUT without breaching the rules is thus practically challenging. The trustee needs to raise equity (unit) funding whenever any extra funding is required. From a practical and paperwork burden perspective, using partly-paid units is a strategy that might be considered wherever the trust needs a flexible equity facility.

3.    The activity of the NGUT that invests in land also needs to be monitored and carefully planned and structured. It is possible for real estate activity by trustees to be considered the carrying on of a business under tax rules. As stated a NGUT cannot carry on a business under the NGUT regulations nor, if it has a trust deed to suit, under its trust deed.

4.    Under the special trust rules in NSW, a special trust pays land tax at the highest land tax rate without a threshold. A SMSF can attract a better land tax rate. A NGUT will not automatically qualify for the rate for a SMSF to the extent a SMSF invests in it. However if the NGUT is a “fixed trust” under the land tax rules then a better rate than the special trust rate can be achieved. Hence there can be advantage to structuring a NGUT with a trust deed so that the NGUT can be treated as a fixed trust under the land tax rules.

5.    A carefully crafted trust deed can be very useful to assist the trustees of a SMSF and a NGUT to keep within the express requirements and restrictions on NGUTs.

Australia is now tracking & surcharging foreign buyers of land

Turning missing demographics into tax revenue

Hats off to Australian governments who have turned an imperative into a revenue opportunity. The Australian federal government regulator, the Foreign Investment Review Board  (the FIRB), has not been well placed to track foreign purchases of real estate to date. The FIRB has been reliant on disclosure, and if prospective foreign buyers didn’t voluntarily disclose their planned land acquisitions, the FIRB has been none the wiser. There has been no register of (foreign) beneficial ownership of buyer entities which the FIRB can go and check even in the case of foreign real estate acquisitions completely prohibited under the foreign acquisitions law: the Foreign Acquisitions and Takeovers Act (C’th) 1975.

That has all changed. Buyers now need to demonstrate that they are not foreign to avoid hiked stamp duty in New South Wales, Victoria and Queensland. Foreigners who buy and sell Australian real estate are now under great scrutiny at both the buyer and seller ends of the land sale especially if the sale is for more than $750,000.

Big city real estate markets are buoyant, prices are high and foreign buyers are not exactly welcome by those looking to buy the same city real estate. The community has been surprised to learn that foreign purchases of Australian land have not been closely monitored. So, politically, it has been an opportune time to introduce these changes. Time will tell if they will be successful. They may well be. They will be a boon to the FIRB, but Australian buyers too will get caught up in the ramp up of imposts on foreign buyers. Why?

Buyers of Australian land

This is the bit for the FIRB. The New South Wales, Victorian and Queensland governments have just introduced hefty stamp duty and land tax surcharges on foreigners. From 21 June, 2016 a sworn Purchaser Declaration (“PD”) is now required from buyers, whether foreign or not, buying real estate in New South Wales. The PD is required along with stamp duty at the band the PD establishes that the buyer should pay to complete the conveyancing of a land sale. If the buyer of land in New South Wales is a foreign person (entity):

  • a 8% SURCHARGE (for the 2018 tax year, it was 4% for the 2017 tax year) on the stamp duty (i.e. extra) applies (it’s a 7% surcharge in Victoria);
  • the buyer is not entitled to the 12 month deferral for the payment of stamp duty for off-the-plan purchases of residential property; and
  • the buyer faces 2% SURCHARGE (for the 2018 tax year, it was 0.75% for the 2017 tax year)  on land tax (i.e. extra).

It’s plain on the PD that the information is going to the ATO – it asks for the FIRB application number for the purchase. This will let the Australian Taxation Office (“ATO”) and the FIRB gather comprehensive data on foreign land acquisitions. Coupled with significantly increased penalties for breach of the foreign acquisitions rules, the availability of this information to the ATO and to the FIRB will give the federal government real capability to penalise unlawful real property acquisitions by foreigners.

Where an Australian buyer will be caught out too – example of a buyer that is an Australian-based family discretionary trust

It is notable that the PD doesn’t seek the confidential tax file number (understandable as the ATO can’t get the States to collect those) or the Australian Business Number (if any) of a buyer trust. It relies on the name of the buyer trust and a copy of the trust deed of the buyer trust with all amendments must be included with the PD.

If a foreign individual, company or trust is a potential beneficiary of the usual style of Australian family discretionary trust that is a New South Wales land buyer then, usually, the trustee can distribute 20% or more  (Victoria – more than 50%) of the income and capital to that foreign person. That gives the foreign person a “significant interest” in the trust enough to cause the trust to be a foreign trust under these rules to whom the foreign stamp duty and land tax surcharges apply.

So if the copy trust deed supplied with the PD indicates that a remoter family member,  who is not an Australian citizen or an Australian permanent resident, but is a foreigner who is a potential beneficiary of an (otherwise) Australian family discretionary trust ABLE to receive 20% of income or capital (more than 50% in Victoria), even if that remoter family member/foreigner may not have:

  • any current or past entitlement to income or capital of the trust; nor
  • any strong likelihood of participating in income or capital of the trust;

his or her eligibility under the trust deed exposes the trust to foreign trust/person status and liability for the stamp duty and land tax surcharges under these rules accordingly.

Sellers of Australian land

The ATO has had a problem collecting capital gains tax from sellers who are offshore after the sale of Australian land. Under tax treaties worldwide rights to tax interests in land are almost universally reserved to the governments where the land is. As other forms of assets and activity are moveable and relocatable taxation based on place is not so reserved because it is less effective than taxation based on residence and/or makes less sense.

So, frequently, when a non-resident sells land and makes a capital gain taxable in Australia, the ATO has no interaction with the non-resident, aside from due to their Australian landholding. This has often left the ATO with little leverage to assist them to collect tax debts arising from CGT on disposals of Australian land by non-residents ceasing investment in land in Australia.

The solution is the tried and trusted withholding tax model. From 1 July, 2016, the non-resident capital gains tax withholding tax (“NCGTWHT”) is an obligation on the buyer (statistically likely to be a resident) to pay a non-final withholding tax to cover capital gains tax (likely to be) owing by the non-resident seller.

The NCGTWHT broadly applies as a non-final tax on sales of land worth more than $750,000 (from 1 July 2017, was $2m from 1 July 2016 to 30 June 2017). If the buyer does not receive an ATO clearance certificate from the seller then the buyer must withhold 12.5% (from 1 July 2017, was 10% from 1 July 2016 to 30 June 2017) of the value of the property (so 12.5% of the price for the land if it is an arms length sale, 12.5% of the “first element of the cost base” of the land to the acquirer if a CGT market value substitution rule applies in a non-arms length transaction).

Where an Australian seller will be caught out too – a non-final 12.5% tax

It is of no consequence that the seller is, or might be, an Australian resident/tax resident and the buyer is assured of this. There is no “reason to believe the seller is an Australian resident” exception for sales of freehold interests in land. Even the seller could be wrong – tax residence can a vexed question which is frequently litigated in tax cases.

The liability to the ATO is on the buyer unless the seller can obtain and provide a clearance certificate from the ATO to the buyer no later than settlement of the land sale so, if the seller does not return and pay the CGT on the seller for the sale, the NCGTWHT paid by the buyer on the seller’s behalf won’t be refunded.

Template contracts for the sale of land across Australia have been hastily adjusted to include conditions confirming that, where the land is worth more than $750,000:

  • the buyer can contractually withhold the NCGTWHT from the price if the clearance certificate is not provided; and
  • the seller can be assured that the NCGTWHT will be paid immediately by the buyer to the ATO to the credit of the seller.

NCGTWHT

Is a family trust a good way for setting up a new franchisor business?

A family discretionary trust structure is a slightly more complicated and costly structure but it has more flexibility than a holding company structure for distributing income tax effectively while also being capable of having limited liability protection for the franchisor along with potential access to the company tax rate through a beneficiary company.

But is one trust enough?

For asset protection and management reasons it may be multiple structures are desirable into the future to separately hold IP and property interests (including lease interests to be sub-let).

Trust a conduit to beneficiaries

A family trust can distribute business profits as trust distributions as a conduit of taxable income to adult resident beneficiaries.

Division 7A would not usually apply

A significant advantage with a family trust structure is that Division 7A does not apply to loans from the trust to associated parties (where companies are not involved) to treat them as taxable/unfrankable deemed dividends.

Capital gains tax advantages

The adult resident beneficiaries of a family trust can also use the CGT discount if the trust makes a capital gain. Sometimes a trust is a more difficult structure than a company if a new franchise venture makes losses (say due to difficulties finding and keeping franchisees on good terms).

Bringing in new equity

A family trust isn’t as good as a unit trust or a company for bringing in new equity participants however it appears that, with the new small business restructure CGT rollover relief, a later conversion to a unit trust structure can be done for a low cost.

CGT discount and small business CGT concessions

Capital gains made by a family trust structure could attract the CGT discount and the small business concessions (a company can only get the latter), such as the 50% active assets reduction. A family trust structure has the tax advantage over a company structure if CGT assets of the business, including goodwill, are at some stage sold for a capital gain by the trust.