Tag Archives: sham

Bringing trusts to a timely ending

MovingOnEnding a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.

That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.

Ending is all in the timing

In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.

Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.

Bringing forward the ending of a trust

The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.

An objective of winding up a trust is to satisfy all parties with interests, in the wider sense,  in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.

Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.

Ending by depletion and merger

Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.

Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.

Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.

Merger and SMSFs with individual trustees

Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.

Some starting points

Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.

If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.

Tax planning

The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end.  In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.

Errors frustrate the ending

Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:

  • the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
  • distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
  • backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.

The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.

Conclusion

The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.

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.

Are there limits to interest deductions in Australia in participative loan arrangements involving entities in the same economic group?

Question on taxlinked.net members forum about Participative Loan Taxation

Since 1st January 2015 in Spain, interests are (interest is) not tax deductible when the participative loan is agreed to between entities of the same economic group. Is there similar treatment in your countries?

Response to post

Generally not in Australia.

In Australia interest is deductible if incurred on debt finance obtained to earn assessable income or to carry on a business even if debt finance arrangements include entities not dealing with each other at arms length.

These deductibility tests are serious purposive tests so non-arms length transactions attract particular scrutiny and, like in most jurisdictions, the burden of making out either purpose is on the taxpayer. As well as the general construct of sham there are a numerous specific instances where the Australian law denies interest deductions including:

  • sometimes where deductions are prepaid;
  • where there is not a sufficient relation between the loan and income received after a “commonsense” or “practical” weighing of the circumstances; and
  • where deductions are artificial or contrived or have those elements– if specific anti-avoidance rules do not apply.

Australia has a longstanding general anti-avoidance provision that can apply even if the interest deduction was otherwise available under the law. In international outbound financing the deduction can be lost because foreign income can be treated as other than assessable income. International debt/hybrid mismatch rules are being developed in Australia following some taxpayer success resisting anti-avoidance rules and the international experience.

Deductions are also lost if a “loan” is technically found to have characteristics of equity in substance.

Australian courts look at the role of associated entities to understand their purpose and look at transactions holistically. In other words they will focus on the economic units, rather than on juristic entities which seems to happening in Spain from what you say. Hence an interest deduction to an entity can be reduced, for instance, if the debt finance is on-lent to a related entity to earn income palpably less than the deduction.

Australia also has thin capitalisation rules which apply to limit otherwise allowable large cross border interest deductions.

Chevron Australia is involved in the first major transfer pricing case under the new BEPS regime where the Commissioner of Taxation is fighting to contend that interest paid and deducted exceeded the arms length amount based on BEPS arms length principles. The Commissioner won the first stage of the case in 2015.