Taxing times - April 2007

In the August 2006 INTHEBLACK, I considered the decision of the Administrative Appeals Tribunal in McNally v FC of T (Administrative Appeals Tribunal, 22 June 2006).

That decision involved an accountant who had been a partner with Deloitte. Deloitte (a partnership of accountants) decided to expel McNally from that partnership.

McNally refused to accept expulsion; he intended to instigate legal proceedings against Deloitte (seeking damages). That dispute, however, was settled. As part of the settlement, Deloitte agreed to pay McNally $500,000. Deloitte claimed (and the Tax Office assessed McNally on that basis) that part of that $500,000 was a 'profit distribution – partnership – gratuitous payment'.

Deloitte followed the method of tax accounting (common in accountancy practices) where opening tax differences (which one would expect would be on account of unbilled work in progress) of a first-year partner’s share of financial net income of the partnership would not be treated as part of that partner’s share of the tax income of the partnership.

This was because at the beginning of a partner’s first year of partnership that partner had no interest in any of the assets of the partnership as at the start of that year (those assets belonging to the continuing partners).

This means that for tax purposes, a new partner’s share in the taxable income of a partnership will be less than his or her share in the financial income of the partnership. This gives new partners a financial bonus, since they can effectively receive a large amount of their first year’s income as a partner effectively tax free.

Partnerships, however, expect to recoup that tax benefit from partners when they retire from the partnership. Consequently, Deloitte adopted the practice that when a partner retires, the firm would not attribute to the partner (for tax purposes) some share of the closing work in progress of the partnership.

That is, a partner’s share in the tax income of a partnership for that year is not reduced by any unbilled work in progress at the end of that year of income.

Firms (and the large accounting firms in particular adopt this practice) see this as a way of making certain that a retiring partner pays the appropriate amount of tax on partnership income derived while serving as a member of the partnership. While this is an attempt to seek equity as between partners (although it is not clear that it matters in a continuing partnership), whether this is correct as a matter of law or not is another matter.

McNally argued that he should not be assessed on the adjustment attributed to him by Deloitte. However, the Administrative Appeals Tribunal disagreed with McNally. It said the amount of 'timing differences' excluded from his 1997 assessable income should have been included as assessable income in his 1998 return (and also said that he should be penalised for 'recklessness').

McNally appealed against that decision. The Tax Office cross appealed (not considered here). Justice Jessup (who decided the matter) recognised that Deloitte’s assessable income should not include timing differences (being that work in progress adjustment), and that necessarily McNally’s share of his taxable income for a year could not include any part of that work in progress.

As a result (given the nature of the appeal) he remitted the matter back to the tribunal for it to reconsider the Tax Office assessment in accordance with his reasons. That is, he expects the tribunal to reduce McNally’s assessment, and to reflect that work in progress adjustment.

I am vindicated by the court’s decision, because in my August 2006 column I expressed doubt as to the correctness of the tribunal’s decision. This decision has given many partners in accounting firms a tax prize.

What it will mean is they should be able to obtain a permanent escape from tax on at least part of the income they make when first becoming a partner of the firm.

Allocation of income

In his judgement Justice Jessup said 'Deloittes filed a return of income of the partnership ... for the 1998 year. Not unreasonably, the [Tax Office] seems to have treated the allocation of that partnership income as between the partners of Deloittes as primarily a matter for the partners themselves.'

If read literally, that observation would seem to mean that partners could decide how to allocate tax income as between themselves, without any regard to any underlying financial allocation.

For example, a high-tax-paying partner might decide (perhaps in return for some financial incentive) to allocate his or her tax income to some other partner who has tax losses.

I cannot believe that Justice Jessup meant this. If I am wrong, the judge is pointing to a quite simple planning device for members of partnerships.

The Tax Office is kidding itself

If I was to ignore a court’s interpretation of an income tax law and lodge a tax return based on my view as to what the law should be (even if – as I sometimes am – convinced that a court is incorrect) I could expect Tax Office retribution.

I could (apart from it having being wrong for me to ignore the court) expect the Tax Office to levy penalties on me at the maximum allowed rate. So I would not do it.

However, as the decision in FC of T v Indooroopilly Children Services (Qld) Pty Ltd (Full Federal Court, 22 February 2007) shows, the Tax Office obviously believes there is one law for it and one law for everyone else.

That decision involved the fringe benefits tax law. The issue there was whether or not the allotment of shares by an employer by way of gift to an employee share trust was subject to fringe benefits tax.

The taxpayer sought a ruling from the Tax Office confirming that there was no fringe benefits tax liability. The Tax Office, however, said there was. The taxpayer then appealed to the Federal Court.

At first instance (Federal Court, 14 June 2006) Justice Collier said there was no fringe benefits tax liability (she was relying on the decision of Justice Keifel in Essenbourne Pty Limited v FC of T, Federal Court, 17 December 2002 and Justice Hill in Walstern Pty Ltd v FC of T, Federal Court, 8 December 2003). She said this was because the shares gifted to the trust were not provided in connection with any one particular employee.

The Tax Office appealed against this decision. Its primary argument was that it was sufficient for there to be fringe benefits tax liability if the employer had provided a benefit for its employees and if there was a link between those employees’ employment and the provision of the benefit. It argued it did not matter that no one employee had an immediate right to that benefit.

The Full Federal Court rejected the Tax Office’s appeal. Where the decision is particularly interesting is that the court was highly critical of the Tax Office’s attempt to ignore – when issuing the ruling – established law. Justice Allsop said: 'I wish, however, to add some comments about the attitude apparently taken by, and some of the submissions of, the [Tax Office].

From the material that was put to the Full Court, it was open to conclude that the [Tax Office] was administering the relevant revenue statute in a way known to be contrary to how this court had declared the meaning of that statute.

Thus, taxpayers appeared to be in the position of seeing a superior court of record in the exercise of federal jurisdiction declaring the meaning and proper content of a law of the parliament, but the executive branch of the government, in the form of the Australian Taxation Office, administering the statute in a manner contrary to the meaning and content declared by the court; that is, seeing the executive branch of government ignoring the views of the judicial branch of government in the administration of a law of the parliament by the former.

This should not have occurred. If the [Tax Office] has the view that the courts have misunderstood the meaning of a statute, steps can be taken to vindicate the perceived correct interpretation on appeal or by prompt institution of other proceedings; or the executive can seek to move the legislative branch of government to change the statute.

What should not occur is a course of conduct whereby it appears that the courts and their central function … are being ignored by the executive in the carrying out of its function …'

Grape expectations cut down by Part IVA

Cases involving Part IVA continue to bubble along. One such recent case was that of Macpherson v FC of T (Administrative Appeals Tribunal, 22 January 2007).

That case involved a taxpayer who was denied deductions – by reason of an application of Part IVA – for costs incurred by her as a result of her participation in a winemaking venture. She borrowed from a lender the money necessary to fund her participation. However, those borrowed funds did not find their way into the venture but rather were by way of a 'round robin' relent to that lender.

The Administrative Appeals Tribunal held, most probably because of the nature of the financing, that Part IVA applied to deny the taxpayer the claimed deductions. I find that hardly significant.

However, what some accountants will find noteworthy – in so far as the tribunal rejected a commonly held myth – were its remarks that Part IVA could apply to scheme even though the scheme had a commercial purpose.

The tribunal said: 'The evidence points to the fact that [the taxpayer] did not take a careful or critical view of the projected returns from the project. If her dominant purpose was to obtain a long-term income stream, she would have done so and made some comparisons between the projected returns from [the winemaking project] and other forms of investment return.

For example, an investment in a managed fund holding a mixed portfolio of international and Australian equities, property and cash would have produced a higher and more certain rate of return. Despite that, [the taxpayer] chose this project and other so called tax-effective schemes, which created a substantial deduction in the first income year for minimal cash outlay.

There is also ample evidence that [the taxpayer] entered into this scheme for the purpose of reducing her taxable income.

Therefore, I do not accept [the taxpayer’s] submission that she entered into this scheme predominantly for commercial returns,' and that '’It also appears that [the taxpayer] … is of the view that it is sufficient to avoid the impact of Part IVA if a project exhibits a genuine commercial purpose.

That, however, is not the test. The test is whether a person who entered into or carried out the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit.'

When trust is lost

When someone establishes a discretionary trust they normally find the nominated beneficiaries of that trust include not just themselves and their family members but any other trust from which they or their family members might benefit.

This is to allow flexibility as to the range of potential beneficiaries; it provides a simple mechanism for adding beneficiaries to a trust arrangement.

It gives the discretionary trust the opportunity of distributing its income to another trust that has tax losses (so as to shelter the income of that first trust from tax).

But as the decision in Raftland Pty Ltd v FC of T (Full Federal Court, 31 January 2007) shows, there are limits to this tax--planning ploy.

That decision was an appeal from a single judge of the Federal Court (Federal Court, 17 February 2006). The case involved the 'purchase' of a loss trust ($250,000 being paid to the trustee of that trust).

It appeared that moneys had been extracted from a profitable company and diverted through a series of transactions to the loss trust. Also, apart from the $250,000 no actual payment of distributed income was paid to the lost trust. Rather, purportedly distributed moneys were used to purchase shares in an associated company.

Justice Keifel (who heard the matter at first instance) found that the arrangement was a sham.

On appeal the Full Federal Court said that the arrangement was not a sham but used the 'present entitlement arising from reimbursement agreements' provisions contained within section 100A of the Income Tax Assessment Act 1936 to defeat that arrangement.

The decision, however, does not mean that all arrangements to make use of trust losses will be ineffective. The 'reimbursement agreement' provisions need to be considered on a case-by-case basis.

I still think there is room for an arrangement to be defeated as a 'sham'. The loss-carried-forward provisions are very complicated and should not be ignored.

Finally, although not considered in the Raftland decision, there is Part IVA. And I suspect that in many instances that part will cause most concern.

But while all these problems show the need for care, intra-group trust loss transfer arrangements remain a legitimate and effective way to tax plan. 

Reference: April 2007, volume 77:03, p. 62-65

About the author: Robert Richards

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