Protecting the rights of a small business client. A Bendigo CPA tried out the test case funding process and won.
By Michael Lawrence
Testing times
A senior tax lawyer told Bendigo accountant Phil Eddy several years ago that he would be wasting his time by seeking test-case funding. Eddy was hoping to challenge the commissioner of taxation on behalf of a small business client, Helen Long.
As a director and senior executive of her family company, Long had effectively dismissed herself as an employee and the commissioner had refused to treat her termination payout as a tax-free, bona fide redundancy payment.
'Being told I would be wasting by time was like a red rag to me,' Eddy recalls. The managing partner of a five-partner practice, Philip J Eddy & Partners, was convinced that the commissioner's action was not supported by the law.
Despite the warning that he would be wasting his time, Eddy pushed ahead and successfully applied for test-case funding. After gaining approval for the funding, he hired Melbourne lawyers Hall & Wilcox to conduct the test case before the Administrative Appeals Tribunal, resulting in a resounding victory for his client.
The tribunal found that the termination of Long's employment qualified as a bona fide redundancy under the Income Tax Assessment Act 1936 and that she was eligible for concessional tax treatment on the termination payout.
This was contrary to the commissioner's long-standing view that a person who was both a director and employee of an employer's company, and took part in the decision to terminate the employment, was ineligible for a termination payout to be treated as a bona fide redundancy payment.
The tribunal considered that the termination of Long's employment had been against her wishes and had been forced upon her family company.
Further, the tribunal found that the payment to Long was not excessive and could have been reasonably expected had she been dealing with the employer on an arm's-length basis.
The commissioner has agreed to apply the tribunal finding in the Long case to other redundancy claims provided the facts are essentially similar.
Since the tribunal's ruling in mid 2007, Eddy has been thinking carefully about the role of the ATO's test-case litigation program and its potential benefit for the clients of other small accounting practitioners. Test-case funding is limited to paying solicitors and barristers plus disbursements, it does not extend to accountants' fees.
An accountant's view
Although the Long case has been examined in professional journals, this is the first time that Eddy has discussed his personal views on the litigation and its possible consequences.
'I am just a country accountant who made a stand,' Eddy says. 'And I didn't charge my client a cent.'
Before the Long case, Eddy had not given the possibility of seeking test-case funding much thought. 'I thought larger firms with more resources could do that,' he says.
But his views began to change when the family business of long-time clients, the Long family, lost its only contract and had to be wound up, with all employees losing their jobs, including the directors who were also employees.
The Long's business, VBS Pty Ltd, had been solely occupied with installing and maintaining television satellite dishes as a contractor for Austar Entertainment. It was the company's only business activity. And the unique nature of its work meant that it could not win any new business after losing the Austar contract.
'The business had nowhere to go,' says Eddy.
Helen Long and her husband, Peter, controlled the business as joint managing directors and were actively involved in its operation. And each member of the Long family was employed by VBS along with five other unrelated employees. There were also 50 sub-contractors who installed the dishes.
Mrs Long was paid her salary to the date that the business stopped operating plus an $18,535 redundancy payout, which was the then tax-free maximum for a bona fide redundancy payment.
Eddy had asked himself: if employees of large employers could receive tax-free, bona fide redundancy payments if eligible, why should it be any different for employees of small businesses who were also directors?
He studied all ATO documents he could find on the issue. 'And the more I read about the commissioner's view, the more I felt it wasn't right. I couldn't find anything in case law to support it,' he says. 'I believed genuinely that Helen Long was entitled to a tax-free, bona fide redundancy payment; the same as employees in the big end of town.'
When test-case funding was granted, Eddy gained an assurance from the ATO that Mrs Long would not be treated in a hostile fashion during the litigation. 'I can't make one word of criticism of the tax office over my application for test-case funding. they guided me through it, and over its conduct during the tribunal hearing.'
Eddy believes that his colleagues in the tax profession would deal with hundreds of matters over the years that involve what they regarded as bona fide redundancy payouts to small business owners who were also employees.
'My colleagues should be encouraged by the Long case,' Eddy says. 'If they really believe in something, they should pick it up and run with it rather than taking the easy way out. This is assuming that they have done their research [concerning the law] and covered all of the fundamentals.
'Test-case funding is a much untapped opportunity for members of the profession. A lot of things haven't been tested.'
Eddy didn't think he had a chance of getting test-case funding, even though he believed in this case. And if his firm wasn't successful in gaining funding for the litigation, it couldn't have proceeded.
Inside the test-case program
The numbers of cases that receive test-case funding is relatively small, yet the percentage of successful applications for funding is, perhaps, surprisingly high.
The ATO's chief tax counsel Kevin Fitzpatrick told INTHEBLACK that in 2005-06, 19 of the 35 applications for test-case funding were approved. Five, however, did not proceed to court or tribunal. (In some instances, an issue is resolved before litigation and sometimes a taxpayer decides a case is too weak; and sometimes the ATO may decide not to proceed.)
Five of these cases are still in the court system (with some perhaps on appeal). And the ATO won five of the nine cases that were finalised.
In 2006-07, 22 of the 52 applications for test-case funding were successful in gaining funding. In these two financial years, 47 per cent of applications gained test-case funding.
Fitzpatrick says most test-case funding is given, at first instance, for cases to be heard by the Federal Court. (The Helen Long case is one of the exceptions.) This is for two reasons: the facts of the case have already been before the Administrative Appeals Tribunal, and the court judgement could set a legal precedent, unless successfully challenged. (A tribunal finding can set a precedent if a judge has presided.)
'We are not fussed if we lose a [test] case,' Fitzgerald says. 'The important thing is that we get clarification of the law.'
The test-case program was established in 2005 to clarify uncertainty or contention in the operation of the tax law that had implications for a large section of the public or had significant commercial implications for an industry sector. And litigation of a matter receiving funding had to be in the public interest.
Applications for test-case funding are considered by a test-case litigation panel, which recommends to Fitzpatrick whether funding should be provided. Fitzpatrick emphasises that he is the one who makes the final decision on behalf of the commissioner, in most instances following the panel's recommendations.
The current panel comprises Fitzpatrick as chair, Stephen Martin, the ATO's senior tax counsel (strategic litigation), and four outside members, a retired judge from the NSW Court of Appeal, a solicitor, a barrister and an accountant.
Fitzpatrick has a tip for taxpayers and their representatives in order to maximise their likelihood of gaining approval for test-case funding. Applications should focus on what legal issue needs clarification and why its clarifi-cation is of significant public interest.
'That's what they should focus on; they should not focus on why the ATO [in their view] was wrong' in its treatment of a taxpayer.
Fitzpatrick emphasises that most tax cases turn on their facts: 'If that's the situation, you won't get test-case funding.'
The test-case program is criticised from time to time within the tax and legal professions. And a report publicly released in August 2006 by the inspector-general of taxation, David Vos, into tax office litigation suggested that the test-case program had inadequate quality assurance and that the ATO had failed to ensure that all cases warranting funding were identified.
Fitzpatrick rejects Vos' finding that the program had inadequate quality assurance, and that the ATO had failed to identify issues that needed clarification through a ruling or litigation.
A lawyer's view
Keith James, a senior tax partner with Hall & Wilcox in Melbourne, who acted for Helen Long, says: 'What Phil Eddy has done is a really good news story. He has shown smaller accountancy firms that they can really make use of the test-case program.
'Phil thought the ATO's decision not to treat the termination payout to Helen Long as a bona-fide redundancy payment was wrong, and he did something about it.' James regards the Long case as an important win for small business taxpayers. 'An underlying area of the law concerning bona fide redundancy payments has been determined.'
In James' experience, applications for test-case funding to clarify the tax law are typically not successful for the first hearing. 'However, if the taxpayer wins the first case, then test-case funding [if warranted] is almost guaran-teed for subsequent hearings.'
This has been his experience when acting in many matters that eventually gained test-case funding. These include Ryan's case (involving tax assessments, heard by the High Court in 2000), Cajkusic's case (involving a family trust, heard by the Full Federal Court in 2007), and Condell's case (involving the taxation of dividends, heard by the Full Federal Court in 2007).
Get the basics right
Phil Eddy has some straightforward tips for other accountancy practitioners with clients who have effectively dismissed themselves following the winding up of their businesses and want their termination payouts treated as bona fide redundancy payments.
Eddy says practitioners should get the basics right to establish their clients' eligibility for a bona fide redundancy payment, whether or not they have to proceed to litigation as he did on behalf of a client, Helen Long.
'If you don't get the fundamentals right, I believe that you will be knocked back every time. You won't even get into the boxing ring.'
His practical tips include:
Create an audit trail: 'Be able to substantiate that redundancy payments were actually incurred,' he says.
Hold shareholder meetings: 'Keep minutes of the meetings that record the decision to wind up a business and why the termination payments to the owner / employees and to other employees, are being made. 'Follow the rules of the entity concerning the decision to wind down the business,' Eddy says.
Ensure an arm's length approach: Business owners who are also employees should deal with themselves in the same way as other employees as to how their termination payouts are calculated and paid. 'Draw the cheques to other employees at the same time, but not, of course, for necessarily the same amounts.'
Appoint remuneration consultants: These consultants should develop a remuneration policy for employees and assess their salaries and entitlements. This is part of proving that the employer has taken an arm's length approach to redundancy payments.
Have written employment contracts: As a general practice, recommend that your clients who are both owners of the business and employees have written employment contracts. The contracts should include their entitlements in the event of redundancy. This should obviously be done as a matter of course before there is any suggestion that a business is to be wound up.
Appoint a voluntary administrator or liquidator to wind up the business: this will further show that the wind up and the termination payments were dealt with on an arm's length, independent basis.
