The High Court attacks discretionary trusts
In Spry v Kennon, the High Court was asked to consider whether assets held in a family trust were property of the parties to the marriage and therefore the subject of a Family Court order.
- After 23 years of marriage, the parties separated. Prior to the commencement of the proceedings, the husband removed both her and himself as beneficiaries of the trust.
- The husband established the trust ten years prior to the marriage.
- The husband:
- was the trustee and controlled the trust;
- made the majority of the financial contributions to the trust; and
- transferred trust assets ($3.5 million) to trusts established for the parties' four children without the wife's knowledge or consent.
- The Family Court set aside:
- the deeds that removed the wife as a beneficiary of the trust; and
- the disposition of the trust assets to the children's trusts.
- The Court held that the assets, once returned to the trust, should be treated as property of the husband and wife.
- The High Court confirmed that where assets have been acquired by or through the efforts of a person or his or her spouse, before or during the marriage, those assets do not lose the characteristic as property of the marriage merely because a trust is declared over those assets.
- Significantly, neither the husband nor the wife held beneficial interests in the capital of the trusts at the time this finding was made.
Implications:
This case undermines the effectiveness of family or discretionary trusts for asset protection. It now appears difficult to effectively quarantine an asset from a family law dispute. The only solution appears to be to place the asset in a trust and have no position of control within the trust (ie as trustee or appointor). Both parties to the marriage should also be excluded as beneficiaries of the trust. In essence, this requires the relevant party to forfeit all control of the asset and legal and beneficial ownership of the asset.
Black v Black: Black and White?
Black v Black [2008] FamCAFC 7
The Family Law Act (Act) allows parties to a marriage or who are planning to marry to enter into binding financial agreements (BFA).
A BFA is an agreement entered into by a husband or wife which deals with how their assets are to be divided if their relationship breaks down. A BFA can also include matters relating to superannuation and spousal maintenance.
The Act prescribes four types of BFAs, which can be entered into:
- before marriage BFA (s90B);
- during marriage but before separation BFA (s90C);
- during marriage but after separation BFA (s90c); and
- after divorce BFA (s90D).
Section 90G of the Act sets out the formal requirements for a BFA to be valid. The agreement must be in writing, signed by both parties and include a statement to the effect that both parties have received independent legal advice regarding the effect of the agreement and outlining the advantages and disadvantages upon entering the agreement.
Section 90K of the Act allows a Court to set aside a BFA, in a number of circumstances, such as fraud or if the agreement is invalid or unenforceable.
To date the only BFAs which have been struck down by the Court have been because they were technically deficient, not because the terms were unfair or oppressive.
In the case of Black v Black, the parties entered into a BFA during their marriage pursuant to section 90C of the Act. Under the terms of the BFA the parties agreed to sell the husband's house and pool their money in a joint deposit account. The parties agreed to use the funds to purchase a house in joint names. The wife was to receive a personal injury payout which she was to contribute towards the deposit for the new house. It was set out in the terms of the BFA that if the marriage broke down the house was to be sold with the proceeds divided equally between the parties. The parties purchased a house prior to the wife receiving her personal injury payout. The parties had expected the wife would receive $200,000. The wife's payout was less than anticipated and she received only $41,000.
When the marriage broke down the husband sought to set aside the BFA. He wanted 80% of the value of the house, based on his contributions. The husband argued that the BFA was unfair because he had contributed more money than the wife towards the purchase of the house, yet she was to receive half of the sale proceeds of the house. The wife sought to enforce her 50% entitlement to the sale proceeds pursuant to the BFA.
The trial judge found that the BFA was binding pursuant to Part VIII of the Act and that the Court had no jurisdiction to make the adjustment sought by the husband. The husband appealed to the Full Court of the Family Court. The husband argued that the BFA was not enforceable because it failed to strictly comply with the requirements of s 90G of the Act. The Act requires each party to receive a certificate which states that they have received independent legal advice regarding the terms and effect of the BFA prior to executing the agreement.
The BFA was amended three days after it was executed by the parties. The husband's solicitors failed to re-certify the certificate of independent legal advice on the date the agreement was amended. The husband argued this rendered the BFA invalid.
The Full Court held that strict compliance with s 90G of the Act is required in relation to BFAs. The Full Court held that the certificate given to the parties by their legal representatives is required at the time of execution and the failure by the husband's lawyers to re-certify the certificate meant that the BFA did not comply with the specific requirements of the Act.
The BFA was held to be flawed and not binding on the parties.
The Full Court allowed the husband's appeal and ordered a re-trial of the parties' applications for property settlement.
Fixed trusts: when do you need them?
Often a unit trust is assumed to be a fixed trust for the purposes of taxation legislation. This is frequently not the case. If a trust is a fixed trust it reduces the tests that must be met in order to claim the trust losses. There are two definitions or concepts that must be understood: 'fixed trust' and 'fixed entitlement'.
What is a 'fixed trust'?
The easiest way to satisfy the fixed trust definition (or to avoid having to satisfy the definition) is to make a family trust election. However, this is not always possible or appropriate.
Ordinarily, a fixed trust is a trust where each beneficiary has fixed entitlements to income and capital of a trust. For the purposes of the 1936 Act however, a fixed trust is a trust where "...persons have fixed entitlements to all of the income and capital of the trust..."
What is a 'fixed entitlement'?
If under a trust instrument, 'a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derived from time to time, or of the capital of the trust, the beneficiary has a "fixed entitlement" to that share of the income or capital.'
What is 'Vested and Indefeasible'?
In the case of listed trusts, a unitholder's interest will be vested and indefeasible if the units held will be redeemed, or any further units will be issued at the same price that other similar units are offered for sale at an approved stock exchange. This is usually the case.
For unlisted trusts, the requirement is that units held by the unit-holder will be redeemed, or further units will be issued for a price determined on the basis of the net asset value according to Australian accounting principles, of the unit trust at the time of redemption or issue. This is determined by the terms of the trust instrument. This will present an issue for many unit trusts, as it is usual for the trustee to have a discretion to issue or redeem units at any price.
In the absence of such a provision, the Commissioner of Taxation has discretion to treat interests in a unit trust as having 'fixed entitlements' to income and capital. Such an assessment can only be made having regard to:
- the circumstances in which the entitlement is capable of not vesting or the defeasance can happen;
- the likelihood of the entitlement not vesting or the defeasance happening; and
- the nature of the trust.
Ordinarily these factors will be sufficient to satisfy the Commissioner that the unit holders enjoy a fixed entitlement to a share of the income or capital of the trust, however every matter must be determined on the relevant fact scenario. Some guidance is provided by the Explanatory Memorandum to the Bill which introduced this provision. The discretion is intended to:
"provide for special circumstances where there is a low likelihood of a beneficiary's vested interest being taken away or defeated and, having regard to the scheme of the trust loss provisions, to provide for the transfer of tax benefit of losses and other deductions incurred by trusts, it would be unreasonable to treat the beneficiaries' interest as not constituting a fixed entitlement".
All requests for advice involving the consideration of fixed entitlements should be forwarded to the 'Losses Centre of Expertise' within the Australian Taxation Office (ATO). We understand that it is unlikely that the discretion would be exercised for the purposes of the trust loss rules.
When does your trust need to be fixed?
The two most common situations when a fixed trust is needed are for trust loss recoupment and the flow through of imputation credits in a trust.
As we approach harder financial times, the carry forward of company losses and claiming of bad debts will be more prevalent. Again, a trust which is a majority company shareholder will need to be a fixed trust. A less common but potentially significant scenario is the Division 124-M scrip for scrip rollover relief.
The reality is that in many cases, the only trusts that will meet the fixed trust definition will be those where a family trust election has been made. Everything else will not be a fixed trust.
Senate rejects changes to family trust elections
The definition of 'family' is central to the operation of the tax concessions applicable to family trusts. A family trust election must specify a test individual as the individual whose family is taken into account in relation to the election.
The definition of 'family' was amended by the former Howard federal government with effect from 24 September 2007. That amendment extended the definition of family to include any lineal descendent of a nephew, niece or child of the test individual or the test individual's spouse.
Earlier this year, the Rudd federal government sought to reverse the 24 September 2007 changes. Schedule 2 of the Tax Laws Amendment (2008 Measures No 4) Bill 2008 (Bill) was designed to:
- change the definition of 'family' in the family trust election rules to limit lineal descendants to the children or grandchildren of the test individual or their spouse; and
- remove the ability of family trusts to make a one-off variation of the test individual specified in a family trust election.
These changes were ultimately rejected by the Senate and Schedule 2 was removed from the Bill. As a result, the existing definition of 'family' in the family trust election rules will remain and will continue to include lineal descendants of any nephew, niece or child of the test individual or their spouse. The capacity for family trusts to make a one-off variation of their test individual in limited circumstances will also continue.
Trust cloning exception removed
Is it a case of too much of a good thing? On 31 October 2008 the Government announced that the trust cloning exception to CGT events E1 (creating a trust over a CGT asset) and E2 (transferring a CGT asset to a trust) will be removed. The amendments will apply to CGT events occurring on 1 November 2008 onwards, despite the fact that legislation implementing the amendments is yet to be introduced.
According to the press release, the removal of the trust cloning exception is intended to:
- ensure consistency with the policy principle of taxing capital gains resulting from a change in beneficial ownership of an asset;
- resolve uncertainty surrounding the application of the exception; and
- remove the possibility for the trust cloning exception to be used to eliminate tax liabilities on accrued capital gains.
A mere change of trustee of a single trust will continue not to trigger CGT consequences. As noted above, the battle on family trust election changes was won. We may yet win the war. The same goes for this proposed amendment.
GST impact of leasing new residential premises
Australian Taxation Office Interpretative Decision 2008/114 (ATO ID 2008/114) discusses the situation of a property developer who has incurred significant building and other costs to construct new residential premises as part of its property development enterprise with the sole intention of selling these premises on completion (which are subject to GST). If efforts to sell the property are unsuccessful, an issue arises as to whether input tax credits can be claimed on these 'creditable acquisitions' (or purchases), where the property is leased for an interim period to produce residential rent, before its eventual sale. In a cooling property market, where clearance rates have markedly decreased, this ATO ID could have significant operation.
Generally, residential rent is input taxed, meaning that no input tax credits can be claimed on any purchases that contribute to the supply of residential rent. The ATO ID will allow input tax credits, even where new residential premises are being leased, provided active marketing of the new residential premises is taking place.
No single factor is conclusive as to what constitutes active marketing, however the following factors are relevant:
- listing the property for sale with a real estate agent/s;
- advertising the premises for sale in relevant publications or via the internet;
- arranging 'open for inspection' times;
- showing prospective buyers through the premises; and
- in the case of stratum units, actual arm's length sales would be evidence of active marketing.
On the other hand, listing the premises for sale at a price that is significantly above market value may be an indicator that the premises are not being actively marketed for sale. The active marketing demonstrates that the premises have been applied to some extent for the creditable purpose of sale.
The extent to which input tax credits may be claimed in this situation must be calculated by using a fair and reasonable basis of apportionment. One suggested method involves estimating the sale price of the premises, which is then divided by the sum of this estimated sale price and any further rent received. The fraction calculated would thereafter be used to ascertain the amount of input tax credits that can be claimed. The longer that the new residential premises remain unsold, the entitlement to input tax credits will proportionately be decreased.
A practical example of this ATO ID in operation is as follows:
Property Developers Acme Pty Ltd (Acme) have built new residential premises and claimed $50,000 of input tax credits. Acme believes that the property is worth $1,100,000 (including GST) if sold.
For the first year, the new residential premises remains unsold, however for six months, to recoup some of this expenditure, Acme decides to let the property for residential rent, for which it receives $25,000 rent. In such a situation, the percentage of input tax credits that can be claimed in the first adjustment period following the letting of new residential premises, would be 97.8% of $50,000 which is calculated as follows:
$1,100,000 (expected sale price)
$1,100,000 + $25,000 (rent received)
The longer that the premises remains unsold and rented out, the entitlement to input tax credits is proportionately decreased. If in the following year, the premises remain unsold for the entire year, the percentage of input tax credits that can be claimed is further reduced to 93.6% of the $50,000 calculated as follows:
$1,100,000 (expected sale price)
$1,100,000 + $75,000 (rent received)
Given that the expected sale price is likely to exceed any residential rent received, there will continue to be a generous entitlement to input tax credits for construction and other costs in any ordinary circumstances, even though the longer the premises remain unsold, a small increasing adjustment may be needed each period.
Mixing business with pleasure: when is a hobby an 'enterprise'?
An 'enterprise' for the purposes of the GST Act includes an activity, or series of activities, done in the form of a business but excludes those done as a private recreational pursuit or hobby. Three recent decisions of the Administrative Appeals Tribunal (AAT) look at the distinction between a hobby and a business:The Taxpayer v C of T (Artwork case), D'Arcy and C of T (D'Arcy) and Alexander Drysdale v C of T (Drysdale).
In the Artwork case, the Commissioner was unsuccessful in defending a decision to retrospectively cancel a company's GST registration from 1 July 2000 on the basis that it was not carrying on an enterprise. The AAT accepted that on the evidence the company's acquisition of artwork and antiques constituted an 'enterprise'. In doing so, the AAT rejected the Commissioner's submission that acquiring assets for long term investment could not be viewed as an acquisition for commercial purposes. From early 1997 until November 2005, the company had spent $4.8 million on acquiring 225 antique items and 87 paintings. Three items had been sold for $106,000, generating a loss of approximately $35,000.
In the earlier decisions of D'Arcy and Drysdale, the taxpayers were unsuccessful.
In D'Arcy, the taxpayer was involved in breeding thoroughbred horses. He took the view that he was 'carrying on an enterprise', and therefore applied for, and was granted, an Australian Business Number (ABN) and GST registration.
His full-time occupation was a building project manager, in which he earned significant salary and bonuses. He spent between eight and 12 hours a week on horse breeding activities. He held an interest in up to eight mares, producing 22 progeny in total, most of which were sold. His interest in the mares varied from 10% or 12.5% to 30%. Although claiming that he was in the business to 'make money,' he was unable to produce any real business plan before he commenced horse breeding for the relevant years of income; nor was he able to produce profit and loss forecasts for the relevant years or books of account and records. There was no written agreement between the other co-owners governing their relationship and decision-making. The AAT concluded that the taxpayer's activities did not amount to the carrying on of an enterprise. The Tribunal was not able to distinguish the taxpayer's activities from those of a person who, with a keen interest in horses and their breeding, chooses to become a part-owner of broodmares for the purpose of pleasure or recreation, or as a hobby.
In Drysdale, the taxpayer had spent about $425,000 on purchasing a boat and fitting it out with additional equipment and safety items and claimed input tax credits on the basis that it was acquired for the purposes of carrying on his enterprise. When he purchased the boat (on which he claimed input tax credits), he entered into a 'sub-dealer's' agreement with the vendor, under which he would make his boat available for demonstration purposes to promote the brand and in return receive a commission for each boat of the same type that was sold within Victoria. No boats were actually sold. The AAT found that the absence of any or any adequate or reasonable planning, control, revenue projections or expectation pointed to the taxpayer not being engaged in activities done in the form of a business.
The Artwork case, D'Arcy and Drysdale illustrate the activities sufficient to support the conclusion that an enterprise is being carried on. These include:
- activities conducted in accordance with a pre-formulated policy, coupled with a carefully devised investment strategy (Artwork case);
- activities characterised by system, repetition and regularity;
- use of a system and systematic conduct of the activity (Artwork case);
- the activities are approached in a business-like way (D'Arcy); and
- a sufficient level of investment, involvement, planning, time, effort, promotion, marketing and enthusiasm (Drysdale).
Cleaning up after the party: tax issues in a bear market
Deducting bad debts
The deductibility of debts written off as bad is addressed in section 25-35 of the 1997 Act. Section 25-35(1) states that a taxpayer "...can deduct a debt (or part of a debt) that [is written] off as bad in the income year if it was included in [the taxpayer's] assessable income for the income year or for an earlier income year". This article does not discuss in detail the special provisions that apply to money lenders (ie entities in the business of lending money) and bad debts arising from luxury car leases (see sub-sections 25-35(2), (3), (4), (4A), (4B) and (4C)).
The availability of a deduction under section 25-35(1) is subject to a number of conditions and further requirements, which are set out at section 25-35(5). These include:
- the requirement that the entity satisfy the continuity of ownership or same business test (specifically, the rules in subdivision 165-C and 166-C);
- where debts are forgiven between companies under common ownership and the creditor agrees to forgo a deduction (relevant to the debt forgiveness rules); and
- importantly, that if a debt written off as bad is eventually recouped, the recoupment may become assessable (subdivision 20-A).
Any practitioner required to consider the bad debt deduction rules must read Taxation Ruling TR 92/18. While this ruling considers the application to the predecessor to section 25-35 of the 1997 Act (section 63 of the 1936 Act), it has not been withdrawn and its principles are relevant to determining, among other things, when a debt is a "bad debt" for the purposes of section 25-35.
In the ruling the Commissioner states that these four elements must be satisfied to obtain a deduction for a bad debt:
The Commissioner defines a debt as a "sum of money due from one person to another". This does not imply there needs to be a physical provision of money from one party to the other to create the debt. Nor does the debt need to be enforceable under a contract or agreement: an equitable entitlement to a debt will also qualify.
Second, the debt must be bad
This is a question of fact that can be controversial. The Commissioner states that the debt does not have to be totally irrecoverable because the debtor has died without assets or has become insolvent in order for it to be a bad debt. However, at the same time, the prospects of recovery must not be merely 'doubtful'.
The Commissioner outlines at paragraph 31 of the ruling a number of situations where a debt might be considered a bad debt, including because the debt has become statute barred, the debtor has disappeared and they have no assets or, if the debtor is a company, it is in liquidation or receivership. At paragraph 32 of the ruling, the Commissioner outlines a number of steps that he would want to see the creditor have taken to recover the debt before it is written off as bad, including following up the debtor with reminder notices, taking action to ascertain their asset position and issuing recovery proceedings.
A word of warning: we have been involved in disputes with the Commissioner where the requirements of paragraphs 31 and 32 have been treated by the ATO something like a checklist that the taxpayer is expected to have ticked off. The Commissioner will not hesitate to supplant his own 'commercial' judgement of when a debt is bad with that of the creditor, who has direct knowledge of the context and circumstances in which the debt was considered bad!
Third, the debt must have been written off as bad during the year of income in which the deduction is claimed
The bad debt must not merely be provided for in the accounts, it must be written off before year end. This involves a physical writing off of the debt, although it is not necessary that the debt be written off in the creditor's books of account. For example, documentation in the form of a board minute or company correspondence will suffice.
This point is vital and worth repeating: the debt must be written off before year end, if you wait until you prepare the accounts, it is too late! We have seen this happen and the consequences can be catastrophic.
The debt must have been brought to account as assessable income
The Commissioner makes the point that this presumes that the creditor is using an accruals basis for recognising income for tax purposes. Taxpayers on a cash basis would not have brought the income to account until it was received and as such, have no use for a deduction for bad debts.
The CDF rules
The CDF rules are contained in Schedule 2C of the 1936 Act. The CDF rules do not apply to the creditor that forgives the debt but rather, the debtor that receives the benefit of the debt forgiveness. The rules operate by requiring a Debtor that has been forgiven a Commercial Debt to reduce certain amounts (called Reducible Amounts) which would otherwise be taken into account in reducing the Debtor's assessable income, such as revenue and capital losses, the cost base of certain assets and certain future deductions. The purpose of the rules is to ensure that the debtor does not retain the full advantage of future deduction in respect of the Reducible Amounts where the creditor (that provided the debt which funded the Reducible Amounts), gets the advantage of a revenue of capital loss for the forgiven debt.
Is the debt a Commercial Debt?
A Commercial Debt is defined as a debt the interest on which is deductible to the payer, or which would be deductible to the payer if interest applied to the loan (subsections 245-25(2) and (3)). This includes the component of a debt that represents accrued interest (section 245-20).
Is the debt 'forgiven'?
A Commercial Debt may be forgiven in any number of ways, including by the debt being waived or extinguished in any way, the creditor being barred from recovering a debt by the expiration of a statutory limitation period, by the parties entering into an agreement to end the debtor's obligation to pay the debt at a future point in time or by being 'parked' within a separate entity (sections 245-35(1), (2), (3) and (4) respectively).
What is the amount of the forgiven debt?
The amount which is applied against the Reducible Amounts is the total of all Net Forgiven Amounts of all debts of a particular Debtor forgiven in the same year of income.
The starting point in determining the Net Forgiven Amount of a Debtor's debts is the calculation of the Gross Forgiven Amount of debt, this is the difference between the Notional Value of the debt and the Consideration in respect of the debt forgiveness (subdivision 245-C).
The Notional Value of the debt will generally be the value at which the debt would be carried in the books of the creditor, on the assumption that the debtor was solvent and able to repay the debt. Further adjustments may be made to reflect changes in market variables and in respect of any debt that is a 'moneylending debt' ie provided by a moneylender.
The consideration provided for the forgiveness of the debt is the cash provided, or the market value of property provided, for the forgiveness of the debt: section 245-65(1). Where no consideration is provided (or is provided and cannot be valued) or the creditor and the debtor are not transacting at arm's length in respect of the debt forgiveness, consideration equal to the 'market value' of the forgiven debt will be deemed to have been provided: section 245-65(2). In cases where there is debt forgiveness between related entities where the debtor is solvent and no consideration is provided, this provision may result in a gross forgiven amount of nil, meaning the CDF provisions have no practical application.
The net forgiven amount of a debt is calculated by adjusting the gross forgiven amount for certain items which would otherwise be double counted, such as amounts that are otherwise assessable or deductible to the debtor as a result of the debt forgiveness.
How will the Net Forgiven Amount of the debt be applied against the Reducible Amounts?
The net forgiven amount of all the Debtor's debts in an income year are added together and this amount is applied against the following Reducible Amounts (as set out in Subdivision 245-E) in order:
- Revenue losses: sections 245-110 to 120;
- Net capital losses: sections 245-125 to 135;
- Future deductions in respect of particular expenditure (set out at section 245-140): sections 245-140 to 160; and
- The cost bases of certain assets (being any asset of the Debtor other than an excluded asset as set out in section 245-170): sections 245-165 to 190.
Comments
The bad debt and CDF rules are two areas that might become more relevant to practitioners in the current market. If you have clients that are considering writing-off debts, read TR 92/18, advise them to take some positive action to recover the debt and make sure they have evidence in writing that the debt was written off before year end. If you have a client that is the beneficiary of a debt forgiveness, remember the CDF rules and the affect these may have on carried-forward losses and other potential claw-backs - no 'bear market' pun intended!
Duty on sub-sales of land: more changes proposed
The State Taxation Acts Further Amendment Bill 2008 (Bill), which was introduced into the Victorian Parliament on 29 October 2008, will amend the provisions of Part 4A of Chapter 2 of the Duties Act 2000 (Vic) (Duties Act) that impose duty on transactions considered to be 'sub-sales' of land.
In broad terms, the sub-sale provisions impose additional duty on a transfer of land where a person other than the purchaser under the sale contract obtains a right to take a transfer of the land on completion of the contract and additional consideration is given for the right or land development occurs on the land. Additional duty is also imposed on a transfer of land resulting from the exercise of an option where a person other than the grantee of the option obtains a right to enter into a sale contract or to take a transfer of the land and land development occurs on the land.
The person (subsequent purchaser) may obtain the right to take a transfer (transfer right) by way of assignment, nomination, novation or other arrangement (subsequent transaction). The Bill, if enacted, will make the following changes:
Sub-sales involving both additional consideration and land development
Where both additional consideration is paid and land development occurs before completion of the sale contract, additional duty is presently imposed only in respect of the land development. The proposed changes will impose the duty in respect of the additional consideration. This change purports to reinstate the underlying policy of Part 4A that additional consideration is the principal indicator of a sub-sale.
Exception for sub-sales involving land development
Under a current exception, additional duty is not imposed on sub-sales involving land development if 'the land development did not occur at any time at which the subsequent purchaser held a transfer right'. This exception results in no duty imposed where the land development occurs before the subsequent purchaser obtains a transfer right. The proposed changes will address this gap by ensuring that the exception does not apply to the last or only subsequent transaction and that the exception is available only where the land development did not occur before the subsequent purchaser obtained a transfer right.
Exemption for transactions involving sub-sales between relatives
No additional duty is presently imposed in respect of a sale contract or option where the first purchaser is a relative of the vendor or in respect of a subsequent transaction where the subsequent purchaser is a relative of the first purchaser. The new provision proposes to remedy this exemption by ensuring that the exemption applies to relatives of the first purchaser and by shifting the obligation to pay the primary duty to the last or only subsequent purchaser.
Duty to be imposed on 'fractional' sub-sales
The proposed amendments will also impose additional duty on partial sub-sales to the extent of the interest obtained. Where, by a subsequent transaction, a person obtains an increase in its transfer right or obtains a transfer right while another retains its transfer right, the person will be a subsequent purchaser in relation to that subsequent transaction to the extent of the increase of the right or the transfer right obtained.
The new provisions will apply to a transfer resulting from a contract entered into, or an option granted, on or after the day after the day of Royal Assent.
The amendments do not address other areas of concern with the sub-sale provisions. In particular, the broad definition of 'land development' has been left in place. The doing of any prescribed activity in relation to the land (eg preparing a plan of subdivision or applying for a permit) will bring a sub-sale within the scope of these provisions whether or not that activity increases or enhances the value of the land.
Further, the changes will do little to reduce the complexity of the sub-sale provisions. There will remain situations where the sub-sale provisions have unintended consequences for both the taxpayer and the revenue office.
Transfers to and from bare trustees
Section 35 of the Duties Act exempts from duty the transfer of dutiable property to a trustee or nominee to be held solely for the transferor without any change in the beneficial ownership or the re-transfer of the property to the transferor. The Bill proposes to replace this section.
New section 35 will extend the exemption to a declaration of trust recording the trust and also limit the exemption for a re-transfer of the property by including conditions that there be no change in beneficial ownership of the property and that no person other than the transferor hold a beneficial interest in the property whilst the trust subsists.
Employee entitlements in insolvency
The Corporations Act 2001 (Cth) gives employees of a company that is being wound up priority over certain employment-related entitlements arising under an industrial instrument. Employee entitlements are also protected against agreements and transactions entered into with the intention of defeating their recovery or significantly reducing the amount available to be recovered. The law makes it an offence for a person to intentionally enter into such an agreement or transaction.
As a result of a number of prominent corporate collapses in recent years, the degree to which the law provides meaningful protection to employees of failed businesses has received considerable public scrutiny.
In response, the federal government introduced the General Employee Entitlements and Redundancy Scheme (also known as 'GEERS') in 2001. GEERS is administered by the Federal Department of Education, Employment and Workplace Relations; its purpose is to financially assist employees who lose their job as a result of their employer's liquidation or bankruptcy and are owed money by their employer. Over $72 million was paid to employees under the scheme in 2006/07.
Prior to the introduction of GEERS, employees had to wait until the employer's assets were liquidated to recover their entitlements. Sometimes they missed out. By contrast, the scheme entitles eligible employees to relatively prompt payment of:
- up to three months' unpaid wages for the period before the insolvency practitioner was appointed;
- all unpaid annual and long service leave;
- all unpaid payment in lieu of notice; and
- up to 16 weeks' unpaid severance pay.
Directors, principals and their relatives employed in the defunct business may be entitled to up to $2,000 unpaid wages and $1,500 in total for unpaid annual and long service leave.
A monetary cap applies. For the 2008-09 financial year, the cap is $106,400 per annum such that an eligible employee earning more than that will have their GEERS entitlement calculated as if they earned that amount. The cap is indexed annually.
There are several exceptions to the scheme's coverage including:
- where the employer is under the control of an administrator, receiver manager or is the subject of a deed of company arrangement, etc (the employer must be in liquidation or bankruptcy for employees to be eligible);
- employees who resign from the business voluntarily; and
- independent contractors.
A claim for an advance under the scheme must be lodged within 12 months after the employee's employment was terminated or the employer became insolvent, whichever is later.
The ATO released several interpretive decisions in early 2008 which provide guidance on how liability for the superannuation guarantee charge will arise in relation to a GEERS advance. (See ATO ID 2008/25, ATO ID 2008/26, ATO ID 2008/27, ATO ID 2008/28).
Self-managed superannuation fund compliance processes and procedures
On 13 August 2008, the Australian Taxation Office (ATO) issued a media release outlining its superannuation compliance focus for the 2008/2009 financial year, which includes:
- early access to benefits;
- over-claiming deductions for contributions;
- ensuring investment and contribution income is taxed correctly;
- identifying unintended consequences fir the 'Simpler Super' amendments;
- monitoring claims for rebates and exemptions;
- monitoring compliance with the funding credit rules;
- investigating complaints from employees where employers have not met their superannuation guarantee or choice of fund obligations; and
- seeking to improve the knowledge and understanding of trustees by sending out start-up kits for new trustees setting out the role and responsibilities of trustees.
Where an auditor reports a breach of the Superannuation Industry (Supervision) Act 1993 (SIS Act) in a fund's first year of operation, the ATO will audit the fund. An auditor is required to report each and every breach made by a trustee in the first year, irrespective of how minor. The ATO will audit 900 auditors in the 2009 financial year.
Is the fund deed up-to-date?
In light of the ATO's increased focus on the knowledge and understanding of trustees of their role and responsibilities in operating and maintaining the fund, trustees should ensure the fund deed is up-to-date.
If the fund deed is misplaced and despite the trustee's best efforts to locate another copy (usually someone will have a copy - the accountant, financial planner, auditor, bank or lawyer), the trustee will not be able to administer the fund with any certainty. A deed of confirmation can be prepared, which essentially reconstructs the terms of the misplaced deed using the available fund records. It is important that the people originally involved in the establishment of the fund are parties to the deed of confirmation. However, there is a risk that third parties dealing with the trustee might form the view that the deed of confirmation is not sufficient.
An alternative is for the trustee to apply to the relevant state court to vary the governing provisions of the fund deed. This is costly and time consuming but has the following benefits:
- it limits the exposure of the trustee for any claim brought by a beneficiary that the trustee is acting outside its powers in administering the fund, although the possibility of such a claim is minimal as the directors of the trustee are also the fund members; and
- it would provide the trustee with greater certainty when dealing with third parties.
As the trustee is required to operate the fund in accordance with the terms of the deed, it is crucial that the deed is consistent with the provisions of the SIS Act and that the original deed is kept in a secure place.
Processes and procedures
At the end of a fund's first year of operation, the fund will be audited and issued a certificate stating that it is complying or non-complying.
In light of the harsh penalties associated with a fund being made non-complying (ie 46.5% tax on the asset base and earnings of the fund for the year), the ATO will generally work with a fund trustee to assist them in rectifying the breach, if possible, rather than make a fund non-complying.
The options available to the ATO to deal with a contravention of the SIS Act, include:
- requiring the trustee to enter into an enforceable undertaking to rectify the breach;
- disqualifying the trustee and prohibiting it from acting as the trustee of a fund; suspending or removing the trustee;
- freezing the assets of the fund to prevent them being eroded; and
- bringing a civil or criminal penalty against the trustee.
Generally, the ATO will not make a fund non-complying where the trustee has wound up the fund and assets have been rolled into an independently managed fund.
The circumstances the Commissioner will consider before making a fund non-complying are:
- whether the contravention has been rectified; the trustee's level of skill and knowledge;
- the compliance history of the fund both before and after the contravention; and
- the events leading up to the contravention and whether these affected the trustee's decision-making processes (ie the serious illness or death of a close relative).
The ATO will also look at the following factors when determining whether the breach is sufficiently serious and/or repetitive to justify the tax penalties of the fund being made non-complying:
- whether the contravention results from the reckless or intentional disregard of the trustee or is the result of an honest mistake;
- the extent to which the contravention affects the fund's assets;
- the exposure of the fund's assets to financial risk and/ or loss;
- the number and duration of any contraventions; and
- whether the contravention is the result of a scheme designed to avoid a regulatory provision of the SIS Act.
Serious breaches generally include early access to superannuation benefits and loans to related parties. There has only been one instance of the ATO bringing a criminal proceeding against a trustee under the SIS Act for serious and repetitive breaches of the sole purpose test, under a scheme designed to facilitate early access to benefits.
Can a small error become a reckless mistake?
The decision of Archibald Dixon as trustee for the Dixon Holdsworth Superannuation Fund v Commissioner of Taxation (Dixon) adopted a low threshold interpretation of what constitutes reckless mistake. A tax agent had been engaged who believed that the property purchased was not the purchase of a going concern and claimed an entitlement to an input tax credit, that was not available. A penalty of 50% of the shortfall amount was imposed on the taxpayer.
Penalties imposed on reckless mistakes are substantial. This hard line approach by the Commissioner was also apparent in Tavco Group Pty Ltd v Commissioner of Taxation (Tavco). In Tavco, one invoice was mistakenly omitted in the original Business Activity Statement (BAS) calculations relating to one of the taxpayer's property developments which resulted in a failure to report the GST liability for more than one year.
In Tavco, a 50% penalty was imposed. The reckless act was missing one invoice out of 20,000. The problem for the taxpayer was that the error resulted in a significant shortfall: approximately $80,000.
Similarly in Dixon, the fund did not have any history of non compliance, however a good compliance record was found to be insufficient to rebut a finding of recklessness because the input tax credit wrongly claimed was significant (approximately $171,000). Although the reckless acts were isolated in nature, the issue in both cases related to the fact that the errors were significant in monetary terms.
Both Dixon and Tavco highlight the need for tax agents and taxpayers to be vigilant. The GST honeymoon period is well and truly over.
This article was written with the assistance of Christopher Brett-Young, Lawyer.
Consolidated groups and straddle contracts
Each determination covers a different aspect of a straddle contract, including entry/sell, entry/buy, etc, and purports to modify some of the core consolidation rules. Of particular interest is the exit/sell scenario. This scenario arises where a subsidiary member of a consolidated group contracts to sell a capital gains tax (CGT) asset and, prior to settlement, all or some of the shares in the subsidiary member are disposed of such that it exits the consolidated group.
TD 2008/D9 provides that CGT event A1 is taken to have happened to the head company of the consolidated group to which the exiting entity belonged at the time the contract is entered into (Old HC). Accordingly, it is the Old HC who will be assessed on the resulting capital gain (if any). Ordinarily, the entity assessed on a capital gain is also the entity entitled to the proceeds on disposal; this natural order of 'sale and receipt' has the added advantage of funding any tax liability that may arise.
The Full Court decision of the Federal Court in Metlife landed with the taxpayer, but, when viewed in conjunction with the Australian Taxation Office's (ATO) straddle contract draft determinations, is a frank warning about the Commissioner's reach to investigate a head company's CGT compliance.
In Metlife, the Court was asked to consider whether subsection 170(10AA) of the 1936 Act conferred upon the Commissioner an unlimited power to amend a taxpayer's assessment in respect of certain CGT events, including CGT event A1. The Court held that where an assessment has been made which takes into account all relevant events, the Commissioner has no recall to subsection 170(10AA). This subsection can only be used to address new facts that arise after the original assessment (eg settlement).
The Court considered the scenario where a contract is entered into in one income year and settled in a subsequent income year. Where a taxpayer includes the capital gain in their original assessment (ie where settlement occurs prior to lodging a tax return), the Commissioner cannot rely on subsection 170(10AA) to amend the assessment; the normal four year limitation in subsection 170(1) applies.
However, where settlement occurs after the lodgement of a tax return, such that new information comes to light after the time of assessment, the Court left open an unlimited power of assessment for the Commissioner by virtue of subsection 170(10AA).
Consider this: SubCo enters into a contract to sell a CGT asset in the 200X income year; later, in the same income year and prior to settlement, the Head Company disposes of all the shares in SubCo. TD 2008/D9 requires HC to include the capital gain as its assessable income, however, at the time HC lodges its tax return for the 200X year the sale contract has not yet completed and HC, correctly, does not include the capital gain in its tax return.
In this instance, the decision in Metlife provides the Commissioner with unlimited reach to assess HC on the capital gain once settlement concludes. However, as SubCo has exited the consolidated group, HC may have little or no ability to obtain information about the date of settlement, the quantum of proceeds, incidental costs of disposal, let alone access to funds received to satisfy any tax liability. Thus, HC is left exposed to the imposition of penalties and interest, not to mention the commencement of proceedings by the ATO.
TD 2008/D9 confirms that a dislocation exists between the entity assessed and the entity receiving proceeds. The decision in Metlife confirms the Commissioner's extended reach to assess capital gains in certain circumstances. A prudent vendor, and also purchaser, should exercise caution when drafting a share sale agreement where the sale results in the exit of a subsidiary member from a consolidated group. Similarly, advisors should be alert to the possibility of an exit/sale scenario and ensure the sale agreement contains adequate protection for a vendor.
Intellectual property considerations for internal restructuring
Asset protection
Structures can be implemented to reduce the risk that intellectual property assets will be exposed to claims by other parties. For example, a separate legal entity can hold the intellectual property and licence it to entities within the group to afford some protection.
Enforcement
What is also often overlooked is which entity within a corporate group has the legal right to bring infringement proceedings, should a competitor be using the intellectual property without authority of the owner.
For example, in respect of a patent, only the owner or an exclusive licensee of that patent has the right to enforce infringements. It follows that if a subsidiary company is a non-exclusive licensee, it has no right to bring patent infringement claims.
The US case of LP v GSE Lining Technology, Inc. 383 F.3d 1202 (Fed Cir 2004) illustrates how this could be an issue. In that case, the holding company owned the relevant patents and granted a non-exclusive licence to one of its subsidiaries. The holding company sued a competitor for lost profits resulting from infringement of its patent. However, as the subsidiary was the trading entity, not the holding company, the Court on appeal did not allow the holding company to sue for lost profits incurred by its subsidiary.
If the licence within the corporate group had been an exclusive one, the trading entity subsidiary would most likely have been able to recover lost profits.
Summary
When restructuring within a corporate group, the following issues should be considered:
- What is the appropriate entity to hold the intellectual property?
- Are licenses of intellectual property documented properly?
- What rights has the licensee been granted under a licence?
- Is the licensee able to enforce its rights in the event of any infringement?
Major reforms to the Family Law Act
The Family Law Amendment (De Facto Financial Matters and Other Matters) Bill 2008 (Bill) has been introduced into Parliament. The Bill will amend the Family Law Act 1975 (Act) to provide for financial matters arising from the breakdown of de facto relationships to be dealt with by the Family Court.
Once the Bill has been enacted there will be major changes to the Act which will enable the Family Courts to deal with all de facto partnerships including the same sex de facto relationships.
De facto partners will be able to:
- apply for the division of property;
- superannuation splitting;
- maintenance; and
- enter into binding financial agreements.
It will not cover de facto relationships which have broken down prior to the commencement of the Act but it will allow some existing agreements made under State Law for example the Property Law Act 1958 of Victoria to be binding.
The definition of a de facto relationship under the Bill is a person is in a de facto relationship with another person if:
- the persons are not legally married to each other;
- they are not related by family; and
- having regard to all the circumstances of their relationship they have a relationship as a couple living together on a genuine domestic basis.