Share transfer to family partnership ineffective

The Administrative Appeals Tribunal (AAT) has dismissed applications from a married couple and found that they were each assessable on dividends of some $1.8 million that they did not return in their assessable income. In doing so, the AAT dismissed the taxpayers’ argument that shares in a family company that gave rise to the dividend income had been transferred to a family partnership, and as a result they had not derived the dividend income themselves.

Background

The husband-and-wife taxpayers were the sole shareholders in a family company (Rocbit Pty Ltd) that had been established in 1994. The taxpayers and Rocbit were also named beneficiaries of a family discretionary trust (Yazbek Trust) established in 1982.

In 2005, a limited partnership was formed under relevant NSW legislation, the partners of which were the taxpayers, and a company which was named as the “general partner” (of which, importantly, its sole director was at all relevant times the husband taxpayer). The terms of the partnership agreement required the taxpayers to contribute the shares they each owned in the family company to the partnership as “initial capital”. A related agreement provided that this was to be done by providing the general partner with the power of attorney to deal with shares and to apply any proceeds from the sale of the shares to the business of the partnership. Despite this arrangement, the taxpayers remained the full registered owners of the shares.

In the 2005 income year, the family trust distributed some $2 million to the family company which returned it as assessable income and then declared a dividend of that amount to its respective shareholders (including the taxpayers, as registered shareholders). However, the dividend income was credited to the loan accounts of the shareholders. Similar patterns of distribution occurred in the 2006 to 2008 years, but for lesser amounts. At the same time, in those years, Rocbit declared a dividend in favour of the family partnership which was returned as assessable income of the partnership. As the distributions were fully franked, no tax was paid.

Following an audit, the Commissioner increased the taxpayers’ assessable income for the years 2005, 2007 and 2008 for some $1.8 million in dividend income each that they had not declared. He did this on the basis that, as registered shareholders of Rocbit, they had derived the income despite their claim that their shares had been transferred to the family partnership and that it, instead, had derived the income. The Commissioner also imposed 50% shortfall penalties for recklessness.

Decision

The AAT affirmed the assessments on the basis that the relevant partnership agreements did not have the effect of transferring the ownership of the shares in the family company to the family partnership, and that therefore the shares did not become partnership property. Instead, the AAT found that while the primary partnership agreement required the taxpayers to contribute all the shares they held in Rocbit to the family partnership agreement, this was qualified by the effect of the accompanying power-of-attorney arrangement which meant that the shares were at all relevant times owned both legally and beneficially by the taxpayers.

In this regard, the AAT noted among other things that the partners were not required to actually transfer their shares to the partnership and the general partner (whose sole director was the husband taxpayer) had the power of attorney to deal with the property (whereby the partners were required to permit the property to be mortgaged or charged by the general partner). The AAT also emphasised that the register of members of Rocbit recorded that throughout the whole of the period, from the beginning of the 2005 income year to the end of the 2008 income year, the taxpayers each held one ordinary share and that those shares were beneficially held by each of them.

Accordingly, the AAT concluded that the relevant partnership agreements, when read together, did not provide for a transfer of the shares. All they allowed for was a right to use the shares for certain purposes and a right to an application of the income of the shares – with the result that the dividend income was derived by, and belonged at all times to, the taxpayers. The AAT also found that the effect of the crediting of the loan accounts meant that the dividend income had been “applied” to the taxpayers’ benefit for the purpose of being derived in terms of s 44 of the Income Tax Assessment Act 1936 (ITAA 1936).

As a result of its finding, the AAT found it unnecessary to deal with the issue of whether a capital gain arose on the claimed transfer of the shares to the partnership and whether any rollover relief applied. However, it found that 50% shortfall penalties imposed for recklessness should be substituted with 25% shortfall penalties for “carelessness”. The AAT’s view is that the Commissioner’s claim that the taxpayer’s failure to seek a second opinion on the arrangement put in place by its advisers could not amount to “recklessness” in these (or any) circumstances.

Appeals update

The taxpayers have appealed to the Federal Court against the decision.

Re Yazbek and FCT [2014] AATA 423, www.austlii.edu.au/au/cases/cth/AATA/2014/423.html.

Property developers and use of trusts under scrutiny

The ATO has issued Taxpayer Alert TA 2014/1 which describes an arrangement where property developers use trusts to return the proceeds from property development as capital gains instead of income on revenue account.

ATO Deputy Commissioner Tim Dyce said the ATO has “begun auditing property developers who are carrying out activities which conflict with their stated purpose of capital investment”. He said a “growing number of property developers are using trusts to suggest a development is a capital asset to generate rental income and claim the 50% capital gains discount”. Mr Dyce warned that penalties of up to 75% of the tax avoided can apply to those found to be deliberately using special purpose trusts to mischaracterise the proceeds of property developments.

The ATO said the Taxpayer Alert applies to arrangements which display all or most of the following:

1. An entity with experience in either developing or selling property, or in the property and construction industry, establishes a new trust for the purpose of acquiring property for development and sale.
2. In some cases the trust deed may expressly state that the purpose of the trust is to hold the developed property as a capital asset to generate rental income. In other cases the trust deed may be silent as to its purpose.
3. Activity is then undertaken in a manner which is at odds with the stated purpose of treating the developed property as a capital asset. For example:
   • documents prepared in connection with obtaining finance for the development may indicate that the dwellings constructed on the land are to be sold within a certain timeframe and that the proceeds are to be used to repay the loan;
   • communication with local government authorities overseeing building approvals may describe the activity as being the development of property for sale;
   • real estate agents may be engaged early in the development process, and advertising to the general public may indicate that the dwellings/subdivided blocks of land are available to be purchased well in advance of the project’s completion, including sales off the plan.
4. The property is sold soon after completion of the development, where the underlying property may have been held for as little as 13 months.
5. The trustee treats the sale proceeds as being on capital account, and because the trustee acquired the underlying property more than 12 months before the sale, it claims the general 50% CGT discount (in other words, it treats the gain/profit of each sale as a discounted capital gain).

The ATO said it was concerned that arrangements of this type could give rise to various tax issues, including the following:

• whether the underlying property constitutes trading stock for the purposes of s 70-10 of the ITAA 1997, on the basis that the trustee is carrying on a business of property development;
• whether the gross proceeds from sale constitute ordinary income under s 6-5 of the ITAA 1997 on the basis that the trustee is carrying on a business of property development; and
• whether the net profit from sale is ordinary income under s 6-5 on the basis that although the trustee is not carrying on a business of property development, it is nevertheless involved in a profit-making undertaking.

The ATO said it has made adjustments to increase the net income of a number of trusts. It said penalties will be significantly reduced if taxpayers make a voluntary disclosure.

Sources: Taxpayer Alert TA 2014/1, 28 July 2014, http://law.ato.gov.au/atolaw/view.htm?DocID=
TPA/TA20141/NAT/ATO/00001; ATO media release, 28 July 2014, www.ato.gov.au/Media-centre/Media-releases/ATO-warns-property-developers-to-declare-income.

Residency depends on facts and circumstances of each case

The ATO has released Decision Impact Statement on the decision in Re Dempsey and FCT [2014] AATA 335. In that case, the AAT allowed the taxpayer’s objection to amended assessments issued to him for the 2009 and 2010 income years after finding the taxpayer was not a “resident” of Australia as defined in s 6(1) of the ITAA 1936. The AAT concluded that – based on the circumstances peculiar to the taxpayer and after weighing the evidence presented to it at the hearing, including the taxpayer’s statements about his intention – he had made a settled employment, lifestyle and residence choice for the indefinite future and that was to make his home in Saudi Arabia.

The ATO said the decision was reasonably open to the AAT. It said the approach taken by the AAT in reaching its decision was consistent with its approach to issues of residency, including the ATO view expressed in IT 2650. Under this approach, the issue requires a weighing of all the relevant facts and circumstances and an application of the statute and authorities to those facts. The ATO considered the outcome of the case was confined to its facts and created no new law in this area.

The ATO provided its administrative treatment as follows. It said the decision of the AAT does not change its approach to residency cases. It said these matters involve questions of fact and degree and different facts may result in different conclusions as to residency. The ATO said it will continue to approach residency cases by weighing all the relevant facts and circumstances and applying the relevant tax law and authorities to those facts.

Source: ATO Decision Impact Statement on Re Dempsey and FCT [2014] AATA 335, http://law.ato.gov.au/
atolaw/view.htm?docid=%22LIT%2FICD%2F2013%2F4861-2013%2F4862%2F00001%22.

Billions in lost super waiting to be claimed

According to the ATO, more than $14 billion in lost super is waiting to be claimed. The ATO said $8 billion in super was sitting in accounts that have not received a contribution in five years. A further $6 billion in super was sitting in accounts where funds have not been kept up-to-date with changes to personal details. ATO Assistant Commissioner John Shepherd said it was “easy for this to happen because when people get married or move house, the last thing on their mind is updating their name and address details with a super fund”. However, he said it was important to provide funds with tax file numbers (TFNs) which can help individuals be reunited with their super.

More than 40% of super account holders have more than one account and many of these additional accounts have not received a contribution for quite some time, said Mr Shepherd. The ATO was also seeing many people failing to take advantage of their ability to choose a fund when they start a new job.

The ATO has released the following research and statistics:

• Lost and ATO-held super overview – www.ato.gov.au/About-ATO/Research-and-statistics/In-detail/
  Super-statistics/Lost-and-ATO-held-super/Lost-and-ATO-held-super-overview.
• Lost and ATO-held super by postcode – www.ato.gov.au/About-ATO/Research-and-statistics/In-detail/
  Super-statistics/Lost-and-ATO-held-super/Lost-and-ATO-held-super-by-postcode.

Source: ATO media release, 1 August 2014, www.ato.gov.au/Media-centre/Media-releases/New-statistics-reveal-$14-billion-in-lost-super.

ASIC eye on SMSF property investment advice

In a recent speech, Commissioner Greg Tanzer of the Australian Securities and Investments Commission (ASIC) warned of ASIC’s concern about advice being given to self managed superannuation funds (SMSFs) to invest in property. He said ASIC was aware there had been a sharp rise in promoters recommending that investors either set up or use an existing SMSF to invest in property. ASIC is concerned these promoters may not be complying with the law.

Mr Tanzer said ASIC was concerned that, with the increased popularity of SMSFs and property investment, real estate agents and property advisers may not realise they may be carrying on a business of providing financial product advice and may need an Australian financial services (AFS) licence, or authorisation under an AFS licence, when making recommendations or statements of opinion to a person to use an SMSF to invest in property.

Mr Tanzer said ASIC is now working with individual businesses suspected of engaging in unlicensed conduct to help them understand their obligations.

Other points made by Mr Tanzer include the following:

SMSF “one-stop shop” operators

Mr Tanzer provided an update of ASIC’s work done to explore the trend of “one-stop shop” operators offering a range of services to SMSFs. He said so far the project team has identified that a feature of these business models is a “one size fits all” approach where all investors who use their multiple services receive the same suite of products and services – that is, they end up with an SMSF, a property investment and a limited-recourse borrowing arrangement. The project team was also exploring whether commissions are being paid within these business models and whether these commissions are consistent with the restrictions on payment of commissions for advice under the Future of Financial Advice (FOFA) reforms.

Limited AFS licence

As at 27 May 2014, the ASIC Licensing team received 62 applications for a limited AFS licence. Although noting it was early days in the implementation of the limited AFS licence regime, Mr Tanzer noted that ASIC has identified some “concerning trends” from the process so far. Among other things, ASIC has found inadequate or no evidence of RG 146 training course completion for all or some of the financial products sought under the application. ASIC has also found inadequate coverage of professional indemnity insurance. Other issues included: limited or no knowledge of the restricted scope of the “class of product” advice authorisation; and financial statements lodged in the name of a trust and not the entity or individual applicant.

In response to these trends, ASIC has updated Information Sheet 179 Applying for a limited AFS licence. The updated Information Sheet is available on the ASIC website at www.asic.gov.au/
asic/pdflib.nsf/LookupByFileName/Applying_for_a_limited_AFS_licence_0179.pdf/$file/Applying_for_a_limited_AFS_licence_0179.pdf.

ASIC is also looking at putting together another information sheet to provide guidance on what activities the limited AFS licence will cover as well as what activities do not need a licence.

SMSF auditors

Mr Tanzer said he hoped that accountants were using ASIC’s public register of approved SMSF auditors to verify that the auditors they are referring to SMSFs are registered, or are using the register to establish to others that they are, in fact, registered. ASIC also maintains a public register of disqualified SMSF auditors. Since the commencement of the regime, Mr Tanzer said ASIC has issued one disqualification order preventing a person from being an approved SMSF auditor. In relation to administrative actions in response to poor auditor conduct, Mr Tanzer noted the ATO has commenced referral of matters to ASIC as a result of its compliance program, and that ASIC will consider those matters with regard to administrative action.

Source: ASIC Commissioner Greg Tanzer speech at CPA Australia’s SMSF Conference 2014, 16 July 2014, www.asic.gov.au/asic/asic.nsf/byHeadline/Regulators-perspective-on-the-regulation-of-SMSFs–speech?opendocument.

Bad debt deduction for “unpaid trust entitlements” refused

The AAT has affirmed a decision of the Commissioner refusing a taxpayer’s bad debt deduction claim in relation to certain trust distributions.

Background

The taxpayer was a beneficiary of a family discretionary trust. Over the years, the trust determined to distribute some of the trust’s income the taxpayer. Some of the distributions were actually paid to the taxpayer, but the bulk was credited to an account in the books of the trust in the taxpayer’s name. In 2012, the taxpayer decided the trust was not going to be able to pay him the amount of $227,258 then standing to his credit in the accounts of the trust. In his tax return for the year ended 30 June 2012, the taxpayer claimed a deduction of $227,258 on the basis that it was a bad debt under s 25-35(1) of the Income Tax Assessment Act 1997 (ITAA 1997). The Commissioner refused the deduction and the taxpayer sought a review. The AAT noted the trustee was a company in which the taxpayer and his wife (another beneficiary) were the only members.

The taxpayer contended before the AAT that $142,545 of the $227,258 amount written off was deductible pursuant to s 25-35. The taxpayer accepted that, on his argument, only part of the amount written off could be deducted. He argued that the debt was to be characterised as unpaid trust entitlements and that the debt written off had the same character of the trust distributions included in his assessable income in the 2005 and 2007 income years.

The Commissioner, before the AAT, accepted the amount written off was a debt but contended the amount written off was not the taxpayer’s unpaid present entitlement – rather, it was the outstanding balance in the loan account in the taxpayer’s name in the books of account of the trust. As such, it was of an entirely different character to the monies included in the taxpayer’s assessable income in 2005 and 2007 and therefore not deductible under s 25-35.

Decision

The AAT said the starting point must be an analysis of the distribution transaction and that analysis is necessarily informed by the terms of the deed creating the trust. It said the trustee, having resolved to distribute to the taxpayer, could pay the income of the trust to the taxpayer or it could set it aside to a separate account in the books of the trust in the name of the taxpayer.

The AAT did not accept that the amounts set aside in the books of the trust constituted “unpaid entitlement”. The AAT was of the view the taxpayer’s entitlement was paid in the manner prescribed by the deed, and once paid, lost its character as unpaid entitlement. It agreed that the subject amounts became a loan at call from the taxpayer to the trust.

The AAT was also of the view that the debt written off was different in character to the income included in the taxpayer’s assessable income in the 2005 and 2007 income years. It said what “was included in the [taxpayer’s] assessable income in those years had as its source the share of the trust income to which he became presently entitled. What was written off was of an entirely different character; it was an investment [the taxpayer] chose to make in the business of the trust”.

The AAT went on and said there was nothing anomalous or unusual in the result. It said the taxpayer, “who was the alter ego of the trust in any event, chose to leave the bulk of the amounts distributed to him invested in the business of the trust”. Once he chose that course, the AAT said, the “debt” thereby created was of an entirely different character to his entitlement to the distribution from the trust.

Re Pope and FCT [2014] AATA 532, www.austlii.edu.au/au/cases/cth/AATA/2014/532.html.

Family fails to prove assessments excessive

Taxpayers from the same family have been unsuccessful before the AAT in discharging the onus of proving that assessments issued to them, which were based on an asset betterment test, were excessive. This was despite the fact that the Commissioner conceded, and the AAT acknowledged, that the amounts in issue were not entirely accurate because of inherent flaws in the nature of an asset betterment test.

Background

The taxpayers were six members of a family group which included the father and one of his sons who described himself as “the CEO in the family” in relation to the family businesses (and who represented the family during the proceedings). The matter spanned various income years (ie the 2001 to 2008 income years depending on the taxpayer). It involved unexplained large sums of moneys flowing through family bank accounts, and the purchase of properties in family names in circumstances where relatively little income was returned from various small businesses conducted by the family and the father was on an age pension. Also at issue was the apparent receipt of £3.17 million by the son between 2003 and 2008 from his apple exporting business, in which he acted as a buyer’s agent.

After an audit of the taxpayers which included an asset betterment analysis, the Commissioner issued amended notices of assessment and default assessments against the various members of the family in the relevant years of income, and also imposed 75% administrative penalties for intentional disregard of the law. The Commissioner claimed that the taxpayers’ patterns of expenditure and asset acquisition suggest they had access to much greater income than they returned and that the large flows of cash through the accounts and many of the expenditures (including transfer of funds overseas) should be regarded as assessable income. The Commissioner also claimed that there was fraud or evasion (for some of the taxpayers) allowing the issuing of assessments out of time.

The taxpayers claimed, among other things, that the moneys arose from savings by all family members, gifts from weddings, and gambling successes. One of the family members admitted to regularly taking business proceeds from the till for private purposes. The taxpayers also claimed that deposits for each property were scraped together from the family trust, savings and other legitimate sources and the rest of the purchase price was funded by debt. The son also claimed that the moneys received from the apple exporting business were reinvested in the business in various ways, including the preparing of the export containers, and in the acquisition of a new wholesaling business in 2006. In addition, they claimed that business records were lost in the Brisbane floods of 2011.

Decision

The AAT clearly found that the taxpayers had not discharged the onus of proving that the assessments were excessive, despite agreeing with the Commissioner that there were “flaws” in the asset betterment analysis used to raise the assessments. However, the AAT said that there was “nothing remarkable or improper in that” as the asset betterment analysis was a “blunt tool”, but one that “provided a starting point for the analysis and a basis for the assessments”. The AAT then noted that “as more information about the taxpayers’ affairs was gathered in the course of these proceedings, it became apparent the amended assessments were indeed wide of the mark”. However, the AAT reiterated that it was not enough for the taxpayers to show the amended assessments were incorrect: they had to go further and “positively prove” the “actual taxable income” and must show that the amount of money for which tax was levied by the assessment exceeded the actual substantive liability.

In arriving at this conclusion, the AAT took into account a range of matters including the “conspicuous” inability to explain the transactions recorded in the bank accounts, inconsistent evidence as to which family member had the authority to deal with the funds in the accounts, the fact that the gambling explanation was inconsistent with the pattern of deposits and the lack of credibility of evidence given by the family members. In relation to the property acquisitions, the AAT had difficulty in seeing how the acquisition of the properties could be funded in circumstances where “none of the family members reported earning significant amounts of assessable income during the years under review, yet they collectively managed to acquire a large number of properties in that period” and that other possible sources of funds were not satisfactorily explained.

The AAT also gave weight to inconsistent evidence given in relation to the son’s exporting business as to how the business operated (in the absence of a written agreement). In this regard, the AAT said that there was no doubt that the purchaser (who gave his evidence via video link) paid a relatively large amount to the son and that payments were made on a reasonably regular basis, but that it was unclear how many of those payments were made or how much profit the son actually made (albeit, there was evidence that each transaction was structured so there would be a profit margin). The AAT also found that there was evidence that the son used funds from business accounts for his own purposes, despite his claims that the funds were only used for reinvestment in the business and in the acquisition of another business.

The AAT also dismissed evidenced presented by a tax agent engaged by the taxpayer to explain the sources of their funds. It did so on several grounds, including the tax agent’s reliance on his own asset betterment test to generate estimates of the taxpayers’ income. In this regard, the AAT said that “it is one thing for the Commissioner to use that method to help him identify potential under-reporting and make an assessment in the first place – the Commissioner has no choice but to make an informed guess and then put the taxpayer to proof [but] more should be expected of a taxpayer, even one who has lost records in a flood”. The AAT also said that it was unhelpful for the tax agent to “merely point out the flaws in the Commissioner’s asset betterment effort”.

In relation to the issuing of assessments out of time, the AAT found that there was fraud or evasion which permitted this course of action. The AAT also found that 75% shortfall penalties imposed for “intentional disregard of the law” (plus the accompanying 20% uplift factor) were appropriate in the circumstances (except in the case of one of the family members) and that, furthermore, there were no grounds to remit the penalties.

LNNB and FCT [2014] AATA 527, www.austlii.edu.au/au/cases/cth/AATA/2014/527.html.

Tax consequences following marriage break-up

Taxation Ruling TR 2014/5 outlines the taxation effect under s 44 of the ITAA 1936, Div 7A of the ITAA 1936, Subdiv 126-A of Pt 3-3 of the ITAA 1997, and Div 207 of the ITAA 1997, of private companies paying money or transferring property in compliance of orders made by the Family Court under s 79 of the Family Law Act 1975.

Specifically, the Ruling outlines the following consequences:

• Money or property to be paid or transferred to a shareholder – to the extent paid out of the private company profits and is an ordinary dividend, the ATO says it is assessable income of the shareholder under s 44.
• Money or property to be transferred to an associate of a shareholder – the ATO says the payment of money or transfer of property is a payment for the purposes of s 109C(3). In addition, the ATO indicates that s 109J does not prevent the payment from being treated as a dividend under s 109C(1).
• Dividends frankable – payments that amount to ordinary dividends are frankable. Where a dividend is taken to be paid to an associate of a shareholder under s 109C is franked, that associate is themselves treated as being a shareholder.
• CGT rollover applies – where a private company transfers property to a shareholder in compliance with a s 79 order, the rollover consequences in s 126-5 of the ITAA 1997 apply (if acquired after 20 September 1985) and the cost base of the shareholder’s shares in the private company are both reduced pursuant to s 126-15(3) and increased pursuant to s 126-15(4) of the ITAA 1997. In addition, where a private company transfers property to an associate of a shareholder, the rollover consequences in s 126-5 apply and the cost base of the shareholder’s shares in the private company are reduced (s 126-15(3)).

The Ruling includes eight examples to illustrate different outcomes of transfers. It was previously released as Draft Taxation Ruling TR 2013/D6 and contains some changes, eg ATO comments on how an associate receiving a deemed dividend can access franking credits on the deemed distribution.

Date of effect

The Ruling applies both before and after its date of issue.

Source: Taxation Ruling TR 2014/5, 30 July 2014, http://law.ato.gov.au/atolaw/view.htm?docid=%22TXR%
2FTR20145%2FNAT%2FATO%2F00001%22.

Important: Clients should not act solely on the basis of the material contained in Client Alert. Items herein are general comments only and do not constitute or convey advice per se. Also changes in legislation may occur quickly. We therefore recommend that our formal advice be sought before acting in any of the areas. Client Alert is issued as a helpful guide to clients and for their private information. Therefore it should be regarded as confidential and not be made available to any person without our prior approval.