Income tax: what are the results for income tax purposes of entering into a profit washing arrangement as described in Taxpayer Alert TA 2005/1?
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FOI status:may be released
|The number, subject heading, date of effect and paragraphs 1 to 20 of this document are a 'public ruling' for the purposes of Part IVAAA of the Taxation Administration Act 1953 and are legally binding on the Commissioner.|
1. Taxpayer Alert TA 2005/1 ('the Alert') was issued on 2 May 2005. It described an arrangement where the business of a taxpayer is structured so that the income of the business passes through a chain of trusts and on to a loss company, and the income, less an amount for promoter fees, remains effectively under the control of the taxpayer or associates of the taxpayer. The Alert indicated that we are examining the arrangement.
- a trading entity (the 'taxpayer') derives an income from a business that it carries on. The business is structured so that a hybrid trust (the 'new trust') receives the income. The promoter derives a fee for establishing the new trust;
- the new trust has a number of classes of units. Each class of units has different rights attached. The taxpayer or associates hold units with income, capital and voting rights in the new trust (class A units). A trust which is unrelated to the taxpayer (the 'promoter trust') holds units in the new trust with either income rights only, or income and capital rights (class B units);
- the trustee of the new trust has discretion as to the distribution of income to unit holders;
- the promoter trust has a number of classes of units. Each class of units has different rights attached. The promoter holds units with income, capital and voting rights in the promoter trust. A company with carry forward losses (the 'loss company') holds units in the promoter trust with income rights only;
- the new trust distributes a large proportion of the trust income to the promoter trust. A smaller proportion may be distributed to the class A unit holders;
- a small proportion (for example, 10%) of the distribution to the promoter trust is paid in cash. This amount represents the fee paid by the taxpayer for the use of the arrangement. The remaining amount (that is, 90%) is never paid to the promoter trust, and by agreement (usually verbal) between the parties, is never intended to be paid; and
- the promoter trust then distributes all of the income distribution from the new trust to the loss company. The promoter claims that the loss company has carry forward losses that offset the distribution from the promoter trust.
3. The arrangement may also include the use of a joint venture formed between the new trust and the promoter trust whereby the new trust contributes as capital to the joint venture the amount of the distribution made to the promoter trust. This allows the new trust to maintain effective control of the funds.
The distribution of income to the promoter trust constitutes a sham
5. A sham transaction is essentially a transaction which involves a common intention between the parties to the apparent transaction that it be a disguise for some other and real transaction or for no transaction at all (see Richard Walter Pty Ltd v. Commissioner of Taxation (1996) 67 FCR 243; (1996) 96 ATC 4550; (1996) 33 ATR 97).
6. As confirmed by AAT Case 10,796 (1996) 96 ATC 296; (1996) 32 ATR 1168, AAT Case 11,115 (1996) 96 ATC 443; (1996) 33 ATR 1128 and AAT Case 11,125 (1996) 96 ATC 453; (1996) 33 ATR 1140, purported trust distributions may be shams where the beneficiaries are never intended to receive the benefit of the trust income. The Tribunal held in AAT Case 11,125 (1996) 96 ATC 453; (1996) 33 ATR 1140 (at page 454) that:
The attempt to create present entitlement to income of the trusts by the non-residents was a sham and not intended to have the legal effect which it purported to have. The resolutions were designed to retain the maximum funds within the trust for the ultimate benefit of Mr M and his immediate family with a minimum reduction by the impact of income tax.
7. In the arrangement described in paragraph 2, it is agreed between the parties that only a small proportion of the distribution to the promoter trust ever be paid in cash. Further, the amount paid in cash is effectively the fee paid by the taxpayer for the use of the arrangement. There is no intention by either party for the promoter trust to receive the benefit of the income of the new trust. There is simply an attempt to create the appearance of the promoter trust having present entitlement to the income of the new trust so as to avoid tax being payable by the taxpayer and associates of the taxpayer who ultimately receive the benefit of the trust income.
8. The purported distribution of income from the new trust to the promoter trust is considered to be a sham and of no legal effect. The trust deed and resolutions of the new trust determine if any other unit holder is presently entitled to the trust income. If no unit holder is presently entitled to the trust income, the trustee will be assessed on this income under section 99A of the Income Tax Assessment Act 1936 (ITAA 1936).
Part IVA of the ITAA 1936 applies
9. The application of Part IVA depends on a careful weighing of all the relevant circumstances of each case and the relative weight that should be attached to each of those circumstances. Therefore, in the absence of all relevant information, it is not possible to state definitively whether a particular scheme will attract Part IVA.[F1]
10. It is considered however that the whole or some part of the arrangement described in paragraph 2 constitutes a scheme under section 177A. Should the purported distribution of income from the new trust to the promoter trust be held not to be a sham, this scheme would give rise to a tax benefit under paragraph 177C(1)(a) in that but for the scheme the income which was distributed from the new trust to the promoter trust would have been included in the assessable income of the taxpayer or associates of the taxpayer.
11. It is also considered that it would be reasonable to conclude, having regard to the matters set out in section 177D, that the sole or dominant purpose of the taxpayer (and the promoter) in entering into or carrying out the scheme was for the taxpayer or associates of the taxpayer to obtain the tax benefit.[F2] In this context the following general observations can be made:
- the manner in which the scheme was entered into or carried out will demonstrate that the steps taken to bring the income into the new trust and to distribute it to the promoter trust are undertaken only to avoid the taxpayer and associates of the taxpayer from being assessable on this income;
- the form of the scheme is to confer ultimate beneficial entitlement to income of the new trust to a company with substantial carry forward losses. The substance of the scheme is that the income of the new trust remains under the control of the new trust and is used for the ultimate benefit of the taxpayer and associates of the taxpayer without being reduced by the payment of income tax;
- but for the operation of Part IVA, the distributions made from the new trust to the promoter trust and then on to the loss company, would be effective. The result would therefore be that no tax is payable by any entity on the income earned by the new trust, as the ultimate beneficiary of this income is a company with carry forward losses; and
- by entering into the scheme, the taxpayer or associates avoid any liability to tax on the income of the new trust for which they receive the benefit. The promoter generally derives a fee for establishing the new trust as well as a fee for each distribution made by the new trust to the promoter trust. The loss company derives a fee for enabling the promoter trust to utilize its carry forward losses.
12. The Commissioner is therefore likely to exercise his powers under section 177F to cancel the tax benefit and include in the assessable income of the taxpayer or associates of the taxpayer the income of the new trust that was purported to be distributed to the promoter trust.
Section 100A of the ITAA 1936
13. Section 100A is an anti-avoidance provision designed to counter trust stripping schemes. Subsection 100A(1) states that where a beneficiary of a trust is presently entitled to income of the trust and the present entitlement arose out of a reimbursement agreement, the beneficiary shall be deemed never to have been presently entitled to the trust income.
14. A reimbursement agreement is an agreement entered into otherwise than in the course of ordinary family or commercial dealing that provides for the payment of money (including the payment of money by way of loan) or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary.
15. In the arrangement described in paragraph 2, there is an agreement between the parties that only a small proportion of the income distributed to the promoter trust would ever be paid in cash and that the remaining monies are to be retained by the new trust for the ultimate benefit of the taxpayer and associates. This constitutes a reimbursement agreement. It is considered that the present entitlement of the promoter trust to the income of the new trust, if not a sham, arose out of this reimbursement agreement, and as such section 100A must be considered.
16. Subsection 100A(3A) provides that where a trustee of a trust (the 'interposed trust') is the beneficiary of another trust and subsection 100A(1) would otherwise operate to deem the interposed trust not to be presently entitled to income of the other trust, subsection 100A(1) does not apply to so much of that income to which a beneficiary of the interposed trust is in turn presently entitled.
17. Therefore, in those cases where present entitlement of the loss company to income of the promoter trust is validly established and this income is attributable to income of the new trust to which the promoter trust is presently entitled, subsection 100A(3A) will be relevant. It will preclude subsection 100A(1) from applying to deny present entitlement of the promoter trust to income of the new trust.
CGT event may occur
18. Where the business of the trading entity is restructured into the new trust, a CGT event may occur which gives rise to an assessable net capital gain. The circumstances of each restructure will need to be considered to determine whether a CGT event occurs and whether a capital gain arises.
Carry forward losses may not be deductible
19. No deduction is available for prior year losses unless the loss company satisfies the continuity of ownership test or the same business test as outlined in Division 165 of the Income Tax Assessment Act 1997 (ITAA 1997) (previously sections 80A and 80E of the ITAA 1936).
20. If the loss company satisfies the continuity of ownership test, the Commissioner may still disallow the relevant losses pursuant to Subdivision 175-A of the ITAA 1997 (previously section 80DA of the ITAA 1936). Subdivision 175-A applies where income is channelled or injected into a loss company in order to take advantage of its losses, or where a person has obtained a tax benefit in connection with a scheme which would not have been entered into if the loss had not been available for deduction.
Date of effect
21. This Determination applies to years commencing both before and after its date of issue. However, it does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of the Determination (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).
Commissioner of Taxation
17 August 2005
1 There have been a number of decisions of the High Court and Federal Court concerning the operation of Part IVA. A useful summation of the principles emerging from these decisions can be found in the judgement of Hill J in Commissioner of Taxation v. Sleight (2004) 136 FCR 211; (2004) 2004 ATC 4477; (2004) 55 ATR 555.
2 The question posed by section 177D concerning purpose is one that is objectively determined and does not depend on why the taxpayer or any of its agents acted as they did (see FCT v. Hart (2004) 217 CLR 216; (2004) 2004 ATC 4599; (2004) 55 ATR 712).
Not previously issued as a draft
TAA 1953 Pt IVAAA
ITAA 1936 80A
ITAA 1936 80DA
ITAA 1936 80E
ITAA 1936 99A
ITAA 1936 100A
ITAA 1936 100A(1)
ITAA 1936 100A(3A)
ITAA 1936 Pt IVA
ITAA 1936 177A
ITAA 1936 177C(1)(a)
ITAA 1936 177D
ITAA 1936 177F
ITAA 1997 Div 165
ITAA 1997 Subdiv 175-A
AAT Case 10,796
(1996) 96 ATC 296
(1996) 32 ATR 1168
AAT Case 11,115
(1996) 96 ATC 443
(1996) 33 ATR 1128
AAT Case 11,125
(1996) 96 ATC 453
(1996) 33 ATR 1140
Commissioner of Taxation v. Sleight
(2004) 136 FCR 211
(2004) 2004 ATC 4477
(2004) 55 ATR 555
FCT v. Hart
(2004) 217 CLR 216
(2004) 2004 ATC 4599
(2004) 55 ATR 712
Richard Walter Pty Ltd v. Commissioner of Taxation
(1996) 67 FCR 243
(1996) 96 ATC 4550
(1996) 33 ATR 97
Taxpayer Alert TA 2005/1
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