A recent Administrative Appeals Tribunal (AAT) decision upheld a determination of the Commissioner who used an argument of sham to unmask a series of contrived ‘subcontracting arrangements’ and impose tax and penalties.
The concept of ‘sham’
A transaction may be a ‘sham’ and thus without legal effect if the parties to the transaction share a common intention that the transaction will not create the legal rights and obligations that it appears to.
Sham can be a radical concept and an attractive argument to make. It can reverse or nullify transactions which are otherwise legally effective. It can allow evidence of previous negotiations, declarations of intent and subsequent conduct which might otherwise be excluded or overridden by evidence contained in the primary documents.
Sham has rarely been used successfully due to the high threshold to satisfy and the narrow judicial concept of sham. Although a broader doctrine of sham capable of dealing with ‘artificial and contrived transactions for tax avoidance’ was rejected by the High Court in 2008, this recent AAT decision may signal greater acceptance of this approach.
As part of a change in structure, the taxpayer incorporated a company (Sunraysia) in 2011 to run his business of supplying casual labour. He argued that the business (now Sunraysia) no longer engaged employees but rather instead contracted with three other companies to engage and pay the employees and account for PAYG withholding deductions.
An audit of Sunraysia by the Commissioner resulted in a conclusion that the arrangements between Sunraysia and the three companies were a “sham”. As a result, the Commissioner:
- disallowed input tax credits claimed by Sunraysia on supplies said to have been received from the three companies between July 2011 and December 2013;
- imposed penalties for GST shortfall and for Sunraysia’s failure to deduct and remit PAYG amounts; and
- determined that any amounts paid to the three other companies in the arrangement were not allowable deductions for income tax purposes, instead allowing a deduction calculated according to industry standards.
The burden was on the taxpayer to show that the Commissioner’s assessments were excessive. This required showing that the arrangements between Sunraysia and the other companies were genuine and not a sham and that there was no inconsistency between the appearance and the reality of the documents and actions involved.
The AAT affirmed the conclusions of the Commissioner, ultimately holding that the taxpayer’s arrangements with the three companies were a facade undertaken for the purpose of avoiding remitting PAYG deductions while still claiming input tax credits on amounts paid to the three companies The taxpayer was deemed to control the financial and business affairs of the three companies and did not deal with those companies at arm’s length.
How sham was used so effectively
The AAT drew attention to the following details which it used to uphold the Commissioner’s decision:
- Sunraysia and the three companies all used the address of “SME’s R Us”, who acted as an advisor to the advisor, as their registered office and principal place of business;
- a coincidence in timing - Sunraysia made wage payments electronically and a company it allegedly dealt with at arm’s length also made its similar payments an hour later, which suggested that the taxpayer undertook both transactions;
- Sunraysia paid for workers’ clothing and accommodation for the employees and was identified as the employer for the purposes of compensation medical certificates;
- two persons listed as member and director of one of the companies Sunraysia dealt with were, on the evidence, ‘straw men’ who were paid to assume their respective roles; and
- invoices of a company Sunraysia dealt with allegedly at arm’s length were handwritten by the taxpayer.
- The Commissioner has successfully argued a sham. As a result it is necessary to examine the substance, and not the form, of transactions and arrangements entered into.
- When arguing sham, the Commissioner may be able to ignore accounting records and contracting and payment structures (because in this case it allowed the Commissioner to determine where PAYG withholding obligations and tax liabilities should lie).
- Where a taxpayer is responsible for, or should reasonably be aware of, a scheme to avoid tax, shortfall penalties may be imposed on the taxpayer personally despite legal structures and purported payment structures etc.