In this issue of Talking Tax, we examine the Full Federal Court’s decision in the Greensill appeal and when a settlement payment will be an employment termination payment, as considered in the Stark case.
We also provide an update on the latest ATO guidance on undeclared foreign income disguised as gifts or loans, expenses associated with holding vacant land, the application of the NALI/NALE rules, and the 2020-21 highlights for the Tax Avoidance Taskforce.
Appeal update: another win for the Commissioner in Greensill and N&M Martin
The Full Federal Court has dismissed the Taxpayers' appeal in Peter Greensill Family Co Pty Ltd (Trustee) v Commissioner of Taxation  FCAFC 99 affirming the Federal Court’s decision at first instance and the Commissioner’s preliminary views in TD 2019/D6 and TD 2019/D7.
The Court held that, while a foreign tax resident may be exempt from Capital Gains Tax (CGT) on capital gains relating to non-taxable Australian property assets (TAP) under section 855-10 of the Income Tax Assessment Act 1997, that is not the case where the gains are realised by a discretionary trust and distributed to them.
The Taxpayers, and many practitioners, argue that this construction of the relevant provisions is inconsistent with the accepted policy objectives of Parliament. Specifically, that Australia should not be asserting a right to tax non-residents on income that does not have an Australian source.
This may be the case but, as the Full Federal Court confirmed, neither policy nor a desire to avoid an anomalous result are grounds for departing from the ordinary rules of statutory interpretation. The Court, in its decision, reminded the Taxpayers that ‘a court is not justified in using an anomaly as a reason for rejecting what otherwise seems the correct construction where on all other tests of construction, it is the correct construction’.
The Taxpayers are seeking special leave to appeal to the High Court. Given the High Court has, in a number of recent decisions (including the decision in WorkPac Pty Ltd v Rossato, an employment law case), shown a propensity toward strict legal interpretation, and with the Full Federal Court generally considered the ‘final’ court of appeal in tax matters other than the most exceptional, our prediction is the special leave application has limited prospects of success.
AAT holds that settlement sum is an employment termination payment
The AAT in Stark and Commissioner of Taxation (Taxation)  AATA 2583 (29 July 2021) has decided that a litigation settlement sum paid in relation to alleged loss of earnings is an employment termination payment (ETP) for tax purposes.
The Taxpayer in this case was a 55-year-old chartered accountant seeking employment. In October 2000 he was offered a position with Company 1, which he accepted.
Prior to commencing work, the Taxpayer was offered a job with Company 2 and withdrew his acceptance of the original job offer in favour of a position with Company 2. After about 12 months, his employment with Company 2 was terminated.
The Taxpayer instigated proceedings against Company 2 for breach of contract and misleading and deceptive conduct. In 2009, he agreed to discontinue the litigation for an agreed sum of money. The settlement deed referred to the settlement payment as compensation for lost earnings.
The Commissioner initially assessed the settlement payment as ordinary income. However, before the Administrative Appeals Tribunal, the Commissioner’s primary submission was that it was an ETP, as it was a payment received in consequence of the termination of employment and not subject to a statutory exclusion.
The Taxpayer argued that:
- the settlement payment was excluded from the definition of ETP as it was a payment of a capital nature for, or in respect of, personal injury to him. He asserted the payment represented compensation for the destruction of his earning capacity.
- if that was to be accepted, the settlement payment was also exempt from CGT as compensation or damages received for a wrong or injury suffered in his occupation.
To this end, the Taxpayer argued that:
- he was induced to accept the position with Company 2 by deceptive representation;
- due to these representations, he relinquished the opportunity for gainful employment with Company 1;
- this destroyed his earning capacity as evidenced by unsuccessful attempts to secure other employment; and
- the payment is properly characterised as compensation for destroying his earning capacity.
The Tribunal held that:
- there must be a causal relationship between the termination and the payment. The relevant question is whether there is a sufficient connection between the termination of employment and the payment to warrant a finding that the payment was made ‘in consequence of the termination of your employment’. This will be satisfied where the payment was an effect or result of the termination in the sense that there was a sequence of events following the termination of the employment which had a relationship and connection which ultimately led to the payment.
- however, it is not necessary for the termination of the employment to be the sole or even dominant cause of the payment, in order for a payment to be characterised as received in consequence of termination of employment. It is sufficient if it follows on from termination of employment.
- where claims for damages for termination of employment and deceptive conduct are interwoven, the settlement of the latter does not break the causal relationship between termination of the employment and the payment of the settlement amount. It does not detract from the characterisation of the payment as an effect of or following on from, and thus in consequence of, termination of employment.
- accordingly, the payment is characterised as an ETP and assessable as income.
TA 2021/2: disguising undeclared foreign income as gifts or loans
The ATO has issued taxpayer alert TA 2021/2 to highlight its concerns in relation to arrangements they believe are designed to intentionally disguise taxable income as funds received as a gift or a loan from related overseas entities.
This alert is a timely reminder that Australian tax residents are taxed on their worldwide income, not just income from Australian sources, and taxpayers have the burden of proof in tax disputes. If you receive payments from overseas sources it is crucial that you have appropriate documentation to establish the nature and source of the payments.
The ATO notes these arrangements typically include all or most of the following features:
- an Australian-resident taxpayer derives foreign assessable income (such as income from employment, interest, dividends, or a capital gain on the disposal of assets, such as shares in a foreign company) and does not declare it in their Australian income tax return.
- the foreign assessable income is repatriated to the taxpayer, or an associate of the taxpayer, in Australia. The repatriation is achieved by a related overseas entity transferring the funds directly to the taxpayer (or an associate), or by using the services of an offshore financial intermediary to transfer the funds. The related overseas entity is typically a family member, a friend or some other kind of associate, such as a related company or trust.
- the repatriation of funds may be by way of a lump sum or instalments and may occur in the year the amount is derived or in subsequent years.
- documentation is prepared that purports to show that the repatriated funds have the character of a gift, or an advance of funds by way of a loan, but that occurs in circumstances where the objectively ascertainable facts do not support that characterisation. This includes where the parties act in a way that is inconsistent with the documented agreement or the terms of the documented agreement lacks commercial explanation.
Concerns to note
While this taxpayer alert focuses on intentionally fraudulent arrangements, there are risks generally in having overseas persons or entities make unexplained and undocumented transfers of cash to you, even where they are genuine gifts or loans.
If the ATO commences an audit and alleges that a payment is an amount of income, the burden is on the taxpayer to establish that it is not. If the taxpayer has no contemporaneous documentation in place, they may not be able to prove their case.
What can you do?
If you receive money transfers from overseas sources, it is important that the underlying legal substance of the transaction is carefully and contemporaneously documented by the parties so that there is objective evidence of the nature and source of the payment.
If the payment is an amount of income and you are an Australian tax resident, it must be declared in your income tax return. Income such as foreign dividends or capital gains from disposing of foreign shares are often overlooked.
TR 2021/D5: deductions for costs of holding vacant land
The ATO has released draft taxation ruling TR 2021/D5 explaining the Commissioner’s view of the application of section 26-102 of the 1997 Act. This section, which has effect from 1 July 2019, limits deductions that may be claimed in relation to holding vacant land.
Section 26-102 denies taxpayers a deduction for losses or outgoings relating to holding vacant land to the extent that the land is not in use, or available for use, in carrying on a business carried on for the purpose of gaining or producing assessable income for the landowner, their spouse, their minor children and their affiliates and connected entities.
TR 2021/D5 sets out three tests to determine whether the section applies:
- Is there a substantial and permanent structure on the land?
A substantial structure is one that is significant in size, value or other criterion of importance in relation to the property. A permanent structure is one that is fixed and enduring. The ATO will consider whether any substantial and permanent structure has an independent purpose in the context of the land on which it is located.
Residential premises that are constructed or substantially renovated are not substantial and permanent structures unless it can be lawfully occupied and be leased, hired or licensed or be available for lease, hire or license.
- If there is a structure, is it in use or available for use?
‘In use or available for use' refers to the capability of premises to be occupied unless deemed unsafe by a council or relevant body.
- If there is a structure available for use, is it independent of and not incidental to the purpose of any other structure, or proposed structure on the land?
Structures that increase the utility of other structures are not independent (eg garages and fencing of residential properties).
The ATO does not consider the costs of constructing a substantial and permanent structure on the land, or any interest or borrowing costs associated with the construction to be a loss or outgoing related to holding land.
In contrast, deductions for holding costs of vacant land that is used for or available to be used for in business operations that lead to assessable income is included as a loss or outgoing relating to holding land.
What constitutes as activities that involve ‘carrying on a business’ is reasonably determined in relation to multiple factors, as outlined in the ruling.
LCR 2021/2: expenditure incurred under a non-arm’s length arrangement
The ATO has issued Law Companion Ruling LCR 2021/2 to clarify how the recent amendments to the non-arm’s length income (NALI) rules apply.
The key items to note are that:
- items of expenditure incurred to derive income under an arrangement whereby parties are not acting at arm’s length arrangement, that are less than what would be expected in an arm’s length arrangement (or where there is no expenditure where there ordinarily would be) will be non-arm’s length expenditure (NALE).
- NALE incurred in relation to specific items of income may cause that income to be NALI, taxed at the highest marginal rate. NALE incurred in relation to a capital asset may cause any capital gain realised on the disposal of that asset to be NALI.
- NALE of a general nature, such as audit and accountancy fees, may cause all income of the fund to be NALI for that year.
In summary, the NALI rules provide that certain income of a super fund will be NALI and taxed at the highest marginal rate (as opposed to the concessional rate) where:
- there is a scheme in which the parties were not dealing with each other at arm's length.
- the fund incurs a loss, outgoing or expenditure of an amount in gaining or producing income.
- the amount of the loss, outgoing or expenditure is less than the amount that the fund might have been expected to incur had those parties been dealing with each other at arm's length in relation to the scheme (thereby being an amount of non-arm’s length expenditure, or NALE).
The relevant issues to determine are:
- whether the fund incurs non-arm's length expenditure; and
- whether there is a sufficient nexus between the non-arm’s length expenditure (or lack of expenditure) and the fund’s ordinary or statutory income, or the acquisition of a fixed entitlement to the income of a trust.
NALE incurred to produce a specific item of income alone, with no connection to any other income, will have a sufficient nexus to that item.
Likewise, NALE incurred to acquire an asset (including financing costs) will have a sufficient nexus to all ordinary or statutory income derived by the fund in respect of that asset. This includes any capital gain derived on the disposal of the asset even if the trustee subsequently refinances the borrowing arrangement on arm's length terms.
The more controversial issue is that in some instances, the non-arm's length expenditure will have a sufficient nexus to all of the ordinary and/or statutory income derived by the fund.
This may occur where a fund incurs expenditure that does not specifically relate to a particular amount being derived by the fund, but still has a sufficient nexus more generally to all income derived by the fund, such as actuarial costs, accountancy fees, audit fees, costs in connection with the calculation and payment of benefits to members, investment adviser fees and other administrative costs incurred in managing the fund.
This may even arise as an issue where a director of the fund provides services to the fund outside their role as director and does not accept remuneration, or accepts below-market remuneration.
Where a fund incurs NALE of a recurrent nature under a scheme that has a nexus with the fund generally deriving ordinary or statutory income during a particular income year, and subsequently ceases to incur that non-arm's length expenditure in a later income year, income derived by the fund in that later income year is not NALI.
Given the massive impact that non arm’s length general expenditure may have on the fund, the ATO has provided a lighter touch compliance approach in this regard. This doesn’t apply to items of specific expenditure.
Currently, the ATO will not allocate compliance resources to determine whether expenses of a general nature with a sufficient nexus to all ordinary and/or statutory income of the fund (for example, non-arm's length expenditure on accounting services) are non-arm's length expenditure. This transitional compliance approach only applies to general expenditure that is incurred on or before 30 June 2022.
From 1 July 2022, if the ATO applies any compliance resources toward considering whether general fund expenses are NALE, they will only be directed:
- for an SMSF: toward ascertaining whether the parties have made a reasonable attempt to determine an arm's length expenditure amount for services provided to the fund, other than services provided by an individual either acting in the capacity as trustee of the SMSF or as a director of a body corporate that is a trustee of the fund.
- for a large APRA-regulated superannuation fund: toward reviewing supporting documentation that evidences that appropriate internal controls and processes are in place and that reasonable steps were taken to determine an arm's length expenditure amount.
Provided that is the case, the ATO will not allocate compliance resources to determine whether those expenses are in fact arm's length expenses.
Tax Avoidance Taskforce highlights 2020-21
The ATO has published its Tax Avoidance Taskforce highlights for the 2020-21 year.
In our practice, we have observed an increased focus by the ATO on compliance and assurance programs for private business and high net-wealth taxpayers, with a focus on issues involving trusts (trust resolutions and compliance, section 100A), aggressive tax planning (including pre-transaction restructuring involving CGT rollover relief) and the application of the small business CGT concessions. We expect this to continue over the coming months and years.
In total, ATO compliance activities generated over $3 billion in tax liabilities and $1.25 billion in audit yield from large public groups and multinational corporations, wealthy individuals and private groups in the past year.
The Taskforce continues to engage with taxpayers through programs such as Top 500, Next 5,000, Medium and Emerging and International Risk. All told, these programs engaged with over 3,300 taxpayers and their associated entities and engaged in 325 activities with privately owned wealth groups and non-resident taxpayers on international related matters.
Compliance activities also resulted in two tax agents withdrawing their registration for their part in structuring contrived trust arrangements and favourable promoter penalty outcomes in two Federal Court applications (the Bogiatto and Rowntree cases).
In 2021-22, the ATO will continue its work on its engagement and streamlined assurance programs. It will focus in particular on certain persistent tax avoidant private wealth individuals and groups, taxpayers who use complex trust structures and distribution flows, and specialist large market advisors who promote and run tax avoidance schemes, and engage in uncooperative, misleading and obstructive behaviour (including the misuse of legal professional privilege).
This article was written with the assistance of Kevin Dorostkar, Law Graduate and Gabrielle Terliatan, Paralegal.