Hart v CofT – attempt to divert trust’s legal practice income through a ‘loss company’ failed – director assessed personally on a ‘present entitlement’ to the income and Part IVA applied – 50% penalties upheld too

The Full Federal Court ruled that an attempt to divert law firm earnings (and related earnings) through a lost trust, were ineffective, partly on first principles (as he was ‘presently entitled’ under s97(1) of the ITAA36) and partly because our general anti-avoidance provisions (in Part IVA of the ITAA36) applied to justify the assessment.

This case initially caught my eye as it was billed as: ‘Scheme diverting law firm’s earnings caught by Pt IVA’, which seemed to be relevant to the Commissioner’s renewed interest in the extent to which professional firms can divert income away from the individual professional, to related entities, without attracting Part IVA. However, it came nowhere near throwing light on this question. Rather, it involved the an elaborate tax scheme, used by a partner in a law firm.

The basic facts were these.

1. The Taxpayer was a tax ‘partner’ in the Queensland law firm: Cleary Hoare, which was structured as a unit trust (the Practice Trust). It had ordinary units, which were held by the directors’ related equity holding trusts and ‘special units’, which were held by the directors personally.
2. The firm also generated income from the sale of tax schemes, devised by the firm’s tax experts, including (and perhaps, mainly) by the Taxpayer. These schemes were sold by trusts that were separate from (though related to) the the Practice Trust. They were called ‘income earning trusts’ (IETs). Equity in these trusts was held in the same way.
3. By the end of the 1997 financial year (the year in question), the firm’s ownership structure had become complex and multi-tiered. It involved a ‘loss company’, with 3 trusts between it and the Practice Company and a further 3 trusts between it and the directors’ equity holding trusts. The structure for the ownership of the IETs was the same.
4. The Taxpayer (and presumably the other directors) claimed that there was no tax to pay on ‘his’ share of the income generated by Practice Trust or the IETs. He argued that this was the result of a mixture of trust distributions and gifts through the Loss Company, up to his equity holding trusts. He expected that this allowed him to use the tax losses in the Loss Company (to shelter this income).
5. The Commissioner treated the new entities, and the transactions with, and between, them, to be a ‘scheme’ for Part IVA purposes.
6. The problem for the Taxpayer (and presumably the other directors), was that the money did not follow the route devised, for their scheme, and caught the Taxpayer out. In fact there was little to evidence the reality, of the scheme, other than establishing the entities and the relevant resolutions.
7. The Taxpayer’s share of the Practice Trust’s income, for the 1997 Year, was $220,398 (that is ‘his’ share, directly and/or indirectly, through his related trust). In the Court’s reasons, this was called this the ‘Practice Amount‘.
8. In a similar way, the Taxpayer’s share of the income, of the IETs, was $275,481. This was similarly called the ‘IET Amount‘.
9. The Taxpayer’s equity holding related trusts, and the Taxpayer himself, claimed they had no income that came (directly or indirectly) from either the Practice Trust or the IET’s. And, likewise, no other beneficiaries declared any such assessable income, in their tax returns.
10. Despite this, the Commissioner assessed the Taxpayer, personally, on the Practice Amount and the IET Amount. The Taxpayer objected and his appeal found its way to this Court (via the Federal Court, at first instance, before Bromwich J, in Hart v Commissioner of Taxation (No.4) [2017] FCA 572).

The Court agreed with Bromich J, at first instance, and with the Commissioner of Taxation. It held that the Taxpayer had not discharged his onus of showing that his assessment, on the Practice Amount, or on the IET Amount, was excessive.

• This was on the basis that he (personally) was ‘presently entitled’ to the income from the Partnership Trust (and thus assessable on it, under the Trust assessing provisions, in Div 6 of Part III of the ITAA36).
• It was also on the basis that the ‘general anti-avoidance provisions’ in Part IVA would reverse a ‘tax benefit’, equal to both of these amounts.

The factual matters that caused the Taxpayer problems, were the following.

1. During the 1997 financial year, regular amounts were paid into accounts of the Taxpayer or accounts he controlled. They totalled $97k. They included 22 payments, totalling $49k, deposited into his joint account with his wife. They all had narrations like: “Cleary Hoare Sol Pay“. There were another 22 payments into the bank account one of the trusts he controlled (Oak Arrow Trust). They totalled about $35k, with very similar narrations. [para 19]
2. There was hardly any evidence to support the Taxpayer’s assertion that $185k, of what he received, was a loan. The Court noted that it was undocumented; no repayments of principal or interest were made; its terms were never identified; and there was no evidence that the Taxpayer had any capacity to repay this amount (especially if he asserted he was not getting any income). [para 21]
3. The Taxpayer made various written loan applications, in which he stated that his income was about $220k (and one was precisely the Practice Amount of $220,398). Some of these described these amounts as the Taxpayer’s personal income [para 26 of the reasons].
4. The Practice Trust had minuted a resolution, that that the Special Unitholders (the directors) were entitled, to the amounts that had been paid to them, as distributions of its net income.

Practice Amount – the Court gave the following reasons for assessing the Taxpayer personally (or for concluding that the Taxpayer had not discharged his onus of showing that this part of the assessment was excessive).

1. The Commissioner alleged that the Taxpayer had received distributions of income from either, or both, the Practice Trust, or his equity holding trust and that he was ‘presently entitled’ to these amounts of the trusts’ net income. [para 38]
2. The Commissioner didn’t argue ‘sham’ expressly, but effectively did by articulating what the ‘real transaction’ was, and then, relying on the Taxpayer to discharge his onus, of showing that this part of the assessment was excessive. [para 36 & 37]
3. The Taxpayer had a deemed ‘present entitlement’ under s95A of the ITAA36 (a vested and indefeasible interest) in the Practice Trust’s income, and s101 of the same Act, which deemed amounts he had already received, to still be ‘present entitlements’ (albeit entitlements already satisfied). [para 39] Such entitlements and payments arose in various ways, including through the Practice Trust’s resolution to distribute income, equal to the amounts already paid to the directors. [para 42]
4. Though the Commissioner did not argue that these amounts were assessable as ‘ordinary income’ (under s6-5 of the ITAA97), the Court held that it was, as “the objective circumstances of their receipt show that the amount derived was likely to have been the product of the [Taxpayer’s] work as a solicitor and was also relied upon by him for his ordinary expenditure.” [para 61]

The Court also concluded that Part IVA justified assessing both amounts – the Practice Amount (in the alternative) and the IET Amount, as the sole basis. The Court’s reasoning can be summarised as follows.

1. The Taxpayer conceded the Commissioner’s scheme [para 74], and effectively conceded that he would have entered into this scheme, for the relevant dominant purposes of obtaining a ‘tax benefit’, if there were one. [para 75(a)&104 etc]
2. The Taxpayer’s main argument was that there was no ‘tax benefit’, under s177C(1)(a) as there was no “amount [that] might reasonably be expected to have been included, in [his] assessable income … if the scheme had not been entered into” [para 75(b)].
3. The Commissioner contended that “but for the entering into of the … Scheme” the Taxpayer could reasonably be expected to have included the Practice and IET Amounts, in the way particularised, in para 77 of the Full Court’s reasons.
4. The Taxpayer contended that this was the least likely scenario. [para 79]
5. In support of his contention, the Taxpayer pointed to:  (1) his practice, in the 3 preceding years, of not paying tax, by using trust losses; and (2) the interposed entities were all ‘new’, so that there was no pattern of prior distributions, that was being disturbed.
6. The Court was unimpressed, and noted that the Taxpayer had not provided any evidence of what would have been the more likely counterfactual. He only made submissions that his children might have, otherwise been, the beneficiaries, or the loss trust, they’d used in previous years, might have been the beneficiary (although, its remaining losses were nowhere near enough to absorb the whole year’s combined income of the Practice Trust and the IETs). [para 81]
7. The Court noted that any evidence, a taxpayer may lead, about a more likely counterfactual, would be relevant (but not determinative). Also, a taxpayer may establish a more likely ‘counterfactual’, purely by submissions, as to the objective purpose, evident in the other established facts. [see para 82 the reference to a portion of the reasons of Edmonds J, in the Ashwick case  [2011] FCAFC 49, together with the other cases, to which His Honour refers]
8. But the Court also noted that a taxpayer cannot discharge its onus (that the assessment is excessive), by simply arguing that the Commissioner’s counterfactual is ‘unreasonable’. [see para 83 and references to the RCI case [2011] FCAFC 104]
9. Importantly, the Taxpayer could not successfully insist, that there was no ‘tax benefit’ because he would just have used another Part IVA scheme, to avoid tax. The Court referred to the Trail Bros case, as establishing the principle that “The counterfactual must not itself be a scheme with a dominant tax purpose”. [see para 94, and observations of Besanko J in the Futuris case: [2010] FCA 935, at [113] referring to Trail Bros [2009] FCA 1210 at para 52]
10. And finally, the Court agreed, with the trial judge, that “any counterfactual transaction would also need to be one that would have complied with the rules of the Queensland Law Society” (which preclude practice income, earned by a trust, being distributed to any non-family member). Though not relevant to the ‘counterfactual’, the Court noted that the scheme, as carried out, did breach the Society’s rules, by the chain of distributions ending in the Loss Company.

And the Court upheld the 50% shortfall penalty, too.

• In the 1997 Year, it was the old s226 of the ITAA36, that established the shortfall penalty regime, in Part IVA cases. It was  50% of the shortfall, unless it was reasonably arguable that Part IVA did not apply.
• The Taxpayer argued, that it was reasonably arguable that Part IVA did not apply, but the Court agreed with the judge, at first instance, that the case was ‘blatant’ and there was no prospect of making out this argument. [para 109 and following]

(Hart v FCT [2018] FCAFC 61, Full Federal Court, Robertson, Wigney and Steward JJ, 20 April 2018.)

[FJM; LTN 76,23/4/18; Tax Month April 2018]

Study Questions (answers available)

1. Did the taxpayer win?
2. Did the case throw light on the extent to which professionals can arrange family members to derive income profits from their firm?
3. Did the taxpayer’s related entity own units in the Practice Trust and the IET’s, indirectly, through a loss company?
4. Did the case involve a Practice Amount of $275481 and an IET Amount of $220,398?
5. Was the taxpayer assessed on these amounts personally?
6. Were 44 amounts, regularly deposited into the taxpayer’s joint account, with his wife, with narrations, to the effect of “Cleary Hoare Sol Pay”?
7. Did the Practice Trust minute a resolution entitling directors (as Special Unitholders) to receive amounts already paid to them, as distributions of the Trust’s net income?
8. Did the Commissioner assess the Taxpayer on the Practice Amount, on the basis that he had a s97(1) ‘present entitlement’ to that amount?
9. Did the Court also find that this amount could be assessable as ‘ordinary income’ being reward for his services as a lawyer?
10. Did the Court apply Part IVA only to the other ITE Amount?
11. Was it open to the Taxpayer to argue that, it was not reasonable to assume, that absent this scheme, he would have done something else to ensure that no tax was paid on this income?