The general anti-avoidance provisions in Pt IVA of the ITAA 1936 are a lethal weapon in the Commissioner's arsenal combating tax avoidance schemes. The most recent changes (contained in the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013) have only strengthened the Commissioner's position by, inter alia, eliminating the "do nothing" defence (RCI Pty Limited v FCT [2011] FCAFC 104). That is, a taxpayer may no longer raise as a reasonable alternative to the scheme that they would have maintained the status quo and "done nothing". In the context of discretionary trusts, deprived of the "do nothing" defence, trustees and beneficiaries often struggle to adduce evidence sufficient to refute the Commissioner's postulate, even when it is contrary to the genuine intention of the trustees.
The burden of challenging a Pt IVA assessment (or any amended assessment) is heavy. The onus of proof is on the taxpayer; though principles of law are important, evidence is king. Unfortunately, for many taxpayers who have had to run this gauntlet, evidence has been lacking with one taxpayer having their evidence likened to nothing more than a "self-serving assertion" (Hart v FCT [2018] FCAFC 61). A declaration by a trustee that they would not have done the step hypothesised by the Commissioner is insufficient. Historical or persuasive evidence in support of the taxpayer's position is critical. In providing this evidence, trustees and beneficiaries must often contend with:
complacency in the trustee's approach to trust records;
the traditional approach to trustee minutes – less is best; and
a lack of contemporaneous documentation to support the taxpayer's assertions.
As trust resolution season fast approaches, trustees are encouraged to revisit their approach to trust records. Accountants and advisors – who are usually responsible for preparing the trust documents – should consider the nature of the year's transactions and how best to record them with one eye on the potential consequences of a Pt IVA assessment on the trust's transactions. Significant transactions require more attention. Whenever we are asking ourselves "how can we pay less tax", we must consider Pt IVA. Unfortunately, some trustees will not want the additional upfront expense. But, in the end, they may pay many times over.
Part IVA generally
Briefly, the essence of Pt IVA is:
if there is a scheme;
a taxpayer receives a tax benefit as a result of a scheme; and
the dominant intention of the person directing the scheme is that a tax benefit result;
then the Commissioner is empowered to disallow that tax benefit.
It is trite to say that most actions taken by taxpayers relating to their tax affairs will amount to a scheme. While there is ample authority on what constitutes a scheme (eg Hart v FCT [2018] FCAFC 61; British American Tobacco Australia Services Limited v FCT [2009] FCA 1550), the heavy lifting is consistently done by assessing 3 aspects: what tax benefit has been obtained, by whom, and for what purpose.
One category of tax benefit requires an assessment of which taxpayer(s) "would have, or might reasonably be expected to have" had the disputed amount of income included in their assessable income had the scheme not been entered into or carried out – s 177F(1)(a) of ITAA 1936. Determining who "might reasonably be expected to have" received an amount of assessable income involves a (reasonable) prediction as to the events which would have taken place but for the scheme (FCT v Peabody (1994) 181 CLR 359, 385).
Practically, this prediction often manifests itself in assessments to multiple different taxpayers – in many cases, for the same amount of money!
Challenge and the Burden of Proof
Taxpayers assessed pursuant to a Pt IVA determination must challenge the assessment by instituting proceedings in either the AAT or the Federal Court. Once there, the taxpayer must show the Commissioner's assessment is excessive. Proving the assessment is excessive necessarily involves the presentation of evidence why the taxpayer would not have been the recipient of the assessable income, absent the scheme. Taxpayers seeking to discharge this onus often provide evidence in the form of affidavits and/or oral testimony to the AAT or Court.
The case of McCutcheon v FCT [2008] FCA 318 provided useful guidance as to the standard of evidence required to discharge the taxpayer's onus. In McCutcheon, Mr McCutcheon and his wife each received assessments pursuant to a Pt IVA determination for 50% of a trust's net income. Mr McCutcheon argued that "the P & A Trust 'would never have distributed such a substantial portion' of the Trust's income to [himself] or his wife" – Ibid, 318 at [4].
Specifically, Mr McCutcheon's affidavit read:
"Further, the P & A Trust has never distributed large amounts of income to either my wife or I and would never have distributed such a substantial portion to either my wife or I".
The Commissioner objected to the words in italics and argued that such a conclusion was for the AAT to determine – not Mr McCutcheon. Ultimately, the Court disagreed and allowed the objected words into evidence on the stipulation "foundation facts are given in evidence which support what would otherwise be a bald speculative statement" – Ibid, 318 at [37]. In obiter, the Court further suggested the taxpayer might have said, "'the trustee would never have distributed such a substantial portion to either my wife or I' because… and then identified factual circumstances which support the proposition" – Ibid, 318 at [37]. The standard of evidence described in McCutcheon has become known as the "foundation facts" (Hart v FCT [2018] FCAFC 61; RCI Pty Limited v FCT[2011] FCAFC 104; FCT v Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49). Foundation facts are vital where advancing a claim that it is unreasonable to assume the assessed taxpayer might reasonably be expected to have received the disputed assessable income.
Documenting the foundation facts
The inability of a taxpayer to adduce sufficient and compelling evidence is a common scenario that plays out within the Pt IVA case law; including a number of cases that have involved sophisticated taxpayers as "the taxpayer" – see Rowntree v FCT [2018] FCA 182. What the cases show is that all taxpayers, sophisticated or not, are predisposed to the same failures – inattentiveness and complacency. These failures variously manifest in trust loans not being documented or evidenced by journal entry only, deficient trust minutes, and inconsistent bank records – where transactions are recorded as "pay" and later said to be a loan. All of these "inattentions" have been detrimental to a taxpayer subject to a Pt IVA assessment.
Unfortunately, comprehensive recording of extenuating circumstances is rarely front of mind for a trustee when making a distribution. The nature of the relationship between trust and beneficiary does not mandate such formal steps be taken. Yet, the first step in any audit or enquiry is the collection and analysis of documents. Very recently, the Authors' firm has had great difficulty convincing the ATO that it is a reality of life that related parties do not necessarily create inter-party documents in the same way as big business or arm's length parties do. That concept is lost on the ATO; as it is the courts. Again, evidence is king!
What is required?
With trust distribution season fast approaching, trustees should reconsider their approach when evidencing the distribution of trust income. In the Authors' experience, it is not uncommon for an income distribution resolution to include a number of short paragraphs outlining: the calculation of income of the trust, who the beneficiaries (to be distributed to) are, and a short resolution to distribute income of the trust to certain beneficiaries.
This might look like:
"Pursuant to the powers granted to the trustee under clause 3(1) of the deed the income of the trust estate for the year ended 30 June 2021 (excluding capital gains and franked distributions already distributed by way of specific entitlement) be distributed to beneficiaries as follows:
1. Barry Kennedy 25%
2. Harry Kennedy 25%
3. Judy Kennedy 30%
4. Trudy Kennedy 20%". [CPA Trust Streaming Manual]
This is not meant as a criticism of the above distribution minute; it is appropriate. However, when viewed in the context of creating foundation facts to disprove a Pt IVA assessment, the resolution is of little value and, consequently, the taxpayer's chances of success are greatly reduced.
Trustees should consider establishing a matrix of appropriate foundation facts which outline the reasoning behind a distribution. Those facts must exist at the time. Trustees should also play the fortune teller and contemplate who the Commissioner may seek to assess under Pt IVA and document the reason why that beneficiary did not and would not receive a distribution. A common refrain from taxpayers (and their advisors) is that the taxpayer would not have received the assessable income for asset protection reasons. While often genuine, without more, such assertions will be insufficient (Hart v FCT [2018] FCAFC 61).
Trustees should consider incorporating one or more from the following non-exhaustive list of evidentiary documents to lay the foundation facts for later use.
Comprehensive trust distribution minutes or resolutions.
Separate records detailing the reasoning of the trustee for making the distributions – including why certain taxpayers are not receiving trust income. This may also include an asset protection analysis, if that is the reason.
Formal loan agreements between related parties.
Legal analysis of alternatives to the scheme.
Supporting bank transactions or the use of financial instruments to evidence payments.
Conclusion
Part IVA case law is littered with trustee exhortations that the Commissioner's position is incorrect as the trustee "would never" have made the suggested distribution. Without evidence in support of their position, such declarations carry limited weight.
Trustees should form the habit of laying the foundation facts for later use when making trust distributions. In the Authors' experience, trustees (often on the advice of their lawyers and accountants – the Authors included) have shied away from documenting reasons for a particular distribution or non-distribution; generally because of the impact those notes might have if the trustee is challenged by a beneficiary in a different setting. However, the spectre of a revamped Pt IVA looms large and trustees who are involved in transactions that might have Pt IVA applied need to consider building a solid foundation to argue from.
This article was written by Paul Mackenroth and Helen Jerrard and published in Thomson Reuters Weekly Tax Bulletin