The s100A B Blood and Guardian cases cover two very specific scenarios.
s100A B Blood and Guardian Case
In Update 33, Andrew Henshaw of Velocity Legal in Melbourne discussed the final versions of TR 2022/4 and PCG 2022/2 about s100A. In this update, Update 34, Andrew Henshaw will discuss two recent court cases with you about reimbursement arrangements under s100A – s100A B Blood and Guardian Case.
Here is what we learned but please listen in since Andrew explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
s100A B Blood and Guardian Case
Two court cases. Each is quite a unique setup – not your run-of-the-mill s100A set-up.
B Blood Case
The B Blood case is a new court case. Please listen to this episode to hear what happened.
Guardian Case
We already discussed the Guardian Case episode 345. In 2021, in front of a single judge of the Federal Court, the Guardian Case ended with a big win for the taxpayer and a humiliating loss for the ATO. The taxpayer didn’t just win one point – one point was all he needed. He won on three counts.
However, the ATO appealed. And the case went to the Full Federal Court. And so this Full Federal Court ruling is what we cover in this episode. However, before we do that, let’s go through what actually happened in the Guardian Case.
Australian Trust with Rental Income
You already heard in episode 345 how the Guardian Case is about a resident of Vanuatu, an Australian discretionary trust and a bucket company that together turned rental income into a franked dividend.
Mr Vanuatu
The controller and beneficiary of this trust is a resident of Vanuatu and hence a foreign resident. Let’s call him Mr Vanuatu.
Australian Bucket Company
There is an Australian bucket company held by the trust. So the trust is the 100% shareholder of the bucket company. The bucket company is registered in Australia, so even if the central management and control were in Vanuatu, it is still an Australian tax resident.
Australian Discretionary Trust
The Australian trust has a property in Australia with AUD 2m rental income per year. So Mr Vanuatu is not a poor man. So how would this AUD 2m of rental income have been taxed without any funny business? And what did they do instead?
No Funny Business
When you distribute income from a trust, it is assessed to the beneficiaries under section 97 (ITAA 1936).
However, if the beneficiary is a non-resident as Mr Vanuatu is, the trustee (rather than Mr Vanuatu) is taxed under section 98 subsection 3 of the ITAA 1936. And that at top marginal tax rates.
Withholding Tax v Trustee Tax
As you know when a non-resident receives Australian-sourced income from a trust, Australia wants to make sure it gets its taxes. And it does this in two ways: Withholding tax or assessing the trustee.
Think of it as two buckets. Dividends, interest and royalties are in one bucket where the withholding tax rules apply. And any other income is in the other bucket where the trustee gets assessed at top marginal tax rates.
Rental income is not subject to withholding tax since not a dividend, interest or royalty. So it is in the bucket where instead the trustee is assessed.
Yes, the tax to the trustee is not a final tax, Mr Vanuatu could have prepared an Australian tax return and claim expenses as well as a credit for the tax paid by the trustee (per 98A subsection (2)), but he would have been taxed as a foreign resident and so the tax outcome wouldn’t have been great. As a non-resident with AUD 2m of assessable income, he would have paid about AUD 880k of income tax as a non-resident.
So clearly not a great tax outcome. So what did Mr Vanuatu and the trust do? Did they assess the trustee and pay AUD 880k of tax?
Distribution to the Bucket Company
You already guessed it, they didn’t.
The trust didn’t distribute the trust income to Mr Vanuatu. Instead, it distributed the trust income to the bucket company.
And so the bucket company paid 30% of tax . The rental income was AUD 2m, so the company paid AUD 600k of corporate income tax. There is a small possibility that the company only paid 25% of tax as a small business, but unlikely, so let’s go with 30%.
Still all fine. But Mr Vanuatu wants his money, and the bucket company currently holds it. So what did they do next?
Now the funny business begins.
So now the bucket company pays a $1.4m franked dividend to its shareholder, the trust, with an AUD 600k franking credit attached. So the income arrives back in the trust. But now it is no longer rental income, but a franked dividend.
And now you can see where this is heading. Now we are no longer in the bucket where income gets assessed to the trustee. But we are in the bucket where withholding tax applies.
Dividends
But franked dividends are specifically excluded from these withholding rules. So if a non-resident receives franked dividends, then no withholding but also no refund of franking credits. So you lose the franking credits….
Or saying this in ATO lingo,
“If a non-resident beneficiary is taken by Division 11A of Part III to be presently entitled to a franked distribution received by a trust, the franking credits attached to that distribution are not taxed to the trustee, do not reduce the tax payable of either the trustee or beneficiary, and are not refundable.”
So you lose the franking credits, but you gain by not having to pay withholding tax either.
AUD 280,000 Tax Saving
So now you can see why this is highly advantageous. Instead of AUD 880k of tax Mr Vanuatu would have paid if the rental income had been distributed directly to him. He only paid AUD 600k in the form of lost franking credits. That is a AUD 280,000 saving – each year. So clearly worth the bother.
It is obvious why the ATO didn’t like this and took him to court.
2021 Single Judge Federal Court Decision
In 2021, the ATO lost on three points, which were as follows.
1 – No Reimbursement Agreement at Time of Distribution
The Court accepted that there was no agreement at the time of distribution. So when the trust distributed the income to the bucket company, there was no intention of feeding it back into the trust the following year.
Even though they did that three times. Even though they did reimburse the trust. The Court held that there was no intention at the time of the original trust distribution, so no s100A. Hard to believe, but true.
2 – No Tax Reduction Purpose
In order for s100A to apply the purpose of the agreement must be a reduction of income tax.
But the problem is a reduction of income tax in comparison to what? Which other hypothetical scenario do you use?
And of course, you would have used the distribution of rental income directly to Mr Vanuatu. And that’s what the ATO did as well.
The ATO argued that the distribution should have gone straight to Mr Vanuatu.
But Mr Vanuatu argued that he would never have done that. He would have kept the income in the company for asset protection purposes. And so they did not save any tax.
The Court accepted that. And ruled that you can only look at the dividends and can’t go back to the original trust distribution. So no tax savings and another point lost to the ATO.
3 – Ordinary Commercial or Family Dealings
As you are aware, if there is an ordinary commercial or family dealing, then it excludes the application of s100A. And, of course, Mr Vanuatu asserted that it was a family dealing – that his sole concern was asset protection and nothing more.
The Court said that you can’t use the benefit of hindsight. And accepted Mr Vanuatu’s claim that this was an ordinary family dealing. The third and lost point lost.
Would have been great.
And in a way, this had been really good news for tax advisers. Because you would be in a strong position to help your overseas clients with trust income in Australia.
You would do what Mr Vanuatu did. You feed any trust income that is not interest, dividends or royalties into a bucket company, and then pay it out as dividends without any further withholding tax.
The Guardian case as it stood in 2021 would have given you a stronger defence. Not watertight as Andrew Henshaw highlights in this update, but definitely a stronger defence. But now the Full Federal Court has ruled and Andrew will tell you what that outcome was.
Part IVA
So Part IV came to the ATO’s rescue. Part IV turned out – as it so often does – to be the white knight in the night for the ATO when all else including s100A had failed.
So these were two updates about s100A, the two finalised rulings in Update 33 and the two court cases the B Blood and the Guardian case.
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