Ierna v Commissioner of Taxation - section 45B and Part IVA

Ierna v Commissioner of Taxation [2024] FCA 592

Federal Court of Australia

Logan J

Date: 6 June 2024

Decision: in favour of the Taxpayer

Synopsis of decision

In 2016, a corporate restructure was effected by the taxpayers. The Commissioner argued that the result of this restructure was that either:

• the taxpayers received a capital benefit that was subject to taxation pursuant to section 45B of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936); or
• (in the alternative) the taxpayers received a tax benefit arising in connection with a scheme pursuant to Part IVA of the ITAA 1936.

The taxpayers were successful in both arguments and were able to establish that no capital benefit was received nor was there a Part IVA arrangement.

Facts

Before 1985, Mr Ierna and Mr Hicks (the Applicants) started a fashion retailing business. The business was conducted by an Australian resident company in its capacity as a trustee of a trust. The use of unpaid present entitlements (UPEs) was a regular part of the operation of the business.

In 2010, the Applicants formed the view that Taxation Ruling TR 2010/3W Income tax: Division 7A loans: trust entitlements (TR 2010/3W) would severely disadvantage their business. TR 2010/3W stated the Commissioner’s view that unpaid UPEs were to be characterised as loans. If followed, TR 2010/3W would impact the Applicant’s business in a number of ways, including:

• UPEs had historically been used to fund business operations and replacement external debt funding would be difficult to obtain; and
• the ruling would create an ever-present concern with respect to ensuring funds were available to make timely repayments to comply with Division 7A of Part III of the ITAA 1936.

By this time, the Applicants had also long been troubled by their inability to accumulate profits in the business without those profits being taxed in the hands of the trustee at the highest marginal rate.

By 2014, these problems were of such significance that the Applicants sought advice with respect to restructuring their business. Pursuant to that advice, a restructure occurred under which:

• the Applicants’ Division 7A loans were discharged; and
• a new company was formed to conduct the Applicants’ business (New Co).

The Commissioner reviewed the restructure and was of the view that the Applicants:

• were liable to taxation on a capital benefit of $26 million pursuant to sections 45B and 45C of the ITAA 1936; or
• (in the alternative) would have amounts of approximately $33.7 million included in their assessable income under Part IVA pursuant to subsections 177F(1) and (2) of the ITAA 1936.

Decision

The Court found that the two issues for determination were:

1. Whether the 2016 restructure entailed, in terms of section 45B, a scheme under which a demerger benefit or a capital benefit was provided for a purpose (the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit?

• If so, whether the Commissioner was entitled make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C applied such that the amounts nominated in the determination were taken to be an unfranked dividend paid out of the profits of New Co, and thereby to be included in assessable income for the 2015–16 income year pursuant to subsection 44(1) of the ITAA 1936.

2. In any event, whether Part IVA applied.

With respect to the first question, the primary contention was the extent to which the capital benefit received by the Applicants was attributable to the profits of the original trust and whether that trust was an associate of New Co. The Court conducted an extensive analysis of the history of section 45B and noted that its evident purpose was to ensure companies did not ‘distribute what are effectively profits to shareholders as preferentially taxed capital rather than a dividend.’ The Court also provided an in-depth analysis with respect to the meaning and definition of ‘profit’ and ‘dividend.’

As a consequence of this analysis, the Court rejected the Commissioner’s argument. This was because there was no pattern of distributions of dividends, bonus shares and returns of capital, or share premium on the part of the original trust or its associated entities (which included New Co).

Further, the Court found that the transaction was explicable by a desire to access rollover relief under Division 615 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). In short, the entities comprising the group had not previously exhibited the desire, or even had the capacity, to undertake such activity.

With respect to the second question, the Court determined that Part IVA did not apply. Interestingly, a large part of the evidence was adduced by the Applicants’ professional advisers. The advisers were able to give critical supporting detail with respect to the financial position of the business at historical points in time, as well as how that position impacted on advice given and therefore the course of action ultimately adopted.

This evidence was ultimately crucial because it allowed the Court to conclude that the Applicants would be unable to repay certain Division 7A loans, and those loans were a central plank of the Commissioner’s Part IVA counterfactual. The Court stated, for the purposes of the alternate postulate under Part IVA, a theoretical possibility is not sufficient and that ‘what is necessary is a prediction based on evidence.’ The Court relevantly made the following findings with respect to facts adduced into evidence:

• the Commissioner did not identify a basis on which the Applicants would have been able to fund the Division 7A loans required by his alternate postulate; and
• the entities that might have provided the funding for any repayment of the loans were required to meet the significant ongoing demands for cash in the business.

Significance of the decision

The significance of this decision will become apparent only once it is known if there is to be an appeal, and if so, once the outcome of such an appeal is determined. In the interim, it is possible to make a few brief remarks.

First, Part IVA cases continue to result in successful outcomes for the Taxpayer. Part IVA matters are notoriously dependent on their facts, and so the significance of these decisions can be difficult to ascertain. That said, a key component of the finding with respect to Part IVA was a forensic examination of the capability of the evidence to support the Commissioner’s alternate postulate. The inability of the evidence to do so weighed against the Commissioner with respect to Part IVA.

Second, the decision highlights the importance of meticulous record-keeping by taxpayers and their advisers. The facts as described in the judgment gave rise to a compelling narrative arc.

The witnesses for the Applicants were able to give detailed and cogent evidence as to:

1. the historical financial position of the business;

2. the need for the restructure;

3. the various options that were considered; and

4. the basis for the form of the restructure that was ultimately adopted.

The Court was able to make those factual findings only because the evidence adduced by the Applicants allowed those findings to be made.

Further guidance

If you have any specific concerns that have not been outlined above, please email taxpolicy@taxinstitute.com.au.