Trail Bros Steel and Plastics Pty Ltd and Commissioner of Taxation

[2007] AATA 1850

Administrative Appeals Tribunal

DECISION AND REASONS FOR DECISION [2007] AATA 1850

ADMINISTRATIVE APPEALS TRIBUNAL      )

)          No QT200400251-252

TAXATION APPEALS DIVISION		)
Re		TRAIL BROS STEEL & PLASTICS PTY LTD

Applicant

And COMMISSIONER OF TAXATON

Respondent

DECISION

Tribunal Deputy President P E Hack SC

Date12 October 2007  

PlaceBrisbane

Decision

The Tribunal, in each application:

1.    sets aside the respondent’s objection decision made on 17 November 2004;

2.    substitutes a decision that the applicant’s objections be allowed in full;

3.    remits the matter to the respondent to amend the assessments in accordance with these reasons;

4.    certifies that the proceedings have terminated in a manner favourable to the applicant.  

..............................................

Deputy President

CATCHWORDS

TAXATION – allowable deductions – amounts paid to employee welfare fund – amounts paid in the discharge of obligation in employment contract deductible – schemes to avoid taxation – whether a tax benefit was obtained – no tax benefit to taxpayer in connection with the scheme – Part IVA does not operate to deny deductibility – decision set aside – matter remitted to respondent for amendment of assessments.

Income Tax Assessment Act 1936 (Cth) – ss 51(1), 82AAC, 177C

Income Tax Assessment Act 1997 (Cth) - s 8-1

QCT Resources Ltd v Commissioner of Taxation (1997) 36 ATR 184; 97 ATC 4432

Benstead Services Pty Ltd and Commissioner of Taxation (2006) 64 ATR 1232; 2006 ATC 2511

Commissioner of Taxation v Hart (2004) 217 CLR 216

Commissioner of Taxation v Peabody (1994) 181 CLR 359

REASONS FOR DECISION

12 October 2007	Deputy President P E Hack SC
Introduction

1.These are applications by Trail Bros Steel & Plastics Pty Ltd (Steel & Plastics) to review decisions of the respondent, the Commissioner of Taxation, to disallow objections by Steel & Plastics to assessments made by the Commissioner in the years ending 30 June 1997 and 30 June 1998. In each of those years Steel & Plastics claimed an amount of $210,000 as a deduction from its assessable income on the basis that the amounts had been paid to an Employee Welfare Fund, that is, a fund established for the benefit of its employees.

2.The Commissioner disallowed the claimed deductions on the basis that the amounts were not deductible pursuant to s 51(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) in relation to the 1997 income year and pursuant to the identical provision in s 8-1 of the Income Tax Assessment Act 1997 (Cth) in relation to the 1998 income year. In addition, the Commissioner made determinations disallowing the deductions pursuant to Part IVA of the ITAA 1936. Penalties were imposed at 40% of the amount of the primary tax applicable to the adjustment on the basis that it was not reasonably arguable that the amounts claimed were deductible. Steel & Plastics seeks a review of the Commissioner’s objection decision.

3.The questions that arise for determination are:

(a)are the amounts deductible;

(b)does Part IVA of the ITAA 1936 operate to deny deductibility;

(c)were penalties correctly imposed.

Factual Background

4.Mr Mark Trail, Mr Allan Trail and Mr Robert Trail are brothers. In 1986 they commenced business in partnership manufacturing cane-harvesting machinery, undertaking engineering repairs and manufacturing plastics components for the cane-harvesting industry. They carried on business in Home Hill in Northern Queensland. From 1988 the business was carried on by a corporation, Trail Bros Pty Ltd (Trail Bros). Each of the brothers held one third of the issued capital of Trail Bros.

5.Within a relatively short time after incorporation Mr Robert Trail withdrew from active participation in the business. He resigned as a director and disposed of his shares in Trail Bros. From that time Trail Bros was controlled by Mr Mark Trail and Mr Allan Trail. The business of Trail Bros grew and by early 1996 had 17 salaried employees.

6.In early 1996 Mr Mark Trail and Mr Allan Trail decided to restructure the affairs of Trail Bros. They did this by bringing three others into the business: Mr Joseph Patane (the fabrication and floor manager), Mr Chris Holden (the finance manager) and Mr Terry Dall’Osto (an outsider to the business but a close friend of the brothers). The restructure was achieved by incorporating Steel & Plastics and selling the business of Trail Bros (i.e. stock, work in progress, and goodwill) to Steel & Plastics at a price of $175,000.00. Mr Patane, Mr Holden, Mr Dall’Osto, Mr Mark Trail and Mr Allan Trail become members[1] and directors of Steel & Plastics. After settlement of the sale the shareholding in Steel & Plastics was held in this  way:

·Trail Bros – 45%

·Lynpros Pty Ltd  – 20%

·Mr Patane – 25%;

·Mr Dall’Osto – 10%.

[1]       Either directly or through an associated company.

7.In the restructured organization Mr Mark Trail was the general manager, Mr Allan Trail was the manager of the Plastics division, Mr Patane was in charge of production and engineering, Mr Holden was in charge of finance and administration and Mr Dall’Osto was in charge of sales and marketing. Not long after the restructure Mr Dall’Osto left the business and sold his shares. Trail Bros acquired a further 6% shareholding, giving it a total of 51%, and the remaining 4% was acquired by the other members.

8.As part of the restructure Steel & Plastics entered into written contracts of employment, each dated 1 April 1996, with Mr Mark Trail and Mr Allan Trail. Those agreements have obviously been prepared professionally. They provided for quite modest remuneration, reviewable annually, but, importantly, required Steel & Plastics to make contributions of superannuation on behalf of each of Mr Mark Trail and Mr Allan Trail to a self-managed superannuation fund – Trail Bros Superannuation Fund – of which Mr Allan Trail and Mr Mark Trail were the trustees.

9.Each agreement required that a total of $297,000.00 be paid during the first four years of the trading operations of Steel & Plastics. An amount of $60,000.00 was required to be contributed prior to 30 June 1996 and the balance was to be paid over the ensuing three years. Steel & Plastics had a discretion as to the timing and amounts of the payments, provided the total amount due was paid within the first four years of operation of Steel & Plastics.

10.An amount of $120,000.00 was paid to Trail Bros Superannuation Fund in the year ended 30 June 1996 and, by virtue of s 82AAC(2D) of the ITAA 1936, that payment was fully deductible from the assessable income of Steel & Plastics. During the next financial year amendments to the ITAA 1936 abolished the complete deductibility of superannuation contributions and introduced age-based limits for deductibility[2]. The effect of the amendments was to severely limit the deductibility of the amounts that Steel & Plastics had agreed to pay to Mr Mark Trail and Mr Allan Trail over the ensuing years had the amounts been paid as superannuation.

[2]       See Superannuation Contributions Tax (Consequential Amendments) Act 1997 (No 71 of 1997) (Cth) and Superannuation Contributions and Termination Payments Taxes Legislation Amendment Act 1997 (No 191 of 1997) (Cth).

11.Those who advised Steel & Plastics became aware of this change to the legislation. The events thereafter are described by Mr Mark Trail in his affidavit in this way:

“21.Before 30 June 1997 Allan [Trail] and I spoke with the other directors about varying our arrangement in relation to Allan’s and my remaining superannuation entitlements (of $474,000 over three years for Allan and me) so that the Applicant would instead contribute that amount to Trail Bros, which was still controlled by Allan and me. Trail Bros was to be the trustee of the Trail Bros Pty Ltd Employee Welfare Fund (‘the Employee Welfare Fund’).

22.We had explained to the other directors that this could be of additional benefit to the Applicant, because the Fund was established not only for the benefit of Allan and me, but also the other employees and their dependants. The other directors were agreeable to this and were agreeable to the Applicant bearing the costs of establishing the Employee Welfare Fund.”  

12.Mr Davies QC, who led Ms Brennan of counsel for the Commissioner, submitted that I ought be sceptical about the existence of the agreement sworn to by Mr Mark Trail. He pointed to the absence of evidence from the other directors who are said to have been parties to the agreement relied upon and the absence of documents evidencing the claimed agreement. It is certainly the case that the language used in the affidavit is the language of legal conclusion rather than language of facts and conversations from which the legal conclusion of an agreement to vary might be drawn. But despite the reservations I have on that account and despite the absence of documentary or other evidence I consider that I ought accept that there were, indeed, agreements between Steel & Plastics, as employer, and Mr Mark Trail and Mr Allan Trail, as employees, to vary the terms of the contracts of employment entered into the previous year such that the contributions required by those agreements to be made to superannuation would, instead, be made to the Employee Welfare Fund.

13.I reach that conclusion on the basis that it accords with logic and common sense, not merely because Mr Mark Trail says that the agreements were varied. His evidence is, in many respects, unsatisfactory. His evidence about the “practice” of Steel & Plastics in helping employees, when tested by cross-examination, turned out to be hyperbole. Likewise I have considerable doubts about his evidence of the motivation for setting up the Employee Welfare Fund, in part, to benefit employees. Logic and common sense suggests that the Employee Welfare Fund was set up as a mechanism by which Steel & Plastics could continue making the payments that it was obliged to make to Mr Mark Trail and Mr Allan Trail. They were unlikely to agree to forego their entitlements and they, as the controllers of a majority of Steel & Plastics’ issued capital, had an obvious interest in ensuring that payments made by Steel & Plastics retained deductible status. Thus I conclude that there was a variation to the contracts of employment such that payments due would, from the 1997 income year onwards, be made to the Employee Welfare Fund.

14.The Employee Welfare Fund was set up with the assistance of Cleary Hoare, a firm of solicitors who were promoting the arrangement. A fee of $10,000.00 was paid by Steel & Plastics to Cleary Hoare Corporate to set up the arrangement. The Employee Welfare Fund was established by a deed of trust dated 19 June 1997. Trail Bros was the trustee and Steel & Plastics was the employer. The trust was a discretionary trust. The beneficiaries were the employees, including the directors, of Steel & Plastics. It is unnecessary, in the circumstances, to have regard to the precise terms of the trust.

15.On 24 June 1997 Steel & Plastics paid an amount of $210,000.00 to the Employee Welfare Fund in accordance with a resolution of its directors. A further sum of $210,000.00 was paid on 4 July 1997, again in accordance with a resolution of directors. No further contributions were made to the Employee Welfare Fund with the result that Steel & Plastics paid $54,000.00 less than it was required to pay. Mr Mark Trail is not able to explain why that was so beyond thinking that it may have had something to do with the Commissioner taking a hostile attitude towards Employee Welfare Fund schemes in general. No sum has ever been paid out of the Fund for the benefit of any employee of Steel & Plastics.

16.In each of its income tax returns for 1997 and 1998 Steel & Plastics claimed a deduction of $210,000.00, representing the payments to the Employee Welfare Fund. The returns, lodged on 24 February 1998 and 15 February 1999 respectively, resulted in “nil” assessments.

17.On 25 March 2003 the Commissioner made determinations under Part IVA of the ITAA 1936 in relation to the claimed deductions of $210,000.00 in each of the 1997 and 1998 income years. Subsequently on 14 and 15 April 2003 he made assessments disallowing the deductions on the basis that the amounts were not deductible, or, if they were, that Part IVA operated to deny deductibility. Penalty was imposed at the rate of 50% on the basis that the claims were not “reasonably arguable” however that penalty was discounted to 40% on the basis that Steel & Plastics had made a voluntary disclosure.

18.Steel & Plastics objected to the assessments on 16 July 2003. Those objections were disallowed in full on 17 November 2004. These proceedings were commenced shortly thereafter.

Are the Amounts Deductible?

19.It is not necessary, in the circumstances of this case, to delay long on this question. Mr Davies accepted that if I were to conclude that the payments were made pursuant to a contractual obligation arising out of the employment agreements, the amounts paid pursuant to that obligation were deductible as they went to discharge an employment obligation.  

20.Having regard to my conclusion in paragraph 12 above that there was a variation to the contracts of employment such that payments due to the brothers would be made by means of the Employee Welfare Fund I am satisfied that the payments made were deductible having regard to the character of the promise that underlay the payments[3]. The present case is quite different to that in Benstead Services Pty Ltd and Commissioner of Taxation[4] where a similar Employee Welfare Fund had been set up.

[3]       See e.g. QCT Resources Ltd v Commissioner of Taxation (1997) 36 ATR 184; 97 ATC 4432.

[4] (2006) 64 ATR 1232; 2006 ATC 2511.

21.It follows that, in my view, the payments made by Steel & Plastics were deductible in each of the income years.

Does Part IVA Operate to Deny Deductibility?

22.So far as is presently material Part IVA of the ITAA 1936 operates to deny deductibility where:

(a)     there is a scheme as defined;

(b)a taxpayer has obtained, or would, but for the operation of Part IVA, have obtained, a tax benefit as defined; and

(c)having regard to the matters set out in s 177D(b)(i) to (viii), it would be concluded, putting the matter in the simplest form, that the sole or dominant purpose for entry into the scheme was the obtaining of the tax benefit.

23.“Scheme” is widely defined[5]. The scheme in existence here was said by the Commissioner[6] to comprise the agreements to vary the contracts of employment and the implementation of that variation, including the establishment of the employee welfare fund and the contributions made to it.

[5] For the purposes of Part IVA of the ITAA 1936, “scheme” is defined in s177A(1).

[6] Exhibit 8, para [47].

24.I did not understand Mr Robertson, counsel for Steel & Plastics, to argue that the arrangements did not satisfy the definition of scheme. I find that the arrangements satisfy the definition.

25.The real controversy in the case is whether Steel & Plastics obtained a tax benefit. The circumstances in which a tax benefit is obtained are set out in s 177C(1) of the ITAA 1936. So far as it is presently material it is in these terms:

“(1)Subject to this section, a reference in this Part to the obtaining by a taxpayer of a tax benefit in connection with a scheme shall be read as a reference to:

(a)…

(b)a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out; or

…

and, for the purposes of this Part, the amount of the tax benefit shall be taken to be:

…

(d)in a case to which paragraph (b) applies—the amount of the whole of the deduction or of the part of the deduction, as the case may be, referred to in that paragraph; and

…”

26.The Commissioner’s submissions identified the tax benefit as the “deductions in respect of contributions [Steel & Plastics] made in relation to” the Employee Welfare Fund. The submissions continued:

“49.… But for the scheme, the applicant would not have made the relevant contributions to the [Employee Welfare Fund] and accordingly the deductions for those contributions would not have been allowable to the applicant.

50.Any payment made in the 1997 and 1998 financial years by the applicant pursuant to its obligations to make superannuation contributions pursuant to the contracts of employment in accordance with their original terms would not have been wholly deductible under s 82AAC of the ITAA 1936.”

It seemed to be common ground that the amounts that would have been deductible as superannuation contributions were, in 1997, $27,170 (Mr Mark Trail) and $9,782 (Mr Allan Trail) and, in 1998, $28,620 (Mr Mark Trail) and $10,232 (Mr Allan Trail).

27.The legislation requires the making of an hypothesis as to what might reasonably be expected to have happened had the scheme not been entered into or carried out. As Gummow and Hayne JJ put it in Commissioner of Taxation v Hart[7]:

“… the inquiry directed by Part IVA requires comparison between the scheme in question and an alternative postulate.”

Earlier, in Commissioner of Taxation v Peabody[8], the High Court expressed the matter in this way:

“A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable …”

[7] (2004) 217 CLR 216 at 243, para [66].

[8] (1994) 181 CLR 359 at 385.

28.As it seems to me, the starting point in considering the prediction involved here is recognition of the fact that, by virtue of the contracts of employment, Steel & Plastics was bound to make payments totalling $237,000 for the benefit of Mr Mark Trail and Mr Allan Trail in the three years after 1 July 1997. At the time when that obligation first arose it was an obligation to make payments of superannuation and, at that time, those payments were fully deductible from the assessable income of Steel & Plastics. The subsequent amendment to the legislation meant that the deductibility was significantly reduced had the payments required to be made retained their character as superannuation payments.

29.What the scheme achieved was to make the full amount of the payments deductible by changing the character of the payments from superannuation payments to payments to the Employee Welfare Fund. But, had the scheme not been implemented, I find it impossible to conclude that Steel & Plastics would have discharged its obligations to Mr Mark Trail and Mr Allan Trail in a way that was not fully tax deductible. It made no sense for Steel & Plastics, or for Mr Mark Trail and Mr Allan Trail as the ultimate beneficial owners of 51% of its capital, to make significant payments on the revenue account that were deductible only in part, and a relatively small part at that. It made even less sense for the minority shareholders.

30.The employment agreements were, I infer from their form, professionally prepared and the product of advice. The company obtained further advice when the legislation changed. The Employee Welfare Fund was the end product of that advice. In the circumstances of this case the “alternative postulate” necessarily starts with the continuing obligation to make the payments for the benefit of Mr Mark Trail and Mr Allan Trail. Because of the character of that obligation any payment by Steel & Plastics in discharge of the obligation would have been deductible except in circumstances, such as s 82AAC of the ITAA 1936, where the legislature limited the extent of the deductibility. It was contrary to the interests of all involved to discharge that obligation in a way that did not allow for complete deductibility of all payments.

31.I accept the submission advanced by Mr Robertson that the payments would have been deductible in the hands of Steel & Plastics even if Mr Mark Trail and Mr Allan Trail had “asked for those payments to be made to themselves, or to their wives, or even to unrelated third parties”. There may well have been adverse tax consequences for those recipients but that does not detract from my conclusions about the position of Steel & Plastics.

32.In my view, absent the scheme, the payments would have been made, and would have been made in a way that would have entitled Steel & Plastics to deduct the amount of the payments from its assessable income. Thus, when the comparison is undertaken between the scheme and what I regard as the alternative postulate, no amount is allowable as a deduction that would not otherwise have been allowable.

33.It follows that Steel & Plastics has not obtained a tax benefit in connection with the scheme and Part IVA of the ITAA 1936 has no application. It is not then necessary to consider the purpose of entry into the scheme.

Were Penalties Correctly Imposed?

34.In light of my conclusion as to the application of Part IVA of the ITAA 1936 it is unnecessary for me to consider this issue.

Conclusion

35.In the result I would, in each application, set aside the Commissioner’s objection decision and remit the matter to the Commissioner for the purpose of giving effect to my conclusion.

I certify that the 35 preceding paragraphs are a true copy of the reasons for the decision herein of Deputy President P E Hack SC

Signed:         .....................................................................................
           Eleanor O’Gorman, Associate

Date of Hearing  12 September 2007
Date of Decision  12 October 2007
Counsel for the Applicant         Mr M L Robertson
Solicitor for the Applicant          Cleary Hoare Solicitors
Counsel for the Respondent     Mr G J Davies QC and Ms M M Brennan
Solicitor for the Respondent     Australian Government Solicitor