Advances from a Trust to an individual need to be carefully scrutinized before they are labelled either a 'loan' or 'income'.
A recent case highlights the serious consequences for categorising an advance from a Trust as a 'loan' when the payments are in fact 'income'.
For the Australian Taxation Office to even consider treating an advance paid from a Trust as a 'loan', you will need to provide at least: loan agreements, and information about the method of repayments and interest payable.
Lessons to be learned from The Taxpayer and Commissioner of Taxation
If an individual who receives payments or advances from a Trust wishes to categorise them as a 'loan' for tax purposes, then the person needs to ensure that the payments are documented as a proper commercial arrangement. The arrangement must have at least the following elements:
- a written loan agreement that has been executed by all parties;
- the loan agreement sets out the requirements for repayment of the loan;
- the loan is interest bearing with an appropriate commercial rate attached; and
- proper accounting records exist evidencing the existence and repayment of the loan.
If the taxpayer is unable to provide that evidence, then the Commissioner may:
- take the view that the payments are actually 'income'; and
- can impose a 75% tax penalty on any amounts of income that were not disclosed for tax purposes.
A recent case confirms that individuals who do not set up proper commercial loan arrangements when receiving payments from a Trust, cannot assume the Commissioner will agree with their interpretation that the payments are a 'loan'.
Summary of The Taxpayer and Commissioner of Taxation
The Taxpayer was a director of Viscount Nominees Pty Limited (Company). The Company was the trustee of two trusts:
- the Viscount Trust; and
- the Tiga Trust.
The surrounding facts are complex and convoluted. In summary:
- From 1 July 1993 to 30 June 2000, the Taxpayer, and other participants, were involved in a scheme that used limited recourse loans to increase the Taxpayer's income tax deductions;
- The limited recourse loans were created by using bills of exchange which were subject to a 'round robin' arrangement and never converted to cash: the transactions on the bills of exchange were simply a round robin of promises to pay, however, there was no actual transfer of funds.
- During this time, all participants claimed $76.9 million in deductions, of which $62 million represented funds created by means of the 'round robin' of bills of exchange and $14.9 million represented cash contributions by participants. Of these cash contributions, $175,000 represented cash contributions from the Viscount Trust for the Taxpayer's benefit.
- The Taxpayer submitted tax returns which categorised the advances from the Viscount Trust as 'loans' either in the Taxpayer's name or in the Taxpayer's name jointly with his wife. The advances were repaid through the use of a bill of exchange which the Viscount Trust accepted as 'full satisfaction' of money owing from the Taxpayer.
- The Commissioner made two important determinations:
- that the 'loans' were, in fact, income in the taxpayer's hands — and so issued amended assessments; and
- that the taxpayer had reduced its tax liability by fraud or evasion — and so imposed a penalty of 75% of the tax shortfall amount, for the relevant years.
The Taxpayer appealed the Commissioner's determinations.
What were the issues in the case?
The Court considered these issues:
- Were the advances (which had been described as 'loans') from the Viscount Trust to the Taxpayer actually income? In which case, they needed to be included in the Taxpayer's assessable income for the relevant years; and
- If the advances were income, then could their omission from the Taxpayer's income tax returns be considered an avoidance of tax by fraud or evasion? In which case, the Taxpayer was liable to pay a tax penalty of 75% of the tax shortfall amount.
What did the taxpayer argue?
The Taxpayer argued that the advances from the Viscount Trust were 'loans' because:
- The advances made from the Viscount Trust were 'loans' which created 'legal debtor and creditor' obligations between the Company, as corporate trustee, and himself;
- His intention was to always repay the advances made from the Viscount Trust and the advances were actually repaid;
- The advances were recorded as 'loans' in the Company's account; and
- The advances could not be considered income 'according to ordinary concepts'.
What was at stake?
At stake were the Taxpayer's income tax returns, for the relevant years, being re-assessed by the Commissioner to:
- treat advances received from the Viscount Trust as income; and
- to include the severe tax penalty of 75% of the tax shortfall arising from the Taxpayer not disclosing the advances from the Viscount Trust as income.
What did the Tribunal decide?
The Tribunal decided that the advances from the Viscount Trust were income of the Taxpayer, for the following reasons:
- there were no written loan agreements or agreed terms of repayment;
- the apparent loans were unsecured and did not bear interest;
- evidence showed that the Taxpayer regarded the Viscount Trust as the 'bank' of the group of his associated entities from which he would draw money whenever he required;
- the fact that the advances were repaid was irrelevant, as there was no objective evidence to prove that the advances were indeed 'loans'; and
- the advances could be included in the Taxpayer's assessable income 'according to ordinary concepts' because assessable income includes the gross income derived directly and indirectly from all sources.
The Tribunal also held that:
- the Taxpayer's avoidance of tax was due to evasion; and
- there was an 'intentional disregard' of the law as the Taxpayer 'was a principal player in a series of artificial, transactions, calculated to disguise the real character of the payments'.
The Commissioner's decision was upheld by the Tribunal.
More information from Maddocks
For more information, contact Maddocks on (03) 9288 0555 and ask for a member of the Maddocks Tax and Revenue Team.
More Cleardocs information on trusts — www.cleardocs.com
You can access various ClearLaw articles for more relevant information relating to discretionary, hybrid and unit trusts:
Order Cleardocs trust packages
Download a checklist of the information you need to order a document package.
  AATA 726.
  AATA 726 at 8.
  AATA 726 at 24.
  ATAA 726 at 9.
  ATAA 726 at 23.
  AATA 726 at 4.
  AATA 726 at 37.
 [2009[ AATA 726 at 54.