Surfing the ITAA: Federal Court upholds ATO's position on dividend stripping

On 22 April 2025, the Federal Court handed down its decision in Merchant v Commissioner of Taxation[1]. The case involved Mr. Merchant and GSM Pty Ltd challenging an ATO decision, with the Court examining whether their arrangements breached anti-avoidance rules under Part IVA[2], particularly in relation to dividend stripping.

This article outlines the key issues, the Court's findings, and what the decision means for future ATO scrutiny of similar tax arrangements.

Key Issues and Court Findings

Dividend Stripping Allegation:

The ATO argued that Mr. Merchant and GST used a scheme to avoid tax by forgiving debts between related companies. This was seen as a form of dividend stripping – converting company profits into tax-free amounts.

The ‘taxpayer Appellants’ argued:

• The forgiven debts were still taxable, so there was no tax-free benefit.
• The arrangement could lead to double taxation – once as a capital gain (when the debt was forgiven) and again as a dividend (when the amounts were paid to the shareholder).
• The debt forgiveness was part of a genuine commercial transaction to help sell shares to an unrelated party.
  
  

The Court rejected these arguments, agreeing with the ATO that the scheme had a tax avoidance purpose. As a result, the forgiven debts were included in Mr. Merchant’s taxable income.

TOFA Provisions:

The Court also considered the Taxation of Financial Arrangements (TOFA) rules. It found that certain expired rights to receive milestone payments were linked to the business’s performance. Because of this, the resulting losses were deductable under TOFA.

Implications to be aware of

This case reinforces several important points for professionals advising on tax matters:

• Substance over form: the Court focused on the purpose and effect of the arrangement, not just whether it resulted in a tax-free outcome.
• Commercial Intent Isn’t Always Enough: Even if a transaction appears commercial, it can still fall under anti-avoidance rules if it reduces tax in a deliberate and problematic way.
• Size of Benefit Doesn’t Matter: The Court clarified that the value of the tax benefit is not the key issue – what matters is whether the arrangement fits the definition of dividend stripping.
• ATO’s Approach Confirmed: The decision shows the ATO’s interpretation of Part IVA and dividend stripping provisions is likely to be upheld in similar cases.

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More information from Maddocks

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[1] [2025] FCAFC 56

[2] Part IVA of the Income Tax Assessment Act 1936 (Cth)