ATO penalises professional for defective internal loan documents – HNW groups beware!


Posted By on 28/03/18 at 10:37 AM

The recent Federal Court decision of Rowntree v FCT [2018] FCA 182 (reported at 2018 WTB 9 [243]) highlights how much additional care must be taken in documenting even simple related-party transactions, such as loans, that are so prevalent within high net wealth (HNW) private client groups.

In this case, the taxpayer, a practising NSW lawyer, claimed he borrowed over $4m (the “challenged payments”) from his group of private companies (Group) over the 2010 to 2013 financial years. Each of those companies were either absolutely controlled directly by him, being its sole director, and/or indirectly via his shareholdings.

The Commissioner not only assessed these receipts as income, but initially imposed penalties of 75% (intentional disregard of a taxation law – s 284-90(1), item 1, Sch 1 to the TAA) with a 20% uplift for the 2011 to 2013 financial years. Through the appeal process, the taxpayer was able to reduce his assessable income (for the reasons explained below) by circa $1.1 million and the base penalties from 75% to 50%, as the Court found there had been gross carelessness rather than intentional disregard of his tax obligations. Nevertheless, subject to the outcome of any further appeal, the taxpayer currently faces a shortfall income tax assessment of some $1.4 million, penalties of circa $0.7 million, plus substantial interest for failing to properly record in writing that the money transfers were in fact advances made under a legally enforceable loan agreement or agreements before the subject transactions occurred.

Curiously, neither the AAT or the Court decision set out which section or sections the Commissioner relied upon to have the transfer of funds brought to account as assessable income of the taxpayer (eg s 44, Div 7A or others).

Taxpayer’s arguments – first transactions

In his capacity as sole director of the three Group lending companies, and as a co-director and controlling shareholder of a fourth lending company, the taxpayer contended before the AAT at first instance (see 2016 WTB 28 [958]) that the challenged payments were not income but non-taxable loan principal advances which he had a legal obligation to repay.

The AAT noted, based on the taxpayer’s sworn testimony, “he genuinely believed in his own mind that the amounts in question were loans”.

However, both the AAT and Court considered he could not discharge the onus of proof that the assessments were excessive under s 14ZZK of the TAA, as he failed to introduce into evidence “contemporaneous, corroborating” loan or other supporting documents. They held the first transactions, comprising transfers totalling $640,000 to the taxpayer personally, were income as there was:

  • no documentary evidence whatsoever to suggest the existence of a loan agreement between the payer and the taxpayer;
  • no confirmatory contemporaneous director resolutions; and
  • no interest ever paid.

Further, these alleged loans were not recorded in bank documents or valuations.

The taxpayer argued that evidence that there were loan agreements did in fact exist, but by inference. This, he said, arose under an Agreement of Assignment dated 6 months later, under which the lender company of which he was a sole director purported to assign that alleged loan debt of $640,000. However, that document was on its face defective as it said the debt (the subject of the assignment) arose around 30 June 2010, and not between August 2009 and January 2010, when the transfers of $640,000 actually occurred. Also, he argued repayments made from 30 June 2014 onwards supported his contention that the $640,000 transferred was a loan. The AAT noted the repayments commenced “only after [the taxpayer] became aware that the [Commissioner] was conducting a careful review of these financial arrangements and was likely to challenge the existence of the loans in question”. In addition, the AAT stated the loan repayments weren’t made in accordance with a prescribed repayment schedule.

Also, the unsigned and unaudited accounts of lender companies of which the director was a sole director was not objective evidence of the existence of a loan, especially as the taxpayer was solely responsible for their preparation.

Taxpayer’s arguments – second transactions

There were $1.6m in transfers made from Group companies to the taxpayer between August 2010 and 4 July 2011. Concerning the second transactions, the taxpayer asserted a formal loan agreement dated 22 July 2011 applied. Unfortunately, the document stated it covered “…any advance or loan made to the Borrower by the Lender after the date of this agreement.” As the 4 amounts transferred comprising the $1.6m occurred well before that loan document date, it was ineffective at law to evidence the $1.6m transferred was in fact an advance under that loan agreement. Although clause 3.1 provided for interest payments, none were actually paid – which further hindered the taxpayer’s evidentiary position.

Taxpayer’s argument – third transactions

For the third transactions, the 5 amounts transferred totalled $1.880m with the last 2 being $1m on 17 July 2012 and $80,000 on 18 December 2012. The taxpayer produced a similarly worded loan agreement dated 19 July 2011 to support his loan advance arguments for all these transfers.

As the first 3 occurred well before the loan agreement date, they were similarly rejected for the above reasons. The 18 December 2012 transfer of $80,000 was upheld as a loan advance under that document as it clearly post-dated 19 July 2011. Interestingly, even though the million-dollar transfer occurred on 17 July 2012, preceding the loan agreement date by 2 days, the AAT still held it was so close in time so as to constitute an advance under the subject loan facility agreement dated 19 July 2012. That conclusion was reached even though no interest was paid, and it was noted that its non-payment constituted a default under the loan agreement. The AAT and Court held that the cash transfers of $1.08 million were in fact loan payments or advances under the subject loan agreement and accordingly were non-assessable.

Division 7A argument

The taxpayer argued that s 109N(1)(A) of ITAA 1936 required that a compliant Div 7A loan agreement must be recorded in writing “before the lodgment date for the year of income” in which the loan by the company occurred. Thus, the taxpayer asserted that a loan agreement may be recorded in writing after the alleged advances had occurred. The AAT, however, held that the principle only applied to circumstances where it can be shown objectively the transfers of funds were made under a pre-existing loan: see Rowntree and FCT [2016] AATA 420 at [64]. The clear inference being, absent a prior dated loan agreement, there must be contemporaneous evidence (eg a director’s resolution that has not been backdated to substantiate the nature of the transfer of funds made). The AAT said “s 109N says nothing about what is required to establish the objective existence of the loan” or when it is to be reduced to writing.

Lessons and precautions for HNW groups

Many HNW taxpayer groups transfer large sums of money intragroup throughout a financial year with correcting or creating journal entries, minutes and other supporting documents sometimes done much later – coinciding with the preparation of formal financial statements and returns.

The high onus of proof imposed upon a taxpayer when contesting an ATO adverse assessment in having to prove the nature of an intragroup transactions, or for that matter a prescribed choice, election, agreement, authority or consent under the relevant tax legislation indicates contemporaneous attention to documenting their nature through legal documents, minutes, journals and records needs to be undertaken.

At para [50], the Court noted that “the Corporations Act is largely silent about how a sole director, acting under s 198E(1), should evidence what he or she causes the company to do. That Act provides that a sole director of such a company may pass a resolution or make a declaration by recording it and signing the record (s 248B). Moreover, a company must keep written financial records that correctly record and explain its transactions, financial position and performance that will enable true and fair financial statements to be prepared and audited (s 286(1)).”

The taxpayer appeared to be involved in the promotion and marketing of a “company limited by guarantee arrangement”. Such arrangements became the subject matter of Taxpayer Alert TA 2011/1 and may have attracted the ATO’s attention. Furthermore, both the AAT and the Court both mentioned the taxpayer’s status as a practising lawyer with extensive academic qualifications in law, finance and tax which possibly created an expectation of a greater level of care and attention to documentation.

Nevertheless, this decision raises the real risk of harsh assessments or amended assessments, penalties and interest being visited upon all taxpayers, absent cogent and timely documentary evidence.

Accountants and financial controllers of HNW client groups need to heed the clear warning from this case. That is, to consistently, carefully and comprehensively document the true nature and purpose of intragroup transactions. This includes even the simple transfer of funds whether by loan, dividend, service fee, assignment or otherwise.

If any doubt arises, appropriate and timely legal advice from an experienced tax lawyer should be sought.

Jack Stuk is the National Tax Partner at KHQ Lawyers and President of the National Tax Accountants Association Ltd.

This article was published in Thomson Reuters’ Weekly Tax Bulletin (Issue 12, 23 March 2018).

KHQ Lawyers - Jack Stuk

Jack Stuk Principal Solicitor

Jack is a highly skilled and experienced taxation lawyer, proficient in advising on complex tax issues for high net worth individuals, and across business, commercial and estate matters.

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