J & G KNOWLES & ASSOCIATES PTY LTD v FC of T
Members:BH Pascoe SM
Tribunal:
Administrative Appeals Tribunal
BH Pascoe (Senior Member)
These applications are to review decisions of the respondent to disallow objections against amended assessments of fringe benefits tax for the period 1 July 1986 to 31 March 1987 and the years ended 31 March 1988 and 1989. The amended assessments were issued to include loan benefits and the amounts were as follows:
Loan Benefit Fringe Benefits Tax Additional Tax
$ $ $
Period ended 30 June 1986 152548 70172.08 35220.62
Year ended 30 June 1987 320362 156977.38 47308.25
Year ended 30 June 1988 150972 73976.28 7498.97
2. At the hearing the applicant was represented by Mr G. Pagone QC assisted by Dr K. Hanscombe of counsel and the respondent by Mr G. Davies of counsel. Evidence was given by Messrs G. Knowles, J. Knowles and I. Ball, directors of the applicant, J & G Knowles and Associates Pty Ltd; Mr Daly, a solicitor; Mr Saul, the financial controller of the applicant; and Mr Wardle, a chartered accountant.
ATC 2207
3. The basic facts and background to this matter were not in dispute. The applicant company is the trustee of the Knowles Investment Unit Trust (``KIUT'') and has been since 1976. The trust is part of what was described as the Knowles Group. Within the group is the Knowles Property Unit Trust and other unit trusts and companies. The group had its origins in the late 1970s to operate a building construction business with a special emphasis on developing, marketing and managing retirement villages. All of the unit trusts and companies are owned by four family discretionary trusts. Each of the family discretionary trusts was established for the benefit of the family of one of the four directors. Each of the four directors, Mr G. Knowles, Mr J. Knowles, Mr R. Knowles and Mr I. Ball were the sole directors of each of the entities in the group. The method by which the group operated the sale and repurchase of the retirement village units was said to be unique in the industry. The initial sale of a unit was at or near cost. On the death of the purchaser the group would repurchase the unit at or near market value but with payment to be made to the deceased person's estate at the end of a period equal to the time that the person had lived at the unit, to a maximum of eight years. The group would immediately resell the unit to a new purchaser. An example of the method was given by Mr Daly, in his witness statement:
``1980 Resident A buys the unit from the company at a price of $30,000.
1985 Resident A dies and the company repurchases the unit from the resident's estate at $45,000 on the basis that possession and title passes to the Company in 1985 but the purchase price is not payable until 1990.
1985 The company re-sells the unit to resident B at a price of $45,000.
1990 Resident A or his estate receives $45,000 for the completion of the purchase.
To secure the $45,000 owing to Resident A for five years, the company must procure a Guarantee from the Trustee to Resident A's Estate.
The cashflow effect of the transaction is that the company has the sum of $45,000 from the period 1985 to 1990, interest free, which it may then invest to create its profit. The advantage for the resident is that he or she purchases at a price which is at a significant discount to other similar products on offer. Effectively, it is the resident's beneficiaries who will compensate the company for that original discount.''
4. Although there are several entities within the group, all receipts and payments were dealt with through one bank account in the name of the applicant, J & G Knowles and Associates Pty Ltd, with one centralised accounting system. Funds for the construction of new retirement villages were provided by way of funds borrowed from banks and other financial institutions. The bank account was in overdraft during the whole of the relevant period.
5. Prior to and during the relevant period, amounts were advanced to the four directors and their wives to meet private expenditure such as home mortgage payments, home improvements, purchases of boats and motor vehicles, running costs of motor vehicles, payment of credit card accounts, school fees, insurance, travel, etc. Each director was a sole cheque signatory and could withdraw funds at any time without approval from the other directors. It would appear that in cases of large amounts, the financial controller would be asked if funds were available but, otherwise, no questions were asked. On some occasions the director would write out and sign the cheque himself and, on other occasions, submit the invoice for staff to arrange payment. The rationale of these drawings or advances was explained by Mr J. Knowles in his witness statement as follows:
``9. Each of my two brothers, Ian Ball and I, have treated our respective interests in the Knowles Group through our trusts as being the effective owners of the Group and entitled to its profits and assets. We set directors' salaries during the relevant period but otherwise treated our respective interests as being equivalent to the owners of the assets of the Group. Each of us accessed money from the Group as and when we thought fit with the general concern to ensure that there was equality between us. The concern that each of us had was that we should be equal as owners and not equal by reference to the amount of work each had performed. In fact both Russell and Graham continued to take money from the business during times when they were not working or participating in the activities of the Knowles
ATC 2208
Group. Both Graham and Russell took time off to build their own houses and during those periods of time they borrowed monies from the Applicant even though they had not worked for some of the time. When my family trust took money from the Applicant it did so because I considered that it was a one fourth owner of the Group and therefore entitled to its assets. I was also aware of the fact that the Applicant had available to it surplus funds which it did not need for some years to come.10. It continues to be our policy that each of as [sic] may draw upon the assets of the undertaking on an equal basis even though there may be no relationship between that drawing and the amount that we have worked. This is particularly evident in recent years because my younger brother Russell is very ill with a psychiatric disorder and has been unable to participate actively in the operations of the business for a couple of years. That has not prevented him from drawing equally upon the assets of the business.
11. In any case, the amount available in the business is not related to each of our personal efforts. The money available in the business depends in part on the surplus cash available to the Applicant through the system of buying and selling which I have explained and in part on the money earned by the activities of other people employed through the Knowles Group. It is now a large organisation and employs many people whose work and labour contribute to its profits as does its reputation, good will, and increases in value of the units bought and sold.''
At the end of each accounting period the advances to each of the directors was transferred in the books of KIUT to a loan account in the name of the family discretionary trust of each of the directors and, in the accounts of that family trust, treated as loans to beneficiaries. On 1 August 1988 the loans to the family trusts as unit holders of KIUT were extinguished by a capital distribution of $7,000,000. This distribution was made up of $1,760,549 from a realised capital profits reserve and $5,239,451 from an asset revaluation reserve. A further distribution of $921,367 was made from another unit trust of which the applicant was trustee equally to the four family trusts as unit holders. In each of the family trusts the respective trustee resolved to distribute $1,980,342 equally between the director and his wife.
6. Notwithstanding the statement of Mr Knowles that there was ``concern to ensure there was equality between'' the four directors, the loan account balances varied significantly between them. The following table shows the balances at various dates:
30.6.86 30.6.87 30.6.88 31.7.88
$ $ $ $
J. Knowles Family Trust 767426 772726 1243472 1446594
G. Knowles Family Trust 467310 519372 1494783 1569845
R. Knowles Family Trust (72195) 37980 558285 614312
I. Ball Family Trust 35025 83358 369171 384763
--------- --------- --------- ---------
1,197,566 1,413,436 3,655,711 4,015,514
--------- --------- --------- ---------
After the capital distribution on 1 August 1988 the loan accounts to the trusts were turned into loan accounts from the trusts as this distribution, while not made in cash, was treated as having been lent back to KIUT by the family trust unit holders. Details of the loan accounts provided in evidence showed a subsequent progressive reduction in the credit balances presumably by further payments by KIUT on account of the directors. In addition to these loan accounts, KIUT showed small balances in its accounts as Directors' Loan Accounts. Balances of these were:
As the year end for fringe benefits tax is 31 March, the respondent calculated the loan account balances using an agreed averaging method to arrive at the amounts to be assessed. There was no dispute by the applicant as to the amounts assessed. The dispute centred on whether a liability to fringe benefits tax arose in the circumstances. Each of the directors received the same salary, being $31,558 in each of the years ended 30 June 1987, 1988 and 1989. No salaries have been paid to the directors since 1990 because the group incurred substantial losses. Since that date the group has been under severe pressure from its bankers evidenced by a workout and Moratorium Deed of May 1992 produced in evidence. It is not unreasonable to assume that the substantial funds taken out of the group by its directors on an assumption of surplus funds and ongoing substantial profits may well have contributed to this subsequent financial difficulty.
7. It was submitted for the applicant that the loans in question were not a benefit ``in respect of the employment'' of any of the directors. It was said that the four directors regarded themselves as owners of the business and, although there was a formal legal structure of a unit trust in which the unit holders were the respective family trusts of the directors, the practical view of these non-professionals was that they were the owners. It was argued that the loans were part of the assets of the unit trust available as security for borrowings of the group and were not moneys received absolutely by the directors. It was said that the evidence showed that the moneys borrowed were regarded as equivalent to drawing of the capital of the business by owners and the ultimate extinguishment by a capital distribution demonstrated this. Mr Pagone listed the factors which he considered showed that the loans were not related to employment. These included:
- ``(a) No other employee, even a senior employee such as Mr Saul or Mr Daly, was permitted to receive loan funds;
- (b) The employment of two of the directors, R. Knowles and G. Knowles was interrupted at different times, each for a period of several months, but the loan funds continued to be advanced;
- (c) The quantum of the loans made was not determined with regard to any duties carried out by the borrower;
- (d) Each director drew money without approval from any other director and without being required to justify the drawing to any person;
- (e) There was no real pattern or consistency to the amount of monies advanced to a borrower at any given time;
- (f) The accumulated balance of each of the four loans varied markedly prior to their extinguishment;
- (g) The drawings were determined solely by the individual needs of the director at the relevant time;
- (h) The loans were ultimately extinguished by being repaid from a capital distribution following the revaluation of assets.''
8. For the respondent, Mr Davies agreed that the four directors regarded themselves as owners of the business but maintained that in fact and in law they were not owners. It was said that they operated through a structure which they controlled as directors of the trustee company but the only other interest was as a discretionary beneficiary of a family trust which was a unit holder. It was submitted that only in their capacity as directors could they have accessed the funds. It was said that, even though the salaries and loans may not have been directly related to services to the applicant, the interest free loans could have been obtained
ATC 2210
only as a consequence of employment as directors. Mr Davies submitted that the lack of pattern and consistency in the amounts advanced was a positive indication of a nexus with the directorship as they were not one-off transactions or isolated funds for special purpose but regular funds for private expenditure taken under the individual authority as a director. It was argued that the directors, as discretionary beneficiaries of the family trusts, could not otherwise access funds prior to a distribution to those family trusts and a favourable resolution of the trustees of such family trusts. The consequence of this, it was said, was that the loans were appropriately regarded as assessable loan benefits because the loans could have been made only by reason of the employment as directors.9. The relevant provisions of the Fringe Benefits Tax Assessment Act 1986 (``the Act'') are:
``16(1) Where a person (in this subsection referred to as the `provider' ) makes a loan to another person (in this subsection referred to as the `recipient' ), the making of the loan shall be taken to constitute a benefit provided by the provider to the recipient and that benefit shall be taken to be provided in respect of each year of tax during the whole or a part of which the recipient is under an obligation to repay the whole or any part of the loan.
...
18 Subject to this Part, the taxable value, in relation to a year of tax, of a loan fringe benefit provided in respect of the year of tax is the amount (if any) by which the notional amount of interest in relation to the loan in respect of the year of tax exceeds the amount of interest that has accrued on the loan in respect of the year of tax.
...
136(1) ...
- `fringe benefit' , in relation to an employee, in relation to the employer of the employee, in relation to a year of tax, means a benefit:
- (a) provided at any time during the year of tax; or
- (b) provided in respect of the year of tax;
- being a benefit provided to the employee or to an associate of the employee by:
- (c) the employer;
- (d) an associate of the employer; or
- (e) a person (in this paragraph referred to as the `arranger' ) other than the employer or an associate of the employer under an arrangement between:
- (i) the employer or an associate of the employer; and
- (ii) the arranger or another person;
- in respect of the employment of the employee...
- ...
- `employee' means:
- (a) a current employee;
- (b) a future employee; or
- (c) a former employee;
- ...
- `current employee' means an employee within the meaning of Division 2 of Part VI of the Income Tax Assessment Act 1936;
- ...
- `in respect of' , in relation to the employment of an employee, includes by reason of, by virtue of, or for or in relation directly or indirectly to, that employment;
- ...
- `loan benefit' means a benefit referred to in subsection 16(1);
- `loan fringe benefit' means a fringe benefit that is a loan benefit;
- ...
148(1) A reference in this Act to the provision of a benefit to a person in respect of the employment of an employee is a reference to the provision of such a benefit:
- (a) whether or not the benefit is also provided in respect of, by reason of, by virtue of, or for or in relation directly or indirectly to, any other matter or thing;
- (b) whether the employment will occur, is occurring, or has occurred;
- (c) whether or not the benefit is surplus to the needs or wants of the recipient;
ATC 2211
- (d) whether or not the benefit is also provided to another person;
- (e) whether or not the benefit is, to any extent, offset by any inconvenience or disadvantage;
- (f) whether or not the benefit is provided or used, or required to be provided or used, in connection with that employment;
- (g) whether or not the provision of the benefit is, or is in the nature of, income; and
- (h) whether or not the benefit is provided as a reward for services rendered, or to be rendered, by the employee.''
10. It was not in dispute that the four directors were ``employees'' for the purposes of the Act and there was no dispute as to the calculations of the taxable value of the alleged loan fringe benefits. In addition, there was no dispute that the family trusts were associates of the employer and the wives of the directors were associates of the director/employees. The sole issue in this case was whether it could be said that the loans were made ``in respect of the employment of the employee''. In a passage from the judgment of the Supreme Court of Canada in
Nowegijick v R (1983) 144 DLR (3d) 193 at page 200, which was subsequently adopted by Toohey J of the High Court in
Smith v FC of T 87 ATC 4883 at page 4894; (1987) 164 CLR 513 at page 533, Dickson J said:
``The words `in respect of' are, in my opinion, words of the widest possible scope. They import such meanings as `in relation to', `with reference to' or `in connection with'. The phrase `in respect of' is probably the widest of any expression intended to convey some connection between two related subject-matters.''
Whether or not a benefit will be included as a fringe benefit depends upon finding a connection or relationship between the benefit and employment. That connection, relationship, cause of the benefit need not be the dominant one as provided for in section 148 of the Act but it is necessary to find that employment is a causal factor in the benefit. The applicant submitted that, here, the relationship was one of ownership of the applicant with no element of employee and employer as a factor in the loans. The respondent submitted that there was no ownership by the directors per se and the only relationship which gave rise to the loans was that of director of the applicant company.
11. The applicant sought comfort in Taxation Ruling MT 2019 which discusses fringe benefits tax in relation to shareholder employees of family private companies and directors of corporate trustees. Paragraph 19 of the Ruling states:
``As a general rule, where there are no facts or circumstances which positively indicate that a loan to a shareholder/employee is associated with that person's employment and the loan is consistent with his or her status as a shareholder, it would ordinarily be inferred that the loan was made by virtue of the shareholding. This approach recognises that major shareholders of a family company may obtain loans from the company on a view that these are merely as a return of their own money rather than a reward for any services rendered to the company.''
Comments in the Ruling relating to directors of corporate trustees are confined to provision of non-cash benefits such as free occupancy of a family home. I am unable to see how this Ruling provides much assistance to the applicant. Firstly, the directors are not shareholders or unit holders. They may be regarded as controllers of KIUT but that control stems from their role as directors of KIUT, presumably as directors of the corporate trustees of the family trusts and, to a degree, as appointors in each of the family trusts. However they were not, themselves, owners. Secondly, if the loans were to be regarded as consistent with a status of owners, it would be expected that the loans would be in proportion to the ownership share. They were not, given the lack of pattern, consistency or cumulative amounts of the loans. Thirdly, the applicant was in no position to return money to its owners. The ability to make loans was said to be the result of surplus cash generated by the method of operation of the business. But this was relatively short term surplus cash. It was required to be paid to vendors at the end of an agreed period and, at all times during the relevant period, the group had substantial borrowings and the bank account was in overdraft. Further, the group and KIUT incurred a loss in the year ended 30 June 1987, made a profit in the year ended 30 June 1988 but not sufficient to offset prior year losses and incurred a further loss in the year
ATC 2212
ended 30 June 1989. It was said that the loans were equivalent to drawing out capital of the business and this was demonstrated by their extinguishment from the capital distribution on 1 August 1988. However, approximately 75% of this capital distribution was from unrealised profits and, while this proposition may have demonstrated an increase in asset value of KIUT, was not represented by any cash surplus or provided an ability to make cash distributions. The realised profit proportion of the capital distribution represented some 44% only of the loan balances immediately prior to the resolution and the journal entry for the capital distribution. It may well be that the applicant's advisers performed a disservice to the applicant and its directors in allowing them to believe that it was not unreasonable to borrow in excess of $4 million against funds held to satisfy future liabilities and from unrealised gains.12. It is clear that a benefit does not become a fringe benefit solely because there exists a benefit and an employer-employee relationship. The words ``in respect of the employment of the employee'' in the definition of ``fringe benefit'' in subsection 136(1) require a nexus, some discernible and rational link, between the benefit and the employment. Here the applicant says there was no such nexus and the discernible link was between ownership and the benefits. The respondent says there is no other nexus because there was an employment relationship and no actual ownership relationship. In my view, this is one of those not unusual cases of four businessmen who obtain and accept advice as to an appropriate legal structure within which to own and operate the business but do not understand the legal ramification of the structure adopted and, in fact, ignore it in the day to day operations of the business. The simple facts are that the four directors were not owners of the business and had no vested interest in or entitlement to income, profits or capital of the business. Each was a contingent beneficiary as to income of a family trust with entitlements to income only if KIUT had a net income and the trustee of the relevant family trust resolved in its absolute discretion to distribute part or all of the trust's share of that net income to the director. Under the terms of each family trust the director was not a ``primary beneficiary'' and had an entitlement to capital of the trust only if, prior to the vesting day, the trustee by instrument in writing exercised a power of appointment in favour of such director. In a legal sense, each director had no greater interest in the income or capital of the family trust than any other ``general beneficiary'' which, in each case, included brothers, parents-in-law, children and spouses. True it was, that, on 1 August 1988, each of the directors were favoured by the trustee of each of the family trust with a distribution of 50% of 25% of the capital distribution, or $990,171. However, this was well after the funds were borrowed from KIUT. The decision and resolutions relating to the capital distributions had all the hallmarks of seeking to resolve a problem recognised by the advisers and there is no evidence that such potential distribution was in contemplation by anyone when funds for personal use were borrowed from KIUT.
13. Contrary to the submission of Mr Pagone, several of the factors listed by him and set out in paragraph 7 above do, in my view, support the contention that the loans were related to the employment of the directors. Money was drawn without approval or justification in the interest of KIUT or the family trust unit holders, there was no pattern or consistency which would be expected if the loans were an advance against profits or excess capital, the balance of each of the four loans varied and the drawings were determined by the individual needs of the director. From the evidence it was clear that when one director decided to acquire a Rolls- Royce vehicle for some $170,000 and another decided to buy a block of land for in excess of $300,000, the cheques were drawn on KIUT without any formal approval or concern at equity between unit holders. It was said that the funds were not advanced with regard to the comparative duties of the directors. This may well be so although there was little evidence of the comparison of duties and responsibilities. Salaries were equal but considering the size of the group and the assets and liabilities of the group, the salaries were low and the availability of interest free funds for personal use may well have been seen as additional and useful recompense for such modest salaries. It was said that two directors were absent building their own homes for some of the period in question but their salaries continued at the same rate as those continuing active involvement in the business. Clearly salaries were not paid
ATC 2213
having regard to comparative duties and involvement in the applicant's business.14. In my view there is a clear nexus, causal relationship between the advances or loans and employment of the four directors. It was in that capacity as a director that each was able and permitted to make ``drawings'' from KIUT. The structure of the group was established in such a way that the directors were not owners. In my view, this is a case where the directors have to accept the consequences of that structure. It was in their capacity as directors and directors only that they borrowed money from the company of which they were directors. I do not go so far as to say, and the issue is not before me, that it may be possible to regard the ``drawings'', as some witnesses described the amounts involved, as income of a director. However, they were clearly a benefit and employment was the principle connecting reason for such benefits so as to render the benefit as provided in respect of the employment. Employment was the discernible link with the benefit and while the Act does not require this link to be the sole or even dominant one, there was no other formal or enforceable entitlement which gave rise to the benefit.
15. It follows that the decisions under review should be affirmed.
This information is provided by CCH Australia Limited Link opens in new window. View the disclaimer and notice of copyright.