Decision impact statement

Sent v Commissioner of Taxation

Court Citation(s):
Federal Court
[2012] FCAFC 187
(2012) 208 FCR 462
(2012) 2012 ATC 20-364
(2012) 87 ATR 223
High Court
[2013] HCATrans 108

Venue: Federal Court of Australia
Venue Reference No: VID 363 of 2012
Judge Name: Emmett, Edmonds and Rares JJ
Judgment date: 19 December 2012
Appeals on foot: No
Decision Outcome: Favourable

Impacted Advice

Relevant Rulings/Determinations:

• None

Subject References:
Ordinary income
Derivation
Bonus Entitlements
Reward for services
Penalty
Recklessness

Précis

Outlines the ATO's response to this case which concerned whether a payment made to the taxpayer's nominee by his employer in substitution for past and future bonus entitlements was derived by the taxpayer as ordinary income when paid to the nominee.

Brief summary of facts

The taxpayer was employed as the CEO of Primelife Corporation (PC) under an agreement that provided for a 5-year term from 1 July 1998, and an entitlement to bonuses based on the financial performance of PC. In a series of meetings leading up to June 2001, PC and the taxpayer agreed that he would waive his past and future bonus entitlements in return for the issue to him of 5 million ordinary shares in PC.

By October 2001, an independent expert had advised PC that: the taxpayer's entitlement to bonuses for the 1999 to 2001 financial years totalled $7,246,572; that he could expect to become entitled to further bonuses for the 2002 and 2003 years of between $5,122,462 and $5,532,500; and that the fair value of 5 million fully paid PC ordinary shares was between $10.3m and $12.5m.

On 2 October 2001, the taxpayer and PC executed a Share Issue Deed which provided that, in consideration for the taxpayer waiving his bonus entitlements, PC would issue to him or his nominee 5 million fully paid PC ordinary shares. These terms were made subject to the approval of PC shareholders at the 2001 annual general meeting on 30 November 2001. Approval was duly provided by the shareholders on that date.

The PC Executive Share Trust was created on 4 December 2001, with the taxpayer as the effective sole beneficiary. On 21 December 2001: PC paid $11.6m to the trustee of the Trust on behalf of the taxpayer; the trustee paid $11.6m back to PC as the price for the issue of 5 million PC shares; and PC then issued 5 million ordinary shares to the trustee. The weighted average trading price of PC ordinary shares at that time was $2.32 per share, which gave the parcel of shares a value of $11.6m.

On 23 January 2002, the trustee issued 5 million units in the Trust to the taxpayer for $11.6m ($2.32 per unit). While it was contemplated that the trustee would lend $11.6m to the taxpayer to purchase the units, no loan was actually made, and the taxpayer remained indebted to the trustee to pay the purchase price.

The taxpayer did not include the amount of $11.6m as assessable income in his return for the 2002 income year. The Commissioner issued an amended assessment to the taxpayer on the basis that the payment of $11.6m made by PC to the trustee is included in his assessable income as either ordinary or statutory income. A penalty assessment (50%) for a tax shortfall that resulted from recklessness was also issued. A further amended assessment was issued, including the amount of $11.6m, in the alternative, under Part IVA of the Income Tax Assessment Act 1936 (ITAA 36). A further penalty assessment of 50% was based on the taxpayer not having a reasonably arguable position (RAP) that Part IVA did not apply.

The AAT [2011] AATA 198 found that, of the payment of $11.6m, $7,246,572 was assessable to the taxpayer as ordinary income, being referrable to services already provided by the taxpayer for the 1999 to 2001 years. The balance of $4,353,428 was not ordinary income of the taxpayer as it was in substitution for bonus entitlements for work yet to be performed, and contingent on the financial performance of PC in the future. The AAT also found that Part IVA did not apply to include the balance in the taxpayer's assessable income. The AAT accepted that the taxpayer's tax shortfall did not result from recklessness or from a failure to take reasonable care, but found that he did not have a RAP on the non-assessability of the amount of $7,246,572. No penalty had been remitted by the Commissioner or should now be remitted

On appeal by both parties, the Federal Court (Murphy J) [2012] FCA 383 found that all of the payment of $11.6m was derived as ordinary income by the taxpayer when paid to the trustee. The payment was made in substitution for amounts which the taxpayer had earned or would earn as a reward for services. Once the Share Issue Deed was executed and then approved by the shareholders, the taxpayer had an unconditional entitlement to be provided with 5 million shares, which he exchanged for the non-contingent payment to the trustee. The amount was derived by the taxpayer when paid by PC on his behalf to the trustee. His Honour also found that the AAT erred in not finding that the taxpayer did not discharge the burden of proving that his tax shortfall did not result from the recklessness of his tax agent.

The Full Federal Court dismissed the taxpayer's appeal from the decision of Murphy J. On 10 May 2013, Kiefel and Keane JJ refused special leave to the taxpayer to appeal to the High Court from the decision of the Full Court. Their Honours noted that the judgments of Murphy J and the Full Court applied settled principles and that they saw no reason to doubt the conclusions reached.

Issues decided by the court

The Full Federal Court (Emmett, Edmonds and Rares JJ) agreed with Murphy J that, by 30 November 2001, the taxpayer's accrued and contingent bonus entitlements had been replaced by an absolute entitlement to be issued with 5 million ordinary shares in PC. The character of that entitlement, if provided, would be income as a reward for services. The payment to the trustee in substutution for that entitlement also had the character of ordinary income, and was derived as such by the taxpayer when paid to the trustee as his nominee. The Court rejected the taxpayer's alternative argument that the payment was capital in nature as in lieu of the right to be issued with a capital asset, being the shares in PC.

The Full Court also found that there was no error in the conclusion of Murphy J that the taxpayer did not discharge the onus of establishing that the taxpayer's tax shortfall did not result from the recklessness of his tax agent.

ATO view of Decision

The ATO notes that the decisions of the Federal Court and the Full Federal Court confirm the Commissioner's view on the nature of what is ordinary income as a reward for services, and on when amounts of ordinary income are taken to be derived under subsection 6-5(4) of the Income Tax Assessment Act 1997.

Administrative Treatment

Implications for ATO precedential documents (Public Rulings & Determinations etc)

None

Implications on Law Administration Practice Statements

None

Legislative References:
Administrative Appeals Tribunal Act 1975
s 44

Income Tax Assessment Act 1997
s 6-5

Tax Administration Act 1953
s 14ZZK
Schedule 1 s 284-75
Schedule 1 s 284-90

Case References:
Constable v FC of T
(1952) 86 CLR 402

Hallstroms Pty Ltd v FC of T
(1946) 72 CLR 634