Are Hong Kong Waffles Better than the Belgian Variety?

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Are Hong Kong Waffles Better than the Belgian Variety?

Are Hong Kong Waffles Betterthan the Belgian Variety?The crackdown on unpaidpresent entitlements (“UPEs”)by the Australian Taxation Officehas been made unworkableby recent legal decisions in theAdministrative Appeals Tribunaland the Full Federal Court. Ifyou have ever been assessedto a Division 7A liability or havean outstanding UPE issue, theramifications are considerable.We explain the rationale behindthese decisions, and what theymean for you.The Administrative Appeals Tribunal’sdecision of Waffles (AAT Case [2010]AATA 78) and the H decision of the FullFederal Court (FCT v H [2010] FCAFC128) have important ramifications foranyone who has ever been assessed toa Division 7A liability. Significantly, giventhe Tax Office’s recent crackdown ontrusts with unpaid present entitlements(“UPEs”) to corporate beneficiaries,the Waffles case has made the UPEcrackdown unworkable.The facts of the case are not particularlyrelevant. Waffles was a waste papertrading company established by H (apseudonym) that paid “commissions”to a Hong Kong company. Thecommissions were returned to Australiaunder a typical Wickenby type roundrobin arrangement and held in a bankaccount operated by H. Waffles claimedtax deductions for the commissions.As the bank account was maintainedsolely for H’s benefit, he was assessedto a deemed dividend by the Tax Officein respect of the amounts that had beenpaid into his account by the Hong Kongcompany.The Significance ofDivision 7ADivision 7A applies to deem a dividendto payments, loans and debts forgivenfrom a private company to a shareholderor an associate of a shareholder ofthe private company. The amount ofthe deemed dividend is generally theamount of payment, amount forgivenor the outstanding balance on theloan up to due date for the lodgmentof the company’s tax return. However,February 2011the deemed dividend cannot be morethan the “distributable surplus” of thecompany.The distributable surplus is defined insection 109Y of the 1936 Tax Act as“the amount (if any) at the end of thecompany’s year of income by whichthe company’s assets (according tothe company’s accounting records)”exceed the sum of “the present legalobligations of the company to personsother than the company”.“Present Legal Obligations”– the Key Legal IssueThe key issue in the litigation was themeaning of the term “present legalobligations”, in particular whether currentyear tax obligations and penalties couldpotentially be “present legal obligations”and therefore reduce Waffles’distributable surplus and the quantum ofthe deemed dividend.As noted, Waffles paid fictitiouscommissions to the Hong Kongcompany. It appears that they werejournalised as commissions and werephysically paid to the Hong Kongcompany. On this basis, Waffles claimeda deduction for the amounts paid. Whenthe Tax Office carried out their audit, theydisallowed the deduction. As a result,Waffles’ assessable income increased.The tribunal’s decision (relying on ReMendonca, Ex Parte FCT (1969) 15 FLR256, and FCT v Kavich (1996) 68 FCR519) was “that the obligation to pay taxat the amount subsequently properlyascertained, assessed and determined,is a present legal obligation as at theend of the financial year in respect ofwhich the income is derived”.www.crowehorwath.com.au1


Are Hong Kong Waffles Better than the Belgian Variety?For Further InformationFor further information, please contactyour local Tax Advisor.Steve Di LeoHead of Tax Advisory Group, SydneyTel +61 2 9619 1637steve.dileo@crowehorwath.com.auNorman ElliotHead of Tax Advisory Group, MelbourneTel +61 3 9258 6866norman.elliott@crowehorwath.com.auPeter FallonHead of Tax Advisory Group, PerthTel +61 8 9488 1102peter.fallon@crowehorwath.com.auTony MarksHead of Tax Advisory Group, BrisbaneTel +61 7 3233 3593tony.marks@crowehorwath.com.auAs a result of this decision, in each yearWaffles’ “distributable surplus” wasreduced by Waffles’ increased obligationto pay tax as a consequence of itmaking the undeductible payments. Thisin turn decreased the deemed dividendthat was assessable to H. In addition,the tribunal found that interest on theunpaid tax was also a “present legalobligation” of the company, which furtherreduced its distributable surplus.As the company’s penalties on unpaidtax were unable to be definitelyascertained, they were not present legalobligations. The tribunal reasoned thatbecause the penalty provisions enablepenalties to be increased or remitted“the amount of the penalty is not a fixedor an ascertainable amount” until “theCommissioner issued to Waffles a noticeof assessment, and not before”.What are the Implications?The practical implications of the caseare clear. Firstly, anyone that has beenaudited and had the Tax Office imposea deemed dividend under Div 7A mayhave also had their company denieddeductions during the audit. The denialof the deductions could retrospectivelyreduce the distributable surplus andtherefore the deemed dividend. Thesetaxpayers should now consider seekingamendments for those tax returns.Perhaps more importantly, this decisionmay provide some relief for taxpayersthat are caught up in an UPE issueas a result of TR 2010/3. In this case,the UPE becomes a loan to the trust,increasing the trust’s income by theamount of the deemed dividendthat results from the loan. Under theproportionate rule, this increased incomemust be assessed to the company, butthe increased tax on that income is nowa present legal obligation which reducesthe distributable surplus of the companyand the amount of the deemed dividend.It will be interesting to see whether theTax Office adopts this methodology inpursuing the UPE issue in the comingmonths.About Crowe Horwath InternationalCrowe Horwath International is ranked among the top 10 global accounting networkswith more than 140 independent accounting and advisory services firms with 590offices and nearly 28,800 professionals and staff in more than 100 countries aroundthe world. Crowe Horwath International’s member firms are committed to impeccablequality service, highly integrated service delivery processes and a common set ofcore values that guide our decisions daily. Each firm is well-established as a leaderin its national business community and is staffed by nationals, thereby providing aknowledge of local laws and customs which is important to clients undertaking newventures or expanding into other countries. Crowe Horwath International memberfirms are know for their personal service to privately and publicly held businessesin all sectors and have built an international reputation in the areas of audit, tax andadvisory services.The relationship you can count onCrowe Horwath Sydney Pty Ltd is a member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath is a separate and independent legal entity. Crowe Horwath Sydney PtyLtd and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath or any other member of Crowe Horwath and specifically disclaim any and all responsibility or liability foracts or omissions of Crowe Horwath or any other Crowe Horwath member. Liability limited by a scheme approved under Professional Standards Legislation other than for the acts or omissions offinancial services licensees.This update is provided by Crowe Horwath Sydney Pty Ltd as an information service only. Crowe Horwath Sydney Pty Ltd provides no warranty regarding the accuracy or completeness of theinformation. All opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice by Crowe Horwath Sydney Pty Ltd.Crowe Horwath Sydney Pty Ltd assumes no obligation to update this document after it has been issued. Except for any liability which by law cannot be excluded, Crowe Horwath Sydney Pty Ltd,its Directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error, in accuracy in, or omission from the information contained in this document or any loss ordamage suffered by the recipient or any other person directly or indirectly through relying upon the information. Section 945A of the Corporations Act requires financial planners to obtain informationfrom clients before making recommendations. Equivalent requirements apply also to accountants in relation to the provision of taxation advice. Accordingly, clients and readers should not act onlyon the basis of material obtained in this update because the contents are of a general nature and therefore do not take into account each person’s individual circumstances and may be liable tomisinterpretation. Do not act upon any of the information contained within this update without first obtaining specific advice from your Crowe Horwath Sydney Pty Ltd advisor. Crowe Horwath SydneyPty Ltd ABN 38 001 842 600 is a wholly owned subsidiary of WHK Group Ltd.www.crowehorwath.com.au2

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