Could a recent AAT decision lead to a more favourable approach to dividend schemes for taxpayers?

Michael John Hayes Trading Pty Ltd as trustee for MJH Trading Trust and Commissioner of Taxation (Taxation) AATA 3005 (Hayes case)

Background

At a high level, the facts of the Hayes case are:

• The Applicants were four trading companies, within the Hayes Group (Group), as trustees for the associated trading trusts.
• The Group is controlled by the Hayes family, particularly four brothers.
• In June 2007, four family trusts were created within the Group, each with corporate trustees.
• In 2010, after receiving professional advice, the Group was restructured. Four trading companies, four fixed trusts, four trading trusts and four rural unit trusts were added. Each brother was allocated one of each entity.
• In May 2010, a choreographed arrangement was entered into where the four Applicants – the four trading companies – acquired Z class shares from four Operating Companies within the Group.
• That same day, the operating companies declared and paid out fully franked dividends of $8,008,460 to the Applicants.
• Most of the dividends were sent directly back to the operating companies via a loan from the corporate trustees. 30.46% of the dividends were loaned to the individual Hayes brothers who used the funds to repay existing loan balances owed to the operating companies.
• Each Applicant included the franked dividends and associated franking credits as assessable income in their 2010 income tax return, claiming the tax offsets connected with the franking credits.
• The Commissioner determined that these franked dividends were paid as part of a “dividend stripping operation.” The Applicants appealed to the Administrative Appeals Tribunal (AAT).

Relevant law

Section 207-155 Income Tax Assessment Act 1997 (ITAA 1997) is part of a suite of rules aimed at preventing manipulation of the imputation system.[1]

Section 207-155 of the ITAA 1997 states:

• A distribution made to a member of a corporate tax entity is taken to be made as part of a “dividend stripping operation” if, and only if, the making of the distribution arose out of, or was made in the course of, a scheme that:
  • Was by way of, or in the nature of, “dividend stripping”; or
  • Had substantially the effect of a scheme by way of, or in the nature of, “dividend stripping”.

If a franked distribution is found to be made as part of a “dividend stripping operation,” the franking credits aren’t included in the entity’s assessable income, and they are not entitled to a tax offset.[2]

There are six characteristics of a “dividend stripping operation.” These have been articulated and endorsed by the Full Federal Court, most recently in the landmark decision of BBlood Enterprises Pty Ltd:[3]

1. A target company, which had substantial undistributed profits creating a potential tax liability either for the company or its shareholders;
2. The sale or allotment of shares in the target company to another party;
3. The payment of a dividend to the purchaser or allotee of the share out of the target company’s profits;
4. The purchaser escaping Australian income tax on the dividend so declared (such as through an offsetting loss on the sale of the shares);
5. The vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers; and
6. Careful planning with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends by the target company.

The tax avoidance purpose is the most significant factor in a dividend stripping operation. The closer a scheme gets to completely removing the taxable amounts from the tax system, the more likely the requisite tax avoidance purpose will be made out.

Factors 4, 5 and 6 listed above were in dispute in this matter.

The Commissioner’s argument

The Commissioner contended broadly that the four Hayes brothers entered into schemes by which they distributed retained earnings previously accumulated in the four Operating Companies.

The Commissioner’s position was that the dividends paid to the taxpayer companies were part of a “dividend stripping operation” as the dividends weren’t paid to ordinary shareholders by cash dividend, as would be expected, but as part of an elaborate and contrived scheme.

The Applicant’s argument

The Applicant’s contended that:

1. they received taxable dividends, and the entitlement to tax offsets on account of franking credits does not change that assessment;

2. the latent tax liability in the retained profits which existed before the arrangement, and which was moved from the operating companies to the taxpayers, remained a latent tax liability that would still eventually be taxed when the profits were distributed beyond the corporate environment; and

3. the purpose of the arrangement was not to avoid tax, but instead to achieve improved asset protection and better and diversified ownership arrangements.

The AAT’s decision

The AAT decided in favour of the Applicants – the arrangement they entered into did not constitute a “dividend stripping operation.” In doing so, it made the following determinations:

1. The dividends were not taxed in the hands of the taxpayers because a fully franked dividend of a taxpayer entitled to a tax offset does not bear any taxation liability. This was decided in favour of the Commissioner.

2. The four Hayes Brothers, as the original four shareholders, did not receive any capital sum as a substitute for taxable dividends paid. The majority of the dividends were returned to the trading company as an inter-entity loan. The 30.46% of dividends which were kept by the brothers were used to retire or repay existing debt within the group. This “could be seen to be a refinancing of pre-existing debt” akin to a dollar-for-dollar debt obligation substitution. Because of this, the four brothers did not receive any capital.30.46% was also determined to be well short of the extent of the substitute required to be a “dividend stripping operation.”

3. The requisite tax avoidance purpose was missing. The sole or dominant purpose of the transactions was not to avoid tax on the dividends paid (there was no transformation of the profits into non-taxable amounts, nor were they moved outside the Hayes family). The profits underlying the dividends remained as profits within the family group, and still liable to tax upon ultimate distribution, so they weren’t removed from the Australian tax system.

The key takeaways

The most significant takeaway in this matter is that when corporate groups can demonstrate they have retained corporate earnings within the same group, this is enough to demonstrate that the latent tax liability remains, and that they haven’t entered into the transaction for tax avoidance purposes.

It is also noteworthy that the 30.46% of dividends which were loaned to the Hayes brothers were considered by the AAT to be “well short of the extent of the substitute required to be a dividend stripping operation.”

Lastly, the Commissioner has appealed this AAT decision to the Federal Court. The Australian Taxation Office is clearly aware of the wider implications this decision could have if allowed to stand. We will have an update to this article when that appeal decision is published.

For more information on the implications of this case, please contact Coleman Greig’s expert Commercial Taxation Advice team.

_{[1] Hayes case paragraph 15.}

_{[2] Section 207-145 ITAA 1997.}

_{[3] Hayes case paragraph 18 referencing BBlood Enterprises Pty Ltd v F. C. of T. and B&F Investments Pty Ltd as Trustee for the Illuka Part Trust v F.C. of T. [2023] FCAFC 89.}