Australian Taxation - How Long Should Business Records Be Retained?

A case that was recently decided in the Federal Court highlights a problem in relation to the keeping of business records. During the 1988 income year, a unit trust engaged in the purchase of a significant investment. It was not a good investment. Not too long afterwards the investment was worthless and in May 1993 the investment was sold for $1. This resulted in the unit trust incurring a capital loss of nearly $2.5m.

All of the units in the trust were sold from the original owner to a new owner in two tranches. One was in June 1993 and the other was in June 1995.

Capital losses may only be deducted for tax purposes against capital gains. Put another way, capital losses may not be used as a deduction against normal income. Due to this, the capital losses were carried forward by the unit trust until a capital gain was made by the unit trust in 2001.

The Australia Taxation Office ("ATO") raised amended assessments against the ultimate beneficiaries of the trust and would not allow the capital loss of $2.5m to be set off against the capital gain made in 2001. The beneficiaries objected to this and the matter found its way to the Federal Court.

The main argument of the ATO was that the trust had fundamentally changed through some things that happened in 1993. I won't go into the details of that.

However, the ATO also argued that the taxpayers could not prove that the purchase of the investment occurred in 1988 because, among other things, the primary documents that evidence the transaction no longer existed. This was so even though the financial statements of the unit trust showed the acquisition and there was verbal evidence from the people who actually engaged in the transaction. I note that the financial statements were prepared by a reputable firm of Chartered Accountants.

In his testimony before the court, the original owner of the units said that he did not have any of the business records of any of his companies or entities from 21 years ago. I know of few people that would.

So here's the point. Generally, businesses are required to keep their records for a five year period under the Australian taxation law. But when it comes to capital gains tax, you need to keep records of everything that may be relevant to working out whether you have made a capital gain or capital loss. And, according to the ATO publication "Record Keeping For Small Business", "You must keep these records for five years after you sell or otherwise dispose of an asset...". So, you may need to keep the records for a very long time.

You will note in the case I refer to above that the ATO required the taxpayer to produce business records of a transaction that was 21 years old. Further, the disposal of the investment occurred in 1993, so that was 16 years earlier (not five).

The moral of the story is this: if you think that a transaction may have long term significant tax implications, don't (ever?) throw out the primary documents that relate to that transaction. Keeping an electronic (scanned) image is something that you should consider.

Wishing you easier business.

John M. Jeffreys

Australian Federal Budget - Tax and Superannuation Changes

The Australian Treasurer, Wayne Swan, delivered the 2010-2011 Australian Federal Budget on 11 May 2010. In this article I will concentrate only on the taxation and superannuation matters that will be of more general interest. I will not cover all of the changes. Also, I will not repeat announcements that were part of the Government's response to the Henry review.

The key announcements I will discuss are: (1) An increase in the Low Income Tax Offset (2) An increase in the level of net medical expenditure necessary to obtain a tax rebate (3) An optional standard deduction for work related expenses and cost of managing tax affairs (4) A 50% discount in relation to the earning of certain interest income (5) A change in the way that Capital Gains Tax applies to earn-out arrangements (6) A permanent reduction to the superannuation co-contribution rate. (7) GST changes to the margin scheme and the financial supplies threshold. Here are the details:

Low Income Tax Offset

From the 1st of July 2010 there will be an increase from $1,350 to $1,500 of the Low Income Tax Offset. Due to this, a person that earns up to $16,000 will not have to pay income tax.

Net Medical Expenditure Threshold

Currently, if a taxpayer has net medical expenditure of $1,500 or more, a tax offset can be claimed for 20% of the expenditure above the threshold. From 1 July 2010 the threshold will be raised to $2,000, thus making it more difficult to make a claim. Also, in following years, the threshold will be indexed in line with the Consumer Price Index.

Optional Standard Deduction

In a big win for millions of taxpayers, from 1 July 2012, there will be an optional standard deduction in lieu of claiming work-related expenses and the cost of managing a person's tax affairs. This will only apply to individual taxpayers. The optional standard deduction amount will be $500 in the year ending 30 June 2013. In the year ending 30 June 2014, this amount will be $1,000. The standard deduction is optional as taxpayers will still have the ability to claim actual expenditure.

50% Discount for Interest

To encourage savings, from the 1st of July 2011, there will be a tax discount of 50% on up to $1,000 of interest earned. So if a person has $20,000 in the bank that is earning 5% interest, the whole amount of this interest will be eligible for the discount. This will also mean that some individuals and families will become eligible for Government assistance or be able to obtain larger Government assistance with such things as the Family Tax Benefit, Child Care Benefit and so forth.

Capital Gains Tax and Earn-Out Arrangements

There is going to be a change to an annoying part of the Capital Gains Tax law that relates to the sale of a business where there is an earn-out arrangement. An earn-out arrangement is used to adjust the sale price of a business depending on how it trades after the business changes hands. Typically there will be a set amount paid for the business plus a contingent amount based on trading over, say, the next 12 months. So, for example, a purchaser of a business may agree to pay a certain percentage of the gross margin of a business as further consideration for the purchase of the business.

Under the current interpretation of the law, the earn-out component is a separate asset from the underlying business. This causes a number of problems, including the inability to apply the small business CGT concessions to the earn-out component of the purchase price of the business. The Government will change the capital gains tax law so that the earn-out component of the sale price will be treated as consideration for the underlying business and not consideration for a separate right created by the contract of sale.

This change will apply from the date the law receives Royal Assent. There will be transitional provisions in certain cases from 17 October 2007.

Matching Rate for the Superannuation Co-Contribution System

The Government has announced that it will permanently keep the matching rate for the superannuation co-contribution system at 100%. Further, the maximum co-contribution will be set at $1,000.

Goods and Services Tax Changes

Turning to GST, the Government has announced that there will changes in the way the margin scheme operates. These changes will apply from 1 July 2012. There is not much detail as to how these changes will operate but the changes will be designed to address a number of problems with the current law.

Finally, the threshold below which businesses need not be concerned with making financial supplies will be increased by 3 times from $50,000 to $150,000 of input tax credits. This change will have effect from 1 July 2012.

Wishing you easier business

John M. Jeffreys

Australian Tax - Capital Gains Tax and Earnout Arrangements

It was announced in the recent Australian Federal Budget (11 May 2010) that there would be a change to the way in which capital gains tax applies to earnout arrangements.

What's an earnout arrangement? This is usually encountered in sale of business situations where the parties to the contract either cannot agree on a value or are uncertain about the value of the business. Typically, a lump sum amount is paid with a further amount to be paid if the business performs to certain pre-agreed levels. For example, a business may be sold for $500,000 plus 5% of the sales for the next 12 months. There are many variations of these arrangements.

What's the problem?

On 17 October 2007, the Australian Taxation Office ("ATO") released a Draft Taxation Ruling TR 2007/D10 on this topic. The ATO considered that the contingent, earnout component of the consideration for the sale of the business was a separate asset from the underlying business. The earnout component was seen by the ATO as the vendor disposing of a right to an uncertain amount of money. In addition, the vendor was also selling the actual assets of the business (for example the goodwill) for any amount that was certain in the consideration.

This interpretation created problems. First, the value of the earnout had to be determined in order to determine the capital gain that related to that earnout. In most situations this is quite difficult to do as, of necessity, one must predict the future. Second, the earnout component was not something to which the small business capital gains tax concessions could apply. This was because the earnout right was not an "active asset".

The law is to be changed to what is referred to as a "look through" approach. This means that the law will look through to the underlying transaction - the sale of the business assets - and deal only with those assets and not treat the earnout arrangement as a separate asset.

The new law will apply from the date that it receives Royal Assent. This is after the law passes both houses of parliament and the Governor-General signs it into law.

However, Senator Nick Sherry, the Assistant Treasurer, has released a proposals paper on the topic. The purpose of this paper is to consult with the business community about the changes. The closing date for submissions is 11 June 2010. In this paper some transitional provisions are announced. Taxpayers will have the choice to apply the look-through treatment entered into between the date of announcement and Royal Asset (inclusive). Also the buyer in a standard earnout arrangement will have the choice to apply the new treatment for arrangements entered into on or after 17 October 2007.

If you are considering the sale of a business with an earnout arrangement, I strongly encourage you to obtain a copy of the consultation from the Assistant Treasurer's website.

Wishing you easier business,

John M. Jeffreys

Australian Tax - Bamford Decision and the Streaming of Income to Trust Beneficiaries

Due to the decision impact statement on the Bamford High Court decision and recent statements by high ranking Australian Taxation Office ("ATO") officers, there is a great deal of uncertainty concerning the future ability of a trustee of a trust to stream different classes of income to different beneficiaries of the trust.

First some background. The trustee (or trustees) is the legal owner of the assets of the trust. The trustee derives income from the assets of the trust. This can be just about any type of income that you can think of. It can include interest, dividends, distributions from other trusts, capital gains, trading income and so forth. The trustee must apply that income for the benefit of the beneficiaries and in accordance with the powers given to the trustee under the trust deed. In a discretionary trust, the trustee has the absolute ability to decide how much is to be distributed to each beneficiary and how much is not to be distributed.

It is usually the case that the beneficiaries of the trust have different marginal tax rates and different tax rules can apply to them, depending on what type of taxpayer they are. It is prudent for the trustee to direct certain types of income to certain types of beneficiaries in order to lower the overall tax payable by the beneficiaries on the income derived from the trust. Accordingly, the concept of the streaming of income to beneficiaries has been a widely accepted part of trust administration for some years. This concept came particularly to the fore when the dividend imputation and capital gains tax rules were enacted in the mid 1980's.

The ability to stream income to beneficiaries rests on the assumption that income of different types can be separately identified by the trustee. Further, the expenses that relate to that income can also be separately identified. Alternatively, the expenses of the trust may need to be apportioned over the various types of income. So, the underlying assumption is that income can retain its character, and therefore its tax characteristics, as it flows into and then out of the trust.

Streaming was approved (in a sense) by the ATO when it issued a public ruling in 1992 on the distribution by trustees of dividend income under the imputation system. This was TR 92/13. The ruling referred to the dividend imputation legislation as it existed at that time. This legislation has since been repealed and replaced with another set of dividend imputation rules.

The Bamford Decision

What's all this got to do with the Bamford decision? On one view, nothing. The High Court did not refer to the issue of streaming in the Bamford decision. But, due to the statements that the High Court made in relation to the method by which Sub-section 97(1) of the Income Tax Assessment Act 1936 operates when determining the taxable income of a beneficiary, the ATO considers that TR 92/13 must be withdrawn. Nevertheless, the ATO states that tax returns for the 2009/10 income years and earlier years which are/were reasonably prepared on the basis of TR 92/13 "will not be disturbed".

Why does the ATO consider TR 92/13 should be withdrawn? This is because, according to the High Court, under Sub-section 97(1), a beneficiary is assessed in the following manner:

[1] The beneficiary's percentage share of the trust law income for a particular income year is determined.
[2] The taxable income of the trust is determined.
[3] The percentage under [1] is applied to the taxable income in [2] and the resultant amount is the taxable income of the beneficiary.

In the above process, on one view, there is no regard to the classes of income that have been received by the trustee and whether the trustee has decided to allocate certain classes of income to certain beneficiaries. But there are other provisions in the income tax law that refer to the taxation of the beneficiaries of a trust in relation to certain classes of income. Regard must also be had to these provisions.

Is streaming dead after 30 June 2010?

I think that it is a bit early to say that streaming is dead, although perhaps casket measurements should be taken. I have attended two recent seminars. At one seminar, the speaker (non-ATO) said that the ATO would no longer sanction streaming. At another seminar, there was a senior ATO technical officer speaking. There was no indication from him that streaming was definitely not going to be permitted by the ATO. There is to be a review of the area by the ATO and this will include the scheme of the law in the current imputation provisions and relevant capital gains tax provisions.

Unfortunately, nothing can be said about the future of the streaming of income to beneficiaries with any certainty. We will have to wait for future ATO pronouncements and possible changes to the law. Based on past experience, this will also create further uncertainty. But, this is the Australian tax system.

Wishing you easier business.

John M. Jeffreys