Federal Court decision provides increased clarity on the judicial approach to section 100A

Thawley J’s judgment in the recent Federal Court case of BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112 (“BBlood”) has provided increased clarity on the approach of the Australian judiciary to apply section 100A of the Income Tax Assessment Act 1936 (ITAA 1936)¹.

Critically, the principles enunciated in BBlood (and those enunciated in the earlier Federal Court decision of Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021] FCA 1619 (“Guardian”), currently on appeal) have been reflected in the latest administrative guidance on section 100A from the Australian Taxation Office (ATO), TR 2022/4 Income tax: section 100A reimbursement agreements, which was finalised on 8 December 2022 after several years under development.

WHAT IS SECTION 100A?

Broadly, section 100A is a self-executing integrity provision that applies to situations where a beneficiary’s trust entitlement arises out of or in connection with a ‘reimbursement agreement - e.g., where a distribution is made to one beneficiary, but the economic benefit of the distribution flows to another party and a tax reduction purpose existed.

Section 100A generally operates in such circumstances to disregard the beneficiary’s present entitlement and instead render the trustee liable to tax in respect of the distribution at the top marginal rate (currently 47%).

Critically, section 100A will not apply where the ‘reimbursement agreement’ is entered into “in the course of ordinary family or commercial dealing”².

WHAT WERE THE FACTS OF BBLOOD?

The proceedings concerned an off-market buy-back of shares, carried out in the income year ended 30 June 2014 (“FY14”), by a company with retained earnings (“IP Co”) buying back shares held in it by the trustee (“IP Trustee”) of a discretionary trust (“IP Trust”). The material facts were:

• Prior to 30 June 2014 the trust deed for IP Trust was amended to redefine trust income from subsection 95(1) net income (tax net income) to income according to ordinary concepts.
• The proceeds of the share buy-back were deemed to be a fully franked dividend under Division 16K for tax purposes but (as a consequence of the deed amendment) constituted corpus of the IP Trust for non-tax (i.e., trust law) purposes;
• The IP Trust separately received income distributions from other entities within the relevant group of approximately $300,000 in FY14; and
• A newly introduced corporate beneficiary (“BE Co”) was made presently entitled to the trust income of $300,000, the consequence of which was that it was assessed on the trust’s net income which included the share buy-back dividend.

The broad effect of the foregoing was that no tax was payable on the deemed dividend and the tax-free sale proceeds from the buy-back were accrued as capital of the IP Trust. It is worth noting that the plaintiff’s tax advisor had implemented similar arrangements for at least seven other clients during FY14.

WHAT WAS THE DECISION IN BBLOOD?

In BBlood, Thawley J held that the arrangement was implemented with a purpose of ensuring the profits of IP Co were distributed in a tax-free form and not as a result of an ‘ordinary family or commercial dealing’, resulting in section 100A applying. The result, which is subject to an appeal, is that BE Co is deemed  not to have any entitlement to IP Trust’s income, and IP Trustee’s assessable income is increased by the amount of the franking credits and share buy-back dividend.

Key elements of Thawley J’s holding in BBlood included:

• The term ‘reimbursement agreement’ is not constrained by its ordinary meaning and instead has a wide meaning restricted only by the tax reduction purpose and ‘ordinary family and commercial dealing’ exceptions;
• The fact that an income distribution was made and paid out in full was not in and of itself sufficient to conclude that section 100A did not apply. Thawley J considered that the income distribution enabled IP Co to transfer retained profits on a tax-free basis to IP Trust and retention of the corresponding cash by IP Trust as its corpus amounted to a ‘reimbursement agreement’ with a tax reduction purpose under section 100A;
• Section 100A can apply to an amount that was capital under trust law concepts and that a ‘reimbursement agreement’ arising out of capital is not a defence to the application of section 100A;
• The taxpayer needs to be able to prove that the agreement (viewed holistically where there are a series of connected transactions or steps) has been entered into in the course of an ordinary family or commercial dealing.
• If the dealings are overly complex, contrived, artificial or more involved than necessary to achieve the relevant objective, this may lead to a conclusion that the dealing was not ordinary;
• Commercial motivation, commercial justification or commercial necessity are relevant indicia of a commercial dealing.

WHAT ARE THE PRACTICAL IMPLICATIONS OF BBLOOD?

BBlood has provided additional clarity on the judicial approach to interpreting the ‘ordinary family or commercial dealing’ exception to section 100A.

The case highlights the importance of ensuring that there is robust and objective documentation to support a position as to why an agreement is an ordinary family or commercial dealing.  In Guardian the taxpayer’s saving grace was their documentation and strong and credible witnesses that provided evidence consistent with the documentation as opposed to the general assertions of the taxpayer in BBlood that they entered into an arrangement for estate planning and group simplification, this was not sufficient to prove their point or discharge the taxpayer’s onus of proof.

What has become clear is that section 100A is expected to become a constant issue in the preparation of advice in relation to year end trust distribution minutes. 

With the TR 2022/4 now finalised, but BBlood and Guardian both on appeal, it will be interesting to see if or how the administrative and judicial approach to applying section 100A evolves in 2023 and beyond.