The ATO is increasingly delving into its arsenal of weapons to attack arrangements which the Commissioner suspects may have a tax avoidance motivation.
As part of this mission, alongside the specific and general anti-avoidance legislative tools, the ATO has also resorted to the older legal concept of sham.
This article looks at the meaning of sham, and the ATO’s attempted use of sham in the context of a taxpayer’s conversion of an unpaid present entitlement to a loan (for Division 7A).
In light of the recent Federal Budget tax announcements (see our previous article here), it will be very interesting to see whether the ATO continues to try and apply sham and the older legal concepts or they return to a pseudo-stasis until the ATO meets an opponent it cannot reach with its statutory tools.
What is a sham?
In Australian law, a sham refers to steps that take the form of a legally effective transaction, but which the parties intend should not have the apparent, or any, legal consequences.
Two of the leading authorities on sham, Equuscorp Pty Ltd v Glengallen Investments Pty Ltd (2004) 218 CLR 471 and Raftland Pty Ltd v Federal Commissioner of Taxation (2008) 238 CLR 516, found that a sham requires an element of deliberate deception, and is not merely a transaction that is ineffective or poorly documented. The Courts have also reiterated that the term “sham” is ambiguous and its application can be uncertain, but at its core, it refers to something intended to be mistaken for something else.
Case study
One example where we saw the ATO issue alternative assessments relying on sham was where a taxpayer complied with Division 7A and converted an unpaid present entitlement from a trust to a company into a loan, and the company made loan repayments by declaring a dividend which it set-off against the loan. The trust distributed the dividends to individual beneficiaries.
The central legal issue was whether the loans and distributions were shams. Specifically, whether the steps taken, such as loans from the company to the trust, the dividends, and the distributions from the trust to individuals, were intended to have legal consequences, or were merely a façade.
For the ATO to allege a sham in accordance with the law, they had to identify the “real transaction” and clearly articulate what that was.
In this case, however, the ATO simply denied the existence of the loans or the repayment of those loans by way of set-off with the dividends. This is not and cannot be sufficient to find sham.
In practice (as in this case), the existence of genuine loans and repayments is often supported by formal loan agreements, accounting records, annual correspondence, and tax returns reflecting the transactions.
The economic effect of the arrangements should (and did) match their legal form: a company receives a trust distribution, pays tax, converts the unpaid present entitlement to a loan (per Division 7A), and declares dividends that are set-off against the loan balance. The company pays tax on the distribution, and the individual beneficiary pays tax on the distribution of the dividend (which is set off against the company’s loan).
An allegation of sham is inconsistent with evidence that acknowledges the set-off arrangement and the payment of dividends, which could only occur if the underlying transactions were genuine.
What this means
Since Raftland in 2008, the Courts have expressed the view that in some circumstances, an allegation of sham may be less pejorative than an allegation of fraud.
With this in mind, the ATO appears to use sham when it cannot apply its statutory tax avoidance tools and so that it does not have to allege fraud and meet the associated legal requirements.
However, the view that sham is less pejorative does not mean that an allegation of sham is not pejorative at all and on any interpretation of the law, sham requires an objective of deliberate deception. It requires evidence and the identification of the “real transaction”.
Sham is not a simple or easy alternative to an allegation of fraud to invalidate a transaction.
Instead, before any allegation of sham is made, the ATO should have reference to the serious nature of the allegation which is made and in the words of the High Court in 1938:
“The seriousness of an allegation made, the inherent unlikelihood of an occurrence of a given description, or the gravity of the consequences flowing from a particular finding, are considerations which must affect the answer to the question whether the issue has been proved to the satisfaction of the tribunal…”
(Briginshaw v Briginshaw (1938) 60 CLR 336).
It is also always necessary to bear in mind the advice of Justice Kirby in Raftland, who:
“…warned against allowing the word ‘sham’ to become a ‘legal shibboleth’ so that ‘on its mere utterance it [is] to be expected that contracts will wither like one who encounters the gaze of a basilisk.’”
As the ATO pull out these old tools and look to apply them in the modern world and in more nuanced ways, it is critical to draw up this underlying law and respond directly to any allegation of sham.