09 Feb 10 Sham payments reduced Div 7A distributable surplus - Paper to Paper
The AAT has considered the tax consequences of certain sham payments purportedly made by an Australian company (Paper to Paper) to a Hong Kong company, and deposited in the personal account of Paper to Paper's shareholder (Holland). The Commissioner disallowed deductions claimed by Paper to Paper for the payments, and included the amount of the payments in Holland's assessable income as deemed dividends pursuant to Div 7A ITAA 1936.
The first issue considered was whether Paper to Paper's increased tax liability (after disallowance of the deductions and the imposition of penalties and GIC) was a “present legal obligation" for the purposes of the definition of "net assets" in s 109Y(2) of ITAA 1936. If it was, this would reduce Paper to Paper's distributable surplus which, in turn, would reduce the amount of the deemed dividends assessable to Holland. The AAT held that the income tax on the company's income was a present legal obligation. The AAT said, at paras  to  as follows:
"As at the close of the financial year therefore, there can properly be said to be a present but unquantified obligation to pay tax which is not owing in the sense of “due and payable” until after lodgment or assessment in accordance with the provisions of the Act.
The obligation to pay tax as at 30 June is at that moment a present obligation and not a future obligation or an obligation dependent on a contingency. The liability therefore is to be determined as at the end of the financial year because that is the date from which the obligation operates.
For the above reasons, we conclude that the obligation to pay tax at the amount subsequently properly ascertained, assessed and determined, is a present legal obligation as at the end of the financial year in respect of which the income is derived and, within in the meaning of s 109Y(2) of the 1936 Act.
A consequence of this is that the amount of tax as duly and correctly assessed must be deducted from the net assets in accordance with the formula under s 109Y(2) of the 1936 Act."
So, too, was the GIC, which accrued on a daily basis. In contrast, the penalties were held not to be a “present legal obligation" until imposed on the issue of a notice of assessment.
The next issue considered was whether the Commissioner was entitled to "add back" the value of the sham payments pursuant to the power conferred upon him by s 109Y(2) (which refers to the accounting records overvaluing or undervaluing a company's assets or provisions). The AAT held that he was not so entitled, because although the payments were held to be a sham (for tax purposes), they had moved from Paper to Paper to the Hong Kong company and, on that basis, Paper to Paper's assets were reduced.
The matter was remitted to the Commissioner to calculate Paper to Paper's distributable surplus and to make any necessary adjustments to the assessments issued to Holland.