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18 Apr 12 Payment in substitution for employment bonuses assessable as ordinary income – Sent

The Federal Court has held that a payment to an executive share trust on behalf of a managing director, in connection with the cancellation of his bonus entitlements (accrued, accruing and yet to accrue), was ordinary income and wholly assessable to the managing director. That being so, the court did not have to consider an alternative contention by the Commissioner that Pt IVA ITAA 1936 applied. The court also confirmed the penalties imposed by the Commissioner. The court allowed the Commissioner’s appeal from a decision of the Administrative Appeals Tribunal, and dismissed the taxpayer’s appeal from that decision.

The taxpayer was the managing director and CEO of a public company, Primelife Corporation Ltd. At the commencement of his employment agreement with the company, he was entitled to a base salary, an annual bonus, and three additional bonus payments based on the company’s profits and losses over a number of financial years. At the relevant time, there were three categories of additional bonus payments, one of which had accrued and was payable, one of which was accruing, relating to periods which had been part performed, and one relating to future periods which had not yet accrued in any sense.

The taxpayer entered into an agreement with the company to the effect that he would waive his past and future bonus entitlements in return for the issue to him of five million fully paid ordinary shares in the company. Pursuant to that agreement, an Executive Share Trust was established. The company deposited a cheque for $11,600,000 in the bank account of the trust “in respect of” the taxpayer. On the same day a cheque for $11,600,000 drawn on the trust bank account was paid to the company as the price for the issue of five million shares, which then had a value of about $11,600,000. The trust then issued five million units in the trust to the taxpayer for $11,600,000. The units vested one year from commencement of the taxpayer’s participation in the trust and represented an entitlement to the shares in the trust. The taxpayer thereby had a debt to the trust for $11,600,000 as he had not paid the trust the subscription price for the units.

The Commissioner issued a notice of amended assessment for the 2002 year which treated the $11,600,000 payment as part of the taxpayer’s assessable income as either ordinary or statutory income. The Commissioner also imposed an administrative penalty for recklessness of $2,813,000 assessed at the rate of 50% of the tax shortfall amount. Subsequently, the Commissioner determined in the alternative that Pt IVA ITAA 1936 applied, and that an amount of $11,600,000 should therefore be included in the taxpayer’s assessable income for the 2002 year. The Commissioner issued a further amended assessment and notice of assessment accordingly, and imposed an administrative penalty for recklessness of $2,813,000 assessed at 50% of the scheme shortfall. The taxpayer objected to both assessments and the penalties. The Commissioner disallowed the objections and the taxpayer applied to review that decision.

The Tribunal decided that part of the payment, referable to bonuses that had accrued to the date of the payment, was assessable to the taxpayer, but that the remainder was not. Questions as to exemptions relating to fringe benefits in ss 23L and 26(e) ITAA 1936, and the application of Pt IVA, did not arise. The Tribunal also reduced the penalty imposed by the Commissioner: Re Sent and FCT [2011] AATA 198 (25 March 2011).

Both the taxpayer and the Commissioner appealed from this decision to the Federal Court.

The court decided that the whole of the $11,600,000 payment was assessable as ordinary income under s 6-5 ITAA 1997. The amount in issue was in consideration of the taxpayer waiving an entitlement to bonuses under his employment agreement – it was paid as a reward for services. The payment was ultimately in substitution for income by way of bonuses that were earned but not received, together with bonuses that were likely to be earned but had not yet been received. An entitlement to five million shares was initially substituted for the taxpayer’s bonus entitlements, and then that entitlement to shares was substituted for the payment. The payment maintained its character as ordinary income, being a reward for services.

Further, s 6-5(4) operated to deem that the taxpayer did derive ordinary income from the payment, in that it was applied or dealt with on behalf of or at the direction of the taxpayer.

Given that finding, the court found it unnecessary to decide the alternative question whether the whole or any part of the payment was assessable as statutory income under s 26(e) ITAA 1936 and s 6-10(3) ITAA 1997. Likewise, it was unnecessary to determine the Commissioner’s alternative submission that Pt IVA ITAA 1936 applied. Further, the exemption in s 23L did not apply.

On the question of penalty, the court found that the taxpayer had failed to discharge the onus of establishing that the Commissioner’s imposition of an administrative penalty of 50% of the shortfall amount was excessive. That penalty therefore stood.

Sent v FCT [2012] FCA 382 (Federal Court, Murphy J, 16 April 2012).

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