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The Full Federal Court (Downes, Edmonds and Greenwood JJ) has dismissed the Commissioner's appeal from the decision of the AAT in Waffles Pty Ltd and Anor and FCT [2010] AATA 78 (3 February 2010).

Sham payments were purportedly made by an Australian company to a Hong Kong company, and deposited in the personal account of the company's shareholder (H). The Commissioner disallowed deductions claimed by the company for the payments, and included the amount of the payments in H's assessable income as deemed dividends pursuant to Div 7A ITAA 1936.

The issue before the AAT was whether the company's increased tax liability (after disallowance of the deductions and the imposition of penalties and GIC) was a "present legal obligation" at the end of each relevant year of income for the purposes of the definition of "net assets" in s 109Y(2) of ITAA 1936. If it was, this would reduce the company's distributable surplus which, in turn, would reduce the amount of the deemed dividends assessable to H. The AAT held that the income tax on the company's income, and the GIC that accrued on a daily basis from the date that the income tax became due, was a "present legal obligation" at the end of each relevant year of income.

On appeal, the Commissioner sought to equate a "present legal obligation" with an obligation to pay an amount that is legally "due". In the case of income tax, it does not become "due" until an assessment is issued, some time after the end of the year of income. The taxpayer agreed that income tax does not become "due" until an assessment is issued, but argued that the concept of a "present legal obligation" was broader than expressions such as "due", "payable", "due and payable" and "debt".

The Full Federal Court upheld the taxpayer's arguments, holding that the income tax liability was a "present legal obligation" for Div 7A purposes at the end of the relevant income year. The Court looked at the legislative policy behind Div 7A and said, at paras 35-37, as follows:

"35 This extract from the explanatory memorandum manifests both the legislative policy of Div 7A as a whole, and s 109Y in particular. Section 109Y is to provide a ‘cap’ or limit on such loans, advances or other credits being treated as assessable dividends, namely, up to but not exceeding the realised and unrealised profits in the company.

36 The term ‘distributable surplus’ is to be understood in that context, namely, the realised and unrealised profits in the company available for distribution. The profits of a company available for distribution are its ‘after-tax’ profits. As Fullagar J observed in Commonwealth v O’Reilly (1984) VR 931 at 938:

‘In my opinion the profits out of which dividends may be paid are the profits remaining after deduction from gross profits of, inter alia, federal income tax, or at least a bona fide estimate thereof. A bona fide assessment of profits involves a bona fide estimate of income tax.’

37 It is within this legislative context, informed by the legislative policy and purpose referred to in the explanatory memorandum, that the ingredients of what goes to make up ‘distributable surplus’, including the term ‘present legal obligations’, fall to be considered. A construction of those ingredients which gives the term ‘distributable surplus’ a measure which approximates the profits (realised and unrealised) available for distribution is to be preferred to a construction which results in a divergence between the measure of the distributable surplus so construed and the measure of the profits (realised and unrealised) available for distribution."

The Court found that the GIC was also a "present legal obligation" from each day that it accrued due. The Commissioner's appeal was dismissed: FCT v H [2010] FCAFC 128 (Full Federal Court; Downes, Edmonds and Greenwood JJ; 20 October 2010).


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