For governors of charitable entities, there has always been a question as to the standard of detail and documentation necessary for related party agreements. Such agreements might be loans or alternatively managed service agreements.
In South Seas Holdings Pty Ltd v Commissioner of Taxation [2025] FCA 848, Covlin J of the Federal Court considered an appeal from objections to tax assessments in relation to four related entities with a common controller which had claimed a series of significant deductions over a 10-year period through (what came to be understood as) a series of related party agreements.
The question was whether the deductions had been validly incurred such that the assessable income of the taxpayer had been reduced. Section 8.1 of the ITAA 97 permits deductions from expenses in relation to accessible income on the basis that it is not capital, private, domestic, or specifically prohibited.
This case is a helpful guidance for controllers of charitable entities within larger group structures. In such circumstances, it is common for managed service agreements and loans to mediate between charitable and non-charitable entities (or between charities with differing objects). Often these can be structured so that services to the charitable entity can be provided more efficiently.
South Seas provides helpful guidance as to the content of agreements between related parties.
Background
While there was an immense amount of detail, the broad facts of the case were not complex:
- Four taxpayer entities associated with Mr Vanda Gould, a former tax accountant, claimed deductions for interest on loans and payments pursuant to management fees allegedly incurred in particular tax years between 2001 and 2014.
- The Commissioner of Taxation did not accept the taxpayers were entitled to the deductions claimed, and because it considered the claimed deductions were a fraud on the tax system, imposed a range of penalties. Moreover the Commissioner alleged that the deductions were claimed as a part of a tax avoidance scheme.
- The Commissioner contended that the taxpayers did not incur the interest and management fee obligations and that entries made in the books of account for the taxpayers did not reflect the reality of underlying transactions which it contended to be no more than movements of funds solely for tax purposes.
- The Commissioner alleged, and it was ultimately found by the court, that the offshore recipients of the interest payments and management service agreement payments were entities that were operating for Mr. Gould’s benefit.
Findings of the Court
Given the apparent complexity of the arrangements, the court found that much turned on the credibility of Mr Gould as the fundamental controller of the taxpaying entities. Throughout the case, Mr Gould’s underlying credibility issues were exacerbated by the fact that he took the position he would rather keep his offshore arrangements secret than try and justify them to the Commissioner. This meant that the material before the commissioner was constrained to the material before the court, predominantly the accounts and books of the taxpayers, and the oral evidence of Mr Gould.
Colvin J observed the “Commissioner undertook a measured and detailed attack on Mr Gould’s credibility” [39] following which His Honour concluded “Mr Gould’s evidence was lacking in credibility at almost every turn” [41]. Given that Mr. Gould’s credibility was not accepted, the Court found that the agreements were not genuine and consequentially that none of the claimed deductions were established [45].
The judgment is also notable by the care taken by Colvin J in explaining a range of introductory tax concepts such as the onus on the taxpayer to discharge the burden of demonstrating the claimed state of affairs [27-33] and the correct approach to accounting records [48- 54] .
Guidance on related Party Loans and Managed Services Agreements
In the course of considering whether the related-party agreements could substantiate the deductions claimed, His Honour Colvin J made a number of observations on the considerations.
Mr Gould sought rely on the existence of a number of undocumented and oral loan agreements as the basis for deductible interest payments. It was a contributing factor that the agreement did not particularise interest rates nor benchmark the interest rates against any reasonable external basis. Consequentially, there was extreme variability from year to year in the interest rates charged. Furthermore, there were a number of assignments and novations in relation to the loans, all of which were apparently made orally. Lastly, in substance, the amounts of the interest charges consistently operated to ensure that there was little or no tax liability in the respective entities in the tax year in which they were claimed [109]. The Court found on this basis it was unable to accept that the loans existed.
The circumstances around the alleged managed service agreements were even more dire. The court found no documentary evidence, no apparent basis for the amounts that had been charged, and no coherent explanation as to why fees were charged in particular years and not others. The management fees were charged irregularly, often just end-of-year journal entries, with no formal agreements and no clear methodology or commercial rationale. All of these indicia militated against a finding that the agreement was entered into at an arm’s length.
Another relevant feature of the case was that Mr. Gould had the capacity to bind both the taxpayers and the entities that received the funds. In the course of the hearing, the Court also drew the conclusion that Mr. Gould had established the offshore entities, had his personal instigation and his own interests as a part of his personal financial affairs [177]. Given that no evidence was put on in relation to these offshore entities, this was a conclusion derived entirely from the inconsistent oral evidence and verbal slips of Mr Gould.
Implications for Complex Structures Involving Charities
The ACNC has indicated that its 2024-25 compliance focus will be on the use of complex structures. While this is not a legislative term, the ACNC has indicated that it will characterize a structure as being complex if it involves multiple entities and has one or more, and specifically includes, and relevantly includes, the mix of charitable and non-charitable entities. It would not be unusual for complex structures in that case to institute managed service agreements between the charitable and non-charitable entities.
The key feature of South Seas is the granularity with which the court is willing to look at the complex relationship between entities with particular consideration as to whether movements of capital are substantiated by the provision of value. It should be noted that the publication of a decision like South Seas is a ‘worst case scenario’ for controllers of complex structures, in that it is an instance where the court simply does not accept the characterisation of the relationships proposed by the taxpayer.
Practical Takeaways for Charities
There are a number of significant practical takeaways.
- The Court and the ATO are willing to get into the detail of related party agreements. The taxpayer in this case was not suitably prepared for the level of granularity that the Commissioner undertook the review exercise. Amidst the detail and the cross examination, the evidence of Mr. Gould appeared increasingly unpersuasive and ultimately undermine their asserted characterisation of affairs.
- Related party agreements must meet a high level of rigor. Such agreements:
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- Must have at their core a clear commercial rationale [300];
- Must be reasonable by reference to some independent objective metric or benchmark [107]and loans specifically be on interest rates no less than market rates;
- In respect of managed service agreements, must be referable to contemporaneous evidence, whether an assessment or estimate of a record of time [114]; and,
- Consistency in payments, although it may go without saying, is a critical element.
- The necessity of contemporaneous and/or corroborative records. A significant factor that went against the taxpayer was the absence of contemporaneous records of the dealings [34]. The court considered that books and records were subject to only as much weight as the whole of the evidence permitted which in the present case, in light of Mr Gould’s poor evidence, did not amount to much. If there is any risk such a related party agreement will be scrutinized later, it must be substantiated by evidence.
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If you need assistance or legal advice regarding the above, Vocare Law can well assist. Contact our office on 1300-VOC-LAW / 1300-862-529 or email: enquiry@vocarelaw.com.au
This article was written by Simon Mason.
**The information contained herein does not, and is not intended to, constitute legal advice and is for general informational purposes only.
