However, earlier this year, the Full Federal Court took a different view, unanimously allowing the ATO’s appeal against the decision highlighting the risks of deducting expenses pursuant to undocumented related party arrangements.

Facts

S.N.A Group Pty Ltd, and ATPR Pty Ltd (Taxpayer Companies) were part of the Coronis Real Estate Group (Group). Certain assets of the Group (including rent rolls and IP) (Trust Assets) were owned by two trustee companies (Trustee Companies) for asset protection and commercial reasons.

Between 2005 and 2015 licence agreements between the Taxpayer Companies and Trustee Companies (Licence Agreements) governed the use of the Trust Assets in consideration for the payment of a service fee. After the Licence Agreements came to an end in 2015, the Taxpayer Companies continued using the Trust Assets in exchange for the payment of certain fees to the Trustee Companies (Service Fees).

The Taxpayer Companies then claimed deductions under 8‑1 of the Income Tax Assessment Act 1997 (Cth) on the basis that they were ‘service fees’ paid to the Trustee Companies for the use of the Trust Assets. The ATO disagreed, arguing there was no contractual obligation on the Taxpayer Companies to pay the Service Fees to the Trustee Companies once the agreements expired in 2015 and that around $19 million of Service Fees were therefore non-deductible over the 2016 to 2019 income years.

Federal Court Decision

Dissatisfied with the assessment, the Taxpayer Companies successfully appealed to the Federal Court. While Logan J accepted that the Licence Agreements had come to an end, the Taxpayer Companies were subject to a liability, ‘contractual in nature’, to pay the Trustee Companies’ Service Fees in each relevant year. Therefore, all amounts claimed as deductions were paid to satisfy the liability under an inferred contract, and were thereby allowable deductions.

This decision was welcomed by the SME space because it reflected how many SME groups actually operate in practice, the Court noting that ‘perfection in documentation does not dictate eligibility to a deduction.’

Full Court of the Federal Court

However, on appeal, the Full Court unanimously overturned that decision.

hile the Court did not suggest the arrangements were artificial or that service entities are inherently problematic, the Court found that there was a lack of evidence to substantiate an agreement which made the Taxpayer companies liable to pay fees for the use of the Trust Assets.

In coming to this conclusion, the Court drew attention to the following:

1. there was no written contract giving rise to the obligation to pay the Service Fees after 2015;
2. there was no contemporaneous evidence of communication or conduct showing that the Taxpayer Companies (or their directors) requested the use of the trust assets or agreed to pay the Service Fees to the Trustee Companies, or that the Trustee Companies agreed to the use of the Trust Assets in exchange for Service Fees;
3. the Service Fee payments made were ‘incoherent, inconsistent and seemingly random’, being mixed with reimbursements of expenses incurred by the Trustee Companies and transfers of the surplus funds held by the Taxpayer Companies. They were inconsistent with the asserted agreement that the Taxpayer Companies would pay a fair and reasonable fee no more than 8% of the market value of the net assets of the Trustee Companies; and
4. there was no evidence that the directors of the Trustee Companies or Taxpayer Companies had communicated to the Group’s bookkeeper or external accountant that the Taxpayer Companies were liable to pay for the use of the Trust Assets.

While the directors of the Taxpayer Companies subjectively believed that they were obliged to pay Service Fees to the Trustee Companies for the use of the Trust Assets and that the Service Fees were fair and reasonable, this was not enough; the absence of contemporaneous evidence supporting the agreement meant that a contractual liability to pay the Service Fees did not arise after the written agreements ended in 2015.

Takeaways

While much of the recent focus on intra group fees has been on whether they are at an arm’s length level, this decision brings into sharp focus that fact that there must be a contractual obligation to pay the fees in order to claim a deduction.

If your group has related‑party service fee or licensing arrangements, you should keep the following in mind:

• Courts will require objective evidence of there being mutual obligations owed by the parties to the agreement.
• The subjective intentions of common directors of the parties to the purported contract will be insufficient.
• Arm’s length pricing (i.e. payment of a ‘fair and reasonable fee’) doesn’t necessarily prove a contract exists.
• Accounting labels don’t create legal liabilities.

Critically, while documentation regarding intra-group arrangements doesn’t need to be perfect, something should be in writing to prove intra-group arrangements exist. Even short, simple agreements reviewed periodically would likely have changed the outcome in this case.

For further information, contact Philip Diviny, Principal on philip.diviny@madgwicks.com.au

The information provided in this article is general in nature and cannot be relied on as legal advice, nor does it create an engagement. Please contact one our lawyers listed above for advice about your specific situation.