When is a capital loss susceptible to Part IVA?

A loss for Merchant in the Full Federal Court for a wash sale, with a dividend strip and TOFA.

The Full Federal Court recently handed down its judgment in the Merchant appeal. We discuss the importance of the case and the insights it provides in relation to Part IVA generally, dividend stripping (section 177E) and the taxation of financial arrangements (TOFA) regime.

In Merchant, the Full Federal Court, by a 2–1 majority, held that a sale of ASX-listed shares to a related entity, which triggered a capital loss later used to offset a capital gain from a separate sale of interests to an unrelated entity, was subject to Part IVA. There was a clear divergence of views as to whether the ‘capital loss’ sale was immune from Part IVA. This divergence centred on the relevance of the broader commercial context of the sale, including whether it was a simple sale to a third party or was ‘artificial or contrived’.

Justice Logan found the sale to be immune from Part IVA and cautioned that the Commissioner’s focus on tax collection risked overemphasising the pursuit of tax benefits as the dominant purpose. However, the majority held that Part IVA did apply, emphasising that there is no blanket rule exempting third-party sales resulting in capital losses. This is especially true where the transaction lacks a genuine transfer of ownership risks or benefits, or where it is followed by an immediate repurchase. The majority also accepted that the dividend stripping rules can apply in respect of arrangements to clean up related party loans before a sale where they both have the purpose, and in fact have the effect, of substantially avoiding tax.

The case also highlights the potential for the Commissioner to take a heavy approach in respect of what he considers to be high risk arrangements. In this case, the Commissioner made determinations under both the general Part IVA provisions and the dividend stripping rules in section 177E, to which penalty and interest charges were added and have been maintained for almost a decade. At court, the Commissioner then declined to consider whether any compensating adjustments (which can be used to mitigate the effects of double taxation) should be made.

Facts

High level

At a high level, the case concerns a related party ‘wash sale’. The taxpayer’s group sought to crystallise a capital loss through the transfer of shares in Billabong Limited (BBG) to a related party self-managed superannuation fund with no change in the ultimate economic ownership.

This sale was undertaken in anticipation of the sale of interests in a further company, Plantic Technologies Limited (Plantic), to a third party. The third-party sale gave rise to a significant capital gain, which was largely due to the forgiveness of related party debts. The Plantic sale also included earnouts, which were contingent on sales and capital expenditure.

The taxpayer sought to offset the capital loss from the BBG sale against the capital gain on the Plantic sale, and also sought to claim deductions under the TOFA regime in respect of the earnout rights which expired due to their contingencies not being met.

In detail

Mr Merchant was the director and controlling mind of the Merchant Group, which included GSM Superannuation Pty Ltd (GSMS), the Gordon Merchant Superannuation Fund (GMSF) and the Merchant Family Trust (MFT).

In November 2010, MFT acquired all the shares in Plantic, which was a ‘start up’ company at the time. Relevantly, wholly-owned Merchant Group entities, including GSM Pty Ltd (GSM) and Tironui Pty Ltd (Tironui), were required to continually fund Plantic to the tune of $55 million (Plantic Loans).

On 31 March 2015 a third-party company, Kuraray Co Ltd (Kuraray) entered into a share sale agreement that resulted in it acquiring all of the shares in Plantic from MFT (Plantic Share Sale) in April 2015. A condition precedent to the completion of the Plantic Share Sale was that the Merchant Group entities would forgive amounts owing under the loans. The Plantic Share Sale and the forgiveness of the loans resulted in MFT making a capital gain of approximately $85 million in April 2015.

Mr Merchant knew that the Plantic Share Sale would result in a substantial capital gain. In September 2014, and on the advice of his tax agent, Mr Merchant arranged for MFT to sell shares in BBG to GMSF for approximately $5.8 million (BBG Share Sale). This sale crystallised a capital loss of approximately $56.5 million which was then applied against the $85 million capital gain in the 2015 income year. The reason the BBG Share Sale occurred in September 2014 (i.e. before the Plantic share sale agreement was executed) was said to be because of an ASX trading window for the BBG shares.

In July 2020 the Commissioner made determinations under section 177F of the Income Tax Assessment Act 1936 (ITAA 1936). The first determination was made in reliance upon section 177D (the general anti-avoidance rules (GAAR)) to cancel the tax benefit of the capital loss incurred by MFT on the BBG Share Sale. Further determinations were made in reliance upon section 177E that the entirety of the forgiven debt amounts by GSM and Tironui should be included in Mr Merchant’s assessable income (as sole shareholder) for the 2015 income year.

The decision at first instance

The first instance decision was handed down by Thawley J in May 2024.

General anti-avoidance rules

Thawley J concluded that the GAAR in section 177D was satisfied. It was conceded that the BBG Share Sale was a scheme resulting in a tax benefit. Therefore, the only issue at first instance was whether a person entered into or carried out the scheme for the dominant purpose of obtaining a tax benefit.

Thawley J found that the dominant purpose of Mr Merchant, the MFT and GMSF was to obtain a tax benefit. Having regard to the factors contained in subsection 177D(2), Thawley J found that:

• the BBG Share Sale was conceived in the context of the Plantic Share Sale;
  
  
• at the time of the BBG Share Sale, it was contemplated that the Plantic Share Sale would involve the forgiveness of the $55 million in loan amounts to increase the purchase price;
  
  
• the primary result of the scheme was that a capital loss crystallised;
  
  
• the BBG shares remained in the Merchant Group after the BBG Share Sale and Mr Merchant remained the ultimate economic owner.

Dividend stripping

Thawley J also concluded that the dividend stripping provisions were satisfied. Thawley J found that the forgiveness of the debts by GSM and Tironui had substantially the effect of dividend stripping schemes under section 177E. Relevantly, the dividend strip arose because:

• no consideration was provided for the forgiveness of the debt;
  
  
• the forgiveness:
  
  
  • reduced the undistributed accumulated profits of GSM and Tironui;
    
    
  • would have resulted in top-up tax when paid as dividends;
    
    
  • increased the value of Plantic’s shares and the consideration paid by Kuraray for those shares; and
    
    
  • resulted in an increased capital gain that was offset (in part) by capital losses.

In reaching this conclusion, his Honour considered that the effect of the Commissioner’s general Part IVA determinations to cancel the tax benefit must not be considered.

Taxation of financial arrangements (TOFA)

The other issue before Thawley J concerned the application of the TOFA regime in Division 230 of the Income Tax Assessment Act 1997 (ITAA 1997). Mr Merchant claimed the TOFA regime applied to certain earnout rights on the Plantic Share Sale, which were contingent on Plantic’s sales and capital expenditure (Milestone Amounts). He claimed the expiry of the rights to receive components of those amounts as revenue losses in the 2017 and 2018 income years (noting that the original capital gain included $51 million as capital proceeds from the market value of the Milestone Amounts).

Thawley J concluded that the TOFA regime did not apply because of the exception in subsection 230-460(13) of the ITAA 1997. This relevantly provided that a right to receive a financial benefit from the sale of shares is not subject to TOFA if the amount or value of the benefit is contingent only on the economic performance of the business after the sale (as the provision then read – the relevant provision has since been amended). This was because his Honour considered the Milestone Amounts were rights to receive financial benefits arising from the sale of shares in Plantic and the value of the benefits from sales volume were contingent on the economic performance of Plantic’s business after the Plantic Share Sale.

The Commissioner had also argued that the Plantic share sale agreement was a single arrangement. Therefore, there was no financial arrangement under section 230-45 because the arrangement included non-cash settleable rights, which were not insignificant (for example, rights to information, buyer obligations, non-compete and non-solicit obligations). The Commissioner argued that these obligations “formed part of the value being exchanged between the parties, and were intrinsic to the value of the cash settleable rights” that comprised the earnouts.

As the exception in subsection 230-460(13) applied, it was not necessary for Thawley J to conclude on whether a ‘financial arrangement’ existed within the meaning of section 230-45. However, Thawley J noted that he would have been inclined to conclude that, though these contractual provisions were significant in that they were important contractual protections, they were ‘typical’ contractual protections associated with post-completion financial benefits, and insignificant in comparison with the right to receive the future payments.

Thawley J also noted that, had it been necessary to decide, he would have been inclined to view each of the earnout rights as individual financial benefits “in light of the apparent object of the TOFA provisions”.

Full Federal Court

Mr Merchant appealed all three of the above aspects of Thawley J’s judgment to the Full Federal Court and was unsuccessful on the GAAR and TOFA arguments. However, Mr Merchant was partially successful in relation to section 177E (in respect of the debt forgiven by GSM only).

Separate judgments were handed down by McElwaine and Hespe JJ in the majority, and Logan J in the minority (although his Honour concurred on the TOFA outcome). Our analysis below focuses on the majority judgment.

GAAR – section 177D

The majority agreed with the primary judge and concluded that the GAAR under sections 177D and 177F applied.

In the appeal, the taxpayer argued that:

• the scheme was not artificial or contrived;
  
  
• the scheme served legitimate commercial purposes including maintaining control over the BBG shares, liberating cash from GMSF, placing the BBG shares in a protected superannuation environment and providing for the funding needs of MFT; and
  
  
• the primary judge inappropriately considered subjective purposes of Merchant Group entities.

The majority rejected all of these arguments.

Commercial purposes

The Commissioner accepted that a sale of shares to a third party to realise a capital loss to offset a likely capital gain does not attract Part IVA. The taxpayer then sought to compare the BBG Share Sale to a routine sale of shares to a third party, and to describe the BBG Share Sale as part of the third party Plantic Share Sale.

However, the central and important distinguishing features of this case, which the majority reinforced, were that:

• the sale of the BBG shares was to a related party and had no other practical, commercial or economic consequence for Mr Merchant as the ultimate controller; and
  
  
• the BBG Share Sale was a separate and unrelated transaction to the Plantic Share Sale.

These factors distinguished Mr Merchant’s circumstances to a ‘routine’ realisation of a capital loss to offset an anticipated capital gain. However, this is not a blanket rule. Their Honours also cautioned that Part IVA may apply to a sale of shares to an unrelated third party where the sale does not involve the vendor divesting the risks and benefits of ownership, or where the sale is accompanied by an immediate repurchase.

Their Honours also considered that a related party transfer can be an artificial or contrived arrangement, despite the related parties having different tax characteristics (in this case, a trust and superannuation fund). Their Honours considered that, when also regarding the crystallisation of a capital loss without any alteration to the effective economic ownership and control of the BBG shares, when it was known that a corresponding capital gain would be made on the Plantic Share Sale, the arrangement was contrived.

Their Honours also rejected the taxpayer’s remaining arguments, including that there was a need to release funds from GMSF and a need to maintain control of the BBG shares. In fact, Mr Merchant was able to withdraw cash from GMSF as needed because it was already in pension phase, the GMSF’s acquisition of the BBG shares was contrary to its investment strategy and, by holding shares in BBG through the MFT, Mr Merchant already controlled those shares.

Subjective purpose

Their Honours accepted that it is not appropriate to consider subjective purposes within the Part IVA analysis. Whilst their Honours agreed that it was unfortunate that the primary judge referred to an ‘actual purpose’, when Thawley J’s reasoning was read in its entirety, it could not be said that his Honour had inappropriately considered any entity’s subjective purpose.

Their Honours also noted that, whilst the taxpayer argued that Thawley J inappropriately considered subjective purposes, the taxpayer’s own submissions also included “considerable reference to the subjective evidence of Mr Merchant”.

Tax advisor communications

The case also illustrates the different focus that tax advisor communications can receive in Part IVA cases. Whilst it is trite to say that Part IVA is an objective test, the majority noted that the “existence of the advice and the content of the documents recording the advice are objective facts. It may be accepted that the seeking and obtaining of advice about the taxation implications of transactions of itself does not support a conclusion that the dominant purpose of a party to the scheme was to obtain a tax benefit. However, where a transaction is the product of advice, it is both possible and appropriate to take that advice into account in forming a conclusion as to purpose”. Importantly, Mr Merchant under cross- examination had stated that, with respect to the BBG Share Sale, he did “whatever I was directed to do”, by his taxation adviser

In contrast, in Mylan¸^[1] the Federal Court noted that with regard to “the use to which stray comments in emails may be put… they nevertheless need to be approached with some care. … Mylan was a highly sophisticated taxpayer with significant internal expertise. It obtained advice on a number of topics from a number of advisers, but ultimately had to make its own decisions regarding the transaction. This is not a case where the taxpayer can be assumed to have had no purpose distinct from its advisers... so comments in discrete internal emails of advisers cannot be elevated to impute an overarching purpose to Mylan in relation to broader structuring decision.”

Dividend stripping – section 177E

The Commissioner identified the forgiveness by each of GSM and Tironui of loans made to Plantic in the sums of $50.192 million and $4.215 million respectively for no consideration as schemes “having substantially the effect of a scheme by way of or in the nature of dividend stripping” for the purposes of section 177E(1)(a)(ii). Thawley J considered that the forgiveness by GSM and Tironui of the loans reduced undistributed accumulated profits and increased the value of the Plantic shares before concluding that section 177E applied in respect of those arrangements.

The majority considered that there are three important elements for a scheme to be by way of, or in the nature of, dividend stripping:

• content of the scheme: whilst their Honours considered that the content of a scheme is of little assistance following the decision in Lawrence,^[2] a dividend stripping scheme should involve the distributable profits of a company being extracted otherwise than by payment of a dividend;
  
  
• sole or dominant purpose of the scheme: there must be a purpose to avoid tax on a distribution of profits to the pre-existing shareholder of the company (rather than simply a broad tax avoidance purpose). The alternatives open to taxpayer should also be considered in determining this purpose. This is a forward-looking element which considers the intended outcome of the scheme when it was entered into. It is immaterial if that purpose is not in fact achieved (such as by, in this case, the Commissioner making a GAAR determination to cancel the tax benefit). Importantly for this factor, Plantic was not insolvent and the third party purchaser did not require the forgiveness of the loans. As such, their Honours considered there was no sensible commercial objective from the point of view of either GSM or Tironui in forgiving fully recoverable loans. Rather, whilst it was accepted that related party debt needed to be addressed to move the Plantic Share Sale, there was a “myriad of ways” in which this could be done.
  
  
• the effect or outcome achieved by the scheme: the effect of the scheme must be to strip accumulated past profits from the company, and there must be a substantial depletion of those accumulated profits without substantial tax being paid. Importantly, their Honours considered that merely pointing to the conversion of accumulated profits to a capital sum is not sufficient and the outcome “in fact produced by the scheme” can be considered “with the benefit of hindsight”. In the circumstances of the Merchant Group, the Commissioner made a GAAR determination to cancel the capital loss from the sale of the BBG shares to GMSF which had a retrospective effect that must be considered.

Considering the above three factors, the majority held that the Tironui debt forgiveness had the substantial effect of a scheme by way of or in the nature of dividend stripping because tax was avoided by available capital losses. However, the GSM debt forgiveness did not have that effect because, after the Commissioner cancelled the tax benefit, the capital gain was taxed in the hands of GSM (as beneficiary of the MFT) at a higher rate than a fully franked dividend would have been taxed to Mr Merchant personally (as the original shareholder in GSM).

Crucially, however, the majority considered that, had the Commissioner not made the prior GAAR determination and the scheme then operated as intended, then it may have been open for him to make further Part IVA determinations in relation to section 177E for both debt forgiveness arrangements.

Double taxation and compensating adjustments

This case is interesting because it involves a novel approach to the dividend stripping rules in section 177E and because the Commissioner made determinations under section 177E in addition to the determinations made under section 177D. The determinations were not made in the alternative, and the Commissioner sought to apply penalties and interest charges on top of those determinations. This can result in double taxation, with the Commissioner acknowledging that the outcome in this case was not fair and reasonable but declining to articulate if any compensating adjustments would be made.

This is consistent with the ATO’s general practice of compensating adjustments in which the ATO will generally only consider ameliorating the effects of double taxation after all appeal avenues are exhausted.^[3] This can have concerning outcomes, as highlighted by the majority in this case, especially given the Commissioner originally sought to maintain multiple Part IVA determinations, penalty assessments and interest charges going back nearly a decade.

TOFA and earn outs

The taxpayer argued that the expiry of the MFT’s rights under the share sale agreement to receive Milestone Amounts were subject to TOFA. This would have enabled the taxpayer to claim revenue losses in respect of these amounts on revenue account.

Various Milestone Amounts were available to the taxpayer. This required sales targets to be met and, in some cases, were affected by the capital expenditure incurred by the third party purchaser.

The majority concluded that the exception to the TOFA rules in section 230-460(13) as contained in the legislation at that time applied without considering the broader applicability of the TOFA provisions in depth. Because that exception was amended in 2016 to specifically refer to the definition in section 974-85, the majority’s analysis is of limited utility to the current reading of section 230-460(13). This is because as a result of the 2016 amendment, a contingency based only on receipts or turnover is not excluded under section 230-460(13).

Relevantly, the majority considered:

• The expression ‘contingent only on the economic performance’ bore its ordinary meaning when subsection 230-460(13) was inserted.
  
  
• Economic performance is not limited to accounting concepts of net profit or gross profit (e.g. volume of sales made by a business in a particular geographic region is an indicator of economic performance).
  
  
• It is sufficient for the payment of an identifiable sum to be contingent upon the economic performance of the business, regardless of whether the amount to be paid on satisfaction of the contingency is variable.

With respect to whether the relevant amounts were ‘financial arrangements’ to which the TOFA provisions would apply (noting it was not necessary to express a view on the subject as the rights were subject to the TOFA exception in subsection 230-460(13)), Logan J agreed with Thawley J that the rights would each be a ‘financial arrangement’ within the meaning of section 230-45. Logan J considered that the concept of a financial arrangement more naturally directs attention to an individual right or obligation in itself, as described and sourced in a specific contractual provision, rather than the overall contract in which that right or obligation is found.

A detailed overview of the application of the TOFA provisions to earnouts is beyond the scope of this article. However, the provisions have proven useful in ensuring that appropriate tax outcomes arise when an earnout is not a qualifying earnout. Whilst the ATO appears to have accepted that the TOFA provisions can apply to an earnout, on appeal, the ATO still sought to argue that TOFA would not apply. This is because the ongoing obligations (certain rights to information and undertakings imposed on the parties not to engage in a competitive business or solicit clients) were not insignificant compared to the right to receive future consideration.

^{[1]  Mylan Australia Holding Pty Ltd v Commissioner of Taxation (No 2) [2024] FCA 253 at [426].}

^{[2]  Lawrence v Federal Commissioner of Taxation [2009] FCAFC 29; 175 FCR 277.}

^{[3]  PS LA 2005/24 at [176].}