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A selective capital reduction to extinguish Division 7A loans that raised the Tax Office's eyebrows was not a “sham”, the Federal Court has ruled.
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City Beach founders win tax battle with ATO over $52m restructure
12 June 2024
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The founders of fashion retailer City Beach have won a tax battle with the ATO after the Federal Court ruled that a $52 million capital reduction was a legitimate commercial restructure and not a tax avoidance scheme.
Queensland businessmen Carmelo Ierna and Melville Hicks, who founded the brand in 1985, challenged assessments issued by the ATO that demanded millions in income tax over what it deemed “capital benefits” from restructuring to extinguish Division 7A loans.
In a judgment last week, Justice John Logan ruled that the restructuring was not to avoid the inclusion of the $52 million dividend in their assessable incomes but to “use pre-CGT assets to repay the Division 7A loans”.
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“There has never been, and there could not be, any suggestion that any step in the selective capital reduction was a sham,” he said.
“The Commissioner’s submission does not survive an objective examination of the whole of the circumstances … the assessments have been proved to be excessive.”
Ierna and Hicks ran their business through a trust structure called City Beach Trust (CBT). On the advice of Mazars (known as Hanrick Curran at the time), CBT was restructured in 2016 to address issues with Division 7A loans caused by taxation ruling TR 2010/2.
The ruling, now replaced by TD 2022/11, made unpaid present entitlements owed by trusts to an associated private company Division 7A loans.
While the immediate impact of the ruling was “cushioned by reduced profits” of the business, by 2016, it meant that City Beach “no longer had any room to manoeuvre” over a number of its loans, Justice Logan found.
“Given the structure by which the CBT business was conducted, financing requirements for the conduct of that business, existing third party finance facilities and related securities and net assets at their command (apart from units in the CBT), Messrs Ierna and Hicks no longer had any room to manoeuvre in relation to the Division 7A loans. These loans needed to be repaid by the end of that income year,” he said.
On Mazars’ advice to repay the outstanding loans, a new company called Methuselah Holding, jointly owned by Ierna and Hicks, was registered. In May 2016, it became the holding company of CBT by issuing shares to Ierna and Hicks in exchange for their units.
To realise value from the shares held in Methuselah, Ierna and Hicks implemented a selective capital reduction, which resulted in a cancellation amount payable of $52 million ($26 million each).
Loan agreements were put in place to recognise debts, Mazars said, since the share buy-back created a liability in Methuselah payable to Ierna and Hicks that it “would not have the cash available to fund”.
The loans were then assigned to other entities within the City Beach group, redistributing the debt and allowing for repayment of its outstanding Division 7A loans.
However, following an ATO audit in 2018, the Commissioner issued amended tax assessments that slugged Ierna, Hicks and their related entities with millions in additional tax payable. Ierna’s tax bill increased from $300,500 to over $18 million, while Hicks’ bill went from $290,100 to over $15 million.
The Commissioner argued the City Beach founders’ “scheme” was designed to avoid including a dividend of $26 million in their assessable income and therefore fell under sections 45B, 45C anti-avoidance provisions relating to capital benefits and Part IVA as the general anti-avoidance provision of the Income Tax Assessment Act 1936.
But Justice Logan ruled in the taxpayers’ favour, rejecting the Commissioner’s arguments as “on no objective view could the return of capital from that account to its shareholders be regarded as a substitute for the payment of a ‘dividend’ as defined, to them”.
The fact that Methuselah was a newly formed company without any profit history meant it had no pattern of distributions of dividends, bonus shares and returns of capital or share premium, he said.
“The payment to the shareholders was wholly “attributable to” (actually sourced in or caused by) Methuselah’s share capital account”.
“Objectively in any event, as well as insofar as relevant at all, subjectively on the part of Mr Lee, Messrs Ierna and Hicks had, directly or indirectly, a means – indeed the only means – of repaying these loans. That was via the disposal of the pre-CGT assets constituted by units in the CBT trust.”
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