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Focus: Threshold for successful prosecution of promoter penalty claims lowered

11 September 2013

In brief: In the first appeal court guidance on the proper construction of the promoter penalty provisions, the Full Federal Court has upheld an appeal by the Commissioner of Taxation regarding their application and, in doing so, lowered the threshold for a successful prosecution of a promoter penalty claim. Partner Tony Kuhn (view CV), Senior Associate Jonathan Joseph and Lawyer Sarah Gittus report.

How does it affect you?

  • This case1 is significant because it is the first time the promoter penalty provisions in Division 290 of Schedule 1 to the Taxation Administration Act 1953 (Cth) have been considered by a court (at first instance and on appeal) since they were introduced in 2006.
  • Upholding an appeal by the Commissioner of Taxation concerning the application of the promoter penalty provisions, the Full Federal Court found that the two respondents were promoters of a tax exploitation scheme, and therefore remitted the case to a single judge on the question of penalties.
  • The court found many aspects of the primary judge's approach to the promoter penalty provisions too narrow, and too generous to the alleged promoters' position. The judgment has, therefore, lowered the threshold, set by the primary judge, for the Commissioner to successfully prosecute a promoter penalty case.
  • The court also found that, to establish a breach of the promoter penalty provisions, the Commissioner is not required to plead and prove what an entity would have done if it had not entered into or carried out the scheme, and what its hypothesised tax position would have been in such circumstances (ie the 'alternative postulate'). This contrasts with the position under the anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 (Cth).
  • In a regulatory environment in which the Australian Taxation Office has identified promoters of tax schemes as an area of focus, the Full Court's decision can be expected to lead to a rise in prosecutions of alleged breaches of the promoter penalty provisions.

Overview of promoter penalty provisions

Under the promoter penalty provisions in Division 290 of Schedule 1 to the Taxation Administration Act, an entity must not engage in conduct that results in it or another entity being a promoter of a tax exploitation scheme (section 290-50(1)), or that results in a scheme that has been promoted on the basis of conformity with a product ruling being implemented in a way that is materially different from that described in the product ruling (s290-50(2)).

An entity will be considered a promoter if:

  • the entity markets, encourages the growth of, or encourages interest in, a tax exploitation scheme; and
  • the entity or an associate receives (directly or indirectly) consideration in respect of the marketing or encouragement; and
  • it is reasonable to conclude that the entity had a substantial role in the marketing or encouragement (s290-60(1)).

The Commissioner can seek a civil penalty in relation to a contravention of the promoter penalty provisions (s290-50(3)) or can seek an injunction restraining advisers from promoting tax exploitation schemes (s290-125).

The facts

FCT v Ludekens concerned the actions taken by the two respondents to secure investors in a managed investment scheme, known as the 2006 Gunns Woodlot Project, relating to the cultivation and harvest of trees for timber (the project). The project was the subject of a favourable product ruling by the Australian Taxation Office.

The Commissioner asserted that, in broad terms, the respondents' alleged scheme comprised a plan:

  1. to acquire fully financed woodlots in the project;
  2. to meet loan obligations in respect of the acquisition of these woodlots from profits obtained by investing, into a foreign exchange business carried on by the second respondent, a fund comprising the following:
    1. commission received from Gunns in respect of the acquisition of the woodlots;
    2. GST refunds to be obtained, in accordance with a product ruling, in respect of the acquisition of the woodlots; and
    3. funds obtained from offering the woodlots to subsequent investors; and
  3. to otherwise retain profits from investing the fund in the foreign exchange trading business.

The Commissioner argued that, having regard to this scheme, the respondents breached the promoter penalty provisions in their dealings with investors, regarding the initial acquisition of interests in the project, and also in relation to their dealings with secondary investors regarding the later on-sale of some of those interests.

Specifically, in seeking to invoke the promoter penalty provisions, the Commissioner argued that:

  • there was a scheme, along the lines of the plan referred to above;
  • it was a tax exploitation scheme;
  • each of the respondents was a promoter of the tax exploitation scheme and/or engaged in conduct that resulted in the other being a promoter of the scheme; and
  • one or both of the respondents received consideration in respect of that marketing or encouragement, in the form of: (a) commission received from Gunns for the acquisition of the woodlots; (b) GST refunds in respect of the acquisition of the woodlots in accordance with the product ruling; and (c) tax refund promises made by the investors to the two respondents.

The Commissioner also argued that the project had not been implemented according to the relevant product ruling, and that the respondents were involved in the promotion and encouragement of a 'secondary investment' related to the original managed investment scheme for which the product ruling had been given, even though it could not apply to the secondary investors.

The Full Federal Court's decision

The Full Court upheld the Commissioner's appeal and found that the two respondents had contravened the promoter penalty provisions. In its judgment, it addressed the following key issues concerning the proper construction of these provisions:

(i) Does the identification of a scheme benefit require consideration of an alternative postulate?

Under the promoter penalty provisions, one of the conditions for a scheme to be a tax exploitation scheme is that it must be reasonable to conclude an entity2 that entered into or carried out the scheme (alone or with others) did so for the sole or dominant purpose of that entity, or another entity, getting a 'scheme benefit' (s290-65). An entity gets a scheme benefit if a tax-related liability of the entity is less, or an amount the Commissioner must pay or credit to the entity is greater, than it would be apart from the scheme or a part of the scheme (s284-150).

The primary judge found that this required the Commissioner to plead and prove what an entity would have done if it had not entered into or carried out the scheme, and what its hypothesised tax position would have been in such circumstances (ie the 'alternative postulate').

The Full Court concluded that the primary judge was mistaken in this analysis and that, instead, the provisions only require the assessment of the purpose of a relevant entity at the time of the promotional conduct. The alleged promoters were considered the relevant entities in this context, given that they, along with the other investors in the scheme, entered into and carried out the scheme.

It is not necessary to consider notions of alternative positions when assessing the purpose of a relevant entity. The Full Court distinguished the promoter penalty provisions from the anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 (Cth), which expressly require the consideration of the alternative postulate.

(ii) What was the dominant purpose of the relevant entities?

The Full Court determined that, contrary to the primary judge's finding, the respondents, as entities who entered into or carried out the scheme, did so with the dominant purpose of obtaining scheme benefits (namely, GST refunds and tax refunds) for themselves and others in the scheme.

The court noted that the time at which the matters relevant to the enquiry of whether there was a purpose of getting a scheme benefit are to be assessed is the time of the marketing or encouraging to the entities who entered into or carried out the scheme, which should be understood as covering the whole period prior to and after the implementation of the scheme, whether or not the scheme was implemented and whether it was partly or fully implemented.

(iii) Did the respondents market, encourage the growth of, or encourage interest in, the scheme?

The primary judge found that the respondents were not promoters of the scheme because they were merely involved in developing and implementing it.

The Full Court found that the primary judge's construction of the definition of 'promoter' was too narrow. It observed that, to a point, it could be accepted that activity or conduct that might be described as implementation of a scheme that was of a day-to-day administrative kind, without any element of communication with prospective entrants or the publishing of the advantages of the scheme, does not fall within the definition of 'promoter'. However, the court held that conduct that, when looked at individually, may be considered to be development or implementation may, when examined as a whole in its proper context, form part of a body of conduct that amounts to marketing or encouraging the growth of or interest in a scheme. On this basis, the court found that each respondent's conduct, in relation to both the initial investors and the secondary investors, was marketing and encouraging the growth of, or interest in, the scheme.

(iv) Did the respondents receive consideration in respect of marketing or encouragement in relation to the scheme?

The primary judge found that the respondents did not receive consideration in respect of the marketing or encouragement of the scheme as there was no requisite material connection between the commission and GST refunds and the respondents' promotion of the scheme.

The court held that the primary judge's interpretation of the 'in respect of' requirement was too narrow. According to the court, when the scheme was looked at as an integrated whole, there was a sufficient and clear connection and relationship between the commission received from Gunns and the GST refunds from the acquisition of the woodlots for such consideration to be in respect of the marketing or encouragement of the growth of or interest in the scheme.3

(v) Was the scheme implemented in a materially different way from that described in the product ruling?

The promoter penalty provisions prohibit an entity from engaging in conduct that results in a scheme that has been promoted on the basis of conformity with a product ruling being implemented in a way that is materially different from that described in the product ruling (s290-50(2)).

The Full Court noted that the purpose of the provision was to preserve the integrity of the product ruling system so as to ensure that those that 'implement' schemes that are the subject of product rulings do so in a way that ensures that participants can rely on the rulings.

In relation to this provision, the court found as follows:

  1. There was no breach of s290-50(2). The court emphasised that this provision applies to the implementation of a scheme that is subject to a product ruling in a different way from that described in the ruling.
  2. On the other hand, where a scheme is promoted on the basis of conformity with a product ruling, but in fact falls outside the scope of that product ruling, as was the case in relation to the secondary investment in the project, the implementation of that scheme will not result in a contravention of s290-50(2). However, the promotion of such a scheme may contravene s290-50(1) and other consumer protection legislation prohibiting misleading and deceptive conduct.
  3. The mere fact an entity that enters into a scheme is not within the class to whom a product ruling applies does not cause the scheme to be implemented in a way that is materially different from that described in the product ruling.

The Full Court remitted the question of penalty for hearing by a judge of the court. The current maximum civil penalty for a breach of the promoter penalty provisions by an individual is the higher of $850,000 or twice the consideration received (directly or indirectly) by the individual and their associates in respect of the scheme (s290-50(3)).

It also remains to be seen whether any of the parties will seek special leave to appeal this decision to the High Court of Australia.

Significance of the decision

The Full Court's decision and the first instance decision have provided the court with its first opportunity to interpret the promoter penalty provisions. As such, it is a significant development in the promoter penalty laws and better equips the Commissioner in future cases.

Assuming the decision is not overturned in any appeal, the lower threshold to establish a promoter penalty claim is likely to result in the Australian Taxation Office continuing to sharpen its current focus on such claims.

Footnotes
  1. FCT v Ludekens [2013] FCAFC 100 (Full Federal Court, Chief Justice Allsop, Justices Gilmour and Gordon, 29 August 2013, to be reported in ATR).
  2. 'Entity' is defined in s960-100 of the Income Tax Assessment Act 1997 (Cth) as including, inter alia, an individual, a body corporate and a partnership. Each respondent in the present case, having entered into or carried out the scheme, was an 'entity' for the purposes of the promoter penalty provisions.
  3. Regarding the consideration requirement, the Full Court agreed with the primary judge's refusal, having regard to the pleadings and the running of the trial, to permit the Commissioner to rely upon the promises by the secondary investors to pay their tax refunds over to the respondents.

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