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Cite as: (2005) 79(4) LIJ, p. 64

Even if there is a commercial reason for making a payment, taxpayers must be able to demonstrate a commercial purpose for the amount and timing of the payment, particularly if it is made at the end of the financial year.

In Pridecraft Pty Ltd v FC of T [2004] FCA 339 (Pridecraft), the Full Federal Court disallowed the taxpayer’s appeal against the decision of the Federal Court in FC of T v Spotlight Stores Pty Ltd [2004] FCA 650, upholding the application of Part IVA of the Income Tax Assessment Act 1936 (the Act) to disallow a deduction for an amount contributed by an employer to a trust fund out of which future bonuses to employees were to be paid.

The facts

During the 1996/97 financial year, the directors of Spotlight Pty Ltd (Spotlight) identified a number of problems with its existing employee bonus scheme and, following advice given at a seminar attended by one of the directors, decided to replace it with a new scheme (post-1997 Scheme). The advice was for only one-third of an employee’s bonus to be paid immediately, with the balance being held in reserve and paid over the next two years, thus providing a longer term incentive for employees.

On 30 June 1997, the following happened pursuant to resolutions of the Spotlight directors on that day:

  • a trust fund (Incentive Trust) was established for a class of beneficiaries comprising employees fulfilling certain criteria, to which amounts would be contributed by Spotlight each year for the payment of employee bonuses at the discretion of the trustee;
  • $15 million was contributed by Spotlight to the Incentive Trust; and
  • $14.8 million was lent by the trustee back to Spotlight at interest.

The amount of $15 million was based on an estimate by Spotlight’s finance manager of the amount of employee bonuses that would be payable over the first five years of the post-1997 Scheme (which proved to be accurate).

First instance decision

At first instance, Merkel J held that the $15 million contribution to the Incentive Trust was fully deductible to Spotlight in the 1996/97 income year under s51(1) of the Act, holding that the contribution was not capital or of a capital nature. His Honour found that the contribution was designed to enable payment of bonuses to Spotlight’s employees over the ensuing five years and was to be drawn on progressively throughout that period, in substitution for annual contributions that Spotlight would have had to make over the period.

However, Merkel J held that Part IVA of the Act applied to enable the Commissioner to make a determination to disallow the whole of the deduction. His Honour found that there was both a commercial purpose and the purpose of obtaining a tax benefit in connection with the scheme (which was defined as the creation of the trust, the making of the contribution and the loan back to Spotlight) but concluded, having regard to the eight matters in s177D(b), that the dominant purpose of entering into the scheme was to obtain the tax benefit.

This conclusion was based on the following findings:

  • the employees had not been informed in any meaningful sense about the Incentive Trust or the amount of the contribution made to it, which undermined the commercial benefits of the employees perceiving the scheme as an incentive;
  • there was a large disconformity between the $15 million contribution and the amount necessary to secure the commercial objectives;
  • there was no commercial or legal reason why it had to be done by 30 June 1997; and
  • the scheme had minimal financial impact on Spotlight because of the “round robin” loan back arrangement. (With respect, this ignored the fact that the company now had real financial commitments under the loan, there being no finding that it was not a genuine loan, even if there may have been no immediate cash impact.)

Full Federal Court decision

The Full Federal Court upheld the decision of Merkel J in relation to both s51(1) and Part IVA.

Sackville J (with whom Ryan and Sundberg JJ agreed) dismissed the taxpayer’s allegations of factual errors and inconsistencies in Merkel J’s judgment.

Sackville J said there was no inconsistency between the findings in relation to s51(1) and the conclusion of dominant purpose under Part IVA, noting that the inquiry under s51(1) is quite different from that under s177D(b) and a finding under s51(1) does not foreclose the inquiry required by Part IVA.

Nor was there any inconsistency between the findings of commercial purpose and the conclusion that there was a dominant purpose of obtaining a tax benefit under Part IVA, as this is a “false dichotomy” in accordance with the decisions in FC of T v Spotless Services (1996) 186 CLR 404 and FC of T v Hart (2004) 206 ALR 207.

Sackville J rejected a challenge to the finding that a payment of $15 million was not commercially necessary, noting that Merkel J rejected the assumption that it was necessary to secure a sum equivalent to the total bonuses expected to be paid and found that the only sums theoretically at risk were the amounts in the “reserves” from time to time, which would have required a much smaller contribution.

Sackville J did not accept that Merkel J erred in not considering that the commercial benefits of the Incentive Trust were not available under an alternative scheme. His Honour did not accept that a separate reserve in Spotlight’s accounts was not a practical alternative to the Incentive Trust. Further, even if there was no alternative to the Incentive Trust, that did not mean that a contribution of $15 million on 30 June 1997 was necessary.

Sackville J said that the important factors indicating a dominant purpose of obtaining a tax benefit under s177D(b) were:

  • the fact that the contribution of $15 million bore no relationship to the amount required to meet Spotlight’s commercial objectives (his Honour said this was the most important factor);
  • the timing of the contribution: there was no commercial need or advantage for any contribution to be made in the 1996/97 income year, let alone on the last day of that year, and the timing of the contribution was inexplicable except as a means of obtaining a tax deduction for the whole of that amount in the 1996/97 year, thus deferring a very large amount of tax; and
  • the round robin arrangement: this enabled Spotlight to obtain a large and immediate tax benefit without having to part with any more than $200,000 in the 1996/97 year.

Finally, Sackville J dismissed any suggestion that the tax benefit was only the difference between the $15 million and the amount it would have contributed to the Incentive Trust for purely commercial purposes as, on the primary judge’s findings, the smaller contribution would not have been made in the 1996/97 year.


The Full Federal Court dismissed the Commissioner’s cross appeal on penalty, upholding Merkel J’s decision that the argument that Part IVA did not apply was “reasonably arguable” for the purposes of s222L of the Act (now s284-15 of Schedule 1 to the Taxation Administration Act 1953).

Sackville J agreed with Merkel J that the competing arguments on the application of Part IVA were sufficiently finely balanced to warrant the taxpayer’s position being characterised as “reasonably arguable”. Given the undisputed evidence that the post-1997 Scheme as a whole was prompted by a desire to restructure the previous bonus scheme and had a genuine commercial objective, Sackville J thought it was fair to say that there was room for a rational argument that, viewed objectively, Spotlight’s dominant purpose in entering the scheme was not to obtain a tax benefit.

Fringe benefits tax (FBT)

The Full Federal Court held it was not necessary to deal with the appeal against Merkel J’s holding that Spotlight was not liable to pay FBT on the contribution of $15 million to the Incentive Trust, as the Commissioner had conceded he would not proceed with the FBT assessment if he succeeded on Part IVA.

Sackville J said it was undesirable to consider the correctness of the decision in Essenbourne Pty Ltd v FC of T [2002] FCA 1577 and the reasoning of Hill J in Walstern v FC of T [2003] FCA 1428, which was challenged by the Commissioner, when it was not necessary to do so.


The decision illustrates that, even if there is a commercial reason for making a payment, it is important to be able to demonstrate a commercial purpose for the amount and timing of the payment (particularly if it is made at the end of the financial year).

It is interesting to note that Sackville J refers a number of times to determining Spotlight’s purpose in entering into the scheme or any part of the scheme. With respect, while s177D(b) refers to the purpose of any person who entered into or carried out the scheme “or any part of the scheme”, it still requires the purpose of entering into the entire scheme, not just a part of it, to be determined (see FC of T v Peabody (1994) 181 CLR 359). However, given the breadth of the concept of “scheme” after Hart, indicating that a scheme can comprise a particular aspect of a transaction, this distinction may be of little consequence.

Finally, as the tax benefit in Pridecraft was the $15 million tax deduction in the 1996/97 year, rather than over the subsequent five years (note that the prepayment provisions in s82KZM did not apply as the contribution to the Incentive Trust was not “expenditure under an agreement” in return for a “thing to be done”), presumably the Commissioner should make compensating adjustments under s177F(3)(b) to allow deductions in the subsequent years for the amounts that would have been paid in those years in the absence of the scheme. Sackville J specifically referred to the possibility of such compensating adjustments.

JANE TRETHEWEY is a partner in the tax group of Blake Dawson Waldron’s Sydney office.


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