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November 18, 2016

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Is income splitting an "offense to public policy"?

October 5, 2015

One of the primary reasons small and medium sized businesses seek out the assistance of an accountant is to help them establish their business structures as tax effectively as possible. Other business owners try and setup their affairs themselves, often with only anecdotal knowledge of the corporate and tax law frameworks within which they operate.


For example, increasingly entrepreneurs appear to be trying to secure the talent they need by offering income splitting with their partner. Their intention is obviously to lower their personal income tax bill and help them get more money in their pocket. However, using these types of strategies without the expert advice of an accountant can often lead to a regrettable outcome.


This scenario was recently examined in an Insolvency case before the Federal Court wherein the judge ruled that this type of structure was based on employment contracts that were 'offensive to public policy' (Re: Perthmetro Pty Ltd (in liq) [2015] FCA 671).


This ruling has particular implications for companies going into liquidation because only legitimate claims by employees can be included in any final settlement of funds. 



Where Directors seek to split their own entitlements with a spouse then The Corporations Act automatically caps at a low figure the amounts that can be claimed preferentially in a Liquidation.


In the case under review, a liquidator in WA was appointed to a Perth-based construction company, Perthmetro. Whilst seeking to carry out the responsibilities listed above,  the liquidator noted liabilities to several employees who were unrelated to the directors of the company. The liquidator investigated these claims to ensure that the claims were legitimate before including them in any final settlement of funds.


The investigation determined a scenario in which Pethmetro had agreed with two employees and their spouses to have part of their remuneration paid directly to their spouses, one of whom also worked part-time for the company and one who did not. The primary purpose of the arrangement seemed to be to minimise tax. Under the arrangement the two employees were paid a salary such that they remained within a lower tax threshold and the balance of their remuneration was paid to their partners as if it were their weekly wages. This was clearly evident as one of the spouses did not perform any work on behalf of the company and the other was paid her husband's weekly salary portion in addition to the variable payments she had received for the hours she had actually worked.


The liquidator applied to the court pursuant to s511 (1)(a) of the Corporations Act to seek clarification as to whether these claims should be accepted or rejected on the basis that they may be illegal or offensive to public policy. The Judge agreed that the circumstances were offensive. The court ruled that the employment contracts were unenforceable and the liquidator should not admit the employee entitlement claims because the arrangements were structured to avoid the payment of tax that otherwise would have been payable.


The claims of these employees who actually worked in the business were disallowed entirely. However one spouse could claim only for the amounts arising out of her actual efforts because her separate contract of employment was not caught up in the offending arrangements.


This precedent provides a timely reminder to business advisers that if their clients are going to pay wages to multiple members of a family then in a Liquidation the court will evaluate their claims to ensure they are commensurate with the effort and skill each person has contributed to the business.


The court was not asked to consider any determinations of the Australian Taxation Office about income splitting in coming to his decision and he was also not involved with any determinations under the Government's Fair Entitlements Guarantee Scheme.


This article has, of course, not been published to offer advice, but to highlight the critical importance of obtaining informed guidance from a qualified tax or legal professional who can tailor their advice to your specific situation. 


Bruce Mulvaney is a Fellow Chartered Accountant and Turnaround and Insolvency Practitioner operating from Melbourne's eastern suburbs. He is a past State Chairman and National Board Member of Chartered Accountants Australia and New Zealand.
He is available to business groups and industry associations for speaking engagements.



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