A landmark win: Federal Court rules in favour of City Beach owners, setting new standard for Section 45B

Earlier this month the Federal Court handed down its decision Ierna v FCT [2024] FCA 59 (read the full decision here). This landmark win for Hamilton Locke and and the owners of City Beach highlights the importance of considering all the facts and circumstances in any business restructure.

The outcome

The Federal Court of Australia held that anti-avoidance provisions section 45B and Part IVA did not apply to a $52 million capital reduction that was part of a restructuring of a business.

About the case

The restructuring of the prominent Australian streetwear retailer, City Beach, has attracted the attention of the Commissioner of Taxation (‘Commissioner).

Nevertheless, Damien Bourke and Paul Thompson of Hamilton Locke successfully defended against the Commissioner’s application of section 45B and the general anti-avoidance provision in Part IVA of the Income Tax Assessment Act 1936, saving the owners of City Beach $52 million in tax liability.¹

This case marks the first time that section 45B of the ITAA 1936 (introduced 1 July 1998) has been tested in a Court.

This decision provides new insight into what entities might fall within the meaning of ‘associate’ for the purpose of determining whether a distribution of capital was attributable to profits.

The facts

Following an on-going ongoing audit of the City Beach group which began in late 2017, the Commissioner issued Amended Assessments to the Taxpayers, relevantly contending that the restructure of the business in the 2016 financial year was a scheme within the definition of section 45B ITAA 1936 that had been entered into to obtain a tax benefit. The most relevant tax benefit alleged is that each of the taxpayers received a capital benefit, being the attributable profits (unrealised or realised) of CBT being an associate of Methuselah Pty Ltd (Methuselah). Evidently, this argument relies on CBT being considered an associate of Methuselah.

The original structure

Although not a partnership in a legal sense, Mr Ierna and Mr Hicks founded the retail giant as business ‘partners’ where each held 15 units in a trust called the City Beach Trust (CBT), with Fewstone Pty Ltd as its corporate Trustee. Mr Ierna held most of his units personally. The remaining unit of Mr Ierna and all of Mr Hicks’ units were held in their respective family trusts, namely lerna Familty Trust (IFT) and Willian Hicks Family Trust (WHFT).²

Generally, CBT’s net income was distributed equally between WHFT and IFT, and as a matter of practice, the Trust unitholders would then appoint their income to a corporate beneficiary – Mastergrove Pty Ltd (Mastergrove). Mastergrove would then lend money to Messrs Ierna and Hicks, the Hicks Property Trust (HPT) and Ierna Property Trust (IPT).

In 2012, the practice shifted to WHFT and IFT appointing their income directly to Hicks Beneficiary Pty Ltd and Ierna Beneficiary Pty Ltd respectively. Hicks Beneficiary and Ierna Beneficiary then loaned funds to Messrs Ierna and Hicks, HPT and IPT. These loans (which were on complying with Division 7A terms) approximated $52 million as at 29 June 2016. Minimum annual repayments (including interest) were made each in compliance with the requirements of Division 7A.

The 2016 restructure

Mr Nathanael Lee of Mazars (formally Hanrick Curran) in 2014 proposed a restructure of the City Beach Group that did not proceed. The issue with this proposal was that it would have involved the sale of the pre-CGT business or units. Subsequently, in the first half of 2016, the proposal was reconfigured that would preserve the pre-CGT status of the business by incorporating a Division 615-A rollover (rather than a sale of the business). The following steps were taken to give effect to this restructure:

1. A new corporate entity was formed, called Methuselah, of which the shareholding mirrored the ownership of the units in CBT (15 shares were held by WHFT, 14 shares were owned by Mr Ierna and 1 share was owned by IFT);
2. Methuselah was interposed as a holding company of CBT. In doing so the controllers of Methuselah elected to obtain a 615-A rollover. The units in CBT were transferred to Methuselah in exchange for shares (Each unit was exchanged for 1 million shares).
3. A selective capital reduction was then undertaken resulting in a realisation of pre-CGT capital gains to the shareholders. This was done through the cancellation of 10.4 million of the ordinary shares in Methuselah held by each of Mr Ierna and WHFT at $2.50 per share.
4. Mr Ierna and WHFT agreed to loan (to Methuselah) the amount owed to them from the cancellation of their shares in Methuselah. The result of which was a no-interest no-security loan owed by Methuselah to Mr Ierna and WHFT for the amount of the cancellation ($52 million).
5. Mr Ierna and WHFT assigned almost the entirety of the $52 million loan owed by Methuselah to Mastergrove, Ierna Beneficiary and Hicks Beneficiary in satisfaction of their outstanding Division 7A loans.

The Section 45B Case:

This Commissioner’s case relied on the meaning of ‘associate’ in section 318 of the ITAA36 applied and that the CBT was an ‘associate’ of Methuselah. As an associate, it could be demonstrated that there had been an increase in the value of the units in CBT from $1 to $2,587,626 (the total valuation of the business divided by the 30 units). The misapplication of section 45B by the Commissioner turned on the interpretation of ‘associate’. In judgement, Logan J was confronted with two conflicting submissions.

1. The Commissioner argued that the role of ‘associate’ was attached to the trustee of the trust in its capacity as such with the implication that the profit of a trust was to be regarded as the profit of a trustee.
2. The Applicants argued, that as a trust has no separate legal personality, it is incapable of being an ‘associate’. Furthermore, the Trustee had no profits of its own which might be the source of the capital repayment.

In the judgment, Logan J found for the Applicants that though Fewstone as trustee of CBT might be an associate of Methuselah, the Trust itself was not able to be an associate. Fewstone did not itself have any realised or unrealised profits and therefore the return of share capital was not attributable to any of its profits. Further, the distinction between a trust and its trustee is expressly provided for in section 96 ITAA36 and that “except as provided for in this act, a trustee shall not be liable as trustee to pay income tax upon the income of the trust estate.”

Even if the Commissioner’s position was correct on the point of a trust being an associate, the existence of profits in the company or an associate must actually be a contributory cause of the decision to return the capital.

In his judgement, Logan J reasoned that section 45B could have no application and the Commissioner’s submission did not survive an objective examination of the whole of the circumstances. As articulated by His Honour at [209]:

“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 payment to the shareholders was wholly “attributable to” (actually sourced in or caused by) Methuselah’s share capital account. The method chosen had nothing to do with dividend substitution but was explicable by a purpose of taking advantage of Division 615- A rollover relief.”

Therefore, section 45B could not apply to the scheme postulated by the Commissioner. It is also worth noting that at no point did the Commissioner allege that the selective capital reduction had been a sham.

Considerations and expert guidance for restructures

This is the first time that section 45B has been tested in a Court or the AAT. It does, however, demonstrate yet another example of where a matter comes down to considering the entire set of facts and circumstances – it must survive an objective examination of the whole of the circumstances, not select facts.

The decision is being appealed by the Commissioner.

This landmark decision highlights the importance of considering all the facts and circumstances in any business restructure. If you’re navigating complex tax regulations or planning a corporate restructure, now is the time to seek expert advice to ensure compliance and avoid potential challenges. Reach out to our team to discuss how we can support your business through these processes.

¹Initially there was a Division 7A component – as part of the ‘primary case’. The Commissioner had previously maintained, what the trial judge found to be the ‘odd proposition’ that Division 7A applied to ‘repayments’ made of other Division 7A loans.

²Prior 1991, Mr Lerna held the 15 units directly.