Insights | deferred compensation – the Blank case

This article examines the High Court’s affirmation of the primary decision of Justice Edmonds and the Federal Court of Appeal’s majority upholding that primary decision in Blank v Commissioner of Taxation [2016] HCA 2.  A copy of the High Court decision may be accessed here.

In our view, the High Court’s reasoning is less interesting than the primary decision of Justice Edmonds because, in essence, the High Court agreed with the majority of the Federal Court which in turn agreed with his Honour’s findings; consequently, the appellate decisions did not consider each of the arguments raised during the primary trial as there was no judicial need to pursue the full extent of the parties’ contested positions.

The facts

Justice Edmonds recounts the facts of the case at paragraphs [11] to [46] of the primary decision.  In a nutshell, there were a series of documents across a number of years which created an entitlement to deferred compensation in respect of his employment calculated by reference to, amongst other things, the profits of his “employer” (that expression is used here in a very loose sense to avoid describing the Glencore group of companies).

Importantly, the relevant documents themselves expressly referred to the purpose of the profit participation plan as a means of rewarding the taxpayer with deferred compensation for his services.

Competing tax provisions

Due to the structure of the Income Tax Assessment Acts (being the 1936 and 1997 Acts), the deferred compensation was potentially capable of being assessed under a number of different provisions, which resulted in different tax profiles for the amounts received by the taxpayer.

The heads of assessability considered by Justice Edmonds were:

  1. The payments were assessable as dividends.
  2. The payments were assessable as ordinary income.
  3. The payments were assessable as eligible or employment termination payments.
  4. The payments were assessable as a capital gain.

There was a fifth argument which the taxpayer sought to agitate following his Honour publishing his reasons but before the pronunciation of the final orders, being that the payments were exempt from tax under section 23AG (which concerns foreign service).  The reasoning in respect of the fifth argument appears in the separate judgment delivered in Blank v Commissioner of Taxation (No 2) [2014] FCA 517 which may be accessed here.

Dividend analysis

The first argument considered by Justice Edmonds was the Commissioner’s contention that the deferred compensation payments were dividends.  His Honour held that the instruments issued in connection with the deferred compensation scheme were not “equity” interests and therefore the payments could not be assessed as dividends on equity interests.

Insight: this brief summary does not do justice to Justice Edmond’s analysis of the “debt-equity” provisions in Division 974 of the 1997 and tax professionals are encouraged to work through the decision as it provides guidance on working through those provisions which can be perplexing when sought to be applied against less frequently encountered, complex or hybrid funding schemes and arrangements.

Ordinary income

The second argument, which was ultimately the basis upon which the taxpayer was held to be assessed, proceeded on the basis that the taxpayer derived the deferred compensation as a reward for services as an employee on a cash basis.

As the majority of the justices in the Federal Court appellate decision said (at [30]):

“The beginning and end of the primary judge’s analysis of the nature of the payments were the agreements. His Honour stated (Blank [2014] FCA 87 at [95]):

There can be no doubt, if the recitals (called preamble) to the instruments under the last two manifestations of the PPPs – the IPPA 2003 and the IPPA 2005 – can be taken as a guide, that the plans were intended by the relevant parties – GI, [Glencore] AG and the applicant – to provide the applicant with deferred compensation in consideration of the services to be rendered by the applicant to his Glencore Group employer. Further support for this conclusion is to be drawn from the operative part of the instruments, in the case of the IPPA 2005 – the definition of Incentive Profit Participation/IPP and Plan in paras 10 and 16; Clause [A.1.1]; “GI grants Employee deferred compensation…”; and Clause A.1.2 refers to GS being “issued solely for the purpose of … calculating the amount of deferred compensation”.”

The majority of the Federal Court on appeal concluded Justice Edmonds did not err in his Honour’s findings that the payments received by the taxpayer were assessable at ordinary income (at [92]).

The High Court stated (at [63]):

“As the majority of the Full Court correctly concluded, what the IPPA 2005 conferred on Mr Blank was an executory and conditional promise to pay an amount at a future date determined by reference to the PPU allocated to Mr Blank.  The fact that the Amount was paid after the termination of the contract of service, by a person other than the employer (here, GI) and separately to ordinary wages, salary or bonuses, does not detract from its characterisation as income if the payment is, as here, a recognised incident of the employment”

This being so, it was monetary amount to which the taxpayer was entitled to receive under the executory promise that was the reward for the taxpayer’s service to the Glencorp group of companies, and not a “bundle of rights” which could be likened to an entitlement of a shareholder.

Insight: “if it looks like a duck, walks like a duck, quacks like a duck…“; the lesson here is that the tax outcome will be strongly influenced by the language adopted in legal documents; in the Blank case, the legal documents were consistent with the commercial reality of the scheme providing the taxpayer with deferred compensation.  

It is interesting to note that the “bundle of rights” approach taken by dissenting Justice Pagone on appeal in the Federal Court still did not result in the tax timing result sought by the taxpayer (i.e. to the period before he became a tax resident and was not assessable on foreign source income) – but it would have resulted in a lesser tax profile due to the operation of the capital gains tax discount.

Insight: we consider that the bundle of rights analysis preferred by dissenting Justice Pagone may yet be revisited by the Courts in a different commercial context (as the outcome of the Blank case turned upon the language of the documents giving rise to the payments received by the taxpayer and its nexus with his employment).

Employment Termination Payments

Justice Edmond’s conclusion (at [106]) on this issue is, on our view, unassailable as the documents themselves made it plain that the deferred compensation was a reward for services rendered and not payable in consequence of the taxpayer’s employment; the fact that termination was the event upon which such payments became payable was not sufficient for it to be held that the payments were made in consequence of the termination.

Insight: if it is intended that a payment be characterised as an eligible or termination payment, the documents should be expressed in such language.  Some types of eligible or termination payments attract a concessional tax treatment (within certain limits) meaning certain executives/employees will prefer such a tax characterisation if it is not possible to be assessed under the capital gains tax regime.  

Capital gains tax

Justice Edmond’s conclusion (at [107]) that the payments were in the nature of a reward for service and assessable as ordinary income meant that it was unnecessary to consider their taxation under the capital gains tax regime.  This is because the other provisions in the income tax legislation (which includes the ordinary income rules) apply in precedence to the capital gains tax regime.

Foreign service

A last-ditch effort to reduce the taxpayer’s liability on the deferred compensation payments was raised by the taxpayer on grounds of such payments being “foreign earnings” from “foreign service”; the taxpayer argued that his service included Australian and foreign services and hence the deferred compensation amounts ought to be proportionally taxed (and exempted from tax).  Justice Edmonds was disinclined from a statutory interpretation perspective to introduce any proportionality to the operation of the “foreign service” exemption and in any event the facts were such that the entitlement to the deferred compensation payments were not calculated by reference to days of service.

Insight: if it is intended that a payment be characterised as foreign earnings from foreign service, the documents creating the entitlement to foreign earnings must be consistent with the exclusive performance of foreign service. 

Conclusion

The Blank cases highlight the importance of aligning the language and mechanisms adopted in legal documents with (commercial) reality.  In this case, there was nothing unusual in how the legal documents were drafted (in fact, the legal drafting was in harmony with the commercial reality).  It is possible a differently drafted profit participation plan could result in a different tax profile than ordinary income characterisation.

Disclaimer

This article is intended to provide commentary and general information. It should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this article.

 


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