Wipeout! Merchant the latest decision in wave of anti-avoidance cases

On 14 May 2024 the Federal Court of Australia in Merchant v Commissioner of Taxation [2024] FCA 498 held that the general anti-avoidance rule and dividend stripping provisions contained in Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA36) applied to deny tax benefits obtained by the taxpayer arising from steps it took in connection with a share sale to a third party.

The taxpayer appealed the matter to the Full Federal Court, and on 22 April 2025, in Merchant v Commissioner of Taxation [2025] FCAFC 56 (Merchant), the Court delivered a split decision largely upholding the first instance decision (McElwaine and Hespe JJ, Logan J dissenting).

Key takeaways

• The primary judge correctly identified that the statutory inquiry invited by the general anti-avoidance rule is to objectively analyse the dominant purpose of those persons who entered into or carried out the scheme, and the primary judge’s analysis was consistent with this approach;
• A related party transaction which gives rise to a tax consequence and which otherwise has no practical, commercial or economic consequences may attract Part IVA even if a similar transaction with a third party would not;
• Dividend stripping generally involves the recipient of the profits (or value of the profits) not being subject to substantial tax on those profits. Accordingly, for a scheme to have the effect of dividend stripping, it is necessary to take account of the tax payable by the recipient of the proceeds;
• The assessment of whether there is a scheme which has substantially the effect of dividend stripping should be informed with the benefit of hindsight and with regard to the impact of any valid determination made by the Commissioner under section 177D;
• The exception contained in the Taxation of Financial Arrangements (TOFA) rules for a right to receive or obligation to provide a financial benefit under a business sale (as expressed prior to its April 2015 amendment) is not informed by the similar expression defined in section 974-85(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA97), and will apply where the right or obligation is wholly contingent upon a sales target being met.

Background

The proceedings arose from a series of transactions undertaken by a private group controlled by Gordon Stanley Merchant (Mr Merchant), the co-founder of the Billabong apparel and swimwear brand. The key transactions involved:

1. in September 2014, the sale of approximately 10 million shares in Billabong International Limited (BBG) at market value by Mr Merchant’s family trust (MFT) to a related superannuation fund (GMSF), crystallising a capital loss of almost $57 million for MFT.
2. in April 2015:
   1. MFT selling all the shares in Plantic Technologies Ltd (Plantic), a start-up wholly owned by MFT, to an unrelated third party, resulting in a capital gain (prior to the application of any capital losses) of almost $85 million for MFT; and
   2. the forgiveness of intercompany loans (totalling approximately $55 million) by entities within Mr Merchant’s private group that were owed by Plantic, as a condition of the Plantic share sale.

The capital loss arising from the BBG share sale reduced the net capital gain arising to MFT from the Plantic share sale. Conversely, the forgiveness of the loans had the effect of increasing the amount a third party was willing to pay for Plantic. Had the loans been repaid by Plantic instead, those proceeds would ultimately have been distributed as dividends to Mr Merchant and taxed accordingly.

The Commissioner of Taxation (Commissioner) subsequently made determinations under Part IVA and issued amended assessments to the taxpayers involved, with the effect that:

• the BBG share sale formed part of a scheme that was entered into or carried out for the dominant purpose of obtaining a tax benefit, such that MFT was denied the benefit of the capital loss realised from the BBG share sale; and
• the debt forgiveness transactions constituted schemes having substantially the effect of dividend stripping, such that the amounts of forgiveness were instead included in Mr Merchant’s assessable income as dividends.

A third issue was separately raised in the proceedings, being whether the TOFA provisions applied to the right of MFT to receive “milestone” payments in connection with the Plantic share sale.

Grounds of appeal

Broadly, Mr Merchant raised the following grounds of appeal in the Full Court:

• in relation to section 177D of the ITAA36, the primary judge:
  • conflated the objective inquiry as to the intention of the scheme participants with the actual (subjective) purpose of those persons; and
  • erred in failing to adequately consider the various commercial “objective purposes” in concluding that the scheme was entered into for the dominant purpose of obtaining a tax benefit;
• in relation to dividend stripping, the primary judge incorrectly concluded each debt forgiveness scheme fell within the dividend stripping provisions under Part IVA; and
• the primary judge incorrectly concluded that the exception in section 230-460(13) of the TOFA rules applied to specified “milestone payments”.

The Full Court’s analysis

General anti-avoidance rule − Dominant Purpose (s 177D)

The central issue was whether the BBG share sale was entered into for the dominant purpose of obtaining a tax benefit. Both the majority and Logan J’s judgments emphasised that the statutory test under section 177D of the ITAA36 requires an objective assessment, having regard to the eight factors in section 177D(2), and not an inquiry into the subjective motives of the participants.

The majority held that the Appellant had failed to establish any of its grounds of appeal regarding the general anti-avoidance rule. On a proper application of the statutory test, the majority concluded that the primary judge:

• had correctly identified that the inquiry as to dominant purpose is an objective test. This was found to be the case notwithstanding the primary judge including a reference to the “actual purpose” in summarising the legal principles;
• made objective inferences and findings as to the purpose of the BBG share sale (including, on some occasions, the rejection of Mr Merchant’s subjective evidence); and
• correctly concluded that the BBG share sale was entered into for the dominant purpose of obtaining a tax benefit, notwithstanding the other commercial purposes advanced by the Appellant.

The majority also observed that a related party transaction which gives rise to a tax consequence but otherwise has no practical, commercial or economic consequences may attract Part IVA even if a similar transaction with a third party would not.

Logan J in dissent found that the primary judge had erred by focusing on the “actual purpose” and subjective reasoning of the parties. In reaching this conclusion, his Honour referred to an extract in which the primary judge appeared to infer intention from various documents adduced in evidence. Logan J’s dissent illustrates the complexity of the task faced by the judiciary in attempting to apply an objective test in circumstances where much of the evidence often comprises documented correspondence that reveals the contemporaneous subjective intentions of the parties.

Dividend Stripping (s 177E)

The Commissioner had determined that the forgiveness of loans by entities within Mr Merchant’s private group (GSM and Tironui) to Plantic constituted schemes having substantially the effect of dividend stripping in accordance with section 177E(1) of the ITAA36, such that the amounts forgiven were to be included in Mr Merchant’s assessable income (as sole shareholder of GSM and Tironui).

The majority undertook a detailed analysis of the case law on dividend stripping, observing that section 177E is directed at schemes which have the effect of placing company profits in the hands of shareholders in a tax-free or substantially tax-free form, in substitution for taxable dividends. They also clarified that the second limb of section 177E(1)(a) is informed by a scheme’s content, its sole or dominant purpose, and its achieved effect or outcome. In order to determine the effect of a debt forgiveness scheme entered into by Mr Merchant’s private group, it would also be necessary to have regard to the flow-on impacts of the Commissioner’s section 177F determination vis-à-vis the BBG share sale.

These considerations led the majority to distinguish between the two debt forgiveness transactions:

• in relation to Tironui, the forgiveness of the loan had the effect of transferring substantially all of its retained earnings to MFT in an untaxed form. This was found to have the substantial effect of a dividend stripping scheme; and
• in relation to GSM, however, the amount forgiven represented less than 25% of GSM’s retained earnings. The effect of the Commissioner’s determination that section 177F applied to deny the capital loss which arose from the BBG share sale was such that the GSM scheme did not operate as intended, as a portion of the profits that were “stripped” were subjected to a higher effective tax rate than if Mr Merchant had received a fully franked dividend from GSM.

The majority therefore allowed the Appellant’s appeal in respect of the GSM dividend stripping scheme, finding that section 177E did not apply.

Logan J concluded that section 177E was inapplicable to both debt forgiveness transactions. This was on the basis that the debt forgiveness did not render the capital gain made on the Plantic shares “tax free”; by contrast, the debt forgiveness increased the purchase price which had the effect of increasing the capital gain. His Honour found it difficult, if not impossible, to reconcile this with a dominant purpose of “dividend stripping”.

Taxation of Financial Arrangements

Both the majority and Logan J affirmed the primary judge’s conclusion that the rights to future payments under the Plantic share sale agreement were contingent only on the economic performance of the business and thus were not subject to TOFA in accordance with section 230-460(13) of the ITAA97. In reaching this conclusion, the Court rejected the argument that the statutory definition of “contingent on the economic performance” in Division 974 should inform the meaning of the phrase used in Division 230, on the basis that the composite phrase differed and no asterisk (signalling a reference point to a defined term in the ITAA97) was used. The majority also noted that whether or not the benefit to be provided is fixed or variable is not relevant to the application of the exception.

As part of a broader suite of reforms targeted at “look-through” earnout arrangements, the language contained in section 230-460(13) was amended for arrangements created on or after 24 April 2015 in a manner that now links with Division 974.

Significance of Merchant

This decision clarifies the manner in which courts will apply the general anti-avoidance rule (GAAR) and the dividend stripping provisions in the context of private groups undertaking internal restructures and preparing for asset sales. In recent years, we have observed the Commissioner’s increased willingness to apply the dividend stripping provisions in circumstances where the GAAR might otherwise have been engaged. Provided the Commissioner can establish that there has been a dividend ‘strip’, the dividend stripping provisions may be easier for the Commissioner to apply to schemes than the broader GAAR. In light of the majority’s decision, it is possible the Commissioner will continue to scrutinise these types of arrangements.

Taxpayers engaging in similar transactions should carefully document the commercial rationale for their arrangements and ensure that related party dealings are conducted at market value and for genuine commercial purposes. This is particularly important where there is no change in the effective control, economic ownership, or risk to the underlying assets. Taxpayers with similar arrangements may wish to review their positions in light of this decision.