Constructive Payment By Journal Entry

The fundamental question is whether a journal entry in an entity’s accounts constitutes a constructive payment under s 11-5, Sch 1 TAA53, and, more broadly, what constitutes a constructive payment. This has been considered in some recent cash flow boost (CFB) cases, including The Trustee for JC Mobile Sharpening Discretionary Trust 7 (JC Mobile Sharpening) and Robis Consulting Pty Ltd and FCT 8 (Robis Consulting), with mixed outcomes.

Why payment matters

Although the question of constructive payment in the CFB cases was in relation to time limited legislation, the issue of constructive payment was derived from more generally applicable legislation. It is common practice among trusts and companies to recognise payments to related entities via journal entries, including the payment of dividends, wages etc where a person would frequently draw on money for personal expenses from the entity and have journal entries record the payment into the loan account, akin to a bank overdraft facility. Whether a journal entry constitutes a constructive payment impacts at least the following areas:

• what constitutes a payment under s 11-5, Sch 1 TAA53;
• whether a journal entry constitutes a payment under s 11-5;
• what conditions, in addition to the journal entry, constitute a payment under s 11-5;
• PAYG withholding: if a journal entry does not constitute the payment of salary and wages, there are no requirements in ss 12-35 and 12-40, Sch 1 TAA53 for an entity to withhold PAYG on purported “transfers” of salary as this is treated as a recording of an amount of salary “payable” and not the actual payment;
• superannuation guarantee: if nothing more than a journal entry exists to substantiate the payment of salary and wages, whether a liability to superannuation guarantee arises;
• director penalty notices: if PAYG and superannuation have not accrued because there has been no payment, there is a delay on the Commissioner’s ability to issue a director penalty notice until the payment occurs;
• if a journal entry does not constitute a constructive payment, this can have significant adverse consequences. For example, if a taxpayer trading out of a trust makes all payments of living expenses to a “loan account”, and all net profit of the trust transferred to a “salary and wages payable” account that are never paid to the employer, a payment of salary and wages never occurs but rather remains recognised as being payable. The trust would have no obligation at law to withhold and remit PAYG withholding or pay superannuation guarantee on those amounts until, if ever, the “salary and wages payable” balance is paid to the employee:
• adversely, such an arrangement may not be caught under Pt IVA of the Income Tax Assessment Act 1936 (Cth) as there is no tax advantage achieved; arguably, tax on salary and wages is delayed until lodgment of the employee’s tax return, but delayed payment (if ever) of the superannuation guarantee is not a tax advantage;
• this would have a significant impact on the employer’s cash flow when they lodge their income tax return and are required to pay a large income tax liability, possibly resulting in many taxpayers going bankrupt and thus failing the purpose of the PAYG withholding system; and
• although, for the purposes of the CFB cases, the Commissioner has argued against a journal entry constituting payment or constructive payment, it is not clear to the author that this is a wise policy. At the minimum, it would be disruptive to existing practices for PAYG and superannuation liability, and would reduce or delay the Commissioner’s rights to issue a director penalty notice. Although the amount of tax is not altered because of the change in timing of a payment, the timing of that incidence of tax can be radically altered. In the author’s view, it is important for the administration of the revenue to clear this issue up.

Payment for cash flow boost

There are a number of requirements in the CFB legislation, but at issue in both JC Mobile Sharpening and Robis Consulting are the following:

• s 5(1)(a)(i) of the Boosting Cash Flow for Employers (Coronavirus Economic Response Package) Act 2020 states:

“the entity makes a payment in the period and must withhold an amount from the payment under Subdivision 12-B, 12-C or 12-D in Schedule 1 to the Taxation Administration Act 1953 (regardless of whether the entity actually withholds the amount)”

• s 12-35, Sch 1 TAA53 states:

“An entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee (whether of that or another entity).”

• s 11-5, Sch 1 TAA53 states that a constructive payment exists where money is dealt with on another entity’s behalf; and
• there is also an anti-avoidance matter raised, but that is not relevant for present purposes.

Facts

In both of the cases:
• the taxpayers were small business entities that employed their sole controller;
• the taxpayers commenced paying or increased the amount of the salary that was being paid during the periods of the CFB. Unsurprisingly, this increase was flagged by ATO systems as a potential abuse of the CFB rules;
• the taxpayers, as well as many, if not most, eligible recipients of the CFB who report salary and wages quarterly, and lodge activity statements quarterly, would also have prepared pay slips, activity statements, made superannuation payments, and lodged income tax returns after the announcement of the CFB, part way through the March 2020 quarter;
• the taxpayers transferred money from the business bank accounts to their individual bank accounts or credit cards, on an ad hoc basis;
• some monies credited to the individual were retained by the business entity for business cash flow reasons; and
• the Commissioner argued that the commencement or increase in PAYG was unrelated to CFB and used similar legal arguments in both of the cases.

Commissioner’s view: journal entry is not payment

The Commissioner claimed that, despite declaring payment of salary and wages, it does not necessarily mean that it is in fact salary and wages. The Commissioner relied on Temples Wholesale Flower Supplies Pty Ltd v FCT, 9 FCT v Ross10 and Greig v FCT 11 as apparent authorities that the way in “which a taxpayer treats an amount for taxation purposes is not determinative of its proper characterisation at law”. In the author’s view, this is problematic for the following reasons:
• Temples Wholesale Flower Supplies Pty Ltd v FCT did not concern the taxation treatment of an outgoing, but “whether a mere journal entry, unsupported by any agreement, is enough to constitute a payment of salary and wages”;12
• FCT v Ross considered whether the taxation treatment of the taxpayer’s income as either assessable or non assessable was conclusive to that fact. The issue in the present case is whether a journal entry constitutes a constructive payment of salary and wages (ie the classification of the transaction), not the deductibility of the payment which refers to the taxation treatment; and
• Greig v FCT considered that the way a taxpayer characterises a transaction as revenue or capital for income tax purposes does not determine its proper characterisation. Again, the issue is whether the transaction represents a payment of salary and wages, not how the transaction should be treated for taxation purposes.

Unconsidered authority

In the author’s view, the Commissioner should have instead applied more relevant authority, none of which were cited in the respective judgments:
• Equuscorp v Glengallan Investments13 concerned a tax effective managed investment scheme that resulted in a dispute between the participants. A bank electronically debited its account and credited the account of the participants (structured together as a partnership). The partnership drew cheques on its account and paid management fees to two entities connected with the scheme. Those two entities then drew cheques equal to the fees and deposited them with the same bank as on-call deposits. This was all done on the same day and at the same time; As part of the dispute, the disgruntled participants claimed that the arrangement was a sham and that they had never been lent money to invest in the scheme. As they were never lent money, they had no obligation to repay (so they alleged). The High Court held that the arrangement was legally effective. The High Court held that the participants (and the junior courts beneath the High Court) focused too much on the economic substance of the transaction, not the legal effect. The fact that no “real money” (a term used in that case) did not change hands was not relevant. The debiting of the bank’s account and the crediting of the partnership’s account (which constituted the participants) effected an exchange of money. This electronic transfer was sufficient to create a legal obligation on the participants to repay the bank;
• In The Matter of York Street Mezzanine Pty Ltd (in liq)14 discussed the law concerning promissory notes. The court considered that the ordinary rule is that to discharge a bill of exchange, and also a promissory note, the issuer is required to make a payment in money to the payee or bearer. In other words, the payment must be in legal tender (money) or by the transfer of a money fund; The court further went on to discuss that this method of payment is highly inconvenient, especially where large sums of money are concerned, and it is therefore not uncommon to see parties to a bill of exchange or promissory note agree that payment be made by some other means which is commercially acceptable. Not surprisingly, it has been held that parties to a promissory note may agree that the note can be satisfied by other means than legal tender (money). The result is that, by agreement, payment of money due under a bill of exchange or promissory note can be made by set off, by delivery of goods, by a bond, by cheque or bankers draft, or even by book entry. On book entries, the court stated that there is every reason to permit a payment to be made by book entry:

“26. … Often [book entry] is simply a short-hand for money or a cheque being handed across the table and money or a cheque being handed back. It would be entirely inconsistent with modern commercial life if a payment due by one person to another could not be effected in this manner.”

Accordingly, it would seem that all that is required is an agreement by the relevant parties that payment be made by means of entries in books of account. In the CFB cases, the taxpayer is both the employee and the controller of the employer, such self agreement is evidenced by conduct of entry into the books of account. In the author’s view, the Commissioner’s reasoning failed to properly address the issue of whether an actual payment of salary and wages has been made by citing FCT v Ross and Greig v FCT, which do not deal with this issue. However, Temples Wholesale Flower Supplies Pty Ltd v FCT was relevant. It was determined in that case that the circumstantial facts of an agreement to accompany the journal entry would be assessed when determining that question, and how it was treated in the income tax return would be considered part of that circumstantial evidence as it showed the intention that salary and wages were being paid.

Constructive payment

The Commissioner questioned whether a constructive payment of salary and wages had occurred, while contrasting each of the cases to the earlier CFB decision of MJ and IT Holdings Pty Ltd and FCT:15
• in MJ and IT Holdings, when discussing whether payments of wages via journal entry satisfied s 11-5, Sch 1 TAA53 and the withholding provisions, Senior Member K James stated:

“31. In these circumstances, for the purposes of determining derivation of the income there can be little argument that the director’s remuneration has been constructively derived. The facts and circumstances are very different to the taxpayer in Brent [Brent v FCT [1971] HCA 48] and the directors in Temples Wholesale where constructive payment was not held on the evidence. The PAYG was withheld and remitted to the Commissioner. The director instructed that the balance was not to be paid in cash but recorded in her loan account. The decision to record it in the loan account was the director wearing the hat of the recipient of the remuneration and lender to the company. A payslip confirming the remuneration of $25,000 and the withholding was issued to the director. The evidence in this matter is similar, if not stronger in nature, as was held to satisfy the constructive payment hurdle in the 2008 tax year in Brent.” (emphasis added)

• in MJ and IT Holdings, it was concluded:

“32. In the language of section 11-5 of the TAA, the $11,398 withheld on account of PAYG was applied or dealt with on Mrs Knight’s behalf … what is clear on the evidence is that she made the decision to have it recorded in her loan account, rather than have cash drawn from the company. This is in accord with both section 11-5(1) and section 11-5(2) of the TAA.” (emphasis added)

• it was further concluded in MJ and IT Holdings:

“33. In summary, the Tribunal finds that the sole director determined, together with her husband, the other shareholder, that she was to be paid $25,000 remuneration for her services in March 2020. She instructed the company’s accountant to raise the appropriate accounting entries which included the attending to the appropriate PAYG withholding and recording the balance to her loan account. Upon the expensing of the directors’ fee, the withholding of the PAYG, and the dealing with the balance in the loan account, there was a constructive payment of the $25,000 to her.” (emphasis added)

The issues in respect of the payment of wages in MJ and IT Holdings which ultimately led to the applicants receiving an unfavorable judgment were related to there being a scheme to achieve CFB. But there was still a constructive payment.

Comparison of JC Mobile Sharpening and Robis Consulting

Of particular relevance:
• in Robis Consulting, it was held that a mere lodgment of BASs and an income tax return amounted to constructive payment; and
• in JC Mobile Sharpening, it was held that a crediting of the directors loan account in the general ledger plus payslips plus lodgement of BASs and an income tax return was not constructive payment.

If forced to pick one case to be decided in favour of the Commissioner and one in favour of the taxpayer, the author would have reversed both of the decisions. In the author’s view, JC Mobile Sharpening is clearly the stronger case, and the two sit uncomfortably next to each other. In any event, the author respectfully agrees with Senior Member Olding’s decision in Robis Consulting. A controller of an entity, who on behalf of that entity contracts with themselves and then records in the books of accounts at the appropriate time payment made under that contract, is clearly making a constructive payment, if not an actual payment.

These cases highlight the uncertainty on what constitutes a payment and a constructive payment. This uncertainty extends to all liabilities for taxation (including PAYG and SG) that arise from a payment of wages, and not merely the CFB legislation on which these cases were decided.