Businesses can be structured in many ways, including as partnerships, trusts, joint ventures and corporate models with shareholders’ agreements. Each structure is inherently different in terms of the rights and obligations of the parties involved, they way in which the structures are documented and of course, the tax implications.
A recent decision of the Supreme Court of Western Australia highlights the uncertainty that can arise when the participants adopt a particular structure but then conduct themselves in a manner which suggest they actually intended a different result in overall terms.
Who needs to know?
Businesses, accountants and corporate advisers who assist in putting together and administering business structures. It’s particularly relevant for business participants who are looking to set-up a new structure or formalise their existing relationships. It’s also relevant to participants when relationships unravel and the precise nature of the arrangements between the participants needs to be determined.
Background
The decision of the Court of Appeal of the Supreme Court of Western Australia in Palermo v Palermo [2015] WASCA 49 arose from a dispute between brothers John and Anthony Palermo.
The two brothers had a long history of conducting business activities together. Initially this involved property development projects in the 1970s. These projects were conducted as partnerships between the individual brothers. Subsequent property developments and other activities (including an accounting practice, farming enterprise, share trading and corporate consulting business) were conducted through various companies and trusts which were often, but not always, linked together via intra-group service arrangements. In high level terms, one or both of the brothers (or their respective family members or controlled entities) held all of the shares / equity interests in each of the entities which made up the ‘Palermo group’. Usually, the ownership was shared 50/50 between the brothers (or their respective family members), but critically this was not always the case. Similarly, both of the brothers usually acted as the directors of each entity, but again this was not always the case. It is also noteworthy that the brothers had different levels of involvement with each of the different businesses.
The brothers used a “scrap book” to apparently “pool” the group’s income and then record various reconciliations and adjustments so as to ensure that, irrespective of the structure, the overall sharing between the brothers was ultimately equal and, importantly, done in a tax effective manner.
Unfortunately, the brothers had a falling out in 2011 and a dispute arose as to the basis on which the various business activities had been undertaken. Anthony argued that it was to be inferred from their conduct over the years that there was an “overarching agreement” between them that all of the businesses were to be conducted on the basis that the brothers would share equally in the overall after-tax profits roughly like a partnership. The problem was that the alleged agreement was not supported by any express agreement and nor did it align with all of the various business structures that had been adopted for the group. For example, since the 1970s none of the activities (at least when considered individually) had been conducted as partnerships. Additionally, and in high level terms, the accounting practice and the corporate consulting business were, on the face of it, held by John (not Anthony). Similarly, the farming operations were conducted by John (not Anthony). At trial, the brothers also had different recollections on matters such as who had established each of the separate businesses (particularly the accounting practice) and who contributed funding to purchase properties etc. They also disputed whether Anthony’s involvement in the accounting practice was simply as an employee or as an owner.
Trial Judge
The trial judge held that the business structures adopted by the brothers ruled out any possibility of the “overarching agreement” alleged by Anthony. The trial judge summed it up as follows:
The intention of the [brothers] is crucial. Their intention to work together to create wealth for themselves and their families can be accepted. However, the vehicle by which the wealth was to be created and distributed is all important. From 1976 it was not by partnership. The methods used were the antithesis of a partnership. The brothers gave up partnership for directorship. Thereafter their arrangement was governed through the legal structures they had created, not through any overarching contract or relationship as asserted by the [Anthony]. This was a deliberate decision. There is no acceptable evidence that [the brothers] ever assumed joint liability for all debts and obligations of a partnership after 1976. On the contrary, one of the main purposes for commencing [the main trustee company] and trading thereafter was to limit personal liability.
In reaching this conclusion, the trial judge referred to the earlier decision of Young J in Morgan v 45 Flers Avenue Pty Ltd (1986) 5 ACLC 222 at 224 to 225:
So long as the law permits people to erect structures which have meaningful legal consequences then if a person elects to erect such a structure he must take the consequences of such erection for better for worse, for richer or poorer, in commercial sickness or commercial health.
The trial judge analysed each of the business activities and held that none of them (at least when considered individually) was conducted on a partnership basis. The various corporate structures and trusts precluded any notion that the brothers were carrying on a partnership. The trial judge concluded as follows:
There is no place for a partnership, contract or relationship which gives rise to fiduciary obligations in circumstances where the parties have quite deliberately chosen to take advantage of tax and corporation laws to effectively manage their incomes by the use of companies and trusts.
The trial judge’s decision basically meant that, as a matter of legal principle, the “overarching agreement” alleged by Anthony simply could not exist in the circumstances.
Court of Appeal
The Court of Appeal disagreed. It held that despite the structures that had been adopted, it was nevertheless at least possible for the alleged overarching agreement to exist concurrently with those structures. According to the Court of Appeal:
The appellant’s case did not require that the corporate structure be disregarded. Rather, the appellant asserted an inferred agreement, overarching the corporate and trust entities, under which the affairs of those entities were to be conducted with the object of generating wealth to be shared by them both equally. There is again nothing in Morgan v 45 Flers which supports the conclusion that an inferred agreement of the nature alleged by the appellant could not exist consistently with the corporate and trust structure.
The Court of Appeal went on to say:
It was, in my opinion, clearly open to the parties to agree, as the appellant alleged it was to be inferred that they had agreed, that, as between themselves, the shareholdings in the companies, the beneficial interests in the trusts, and the rights to capital and income (or the burden of losses) of the various entities, under their individual or collective control, were to be dealt with so that the total wealth generated by all of the businesses, to which either or both of them would otherwise be entitled, would be shared equally by the [brothers]; what has conveniently been described by the appellant as an ‘overarching agreement’.
As approached by the Court of Appeal, it did not matter that none of the businesses (considered individually) were not partnerships. Nor did it matter that there was no express agreement between the brothers which recorded the alleged overarching agreement. It would be sufficient if it could be inferred.
Accordingly, the next step was to determine whether or not, the alleged agreement could in fact be inferred from the evidence. Given the trial judge’s decision that the alleged agreement could not exist as a matter of law, the trial judge did not consider all of the evidence on this point. The Court of Appeal therefore ordered a complete re-trial of the case by a different trial judge.
Observations
- It remains to be seen whether the alleged overarching agreement will be inferred by the new trial judge. Whilst this will involve a detailed review of all the evidence (particularly the scrap book), the alleged inferred agreement will still need to satisfy all of the usual requirements for any ordinary agreement (see McHugh JA in Integrated Computer Services Pty Ltd v Digital Equipment Corporation (Aust) Pty Ltd (1988) 5 BPR 11,110).
- For example, there will need to be unequivocal agreement between the brothers on the terms of the inferred overarching agreement, plus the terms of that agreement will need to be sufficiently certain and complete. These aspects may be problematic. The Court of Appeal stated that the alleged overarching agreement was “at a high level of generality” and essentially amounted to “no more than an assertion of the existence of an agreement that everything was to be for their joint benefit”. Overall, the overarching agreement may be too vague.
- Even if the terms of the overarching agreement are sufficiently certain, the court will still need to be satisfied that the brothers intended the overarching agreement to be legally binding. Often with family/domestic arrangements, the parties do not intend to create legally binding relations. This point does not appear to have been raised in the case, but will likely need to be considered as part of the re-trial. Relatedly on the question of intention, the brothers had adopted a complex group of companies and trusts to own and operate the businesses. Whilst this does not rule out the possibility of an overarching agreement, it will clearly make it difficult to prove (on the balance of probabilities) that the parties intended to apply an overarching agreement, especially if the agreement is not supported by any express documents and instead needs to be inferred from conduct.
- Anthony also alleged that the overarching agreement gave rise to fiduciary duties, but the nature and scope of the fiduciary duties was not raised on appeal. The Court of Appeal simply stated that the possible existence of fiduciary duties was ‘reasonably arguable’.
Practical Points to Take Away
- Once you have decided on your preferred business structure, you should adhere to and preserve that structure unless and until you decide to change it. For example, meetings should be held, distributions made and assets and liabilities held in accordance with the legal framework of the adopted structure.
- If you and your fellow participants wish to deal with things differently, then you should consider formally changing your business structure or expressly recording the agreed terms of the new arrangement (including whether or not it is intended to override the existing structure or be legally binding). Even if it is just a one-off departure from the existing structure, there is a risk that, if repeated over a long period of time and not clearly documented, significant uncertainty can arise about the ultimate structure and be grounds for inferring an “overarching agreement” between the participants. Ideally, if there is to be an overarching agreement it should be in the form of a shareholders agreement or similar document.
- Be very clear about what’s in and what’s out of the business structure i.e. what’s yours, what’s mine and what’s ours.
- Keep very clear records. These should cover not just the decisions and transactions, but also include an explanation of the transactions so that it is easier for an outsider (such as a court) to objectively discern the participants’ intentions. The records should include financial records as well as properly documented resolutions for all key decisions made by the directors, shareholders and trustees. In this case, the “scrap book” was a key piece of evidence, but it was seemingly difficult for the trial judge to readily understand the meaning of all the entries and adjustments it recorded.