In a Q&A session with Legalwise Seminars, Sacha Oudyn, Special Counsel at MinterEllisonRuddWatts, shares some insight into why tax is an important factor to bear in mind when settling disputes and negotiating settlement agreements. He will be covering this topic in depth at the upcoming webinar on Mastering Settlement Agreements in Commercial Disputes being held on Tuesday, 22 September 2020.
So why is it important to consider tax when negotiating settlements?
A trite answer to this question is that it ensures that the parties treat any settlement payment correctly in their tax returns. While this is obviously important, there is a more fundamental commercial reason to consider tax early. This is, that tax impacts can (and often do) affect the amount ultimately paid and received under a settlement arrangement. If the parties don’t think about tax, they risk paying too much or receiving too little.
Say, for example, that a company (Person A) suffered a $100 loss caused by the actions of another person (Person B) and receives a $100 settlement payment. If the settlement payment is taxable, Person A would only receive $72 net of tax (assuming a 28% tax rate) leaving it $28 out of pocket. Person A would need $138.88 from Person B (being $100 net of tax) to be fully compensated for its loss.
The handling of tax in a settlement agreement can be complex. In your experience, what causes the most issues?
Issues typically arise when tax is left on the back burner until late on in the settlement negotiations, or even worse, is not considered at all. Settlement negotiations can be difficult and protracted affairs at the best of times, and no will be thanked for raising tax issues after the commercial terms have already been hammered out.
The complex tax rules applicable to settlement payments can also cause issues. Parties normally must apply “capital/revenue” tests established by the courts to work out whether or not a settlement payment (or part of a settlement payment) is taxable. Capital/revenue determinations can be notoriously difficult (even for experienced tax advisors) and have famously been described as “an intellectual minefield in which the principles are elusive and analogies treacherous”!
Are there any issues people should be aware of when apportioning a settlement payment?
Absolutely. The main one involves ensuring that the apportionment approach is suitably robust and can withstand scrutiny if ever challenged.
The tax treatment of a settlement payment is determined by working out the purposes for which it is being paid (which can be many and varied), and then determining how much of the aggregate settlement payment is being paid to achieve each purpose. The tax rules are then applied separately to the amount of the settlement payment allocated to each purpose to determine whether any tax is payable.
As the tax treatment flows from the allocations made, there can sometimes be issues when the parties adopt inconsistent allocation approaches. To avoid that, it can be helpful for the settlement agreement to expressly set out the allocations the parties will use.
However, this will often not be possible. Understandably parties can be very sensitive about stating in black and white why they are making a settlement payment (other than to end the relevant dispute). They may also have different views on the approach that should be adopted to apportionment and may be incentivised to adopt different positions to maximise tax deductions (payer) or to minimise taxable income (payee).
If a settlement agreement does not deal with apportionment, the onus will be on each party to work out an appropriate basis for apportionment. Inland Revenue guidance in this area takes the view that the burden of proving an apportionment approach is reasonable rests with the taxpayer. Inland Revenue also reserves its ability to make its own “fair and reasonable” apportionment if a taxpayer has failed to do so.
How can parties best protect themselves against potential tax risks?
Understanding the tax position early is critical. It’s a good idea to seek guidance from a reputable tax advisor that has with experience in negotiating settlement arrangements and a good understanding of the tax issues involved.
Further protection can be obtained by ensuring that any settlement arrangement is documented in a clear and concise manner, and (where possible) includes terms setting out the agreed apportionment approach.
Sacha Oudyn is an experienced corporate and taxation lawyer at MinterEllisonRuddWatts. He has more than 15 years’ experience as a tax advisor and has provided advice on wide range of different transactions, including business sales, divestments, restructurings, property and leasing transactions, settlement arrangements, financings and securitisations. Sacha was recognised as a Next Generation Partner by the Legal 500 Asia Pacific in 2019. Connect with Sacha via email or LinkedIn 
