Journal entries and Book entries do not work: ATO

Commonly Dad borrows money cheaper than his trust. In this recent case, Dad borrows money from the CBA and gives it to his trust. Everything goes wrong.

In Chadbourne v FCT [2020] AATA 2441:

1. the taxpayer, Mr Chadbourne, borrows money from CBA
2. he on-lends the money to his family trust
   • his lawyer and accountant fail to recommend a Loan Agreement
   • he has no Loan Agreement
3. his family trust buys investments
4. he attempts to claim a deduction for the interest
5. the ATO denies the deduction
6. the ATO claims:
   • you cannot infer a loan relationship
   • a written Loan Agreement is required
   • you cannot claim deductions in deriving income from a family trust distribution

Mr Chadbourne borrows money from the Commonwealth Bank. This is to finance the purchase of income-producing investment properties. But, Mr Chadbourne purchases the properties in the name of his discretionary trust.

Later Mr Chadbourne borrows more money. This is to finance the purchase of shares. Once again, the shares are purchased by the trust, not the taxpayer.

Do Journal entries and book entries have the force of law?

Without a Loan Agreement, the ATO contends that there is no nexus between Mr Chadbourne’s interest expense and the assessable income from the trust’s investments. We agree with the ATO.

When you borrow money do not just do a journal entry:

1. that the motive for purchasing the investment properties and shares is to generate income and profits
2. sure the interest was paid by him and the profits were in another entity being a family trust
3. but the interest deductions should still be allowed as it is associated with the income-producing assets of the trust

Mr Chadbourne’s mistake – loan agreements on the back of an envelope do not work

He becomes desperate without a Loan Agreement between Mr Chadbourne and his family trust. Clutching at straws, Mr Chadbourne claims a deduction for the interest expense against the income derived by the trust. However, in truth, the interest expense is claimed against the distribution of income he received from the trust. This is NOT income derived by Mr Chadbourne.

Mr Chadbourne does not derive the assessable income for the Income Tax Assessment Act. Without the protection of the Loan Agreement, he merely receives a trust distribution of income.

This makes all the difference. Without a Loan Agreement, there is no nexus between income and expense, which denies him a tax deduction for the interest. If Mr Chadbourne had merely built a Loan Agreement lending the money to his trust, then the interest would be claimable. 

One wonders, whether Mr Chadbourne, has a claim against the Commonwealth Bank. 

This is a step-by-step guide on how Mr Chadbourne should have structured the borrowings.

Manzi v Smith [1975] HCA 35 – another example of why Journal entries do not work

The High Court is Australia’s highest court. In Manzi v Smith [1975] HCA 35 the court confirms that a journal or book entry is not enough you need a Deed:

‘We were referred to cases in which a payment of money was held to have been made by means of entries in books of account. But in those cases the entries represented the agreement of the appropriate parties….

These decisions, quite clearly, are not authority … that a payment of money was made by the making by the company of a journal entry in the books of account without reference to, or without the agreement of, the persons said to be the recipients of the money.|

The company’s assertions in its books of account did not establish the indebtedness of the appellants or any payment of money in discharge of that indebtedness.’

See also Mingos v Commissioner of Taxation [2019] FCA 834. 

What the Australian Tax Office say about journal and book entries

The Australian Tax Office confirms that journal entries do not themselves constitute the transactions. A party making a mere entry in its books does not alter liabilities between the parties.

Actions must be supported by a valid, binding Deed together with the journal entry.

On 9 July 2019, speaking to Accountants Daily, former ATO technical director Vincent Licciardi observed a common misconception in the accounting industry regarding the nature and use of accounting entries. He noted:

“Many accountants believe that making accounting entries is equivalent to the transactions those entries represent being factual; legally, this is incorrect.”

“Accounting entries are merely records of transactions that have already taken place,” he explained. “It’s important to understand that a journal entry only documents the transaction; it is not the transaction itself. That’s the critical point.”

Journal entries do not work – you need a Deed or an Agreement

Journal entries on their own often do not suffice as a substitute for deeds. Deeds are formal documents that typically require specific formalities to be valid, such as being in writing, signed, witnessed, and delivered to the other party involved. Journal entries, on the other hand, are internal records that document transactions and decisions but do not meet the formal requirements needed to legally bind parties as deeds do.

In contexts like trusts, property transactions, or corporate governance, relying solely on journal entries instead of executing proper deeds can lead to disputes and legal challenges. For example, changes in the structure of a trust or company resolutions might be recorded in journal entries, but without the signing of formal deeds, these changes might not be enforceable. The Bankruptcy Court, Family Court, ASIC and the ATO ignore the journal entry.

Deeds have to be updated by other Deeds. Journal entries and book entries cannot update a Deed

Family Trusts, Unit Trusts, and Self-Managed Superannuation Funds are drafted as Deeds.

A Deed can only be updated by another Deed. Journal entries and book entries are insufficient. This principle upholds the integrity and formal nature of deeds. By law, deeds are binding documents. They represent solemn promises. Any change to these promises must maintain the same level of formality as the original agreement.

The Limits of Journal and Book Entries

Journal and book entries may help to record transactions and adjustments in financial records. However, they lack the legal standing to modify deeds. Journal entries are internal documents. They do not meet the stringent requirements set for the execution of deeds. These requirements include the need for writing, signing, witnessing, and sealing.

Why another Deed and not Minutes?

Updating a deed through another deed ensures compliance with legal formalities. This process reaffirms the parties’ consent to the amendments. It also provides a clear, traceable, and authoritative record of the changes. The need for another deed protects all parties involved. It prevents disputes and ensures that any modifications are deliberate and transparent.

Executing an Updating Deed v Minutes and Book Entries

To update a deed, you create a new document, often called an “amending deed” or “deed of variation.” This document states the changes to the original deed. Legal Consolidated updates, that you can build on our law firm’s website, identify the parts of the original deed that are amended. This execution must follow the same formalities as the original.